Solution Manual for Microeconomics, 13th Edition Michael Parkin

Solution Manual for Microeconomics, 13th edition Michael Parkin

Table of Contents

Preface  Part 1

iii Introduction

Chapter 1 What is Economics?

Appendix Graphs in Economics Chapter 2 The Economic Problem  Part 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7  Part 3

1 9 21

How Markets Work Demand and Supply Elasticity Efficiency and Equity Government Actions in Markets Global Markets in Action

39 53 65 79 93

Households’ Choices

Chapter 8 Utility and Demand 107 Chapter 9 Possibilities, Preferences, and Choices 121  Part 4

Firms and Markets

Chapter 10 Organizing Production Chapter 11 Output and Costs Chapter 12 Perfect Competition Chapter 13 Monopoly Chapter 14 Monopolistic Competition Chapter 15 Oligopoly  Part 5

137 151 165 179 197 209

Market Failure and Government

Chapter 16 Public Choices, Public Goods, and Healthcare Chapter 17 Externalities 237  Part 6

Factor Markets, Inequality, and Uncertainty

Chapter 18 Markets for Factors of Production Chapter 19 Economic Inequality Chapter 20 Uncertainty and Information

© 2018 Pearson Education, Inc.

249 261 275

223

VI

CHAPTER 1

C h a p t e r

Answers to the Review Quiz

1

WHAT IS ECONOMICS?

Page 2 1.

List some examples of the scarcity that you face.

Examples of scarcity common to students include not enough income to afford both tuition and a nice car, not enough learning capacity to study for both an economics exam and a chemistry exam in one night, and not enough time to allow extensive studying and extensive socializing.

2.

Find examples of scarcity in today‘s headlines.

A headline in The Baltimore Sun on June 20, 2017 was ―Davis Says Special Deployment Helped Stall Violence.‖ The story presented Police Commissioner Kevin Davis stating that a week-long deployment of uniformed police officers on the streets of Baltimore helped reduce shootings in the city. But the story pointed out the role of scarcity when Commissioner Davis said that ―the deployment was not sustainable over the long term‖ due to its cost.

3.

Find an example of the distinction between microeconomics and macroeconomics in today‘s headlines.

Microeconomics: On June 20, 2017 a headline in East Bay Times was ―Reality vs Fantasy: FTC to Block FanDuel-DraftKings Merger.‖ This story covers a microeconomic topic because it discusses how two online fantasy sports sites, which were trying to merge, now faced opposition by the Federal Trade Commission (FTC) which announced it would challenge the merger. Macroeconomics: On June 20, 2017, a headline in The Wall Street Journal was ―Ryan Talks Up Likelihood of Tax Overhaul.‖ This story covers a macroeconomic topic because it concerns taxes that affect every business and individual in the entire economy.

Page 7 1.

Describe the broad facts about what, how, and for whom goods and services are produced. © 2018 Pearson Education, Inc.

2

CHAPTER 1

What gets produced is significantly different today than in the past. Today the U.S. economy produces more services, such as medical operations, teaching, and hair styling, than goods, such as pizza, automobiles, and computers. How goods and services are produced is by businesses determining how the factors of production, land, labor, capital and entrepreneurship, are combined to make the goods and services we consume. Land includes all natural resources, both renewable natural resources such as wood, and nonrenewable natural resources such as natural gas. Labor’s quality depends on people’s human capital. In the U.S. economy, human capital obtained through schooling has increased over the years with far more people completing high school and attending college than in past years.

Finally, for whom are goods and services to be produced depends on the way income is distributed to U.S. citizens. This distribution is not equal; the 20 percent of people with the lowest income earn about 5 percent of the nation’s total income while the 20 percent of people with the highest incomes earn about 50 percent of total income. On the average, men earn more than women, whites more than non-whites, and college graduates more than high school graduates.

2.

Use headlines from the recent news to illustrate the potential for conflict between self-interest and the social interest.

One example of an issue concerns the use of a school board’s credit card to make personal purchases. A June 20, 2017 headline from Star Tribune was ―Shakopee Board Approves Superintendent’s Resignation Will Pay Him $50,000.‖ This story discusses the superintendent’s use of a school board credit card to buy items such as a television and trip to Nashville. The superintendent was following his selfinterest because he may not have repaid the purchases had they not been uncovered. The school board chair said ―In light of the current issues facing the school district, the school board feel (sic) that a change in leadership is warranted.‖ The chair believes that the social interest is served by having a new superintendent without the issue of misuse of a credit card hanging over his or her head.

Page 10 1.

Explain the idea of a tradeoff and think of three tradeoffs that you have made today.

A tradeoff reflects the point that when someone gets one thing, something else must be given up. What is given up is the opportunity cost of whatever is obtained. Three examples of tradeoffs that are common to students include: a) When a student sleeps in rather than going to his or her early morning economics class, the student trades off additional sleep for study time. The opportunity cost of the decision is a lower grade on the exam. b) When a student running late for class parks his or her car illegally, the student trades off saving time for the risk of a ticket. The potential opportunity cost of the decision is the goods and services that cannot be purchased if the student receives an expensive parking ticket. c) A student trades off higher income by spending time during the day working at a part-time job for less time spent at leisure time and © 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?

3

study. The opportunity cost for the higher income is less leisure and lower grades in classes.

2.

Explain what economists mean by rational choice and think of three choices that you‘ve made today that are rational.

A rational choice is one that compares the costs and benefits of the different actions and then chooses the action that has the greatest benefit over cost for the person making the choice. Three rational choices made by students include: a) The choice to skip breakfast to go to class. In this case the benefit is the higher grade in the class and the cost is the breakfast forgone. b) The choice to stop talking with a friend on the phone and start studying for an impending exam. In this case the benefit is the resulting higher grade in the class and the cost is the conversation forgone. c) The choice to do laundry today rather than watch television. In this case the benefit is the fact the student will have clean clothes to wear and the cost is the loss of the entertainment the television show would have provided.

3.

Explain why opportunity cost is the best forgone alternative and provide examples of some opportunity costs that you have faced today.

When a decision to undertake one activity is made, often many alternative activities are no longer possible. Often these activities are mutually exclusive so only the highest valued alternative is actually forgone. For instance, the decision to go to a student’s 8:30 AM class eliminates the possibility of sleeping in during the hour and of jogging during the hour. But in this case, it is impossible to both sleep in and to jog during the hour, so the opportunity cost cannot be both activities. What is lost is only the activity that otherwise would have been chosen—either sleeping in or jogging—which is whatever activity would have been chosen, that is, the most highly valued of the forgone alternatives. For students, attending class, doing homework, studying for a test are all activities with opportunity costs.

4.

Explain what it means to choose at the margin and illustrate with three choices at the margin that you have made today.

Choosing at the margin means choosing to do a little more or a little less of some activity. Three common examples students encounter are: a) When a student faces a chemistry and an economics final exam in one day, the student must determine whether spending the last hour studying a little more chemistry or a little more economics will yield a better contribution (marginal benefit) to his or her overall GPA. b) A college student buying a computer must decide whether the marginal benefit of adding 1 GB of additional memory is worth the marginal cost of the additional memory. c) A student football fan with a choice of a cheap seat in the student bleachers located at the far end of the playing field or a more expensive seat located on the 30 yard line must determine whether the marginal benefit of watching the game from a better seat is worth the marginal cost of the higher ticket price. © 2018 Pearson Education, Inc.

4

5.

CHAPTER 1

Explain why choices respond to incentives and think of three incentives to which you have responded today.

People making rational decisions compare the marginal benefits of different actions to their marginal costs. Therefore people’s choices change when their incentives, that is the marginal benefit and/or marginal cost, of the choice changes. Just as everyone else, students respond to incentives; a) A student studies because of the incentives offered by grades. b) A student is more likely to attend a class if attendance is factored into the grade. c) A student might attend a meeting of a club if the student’s significant other is eager to attend the meeting.

Page 11 1.

Distinguish between a positive statement and a normative statement and provide examples.

A positive statement is a description of how the world is. It is testable. A normative statement is a description of how the world ought to be. It is, by its very nature, not testable because there is no universally approved criterion by which the statement can be judged. ―I will receive an A for this course,‖ is a positive statement made by an economics student—it might not be true, but it is testable. ―I will receive a good grade for this course,‖ is a normative statement. Whether someone agrees with it depends on his or her interpretation of what makes for a ―good‖ grade.

2.

What is a model? Can you think of a model that you might use in your everyday life?

A model is a description of some aspect of the economic world. It includes only those features that are necessary to understand the issue under study. An economic model is designed to reflect those aspects of the world that are relevant to the user of the model and ignore the aspects that are irrelevant. A typical model is a GPS map. It reflects only those aspects of the real world that are relevant in assisting the user in reaching his or her destination and avoids using information irrelevant to travel.

3.

How do economists try to disentangle cause and effect?

Economists use models to understand some aspect of the economic world. Testing the predictions of models makes it necessary to disentangle cause and effect. To overcome this problem, economists have three methods of testing their models: Using a natural experiment, using a statistical investigation, and using economic experiments. A natural experiment is a situation that arises in the ordinary course of life in which one factor being studied varies and the other factors are the same. This method allows the economist to focus on the effect from the factor that differs between the two situations. A statistical investigation looks for correlations between variables but then determining whether the correlation actually reflects causation can be difficult. An economic experiment puts people into decision making situations and then varies the relevant factors one at a time to determine each factor’s effect.

4.

How is economics used as a policy tool? © 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?

5

Individuals, businesses, and governments use economics as a policy tool. Individuals use the economic ideas of marginal benefit and marginal cost when making decisions for such topics as attending college, paying cash or credit for a purchase, and working.

Businesses also use the concepts of marginal benefit and marginal cost when making decisions about what to produce, how to produce, and even how many hours to stay open. Finally governments also use marginal benefit and marginal cost when deciding issues such as the level of property taxes, the amount to fund higher education, or the level of a tariff on Brazilian ethanol.

Page 13 1.

What types of jobs do economists do?

Economists are found in a large variety of jobs. Many of these jobs are analysts of various sorts. Some economists are market research analysts—they work with data on sales and try to predict a product’s success and the price that should be set for it. Other economists are financial analysts—they work with data on interest rates, stock and bond prices to try to forecast the cost of borrowing the returns that can be expected on investments. Still other economists work as budget analysts—they use data on an organization’s cash inflows (its receipts) and its outflows (its payments) in order to prepare plans forecasting future cash flows.

2.

What is the range and median level of economists‘ pay?

Economists’ pay ranges from $41,226 to $124,177 and has a median salary of $72,279. Students who earn a PhD in economics typically earn about $100,000 by mid-career. Economists who work as analysts have incomes that range from an average of $62,000 for market research analysts to $80,000 for financial analysts.

3.

What are the skills needed for an economics job?

Economists need five important skills: 

Critical-thinking skills: Economists need the ability to use logical thinking to clarify and then solve real-world problems.



Analytical skills: Economists must be able to use economic ideas and tools to analyze data in order to determine important patterns and reach logical conclusions.



Math skills: Economists need to be able to use mathematical and statistical tools to explore and analyze data in order to reach valid conclusions.



Writing skills: Economists must be able to clearly write reports presenting ideas, conclusions from any analysis and reasons why the conclusions are valid.



Oral communication skills: Economists need the ability to orally explain ideas, conclusions, and the reasons why the conclusions are correct to a variety of people, including those with little knowledge of economics. © 2018 Pearson Education, Inc.

6

CHAPTER 1

© 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?

7

Answers to the Study Plan Problems and Applications 1.

Apple Inc. decides to make iTunes freely available in unlimited quantities. a. Does Apple‘s decision change the incentives that people face?

Apple’s decision changes people’s incentives. For example, it increases people’s incentives to buy an iPod to take advantage of the newly ―free‖ music available on iTunes.

b. Is Apple‘s decision an example of a microeconomic or a macroeconomic issue?

Apple’s decision is a microeconomic decision because it affects a single company and a single market.

2.

Which of the following pairs does not match? a. Labor and wages Labor earns wages, so this pair matches.

b. Land and rent Land earns rent, so this pair matches.

c. Entrepreneurship and profit Entrepreneurship earns profit, so this pair matches.

d. Capital and profit Capital earns interest, so this pair does not match.

3.

Explain how the following news headlines concern self-interest and the social interest. a. Starbucks Expands in China Starbucks’ expansion is a decision made by Starbucks to further Starbucks’ interest. Thus the decision is directly in Srarbucks’ self interest. The social interest is affected because Starbucks’ expansion will have an effect in China. For instance, more Chinese citizens might drink coffee rather than tea and fewer coffee shops run by Chinese firms might open.

b. McDonald‘s Moves into Gourmet Coffee McDonald’s decision to serve gourmet coffee is a decision made by McDonald’s to further McDonald’s interest. Thus the decision is directly in McDonald’s self interest. The social interest is affected because more people will drink coffee rather than other drinks such as sodas.

c. Food Must Be Labeled with Nutrition Data The decision to require that food must be labeled with nutrition information is made in the social interest. This decision is not made by any one single firm and so does not (necessarily) reflect anyone’s self interest.

4.

The night before an economics test, you decide to go to the movies instead of staying home and working your MyEconLab Study Plan. Your grade on the test was 50 percent, lower than your usual 70 percent score. a. Did you face a tradeoff?

Yes, you faced a tradeoff. The tradeoff was between a higher test score and an evening with your friends at the movies.

© 2018 Pearson Education, Inc.

8

CHAPTER 1

b. What was the opportunity cost of your evening at the movies?

The opportunity cost of going to the movies is the fall in your grade. That is the 20 points forgone from choosing to see the movie rather than study.

© 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?

5.

9

Cost of Rio Olympics Brazilian federal, state, and local governments spent R$2.8 billion and private sponsors spent R$4.2 billion on 17 new Olympic facilities, 10 of which will be used for sporting events after the Olympics.

Source: Financial Times, August 6, 2016 Was the opportunity cost of the Rio Olympics R$2.8 or R$7 billion? Explain your answer.

The R$7 billion spent on the 17 new Olympic facilities is an opportunity cost of the Olympics if the funds would not have spent otherwise. However, if there were already plans underway to build the 10 facilities that will be used after the Olympics, then their cost is not an opportunity cost of the Olympics because the cost would have been paid even if Rio did not host the Olympics.. The cost of the 7 facilities that will not be used afterwards, however, is definitely an opportunity cost of the Rio Olympics.

6.

Which of the following statements is positive, which is normative, and which can be tested? a. The United States should cut its imports.

The statement is normative and cannot be tested.

b. China is the largest trading partner of the United States.

The statement is positive and can be tested.

c. If the price of gasoline rises, people will drive less and use less gasoline.

The statement is positive and can be tested.

© 2018 Pearson Education, Inc.

10

CHAPTER 1

Answers to Additional Problems and Applications 7.

Kanye West Offers Free Concert Tickets Kanye West has teamed with Los Angeles inner-city schools to offer free passes for students.

Source: consequenceofsound.net, November 27, 2016 When Kanye West gave away tickets, what was free and what was scarce? Explain your answer.

The seats in the arenas are scarce—there are only a limited number.

The time of school adminstrators used to distribute the tickets is also not free. In addition, if the students who are given the ―free‖ ticket attended the concert rather than sell their free tickets, they incurred the opportunity cost of the foregone ticket price. So the concert was far from ―free‖ for the concert-goers. The publicity that Kanye West receives is free to him but the publicity used reporters’ scarce time to report on the tickets rather than reporting on other news worthy events.

8.

How does the creation of a successful movie influence what, how, and for whom goods and services are produced?

The ―what‖ question is affected in two ways. First, one good or service that is produced is the successful movie. Second, spinoffs (Iron Man II) and/or similar films likely will be created in the future. The ―how‖ question is affected to the extent that movies use different production methods. Some movies, for instance, have a lot of special effects while other movies have few or none. The ―for whom‖ question is influenced because those people who, as the result of the blockbuster movie, have higher incomes so that more goods and services are produced for them.

9.

How does a successful movie illustrate self-interested choices that are also in the social interest?

The a successful movie increases the income of the people involved with the movie. Hence these people’s choices are driven largely by self interest. However the creation of a successful movie also increases the quantity of widely enjoyed entertainment. The amount of entertainment available in the economy increases which benefits society. So the choices the people made in their self interest also reflected choices made in the social interest.

10.

Before starring in Guardians of the Galaxy, Chris Pratt had appeared in 11 movies that grossed an average of $7 million on the opening weekend. Guardians of the Galaxy grossed $94 million. a. How will the success of Guardians of the Galaxy influence the opportunity cost of hiring Chris Pratt?

The salary that must be paid to Chris Pratt to appear in future movies increased because some of the success of Guardians of the Galaxy was attributed to Mr. Pratt. As a result the opportunity cost to movie producers of hiring Mr. Pratt increased.

b. How have the incentives for a movie producer to hire Chris Pratt changed?

There are two effects on the incentives of producers to hire Mr. Pratt. First, because the opportunity cost of hiring Mr. Pratt increased, the incentive to hire him decreased. However because part of the success of Guardians of the Galaxy was attributed to Mr. © 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?

11

Pratt acting in the leading role, producers expect that his acting will lead to increased success for future movies. This belief increases producers’ incentives to hire Mr. Pratt.

11.

What might be an incentive for you to take a class in summer school? List some of the benefits and costs involved in your decision. Would your choice be rational?

Early graduation, smaller class sizes, and/or retaining eligibility for a scholarship are examples of incentives that encourage taking summer classes. The benefits of taking summer classes might include early graduation, more personal attention from the instructor, retained eligibility for a scholarship, and increased knowledge about some aspect of the world. Costs potentially include forgone summer jobs or internships, less time to spend with friends, and additional tuition and other class-related expenses if the class I not one that would be taken otherwise. The choice is rational as long as the student determines that taking summer classes offers the highest benefit over cost for the use of his or time and efforts.

12.

Look at today‘s Wall Street Journal. What is the leading economic news story? With big economic questions and tradeoffs does it discuss or imply?

On June 20, 2017, the top economic news story discussed the Senates plan to vote on legislation repealing large parts of the Affordable Care Act. One option under consideration would cap the amount the federal government would pay toward the cost of Medicaid, the program that pays for healthcare for poor and disabled people.

This story clearly discusses the ―for whom‖ question: If Medicaid spending is reduced, fewer poor and disabled people will receive certain types of healthcare. It also discusses the ―what‖ question: If fewer Americans have health insurance, less goods and services related to health care will be produced.

The story implicitly illustrates a tradeoff: If choices are taken to limit the amount of healthcare poor and disabled people receive, their health will generally be worse than otherwise.

13.

Provide two microeconomic statements and two macroeconomic statements. Classify your statements as positive or normative, and explain your classifications.

Microeconomic statements are: Fewer deep water oil wells should be drilled in the Gulf of Mexico. If less oil is produced, the price of oil will rise. The first statement is normative because it relies on what the person thinks ―should‖ be done. The second statement is positive because it is possible to test the effect of less oil being produced.

Macroeconomic statements are: The currently unemployment rate is too high. The current unemployment rate is higher for blacks than for whites. The first statement is normative because it depends on what is deemed ―too high.‖ The second statement is positive because it can be checked to determine its validity.

© 2018 Pearson Education, Inc.

12

CHAPTER 1

Appendix

Answers to the Review Quiz

1

GRAPHS IN ECONOMICS

Page 30 1.

Explain how we ―read‖ the three graphs in Figs. A1.1 and A1.2.

The points in the graphs relate the quantity of the variable measured on the one axis to the quantity of the variable measured on the other axis. The quantity of the variable measured on the horizontal axis (the x-axis) is measured by the horizontal distance from the origin to the point. Similarly, the quantity of the variable measured on the vertical axis (the y-axis) is measured by the vertical distance from the origin to the point. The point relates these two quantities. For instance, in Figure A1.2, point A shows that at a price of $8.43 per ticket, 1.3 billion tickets are sold.

2.

Explain what scatter diagrams show and why we use them.

Scatter diagrams plot the value of one economic variable against the value of another variable for a number of different values of each variable. We use scatter diagrams because they quickly reveal if a relationship exists between the two variables. Moreover, if a relationship exists, scatter diagrams show whether increases in one variable are associated with increases or decreases in the other variable. © 2018 Pearson Education, Inc.

10

3.

APPENDIX 1

Explain how we ―read‖ the three scatter diagrams in Figs. A1.3 and A1.4.

The scatter diagram in Figure A1.3 shows the relationship between a film’s worldwide box office ticket sales and the film’s production budget. The figure shows that higher box office sales are associated with a higher production budget.

The scatter diagram in Figure A1.4a shows the relationship between income, in thousands of dollars per year, and expenditure, also in thousands of dollars per year, for the years 2001 to 2016. The scatter diagram shows that higher income leads to higher expenditure. The figure also shows that the relationship is relatively strong.

The scatter diagram in Figure A1.4b shows the relationship between the inflation rate and the unemployment rate for the years 2001 to 2016. The figure shows that for most of the years, there was a weak relationship between these variables, with perhaps higher inflation being associated with lower unemployment.

© 2018 Pearson Education, Inc.

GRAPHS IN ECONOMICS11

4.

Draw a graph to show the relationship between two variables that move in the same direction.

A graph that shows the relationship between two variables that move in the same direction is shown by a line that slopes upward. Figure A1.1 illustrates such a relationship.

5.

Draw a graph to show the relationship between two variables that move in opposite directions.

A graph that shows the relationship between two variables that move in the opposite directions is shown by a line that slopes downward. Figure A1.2 illustrates such a relationship.

© 2018 Pearson Education, Inc.

12

6.

APPENDIX 1

Draw a graph of two variables whose relationship shows (i) a maximum and (ii) a minimum.

A graph that shows the relationship between two variables that have a maximum is shown by a line that starts out sloping upward, reaches a maximum, and then slopes downward. Figure A1.3 illustrates such a relationship with curve B. A graph that shows the relationship between two variables that have a minimum is shown by a line that starts out sloping downward, reaches a minimum, and then slopes upward. Figure A1.3 illustrates such a relationship with curve A.

7.

Which of the relationships in Questions 4 and 5 is a positive relationship and which is a negative relationship?

The relationship in Question 4 between the two variables that move in the same direction is a positive relationship. The relationship in Question 5 between the two variables that move in the opposite directions is a negative relationship.

8.

What are the two ways of calculating the slope of a curved line?

To calculate the slope of a curved line we can calculate the slope at a point or across an arc.

The slope of a curved line at a point on the line is defined as the slope of the straight line tangent to the curved line at that point.

The slope of a curved line across an arc—between two points on the curved line—equals the slope of the straight line between the two points.

9.

How do we graph a relationship among more than two variables?

To graph a relationship among more than two variables, hold constant the values of all the variables except two. Then plot the value of one of the variables against the other variable.

10.

Explain what change will bring a movement along a curve.

A movement along a curve occurs when the value of a variable on one of the axes changes while all of the other relevant variables not graphed on the axes do not change. The movement along the curve shows the effect of the variable that changes, ceteris paribus (holding all of the other non-graphed variables constant).

11.

Explain what change will bring a shift of a curve.

A curve shifts when there is a change in the value of a relevant variable that is not graphed on the axes. In this case the entire curve shifts. © 2018 Pearson Education, Inc.

GRAPHS IN ECONOMICS13

Answers to the Study Plan Problems and Applications Use the spreadsheet to work Problems 1 to 3. The spreadsheet provides data on the U.S. economy: Column A is the year, column B is the inflation rate, column C is the interest rate, column D is the growth rate, and column E is the unemployment rate.

1.

1 2 3 4 5 6 7 8 9 10 11

A 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

B 2.5 4.1 0.1 2.7 1.5 3.0 1.7 1.5 0.8 0.7 2.1

C 4.9 4.5 1.4 0.2 0.1 0.1 0.1 0.1 0.0 0.1 0.3

D 2.7 1.8 −0.3 −2.8 2.5 1.6 2.2 1.7 2.4 2.6 1.6

E 4.6 4.6 5.8 9.3 9.6 8.9 8.1 7.4 6.2 5.3 4.9

Draw a scatter diagram of the inflation rate and the interest rate. Describe the relationship.

To make a scatter diagram of the inflation rate and the interest rate, plot the inflation rate on the x-axis and the interest rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.4. The pattern made by the dots tells us that as the inflation rate increases, the interest rate usually increases so there is a (weak) positive relationship.

2.

Draw a scatter diagram of the growth rate and the unemployment rate. Describe the relationship.

To make a scatter diagram of the growth rate and the unemployment rate, plot the growth rate on the x-axis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.5. The pattern made by the dots tells us that when the © 2018 Pearson Education, Inc.

14

APPENDIX 1

growth rate increases, the unemployment rate usually decreases so there is a negative relationship.

3.

Draw a scatter diagram of the interet rate and the unemployment rate. Describe the relationship.

To make a scatter diagram of the interest rate and the unemployment rate, plot the interest rate on the x-axis and the unemployment rate on the yaxis. The graph will be a set of dots and is shown in Figure A1.6. The pattern made by the dots tells us that when the interest rate increases, the unemployment rate usually decreases so there is a negative relationship.

Use the following news clip to work Problems 4 to 6.

Lego Shatters More Records: Source: Boxofficemojo.com, Data for weekend of March 10-12, 2017 4.

Draw a graph of the relationship between the revenue per theater on the y-axis and the number of theaters on the x-axis. Describe the relationship.

Figure A1.7 shows the relationship. As the figure shows, there is a positive relationship.

5.

Movie Kong: Skull Island Logan Get Out The Shack

Calculate the slope of the relationship in Problem 4 between 3,846 and 4,071 theaters.

The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($15,867  $9,362)/(3,846  4,071) which equals −$28.91 per theater. © 2018 Pearson Education, Inc.

Theate rs (numbe r) 3,846

Revenue (dollars per theater)

4,071 3,143 2,888

$9,362 $6,600 $3,465

$15,867

GRAPHS IN ECONOMICS15

6.

Calculate the slope of the relationship in Problem 4 between 4,071 and 3,143 theaters.

The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($9,362  $6,600)/(4,071  3,143 which equals $2.98 per theater.

© 2018 Pearson Education, Inc.

16

7.

APPENDIX 1

Calculate the slope of the relationship shown in Figure A1.8.

The slope is 5/4. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the x-axis. To calculate the slope, you must select two points on the line.

One point is at 10 on the y-axis and 0 on the x-axis, and another is at 8 on the x-axis and 0 on the y-axis. The change in y from 10 to 0 is associated with the change in x from 0 to 8.

Therefore the slope of the curve equals 10/8, which equals 5/4.

Use the relationship shown in Figure A1.9 to work Problems 8 and 9.

8.

Calculate the slope of the relationship at point A and at point B. The slope at point A is 2, and the slope at point B is 0.25.

To calculate the slope at a point on a curved line, draw the tangent to the curved line at the point. Then find a second point on the tangent and calculate the slope of the tangent.

The tangent at point A cuts the y-axis at 10. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 4 (6 minus 10) and the change in x equals 2 (2 minus 0). The slope at point A is 4/2, which equals 2.

Similarly, the slope at point B is 0.25. The tangent at point B goes through the point (4, 2). The change in y equals 0.5, and the change in x equals 2. The slope at point B is 0.25. © 2018 Pearson Education, Inc.

GRAPHS IN ECONOMICS17

9.

Calculate the slope across the arc AB. The slope across the arc AB is 1.125. The slope across an arc AB equals the change in y, which is 4.5 (6.0 minus 1.5) divided by the change in x, which equals 4 (2 minus 6). The slope across the arc AB equals 4.5/4, which is 1.125.

Price (dollar s per ride) 5 10 15

© 2018 Pearson Education, Inc.

Balloon rides (number per day) 50F 70F 90F 32 27 18

40 32 27

50 40 32

18

APPENDIX 1

Use the table to work Problems 10 and 11. The table gives the price of a balloon ride, the temperature, and the number of rides a day.

10.

Draw a graph to show the relationship between the price and the number of rides, when temperature is 70°F. Describe this relationship.

Figure A1.10 shows the relationship between the price and the number of balloon rides when the temperature is 70F. The relationship between the price and the number of rides is inverse; that is, when the price rises, the number of rides decreases.

11.

What happens in the graph in Problem 10 if the temperature rises to 90°F? If the temperature rises to 90F, the curve shifts rightward. This shift is illustrated in Figure A1.11. In that figure, both the initial curve, which applies when the temperature is 70F, and the new curve, which applies when the temperature is 90F, are illustrated. The curve when the temperature is 90F lies to the right of the curve when the temperature is 70F indicating that at every price, more balloon rides are taken when the temperature is 90F rather than 70F.

© 2018 Pearson Education, Inc.

GRAPHS IN ECONOMICS19

Answers to Additional Problems and Applications Use the spreadsheet to work Problems 12 to 14. The spreadsheet provides data on oil and gasoline: Column A is the year, column B is the price of oil (dollars per barrel), column C is the price of gasoline (cents per gallon), column D is U.S. oil production, and column E is the U.S. quantity of gasoline refined (both in millions of barrels per day).

12.

1 2 3 4 5 6 7 8 9 10 11

A 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

B 66 72 100 62 79 95 94 98 93 49 45

C 262 284 330 241 284 354 364 353 344 252 225

D 5.1 5.1 5.0 5.4 5.5 5.7 6.5 7.5 8.8 9.4 8.9

E 15.6 15.4 15.3 14.8 15.2 15.1 15.5 15.2 15.5 16.6 16.4

Draw a scatter diagram of the price of oil and the quantity of U.S. oil produced. Describe the relationship.

Figure A1.12 shows the scatter diagram between the price of a barrel of oil and the quantity of U.S. oil produced. It shows a weak negative relationship.

13.

Draw a scatter diagram of the price of gasoline and the quantity of gasoline refined. Describe the relationship.

Figure A1.13 shows the scatter diagram between the price of a gallon of gasoline and the quantity of gasoline refined. It shows a weak negative relationship.

© 2018 Pearson Education, Inc.

20

14.

APPENDIX 1

Draw a scatter diagram of the quantity of U.S. oil produced and the quantity of gasoline refined.

Describe the relationship.

Figure A1.14 shows the scatter diagram between the quantity of U.S. oil produced and the quantity of gasoline refined. It shows a positive relationship.

Use the following data to work Problems 15 to 17.

Draw a graph that shows the relationship x between the two variables x and y in the table to the right. y To make a graph that shows the

0 25

2 1 24

22

3 18

5 4 12

0

relationship between x and y, plot the x variable on the x-axis and the y variable on the y-axis.

Figure A1.15 shows this graph.

15. a. Is the relationship positive or negative?

The relationship is negative because x and y move in opposite directions: As x increases, y decreases.

b. Does the slope of the relationship become steeper or flatter as the value of x increases?

The slope becomes steeper as x increases.

c. Think of some economic relationships that might be similar to this one.

The less expensive a good, the greater is the number of people who buy it. The higher the interest rate, the smaller is the number of people who take out home mortgages. The less expensive gasoline, the greater the miles car owners drive.

© 2018 Pearson Education, Inc.

GRAPHS IN ECONOMICS21

16.

Calculate the slope of the relationship between x and y when x equals 3.

The slope equals 4.0. The slope of the curve at the point where x is 3 is equal to the slope of the tangent to the curve at that point. Plot the relationship and then draw the tangent line at the point where x is 3 and y is 18. Now calculate the slope of this tangent line by finding another point on the tangent. When x equals 5, y equals 10 on the tangent, so another point is x equals 5 and y equals 10. The slope equals the change in y, 8, divided by the change in x, 2, so the slope is 4.0.

17.

Calculate the slope of the relationship across the arc as x increases from 4 to 5.

The slope is –12. The slope of the relationship across the arc when x increases from 4 to 5 is equal to the slope of the straight line joining the points on the curve at x equals 4 and x equals 5. When x increases from 4 to 5, y falls from 12 to 0. The slope equals the change in y, 12 (12 minus 0), divided by the change in x, 1 (4 minus 5), so the slope across the arc is 12.0.

18.

Calculate the slope of the curve in Figure A1.16 at point A. The slope is 2. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the x-axis. To calculate the slope, select two points on the line. One point is at 18 on the y-axis and 0 on the x-axis, and another is at 9 on the x-axis and 0 on the y-axis.

The change in y from 18 to 0 is associated with the change in x from 0 to 9. Therefore the slope of the curve equals 18/9, which equals 2.

Use Figure A1.17to work Problems 19 and 20.

19. Calculate the slope at point A and at point B. The slope at point A is 4, and the slope at point B is 1. To calculate the slope at a point on a curved line, draw the tangent to the line at the point. Then © 2018 Pearson Education, Inc.

22

APPENDIX 1

find a second point on the tangent and calculate the slope of the tangent.

The tangent at point A cuts the x-axis at 2.5. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 6 (6 minus 0) and the change in x equals 1.5 (1 minus 2.5). The slope at point A is 6/1.5, which equals 4.

Similarly, the slope at point B is 1. The tangent at point B cuts the y-axis at 5. The change in y equals 3, and the change in x equals 3. The slope at point B is 1.

20.

Calculate the slope across the arc AB. The slope across the arc AB is 2. The slope across the arc AB equals the change in y, which is 4 (6 minus 2) divided by the change in x, which equals 2 (1 minus 3). The slope across the arc AB equals 4/2, which equals 2.

Use the following table to work Problems 21 to 23.

The table gives information about umbrellas: price, the number purchased, and rainfall in inches.

21.

Draw a graph to show the relationship between the price and the number of umbrellas purchased, holding the amount of rainfall constant at 1 inch. Describe this relationship.

Price (dollar s per umbrell a) 20 30 40

Figure A1.18 shows the relationship. To draw a graph of the relationship between the price and the number of umbrellas when the rainfall equals 1 inch, keep the rainfall at 1 inch and plot the data in that column against the price.

This curve is the relationship between price and number of umbrellas when the rainfall is 1 inches. The relationship between the price and the number of umbrellas is an inverse relationship; as the price rises, the number of umbrellas decreases.

22.

Umbrellas (numbers per day) 0 1 2 (inches of rainfall) 4 2 1

7 4 2

8 7 4

What happens in the graph in Problem 21 if the price rises and rainfall is constant?

If the price rises, the number of umbrellas decreases. In Figure A1.18, there is a movement upward along the (unchanged) curve.

© 2018 Pearson Education, Inc.

GRAPHS IN ECONOMICS23

23.

What happens in the C h a p t e r graph in Problem 21 if the rainfall increases from 1 inch to 2 inches?

As shown in Figure A1.19, the curve shifts rightward. In that figure, both the initial curve, which applies when the rainfall is 1 inch, and the new curve, which applies when the rainfall is 2 inches, are illustrated. The curve when the rainfall is 2 inches lies to the right of the curve when the rainfall is 1 inch indicating that at every price, more umbrellas are purchased when the rainfall is 2 inches than when the rainfall is 1 inch.

2

THE ECONOMIC PROBLEM

© 2018 Pearson Education, Inc.

Answers to the Review Quizzes Page 36 1.

How does the production possibilities frontier illustrate scarcity?

The unattainable combinations of production that lie beyond the PPF illustrate the concept of scarcity. There simply are not enough resources to produce any of these combinations of outputs.

Additionally, while moving along the PPF to increase the production of one good requires that the production of another good be reduced, which also illustrates scarcity.

2.

How does the production possibilities frontier illustrate production efficiency?

The combinations of outputs that lie on the PPF illustrate the concept of production efficiency. These points are the maximum production points possible and are attained only by producing the goods and services at the lowest possible cost. Any point inside the frontier reflects production where one or both outputs may be increased without decreasing the other output level. Clearly, such points cannot be production efficient.

3.

How does the production possibilities frontier show that every choice involves a tradeoff?

Movements along the PPF frontier illustrate that producing more of one good requires producing less of other good. This observation reflects the result that a tradeoff must be made when producing output efficiently.

4.

How does the production possibilities frontier illustrate opportunity cost?

The negative slope of the production possibility curve illustrates the concept of opportunity cost. Moving along the production possibility frontier, producing additional units of a good requires that the output of another good must fall. This sacrifice is the opportunity cost of producing more of the first good.

5.

Why is opportunity cost a ratio?

The slope of the PPF is a ratio that expresses the quantity of lost production of the good on the y-axis to the increase in the production of the good on the x-axis moving downward along the PPF. The steeper the slope, the greater ratio, and the greater is the opportunity cost of increasing the output of the good measured on the horizontal axis.

6.

Why does the PPF bow outward and what does that imply about the relationship between opportunity cost and the quantity produced?

Some resources are better suited to produce one type of good or service, like pizza. Other resources are better suited to produce other goods or services, like DVDs. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. Consider a PPF with pizza measured on the x-axis and DVDs measured on the y-axis. A small increase in pizza output when pizza production is relatively low requires only a small increase in the use of those resources still good at making pizza and not good at making DVDs. This yields a small decrease in DVD © 2018 Pearson Education, Inc.

22

CHAPTER 2

production for a large increase in pizza production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF over this range of output. However, the same small increase in pizza output when pizza production is relatively large will require society to devote to pizza production those resources that are less suited to making pizza and more suited to making DVDs. This reallocation of resources yields a relatively small increase in pizza output for a large decrease in DVD output, creating a relatively high opportunity cost reflected in the steep slope of the PPF over this range of output. The opportunity cost of pizza production increases with the quantity of pizza produced as the slope of the PPF becomes ever steeper. This effect creates the bowed out effect (the concavity of the PPF function) and means that as more of a good is produced, the opportunity cost of producing additional units increases.

Page 39 1.

What is marginal cost? How is it measured?

Marginal cost is the opportunity cost of producing one more unit of a good or service. Along a PPF marginal cost is reflected in the absolute value of the slope of the PPF. In particular, the magnitude of the slope of the PPF is the marginal cost of a unit of the good measured along the x-axis. As the magnitude of the slope changes moving along the PPF, the marginal cost changes.

2.

What is marginal benefit? How is it measured?

The marginal benefit from a good or service is the benefit received from consuming one more unit of it. It is measured by what an individual is willing to give up (or pay) for an additional that last unit.

3.

How does the marginal benefit from a good change as the quantity produced of that good increases?

As the more of a good is consumed, the marginal benefit received from each unit is smaller than the marginal benefit received from the unit consumed immediately before it, and is larger than the marginal benefit from the unit consumed immediately after it. This set of results is known as the principle of decreasing marginal benefit and is often assumed by economists to be a common characteristic of an individual’s preferences over most goods and services in the economy.

4.

What is allocative efficiency and how does it relate to the production possibilities frontier?

Production efficiency occurs when production takes place at a point on the PPF. This indicates that all available resources are being used for production and society cannot produce additional units of one good or service without reducing the output of another good or service. Allocative efficiency, however, requires that the goods and services produced are those that provide the greatest possible benefit. This definition means that the allocative efficient level of output is the point on the PPF (and hence is a production © 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM23

efficient point) for which the marginal benefit equals the marginal cost.

5.

What conditions must be satisfied if resources are used efficiently?

Resources are used efficiently when more of one good or service cannot be produced without producing less of some of another good or service that is valued more highly. This is known as allocative efficiency and it occurs when: 1) production efficiency is achieved, and 2) the marginal benefit received from the last unit produced is equal to the marginal cost of producing the last unit.

Page 44 1.

What gives a person a comparative advantage?

A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else, If the person gives up the least amount of other goods and services to produce a particular good or service, the person has the lowest opportunity cost of producing that good or service.

2.

Distinguish between comparative advantage and absolute advantage.

A person has a comparative advantage in producing a good when he or she has the lowest opportunity cost of producing it. Comparative advantage is based on the output forgone. A person has an absolute advantage in production when he or she uses the least amount of time or resources to produce one unit of that particular good or service.

Absolute advantage is a measure of productivity in using inputs.

3.

Why do people specialize and trade?

People can compare consumption possibilities from producing all goods and services through self-sufficiency against specializing in producing only those goods and services that reflect their comparative advantage and trading their output with others who do the same. People can then see that the consumption possibilities from specialization and trade are greater than under selfsufficiency. Therefore it is in people’s own self-interest to specialize. It was Adam Smith who first pointed out in the Wealth of Nations how individuals voluntarily engage in this socially beneficial and cooperative activity through the pursuit of their own self-interest, rather than for society’s best interests.

4.

What are the gains from specialization and trade?

From society’s standpoint, the total output of goods and services available for consumption is greater with specialization and trade.

From an individual’s perspective, each person who specializes enjoys being able to consume a larger bundle of goods and services after trading with others who have also specialized, than would otherwise be possible under self-sufficiency. These increases are the gains from specialization and trade for society and for individuals.

5.

What is the source of the gains from trade?

As long as people have different opportunity costs of producing goods or services, total output is higher with specialization and

© 2018 Pearson Education, Inc.

24

CHAPTER 2

trade than if each individual produced goods and services under self-sufficiency. This increase in output is the gains from trade.

6.

Why does specialization and the gains from trade make the economy‘s PPF outward bowed?

Specialization and the gains from trade make the economy’s PPF bow outward because the resources that have the comparative advantage in producing a good or service are the first to be utilized to produce that good or service. Consequently when the good or service is first produced, its opportunity cost—the amount of the other good or service forgone—is small and so the PPF is relatively flat.

Ultimately, when so much of the good or service is produced such that resources without a comparative advantage in it must be utilized, the opportunity cost becomes larger so that the PPF becomes steeper. When the PPF starts out flatter and becomes steeper, it bows outward.

7.

Why is not specializing and reaping the gains from trade inefficient?

By not specializing and trading, some suppliers are not producing the good in which they have a comparative advantage. Consequently production occurs inside the PPF at a production inefficient point.

All of the economy’s resources might be employed but they are misallocated.

Page 47 1.

What generates economic growth?

The two key factors that generate economic growth are technological change and capital accumulation. Technological change allows an economy to produce more with the same amount of limited resources, Capital accumulation, the growth of capital resources including human capital, means that an economy has increased its available resources for production.

2.

How does economic growth influence the production possibilities frontier?

Economic growth shifts the PPF outward. Persistent outward shifts in the production possibility frontier—economic growth—are caused by the accumulation of resources, such as more capital equipment or by the development of new technology.

3.

What is the opportunity cost of economic growth?

When a society devotes more of its scarce resources to research and development of new technologies, or devotes additional resources to produce more capital equipment, both decisions lead to increased consumption opportunities in future periods at the cost of less consumption today. The loss of consumption today is the opportunity cost borne by society for creating economic growth.

4.

Explain why Hong Kong has experienced faster economic growth than the United States.

Hong Kong chose to devote a greater proportion of its available resources to the production of capital than the United States. This allowed Hong Kong to grow at a faster rate than the United States.

By foregoing consumption and producing a greater proportion of capital goods over the last few decades, Hong Kong was able to © 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM25

achieve output per person equal to 94 percent of that in the United States.

5.

Does economic growth overcome scarcity?

Scarcity reflects the inability to satisfy all our wants. Regardless of the amount of economic growth, scarcity will remain present because it will never be possible to satisfy all our wants. For instance it will never be possible to satisfy all the wants of the several thousand people who all would like to ski the best slopes on Vail with only their family and a few best friends present. So economic growth allows more wants to be satisfied but it does not eliminate scarcity.

6.

How does economic growth change the patterns of production?

In low-income nations a large fraction of production is agriculture with distinctly less devoted to industry. For example, in Ethiopia agriculture accounts for 36 percent of production and industry for 17 percent. As the nation grows to middle income, investment in capital and new technology leads to an increase in the fraction of production that is industrial and a decrease in the fraction that is agricultural. For example, in China 9 percent of production is agriculture and 41 percent is industry. Finally, in high-income nations, services becomes an increasingly large proportion of production. In the United States, for example, services account for 80 percent of production while industry and agriculture together account for 20 percent of production.

7.

Why does economic growth destroy and create jobs?

Economic growth leads to changes in the pattern of production—some sectors and products increase while others decrease. In the areas that increase in size, new jobs are created while in those that decrease, jobs are destroyed. Often workers who lose their jobs in the declining sectors need to acquire new skills for the new jobs and/or uproot their life to move to a new location. Some unemployed workers are unwilling to incur these costs and, as a result, remain unemployed, leading the economy to produce at a point inside its PPF.

Page 49 1.

Why are social institutions such as firms, markets, property rights, and money necessary?

These social institutions factors necessary for a decentralized economy to coordinate production. Firms are necessary to allow people to specialize. Without firms, specialization would be limited because a person would need to specialize in the entire production of a good or service. With firms people are able to specialize in producing particular bits of a good or service. For a society to enjoy the fruits of specialization and trade, the individuals who comprise that society must voluntarily desire to specialize in the first place. Discovering trade opportunities after a person has specialized in his or her comparative advantage in production is what allows that person to gain from his or her own specialization efforts. Trading opportunities can only take place if a market © 2018 Pearson Education, Inc.

26

CHAPTER 2

exists where people observe prices to discover available trade opportunities. Money is necessary to allow low-cost trading in markets. Without money, goods would need to be directly exchanged for other goods, a difficult and unwieldy situation. Finally people must enjoy social recognition of and government protection of property rights to have confidence that their commitments to trade arrangements will be respected by everyone in the market.

2.

What are the main functions of markets?

The main function of a market is to enable buyers and sellers to get information and to do business with each other. Markets have evolved because they facilitate trade, that is, they facilitate the ability of buyers and sellers to trade with each other.

3.

What are the flows in the market economy that go from firms to households and the flows from households to firms?

On the real side of the economy, goods and services flow from firms to households. On the monetary side of the economy, payments for factors of production, wages, rent, interest, and profits, flow from firms to households. Flowing from households to firms on the monetary side of the economy are the expenditures on goods and services and on the real side are the factors of production, labor, land, capital, and entrepreneurship.

© 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM27

Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 to 3.

Brazil produces ethanol from sugar, and the land used to grow sugar can be used to grow food crops. The table to the right sets out Brazil‘s production possibilities for ethanol and food crops.

1. a. Draw a graph of Brazil‘s PPF and explain how your graph illustrates scarcity.

Ethanol (barrels per day)

Figure 2.1 shows Brazil’s PPF. The production possibilities frontier indicates scarcity because it shows the limits to what can be produced. In particular, production combinations of ethanol and food crops that lie outside the production possibilities frontier are not attainable.

70 64 54 40 22 0

and and and and and and

Food crops (tons per day) 0 1 2 3 4 5

b. If Brazil produces 40 barrels of ethanol a day, how much food must it produce to achieve production efficiency?

If Brazil produces 40 barrels of ethanol per day, it achieves production efficiency if it also produces 3 tons of food per day.

c. Why does Brazil face a tradeoff on its PPF? Brazil faces a tradeoff on its PPF because Brazil’s resources and technology are limited. For Brazil to produce more of one good, it must shift factors of production away from the other good.

Therefore to increase production of one good requires decreasing production of the other, which reflects a tradeoff.

2. a. If Brazil increases ethanol production from 40 barrels per day to 54 barrels per day, what is the opportunity cost of the additional ethanol?

When Brazil is production efficient and increases its production of ethanol from 40 barrels per day to 54 barrels per day, it must decrease its production of food crops from 3 tons per day to 2 tons per day. The opportunity cost of the additional ethanol is 1 ton of food per day for the entire 14 barrels of ethanol or 1/14 of a ton of food per barrel of ethanol.

b. If Brazil increases food production from 2 tons per day to 3 tons per day, what is the opportunity cost of the additional food?

When Brazil is production efficient and increases its production of food crops from 2 tons per day to 3 tons per day, it must decrease its production of ethanol from 54 barrels per day to 40 barrels per day. The opportunity cost of the additional 1 ton of food crops is 14 barrels of ethanol. © 2018 Pearson Education, Inc.

28

CHAPTER 2

c. What is the relationship between your answers to parts (a) and (b)?

The opportunity costs of an additional barrel of ethanol and the opportunity cost of an additional ton of food crop are reciprocals of each other. That is, the opportunity cost of 1 ton of food crops is 14 barrels of ethanol and the opportunity cost of 1 barrel of ethanol is 1/14 of a ton of food crops.

3.

Does Brazil face an increasing opportunity cost of ethanol? What feature of Brazil‘s PPF illustrates increasing opportunity cost?

Brazil faces an increasing opportunity cost of ethanol production.

For instance, when increasing ethanol production from 0 barrels per day to 22 barrels the opportunity cost of a barrel of ethanol is 1/22 of a ton of food while increasing ethanol production another 18 barrels per day (to a total of 40 barrels per day) has an opportunity cost of 1/18 of a ton of food per barrel of ethanol. The PPF’s bowed outward shape reflects the increasing opportunity cost.

Use the above table (for Problems 1 to 3) to work Problems 4 and 5.

4.

Define marginal cost and calculate Brazil‘s marginal cost of producing a ton of food when the quantity produced is 2.5 tons per day.

The marginal cost of a good is the opportunity cost of producing one more unit of the good. When the quantity of food produced is 2.5 tons, the marginal cost of a ton of food is the opportunity cost of increasing the production of food from 2 tons per day to 3 tons per day. The production of ethanol falls from 54 barrels per day to 40 barrels per day, a decrease of 14 barrels per day. The opportunity cost of increasing food production is the decrease in ethanol product, so the opportunity cost of producing a ton of food when 2.5 tons of food per day are produced is 14 barrels of ethanol per day.

5.

Define marginal benefit. Explain how it is measured and why the data in the table does not enable you to calculate Brazil‘s marginal benefit from food.

The marginal benefit of a good is the benefit received from consuming one more unit of the good. The marginal benefit of a good or service is measured by the most people are willing to pay for one more unit of it. The data in the table do not provide information on how much people are willing to pay for an additional unit of food.

The table has no information on the marginal benefit of food.

6.

Distinguish between production efficiency and allocative efficiency. Explain why many production possibilities achieve production efficiency but only one achieves allocative efficiency.

Production efficiency occurs when goods and services are produced at the lowest cost. This definition means that production efficiency occurs at any point on the PPF. Therefore all of the production points on the PPF are production efficient. Allocative efficiency occurs when goods and services are produced at the lowest cost and in the quantities that provide the greatest possible benefit. The allocatively efficient production point is the single point on the PPF that has the greatest possible benefit.

© 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM29

7.

In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. a. Calculate Sue‘s opportunity cost of producing a cap.

Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of producing one cap is (4 jackets)/(40 caps) or 0.1 jacket per cap.

b. Calculate Tessa‘s opportunity cost of producing a cap.

Tessa forgoes 4 jackets to produce 80 caps, so Tessa’s opportunity cost of producing one cap is (4 jackets)/(80 caps) or 0.05 jacket per cap.

c. Who has a comparative advantage in producing caps?

Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps.

d. If Sue and Tessa specialize in producing the good in which they have a comparative advantage, and they trade 1 jacket for 15 caps, who gains from the specialization and trade?

Tessa specializes in caps and Sue specializes in jackets. Both Sue and Tessa gain from trade. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket)/(15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa also gains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap.

8.

Suppose that Tessa buys a new machine for making jackets that enables her to make 20 jackets an hour. (She can still make only 80 caps per hour.) a. Who now has a comparative advantage in producing jackets?

Sue forgoes 40 caps to produce 4 jackets, so Sue’s opportunity cost of producing one jacket is (40 caps)/(4 jackets) or 10 caps per jacket. Tessa forgoes 80 caps to produce 20 jackets, so Tessa’s opportunity cost of producing one jacket is (80 caps)/(20 jackets) or 4 caps per jacket. Tessa has the comparative advantage in producing jackets because her opportunity cost of a jacket is lower than Sue’s opportunity cost.

b. Can Sue and Tessa still gain from trade?

Tessa and Sue can still gain from trade because Tessa (now) has a comparative advantage in producing jackets and Sue (now) has a comparative advantage in producing caps. Tessa will produce jackets and Sue will produce caps.

c. Would Sue and Tessa still be willing to trade 1 jacket for 15 caps? Explain your answer.

Sue and Tessa will not be willing to trade 1 jacket for 15 caps. In particular, Sue, whose comparative advantage lies in producing caps, can produce 1 jacket at an opportunity cost of only 10 caps. So Sue will be unwilling to pay any more than 10 caps per jacket.

9.

A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced.

© 2018 Pearson Education, Inc.

30

CHAPTER 2

a. Make a graph that illustrates the farm‘s PPF. The PPF is illustrated in Figure 2.2 as PPF0. Because the marginal cost of both wheat and pork increase as more of the good is produced, the PPF displays increasing opportunity cost so it has the ―conventional‖ bowedoutward shape.

b. The farm adopts a new technology that allows it to use fewer resources to fatten pigs. On your graph sketch the impact of the new technology on the farm‘s PPF. The new technology rotates the PPF outward from PPF0 to PPF1.

c. With the farm using the new technology in part (b), has the opportunity cost of producing a ton of wheat changed? Explain and illustrate your answer.

The opportunity cost of producing wheat has increased. The opportunity cost of a bushel of wheat is equal to the magnitude of 1/(slope of the PPF). As illustrated in Figure 2.2, for each quantity of wheat the slope of PPF1 has a smaller magnitude than the slope of PPF0 so the opportunity cost of a bushel of wheat is higher along PPF1. For a specific example, the opportunity cost of increasing wheat product from 600 bushels per week to 800 bushels per week along PPF1 is 6,000 pounds of pork but is only 3,000 pounds of pork along PPF0.

d. Is the farm more efficient with the new technology than it was with the old one? Why? The farm is able to produce more with the new technology than with the old, but it is not necessarily more efficient. If the farm was producing on its PPF before the new technology and after, the farm was production efficient both before the new technology and after.

10.

For 50 years, Cuba has had a centrally planned economy in which the government makes the big decisions on how resources will be allocated. a. Why would you expect Cuba‘s production possibilities (per person) to be smaller than those of the United States?

Cuba’s economy is almost surely less efficient than the U.S. economy. The Cuban central planners do not know people’s production possibilities or their preferences. The plans that are created wind up wasting resources and/or producing goods and services that no one wants. Because firms in Cuba are owned by the government rather than individuals, no one in Cuba has the self-interested incentive to operate the firm efficiently and produce goods and services that consumers desire. Additionally Cuba does not actively trade so Cuba produces most of its consumption goods rather than buying them from nations with a comparative advantage. Because Cuba uses its © 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM31

resources to produce consumption goods, it cannot produce many capital goods so its economic growth rate has been low.

b. What are the social institutions that Cuba might lack that help the United States to achieve allocative efficiency?

Of the four social institutions, firms, money, markets, and property rights, Cuba’s economy has firms and money. Markets, however, are less free of government intervention in Cuba. But the major difference is the property rights in the Cuban economy. In Cuba the government owns most of the firms; that is, the government has the property right to run the producers. Because the firms are not motivated to make a profit, the managers of these firms have little incentive to operate the firm efficiently or to produce the goods and services that consumers desire. In the United States, firms are owned by individuals; that is, people have the property right that allows them to run firms. These owners have the self-interested incentive to operate the firm efficiently and to produce the goods and services people want, an incentive sorely lacking in the Cuban economy.

© 2018 Pearson Education, Inc.

32

CHAPTER 2

Answers to Additional Problems and Applications Use the table to work Problems 11 and 12. Suppose that Yucatan‘s production possibilities are given in the table.

11. a. Draw a graph of Yucatan‘s PPF and explain how your graph illustrates a tradeoff.

Yucatan’s PPF is illustrated in Figure 2.3. The figure illustrates a tradeoff because moving along Yucatan’s PPF producing more of one good requires

Food (pounds per month) 300 200 100 0

and and and and

Sunscreen (gallons per month) 0 50 100 150

producing less of the other good.

Yucatan trades off more production of one good for less production of the other.

b. If Yucatan produces 150 pounds of food per month, how much sunscreen must it produce if it achieves production efficiency?

If Yucatan produces 150 pounds of food per month, then the point labeled A on the PPF in Figure 2.11 shows that Yucatan must produce 75 gallons of sunscreen per month to achieve production efficiency.

c. What is Yucatan‘s opportunity cost of producing (i) 1 pound of food and (ii) 1 gallon of sunscreen?

Yucatan’s PPF is linear so the opportunity cost of producing 1 pound of food is the same at all quantities. Calculate the opportunity cost of producing 1 pound of food when increasing the production of food from 0 to 100 pounds per month. Between these two ranges of production, the quantity of sunscreen produced falls from 150 gallons per month to 100 gallons per month, a decrease of 50 gallons. The opportunity cost is 50 gallons of sunscreen to gain 100 pounds of food. The opportunity cost per pound of food equals (50 gallons of sunscreen)/(100 pounds of food), or an opportunity cost of 0.5 gallon of sunscreen per pound of food.

Yucatan’s PPF is linear so the opportunity cost of producing 1 gallon of sunscreen is the same at all quantities. Calculate the opportunity cost of producing 1 gallon of sunscreen when increasing the production of sunscreen from 0 to 50 gallons per month. Between these two ranges of production, the quantity of food produced falls from 300 pounds per month to 200 pounds per month, a decrease of 100 pounds. The opportunity cost is 100 pounds of food to gain 50 gallons of sunscreen, or (100 pounds of food)/(50 gallons of sunscreen) which yields an opportunity cost of 2.0 pounds of food per gallon of sunscreen. © 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM33

e. What is the relationship between your answers to part (c)?

Answers (c) and (d) reflect the fact that opportunity cost is a ratio. The opportunity cost of gaining a unit of a good moving along the PPF equals the quantity of the other good or service forgone divided by the quantity of the good or service gained. The opportunity cost of one good, food, is equal to the inverse of the opportunity cost of the other good, sunscreen.

12.

What feature of a PPF illustrates increasing opportunity cost? Explain why Yucatan‘s opportunity cost does or does not increase.

If opportunity costs increase, the PPF bows outward. Yucatan’s PPF is linear and along a linear PPF the opportunity cost is constant.

Yucatan does not face an increasing opportunity cost of food because the opportunity cost remains constant, equal to 0.5 gallons of sunscreen per pound of food. Yucatan’s resources must be equally productive in both activities.

13.

In problem 11, what is the marginal cost of 1 pound of food in Yucatan when the quantity produced is 150 pounds per day? What is special about the marginal cost of food in Yucatan?

The marginal cost of a pound of food in Yucatan is constant at all points along Yucatan’s PPF and is equal to 0.5 gallons of sunscreen per pound of food. The special point about Yucatan’s marginal cost is the fact that the marginal cost is constant. This result reflects Yucatan’s linear PPF.

14.

The table describes the preferences in Yucatan. a. What is the marginal benefit from sunscreen and how is it measured?

Sunscreen (gallons per month)

Willingness to pay (pounds of food per gallon) 3 2 1

The marginal benefit from sunscreen is the benefit enjoyed by the person 25 who consumes one more gallon of 75 sunscreen. It is equal to the 125 willingness to pay for an additional gallon. For example, in the table when 75 gallons of sunscreen are produced, the marginal benefit of a gallon is 2 pounds of food per gallon.

b. Use the table in Problem 11. What does Yucatan produce to achieve allocative efficiency?

To achieve allocative efficiency, the marginal benefit of a gallon of sunscreen must equal the marginal cost of a gallon of sunscreen.

Yucatan’s marginal cost of a gallon of sunscreen is 2 pounds of food per gallon. When Yucatan produces 75 gallons of sunscreen, the table shows that Yucatan’s marginal benefit is 2 pounds of food per gallon. Therefore allocative efficiency is achieved when 75 gallons of sunscreen and, from the PPF, 150 pounds of food are produced.

15.

Macy‘s, Kmart, JCPenney: More Retailers Closing Brick-and-Mortar Stores As more people choose online shopping over brick-and-mortar stores, Macy‘s, Kmart, JCPenney and others are closing stores.

Source: Springfield News-Sun, March 24, 2017 a. Draw the PPF curves for brick-and mortar retailers and online retailers before and after the © 2018 Pearson Education, Inc.

34

CHAPTER 2

Internet became available.

Before there was an Internet, there were no online retailers and the production possibilities frontier was PPF0 in Figure 2.4, the flat line along the x-axis.

The only sales of retail goods were from brick-and-mortar retailers. After the Internet was developed, online retailers were created and started to sell goods and services. The Internet is a technological advance that changed the production possibilities frontier to PPF1 in Figure 2.4.

© 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM35

b. Draw the marginal cost and marginal benefit curves for brick-and-mortar retailers and online retailers before and after the Internet became available.

The marginal benefit for the goods is the same regardless of whether they came from an online store or a brick-and-mortar store. Therefore in Figure 2.5 the marginal benefit curve for retail goods is MB. The marginal cost of brick-and-mortar stores increases as the quantity increases, so both pre-and postInternet, the brick-and-mortar marginal cost curve is MCB&M. Before the Internet, no online retailing could occur so the marginal cost curve is the vertical marginal cost curve MCPRE-INT running along the y-axis.

After the Internet was developed online retailers have a lower marginal cost than do brick-and-mortar retailers, so the marginal cost curve of online retailers is MCPOST-INT.

c. Explain how changes in production possibilities, preferences, or both have changed the way in which goods are retailed.

The change in production possibilities, which created lower-cost online retailers, have changed the way retail goods are purchased.

The expansion of the production possibilities did not change people’s preferences, so the marginal benefit does not change. But, with the lower cost of retailing, the quantity of retailing increases. Because the marginal cost of these goods is less using an online retailer, today consumers are purchasing increasingly larger amounts online. Consequently brick-and-mortar retailers are shrinking and disappearing as they go bankrupt.

Use the following news clip to work Problems 16 and 17.

Gates Doubles Down on Malaria Eradication The End Malaria Council, convened by Bill Gates and Ray Chambers, seeks to mobilize resources to prevent and treat malaria. The current level of financing is too low to end malaria. Bruno Moonen, deputy director for malaria at the Gates Foundation, says that more resources, more leadership, and new technologies are needed to eradicate malaria in the current generation.

Source: Catherine Cheney, Devex, January 20, 2017, 16.

Is Bruno Moonen talking about production efficiency or allocative efficiency or both?

Mr. Moonen is talking about allocative efficiency and production efficiency. The allocatively efficient quantity occurs when marginal cost equals marginal benefit. Mr. Moonen’s assessment is that from the current allocatively efficient quantity of malaria eradication more resources need to be devoted to malaria eradication if it is to © 2018 Pearson Education, Inc.

36

CHAPTER 2

be eliminated in the current generation. He suggests that production possibilities need to be increased by developing new technologies for fighting malaria. Once these technologies are developed, the production possibilities frontier and the production efficient points will shift outward. The new technologies will lower the cost of malaria eradication and thereby increase the allocatively efficient quantity of malaria eradication.

© 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM37

17.

Make a graph with the percentage of malaria cases eliminated on the x-axis and the marginal cost and marginal benefit of driving down malaria cases on the y-axis. On your graph, (i) Draw a marginal cost curve and marginal benefit curve that are consistent with Bruno Moonen‘s opinion. (ii) Identify the quantity of malaria eradicated that achieves allocative efficiency.

Figure 2.6 shows a marginal cost curve and a marginal benefit curve that are consistent with Mr. Moonen’s views. According to Mr. Moonen, the current allocatively efficient quantity of malaria eradicated will not eliminate 100 percent of malaria in the current generation. In the figure, the allocatively efficient quantity is 60 percent of malaria cases eliminated because this is the quantity at which the marginal benefit equals the marginal cost.

Use the following data to work Problems 18 and 19.

Kim can produce 40 pies or 400 cakes an hour. Liam can produce 100 pies or 200 cakes an hour.

18. a. Calculate Kim‘s opportunity cost of a pie and Liam‘s opportunity cost of a pie.

If Kim spends an hour baking pies, she gains 40 pies but forgoes 400 cakes. Kim’s opportunity cost of 1 pie is (400 cakes)/(40 pies), or 10 cakes per pie. If Liam spends an hour baking pies, he gains 100 pies but forgoes 200 cakes. Liam’s opportunity cost of 1 pie is (200 cakes)/(100 pies), or 2 cakes per pie.

b. If each spends 30 minutes of each hour producing pies and 30 minutes producing cakes, how many pies and cakes does each produce?

Kim produces 20 pies and 200 cakes. Liam produces 50 pies and 100 cakes. The total number produced is 70 pies and 300 cakes.

c. Who has a comparative advantage in producing (i) pies and (ii) cakes?

Liam has the comparative advantage in producing pies because his opportunity cost of a pie is less than Kim’s opportunity cost. Kim has the comparative advantage in producing cakes because her opportunity cost of a cake is less than Liam’s opportunity cost.

© 2018 Pearson Education, Inc.

38

CHAPTER 2

19. a

Draw a graph of Kim‘s PPF and Liam‘s PPF and show the point at which each produces when they spend 30 minutes of each hour producing pies and 30 minutes producing cakes.

Kim’s PPF is illustrated in Figure 2.7; Liam’s PPF is illustrated in Figure 2.8.

Point A in both figures shows their production points when each spends 30 minutes making cakes and 30 minutes making pies.

b. On your graph, show what Kim produces and what Liam produces when they specialize.

Kim will specialize in cakes and Liam will specialize in pies. Point B in both figures shows the production points when each specializes.

c. When they specialize and trade, what are the total gains from trade?

Kim will specialize in cakes and Liam will specialize in pies. If they specialize and trade, the total production of both cakes and pies increase. When each spends 30 minutes making cakes and 30 minutes making pies, together they produce 300 cakes and 70 pies.

When they specialize, together they produce 400 cakes and 100 pies.

The 100 increase in cakes and the 30 increase pies is the gains from trade.

d. If Kim and Liam share the total gains equally, what trade takes place between them?

Kim will trade 50 cakes (half of the gain in cake production) to Liam in exchange for 15 pies (half of the increase in pie production).

Tony’s Production Possibilities Snowboards Skis (units per (units per week) week) 25 and 0 20 and 10 15 and 20

Patty’s Production Possibilities Snowboards Skis (units per (units per week) week) 20 and 0 10 and 5 0 and 10

© 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM39

10 5 0 20.

and And And

30 40 50

Tony and Patty produce skis and snowboards. The tables show their production possibilities.

Tony produces 5 snowboards and 40 skis a week; Patty produces 10 snowboards and 5 skis a week. a. Who has a comparative advantage in producing (i) snowboards and (ii) skis? (i) Tony’s opportunity cost of a snowboard is (10 skis)/(5 snowboards), or 2 skis per snowboard. Patty’s opportunity cost of a snowboard is (5 skis)/(10 snowboards), or 0.5 skis per snowboard.

Patty’s opportunity cost of a snowboard is lower than Tony’s opportunity cost, so Patty has the comparative advantage. (ii) Tony’s opportunity cost of a ski is (5 snowboards)/(10 skis), or 0.5 snowboards per ski. Patty’s opportunity cost of a ski is (10 snowboards)/(5 skis), or 2.0 snowboards per ski. Tony’s opportunity cost of a ski is lower than Patty’s opportunity cost, so Tony has the comparative advantage.

b. If Tony and Patty specialize and trade 1 snowboard for 1 ski, what are the gains from trade?

Tony has a comparative advantage in producing skis, so he specializes in producing skis. Patty has a comparative advantage in producing snowboards, so she specializes in snowboards. Tony now produces 50 skis and Patty produces 20 snowboards. Before specializing they produced a total of 45 skis (Tony’s 40 plus Patty’s 5) and 15 snowboards (Tony’s 5 plus Patty’s 10). By specializing, the total production of skis increases by 5 and the total production of snowboards increases by 5. This increase in total production is the gains from trade. By trading 1 ski for 1 snowboard, they can share these gains. Tony obtains snowboards from Patty for less than it costs him to produce them and Patty obtains skis from Tony for less than it costs her to produce them.

21.

Capital accumulation and technological change bring economic growth: Production that was unattainable yesterday becomes attainable today; production that is unattainable today will become attainable tomorrow. Why doesn‘t economic growth bring an end to scarcity one day?

Scarcity is always being defeated yet will never suffer defeat.

Scarcity reflects the existence of unmet wants. People’s wants are infinite—regardless of what a person already possesses, everyone can easily visualize something else he or she wants, if only more time in the day to enjoy their possessions. Because people’s wants are insatiable, scarcity will always exist regardless of economic growth.

© 2018 Pearson Education, Inc.

40

22.

CHAPTER 2

SpaceX Plans to Send Two People Around the Moon SpaceX CEO Elon Musk announced that SpaceX has plans to send two private citizens on a one week, 300,000- to 400,000-mile trip around the moon in 2018.

Source: The Verge, February 27, 2017 a. What is the opportunity cost of creating the technology for trips around the moon?

The opportunity cost of creating the technology is the next best alternative forgone by the resources used to develop this technology. For example, the engineers who are working to develop SpaceX’s technology might otherwise be assisting in the production of technology used to more powerful batteries, so the opportunity cost is the more powerful battery.

© 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM41

b. Sketch SpaceX‘s PPF and production point in 2017 and its PPF and planned production in 2018.

Figure 2.9 shows SpaceX’s PPF in 2017 and in 2018. The increase in SpaceX’s technology shifts its PPF outward so that its PPF in 2018 lies beyond its PPF in 2017.

In 2017, a trip around the moon was beyond its PPF but with the technological advance it becomes possible. SpaceX’s production point in 2017 is labeled A, here it devotes all its resources to developing new technology. Its planned production in 2018 is labeled B, where it will produce 1 trip around the moon.

23.

On a graph of the circular flows in the market economy, indicate the real and money flows in which the following items belong: a. You buy an iPad from the Apple Store.

Figure 2.10 shows the circular flows in a market economy. Your purchase of an iPad from Apple is the purchase of a good from a firm. This flow is in the black arrow indicated by point a in the figure. When you pay for the iPad, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled a.

b. Apple Inc. pays the designers of the iPad. Apple’s payment to the designers of the iPad is the payment of a wage to a factor of production.

This flow is in the grey arrow indicated by point b in the figure.

The flow of design services from the designer to Apple is in the black arrow in the opposite direction to the grey arrow labeled b.

© 2018 Pearson Education, Inc.

42

CHAPTER 2

c. Apple Inc. decides to expand and rents an adjacent building.

Apple’s decision to expand by renting a building means that Apple is increasing the capital it uses. This flow is in the black arrow indicated by point c in the figure. The flow of the payment for the rental services of the building is in the grey arrow in the opposite direction to the black arrow labeled c.

d. You buy a new e-book from Amazon.

Your purchase of an e-book from Amazon is the purchase of a good from a firm. This flow is in the black arrow indicated by point d in the figure. When you pay for the e-book, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled d.

e. Apple Inc. hires a student to work as an intern.

Apple’s decision to hire a student intern is Apple increasing the labor it uses. The flow of labor services is in the black arrow indicated by point e in the figure. The flow of the payment for the labor services is in the grey arrow in the opposite direction to the black arrow labeled c.

Economics in the News 24.

After you have studied Reading Between the Lines on pp. 50–51, answer the following questions. a. How have robots changed the U.S. production possibilities?

Robots have increased the U.S. production possibilities and shifted the U.S PPF outward.

b. How have advances in technologies for producing services changed the U.S. production possibilities?

Advances in technologies for producing services have also increased U.S. production possibilities.

c. If robots had been the only technological advance, how would the PPF have changed?

If robots had been the only technological advance, the PPF would have rotated outward. The maximum quantity of other goods and services would not have changed but the maximum quantity of goods produced using robots, such as steel, would have increased. For any quantity of other goods and services, more steel could be produced after the introduction of robots.

d. If robots had been the only technological advance, how would the opportunity cost of producing steel have changed? Would it have been lower or higher than it actually was?

If robots had been the only technological advance, the PPF would have rotated so that for any quantity of services the slope of the new PPF would be smaller than the slope of the initial PPF. Consequently, the opportunity cost of producing steel would have decreased. For any quantity of services the opportunity cost of producing steel would be lower after the introduction of robots.

25.

YouTube Launches Live TV in the US Google has launched YouTube TV, a $35-amonth service that carries live streaming from all the major broadcast and sports networks as well as some cable networks and local sports and news © 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM43

channels. Users will be able to record an unlimited amount of content and multiple shows simultaneously, without using up any data space on mobile devices.

Source: Mediatel, March 1, 2017 a. How has live streaming changed the production possibilities of video entertainment and other goods and services?

Live streaming has increased the production possibilities. For any quantity of other goods and services, now more video entertainment can be produced. The production possibilities frontier has changed so that the maximum quantity of video entertainment has increased but the maximum quantity of other goods and services has not changed.

© 2018 Pearson Education, Inc.

44

CHAPTER 2

b. Sketch a PPF for video entertainment and other goods and services before live streaming.

The PPF should have video entertainment on one axis and other goods and services on the other as illustrated in Figure 2.11. The PPF is bowed outward as a conventional PPF.

c. Show how the arrival of inexpensive live streaming has changed the PPF. The arrival of inexpensive live streaming shifts the PPF outward as shown by the change from PPF0 to PPF1 in Figure 2.11. The intersection of the new PPF along the axis measuring video entertainment increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

d. Sketch a marginal benefit curve and marginal cost curve for video entertainment before and after live streaming.

In Figure 2.12, the marginal benefit and marginal cost from video entertainment is measured along the vertical axis and the quantity of video entertainment is measured along the horizontal axis. As the figure shows, the marginal benefit curve is a conventional downward-sloping marginal benefit curve and the marginal cost curve is a conventional upward-sloping marginal cost curve. The introduction of low cost live streaming does not change the marginal benefit curve—it remains MB. But it lowers the marginal cost and shifts the marginal cost curve from MC0 to MC1.

e. Explain how the efficient quantity of video entertainment has changed.

As Figure 2.12 shows, the allocatively efficient quantity of video entertainment increases. In Figure 2.12, the allocatively efficient quantity increases from 4 million units per year to 6 million units per year

© 2018 Pearson Education, Inc.

THE ECONOMIC PROBLEM45

C h a p t e r

3

DEMAND AND SUPPLY

Answers to the Review Quizzes Page 60 1.

What is the distinction between a money price and a relative price?

The money price of a good is the dollar amount that must be paid for it. The relative price of a good is its money price expressed as a ratio to the money price of another good. Thus the relative price is the amount of the other good that must be foregone to purchase a unit of the first good.

2.

Explain why a relative price is an opportunity cost.

The relative price of a good is the opportunity cost of buying that good because it shows how much of the next best alternative good must be forgone to buy a unit of the first good.

3.

Think of examples of goods whose relative price has risen or fallen by a large amount.

Some examples of items where both the money price and the relative price have risen over time are gasoline, college tuition, and food.

Some examples of items where both the money price and the relative price have fallen over time are personal computers, HD televisions, and calculators.

Page 65 1.

Define the quantity demanded of a good or service.

The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

2.

What is the law of demand and how do we illustrate it?

The law of demand states: ―Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.‖ The law of demand is illustrated by a downward-sloping demand curve drawn with the quantity demanded on the horizontal axis and the price on the vertical axis. The slope is negative to show that the higher the price of a good, the smaller is the quantity © 2018 Pearson Education, Inc.

40

CHAPTER 3

demanded and the lower the price of a good, the greater is the quantity demanded.

3.

What does the demand curve tell us about the price that consumers are willing to pay?

For any fixed quantity of a good available, the vertical distance of the demand curve from the x-axis shows the maximum price that consumers are willing to pay for that quantity of the good. The price on the demand curve at this quantity indicates the marginal benefit to consumers of the last unit consumed at that quantity.

4.

List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand.

Influences that change the demand for a good include:  The prices of related goods. A rise (fall) in the price of a substitute increases (decreases) the demand for the first good.

A rise (fall) in the price of a complement decreases (increases) the demand for the first good.

5.



The expected future price of the good. A rise (fall) in the expected future price of a good increases (decreases) the demand in the current period.



Income. An increase (decrease) in income increases (decreases) the demand for a normal good. An increase in income decreases (increases) the demand for an inferior good.



Expected future income and credit. An increase (decrease) in expected future income or credit increases (decreases) the demand.



The population. An increase (decrease) in population increases (decreases) the demand.



People’s preferences. If people’s preferences for a good rise (fall), the demand increases (decreases).

Why does demand not change when the price of a good changes with no change in the other influences on buying plans?

If the price of a good falls and nothing else changes, then the quantity of the good demanded increases and there is a movement down along the demand curve, but the demand for the good remains unchanged and the demand curve does not shift.

Page 69 1.

Define the quantity supplied of a good or service.

The quantity supplied of a good or service is the amount of the good or service that firms plan to sell in a given period of time at a specified price.

2.

What is the law of supply and how do we illustrate it?

The law of supply states that ―other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.‖ The law of supply is illustrated by an upward-sloping supply curve drawn with the quantity supplied on the horizontal axis © 2018 Pearson Education, Inc.

DEMAND AND SUPPLY41

and the price on the vertical axis. The slope is positive to show that the higher the price of a good, the greater is the quantity supplied and the lower the price of a good, the smaller is the quantity supplied.

3.

What does the supply curve tell us about the producer‘s minimum supply price?

For any quantity, the vertical distance between the supply curve and the x-axis shows the minimum price that suppliers must receive to produce that quantity of output. As a result, the price is the marginal cost of the last unit produced at this level of output.

4.

List all the influences on selling plans, and for each influence, say whether it changes supply.

Changes in the price of the good change the quantity supplied. They do not change the supply of the good.

Influences that change the supply of a good include:  Prices of factor of production. A rise (fall) in the price of a factor of production increases firms’ costs of production and decreases (increases) the supply of the good.

5.



Prices of related goods produced. If the price of a substitute in production rises (falls), firms decrease (increase) their sales of the original good and the supply for the original good decreases (increases). A rise (fall) in the price of a complement in production increases (decreases) production of the original good, causing the supply of the original good to increase (decrease).



The expected future price of the good. A rise (fall) in the expected future price of the good decreases (increases) the amount suppliers sell today. This change in expectations decreases (increases) the supply in the current period.



The number of sellers. An increase (decrease) in the number of sellers in a market increases the quantity of the good available at every price, and increases (decreases) the supply.



Technology. An advance in technology increases the supply.



The state of nature. A good (bad) state of nature, such as good (bad) weather for agricultural products, increases (decreases) the supply.

What happens to the quantity of smartphones supplied and the supply of smartphones if the price of a smartphone falls?

If the price of a smartphones falls and nothing else changes, then the quantity of smartphones supplied will decrease and there is a movement down along the supply curve for smartphones. The supply of smartphones, however, remains unchanged and the supply curve does not shift.

Page 71 1.

What is the equilibrium price of a good or service?

The equilibrium price is the price at which the quantity demanded by the buyers is equal to the quantity supplied by the sellers.

© 2018 Pearson Education, Inc.

42

2.

CHAPTER 3

Over what range of prices does a shortage arise? What happens to the price when there is a shortage?

A shortage arises at market prices below the equilibrium price. A shortage causes the price to rise, decreasing quantity demanded and increasing quantity supplied until the equilibrium price is attained.

3.

Over what range of prices does a surplus arise? What happens to the price when there is a surplus?

A surplus arises at market prices above the equilibrium price. A surplus causes the price to fall, decreasing quantity supplied and increasing quantity demanded until the equilibrium price is attained.

4.

Why is the price at which the quantity demanded equals the quantity supplied the equilibrium price?

At the equilibrium price, the quantity demanded by consumers equals the quantity supplied by producers. At this price, the plans of producers and consumers are coordinated and there is no influence on the price to move away from equilibrium.

5.

Why is the equilibrium price the best deal available for both buyers and sellers?

The equilibrium price reflects that the highest price consumers are willing to pay for that amount of the good or service and is just equal to the minimum price that suppliers require for delivering it.

Demanders would prefer to pay a lower price, but suppliers are unwilling to supply that quantity at a lower price. Suppliers would prefer a higher price, but demanders are unwilling to pay a higher price for that quantity. Hence neither demanders not suppliers can do business at a better price.

Page 77 What is the effect on the price and quantity of smartphones if 1.

The price of a music-streaming subscription falls or the price of a wireless plan rises? (Draw the diagrams!)

Because a large majority of smartphone owners listen to streaming music on their smartphones (68 percent according to a study published by Digital Music News), streaming music is a complement of a smartphone. A fall in the price of a music-streaming subscription increases the demand for smartphones. The demand curve for smartphones shifts rightward. Supply remains unchanged. The price of a smartphone rises and the quantity increases. Figure 3.8 on page 72 illustrates this sort of change.

A rise in the price of a wireless plan decreases the demand for smartphones because a wireless plan is a complement of a smartphone.

The demand curve for smartphones shifts leftward. Supply remains unchanged. The price of a smartphone falls and the quantity decreases.

© 2018 Pearson Education, Inc.

DEMAND AND SUPPLY43

2.

More firms produce smartphones or electronics workers‘ wages rise? (Draw the diagrams!)

An increase in the number of firms that produce smartphones increases the supply of smartphones. The supply curve of smartphones shifts rightward. Demand remains unchanged. The price of a smartphone falls and the quantity of smartphones increases. You can illustrate this outcome by drawing a diagram like Figure 3.9 on page 74.

A rise in the wages of electronic workers decreases the supply of smartphones because it increases the cost of producing smartphones.

The supply curve of smartphones shifts leftward. Demand remains unchanged. The price of a smartphone rises and the quantity of smartphones decreases.

3.

Any two of these events in questions 1 and 2 occur together? (Draw the diagrams!)

There are six combinations: (1) If the price of a music streaming service falls and the price of a wireless plan rises, supply is unchanged and demand might increase, decrease, or not change so the outcome cannot be predicted.

(2) If the price of a music streaming service falls and more firms produce smartphones, demand increases and supply increases so the quantity increases and the price might rise, fall, or not change.

(3) If the price of a music-streaming service falls and the wages paid electronic workers rise, demand increases and supply decreases so the price rises and the quantity might increase, decrease, or not change.

(4) If the price of a wireless plan rises and more firms produce smartphones, demand decreases and supply increases so the price falls and quantity might increase, decrease, or remain the same.

(5) If the price of a wireless plan rises and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise, fall, or remain the same.

(6) If more firms produce smartphones and the wages paid electronics workers rise, demand is unchanged and supply might increase or decrease or remain unchanged, so the outcome cannot be predicted.

© 2018 Pearson Education, Inc.

44

CHAPTER 3

Answers to the Study Plan Problems and Applications 1.

In April 2014, the money price of a carton of milk was $2.01 and the money price of gallon of gasoline was $3.63. Calculate the relative price of a gallon of gasoline in terms of milk.

The relative price of a gallon of gasoline in terms of milk equals ($3.63 per gallon of gasoline)/($2.01 per carton of milk) = 1.81 cartons of milk per gallon of gasoline.

2.

The price of food increased during the past year. a. Explain why the law of demand applies to food just as it does to other goods and services.

The law of demand applies to food because there is both a substitution and an income effect that reinforce each other. When the price of food rises, people substitute to different foods. For instance, some might substitute home cooked meals for dining at a restaurant. And when the price rises, there is a negative income effect, so people buy less food overall with the rising price. On both counts, the higher price of food decreases the quantity of food demanded.

b. Explain how the substitution effect influences food purchases when the price of food rises and other things remain the same.

When the price of food rises, people substitute away from (some) foods and toward other foods and other activities. People substitute cheaper foods for more expensive foods and they also substitute diets for food.

c. Explain how the income effect influences food purchases and provide some examples of the income effect.

Food is a normal good so a rise in the price, which decreases people’s real incomes, decreases the quantity of food demanded. In the United States, restaurants suffer as the negative income effect from a higher price of food leads people to cut back their trips to restaurants. At home, people will buy fewer steaks and instead will buy more noodles. In poor countries (and among the poor in the United States), people literally eat less when the price of food rises and in extremely poor countries starvation increases.

3.

Which of the following goods are likely substitutes and which are likely complements? (You may use an item in more than once.): coal, oil, natural gas, wheat, corn, pasta, pizza, sausage, skateboard, roller blades, video game, laptop, iPad, smartphone, text message, email Substitutes include: coal and oil; coal and natural gas; oil and natural gas; wheat and corn; pasta and pizza; pasta and sausage; pizza and sausage (they type of sausage that cannot be used as a topping on pizza); skateboard and roller blades; skateboard and video game; roller blades and video game; laptop and iPad; and, text message and email.

Complements include: pizza and sausage (the type of sausage that can be used as a topping on pizza); skateboard and iPad; roller blades and iPad; video game (those played on a computer) and laptop; smartphone and text message; and, smartphone and email.

© 2018 Pearson Education, Inc.

DEMAND AND SUPPLY45

4.

As the average income in China continues to increase, explain how the following would change: a. The demand for beef Beef is a normal good. The increase in income increases the demand for beef.

b. The demand for rice Rice is probably an inferior good. The increase in income decreases the demand for rice.

5.

In 2016, the price of corn fell and some corn farmers will switch from growing corn in 2017 to growing soybeans. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer.

This fact illustrates the law of supply: the lower price of corn decreases the quantity of corn grown.

b. Why would a corn farmer grow soybeans?

Corn and soybeans are substitutes in production and soybeans have become more profitable. A corn farmer would switch to soybeans because the profit from growing soybeans exceeds that from growing corn.

6.

Dairies make low-fat milk from full-cream milk, and in the process they produce cream, which is made into ice cream. The following events occur one at a time: (i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With a drought forecasted, dairies raise their expected price of low-fat milk next year. (v) New technology lowers the cost of producing ice cream.

Explain the effect of each event on the supply of low-fat milk. (i) Dairy workers are a factor used to produce low-fat milk. The price of a factor of production rises, which decreases the supply of low-fat milk. (ii) Cream and low fat milk are complements in production. The price of a complement in production rises, which increases the supply of low fat milk. (iii) A rise in the price of low-fat milk does not change the supply of low-fat milk. It does, however, increase the quantity of low-fat milk supplied. (iv) The higher expected price of low-fat milk decreases the (current) supply of low-fat milk. (v) Ice cream and low-fat milk are complements in production. The lower cost of producing ice cream increases the quantity of ice cream produced, which increases the supply of low-fat milk.

© 2018 Pearson Education, Inc.

46

7.

CHAPTER 3

The demand and supply schedules for gum are in the table. a. Suppose that the price of gum is 70¢ a pack. Describe the situation in the gum market and explain how the price adjusts.

Price (cents per pack) 20 40 60 80

Quantit Quantity y supplied demande d (millions of packs a week) 180 60 140 100 100 140 60 180

At 70 cents a pack, there is a surplus of gum and the price falls. At 70 cents a pack, the quantity demanded is 80 million packs a week and the quantity supplied is 160 million packs a week. There is a surplus of 80 million packs a week. The price falls until market equilibrium is restored at a price of 50 cents a pack.

b. Suppose that the price of gum is 30¢ a pack. Describe the situation in the gum market and explain how the price adjusts.

At 30 cents a pack, there is a shortage of gum and the price rises.

At 30 cents a pack, the quantity demanded is 160 million packs a week and the quantity supplied is 80 million packs a week. There is a shortage of 80 million packs a week. The price rises until market equilibrium is restored at a price of 50 cents a pack.

8.

The following events occur one at a time: (i) The price of crude oil rises. (ii) The price of a car rises. (iii) All speed limits on highways are abolished. (iv) Robots cut car production costs.

Explain the effect of each of these events on the market for gasoline. (ii) and (iii) and (iv) change the demand for gasoline. The demand for gasoline will change if the price of a car rises, all speed limits on highways are abolished, or robot production cuts the cost of producing a car. If the price of a car rises, the quantity of cars bought decrease and the demand for gasoline decreases. If all speed limits on highways are abolished, people will drive faster and use more gasoline. The demand for gasoline increases. If robot production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be bought. The demand for gasoline increases. (i) changes the supply of gasoline. The supply of gasoline will change if the price of crude oil (a factor of production used in the production of gasoline) changes. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases.

© 2018 Pearson Education, Inc.

DEMAND AND SUPPLY47

9.

In Problem 7, a fire destroys some factories that produce gum and the quantity of gum supplied decreases by 40 million packs a week at each price. a. Explain what happens in the market for gum and draw a graph to illustrate the changes.

As the number of gum-producing factories decreases, the supply of gum decreases. There is a new supply schedule and, in Figure 3.1, the supply curves shifts leftward by 40 million packs at each price to the new supply curve S1. After the fire, the quantity supplied at 50 cents is now only 80 million packs, and there is a shortage of gum. The price rises to 60 cents a pack, at which the new quantity supplied equals the quantity demanded. The new equilibrium price is 60 cents and the new equilibrium quantity is 100 million packs a week.

b. If, at the time as the fire the teenage population increases and the quantity of gum demanded increases 40 million packs a week at each price. What is the new market equilibrium? Show the changes on your graph.

The new price is 70 cents a pack, and the quantity is 120 million packs a week. The demand for gum increases and the demand curve shifts rightward by 40 million packs at each price. Supply decreases by 40 millions packs a week and the supply curve shifts leftward by 40 million packs at each price. These changes are shown in Figure 3.2 by the shift of the demand curve from D to D1 and the shift of the supply curve from S to S1. At any price below 70 cents a pack there is a shortage of gum. The price of gum rises until the shortage is eliminated.

© 2018 Pearson Education, Inc.

48

10.

CHAPTER 3

Singing the Blues: March Frost Destroys State Blueberry Crop Chris and Rhonda Luther had big plans for their small blueberry farm, but freezing temperatures killed these plans, reducing their usual output by about 95 percent. The Georgia Department of Agriculture estimates the freeze to have cut production 80 percent.

Source: Red and Black, March 25, 2017 Make a graph to illustrate the market for blueberries before and after the unusually cold March weather.

Figure 3.3 shows the effect of the freezing temperatures on the blueberry market. The demand curve is labeled D. The freeze did not affect the demand for blueberries, so the demand curve does not shift. The freeze was a bad state of nature and decreased the supply of blueberries, shifting the supply curve leftward. The supply curve labeled S0 reflects the supply before the freeze and the supply curve labeled S1 shows the supply after the freeze. The equilibrium price of a pound of blueberries rises from $0.60 per pound to $2.40 per pound and the equilibrium quantity decreases from 5 million pounds of blueberries 1 million pounds.

© 2018 Pearson Education, Inc.

DEMAND AND SUPPLY49

Answers to Additional Problems and Applications 11.

What features of the world market for crude oil make it a competitive market?

The world oil market is a competitive market because there are a large number of sellers and a large number of buyers. There are so many sellers and so many buyers that no individual seller or individual buyer can influence the price of oil.

12.

The money price of a textbook is $90 and the money price of the Wii game Super Mario Galaxy is $45. a. What is the opportunity cost of a textbook in terms of the Wii game?

A textbook costs $90 and a Wii game costs $45. Purchasing 1 textbook forces the buyer to give up 2 Wii games. So the opportunity cost of a textbook in terms of Wii games is 2 Wii games per textbook.

b. What is the relative price of the Wii game in terms of textbooks?

The relative price of a Wii game in terms of textbooks equals ($45 per Wii)/($90 per textbook), which is 1/2 of a textbook per Wii game.

13.

The price of gasoline has increased during the past year. a. Explain why the law of demand applies to gasoline just as it does to all other goods and services.

When the price of gasoline rises, people decrease the quantity of gasoline they demand. Both the substitution effect and the income effect lead consumers to decrease the quantity of gasoline demanded.

b. Explain how the substitution effect influences gasoline purchases and provide some examples of substitutions that people might make when the price of gasoline rises and other things remain the same.

When the price of gasoline rises, people substitute other goods and services for gasoline. For instance, people substitute public transport (such as buses), carpools, motorcycles, walking, and bicycles for driving alone in a car to work.

c. Explain how the income effect influences gasoline purchases and provide some examples of the income effects that might occur when the price of gasoline rises and other things remain the same.

When the price of gasoline rises, people’s real incomes fall. People respond by decreasing their demand for normal goods, such as gasoline. In the gasoline market, some people trade in large, fuel guzzling cars because they can no longer afford to fuel the large vehicle. Others will not purchase a car or truck because they are not able to afford the gasoline necessary to use it.

14.

Think about the demand for the three game consoles: Xbox One, PlayStation 4, and Wii U. Explain the effect of the following events on the demand for Xbox One games and the quantity of Xbox One games demanded, other things remaining the same. The events are: a. The price of an Xbox One falls.

An Xbox One and an Xbox One game are complements. When the price of an Xbox One falls, consumers respond by increasing the quantity of Xbox Ones demanded so the equilibrium quantity of Xbox Ones

© 2018 Pearson Education, Inc.

50

CHAPTER 3

increases. Consumers increase their demand for Xbox one games because an Xbox One console is useless without Xbox One games.

b. The prices of a PlayStation 4 and a Wii U fall.

A PlayStation 4 and a Wii U are substitutes for an Xbox One. When these game consoles fall in price, the demand for Xbox One consoles decreases and so the equilibrium quantity of Xbox Ones decreases.

Consumers decrease their demand for Xbox One games because an Xbox One game is useless without an Xbox One console.

c. The number of people writing and producing Xbox One games increases.

The increase in the number of people writing Xbox One games increases the supply of Xbox One games. The demand for Xbox One games does not change but the increase in the supply lowers the price of an Xbox One game. The fall in the price of Xbox One games increases the quantity of Xbox Ones demanded.

d. Consumers‘ incomes increase.

Xbox One games are surely a normal good. So an increase in consumers’ incomes increases the demand for Xbox One games.

e. Programmers who write code for Xbox One games become more costly to hire.

The increase in the cost of programmers decreases the supply of Xbox One games. When the supply of a good or service decreases, the price of that good or service rises. Xbox One games are not an exception, so the price of an Xbox One game rises. The rise in the price of an Xbox One game decreases the quantity of Xbox One games demanded.

f.

The expected future price of an Xbox One game falls.

When the price of an Xbox One game is expected to fall, the (current) demand for Xbox One games decreases.

g. A new game console that is a close substitute for Xbox One comes onto the market.

The new game console decreases the demand for Xbox One consoles. As a result, the equilibrium quantity of Xbox One consoles decreases.

Consumers decrease their demand for Xbox One games because an Xbox One game is useless without an Xbox One console.

15.

Classify the following pairs of goods and services as substitutes in production, complements in production, or neither. a. Bottled water and health club memberships Bottled water and health club memberships are neither substitutes in production nor complements in production. (For consumers, these are complements because people in health clubs drink a lot of bottled water.)

b. French fries and baked potatoes For a restaurant that produces both French fries and baked potatoes, they are substitutes in production. (For a consumer, they are substitutes.)

c. Leather boots and leather shoes Leather boots and leather shoes are substitutes in production.

© 2018 Pearson Education, Inc.

DEMAND AND SUPPLY51

d. Hybrids and SUVs For an auto company that produces both on the same assembly line, they are substitutes in production. (For a consumer, hybrids and SUVs are substitutes.)

e. Diet coke and regular coke For a soda company that produces both on the same assembly line, they are substitutes in production. (For a consumer, Diet coke and regular coke are substitutes.)

16.

When a timber mill makes logs from trees it also produces sawdust, which is used to make plywood. a. Explain how a rise in the price of sawdust influences the supply of logs.

The rise in the price of sawdust motivates timber mills to make more sawdust, which thereby increases the demand for logs and raises the price of logs. There is no change in the supply of logs but instead a change in the quantity of logs supplied.

b. Explain how a rise in the price of sawdust influences the supply of plywood.

The rise in the price of sawdust motivates timber mills to make more sawdust, which thereby increases the supply of plywood.

© 2018 Pearson Education, Inc.

52

17.

CHAPTER 3

New Maple Syrup Sap Method With the new way to tap maple trees, farmers could produce 10 times as much maple syrup per acre.

Source: cbc.ca, February 5, 2014 Will the new method change the supply of maple syrup or the quantity supplied of maple syrup, other things remaining the same. Explain.

The new technology increases the supply of maple syrup. At each price, the new technology increases the quantity that will be supplied. The supply curve shifts rightward.

Use Figure 3.4 to work Problems 18 and 19.

18. a. Label the curves. Which curve shows the willingness to pay for a pizza?

The demand curve is the downward sloping curve and the supply curve is the upward sloping curve. The demand curve shows the willingness to pay for a pizza.

b. If the price of a pizza is $16, is there a shortage or a surplus and does the price rise or fall?

If the price of a pizza is $16, there is a surplus of pizza; the quantity supplied of pizzas exceeds the quantity demanded.

The surplus forces the price lower to the equilibrium price of $14 a pizza.

c. Sellers want to receive the highest possible price, so why would they be willing to accept less than $16 a pizza?

Sellers are willing to accept less than $16 because if they charge $16 the surplus means that some sellers have unsold pizzas. From their perspective it is better to have a lower price for the pizza and sell the (decreased) quantity they produce than to keep the price at $16 and be left with unsold pizza.

19. a. If the price of a pizza is $12, is there a shortage or a surplus and does the price rise or fall?

If the price of a pizza is $12, there is a shortage of pizza; the quantity demanded of pizzas exceeds the quantity supplied. The shortage forces the price higher to the equilibrium price of $14 a pizza.

b. Buyers want to pay the lowest possible price, so why would they be willing to pay more than $12 for a pizza?

If the price of a pizza is $12 the shortage means that not all buyers can buy a pizza. From their perspective they would rather pay more than $12 and be able to purchase a pizza than to keep the price at $12 and leave them without a pizza.

© 2018 Pearson Education, Inc.

DEMAND AND SUPPLY53

Price (cents per bag) 50 60 70 80 90 100

© 2018 Pearson Education, Inc.

Quantit Quantity y supplied demande d (millions of bags a week) 160 130 150 140 140 150 130 160 120 170 110 180

54

20.

CHAPTER 3

The demand and supply schedules for potato chips are in the table. a. Draw a graph of the potato chip market and mark in the equilibrium price and quantity.

Figure 3.5 draws the supply and demand curves for this market. The equilibrium price is 65¢ a bag, and the equilibrium quantity is 145 million bags a week.

b. If the price is 60¢ a bag, is there a shortage or a surplus, and how does the price adjust?

At 60¢ a bag, there is a shortage of potato chips and the price rises. At 60¢ a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 140 million bags a week. The difference is a shortage of 10 million bags a week. The price rises until market equilibrium is restored—65¢ a bag and 145 million bags a week.

21.

In Problem 20, a new dip increases the quantity of potato chips that people want to buy by 30 million bags per week at each price. a. Does the demand for chips change? Does the supply of chips change? Describe the change.

As the new dip comes onto the market, the demand for potato chips increases. Supply does not change. The demand curves shifts rightward.

b. How do the equilibrium price and equilibrium quantity of chips change?

Demand increases by 30 million bags a week. The demand curve shifts rightward as shown in Figure 3.6 by the shift from D to D1. The quantity demanded at each price increases by 30 million bags. The quantity demanded at 65¢ is now 175 million bags a week of potato chips. The price rises to 80¢ a bag, at which the quantity supplied equals the quantity demanded (160 million bags a week). The new equilibrium price is 80¢ per bag and the new equilibrium quantity is 160 million bags.

© 2018 Pearson Education, Inc.

DEMAND AND SUPPLY55

22.

In Problem 20, if a virus destroys potato crops and the quantity of potato chips produced decreases by 40 million bags a week at each price, how does the supply of chips change?

The supply of potato chips decreases, and the supply curve shifts leftward by 40 million bags. The price rises to 85¢ a bag and the quantity decreases to 125 million bags a week.

23.

If the virus in Problem 22 hits just as the new dip in Problem 21 comes onto the market, how do the equilibrium price and equilibrium quantity of chips change?

The result by itself of the new dip entering the market is a price of 80¢ a bag and a quantity of 160 million bags. But now with the virus affecting the market, at this price there is a shortage of potato chips. The price of potato chips rises until the shortage is eliminated. The new equilibrium price is 100¢ a bag, and the new equilibrium quantity is 140 million bags a week.

24.

U.S. Craft Beer Bolsters U.K. Hop Production U.K. hop farmers stepped up production in response to a rapid growth of U.S. craft beer production. U.S. craft beer makers prefer the subtle taste of U.K. hop varieties.

Source: BBC, October 3, 2014 a. Describe the changes in the market for U.S. craft beer.

In the United States, the ―rapid growth of U.S. craft beer production‖ indicates that the supply of craft beers has increased, shifting the supply curve rightward. The increased supply results in a movement along the demand curve for beer so that there is an increase in the quantity demanded of U.S.-brewed craft beer.

b. Explain whether the increase in U.K. hop production is a change in supply or a change in the quantity supplied.

The increased demand for U.K. hops means that the demand curve for U.K. hops shifts rightward. There is a movement up along the U.K. hop supply curve, so there is a change in the quantity supplied.

c. What could be the impact on the price of U.K. hops if U.S. farmers switched to U.K. hop varieties.

If U.S. farmers switched to producing U.K. hop varieties and U.S. craft brewers switch from buying U.K.-produced hops to buying U.K. hop varieties produced in the United States, then the demand for U.K.-produced hops decreases so that the demand curve for U.K. produced hops shifts leftward. The price of U.K. produced hops falls.

25.

Vietnamese Farmers Switch to Pepper as Coffee Prices Fall The high pepper price and falling coffee price have made Vietnamese farmers replace coffee plants with pepper plants. Analysts fear farmers have used diseased pepper plants which could fail.

Source: VietNam News, May 28, 2016 a. Explain how the market for Vietnamese coffee will change as farmers switch to pepper.

As farmers switch some of their crop away from coffee to pepper, the supply of Vietnamese coffee will decrease. The demand for Vietnamese coffee does not change, so the decrease in supply raises the price of Vietnamese coffee and decreases the quantity. © 2018 Pearson Education, Inc.

56

CHAPTER 3

b. If pepper plants fail, what would happen to the price of pepper?

If the pepper plants fail, the supply of pepper decreases. The decrease in the supply of pepper results in the price of pepper rising and the quantity decreasing.

26.

Watch Out for Rising Dry-Cleaning Bills In the past year, the price of dry-cleaning solvent doubled. More than 4,000 dry cleaners across the United States disappeared as budget-conscious consumers cut back. This year the price of hangers used by dry cleaners is expected to double.

Source: CNN Money, June 4, 2012 a. Explain the effect of rising solvent prices on the market for dry cleaning.

Solvents are used to produce dry cleaning, so a rise in the price of solvents increases the cost of dry cleaning. The increase in the cost of dry cleaning decreases the supply of dry cleaning and the supply curve of dry cleaning shifts leftward. The demand for dry cleaning does not change. By itself, the decrease in the supply raises the equilibrium price of dry cleaning and decreases the equilibrium quantity of dry cleaning.

b. Explain the effect of consumers becoming more budget conscious along with the rising price of solvent on the price of dry cleaning.

Consumers becoming more budget conscious means that the demand for dry cleaning decreases and the demand curve for dry cleaning shifts leftward. Combined with the decrease in supply from rising solvent prices, the equilibrium quantity of dry cleaning decreases. The effect on the equilibrium price of dry cleaning, however, is ambiguous. If the decrease in supply exceeds the decrease in demand, the price rises; if the decrease in supply is less than the decrease in demand, the price falls; and, if the decrease in supply equals the decrease in demand, the price does not change.

c. If the price of hangers does rise this year, do you expect additional dry cleaners to disappear?

Explain why or why not.

The increase in the price of hangers raises the costs of dry cleaners but the cost increase is much smaller than the cost increase that resulted from the doubling of the price of drycleaning solvent. Therefore the decrease in supply is smaller, which means that the decrease in the equilibrium quantity of dry cleaning also is smaller. If the small decrease in the equilibrium quantity leads some additional dry cleaners to close, the number will be small.

Economics in the News 27.

After you have studied Economics in the news on pp. 78–79, answer the following questions: a. Would you classify frozen concentrated orange juice as a normal good or an inferior good?

Why? Frozen concentrated orange juice is an inferior good if, as incomes increase the demand for orange juice decreases. The article notes that as incomes have increased, the demand for frozen concentrated orange juice has decreased, which indicates it is an inferior good.

© 2018 Pearson Education, Inc.

DEMAND AND SUPPLY57

b. What would wiped out

C h a p t e r

happen to the price of orange juice if citrus greening the Florida orange crop?

If citrus greening wiped out the Florida orange crop, the price of oranges rises. Oranges are an input into making orange juice, so a rise in their price represents an increase in the cost of making orange juice. Consequently the supply of orange juice would decrease. The decrease in supply raises the price of orange juice.

c. What are some of the substitutes for orange juice and what would happen to the demand, supply, price, and quantity in the markets for each of these items if citrus greening became more severe?

Substitutes for orange juice include other beverages, such as tropical smoothies and energy drinks. If citrus greening becomes more severe, the price of orange juice will rise. The rise in the price of orange juice will lead to consumers switching away from orange juice to its substitutes, so the demand for the substitute beverages will increase. The supply will not change so the price and quantity of the substitute beverages will increase.

d. What are some of the complements of orange juice and what would happen to the demand, supply, price, and quantity in the markets for each of these items if citrus greening became more severe?

Complements for orange juice include other ―classic‖ breakfast foods, such eggs and bacon. If citrus greening becomes more severe, the price of orange juice will rise. The rise in the price of orange juice decreases the demand for its complements. The supply will not change, so the price and quantity of the complements will decrease.

ELASTICITY

4 Answers to the Review Quizzes Page 94 1.

Why do we need a units-free measure of the responsiveness of the quantity demanded of a good or service to a change in its price?

The elasticity of demand is a units-free measure. Compare it as a measure of the responsiveness to some other candidate that depends on the units, such as the slope. The slope of the demand curve changes as the units measuring the same quantity of the good change © 2018 Pearson Education, Inc.

54

CHAPTER 4

(going from pounds to ounces, for example). The value of the elasticity is independent of the units used to measure the price and quantity of the product. As a result, the elasticity can be compared across the same good when quantity is measured in different units and/or the price is measured in different currencies. The elasticities of different goods also can be compared even though they are measured in different units.

2.

Define the price elasticity of demand and show how it is calculated.

The price elasticity of demand is units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same. It equals the absolute value (or magnitude) of the ratio of the percentage change in the quantity demanded to the percentage change in the price. The percentage change in quantity (price) is measured as the change in quantity (price) divided by the average quantity (price).

3.

What makes the demand for some goods elastic and the demand for other goods inelastic?

The magnitude of the price elasticity of demand for a good depends on three main influences:

4.



Closeness of substitutes. The more easily people can substitute other items for a particular good, the larger is the price elasticity of demand for that good.



The proportion of income spent on the good. The larger the portion of the consumer’s budget being spent on a good, the greater is the price elasticity of demand for that good.



The time elapsed since a price change. Usually, the more time that has passed after a price change, the greater is the price elasticity of demand for a good.

Why is the demand for a luxury generally more elastic (or less inelastic) than the demand for a necessity?

Demand for a necessity is generally less elastic than demand for a luxury because there are fewer substitutes for a necessity. Because there are more substitutes for a luxury than a necessity, the elasticity of demand for a luxury is larger is than the elasticity of demand for a necessity.

5.

What is the total revenue test?

The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue, given a change in price, holding all other things constant. The total revenue test shows that a price cut increases total revenue if demand is elastic, decreases total revenue if demand is inelastic, and does not change total revenue if demand is unit elastic.

Page 98 1.

What does the income elasticity of demand measure?

The income elasticity of demand measures how the quantity demanded of a good responds to a change in income. The formula for the income © 2018 Pearson Education, Inc.

ELASTICITY55

elasticity of demand is the percentage change in the quantity of the good demanded divided by the percentage change in income.

2.

What does the sign (positive/negative) of the income elasticity tell us about a good?

The sign of the income elasticity of demand reveals whether a good is a normal good or an inferior good: The income elasticity of demand is positive for normal goods and negative for inferior goods.

3.

What does the cross elasticity of demand measure?

The cross elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good. The formula for the cross elasticity of demand is the percentage change in the quantity of the good demanded divided by the percentage change in the price of the related good.

4.

What does the sign (positive/negative) of the cross elasticity of demand tell us about the relationship between two goods?

The sign of the cross elasticity of demand reveals whether two goods are substitutes or compliments: The cross elasticity of demand is positive for substitutes and negative for complements.

Page 100 1.

Why do we need a units-free measure of the responsiveness of the quantity supplied of a good or service to a change in its price?

The elasticity of supply is a units-free measure. We need a unitsfree measure of the elasticity of supply for the same reason we need a units-free measure of the elasticity of demand: Because the value of the elasticity of supply is independent of the units used to measure the price and quantity of the good, the elasticity of supply can be compared across the same good when quantity is measured in different units and/or the price is measured in different currencies. In addition, the elasticities of supply of different goods also can be compared even though they are measured in different units.

2.

Define the elasticity of supply and show how it is calculated.

The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. The elasticity of supply is calculated by the percentage change in the quantity supplied divided by the percentage change in the price.

3.

What are the main influences on the elasticity of supply that make the supply of some goods elastic and the supply of other goods inelastic?

The main influences on the elasticity of supply are: 

Resource substitution possibilities: the greater the suppliers’ ability to substitute resources, the greater will be their ability to react to price changes and the greater the elasticity of supply.



Time frame for the supply decision: the greater the amount of time available after the price change, the greater is the © 2018 Pearson Education, Inc.

56

CHAPTER 4

suppliers’ ability to adjust quantity supplied, and the greater the elasticity of supply.

4. Provide examples of goods or services whose elasticities of supply are (a) zero, (b) greater than zero but less than infinity, and (c) infinity.

Here are some examples:

5.

a)

The momentary supply of wheat is perfectly inelastic. Once farmers have brought their wheat to market, there is no other alternative use for it and they sell it all regardless of the going price.

b)

The short-run supply of wheat. If the farmers already have a mature wheat crop but have not yet harvested it, farmers with both relatively high and low yield fields may chose to harvest both types of fields if the price for wheat is high. However, the farmers will not harvest their low yield fields when the price of wheat is relatively low to economize on added labor costs.

c)

The supply of wheat to an individual buyer. Any one buyer can purchase as much wheat at the going price as he or she desires.

However, no quantity of wheat will be supplied at a lower price.

How does the time frame over which a supply decision is made influence the elasticity of supply? Explain your answer.

The momentary supply, short-run supply, and long-run supply all illustrate the response of suppliers to changes in the price, but they differ according to how much time has elapsed after the price change. 

The momentary supply is frequently the least elastic and shows how suppliers cannot easily respond to a price change immediately after the price change occurs. Changing the quantity produced means changing the inputs into the production process, which takes time to complete. Sometimes the momentary supply is perfectly inelastic.



The short-run supply shows suppliers’ response after enough time has elapsed for some, but not all, of the possible technological adjustments have occurred. Short-run supply generally is intermediate in elasticity between the momentary supply and the long-run supply.



The long-run supply shows how suppliers react after enough time has passed that all possible adjustments to factors of production have been made to accommodate the price change. It usually is the most elastic of the three supplies.

© 2018 Pearson Education, Inc.

ELASTICITY57

Answers to the Study Plan Problems and Applications 1.

Rain spoils the strawberry crop, the price rises from $4 to $6 a box, and the quantity demanded decreases from 1,000 to 600 boxes a week. a. Calculate the price elasticity of demand over this price range.

The price elasticity of demand is 1.25. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price rises from $4 to $6 a box, a rise of $2 a box. The average price is $5 a box. So the percentage change in the price is $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity decreases from 1,000 to 600 boxes, a decrease of 400 boxes. The average quantity is 800 boxes. So the percentage change in quantity is 400 divided by 800, which equals 50 percent. The price elasticity of demand for strawberries is 50 percent divided by 40 percent, which equals 1.25.

b. Describe the demand for strawberries.

The price elasticity of demand exceeds 1, so the demand for strawberries is elastic.

2.

If the quantity of dental services demanded increases by 10 percent when the price of dental services falls by 10 percent, is the demand for dental services inelastic, elastic, or unit elastic?

The demand for dental services is unit elastic. The price elasticity of demand for dental services equals the percentage change in the quantity of dental services demanded divided by the percentage change in the price of dental services. The price elasticity of demand is 10 percent divided by 10 percent, which equals 1. The demand is unit elastic.

3.

The demand schedule for hotel table. a. What happens to total revenue falls from $400 to $250 a room per $250 to $200 a room per night?

Price (dollars per night)

Quantity demanded (millions of rooms per night) 100 80 50 40 25

rooms is in the when the price night and from

200 When the price is $400, the total 250 revenue is equal to $400 × 50 400 million rooms, or $20 billion.

500 When the price is $250, the total 800 revenue is equal to $250 × 80 million rooms, or $20 billion. So the total revenue does not change when the price falls from $400 to $250 a night.

When the price is $250, the total revenue is equal to $250 × 80 million rooms, or $20 billion. When the price is $200, the total revenue is equal to $200 × 100 million rooms, or $20 billion. So the total revenue does not change when the price falls from $400 to $250 a night.

© 2018 Pearson Education, Inc.

58

CHAPTER 4

b. Is the demand for hotel rooms elastic, inelastic or unit elastic?

The total revenue is the same at all prices, $20 billion. Because a change in price does not change the total revenue at any price, the demand is unit elastic at all prices.

© 2018 Pearson Education, Inc.

ELASTICITY59

4.

The figure shows the demand for pens.

Calculate the elasticity of demand when the price rises from $4 to $6 a pen. Over what price range is the demand for pens elastic?

The price elasticity of demand is 0.72. When the price of a pen rises from $4 to $6, the quantity demanded of pens decreases from 80 to 60 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price.

The price increases from $4 to $6, an increase of $2 a pen. The average price is $5 per pen. So the percentage change in the price equals $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity decreases from 80 to 60 pens, a decrease of 20 pens. The average quantity is 70 pens. So the percentage change in quantity demanded equals 20 divided by 70 and then multiplied by 100, which equals 28.6 percent. The price elasticity of demand for pens equals 28.6 percent divided by 40 percent, which is 0.72.

The demand for pens is elastic at all prices higher than the price at the midpoint of the demand curve, which indicates that the demand for pens is elastic at prices between $12 per pen and $6 per pen.

5.

In 2015, an outbreak of Avian Flu decreased the quantity of eggs produced by 18 percent. A shortage of eggs was avoided by a rise in their wholesale price from $1.34 to $2.40 per dozen. a. If the demand for eggs didn‘t change, what is your estimate of the price elasticity of demand for eggs?

Using the data in the question, the price elasticity of demand is 0.32. The change in the price is $1.06 and the average of the two prices is $1.87, so the percentage change in the price is ($1.06/$1.87)  100, which equals 56.7 percent. The increase in the quantity demanded was 18 percent. The price elasticity of demand equals (18.0 percent)/(56.7 percent), or 0.32.

b. Thinking about the influences on the price elasticity of demand, why would you expect the demand for eggs to be inelastic?

The smaller the proportion of income spent on a good, the smaller the elasticity of demand for that good. In many circumstances, the amount of a person’s income spent on eggs is small, so that the demand for eggs is inelastic.

© 2018 Pearson Education, Inc.

60

CHAPTER 4

When Judy‘s income increased from $130 to $170 a week, she increased her demand for concert tickets by 15 percent and decreased her demand for bus rides by 10 percent. Calculate Judy‘s income elasticity of demand for (a) concert tickets and (b) bus rides.

6.

a.

b.

7.

The income elasticity of demand for (a) concert tickets is 0.56 and (b) bus rides is −0.375. The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $40 and the average income is $150, so the percentage change in income equals 26.7 percent.

The change in the quantity demanded of concert tickets is 15 percent. The income elasticity of demand for concert tickets equals 15/26.7, which is 0.56.

The change in the quantity demanded of bus rides is 10 percent. The income elasticity of demand for bus rides equals 10/26.7, which is 0.375.

If a 12 percent rise in the price of orange juice decreases the quantity of orange juice demanded by 22 percent and increases the quantity of apple juice demanded by 14 percent, calculate the a. Price elasticity of demand for orange juice.

The price elasticity of demand for orange juice is 1.83. The price elasticity of demand is the percentage change in the quantity demanded of the good divided by the percentage change in the price of the good. So the price elasticity of demand equals 22 percent divided by 12 percent, which is 1.83.

b. Cross elasticity of demand for apple juice with respect to the price of orange juice.

The cross elasticity of demand between orange juice and apple juice is 1.17. The cross elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. So the cross elasticity of demand is the percentage change in the quantity demanded of apple juice divided by the percentage change in the price of orange juice. The cross elasticity equals 14 percent divided by 12 percent, which is 1.17.

8.

If a rise in the price of sushi from 98¢ to $1.02 a piece decreases the quantity of soy sauce demanded from 101 units to 99 units an hour and decreases the quantity of sushi demanded by 1 percent an hour, calculate the: a. Price elasticity of demand for sushi.

The price of sushi rises by ($1.02 − $0.98)/$1.00 = 4 percent.

Therefore the price elasticity of demand for sushi equals |( −1 percent)/(4 percent)|, which is 0.25.

b. Cross elasticity of demand for soy sauce with respect to the price of sushi.

The quantity of soy sauce decreases by (99 – 101)/100 = −2 percent.

Therefore the cross elasticity of demand for soy sauce with respect to the price of sushi equals |( −2 percent)/(4 percent), which is −0.5.

© 2018 Pearson Education, Inc.

ELASTICITY61

9.

The table sets out the supply schedule of jeans. a. Calculate the elasticity of supply when the price rises from $125 to $135 a pair.

Price (dollars per pair)

Quantity supplied (millions of pairs per year) 24 28 32 36

The elasticity of supply equals the percentage change in the quantity supplied divided by the percentage 120 change in price. The percentage 125 change in the quantity demanded 130 equals [(36  28)/32] × 100, which 135 is 25.0 percent. The percentage change in the price equals [($135  $125)/$130] × 100, which is 7.7 percent. The elasticity of supply equals (25.0 percent/7.7 percent), which is 3.25.

b. Calculate the elasticity of supply when the average price is $125 a pair.

To find the elasticity at an average price of $125 a pair, change the price such that $125 is the average price—for example, a rise in the price from $120 to $130 a pair. To calculate the elasticity when the average price is $125, calculate the elasticity over the price range from $120 to $130. The percentage change in the quantity demanded equals [(32  24)/28] × 100, which is 28.6 percent. The percentage change in the price equals [($130  $120)/$125] × 100, which is 8.0 percent. The elasticity of supply equals (28.6 percent/8.0 percent), which is 3.58.

c. Is the supply of jeans elastic, inelastic, or unit elastic?

The supply of jeans is elastic.

© 2018 Pearson Education, Inc.

62

CHAPTER 4

Answers to Additional Problems and Applications 10.

With higher fuel costs, airlines raised their average fare from 75¢ to $1.25 per passenger mile and the number of passenger miles decreased from 2.5 million a day to 1.5 million a day. a. What is the price elasticity of demand for air travel over this price range?

The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The quantity demanded changes by 1.0 million passenger miles and the average passenger miles is 2.0 million. The percentage change in the quantity demanded is (1.0 million)/(2.0 million)  100, which is 50 percent. The price changes by $0.50 and the average price is $1.00.

The percentage change in the quantity demanded is ($0.50 /($1.00)  100, which is 50 percent. So the price elasticity of demand is (50 percent)/(50 percent), or 1.00.

b. Describe the demand for air travel.

The demand for air travel between these two prices is unit elastic.

The 50 percent price hike leads to a 50 percent decrease in the quantity of air miles traveled.

11.

Figure 4.2 shows the demand for DVD rentals. a. Calculate the elasticity of demand when the price of a DVD rental rises from $3 to $5.

The price elasticity of demand is 2. When the price of a DVD rental rises from $3 to $5, the quantity demanded of DVDs decreases from 75 to 25 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price.

The price increases from $3 to $5, an increase of $2 a DVD. The average price is $4 per DVD. So the percentage change in the price equals $2 divided by $4 and then multiplied by 100, which equals 50 percent. The quantity decreases from 75 to 25 DVDs, a decrease of 50 DVDs. The average quantity is 50 DVDs. So the percentage change in quantity demanded equals 50 divided by 50 and then multiplied by 100, which equals 100 percent. The price elasticity of demand for DVD rentals equals 100 percent divided by 50 percent, which is 2.

© 2018 Pearson Education, Inc.

ELASTICITY63

b. At what price is the elasticity of demand for DVD rentals equal to 1?

The price elasticity of demand equals 1 at $3 a DVD. The price elasticity of demand equals 1 at the price halfway between the origin and the price at which the demand curve intersects the yaxis. That price is $3 a DVD.

Use the following table to work Problems 12 to 14.

The demand schedule for computer chips is in the table.

12. a. What happens to total revenue if the price falls from (i) $400 to $350 a chip and from (ii) $350 to $300 a chip?

Price (dollars per chip) 200

Quantity demanded (millions of chips per year) 50 45 40 35 30

(i) When the price of a chip is 250 $400, 30 million chips are sold and 300 total revenue equals $12,000 350 400 million. When the price of a chip falls to $350, 35 million chips are sold and total revenue is $12,250 million. The total revenue increases when the price falls. (ii) When the price is $350 a chip, 35 million chips are sold and total revenue is $12,250 million. When the price of a chip is $300, 40 million chips are sold and total revenue decreases to $12,000 million. The total revenue decreases as the price falls.

b. At what price is total revenue at a maximum?

Total revenue is maximized at $350 a chip. When the price of a chip is $300, 40 million chips are sold and total revenue equals $12,000 million. When the price is $350 a chip, 35 million chips are sold and total revenue equals $12,250 million. Total revenue increases when the price rises from $300 to $350 a chip. When the price is $400 a chip, 30 million chips are sold and total revenue equals $12,000 million. Total revenue decreases when the price rises from $350 to $400 a chip. Total revenue is maximized when the price is $350 a chip.

13.

At an average price of $350, is the demand for chips elastic, inelastic, or unit elastic? Use the total revenue test to answer this question.

The demand for chips is unit elastic. The total revenue test says that if the price changes and total revenue remains the same, the demand is unit elastic at the average price. For an average price of $350 a chip, cut the price from $400 to $300 a chip. When the price of a chip falls from $400 to $300, the total revenue remains at $12,000 million. So at the average price of $350 a chip, demand is unit elastic.

14.

At $250 a chip, is the demand for chips elastic or inelastic? Use the total revenue test to answer this question.

The demand for chips is inelastic. The total revenue test says that if the price falls and total revenue falls, the demand is inelastic.

When the price falls from $300 to $200 a chip, total revenue decreases from $12,000 million to $10,000 million. So at an average price of $250 a chip, demand is inelastic. © 2018 Pearson Education, Inc.

64

15.

CHAPTER 4

Your price elasticity of demand for bananas is 4. If the price of bananas rises by 5 percent, what is a. The percentage change in the quantity of bananas you buy?

The quantity of bananas you buy decreases by 20 percent. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. Rearranging this formula shows that the percentage change in the quantity demanded equals the price elasticity of demand multiplied by the percentage change in the price. The percentage change in the quantity demanded equals 4  5 percent, which is 20 percent.

b. The change in your expenditure on bananas?

Your total expenditure decreases because your demand is elastic. The fall in expenditure is approximately 15 percent, the 5 percent rise in price offset by the 20 percent decrease in the quantity purchased.

16.

Memorial Day Gas Cheapest in a Decade Gasoline prices are at their lowest in a decade. The average price in Orangeburg is $2.05 a gallon, 35¢ lower than last year. In a recent AAA survey, 55 percent of Americans said they are more likely to take a road trip this year due to lower gas prices. About 1.5 million Carolinians are expected to drive to their Memorial Day destinations, up 2.1 percent over last year.

Source: The Times and Democrat, May 27, 2016 a. What are the elasticities of demand implicitly referred to in the news clip.

The elasticity of demand that the article references is the price elasticity of demand. The article mentions how drivers respond to the fall in the price of gasoline by increasing the quantity of their road trips.

b. Calculate the price elasticity of demand for road trips using the data in the news clip.

The price elasticity of demand for road trips equals the percentage change in the quantity demanded, 2.1 percent, divided by the percentage change in the price of gasoline. The average price fell 35¢ from $2.40 to $2.05, which makes the average price $2.23. So the percentage change in the price is (0.35/2.23) × 100 or 15.7 percent.

Consequently the price elasticity of demand for road trips equals (2.1 percent/15.7 percent) or 0.13.

Use this information to work Problems 17 and 18.

Public Transit Ridership Is Down Public transit ridership was down in 2016 in most U.S. cities. Uber rides increased and gas prices fell. In some cities, transit service became unreliable.

Source: WBUR, March 21, 2017 17.

List and explain the elasticities of demand implicitly referred to in the news clip.

The article implicitly refers to two cross elasticities of demand: The cross elasticity of demand for transit rides with respect to the price of gasoline and the cross elasticity of demand for Uber rides with respect to the price of gasoline.

© 2018 Pearson Education, Inc.

ELASTICITY65

18.

Are transit tickets, Uber rides, and gasoline substitutes? Explain your answer.

Transit tickets and gasoline are substitutes. As the price of gasoline fell, the demand for transit tickets decreased, so the cross elasticity of demand is positive. Uber rides and gasoline are complements because as the price of gasoline fell, the demand for Uber rides increased, so the cross elasticity of demand is negative.

When Alex‘s income was $3,000, he bought 4 bagels and 12 donuts a month. Now his income is $5,000 and he buys 8 bagels and 6 donuts a month. Calculate Alex‘s income elasticity of demand for (a) bagels and (b) donuts.

19.

20.

a.

The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $2,000 and the average income is $4,000, so the percentage change in income equals 50 percent. The change in the quantity demanded is 4 bagels and the average quantity demanded is 6 bagels, so the percentage change in the quantity demanded equals 66.67 percent. The income elasticity of demand for bagels equals (66.67 percent)/(50 percent), which is 1.33.

b.

From part (a), the percentage change in income is 50 percent. The change in the quantity demanded is −6 donuts and the average quantity demanded is 9 donuts, so the percentage change in the quantity demanded is −66.67 percent. The income elasticity of demand for donuts equals (−66.67 percent)/(50 percent), which is −1.33.

How Much Does an American Wedding Cost?

A survey by The Knot reports the national average cost of a wedding, excluding the honeymoon, was $35,329 in 2016, up from $32,641 in 2015 and $31,213 in 2014. Incomes rose every year.

Source: The Motley Fool, February 20, 2017 a. Do the data imply that a wedding event is a normal good or an inferior good? Explain.

Based on the news clip, wedding events are a normal good. As incomes increased, the demand for wedding events also increased.

b. Is a wedding event more a necessity or a luxury? Would the income elasticity of demand be greater than 1, less than 1, or equal to 1? Explain your answer.

Wedding events are a luxury. Wedding events are not necessities because couples can marry with plain weddings; indeed, couples can marry using a civil ceremony and with no wedding event at all. If wedding events are a luxury, their income elasticity of demand is greater than 1.

21.

Pet Care is a True Recession-Proof Industry Two out of three Americans own a pet—almost half own a dog and a third a cat—and pet ownership is projected to grow. Households have spent more on pets every year through recessions and booms, growing from $17 billion in 1994 to near $63 billion in 2016. People are clearly willing to pay pet expenses even in hard times, and there‘s no reason to expect that to change in the next recession.

Source: Business Insider, January 28, 2017 a. What does this news clip imply about the income elasticity of demand for pet food and pet care products?

The news clip implies that both pet food and pet care products are necessities. Their income elasticities of demand are positive but © 2018 Pearson Education, Inc.

66

CHAPTER 4

very small (since they are a ―true recession-proof industry‖).

b. Would the income elasticity of demand for pet food and pet care products be greater or less than 1? Explain.

The income elasticities of demand are less than 1 because they are necessities.

22.

If a 5 percent fall in the price of chocolate sauce increases the quantity demanded of chocolate sauce by 10 percent and increases the quantity of ice cream demanded by 15 percent, calculate the: a. Price elasticity of demand for chocolate sauce.

The price elasticity of demand for chocolate sauce equals the percentage change in the quantity of chocolate sauce demanded divided by the percentage change in the price of chocolate sauce.

Using the data in the problem, the price elasticity of demand equals (10 percent)/(−5 percent), which is 2.0.

b. Cross elasticity of demand for ice cream with respect to the price of chocolate sauce.

The cross elasticity of demand for ice cream with respect to the price of chocolate sauce equals the percentage change in the quantity of ice cream demanded divided by the percentage change in the price of chocolate sauce. Using the data in the problem, the cross elasticity of demand equals (15 percent)/(−5 percent), which is −3.0. Ice cream and chocolate sauce are complements.

23.

The table sets out the supply schedule of longdistance phone calls. Calculate the elasticity of supply when a. The price falls from 40¢ to 30¢ a minute.

Price (cents per minute)

Quantity supplied (millions of minutes per day) 200 400 600 800

The elasticity of supply is 1.

The elasticity of supply is the 10 percentage change in the quantity 20 supplied divided by the 30 percentage change in the price.

40 When the price falls from 40 cents to 30 cents, the change in the price is 10 cents and the average price is 35 cents. The percentage change in the price is 28.57 percent. When the price falls from 40 cents to 30 cents, the quantity supplied decreases from 800 to 600 calls. The change in the quantity supplied is 200 calls, and the average quantity is 700 calls, so the percentage change in the quantity supplied is 28.57 percent. The elasticity of supply equals (28.57 percent)/(28.57 percent), which is 1.

b. The average price is 20¢ a minute.

The elasticity of supply is 1. The formula for the elasticity of supply calculates the elasticity at the average price. So to find the elasticity at an average price of 20 cents a minute, change the price such that 20 cents is the average price—for example, a fall in the price from 30 cents to 10 cents a minute. When the price falls from 30 cents to 10 cents, the change in the price is 20 cents and the average price is 20 cents. The percentage change in the price is © 2018 Pearson Education, Inc.

ELASTICITY67

100 percent. When the price falls from 30 cents to 10 cents, the quantity supplied decreases from 600 to 200 calls. The change in the quantity supplied is 400 calls and the average quantity is 400 calls. The percentage change in the quantity supplied is 100 percent. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. The elasticity of supply is 1.

24.

Coal Production and Coal Price Down U.S. coal production in 2016 is 17 percent down on that of 2015. Almost all coal use in the United States is for electricity generation and the price of coal for power plants fell from $2.27 per million Btu in 2015 to $2.17 per million Btu in 2016.

Source: Hellenic Shipping News, January 10, 2017 Calculate the price elasticity of supply of coal assuming no change in the supply of coal. Is the supply of coal elastic or inelastic?

The price elasticity of supply of coal equals the percentage change in the quantity of coal supplied divided by the percentage change in the price of coal. The data in the problem gives the percentage change in the quantity supplied as −17 percent. The change in the price is $0.10 and the average price is $2.22, so the percentage change in the price equals ($0.10/$2.22) × 100, or 4.5 percent.

Consequently, the price elasticity of supply equals (–17 percent)/( – 4.5 percent), which is 3.78. The elasticity exceeds 1.0 in value, so the supply of coal is elastic.

Economics in the News 25.

After you have studied Economics in the News on pp. 102–103, answer the following questions. a. Use the information in the news article to estimate the cross elasticity of demand for water with respect to the price of sugar-sweetened drinks.

The cross elasticity of demand for water with respect to the price of sugar-sweetened drinks equals the percentage change in the demand for water divided by the percentage change in the price of sugarsweetened drinks. The article notes that the demand for water increased by 63 percent and the analysis after the article calculated that the price of sugar-sweetened drinks rose by ($0.14/$1.82) × 100, or 7.7 percent. So, the cross elasticity of demand for water with respect to the price of sugar-sweetened drinks equals (63 percent/7.7 percent) or 8.2.

b. How does the total revenue test work for a rise in price? What do you predict happened to total revenue from sugar-sweetened drinks when the tax was imposed on them? Why? The total revenue test concludes that when the price rises, the total revenue decreases if demand is elastic, does not change if demand is unit elastic, and increases if demand is inelastic. The analysis of the article demonstrated that the demand for the sugarsweetened drinks is elastic, so the total revenue from sugarsweetened drinks decreased.

© 2018 Pearson Education, Inc.

68

CHAPTER 4

c. Would you expect the elasticity of demand for Coke, or Gatorade, or Red Bull, or Hawaiian Punch to be the same as the elasticity of demand for sugar-sweetened drinks? Explain why or why not.

The price elasticity of demand for the several drinks named is larger than the price elasticity of demand for sugar-sweetened drinks. The drinks are a narrowly defined good, so they have many close substitutes such as Pepsi, Powerade, Rockstar, and Tropicana Twister. Sugar-sweetened drinks is a more broadly defined product, so it has fewer close substitutes.

26.

Comcast Is Planning a Netflix Rival Comcast plans to compete with Netflix and CBS by offering an online video service featuring hit shows from its NBC Universal TV networks.

Source: Bloomberg, April 11, 2017 a. How will Comcast‘s entry into the online video service market influence the demand for Netflix‘s service?

Comcast’s entry will provide consumers with an alternative (a substitute) for Netflix’s online service and so it will decrease the demand for Netflix’s service.

b. Given your answer to part (a), explain why Netflix might lower its price.

With the lower demand for its service, Netflix might lower its price to limit the number of customers it loses.

c. What can you say about the effect of Comcast‘s entry on the price elasticity of demand for Netflix online movie viewing?

Comcast’s entry into the online video service market increases the number of substitutes for Netflix’s online service. Accordingly, it increases the price elasticity of demand for Netflix’s online video service.

27.

Saudi Arabia Oil Revenues Shrink As the price of oil fell from $99 a barrel in September 2014 to $53 a barrel by September 2015, Saudi Arabia‘s oil revenues fell by 23 percent, compared with its 2014 oil revenues of 444.5 billion riyals.

Source: News.markets, December 29, 2015 a. How can you use the information in the news clip to determine whether the demand for oil is elastic or inelastic?

The total revenue test reveals that the demand for oil from Saudi Arabia is inelastic. The total revenue test concludes that if the demand is inelastic and the price falls, then the total revenue decreases, which is exactly what occurred.

b. How can you use the information in the news clip to estimate the magnitude of the price elasticity of demand for oil?

The price of oil fell from $99 answer to part a barrel to $53 a barrel. Consequently the average price is ($99 + $53)/2, or $76.

Therefore the percentage decrease in the price of oil is [($99 − $53/$76] x 100, or 61 percent.

The percentage change in total revenue is equal to the percentage change in price plus the percentage change in quantity. Total revenue decreased by 23 percent and the price fell by 61 percent. © 2018 Pearson Education, Inc.

ELASTICITY69

Accordingly, the percentage increase in the quantity demanded is 61 percent − 23 percent, which is 38 percent.

The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in price, so a point estimate of the price elasticity of demand is 38 percent/61 percent = 0.62. This estimate makes it likely that the price elasticity of demand falls in a range from 0.70 to 0.50.

C h a p t e r

c. Does the news article tell us whether the supply of oil is elastic or inelastic? Explain.

The article does not allow us to determine the price elasticity of supply because it does not suggest that the demand for oil changed.

Consequently we do not have information about how the quantity supplied changed when the price changed.

Answers to the Review Quizzes Page 111 1.

Why do we need methods of allocating scarce resources?

5

EFFICIENCY AND EQUITY

Because resources are scare, it is not possible to fulfill everyone’s wants. As a result, some method of deciding which wants will be fulfilled and which will not—that is, some method of allocating resources—must be utilized.

© 2018 Pearson Education, Inc.

66

2.

CHAPTER 5

Describe the alternative methods of allocating scarce resources.

Resources can be allocated using:  Market price: People who are willing and able to pay the price get the resource.  Command: Someone in command decides who gets the resource.  Majority rule: The majority vote decides how resources are allocated.  Contest: Winners receive the resource.  First-come, first-served: People first in line get the resource.  Lottery: Randomly selected winners receive the resource.  Personal characteristics: People with the ―right‖ characteristics get the resource.  Force: The stronger person or group gets the resource.

3.

Provide an example of each allocation method that illustrates when it works well.

Below are examples of when each allocation scheme works well:  Market price: Generally works well in competitive markets and for most goods and services. An example is the allocation of cat food.  Command: Generally works well in organizations where lines of authority are clear and it is easy to monitor subordinates. An example is in a fast food restaurant when the supervisor tells a worker to clean the tables.  Majority rule: Generally works well when large numbers of people are affected by the allocation. An example is an election in which people vote whether or not to support a tax to build more parks.  Contest: Generally works well when the efforts of the participates are hard to monitor. An example is the contest run by Pfizer in which three top managers competed to see who would be appointed CEO.  First-come, first-served: Generally works well when a resource can be used by only one user at a time. An example is a line at a movie ticket booth.  Lottery: Generally works well when there is no way to easily distinguish which user of a resource would use it most effectively. An example is the lottery used to allocate cell phone frequencies.  Personal characteristics: Generally works well when resource use is such that different people consume the same resources. An example is the decision whom to marry.  Force: Generally works well when used to uphold the rule of law. An example is the state imprisoning thieves and thereby preventing resource allocation by the thief stealing the resource.

© 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY67

4.

Provide an example of each allocation method that illustrates when it works badly.

Below are examples of when each allocation scheme would work poorly:  Market price: Deciding court cases on the basis of who will pay the most for the decision.  Command: Running an economy.  Majority rule: Deciding how many acres of wheat to plant.  Contest: Allocating food in a winner-take-all contest.  First-come, first-served: Admitting students to college based on who applied first.  Lottery: Assigning grades based on random chance.  Personal characteristics: Renting only to married couples.  Force: Stealing by threat of physical harm.

Page 115 1.

What is the relationship between the marginal benefit, value, and demand?

The value of one more unit of a good is its marginal benefit. The marginal benefit of a good or service is measured by the maximum amount that consumers are willing to pay for one more unit of a good or service. The demand curve shows the maximum consumers are willing to pay for each additional unit, so the demand curve is the same as the marginal benefit curve.

2.

What is the relationship between individual demand and market demand?

The market demand equals the sum of the individual quantities demanded by all the demanders at each price. Therefore the market demand curve equals the horizontal sum of the individual demand curves.

3.

What is consumer surplus? How is it measured?

Consumer surplus is the excess of the benefit received from a good over the amount paid for it. The total consumer surplus is the sum of the consumer surpluses on all the units purchased. It is measured as the area under the demand curve and above the price.

4.

What is the relationship between the marginal cost, minimum supply-price, and supply?

The marginal cost is the cost of producing an additional unit of a good. The marginal cost is the minimum price that producers must receive to induce them to offer one more unit of a good or service for sale. This minimum supply-price determines the supply of the good, so the supply curve is the same as the marginal cost curve.

5.

What is the relationship between individual supply and market supply?

The market supply equals the sum of the individual quantities supplied by all the producers at each price. The market supply curve is equal to the horizontal sum of all the individual supply curves.

© 2018 Pearson Education, Inc.

68

6.

CHAPTER 5

What is producer surplus? How is it measured?

Producer surplus is the excess of the amount received from the sale of a good or service over the cost of producing it. The producer surplus is measured as the area under the price and above the supply curve over the entire quantity sold.

Page 119 1.

Do competitive markets use resources efficiently? Explain why or why not.

In the absence of the obstacles mentioned earlier in the chapter, competitive markets use society’s resources efficiently. For resources to be used efficiently they must be allocated to produce the quantity of a good or service where the marginal cost of the last unit produced in the market is equal to the marginal benefit.

This condition will be met in a competitive market because the quantity occurs where the demand curve (which equals the marginal social benefit curve) intersects the supply curve (which equals the marginal social cost curve).

2.

What is deadweight loss and under what conditions does it occur?

The deadweight loss is the decrease in total surplus that results from an inefficient level of production. This is the decrease in consumer surplus plus the decrease in producer surplus that occurs when the market either overproduces or underproduces relative to the efficient quantity.

3.

What are the obstacles to achieving an efficient allocation of resources in the market economy?

Markets with price or quantity regulations, taxes or subsidies, externalities, public goods or common resources, monopoly power, or high transactions costs will not produce the efficient quantity of a good or service. In each of these situations, the market prices charged or quantities produced and sold will not result in the efficient allocation of resources. Efficiency requires that the marginal social benefit of the last unit produced be equal to the marginal social cost. The equilibrium at the intersection of the demand and supply curves in the competitive market creates this result. When the market price or quantity is pulled away from the market equilibrium, the marginal social benefit of the last unit produced does not equal its marginal social cost.

Page 123 1.

What are the two big approaches to thinking about fairness?

The two big approaches to thinking about fairness are:  ―It’s not fair if the result isn’t fair,‖ or utilitarianism.  ―It’s not fair if the rules aren’t fair,‖ or equality of opportunity.

© 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY69

2.

What is the utilitarian idea of fairness and what is wrong with it?

The utilitarian idea of fairness implies that equality of incomes is necessary for the allocation of resources to be ―fair.‖ There should be income transfers from the rich to the poor until equality is achieved, because the marginal benefit of the last dollar of income is the same for everybody. There are two problem with utilitarianism:  It ignores the cost of implementing the income transfers, which will decrease the total goods and services that the finite resources of society can produce. The size of the economic pie will be smaller.  It ignores the Big Tradeoff, the tradeoff between efficiency and fairness. Taxing people’s incomes makes them work less, which decreases the size of the economic pie and thereby diminishes the total amount that can be transferred to the poor.

3.

Explain the big tradeoff. What idea of fairness has been developed to deal with it?

The big tradeoff is the tradeoff between efficiency and fairness.

Redistributing incomes changes the incentives facing producers and consumers. Taxing income decreases producer surplus and taxing purchases decreases consumer surplus. Producers produce less and consumers consume less, and total economic activity declines, such that the size of the economic pie decreases. The big tradeoff has led to the idea that the fairest distribution is that which makes the poorest person as well off as possible.

4.

What is the idea of fairness based on fair rules?

The fair rules idea of fairness is that of providing equality of opportunity is necessary for the allocation of resources to be ―fair.‖ This is the economic application of the symmetry principle, that people in similar situations be treated similarly. Equality of opportunity can be achieved if two rules are obeyed:  The government must enforce laws that establish and protect rights to private property that are held by individuals in society, and  Private property may be transferred from one person to another only by voluntary exchange and without fraudulent representation.

© 2018 Pearson Education, Inc.

70

CHAPTER 5

Answers to the Study Plan Problems and Applications At Chez Panisse, a restaurant in Berkeley, reservations are essential. At Aladdin‘s Cave, a restaurant near the University of California San Diego, reservations are recommended. At Eli Cannon‘s, a restaurant in Middletown, Connecticut, reservations are not accepted.

Describe the method of allocating scarce table resources at these three restaurants. Why do you think restaurants don‘t use the market price to allocate their tables?

All these restaurants use a first-come, first-serve system. Eli Cannon’s uses this system directly. Chez Panisse uses a first-come, first-serve system because the first person to call to make a reservation at a particular time is allocated the table at that time. Aladdin’s cave uses a combination of the immediate firstcome, first-serve system and the reservation based first-come, first-serve system.

Market allocation requires that customers pay for a table and the price would fluctuate from one hour to the next depending on the number of customers who arrive. Customers would be highly uncertain about the price they would need to pay and such uncertainty decreases the demand for meals from the restaurant. The decreased demand lowers the restaurant’s profit.

Use the following table to work Problems 2 to 4.

The table gives the demand Price schedules for train travel for the (dollar only buyers in the market, Ann, s per mile) Beth, and Cy. 3 2. a. Construct the market 4 demand schedule.

5 The market 6 demand schedule 7 shows the sum of 8 the quantities 9 demanded by Ann,

Quantity demanded (miles) Ann Beth

Cy

30 25 20 15 10 5 0

20 15 10 5 0 0 0

25 20 15 10 5 0 0

Beth, and Cy at each price. When the price is $3 per mile, the market quantity demanded is 75 miles; when the price is $4 per mile, the market quantity demanded is 60 miles; when the price is $5 per mile, the marker quantity demanded is 45 miles; when the price is $6 per mile, the market quantity demanded is 30 miles; when the price is $7 per mile, the market quantity demanded is 15 miles; when the price is $8 per mile, the market quantity demanded is 5 miles; and when the price is $9 per mile, the market quantity demanded is 0 miles.

b. What is the maximum price that each traveler, Ann, Beth, and Cy, is willing to pay to travel 20 miles? Why? Each person’s demand schedule shows the maximum price that person is willing to pay to travel 20 miles. The maximum price Ann is willing to pay to travel 20 miles is $5 per mile, the maximum price Beth is willing to pay is $4 per mile, and the maximum price Cy is willing to pay is $3 per mile. © 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY71

3. a. What is the marginal social benefit when the total distance travelled is 60 miles?

The marginal social benefit when the quantity is 60 miles is $4 per mile. The marginal social benefit is determined from the consumers’ demand schedules and equals the maximum price that consumers will pay for the quantity. The demand schedule shows that the maximum price consumers will pay for 60 miles is $4 per mile and this price equals the marginal social benefit.

b. When the total distance traveled is 60 miles, how many miles does each travel and what is their marginal private benefit?

The three travel a total distance of 60 miles when the price is $4 a mile. Each person’s marginal benefit is $4 per mile. At this price Ann travels 25 miles, Beth travels 20 miles, and Cy travels 15 miles.

4. a. What is each traveler‘s consumer surplus when the price is $4 a mile? What is the market consumer surplus when the price is $4 a mile?

Ann’s consumer surplus is $62.50; Beth’s consumer surplus is $40.00; and, Cy’s consumer surplus is $22.50.

When the price is $4 per mile, Ann buys 25 miles. Ann’s consumer surplus is the triangular area under her demand curve and above the price. The demand curve is linear, so Ann’s consumer surplus is 1/2  ($9  $4)  25, which equals $62.50.

When the price is $4 per mile, Beth buys 20 miles. Beth’s consumer surplus is the triangular area under her demand curve and above the price. The demand curve is linear, so Beth’s consumer surplus is 1/2  ($8  $4)  20, which equals $40.00 When the price is $4 per mile, Cy buys 15 miles. Cy’s consumer surplus is the triangular area under his demand curve and above the price. The demand curve is linear, so Cy’s consumer surplus is 1/2  ($7  $4)  15, which equals $22.50.

The market consumer surplus is the sum of Ann’s consumer surplus, Beth’s consumer surplus, and Cy’s consumer surplus, or $125.00.

Use the following table to work Problems 5 to 7.

The table gives the supply schedules Price of hot air balloon rides for the only (dollar sellers in the market, Xavier, s per Yasmin, and Zack. ride) 100 5. a. Construct the market supply 90 schedule.

80 The market supply 70 schedule shows the 60 sum of the 50 quantities supplied 40

by Xavier, Yasmin,

Quantity supplied (rides per week) Xavier Yasmin Zack 30 25 20 15 10 5 0

25 20 15 10 5 0 0

20 15 10 5 0 0 0

and Zack at each price. When the price is $100 per ride, the market quantity supplied is 75 rides; when the price is $90 per ride, the market quantity supplied is 60 rides; when the price is $80 per ride, the © 2018 Pearson Education, Inc.

72

CHAPTER 5

market quantity supplied is 45 rides; when the price is $70 per ride, the market quantity supplied is 30 rides; when the price is $60 per ride, the market quantity supplied is 15 rides; when the price is $50 per ride, the market quantity supplied is 5 rides; and when the price is $40 per ride, the market quantity supplied is 0 rides.

b. What are the minimum prices that Xavier, Yasmin, and Zack are willing to accept to supply 20 rides? Why? The minimum supply-price equals the lowest price at which a producer is willing to produce the given quantity. The supply schedule tells us the minimum supply-price. Xavier’s minimum supply-price for 20 rides is $80; Yasmin’s minimum supply-price is $90; and, Zack’s minimum supply-price is $100.

6. a. What is the marginal social cost when the total number of rides is 30?

The quantity of rides supplied is 30 when the price is $70 per ride. The marginal social cost of any quantity is equal to the price for which that quantity will be supplied, so when the total number of rides is 30, the marginal social cost equals $70 per ride.

b. What is the marginal cost for each supplier when the total number of rides is 30 and how many rides does each of the firms supply?

When the total number of rides is 30, Xavier supplies 15 rides, Yasmin supplies 10 rides, and Zack supplies 5 rides. The marginal cost for each firm is $70.

7.

When the price is $70 a ride, what is each firm‘s producer surplus? What is the market producer surplus?

Xavier’s producer surplus is $225; Yasmin’s is $100; and, Zack’s is $25.

When the price is $70 per ride, Xavier supplies 15 rides. Xavier’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Xavier’s producer surplus is 1/2  ($70  $40)  15, which equals $225.

When the price is $70 per ride, Yasmin supplies 10 rides. Yasmin’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Yasmin’s producer surplus is 1/2  ($70  $50)  10, which equals $100.

When the price is $70 per ride, Zack supplies 5 rides. Zack’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Zack’s producer surplus is 1/2  ($70  $60)  5, which equals $25.

The market producer surplus is equal to the sum of Xavier’s producer surplus, Yasmin’s producer surplus, and Zack’s producer surplus, which is $225 + $100 + $25 or $350.

8.

The figure shows the competitive market for © 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY73

smartphones. a. What is the market equilibrium?

The equilibrium price is $30 per smartphone and the equilibrium quantity is 100 smartphones per month.

b. Shade in the consumer surplus and label it.

In Figure 5.2 the consumer surplus is the shaded area A.

c. Shade in the producer surplus and label it.

In Figure 5.2 the producer surplus is the shaded area B.

d. Calculate total surplus.

The total surplus is equal to the sum of the consumer surplus plus the producer surplus, or the triangle with area A + area B. The amount of the total surplus equals ½ × ($60 per smartphone − $15 per smartphone) × 100 smartphones, which is $2,250.

e. Is the competitive market forsmartphones efficient?

The equilibrium quantity of smartphones is 100 smartphones per month because this is the quantity at which the demand and supply curves intersect. The demand curve is the marginal social benefit curve and the supply curve is the marginal social cost curve. Therefore the efficient quantity of smartphones is 100 cell phones per month because this is the quantity at which these two curves intersect. This competitive market is efficient because the equilibrium quantity equals the efficient quantity.

9.

Explain why the allocation method used by each restaurant in Problem 1 is fair or not fair.

According to the ―fair rules‖ approach, all of the methods are fair because everyone faces the same rules and therefore the same chance of obtaining a table. According to the ―fair results‖ approach, none of the methods are fair because in each case some people get a table and others do not.

10.

In the Worked Problem (p. 126), how can the 50 bottles available be allocated to beach-goers?

Would the possible methods be fair or unfair?

The 50 bottles could be allocated by market price (the price would be $15, the price that allocates the 50 bottles among the buyers), by command (someone, perhaps the beach patrol, declares who gets © 2018 Pearson Education, Inc.

74

CHAPTER 5

the bottles), by majority rule (beach goers vote to determine who gets the bottles), by a contest (the winners of a beach volleyball game receive the bottles), by first-come, first-served, by a lottery, by personal characteristics (perhaps light-skinned people get the bottles), and by force. None of the methods are fair by the ―results‖ view of fairness unless the personal characteristics method use income, with poorer people getting the bottles. The market exchange method is the only fair method under the ―rules‖ view of fairness.

© 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY75

Answers to Additional Problems and Applications 11.

At McDonald‘s, no reservations are accepted; at Panorama at the St. Louis Art Museum, reservations are accepted; at the Bissell Mansion restaurant, reservations are essential.

Describe the method of allocating tables in these three restaurants. Why do restaurants have different reservation policies?

All these restaurants use a first-come, first-serve system.

McDonald’s uses this system directly. Bissell Mansion uses a firstcome, first-serve because the first person to call to make a reservation at a particular time is allocated the table at that time. Puck’s uses a combination of the immediate first-come, firstserve system and the reservation based first-come, first-serve system.

The speed with which tables turn over at the different restaurants probably is quite different and the customers probably have quite different values of time. Bissell Mansion has a low turnover rate— only 1 or 2 groups of customers can use a table each night—and its customers have a high value of time. If Bissell Mansion refused to take reservations, its customers would need to wait an inefficiently long time and would go elsewhere so that Bissell Mansion profits would be lower. At McDonald’s, the tables have a high turnover rate (indeed, many customers do not use the tables at all, buying their food to go) and the customers have a lower value of time. Allowing reservations would be costly for McDonald’s and would spare its customers only a slight wait at most so that allowing reservations would decrease McDonald’s profits. At Puck’s, the turnover rate of the tables is between that at Bissell Mansion and McDonald’s, so it uses a combination of phone reservation first-come, first-serve and appear in person first-come, firstserve.

Use the following table to work Problems 12 to 15.

The table gives the supply schedules Price for jet-ski rides by the only suppliers: (dollars Rick, Sam, and Tom. per 12. What is each owner‘s minimum ride) supply-price of 10 rides a day?

10.00 Rick’s minimum 12.50 supply- price for 10 15.00 rides is $15.00, 17.50 Sam’s minimum supply20.00

Quantity supplied (rides per week) Rick Sam Tom 0 5 10 15 20

0 0 5 10 15

0 0 0 5 10

price is $17.50, and Tom’s minimum supply-price is $20.00.

13.

Which owner has the largest producer surplus when the price of a ride is $17.50? Explain.

Rick has the largest producer surplus when the price is $17.50.

Rick’s producer surplus is largest because he produces the largest quantity and his costs are lower than those of the other producers.

More formally, each supplier’s producer surplus is equal to the area under the price and above that producer’s supply curve. © 2018 Pearson Education, Inc.

76

CHAPTER 5

Calculating these areas of producer surplus, Rick’s producer surplus is $56.25, Sam’s producer surplus is $25.00, and Tom’s producer surplus is $6.25.

14.

What is the marginal social cost of 45 rides a day?

45 rides are produced when the price is $20.00, so the marginal social cost of producing 45 rides a day is $20.00.

15.

Construct the market supply schedule of jet-ski rides.

When the price is $10.00, the quantity of rides supplied is 0; when the price is $12.50, the quantity supplied is 5 rides; when the price is $15.00, the quantity supplied is 15; when the price is $17.50, the quantity supplied is 30; and, when the price is $20, the quantity supplied is 45.

16.

The table gives the demand and supply schedules for sandwiches. a. What is the maximum price that consumers are willing to pay for the 200th sandwich?

The demand schedule shows the maximum price that consumers will pay for each sandwich. The maximum price consumers will pay for the 200th sandwich is $2.

Price (dollars per sandwich) 0 1 2 3 4 5 6

b. What is the minimum price that producers are willing to accept for the 200th sandwich?

Quantit Quantity y supplied demande d (sandwiches per hour) 300 0 250 50 200 100 150 150 100 200 50 250 0 300

The supply schedule shows the minimum price that producers will accept for each sandwich. The minimum price that producers are willing to accept for the 200th sandwich is $4.

c. If 200 sandwiches a day are available, what is the total surplus?

200 sandwiches a day are more than the efficient quantity because the marginal social benefit (the maximum price consumers will pay) is less than the marginal social cost (the minimum price suppliers will accept). Because production is inefficient, there is a deadweight loss, equal to the sum of the consumer surplus and producer surplus lost because the quantity produced is not the efficient quantity. The deadweight loss equals the quantity (200  150) multiplied by ($4  $2)/2, which is $50. This deadweight loss must be subtracted from the surplus that would be obtained if the market was efficient to calculate the total surplus when 200 sandwiches are produced. When the market produces the efficient quantity, 150 sandwiches are produced. The total surplus at this efficient quantity equals the area of the triangle under the demand curve and above the supply curve to the quantity of 150. This area is ½  ($6  $0)  150, which is $450. So the total surplus when 200 sandwiches are produced equals $450  $50, which is $400. © 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY77

17.

Warm February Gives Minnesotans a Break on Heating Bills When John Wicks opened his natural gas bill for January he was very happy. It was $147, not the usual $300 for the coldest month. Natural gas provider CenterPoint Energy said higher temperatures had lowered the annual bill for the average Minnesota customer by $300 compared with two years ago.

Source: CBC News, March 1, 2017 a. How is the price of natural gas determined?

The price of natural gas is determined in the market for natural gas by demand and supply.

b. When demand decreases, explain the process by which the market adjusts.

When demand decreases, at the initial equilibrium price there is a surplus. The surplus forces the price to fall. As the price falls, the quantity demanded increases and the quantity supplied decreases. The price continues to fall until the quantity demanded equals the quantity supplied. That price is the new equilibrium price. Once that price is reached, there are no further changes.

© 2018 Pearson Education, Inc.

78

CHAPTER 5

c. On a graph, show the effect of the decrease in demand on consumer surplus and producer surplus.

Figure 5.3a shows the in consumer surplus (labeled A) and producer surplus (labeled B). After the decrease in demand, Figure 5.3b shows the new consumer surplus (again labeled A) and the new producer surplus (again labeled B).

18.

Use the data in the table in Problem 16. a. If the sandwich market is efficient, what is the consumer surplus, what is the producer surplus, and what is the total surplus?

150 sandwiches is the efficient quantity and the equilibrium price is $3. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the consumer surplus triangle is ½  ($6  $3)  150, which is $225. The producer surplus is the area of the triangle above the supply curve below the price. The price is $3 and the quantity is 150. The area of the triangle is 1/2  ($3  $0)  150, which is $225. The total surplus is the sum of the consumer surplus plus the producer surplus, which is $450.

b. If the demand for sandwiches increases and sandwich makers produce the efficient quantity, what happens to producer surplus and deadweight loss?

If the demand for sandwiches increases, the price and quantity of sandwiches both rise. The producer surplus definitely increases.

There is no deadweight loss because sandwich makers are producing the efficient quantity.

Use the following news clip to work Problems 19 to 21.

Music’s Value in the Internet Age The price of streaming services has been $10 a month or zero. Amazon and Pandora Media are poised to change the streaming scene. Pandora is a streaming Internet radio service, and its new $5 © 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY79

version will be more like Spotify and Apple Music, which let users create their own playlists.

Amazon, which offers limited on-demand music for $99 a year, is expected to expand its catalog and offer it for $10 a month or $5 a month for customers who use the Echo, Amazon‘s voice-activated speaker system.

Source: The New York Times, September 11, 2016 Assume that the marginal social cost of streaming is zero. (This assumption means that the cost of operating a streaming service doesn‘t change if more people stream more songs.)

19. a. Draw a graph of the market for streaming music with a price of $10 a month. On your graph, show consumer surplus and producer surplus.

Figure 5.4 shows this market.

The marginal social cost curve runs along the horizontal axis.

The consumer surplus is area A and the producer surplus is area B.

b. With a price of $10 a month, is the market efficient or inefficient? If it is inefficient, show the deadweight loss on your graph.

The market is inefficient.

Efficiency requires that the amount be the quantity for which the marginal social benefit equals the marginal social cost, which in this case is the quantity at which the marginal social benefit curve intersects the horizontal axis. The deadweight loss is area C in Figure 5.4.

20.

If the $5 price described in the news clip were adopted, how would consumer surplus, producer surplus, and the deadweight loss change?

The consumer surplus increases. If the demand for streaming is inelastic, then the producer surplus decreases; if the demand is elastic, then the producer surplus increases. Unambiguously the deadweight loss decreases.

21. a. If the $5 price described in the news clip were adopted, would the market be efficient or inefficient? Explain.

The market remains inefficient because the marginal social benefit still does not equal the marginal social cost. The inefficiency is less if the price is $5 per month than $10 because, as the answer to question 20 noted, the deadweight loss is less, but the market is still inefficient.

© 2018 Pearson Education, Inc.

80

CHAPTER 5

b. Is the $5 price described in the news clip a competitive market price? Explain.

With a pure competitive -market price, the price is determined by supply and demand and would be $0. The $5 price is not a competitive market price.

22.

Only 1 percent of the world supply of water is fit for human consumption. Some places have more water than they can use; some could use much more than they have. The 1 percent available would be sufficient if only it were in the right place. a. What is the major problem in achieving an efficient use of the world‘s water?

Water needs to be transported from where it is available to where it is needed. This basic issue leads to two major problems: Overproduction in some areas and underproduction in other areas.

Often overproduction in an area leads to underproduction later in the same area. In particular, markets in water are not competitive.

In many areas, water is ―free‖ to whoever digs a deep enough well.

As a result, too many people dig wells and water is overproduced.

If the overproduction is bad enough, the level of groundwater can be reduced so far that it becomes literally impossible to extract any water. Then water needs to be transported to the now arid area.

In this case, often the government transports the water and sells it at a very low price or gives it away. But because the government does not sell the water at an equilibrium price (and because the government is not motivated by seeking profit) less water is transported than the efficient quantity.

b. If there were a global market in water, like there is in oil, how do you think the market would be organized?

The market for water would be more efficient than the current situation. Areas with a great deal of water, say Canada, could export water to areas with less water, say Mexico. If water was purchased and sold in markets, there would be greater incentive to build desalination plants where they are practical as well as greater incentive to conserve water where it is in abundance.

c. Would a free world market in water achieve an efficient use of the world‘s water resources?

Explain why or why not.

A free world market in water likely would (eventually) bring an efficient use of resources as the necessary infrastructure was constructed. Of the factors that can lead to inefficiency (government price and quantity regulations, monopoly power, and so forth) the only issue that could possibly lead to inefficiency is the point that water is a common resource in some situations.

23.

Use the information in Problem 22. Would a free world market in water achieve a fair use of the world‘s water resources? Explain why or why not and be clear about the concept of fairness that you are using.

A ―fair results‖ approach to fairness would argue that in third world countries, very poor inhabitants (for example, nomads) would not be able to afford ―enough‖ water and so some redistribution is needed for the sake of fairness. A ―fair rules‖ approach to fairness asserts that a competitive market is enough to insure fairness because the exchange of water is voluntary. © 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY81

24.

The winner of the men‘s and women‘s tennis singles at the U.S. Open is paid twice as much as the runner-up, but it takes two players to have a singles final. Is the compensation arrangement fair?

The compensation arrangement is efficient because all the participants play their hardest in an attempt to win the prize. As a result, the quality of play is extremely high and the ―amount‖ of tennis produced is large. But the efficient outcome is not necessarily a fair outcome. The fair results approach to fairness asserts that the compensation scheme is unfair because income is not equally distributed. The fair rules approach asserts that the scheme is fair because the players voluntarily enter the tournament and the symmetry principle is not violated.

© 2018 Pearson Education, Inc.

82

25.

CHAPTER 5

Thousands of Gouging Complaints after Hurricane Matthew After Hurricane Matthew, more than 2,000 Florida consumers complained of price gouging to the State Attorney General. Two examples: a hotel room normally $65 a night cost $150, and a $1 bottle of water was $5. In a declared state of emergency, ―unconscionable prices‖ are prohibited.

Source: news-press.com, October 7, 2016 a. Are the two examples in the news clip examples of price gouging or of competitive markets doing their job of allocating scarce resources? Explain.

Both examples reflect how an increase in demand results in a higher price. From this perspective, both examples demonstrate competitive markets allocating scarce resources.

b. Are the two examples of price increases in the news clip fair?

According to the fair rules approach, the higher prices are fair.

According to the fair results approach, the higher prices are probably not fair unless the higher prices allocated the rooms and water to the poor, which seems unlikely.

c. Is it fair to prohibit ―unconscionable prices‖?

According to the fair rules approach, it is not fair to prohibit ―unconscionable prices‖ because that prohibition prevents voluntary exchange. Under the fair results approach, if the prohibition means that poorer people receive the rooms and water, the prohibition is fair. But it is unlikely that prohibiting high prices will mean that the rooms and water go exclusively (or even generally) to people with lower than average incomes.

Economics in the News 33.

After you have studied Economics in the News on pp. 120–121, answer the following questions. a. What is the method used to allocate highway space in Los Angeles and what is the method used in Singapore?

Highway space in Los Angeles is allocated using first-come, firstserve. Highway space in Singapore is allocated using market price.

b. Who benefits from the LA method of highway resource allocation? Explain your answer using the ideas of marginal social benefit, marginal social cost, consumer surplus, and producer surplus.

In Los Angeles, roads are allocated using first-come, first-served.

This allocation is inefficient and so deadweight loss is created.

Drivers with a low valuation of time (that is, a low marginal benefit) gain consumer surplus and thereby benefit because they are willing to drive even though they create congestion. Some gas stations, oil refiners, and other producers of highway-related goods and services gain producer surplus because of the extra gallons of gasoline wasted because of the congestion.

© 2018 Pearson Education, Inc.

EFFICIENCY AND EQUITY83

c. Who benefits from the Singaporean method of highway resource allocation? Explain your answer using the ideas of marginal social benefit, marginal social cost, consumer surplus, and producer surplus.

In Singapore, roads are allocated using market price. Drivers who have marginal benefit that exceeds the price will drive and will gain consumer surplus. Producers of highway services will gain producer surplus. Because market price is used, the allocation is efficient so the sum of consumer surplus and producer surplus is maximized.

d. If road use were rationed by limiting drivers with even-date birthdays to drive only on even days (and odd-date birthdays to drive only on odd days), would highway use be more efficient? Explain your answer.

Allocation by personal characteristic, such as birthdays, does not make the use of highways more efficient. Efficiency requires that drivers with the highest marginal benefits from highway use are those who use the highways. Allocation by birthdays means that some drivers with high marginal benefits are forbidden from driving on the freeway on days that do not align with their birthday.

34.

Water Rate Hikes Have Farmers Steaming Most residents of Ventura County, California, pay $3.10 per 100 cubic feet of water.

Agricultural water users pay $1.79 per 100 cubic feet. Water officials propose to increase these prices to $4.24 for residential users and to $4.92 for agricultural users by 2020. Water district officials say these price increases are fair.

Source: Moorpark Acorn, January 13, 2017 a. Do you think that the allocation of water between agricultural and residential users is likely to be efficient? Explain your answer.

The allocation of water is almost surely inefficient. If the marginal social cost of distributing water is the same for agricultural and residential users, as is probably the case, the only way that the allocation scheme can be efficient is if the marginal social benefit from water for agricultural is less than that of residential users. Such a situation seems unlikely because water is necessary for agricultural users to grow their crops so the marginal social benefit of water to farmers probably exceeds that for residential users.

b. If agricultural users paid a higher price, would the allocation of resources be more efficient?

If agricultural users paid a higher rate for water, probably the allocation of resources would be more efficient. Efficiency requires that marginal social benefit equals marginal social cost.

Currently it is likely the case that the marginal social benefit of the last unit of water for agricultural users is less than the marginal social cost of producing the last unit of water.

c. If agricultural users paid a higher price, what would happen to consumer surplus and producer surplus from water?

If the price paid by agricultural users rises, the consumer surplus of agricultural users decreases and the producer surplus increases.

© 2018 Pearson Education, Inc.

84

CHAPTER 5

d. Is the proposed change in residential users fair?

C h a p t e r

prices paid by agricultural and

The price is proposed to rise by $1.14 for residential users so that they wind up paying $4.24 per 100 cubic feet of water and by $3.13 for agricultural users so they end up paying more, $4.92 According to the ―fair results‖ approach, the difference in price is fair if agricultural users are wealthier than residential users. If, however, agricultural users are poorer than or comparable to residential users, the difference in price is not fair. The difference in price is not fair according to the ―fair rules‖ approach because the price of water is not determined in competitive markets.

Answers to the Review Quizzes

6

GOVERNMENT ACTIONS IN MARKETS

Page 134 1.

What is a rent ceiling and what are its effects if it is set above the equilibrium rent?

A rent ceiling is a specific example of a price ceiling. A rent ceiling is a government imposed regulation that makes it illegal to charge a rent higher than a specified level. If a rent ceiling is set above the equilibrium rent, it has no effect because it does not make the equilibrium rent illegal.

2.

What are the effects of a rent ceiling that is set below the equilibrium rent?

If the rent ceiling is set below the equilibrium rent, the quantity of housing units demanded by renters exceeds the quantity supplied by landlords. Since landlords are not forced to supply more units than the supply curve would indicate for the rent ceiling price, the quantity of housing units actually rented equals the quantity supplied, rather than the quantity demanded. This causes a shortage in the rental housing market.

© 2018 Pearson Education, Inc.

80

3.

CHAPTER 6

How are scarce housing resources allocated when a rent ceiling is in place?

With an effective rent ceiling, some means for allocation of housing units (other than by price) becomes necessary. Some housing is allocated by first-come, first-serve. Other housing is allocated by discrimination. Black markets also develop, where housing units are allocated at a rent higher than the regulated rent.

4.

Why does a rent ceiling create an inefficient and unfair outcome in the housing market?

A rent ceiling creates inefficiency because at the quantity of apartments that are rented, the marginal social benefit exceeds the marginal social cost. Rent ceilings are unfair under the ―fair rules‖ approach because rent ceilings prevent voluntary transactions. Rent ceilings are unfair under the ―fair results‖ approach because there is no assurance that apartments go to those with lower incomes. Indeed, rent ceilings lead to discrimination, which is perhaps the antithesis to fairness.

Page 137 1.

What is a minimum wage and what are its effects if it is set above the equilibrium wage?

A minimum wage is a price floor applied to the labor market. A minimum wage is a government imposed regulation that makes it illegal to charge (or pay) a wage rate lower than a specified level.

If the minimum wage is set above the equilibrium wage, it creates a surplus of labor—unemployment—and decreases workers’ and firms’ surplus.

2.

What are the effects of a minimum wage set below the equilibrium wage?

If the minimum wage is set below the equilibrium wage, then the law has no impact on the labor market equilibrium wage and quantity.

3.

Explain how scarce jobs are allocated when a minimum wage is in place.

If a minimum wage is set above the equilibrium wage, the ability of the competitive market to allocate resources is thwarted and other means must be used. Sometimes the method used is first-come, firstserved so that those who are first in line to apply for openings are given the jobs. Other times discrimination is used so that those from favored groups are allocated the jobs.

4.

Explain why a minimum wage creates an inefficient allocation of labor resources.

A competitive labor market allowed to reach its equilibrium creates an efficient allocation of resources. At the equilibrium, the amount of employment is such that the marginal social cost of labor to workers equals the marginal social benefit from labor to firms. A minimum wage set above the equilibrium wage rate creates a surplus of labor—the quantity of labor supplied exceeds the quantity of labor demanded. The minimum wage reduces employment so that it is less than the efficient amount.

5.

Explain why a minimum wage is unfair.

Workers who receive wage hikes and retain their jobs gain from the minimum wage but workers who lose their jobs and workers who must © 2018 Pearson Education, Inc.

GOVERNMENT ACTIONS IN MARKETS81

extensively search for a job lose. Those who keep (or find) jobs are not necessarily the least well off, so the minimum wage fails the fair results approach to fairness. And the minimum wage also fails the fair rules approach to fairness because the minimum wage blocks voluntary transactions that otherwise would occur.

Page 142 1.

How does the elasticity of demand influence the incidence of a tax, the tax revenue, and the deadweight loss?

The more elastic the demand for a given supply, the smaller the increase in the price paid by the buyers and the greater the decrease in the price received by the sellers, which means that the incidence on buyers is smaller. Additionally, the more elastic the demand, the smaller the quantity bought so the smaller the tax revenue; and the larger the deadweight loss.

2.

How does the elasticity of supply influence the incidence of a tax, the quantity bought, the tax revenue, and the deadweight loss?

The more elastic the supply for a given demand the larger the increase in the price paid by the buyers and the smaller the decrease in the price received by the sellers, which means that the incidence on buyers is larger. Additionally, the more elastic the supply, the smaller the quantity bought so the smaller the tax revenue and the larger the deadweight loss.

3.

Why is a tax inefficient?

The imposition of a tax on a market causes a wedge to be driven between the price received by the seller and the price paid by the buyer. This causes the marginal social benefit from the last unit sold to be higher than its marginal social cost, and the market will under-produce the good or service being taxed. If more of the good or service were produced, the marginal social benefit gained would be greater than the marginal social cost incurred, and the net benefit to society would increase.

4.

When would a tax be efficient?

A tax is efficient, that is, creates no deadweight loss, when demand is perfectly inelastic or supply is perfectly inelastic. In both these cases a tax does not change the quantity produced and so creates no deadweight loss.

5.

What are the two principles of fairness that are applied to tax systems?

The two principles of fairness are the benefits principle and the ability-to-pay principle. The benefits principle asserts that people should pay taxes equal to the benefits they receive from the government provided services. The ability-to-pay principle asserts that people should pay taxes according to how easily they can bear the burden of the tax.

© 2018 Pearson Education, Inc.

82

CHAPTER 6

Page 145 1.

Summarize the effects of a production quota on the market price and the quantity produced.

A production quota set below the equilibrium quantity raises the price and decreases the quantity.

2.

Explain why a production quota is inefficient.

A production quota is inefficient because it decreases production.

As a result the marginal social benefit of the last unit produced exceeds the marginal cost. Because the marginal benefit exceeds the marginal social cost, there is a deadweight loss.

3.

Explain why a voluntary production quota is difficult to operate.

A voluntary quota is difficult to operate because a production quota results in a massive incentive to ―cheat‖ on the production quota by increasing production. A production quota decreases the quantity produced. By decreasing the quantity produced, a production quota raises the price and reduces the marginal social cost of the last unit produced. Because the price exceeds the marginal social cost, producers have an incentive to increase their production (beyond the quota amount) to boost their profit.

4.

Summarize the effects of a subsidy on the market price and the quantity produced.

A subsidy increases the price received by sellers, shifts the supply curve rightward, and places a wedge between the marginal social benefit and marginal social cost of producing the good. The subsidy creates a deadweight loss, a higher equilibrium quantity sold, overproduction, and a lower price paid by the consumers. The subsidy increases farm revenues to all farmers.

5.

Explain why a subsidy is inefficient.

A subsidy creates inefficiency because a subsidy leads to a lower price and increased production. Marginal social benefit equals the price and so the lower price signals that the marginal social benefit falls. And the increased production means that the marginal social cost of production rises. So at the level of production with a subsidy, the marginal social benefit is less than the marginal social cost and inefficiency is created.

Page 147 1.

How does the imposition of a penalty for selling an illegal drug influence demand, supply, price, and the quantity of the drug consumed?

If the penalty is levied on the seller, the penalty is added to the minimum price required for supplying the good or service. The demand curve remains unchanged but the supply curve shifts leftward, so that the vertical distance between the initial supply curve and the supply curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the good rises and the equilibrium quantity decreases.

2.

How does the imposition of a penalty for possessing an illegal drug influence demand, supply, © 2018 Pearson Education, Inc.

GOVERNMENT ACTIONS IN MARKETS83

price, and the quantity of the drug consumed?

If the penalty is levied on the buyer, the penalty is subtracted from the maximum willingness to pay for the good. The supply curve remains unchanged and the demand curve shifts leftward, so that the vertical distance between the initial demand curve and the demand curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the good falls and the equilibrium quantity decreases.

3.

How does the imposition of a penalty for selling or possessing an illegal drug influence demand, supply, price, and the quantity of the drug consumed?

If buyers and sellers face penalties, both the demand and supply curves shift leftward. If the shift of the supply curve is larger, the equilibrium price rises and quantity decreases; if the shift of the demand curve is larger, the price falls and quantity decreases; if the shifts are the same magnitude, the price is unchanged and the quantity decreases.

4.

Is there any case for legalizing drugs?

To reduce the consumption of drugs, they can be legalized and taxed.

Legalizing and then taxing drugs has the benefit of raising funds for the government that could be used to help educate people about the danger of consuming drugs. However, if very high taxes are necessary to reduce the consumption of illegal drugs to the level of use when they were banned, this will cause buyers and sellers to engage in unreported trade in the black market and avoid the tax through tax evasion.

© 2018 Pearson Education, Inc.

84

CHAPTER 6

Answers to the Study Plan Problems and Applications Use Figure 6.1, which shows the market for rental housing in Townsville, to work Problems 1 and 2.

1. a. What are the equilibrium rent and equilibrium quantity of rental housing?

The equilibrium rent is $450 a month and the equilibrium quantity is 20,000 housing units.

b. If a rent ceiling is set at $600 a month, what is the rent paid? What is the shortage of housing?

If the rent ceiling is set at $600 per month, it is above the equilibrium rent and so is ineffective because renters still pay the equilibrium rent, $450 per month. There is no shortage of housing units: The quantity of housing demanded, 20,000 units, equals the quantity of units supplied.

2.

If the rent ceiling is $300 a month, what is the quantity rented, the shortage of housing, and the maximum price that someone is willing to pay for the last unit of housing available?

The quantity rented is 10,000 housing units. The quantity of housing rented is equal to the quantity supplied at the rent ceiling. The shortage of housing is 20,000 housing units. At the rent ceiling, the quantity of housing demanded is 30,000, but the quantity supplied is 10,000, so there is a shortage of 20,000 housing units.

The maximum price that someone is willing to pay for the 10,000th unit available is $600 a month. The demand curve tells us the maximum price that someone is willing to pay for the 10,000th unit.

Use the following data on the demand and supply schedules of teenage labor to work Problems 3 and4.

3.

Calculate the equilibrium wage rate, the hours worked, and the quantity of unemployment.

The equilibrium wage rate is $7 an hour and 2,000 hours a month are worked.

Unemployment is zero. Everyone who wants to work for $6 an hour is employed.

4.

Wage rate (dollars per hour) 6 7 8 9

Quantity Quantity demanded supplied (hours per month) 2,500 2,000 1,500 1,000

The minimum wage for teenagers is $8 an hour, a. How many hours are unemployed?

At $8 an hour, 1,500 hours a month are employed and 1,000 hours a month are unemployed. The quantity of labor employed equals the quantity demanded at $8 an hour. Unemployment is equal to the quantity of labor supplied at $8 an hour minus the quantity of labor demanded at $8 an hour. The quantity supplied is 2,500 hours a month and the quantity demanded is 1,500 hours a month, so 1,000 hours a © 2018 Pearson Education, Inc.

1,500 2,000 2,500 3,000

GOVERNMENT ACTIONS IN MARKETS85

month are unemployed.

b. If the demand for teenage labor increases by 500 hours a month, what is the wage rate and how many hours are unemployed?

The wage rate is $8 an hour, and unemployment is 500 hours a month.

At the minimum wage of $8 an hour, the quantity demanded is 2,000 hours a month and the quantity supplied is 2,500 hours a month so 500 hours a month are unemployed.

5.

The table sets out the supply schedules for brownies. a. If sellers are taxed 20¢ a is the price and who pays

Price (cents per brownie) 50 60 70 80

Quantity Quantity demanded supplied (millions per day) 5 4 3 2

3 4 5 6

demand and chocolate brownie, what the tax?

The price paid by buyers, including the tax, is 70 cents a brownie. The price received by sellers, excluding the tax, is 50 cents a brownie. If there is no tax, the price is 60 cents a brownie, so consumers and sellers each pay 10 cents of the tax on a brownie.

b. If buyers are taxed 20¢ a brownie, what is the price and who pays the tax?

The price received by sellers, excluding the tax, is 50 cents a brownie, and 3 million brownies a day are consumed. The price paid by buyers, including the tax, is 70 cents a brownie. Consumers and sellers each pay 10 cents of the tax.

Use the following data to work Problems 6 and 7.

The demand and supply schedules Price the table. (dollars per box) Calculate the price, the marginal 1.20 and the quantity produced if the 1.30 6.

Sets a production quota of 1.40 week.

1.50 With a production 1.60

Quantity Quantity demanded supplied (boxes per week) 3,000 1,500 2,750 2,000 2,500 2,500 2,250 3,000 2,000 3,500

for rice are in cost of rice, government 2,000 boxes a

quota of 2,000 boxes a week, the price is $1.60 a box, the marginal cost $1.30 a box, and the quantity produced is 2,000 boxes a week. The production quota decreases the quantity supplied to 2,000 boxes a week. The marginal cost of producing 2,000 boxes of rice is given by the supply schedule and is $1.30 a box.

7.

Introduces a subsidy of $0.30 a box.

With a subsidy of $0.30 a box for rice, the price is $1.20 a box, the marginal cost $1.50 a box, and the quantity produced is 3,000 boxes a week. The subsidy of $0.30 lowers the price at which each quantity in the table is supplied. For example, rice farmers will supply 3,000 boxes a week if the price is $1.50 minus $0.30, which is $1.20. With a subsidy, the market equilibrium occurs at a price of $1.20 a box. At this price, the quantity demanded is 3,000 boxes © 2018 Pearson Education, Inc.

86

CHAPTER 6

and the quantity supplied is 3,000 boxes. The marginal cost of producing rice is given by the supply schedule and is $1.50 a box.

© 2018 Pearson Education, Inc.

GOVERNMENT ACTIONS IN MARKETS87

8.

Figure 6.2 shows the market for an illegal good.

Calculate the market price and the quantity bought if a penalty of $20 a unit is imposed on a. Sellers only or buyers only.

With a penalty of $20 a unit on sellers, the price is $70 a unit and the quantity consumed is 100 units. The $20 penalty on sellers decreases the supply. The supply curve shifts leftward so that the vertical distance between the initial supply curve and the new supply curve is $20. In Figure 6.3, the supply curve shifts to S1 and the demand curve remains D. With this new supply curve, the equilibrium is at point A in Figure 6.3, with an equilibrium price of $70 a unit and an equilibrium quantity of 100 units.

If the penalty is imposed on only buyers, the price is $50 a unit and the quantity consumed is 100 units. The $20 penalty on buyers decreases the demand. The demand curve shifts leftward so that the vertical distance between the initial demand curve and the new demand curve is $20. In Figure 6.3, the demand curve shifts to D1 and the supply curve remains S. With this new demand curve, the equilibrium is at point B in Figure 6.3, with an equilibrium price of $50 a unit and an equilibrium quantity of 100 units.

b. Both sellers and buyers.

With a penalty of $20 a unit on sellers and on buyers, the price is $60 a unit and the quantity consumed is 90 units. The $20 penalty on sellers decreases the supply. The supply curve shifts leftward so that the vertical distance between the initial supply curve and the new supply curve is $20. The $20 penalty on buyers decreases the demand. The demand curve shifts leftward so that the vertical distance between the initial demand curve and the new demand curve is $20. In Figure 6.3, the supply curve shifts to S1 and the demand curve shifts to D1.

With these new supply and demands curves, the equilibrium is at © 2018 Pearson Education, Inc.

88

CHAPTER 6

point C in Figure 6.3, with an equilibrium price of $60 a unit and an equilibrium quantity of 90 units.

© 2018 Pearson Education, Inc.

GOVERNMENT ACTIONS IN MARKETS89

Answers to Additional Problems and Applications The table sets out the demand schedules for college meals.

9. a. What are the equilibrium equilibrium quantity of The equilibrium meal is $6 per equilibrium 2,500 meals per

Price (dollars per meal) 4 5 6 7 8

Quantity Quantity demanded supplied (meals per week) 3,000 1,500 2,750 2,000 2,500 2,500 2,250 3,000 2,000 3,500

and supply meal price and meals? price of a meal and the quantity is week.

b. If the college put a price ceiling on meals at $7 a meal, what is the price students pay for a meal? How many meals do they buy?

The price ceiling is above the equilibrium price, so it is ineffective. The price of a meal remains at $6 per meal and students buy 2,500 meals per week.

10.

If the college put a price ceiling on meals at $4 a meal, what is the quantity bought, the shortage of meals, and the maximum price that someone is willing to pay for the last meal available?

The price ceiling is below the equilibrium price, so it has an effect. The quantity of meals purchased is the quantity supplied at the price of $4 per meal, 1,500 meals per week. At this price, the quantity of meals demanded is 3,000, so the shortage of meals is 3,000 meals demanded minus 1,500 meals supplied, or 1,500 meals. For 1,500 meals, the most someone is willing to pay for a meal is above $8. Indeed, if the demand schedule continues to be linear as in the table, someone is willing to pay $10 for the last meal.

Use the following news clip to work Problems 11 and 12.

E.U. Minimum Wages Bulgaria has the lowest minimum wage in the European Union (E.U.), but its level has doubled. The minimum wage in Greece has fallen.

Source: Euronews, February 10, 2017 Assume that in both countries, the minimum wage is above the equilibrium wage.

11.

What is the effect of the changes in the minimum wage on the quantity of labor employed in Bulgaria and in Greece?

The increase in the minimum wage in Bulgaria decreases the quantity of labor employed in Bulgaria. The decrease in the minimum wage in Greece increases the quantity of labor employed in Greece.

12.

Explain the effect of the change in the minimum wage on the workers‘ surplus, the firms‘ surplus, and the efficiency of the market for low-skilled workers in Bulgaria and in Greece.

The increase in the minimum wage in Bulgaria decreases both the workers’ surplus and the firms’ surplus. It increases the potential loss from job search and, importantly, makes the market less efficient by increasing the deadweight loss. The decrease in the minimum wage in Greece has just the opposite effects: it increases both the workers’ surplus and the firms’ surplus and it decreases the potential loss from job search. Overall, however, it makes the market more efficient by decreasing the deadweight loss.

© 2018 Pearson Education, Inc.

90

13.

CHAPTER 6

The government wants to discourage the consumption of sugary drinks and proposes introducing a 20 percent tax on them. A survey shows that the demand for sugary drinks is perfectly elastic and people are equally happy to stop consuming those drinks and switch to healthier alternatives. Producers of sugary drinks complain and say they will increase their prices by 20 percent. Explain, and illustrate with a graph, why sugary drinks producers are wrong.

Sugary drink producers are wrong because the demand is perfectly elastic.

Consequently consumers are not willing to pay a price that is higher than the price at which the demand is elastic. Figure 6.4 illustrates this situation. The initial price of a drink is $1.00 and the demand for drinks is perfectly elastic at this price. Once the tax is imposed, the supply curve shifts upward by the amount of the tax, 20 percent of the price without the tax, to the supply curve labeled S + tax. The new equilibrium price demanders pay is the same as the price they paid without the tax: $1.00 per drink.

Not only can the producers not mark up the price by 20 percent, they cannot mark it up by anything at all! In this case, the entire incidence of the tax falls on the sellers.

14.

The demand and supply schedules for tulips are in the table. a. If tulips are not taxed, what is the price and how many bunches are bought?

The price is $14 per bunch and 80 bunches are purchased.

b. If tulips are taxed $6 a bunch, what are the price and quantity bought? Who pays the tax?

Price (dollars per bunch) 10 12 14 16 18

Quantit Quantity y supplied demande d (bunches per week) 100 40 90 60 80 80 70 100 60 120

If tulips are taxed $6 a bunch, consumers pay $18 per bunch, suppliers receive $12 per bunch, and 60 bunches per week are bought. Of the $6 tax, consumers pay $4 in the form of a higher price paid and suppliers pay $2 in the form of a lower price received.

15.

Governor’s Proposed “Sin Taxes” Won’t be Enough Kansas Governor Sam Brownback proposes to raise tobacco taxes from 10 to 20 percent and © 2018 Pearson Education, Inc.

GOVERNMENT ACTIONS IN MARKETS91

liquor taxes from 8 to 16 percent. ―I hope it doesn‘t happen,‖ said Patti Hoffman of Patti‘s Wine and Spirits. ―I think it‘s going to affect the consumer more than it will me.‖ State Rep. Russ Jennings is concerned that people in border communities will buy their cigarettes and alcohol in Missouri, where the tax is lower.

Source: Garden City Telegram, January 21, 2017 a. How will the Kansas market for cigarettes and alcohol respond to the tax increase?

The new taxes will increase the wedge between the price the buyers pay and the price the sellers get. It will raise the price the buyers pay and reduce the price the sellers get. The quantity bought will decrease.

b. How does shopping in Missouri impact the elasticity of demand in Kansas?

When the tax raises the price of tobacco or liquor in Kansas, shoppers may go to Missouri where the price will stay lower. Because shopping in Missouri is a good substitute for shopping in Kansas, the elasticity of demand in Kansas is larger than it otherwise would be. And, because shopping in Kansas is a good substitute for shopping in Missouri, the elasticity of demand in Missouri is also large.

c. Why might the increase in the tax rates bring a decrease in the tax revenue?

Tax revenue equals the tax wedge multiplied by the quantity bought.

If the demand is elastic, then the percentage decrease in the quantity bought is larger than the percentage increase in the tax and the tax wedge, so that the government collects less tax revenue.

In the case of the tax imposed in Kansas, as the answer to part b explained, the fact consumers can shop in Missouri increases the elasticity of demand in Kansas and makes it more likely that the demands are elastic.

Use the following news clip to work Problems 16 to 18.

Farmers Get Biggest Subsidy Check in Decade In 2016, 25 percent of an estimated $55 billion farm profit will come from government. Since 2012, global corn and soybean output has increased faster than demand and prices have tumbled. The subsidies law of 2014 ties subsidies to prices—low prices trigger high subsidies.

Source: Bloomberg, April 12, 2016 16. a. Why are U.S. soybean farmers subsidized?

The federal government subsidizes soybean farmers because of extensive farm lobbying. The subsidies help farmers avoid low prices and low incomes.

b. Explain how a subsidy paid to soybean farmers affects the price of soybean and the marginal cost of producing it.

A subsidy increases the supply of soybeans. The increase in supply lowers the price of soybeans and increases the quantity produced.

With the increase in the quantity produced the marginal cost of growing soybeans rises.

© 2018 Pearson Education, Inc.

92

17.

CHAPTER 6

Explain how a subsidy paid to soybean farmers affects the consumer surplus and the producer surplus from soybean. Does the subsidy make the soybean market more efficient or less efficient? Explain.

A subsidy increases the production of soybeans and lowers the market price consumers pay. Without taking account of the loss of surplus from taxes that must be paid in order to finance the subsidy, the consumer surplus increases. The subsidy increases the producer surplus because they produce more and receive a higher price (including the subsidy) than they otherwise would. With the subsidy, production increases so that marginal social cost exceeds marginal social benefit. Consequently, the subsidy makes the market less efficient.

18. In the market for corn, explain why the corn price has fallen and explain how an increased subsidy influences the price and quantity of corn.

In the market for corn, since 2012 the supply of corn has increased more than the demand, so the price of corn fell while the quantity increased. The fall in the price of corn triggered subsidy payments.

The subsidies result in more corn being produced, which further lowers the price of corn.

© 2018 Pearson Education, Inc.

GOVERNMENT ACTIONS IN MARKETS93

Use the following figure, which shows the market for tomatoes, to work Problems 19 and 20.

19.

If the government subsidizes growers at $4 a pound, what is the quantity produced, the quantity demanded, and the subsidy paid to growers?

If the government subsidizes growers at $4 a pound, the supply increases. As shown in Figure 6.7, the supply curve shifts downward by $4. The demand does not change. The new price is $4 per pound and at this price the quantity produced is 3 billion pounds and the quantity demanded is 3 billion pounds. The government pays ($4 a pound) × (3 billion pounds), which is $12 billion.

20.

If the government subsidizes growers at $4 a pound, who gains and who loses from the subsidy?

What is the deadweight loss? Could the subsidy be regarded as being fair?

The suppliers and demanders of tomatoes gain from the subsidy. The taxpayers, who must send the government $12 billion in taxes, lose. Tomato producers in other countries lose because they receive a lower price. The deadweight loss is equal to the area of the grey triangle in Figure 6.6.

Accordingly, the deadweight loss is equal to ½ × (3 billion pounds – 2 billion pounds) × $4 a pound, which is $2 billion.

Using the ―fair results‖ approach, the subsidy is fair if the growers and consumers of tomatoes have lower incomes than the tax payers.

If not, then the tax is unfair.

Using the ―fair rules‖ view, the subsidy is unfair because the taxpayers are forced to pay the tax.

© 2018 Pearson Education, Inc.

94

21.

CHAPTER 6

The table gives the demand and supply schedules for an illegal drug. a. What is the price and how many units are bought if there is Price no penalty on drugs? (dollars The price is $60 per unit and 400 units are per unit) consumed.

50 b. If the penalty on sellers is $20 a unit, what are the price and 60 quantity consumed?

70 The price is $70 per unit and 300 units are 80 consumed.

90 c. If the penalty on buyers is $20 a unit, what are the price and quantity consumed?

Quantity Quantity demanded supplied (units per day) 500 300 400 400 300 500 200 600 100 700

The price $50 per unit and 300 units are consumed.

Economics in the News 22.

After you have studied Economics in the News on pp. 148–149, answer the following questions. a. If Illinois raises its minimum wage to $15 an hour, what do you expect will happen to the state‘s unemployment? Illustrate your answer with a graph.

Unemployment will increase in Illinois. In Figure 6.7, the initial state minimum wage is $8.25 an hour. With that minimum wage, unemployment is 0.1 million workers. When the state sets a minimum wage of $15 an hour, unemployment in the state rises to 0.3 million workers.

b. Describe the gains and losses that will arise when the Illinois minimum wage is rised to $15 an hour; and compare the gains and losses when the equilibrium wage is greater and less than $15 an hour.

If the equilibrium wage rate exceeds $15 an hour, then the minimum wage has no effect and creates no gains or losses. Society’s total surplus is maximized. If the equilibrium wage is less than $15 an hour, then all firms lose. Workers who retain their jobs gain but overall, workers lose because their surplus shrinks due, in part, to increased job search. The deadweight loss increases in size.

c. The news article reports Mr. Guzzardi‘s view that boosting the minimum wage will increase local spending. Explain why, for Mr Guzzardi to be correct, the demand for low-skilled labor must be inelastic.

Local spending will increase if total local income increases. The total income received by workers equals the wage rate multiplied by the quantity of employment, which is the same as firms’ expenditure on these workers. The total revenue test shows that an increase in price (the wage rate) increases total expenditure (the workers’ © 2018 Pearson Education, Inc.

GOVERNMENT ACTIONS IN MARKETS95

total income) only if the demand for the product (labor) is inelastic. Consequently, workers’ total income rises only if the demand for labor is inelastic which means local spending increases only if the demand for labor is inelastic.

© 2018 Pearson Education, Inc.

96

23.

CHAPTER 6

Pot Legalization Brings Fears of Social Costs A C.D. Howe Institute study says the legalized sale of marijuana could bring tax revenues of $675 million in 2018. But if governments get too greedy, consumers will go to the black market as they do for cigarettes. There are deepening concerns about the increased use of pot when it is legalized.

Source: The Gazette, Montreal, April 13, 2017 Assume that the marginal cost of producing a gram of marijuana (legal or illegal) is a constant $5 and that legal marijuana bears a tax of $2 per gram. a. Draw a graph of the market for marijuana, assuming that there are no penalties on either buyers or sellers for breaking the law.

Because the cost of producing a gram of marijuana is constant at $5, as Figure 6.8 shows, the supply is perfectly elastic (the supply curve is horizontal) at the price of $5 per gram. Suppose the $2 tax per gram is imposed on sellers; the effects from a $2 tax imposed on buyers are the same.

The $2 tax shifts the supply curve upward by $2 per gram, to the supply curve labeled S + tax. The buyers pay $7.00 per gram and the sellers get $5 per gram. The quantity is 20,000 pounds per month

b. How does a $2 tax change the market outcome?

Show the effects in your graph.

If there was no tax on either buyers or sellers, the equilibrium price is $5.00 per gram and the equilibrium quantity is 50,000 pounds per month. The $2 tax raises the price buyers pay to $7.00 per gram. The price suppliers get does not change—it remains $5 per gram. The quantity decreases to 20,000 pounds per month.

c. With no penalty on buyers, if a penalty for breaking the law is imposed on sellers at more than $2 per gram, how does the market work and what is the equilibrium price?

The supply decreases and the supply curve shifts up by whatever the amount of the penalty. The price buyers pay rises above $7.00 per gram and the quantity decreases to less than 20,000 pounds.

d. With no penalty on sellers, if a penalty for breaking the law is imposed on buyers at more than $2 per gram, how does the market work and what is the equilibrium price?

The demand decreases and the demand curve shifts down by whatever the amount of the penalty. Buyers still pay $5.00 per gram but the quantity decreases to less than 20,000 pounds.

© 2018 Pearson Education, Inc.

GOVERNMENT ACTIONS IN MARKETS97

e. What is the situations

C h a p t e r

marginal benefit of an illegal gram of marijuana in the described in parts (c) and (d)?

In both cases the marginal benefit is equal to the height of the demand curve at the equilibrium quantity. At this quantity, the marginal benefit exceeds the marginal cost.

f.

Can legalizing and taxing marijuana achieve the same quantity of marijuana use as occurs if marijuana is illegal?

Yes. The government can impose a sufficiently large tax that it decreases the equilibrium quantity so that it equals the quantity that was traded when marijuana was illegal.

Answers to the Review Quizzes

7

GLOBAL MARKETS IN ACTION 2.

Page 158 1.

Describe the situation in the market for a good or service that the United States imports.

The goods and services the United States will import are those in which the United States has a higher opportunity cost of production relative to other countries. In those markets the U.S. no-trade price is higher than the world price.

With trade the quantity produced in the United States is less than the quantity consumed and the difference is imported.

Descr ibe the situatio n in the market for a good or service that the United States exports.

The goods and services the United States will export are those in which the United States has a lower opportunity cost of production relative to other countries. In those markets the U.S. no-trade price is lower than the world price.

With trade the quantity produced in the United States exceeds the quantity consumed and the excess is exported.

© 2018 Pearson Education, Inc.

II

safety, and regulation barriers, and voluntary export restraints to restrict international trade. Export subsidies given by a nation decrease other countries’ exports and thereby restrict their international trade.

Page 160 1.

How is the gain from imports distributed between consumers and domestic producers?

Consumers gain consumer surplus from imports and domestic producers lose producer surplus from imports.

2.

How is the gain from exports distributed between consumers and domestic producers?

2.

A tariff raises the domestic price of the product. The higher price increases domestic production and decreases the domestic quantity purchased.

Consumers lose consumer surplus from exports and domestic producers gain producer surplus from exports.

3.

Why is the net gain from international trade positive?

The net gain from international trade is positive because the gain to the winners exceeds the losses to the losers. For instance, in the case of an imported good, all the loss of producer surplus is transferred to consumers as consumer surplus. In addition, however, consumers also gain additional consumer surplus from the units imported. The total gain of consumer surplus exceeds the loss of producer surplus so that the net surplus increases. The situation is similar for exports: The total gain of producer surplus exceeds the loss of consumer surplus.

3.

What are the tools that a country can use to restrict international trade?

A country can use tariffs, import quotas, other import barriers such as health,

Explain who gains and who loses from a tariff and why the losses exceed the gains.

Domestic consumers lose consumer surplus from the tariff. Domestic producers gain producer surplus from the tariff. The government also gains revenue from the tariff. But the gain in producer surplus plus the gain in government revenue is less than the loss of consumer surplus, so on net a tariff creates a deadweight loss.

4.

Explain the effects of an import quota on domestic production, consumption, and price.

An import quota raises the domestic price of the product. The higher price increases domestic production and decreases domestic purchases.

Page 167 1.

Explain the effects of a tariff on domestic production, the quantity bought, and the price.

5.

Explain who gains and who loses from an import quota and why the losses exceed the gains.

Domestic consumers lose consumer surplus from the ii

WHAT IS ECONOMICS? III

import quota. Domestic producers gain producer surplus from the import quota. The importers also gain additional profit from the import quota. But the gain in producer surplus plus the importers’ profits is less than the loss of consumer surplus, so on net an import quota creates a deadweight loss.

Page 171 1.

What are the infant industry and dumping arguments for protection? Are they correct?

The attempt to stimulate the growth of new industries is the infant-industry argument for protection, which states that it is necessary to protect a new industry from import competition to facilitate the growth of that industry, making it competitive in the world markets. This argument is based on the idea that as firms mature they become more productive. However this argument for protection only works if the benefits also spill over into other industries and other parts of the economy. This is rarely the case, as the entrepreneurs of infant industries and their financial supporters take this risk into account and all returns usually accrue only to them, not to other industries. And it is more efficient to subsidize the infant industry needing protection than it is to protect it by restricting trade.

iii

The dumping argument for protection states that a foreign firm is selling its exports at a lower price than its cost of production.

Foreign firms trying to monopolize the international market may use this practice. Once the competition is gone, the foreign firm will raise prices and reap profits.

This argument fails for several reasons. First, it is virtually impossible to detect the occurrence of dumping since it is impossible to verify a firm’s production costs. The test most commonly used is if the firm’s price when it exports is lower than its domestic price. This test only examines the supply side of the two markets and ignores the demand side. If the domestic market is inelastic and the export market is elastic (which is almost always the case) then it is natural for a firm to price the domestic goods higher than the exports.

Second, it is difficult to see how a global firm could have a monopoly for the goods or services it exports. There are too many foreign suppliers (and potential suppliers), making global competition too extensive for a monopoly to exist in the global market.

And, even if there is global monopoly it is more efficient to regulate it than to impose trade restrictions on its products.

IV

2.

Can protection save jobs and the environment and prevent workers in developing countries from being exploited?

There are many myths about trade restrictions. The problem mentions three of them, all false reasons often offered as reasons to restrict international trade. These arguments are: 



Trade restrictions save domestic jobs: Free international trade does, indeed, cost jobs in the import-competing markets.

But this argument ignores the fact that, under free trade, consumers in the exporting country will have greater disposable income. These consumers will use part of their higher income to buy goods and services from other countries, thereby increasing employment in the exporting sector of the nation. So, although international trade rearranges jobs— decreasing them in import-competing markets and increasing them in exporting markets—it does not, on net, cost jobs.

Trade restrictions penalize lax environmental standards: Not all developing countries have lax environmental standards.

Also, a clean environment is a normal good.

Countries that are relatively poor and have lax pollution standards do not care as much about the environment because



3.

imposing clean air, water, and land standards have a high opportunity cost because they will slow economic development. The best way to encourage environmental quality is not to restrict economic development but to encourage rapid economic growth, which will more quickly increase citizen demand for a cleaner environment in those developing countries.

Trade restrictions prevent rich countries from exploiting poorer countries: Importing goods made in countries with low wage levels increases the demand for labor in those countries, increasing the number of jobs available and raising wages over time.

The more free trade that occurs with these countries, the more quickly the wages will rise and the working conditions will increase in quality and safety.

What is offshore outsourcing? Who benefits from it and who loses?

Offshore outsourcing occurs when a firm in the United States buys finished goods, components, or services from firms in other countries.

Workers who have skills for jobs that have been sent abroad lose from offshore outsourcing. Consumers who consume the goods and services produced abroad and imported into the United States benefit. iv

WHAT IS ECONOMICS?

4.

What are the main reasons for imposing a tariff?

There are two main reasons for imposing tariffs on imports. First the government receives tariff revenues from imports, which can be useful when revenues from income taxes and sales taxes are less effective ways of gaining government revenue. Second rent seeking by individuals in industries that would be hurt by foreign competition can influence the government to impose tariffs.

5.

Why don‘t the winners from free trade win the political argument?

Trade restrictions are enacted despite the inherent inefficiency because of the political actions of rent seeking groups, which fear that foreign competition might have a negative impact on their industry, firm, or jobs. The anti-trade groups are easily organized and have much to gain from trade restrictions, whereas the vast millions of consumers, who would win from free trade, are difficult to organize because each individual has only a small amount of loss when trade restrictions are imposed.

Hence the winners from trade restrictions frequently outlobby the winners from free trade.

v

V

VI

Answers to the Study Plan Problems and Applications

roses. U.S. wholesalers buy the 2 million containers from U.S. growers and purchase 10 million

Use the following data to work Problems 1 to Price Quantity Quantity 3. (dollars demanded supplied Wholesalers buy and sell roses in containers per (millions of that hold 120 stems. The table provides containe containers per year) r) information about the wholesale market for 100 15 0 roses in the United States. The demand 125 12 2 schedule is the wholesalers‘ demand and the 150 9 4 supply schedule is the U.S. rose growers‘ 175 6 6 supply. Wholesalers can buy roses at auction 200 3 8 in Aalsmeer, Holland, for $125 per container.

225 0 10 1. a. Without international trade, what containers from foreign would be the price of a container of sources, which are imported roses and how many containers of roses into the United States. a year would be bought and sold in the 3.

Draw a graph to illustrate the U.S. United States? wholesale market for roses. Show the Without international trade, equilibrium in that in the United States the market with no price of a container of roses is $175 and 6 million international trade containers of roses are and the equilibrium bought and sold. with free trade. Mark b. At the price in your answer to part (a), the quantity of roses does the United States or the rest of the produced in the world have a comparative advantage in United States, the producing roses? quantity imported, The price of roses in the and the total quantity United States exceeds the bought. price in the rest of the world, so the rest of the world has a comparative advantage in producing roses.

2.

If U.S. wholesalers buy roses at the lowest possible price, how many do they buy from U.S. growers and how many do they import?

The price of roses in the United States is $125 per container. At this price, U.S. rose growers supply 2 million containers per year and U.S. wholesalers demand 12 million containers of

In Figure 7.1, the equilibrium without

international trade is determined at the intersection of the demand curve and the supply curve.

Without international trade the equilibrium price is $175 per container and 6 million containers per year are bought and produced. vi

WHAT IS ECONOMICS? VII

With international trade the world price is $125 per container, as shown in Figure 7.1. The quantity produced in the United States is 2 million containers and the quantity bought in the United States is 12 million containers.

Imports into the United States account for the difference between the quantity bought and the quantity produced, 10 million containers.

4.

Use the data on the U.S. wholesale market for roses in Problem 1 to a. Explain who gains and who loses from free international trade in roses compared to a situation in which Americans buy only roses grown in the United States.

U.S. rose wholesalers, who are the consumers in the problem, gain from free international trade. U.S. rose growers lose from free international trade.

b. Draw a graph to illustrate the gains and losses from free trade.

Figure 7.2 illustrates the market with free trade.

Consumer surplus before international trade is equal to area A; after international trade consumer surplus is equal to area A + area B + area C. Producer surplus before international trade is equal to area B + area D; after international trade producer surplus is equal to area D.

c. Calculate the gain from international trade.

The gain from international trade is area C in Figure 7.2. It is equal to ½  ($175  $125)  (10 million containers) which is $250 million.

Use the information on the U.S. wholesale market for roses in Problem 1 to work this problem 5 to 10.

5.

If the United States puts a tariff of $25 per container on imports of roses, explain how the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported changed.

The U.S. price of roses rises from $125 per container (the price with free trade) to $150 per container. The quantity of roses produced in the United States increases from 2 million containers (the vii

VIII

quantity produced with free trade) to 4 million containers. The quantity of roses consumed in the United States decreases from 12 million containers (the quantity consumed with free trade) to 9 million containers. The quantity imported decreases from 10 million containers to 5 million containers.

6.

Who gains and who loses from this tariff?

U.S. rose consumers lose from the tariff. U.S. rose producers gain from the tariff. The U.S. government gains revenue from the tariff.

viii

WHAT IS ECONOMICS?

7.

Draw a graph of the U.S. market for roses to illustrate the gains and losses from the tariff and on the graph identify the gains and losses, the tariff revenue, and the deadweight loss created.

Figure 7.3 shows the effect of the tariff. The amount of the tariff per container is equal to the height of the light gray arrow. Before the tariff U.S. consumer surplus was equal to area A + area B + area C + area E + area F. After the tariff U.S. consumer surplus is equal to area A. U.S. consumers lose consumer surplus equal to area B + area C + area E + area F. Before the tariff U.S. producer surplus was equal to area G. After the tariff U.S. producer surplus is equal to area G + area B. U.S. producers gain producer surplus equal to area B. After the tariff the U.S. government gains tariff revenue equal to area E. The deadweight loss from the tariff is equal to area C + area F.

8.

If the United States puts an import quota on roses of 5 million containers, what happens to the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported?

The U.S. price of roses rises to $150 per container.

9 million containers of roses are purchased in the United States and 4 million containers of roses are produced in the United

ix

IX

States. The difference, 5 million containers, is imported into the United States.

9.

Who gains and who loses from this

quota?

U.S. rose growers and importers of roses gain from the quota. U.S. rose wholesalers lose from the quota.

10.

Draw a graph to illustrate the gains and

X

losses from the import quota and on the graph identify the gains and losses, the importers‘ profit, and the deadweight loss.

Figure 7.4 shows the effect of the import quota. The amount of the quota is equal to the length of the gray arrow. Before the quota U.S. consumer surplus was equal to area A + area B + area C + area E + area F. After the quota U.S. consumer surplus is equal to area A. U.S. consumers lose consumer surplus equal to area B + area C + area E + area F. Before the quota U.S. producer surplus was equal to area G. After the quota U.S. producer surplus is equal to area G + area B. U.S. producers gain producer surplus equal to area B. After the quota the importers of the rose containers earn profit equal to area E. The deadweight loss from the import quota is equal to area C + area F.

x

WHAT IS ECONOMICS?

11.

China Drug Sales to the U.S. Grow Despite Safety Concerns at Home Chinese exports of pharmaceutical products and health supplements worldwide jumped 3 percent to $56 billion last year. Chinese pharma exports to the U.S. rose 4 percent. Questions are being asked in China about the safety of its medicines.

Source: Bloomberg News, August 30, 2016 a. What does the news clip imply about the comparative advantage of producing pharmaceuticals in the United States and China?

Because the pharmaceuticals were produced in China, the news clip suggests that China has the comparative advantage in producing pharmaceuticals.

b. Could product quality be a valid argument against free trade? If it could, explain how.

Product quality is not a valid argument against free trade. Quality is a valid concern for consumers. If consumers cannot judge quality themselves, then government inspection might be necessary. But in that case government inspection of both imported and domestically produced goods is required. To single out imported goods or services makes little sense.

xi

XI

XII

Answers to Additional Problems and Applications 12.

c. How does the quantity of steel bought

by India change?

Steel users in India respond to the higher price by decreasing the quantity of steel bought.

Suppose that the world price of sugar is 10 cents a pound, the United States does not trade internationally, and the equilibrium price of sugar in the United States is 20 cents a pound. The United States then begins to trade internationally. a. How does the price of sugar in the United States change?

d. Does India export or import steel and why?

Because the price of steel in India is lower than the world, India has a comparative advantage in the production of steel. India will export steel.

The price of sugar in the United States falls.

b. Do U.S. consumers buy more or less sugar?

As a result of the lower price, U.S. consumers buy more sugar.

c. Do U.S. sugar growers produce more or less sugar?

As a result of the lower price, U.S. growers produce less sugar.

d. Does the United States export or import sugar and why?

The United States imports sugar. The quantity of sugar demanded increases while quantity supplied decreases.

The difference is made up by imports.

13.

Suppose that the world price of steel is $100 a ton, India does not trade internationally, and the equilibrium price of steel in India is $60 a ton. India then begins to trade internationally. a. How does the price of steel in India change?

The price of steel in India rises to equal the world price.

b. How does the quantity of steel produced in India change?

Producers respond to the higher price by increasing the quantity of steel produced.

14.

A Price Quantity Quantity semic (dollars demanded supplied onduc per (billions of units per tor is unit) year) a key 10 25 0 comp 12 20 20 onent 14 15 40 in 16 10 60 your 18 5 80 20 0 100 laptop , smartphone, and iPod. The table provides information about the market for semiconductors in the United States.

Producers of semiconductors can get $18 a unit on the world market. a. With no international trade, what would be the price of a semiconductor and how many semiconductors a year would be bought and sold in the United States?

With no international trade the price of a semiconductor in the United States is $12 per unit. 20 billion units are bought and sold in the United States.

b. Does the United States have a comparative advantage in producing semiconductors?

The United States has a comparative advantage in producing semiconductors because the U.S. price is xii

WHAT IS ECONOMICS?XIII

lower than the price in the world market.

15.

Biofuel Goals Could Require All the World’s Crops Biofuels to combat global warming and cut carbon emissions are diverting corn from food to fuel, and a World Resources Institute report says meeting a 20 percent bioenergy target in 2050 would need the world‘s annual harvest of plant material to double.

Source: CBS News, January 29, 2015 a. What is the effect on the world price of corn of the increased use of corn to produce biofuel?

The use of corn to produce biofuels increased the demand for corn, thereby raising the price of corn.

b. How does the change in the world price of corn affect the quantity of corn produced in a poor developing country with a comparative advantage in producing corn, the quantity it consumes, and the quantity that it either exports or imports?

The higher world price of corn decreases the consumption of corn and increases the production of corn in poor developing countries. Because the country has a comparative advantage it will export corn. The higher price leads the country to increase its exports.

16.

Draw a graph of the market for corn in the poor developing country in Problem 15(b) to show the changes in consumer surplus, producer surplus, and deadweight loss.

Figure 7.5 shows the situation in the poor country that exports corn.

With the initial lower price, the country produces

xiii

60 million bushels, exports 20 million bushels, and consumes 40 million bushels.

The consumer surplus is equal to area A + area B and the producer surplus is equal to area E. After the world price of corn rises to $8 per bushel, the country produces 80 million bushels of corn, exports 60 million bushels, and consumes 20 million bushels. Consumer surplus decreases to area A and producer surplus increases to area B + area C + area E. There is no deadweight loss; in fact, the country gains additional surplus equal to area C.

Use the following news clip to work Problems 17 and 18.

Watch Out USA—Haggis Could Be on Its Way Scottish haggis made from sheep‘s heart, liver, and lungs, mixed with oatmeal and spices, has been banned in the United States since 1971.

The Scottish government expects the ban to soon be lifted.

Source: CNNMoney, November 23, 2016 17. a. Explain how the U.S. import ban on haggis affected haggis producers and consumers in Scotland.

The U.S. import ban lowered the price of haggis in

XIV

Scotland. The lower price led to decreased production in Scotland, which made Scottish producers worse off. The lower price also led to increased consumption in Scotland, which made Scottish consumers better off.

xiv

WHAT IS ECONOMICS? XV

b. Draw a graph of the market for haggis in Scotland to illustrate your answer to part (a). Identify the changes in consumer surplus and producer surplus in Scotland.

Figure 7.6 shows the effect of the U.S. import ban.

Prior to the ban, presuming the only Scottish exports of haggis were to the United States, the price of haggis in Scotland was $5 per pound. At this price the quantity consumed in Scotland was 30,000 pounds of haggis per year and the quantity produced in Scotland was 80,000 pounds per year. The difference, 50,000 pounds per year, was exported to the United States. Producer surplus in Scotland was equal to area B + area C + area E and consumer surplus in Scotland was equal to area A. With the import ban, the price of haggis in Scotland falls to $4 per pound. At this price 60,000 pounds of haggis per year are produced and consumed in Scotland. There are no exports. Producer surplus in Scotland shrinks to only area E and consumer surplus grows to area A + area B.

18. a. Explain how lifting the U.S. import ban on haggis affects producers and consumers of haggis in the United States.

Lifting the U.S. ban lowers the price of haggis in the United States. U.S. consumption increases and U.S. production decreases so U.S. consumers are better off and U.S. producers are worse off. xv

b. Draw a graph to illustrate your answer to (a) and identify the changes in U.S. consumer surplus and producer surplus deadweight loss.

Figure 7.7 shows the situation in the U.S. market for haggis. With no trade the U.S. price of haggis is $6 per pound. The United States produces and consumes 30,000 pounds of haggis. At this price consumer surplus in the United States is equal to area A and producer surplus is equal to area B + area E. When the U.S. import ban is eliminated, the price in the United States falls to $5 per pound. U.S. production falls to 20,000 pounds per year and U.S. consumption rises to 50,000 pounds. The difference, 30,000 pounds, is imported from Scotland. U.S. producer surplus decreases to only area E. U.S. consumer surplus increases to area A + area B + area C.

XVI

xvi

WHAT IS ECONOMICS?XVII

Use the following information to work Problems 19 to 21.

Before 1995, trade between the United States and Mexico was subject to tariffs. In 1995, Mexico joined NAFTA and all U.S. and Mexican tariffs have gradually been removed.

19. Explain how the price that U.S. consumers pay for goods from Mexico and the quantity of U.S. imports from Mexico have changed. Who are the winners and who are the losers from this free trade?

With NAFTA, the prices that U.S. consumers pay for goods from Mexico have fallen and, as a result, the quantity of imports from Mexico have increased. Winners from this free trade are Mexican producers of goods exported to the United States and U.S. consumers of these goods. Losers are Mexican consumers of the goods and U.S. producers of the goods.

20.

Explain how the quantity of U.S. exports to Mexico and the U.S. government‘s tariff revenue from trade with Mexico have changed.

The prices of U.S. goods in Mexico have fallen and, as a result, the quantity of U.S. goods exported to Mexico has increased. The U.S. government’s tariff revenue from tariffs imposed on trade with Mexico decreased.

21.

Suppose that in 2015 tomato growers in Florida lobby the U.S. government to impose an import quota on Mexican tomatoes. Explain who in the United States would gain and who would lose from such a quota.

U.S. tomato growers gain from such a quota. The importers who hold the quota rights also gain. U.S.

xvii

consumers of tomatoes lose from such a quota.

Use the following information to work Problems 22 and 23.

Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China.

22.

Explain how the tariff on textiles will change the price that U.S. buyers pay for textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States.

The tariff raises the U.S. price of textiles. As a result, the quantity of textiles consumed in the United States decreases and the quantity produced increases. Imports of textiles into the United States decrease.

23.

Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain?

The decrease in trade means that the U.S. and Chinese gains from trade decrease.

In the United States, U.S. producers gain from the tariff. The U.S. government also gains revenue from the tariff. U.S. textile consumers lose.

XVIII

Use the following information to work Problems 24 and 25.

With free trade between Australia and the United States, Australia would export beef to the United States. But the United States imposes an import quota on Australian beef.

24.

a. What are the arguments for bringing jobs back to America? Explain why these arguments are faulty.

The primary argument advanced for being jobs back to America is that it will increase employment in America and the benefits to the U.S. workers who gain these jobs outweigh the costs of restricting trade.

The fact this argument is off base is demonstrated by comparing the cost of saving a job to the wage paid on the job. The cost of restricting trade falls on American consumers, especially low-income Americans, who would face higher prices for imported products such as clothes, shoes, and toys. The cost inflicted on U.S. consumers from higher prices outweighs the benefit of a job to the worker, that is, the wage rate paid on the job.

Explain how this quota influences the price that U.S. consumers pay for beef, the quantity of beef produced in the United States, and the U.S. and the Australian gains from trade.

The quota raises the price of beef in the United States. By raising the U.S. price, the quota increases the quantity of beef produced in the United States and decreases the quantity of beef consumed in the United States. The U.S. and Australian gains from trade decrease.

25.

Explain who in the United States gains from the quota on beef imports and who loses.

U.S. beef producers gain from the quota. The people who hold the import quota rights also gain. U.S. beef consumers lose from the quota.

26.

The Cost of Bringing Home American Jobs Donald Trump says he‘ll bring home jobs lost to China and Mexico. It is possible but costly. American consumers would face higher prices and those on low incomes would suffer most because they spend a high share of their income on clothes, shoes, and toys—things that are made at low cost and imported.

Source: CNNMoney, April 14, 2016

b. Is there any merit in bringing jobs back?

There is merit to the workers whose jobs are brought back and/or and who might not receive any government assistance if their jobs are not brought back. There also is merit to the politicians who can obtain a reward from lobbyists for the protection. There is no merit, however, to society as a whole.

Economics in the News 27.

After you have studied Economics in the News on pp. 172–173, answer the following questions. a. What was the value of U.S. imports from Mexico in 2015 and why would xviii

WHAT IS ECONOMICS?XIX

the value of imports fall if a 20 percent tariff were imposed on them?

U.S. imports from Mexico were $303 billion in 2015. A 20 percent tariff would raise the price of imports, thereby decreasing the quantity of goods and services imported.

b. How do the elasticities of demand and supply influence the revenue that a tariff generates?

The elasticities of demand and supply affect the revenue a tariff will raise because they determine the quantity that will be imported after the tariff is imposed. Imposing a tariff on Mexican imports raises their price in the United States. If the U.S. demand and U.S. supply for these imports are very inelastic, then the quantity demanded will decrease only slightly while the quantity supplied will increase only a little.

Both effects lead to a small decrease in imports and, accordingly, a large amount of tariff-generated revenue.

c. Who in the United States would benefit and who would lose from a 20 percent tariff on imports from Mexico?

U.S. producers of importcompeting products would benefit from a tariff. So, too, would the U.S. government because it would gain revenue. U.S. consumers would lose. Overall the United States loses because the tariff creates a deadweight loss.

xix

XX

d. Illustrate your answer to part (c) with an appropriate graphical analysis.

Figure 7.8 shows the effect of the tariff. Before the tariff, the price is $50 per unit, indicated by the line labeled PW. The United States produces 1.67 million units and consumes 7 million units, so the United States imports 5.33 million units from Mexico. U.S. consumer surplus is equal to area A + area B + area C + area E + area F + area G. U.S. producer surplus is equal to area H. The 20 percent tariff raises the price in the United States to $60 per unit, shown by the line labeled PW + tariff. At this price the United States produces 2.33 million units and consumes 5 million units, thereby importing 2.67 million units. U.S. consumer surplus falls to area A + area C while U.S. producer surplus increases to area B + area H. The U.S. government receives tariff revenue equal to area E. There is a deadweight loss created equal to area F + area G.

28.

Argentina’s Lesson for Trump: Tariffs Made Poverty Worse In 2011, Argentina wanted to protect manufacturing workers, so it imposed a 35 percent tariff on imported smartphones, computers, and tablets.

Blackberry moved jobs to Argentina, but Apple and others passed. Compare Argentine and U.S. prices: iPhone 7 Plus $1,400 versus $869; iPad Pro $1,300 versus $699. Argentina is now removing this tariff.

Source: CNNMoney, April 7, 2017

a. Explain how Argentina‘s tariff on smartphone and tablet imports changes

the country‘s production, consumption, and imports of these items. Illustrate your answer with an appropriate graphical analysis.

The tariff on smartphone and tablet imports raises their price in Argentina. The higher price increases Argentinian production and decreases both Argentinian consumption and importation.

Figure 7.9 illustrates the situation for an iPad Pro. With no tariff, the price would be $699, indicated by the line labeled PW. Argentinian producers would manufacture 1 million iPads and Argentinian consumers would purchase 6 million iPads, so 5 million iPads would be imported. The tariff raises the price to $1,300, shown by the line labeled PW + tariff. At this price, Argentinian producers manufacture 2.5 million xx

WHAT IS ECONOMICS?XXI

iPads and Argentinian consumers purchase 3 million iPads, so 500,000 iPads are imported.

xxi

XXII

b. Show on your graph the C h a p t e r changes in consumer surplus and producer surplus that result from the tariff on smartphones and tablets.

Before there is a tariff, the Argentinian consumer surplus equals area A + area B + area C and Argentinian producer surplus equals area E. With the tariff, Argentinian consumer surplus equals area A and Argentinian producer surplus equals area B + area E.

c. Who in Argentina will oppose the tariff cuts?

Opposing the tariff cuts will be those who gain from the tariffs, specifically the producers, who gain substantial producer surplus, and perhaps some in the government, which gains tariff revenue.

Answers to the Review Quizzes Page 184 1.

Explain how a consumer‘s income and the prices of goods limit consumption possibilities.

UTILITY AND DEMAND

A consumer’s consumption possibilities are limited by the consumer’s income and the prices of the goods. The consumer is unable to consume limitless quantities of goods and services because the consumer must pay a price for each good or service consumed and the consumer’s income is limited. If the consumer’s income increases and/or the prices of the goods and services fall, the quantity of goods and services the consumer can afford increases, thereby increasing the consumer’s consumption possibilities.

8

2.

What is utility and how do we use the concept of utility to describe a consumer‘s preferences?

Utility is the benefit a person gets from the consumption of goods and services. We use total utility to describe a consumer’s preferences by looking at the (total) utility from the consumption of

xxii

108

CHAPTER 8

all the goods and services. We use marginal utility to measure the gain in utility from consuming another unit of a good or service.

3.

What is the distinction between total utility and marginal utility?

Total utility is the entire amount of satisfaction an individual obtains from the total amount of goods and services consumed.

Marginal utility is the change in total utility from a one-unit increase in the consumption of a good or service.

4.

What is the key assumption about marginal utility?

Generally, more consumption gives more utility. A key assumption about marginal utility is that it generally declines as more units of the good are consumed. This assumption is the principle of diminishing marginal utility.

Page 188 1.

Why does a consumer spend the entire budget?

The more goods and services a person consumes, the higher the person’s utility. By spending his or her entire budget, the person is consuming the maximum quantity of goods and services, which means the utility can be at its maximum.

2.

What is the marginal utility per dollar and how is it calculated?

The marginal utility per dollar equals the marginal utility of the good or service divided by its price. The marginal utility per dollar tells the additional utility gained from spending one more dollar on a good or service.

3.

What two conditions are met when a consumer is maximizing utility?

The two conditions that must be met to ensure that a consumer is maximizing his or her utility are: i) all available income is spent, and ii) the marginal utility per dollar spent is equal for all goods and services consumed.

4.

Explain why equalizing the marginal utility per dollar for all goods maximizes utility.

Equating the ratio of marginal utility per dollar for each good and service consumed maximizes utility because it measures the utility gained when an additional dollar of a good or service is consumed.

This allows the consumer to weigh the utility gained from additional consumption of a dollar’s worth of one good against the utility lost from the forgone consumption of a dollar’s worth of another good.

When the marginal utility per dollar for each good and service is equalized, there is no additional utility available from any other consumption combination.

Page 194 1.

When the price of a good falls and the prices of other goods and a consumer‘s income remain the same, explain what happens to the consumption of the good whose price has fallen and to the consumption of other goods.

When the price of a good falls, the marginal utility per dollar for that good increases. The marginal utility per dollar for other goods does not change. To maximize total utility, a consumer makes marginal utility per dollar equal for all goods, so the consumer © 2018 Pearson Education, Inc.

UTILITY AND DEMAND109

buys more of the good that has experienced the fall in price and less of the goods whose marginal utilities per dollar have not changed.

2.

Elaborate on your answer to the previous question by using demand curves. For which good does demand change and for which good does the quantity demanded change?

After the price of a good falls, the consumer increases consumption of the good to lower the marginal utility per dollar. This action means that more of the good is consumed at the lower price, which implies that the demand curve for the good is downward sloping. The consumer increases the quantity demanded of this good. Additionally, the consumer decreases the quantity of the other goods and services consumed, despite the price of other goods and services remaining unchanged. This change implies that the demand curves for each of the other goods and services shift leftward.

3.

If a consumer‘s income increases and if all goods are normal goods, explain how the quantity bought of each good changes.

If the consumer’s income increases and all the goods consumed are normal goods, then the consumption of all goods increase. With the increase in income, the initial consumption possibility is now affordable with money left over. If the consumer’s utility for all goods increases with consumption, because the consumer seeks to maximize utility subject to prices and available income, he or she will use the money left over from the initial bundle to increase the quantity consumed for all goods and services. By doing so the consumer increases his or her total utility. This increase occurs while the price of these goods and services remained unchanged, which indicates there is a rightward shift of the demand curve for all goods and services.

4.

What is the paradox of value and how is the paradox resolved?

The paradox of value asks: ―Why is water, which is essential to life, far cheaper than diamonds, which are not essential?‖ Consumers have diminishing marginal utility for water. The marginal utility of the last unit of water consumed is low because water is readily available and so the quantity consumed is very high. Consumers also have diminishing marginal utility for diamonds. The marginal utility of the last diamond consumed is high because diamonds are very scarce and so the quantity consumed is very low. Consumers maximize utility by equating the marginal utility per dollar for both goods.

The scarcity of diamonds (high marginal utility) and the abundance of water (low marginal utility) indicate people are willing to pay a higher price for an additional unit of diamonds than for an additional unit of water.

5.

What are the similarities between utility and temperature?

The scales of both utility and temperature are arbitrary. The units used to measure both can be changed without changing their predictive abilities. For instance, the scale used to ―measure‖ utility can be changed without consequence and the scale used to measure temperature (such as Celsius, Fahrenheit, or Kelvin) also © 2018 Pearson Education, Inc.

110

CHAPTER 8

can be changed without consequence. Additionally, although neither utility nor temperature can be directly observed, both can be used to make predictions about the observable world.

Page 197 1.

Define behavioral economics.

Behavioral economics studies the ways that limits on the ability of people’s brains to compute and implement rational decisions influence their economic actions.

2.

What are the three limitations on human rationality that behavioral economics emphasizes?

Behavioral economics studies bounded rationality (the point that people’s brain-computing power is limited and this limits people’s ability to make rational decisions), bounded willpower (the point that people’s will power is limited so that at times they make decisions they know they will later regret), and bounded selfinterest (the point that at times people make decisions that do not advance their self-interest).

3.

Define neuroeconomics.

Neuroeconomics studies the activity of the human brain when it makes an economic decision.

4.

What do behavioral economics and neuroeconomics seek to achieve?

Behavioral economics and neuroeconomics seek to explain why we do not always make rational economic decisions. Behavioral economists study how the bounded limitations they study affect people’s decisions so that not all decisions are the consequence of rational behavior. Neuroeconomists study how the brain works to make decisions so that neuroeconomists have a better understanding of the decisions people make.

© 2018 Pearson Education, Inc.

UTILITY AND DEMAND111

Answers to the Study Plan Problems and Applications Jerry has $12 a week to spend on yogurt and berries. The price of yogurt is $2, and berries are $4 a box.

1.

List the combinations of yogurt and berries that Jerry can afford. Draw a graph of Jerry‘s budget line with the quantity of berries plotted on the x-axis.

Jerry can buy 6 yogurts and 0 boxes of berries; 4 yogurts and 1 box of berries; 2 yogurts and 2 boxes of berries; and, 0 yogurts and 3 boxes of berries. Figure 8.1 shows Jerry’s budget line.

2.

How do Jerry‘s consumption possibilities change if, other things remaining the same, (i) the price of berries falls and (ii) Jerry‘s income increases. (i) If the price of a box of berries falls, Jerry’s consumption possibilities increase. His budget line rotates outward around the unchanged vertical intercept, which shows the (unchanged) maximum quantity of yogurt Jerry can buy. (ii) If Jerry’s income increases, Jerry’s consumption possibilities increase. His budget line shifts outward and its slope does not change.

Use the following data to work Problems 3 to 9.

Max has $35 a day to spend on windsurfing and snorkeling and he can spend as much time as he likes doing them. The price of renting equipment for windsurfing is $10 an hour and for snorkeling is $5 an hour. The table shows the total utility Max gets from each activity.

3.

Calculate Max‘s marginal utility from windsurfing at each number of hours per day. Does Max‘s marginal utility from windsurfing obey the principle of diminishing marginal utility?

Hours per day 1 2 3 4 5 6 7

Total Total utility utility from from windsurfing snorkeling 120 40 220 76 300 106 360 128 396 140 412 150 422 158

Max’s marginal utility from windsurfing 1 hour per day is 120; from windsurfing 2 hours per day is 100; from windsurfing 3 hours per day is 80; from windsurfing 4 hours per day is 60; from windsurfing 5 hours per day is 36; from windsurfing 6 hours per day is 16; and, from windsurfing 7 hours per day is 10. Max’s marginal utility from windsurfing obeys the principle of diminishing marginal utility because it decreases as consumption increases. © 2018 Pearson Education, Inc.

112

4.

CHAPTER 8

Calculate Max‘s marginal utility from snorkeling at each number of hours per day. Does Max‘s marginal utility from snorkeling obey the principle of diminishing marginal utility?

Max’s marginal utility from snorkeling 1 hour per day is 40; from 2 hours per day is 36; from snorkeling 3 hours per day is 30; from snorkeling 4 hours per day is 22; from snorkeling 5 hours per day is 12; from snorkeling 6 hours per day is 10; and, from snorkeling 7 hours per day is 8. Max’s marginal utility from snorkeling obeys the principle of diminishing marginal utility because it decreases as consumption increases.

5.

Which does Max enjoy more: his 6th hour of windsurfing or his 6th hour of snorkeling?

Max’s marginal utility from his 6th hour of windsurfing is 16 and his marginal utility from his 6th hour of snorkeling is 10. Max enjoys his 6th hour of windsurfing more than his 6th hour of snorkeling.

6.

Make a table of the combinations of hours spent windsurfing and snorkeling that Max can afford.

The table is Marginal Marginal to the right. utility per utility The first and Hours dollar from Hours per dollar third columns windsurfing windsurfing snorkeling from show the snorkeling combinations 3 8.0 1 8.0 of 2 10.0 3 6.0 windsurfing 1 12.0 5 2.4 and 0 7 1.6 snorkeling Max can afford.

7.

Add two columns to your table in Problem 6 and list Max‘s marginal utility per dollar from windsurfing and from snorkeling.

The columns are in the table, in the second and fourth columns.

8. a. To maximize his utility, how many hours a day does Max spend on each activity?

To maximize his utility, Max windsurfs for 3 hours and snorkels for 1 hour.

Max uses his $35 so that all of the $35 is spent and so that the marginal utility per dollar from each activity is the same. When Max windsurfs for 3 hours and snorkels for 1 hour, he spends $30 renting the windsurfing equipment and $5 renting the snorkeling equipment—a total of $35.

The marginal utility from the third hour of windsurfing is 80 and the rent of the windsurfing equipment is $10 an hour, so the marginal utility per dollar from windsurfing is 8. The marginal utility from the first hour of snorkeling is 40 and the rent of the snorkeling equipment is $5 an hour, so the marginal utility per dollar from snorkeling is 8. The marginal utility per dollar from windsurfing equals the marginal utility per dollar from snorkeling.

© 2018 Pearson Education, Inc.

UTILITY AND DEMAND113

b. If Max spent a dollar more on windsurfing and a dollar less on snorkeling than in part (a), how would his total utility change?

If Max windsurfs another hour, he pays $10 and gains 60 units of utility (the marginal utility from the 4th hour), which is 6.0 units of utility per dollar. So if he spends a dollar more on windsurfing, his utility from windsurfing increases by 6.0. If he spends an hour less on snorkeling, he saves $5 and loses 40 units of utility (the marginal utility from the 1st hour of snorkeling), which is 8.0 units of utility per dollar. So if he spends a dollar less on snorkeling, he loses 8.0 units of utility. Overall, spending a dollar more on windsurfing and a dollar less on snorkeling lowers Max’s total utility by 2.0 units of utility.

c. If Max spent a dollar less on windsurfing and a dollar more on snorkeling than in part (a), how would his total utility change?

If Max snorkels another hour, he pays $5 and gains 36 units of utility (the marginal utility from the 2nd hour), which is 7.2 units of utility per dollar. So if he spends a dollar more on snorkeling, his utility from snorkeling increases by 7.2. If he spends an hour less on windsurfing, he saves $10 and loses 80 units of utility (the marginal utility from the 3rd hour of windsurfing), which is 8.0 units of utility per dollar. So if he spends a dollar less on windsurfing, he loses 8.0 units of utility. Overall, spending a dollar more on snorkeling and a dollar less on windsurfing lowers Max’s total utility by 0.8 units of utility.

Use the data in Problem 3 to work Problems 9 to 13.

9.

If the price of renting windsurfing equipment is cut to $5 an hour, how many hours a day does Max spend on each activity?

Max will now maximize his total utility by spending 5 hours windsurfing and 2 hours snorkeling. This combination of windsurfing and snorkeling uses all of Max’s income and sets the marginal utility per dollar from windsurfing equal to the marginal utility per dollar from snorkeling.

10.

Draw Max‘s demand curve for rented windsurfing equipment. Over the price range from $5 to $10 an hour, is Max‘s demand for windsurfing equipment elastic or inelastic?

From Problem 8 (a), when the price of renting windsurfing equipment is $10 per hour, Max rents windsurfing equipment for 3 hours. From Problem 9, when the price of renting windsurfing equipment is $5 per hour, Max rents windsurfing equipment for 5 hours. These points lead to the demand curve in Figure 8.2. Max’s elasticity of demand for renting windsurfing equipment is inelastic because a fall in the price decreases Max’s total © 2018 Pearson Education, Inc.

114

CHAPTER 8

expenditure on renting windsurfing equipment.

11.

How does Max‘s demand for snorkeling equipment change when the price of windsurfing equipment falls? What is Max‘s cross elasticity of demand for snorkeling with respect to the price of windsurfing? Are windsurfing and snorkeling substitutes or complements for Max? When the price of windsurfing falls, Max increases the hours he snorkels from 1 hour to 2 hours. Max’s demand for snorkeling increases when the price of windsurfing falls. Max’s cross elasticity of demand equals (1 hour/1.5 hours)/($5/$7.50) = 1.00.

Windsurfing and snorkeling are complements for Max.

12.

If Max‘s income increases from $35 to $55 a day, how does his demand for rented windsurfing equipment change? Is windsurfing a normal good? Explain.

To maximize his utility, Max windsurfs for 4 hours and snorkels for 3 hours. Max uses his $55 such that all of the $55 is spent and marginal utility per dollar for each activity is the same. When Max windsurfs for 4 hours and snorkels for 3 hours, he spends $40 renting the windsurfing equipment and $15 renting the snorkeling equipment— a total of $55. The marginal utility from the fourth hour of windsurfing is 60 and the rent of the windsurfing equipment is $10 an hour, so the marginal utility per dollar from windsurfing is 6.

The marginal utility from the third hour of snorkeling is 30 and the rent of the snorkeling equipment is $5 an hour, so the marginal utility per dollar from snorkeling is 6. The marginal utility per dollar from windsurfing equals the marginal utility per dollar from snorkeling.

Max’s demand for rented windsurfing equipment increases. The quantity of windsurfing equipment rented at $10 per hour increases from 3 hours (problem 8 (a)) to 4 hours (this problem). Max’s demand curve for rented windsurfing equipment shifts rightward as shown in Figure 8.3 by the shift from D1 to D2. Windsurfing equipment is a normal good.

13.

If Max‘s income increases from $35 to $55 a day, how does his demand for snorkeling equipment change? Is snorkeling a normal good? Explain.

Max’s demand for rented snorkeling equipment increases.

The quantity of snorkeling © 2018 Pearson Education, Inc.

UTILITY AND DEMAND115

equipment demanded at a price of $5 per hour increases from 1 hour (problem 8 (a)) to 3 hours (this problem). As a result Max’s demand curve for rented snorkeling equipment shifts rightward as illustrated in Figure 8.4 by the shift from D1 to D2. Snorkeling equipment is a normal good.

Use the following news clip to work Problems 14 and 15.

A Great Deal and a Great Way to Enjoy a Game!

The Pittsburgh Pirates offer all the hot dogs, hamburgers, nachos, salads, popcorn, peanuts, ice cream, and soda you can handle for a fixed price at every home game.

Source: Pittsburgh Pirates website 14.

What conflict might exist between utility-maximization and eating ―all you can handle‖? What feature of the marginal utility from ballpark food enables the Pirates to make this offer?

Utility maximization means that the person will eat until the marginal utility per dollar of food equals the marginal utility per dollar of all other goods and services. Eating ―all you can handle‖ implies that the person’s objective is to eat until he or she has eaten as much as possible not to maximize his or her utility though, of course, ―eating all you can handle‖ might bring some utility.

The point that the marginal utility from ballpark food decreases as more is consumed means that fans will be (at least somewhat) limited in the quantity of food and drink they consume and not increase the Pirates’ cost beyond all bounds.

15.

How can over-eating at a ball game be reconciled with marginal utility theory? Which ideas of behavioral economics are consistent with the over-eating at a ball game?

The marginal utility of food consumption includes not only the ―usual utility‖ from food but also the utility from eating ―all you can handle.‖ So the fan receives utility from not only the food but also the reason for overeating.

Bounded willpower seems very consistent with the information.

Undoubtedly the people who ―eat all they can handle‖ in the stadium regret their decisions at later dates when they either have less income to spend than they desire and/or need to lose weight.

© 2018 Pearson Education, Inc.

116

CHAPTER 8

Answers to Additional Problems and Applications 16.

Tim buys 2 pizzas and sees 1 movie a week when he has $16 to spend, a movie ticket is $8, and a pizza is $4. Draw Tim‘s budget line. If the price of a movie ticket falls to $4, describe how Tim‘s consumption possibilities change.

Figure 8.5 shows Tim’s budget line as BL1. Pizza is on the vertical axis and movies on the horizontal axis. If the price of a movie ticket falls to $4, then Tim’s budget line rotates outward, as illustrated in Figure 8.5 by the rotation from BL1 to BL2. Tim’s consumption possibilities expand.

Hours per month

Marginal utility from golf

1 2 3 4 5 6 7

80 60 40 30 20 10 6

© 2018 Pearson Education, Inc.

Marginal utility from tennis 40 36 30 10 5 2 1

UTILITY AND DEMAND117

17.

Cindy has $70 a month to spend, and she can spend as much time as she likes playing golf and tennis. The price of an hour of golf is $10, and the price of an hour of tennis is $5. The table shows Cindy‘s marginal utility from each sport.

Make a table that shows Cindy‘s affordable combinations of hours playing golf and tennis. If Cindy increases her expenditure to $100, describe how her Hours Hours consumption possibilities change. playing playing The table showing Cindy’s affordable combinations golf tennis of hours playing golf and tennis is to the right.

7 0 If Cindy increases her expenditure, then for each 6 2 entry of tennis hours in the table, her hours of 5 4 playing golf increase by 3 hours. Alternatively, 4 6 for each entry of golf hours in the table her 3 8 hours of playing tennis increase by 6. In terms 2 10 of a diagram, Cindy’s budget line shifts to the 1 12 right and its slope does not change.

0 14 Use the information in Problem 17 to work Problems 18 to 24.

18. a. How many hours of golf and how many hours of tennis does she play to maximize her utility?

Cindy plays golf for 5 hours and tennis for 4 hours to maximize her utility. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis.

b. Compared to part (a), if Cindy spent a dollar more on golf and a dollar less on tennis, by how much would her total utility change?

If Cindy played another hour of golf, she pays $10 and gains 10 units of utility (the marginal utility from the 6th hour), which is 1.0 unit of utility per dollar. So if she spends a dollar more on golf, her utility from golf increases by 1.0. If she spends an hour less playing tennis, she saves $5 and loses 10 units of utility (the marginal utility from the 4th hour of tennis), which is 2.0 units of utility per dollar. So if she spends a dollar less on tennis, she loses 2.0 units of utility. Overall, spending a dollar more on golf and a dollar less on tennis lowers Cindy’s total utility by 1.0 unit of utility.

c. Compared to part (a), if Cindy spent a dollar less on golf and a dollar more on tennis, by how much would her total utility change?

If Cindy spends an hour less playing golf, she saves $10 and loses 20 units of utility (the marginal utility from the 5th hour), which is 2.0 unit of utility per dollar. So if she spends a dollar less on golf, her utility from golf decreases by 2.0. If she spends an hour more playing tennis, she spends $5 and gains 5 units of utility (the marginal utility from the 5th hour of tennis), which is 1.0 unit of utility per dollar. So if she spends a dollar more on tennis, she gains 1.0 units of utility. Overall, spending a dollar less on golf and a dollar more on tennis lowers Cindy’s total utility by 1.0 unit of utility.

© 2018 Pearson Education, Inc.

118

19.

CHAPTER 8

Explain why, if Cindy equalized the marginal utility per hour of golf and tennis, she would not maximize her utility.

Cindy would not maximize her utility by equalizing the marginal utility per hour of golf and tennis because golf and tennis have different prices. Golf is twice as expensive as tennis, so effectively every unit of utility that Cindy buys from playing golf costs her twice as much as buying a unit of utility from playing tennis. Equalizing the marginal utilities means that the marginal utility per dollar from tennis is greater than her marginal utility per dollar from golf. This inequality means that Cindy can increase her utility if she spends a dollar less on golf and a dollar more on tennis.

Cindy‘s tennis club raises its price of an hour of tennis from $5 to $10, other things remaining the same.

20. a. List the combinations of hours spent playing golf and tennis that Cindy can now afford and her marginal utility per dollar from golf and from tennis.

The lists of affordable combinations are in the first and third columns in the table to the right.

The lists of the marginal utilities per dollar are in the second and fourth columns in the table.

Hours playing golf

Marginal utility per dollar from golf

Hours playing tennis

7 6 5 4 3 2 1 0

0.6 1.0 2.0 3.0 4.0 6.0 8.0

0 1 2 3 4 5 6 7

b. How many hours does Cindy now spend playing golf and how many hours does she spend playing tennis?

Marginal utility per dollar from tennis 4.0 3.6 3.0 1.0 0.5 0.2 0.1

Cindy now plays golf for 4 hours and plays tennis for 3 hours. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis.

© 2018 Pearson Education, Inc.

UTILITY AND DEMAND119

21.

Use the information in Problem 20 to draw Cindy‘s demand curve for tennis. Over the price range of $5 to $10 an hour of tennis, is Cindy‘s demand for tennis elastic or inelastic?

One point on her demand curve is 4 hours of tennis when the price is $5 per hour. Another point is 3 hours of tennis when the price is $10 per hour. Cindy’s demand curve is in Figure 8.6. The price elasticity of demand between these two points on her demand curve is 0.43, so Cindy’s demand is inelastic.

22.

Explain how Cindy‘s demand for golf changed when the price of an hour of tennis increased from $5 to $10 in Problem 20. What is Cindy‘s cross elasticity of demand for golf with respect to the price of tennis? Are tennis and golf substitutes or complements for Cindy?

The quantity of golf Cindy plays falls from 5 hours before the price of tennis increased to 4 hours after the price increased.

Cindy’s demand for golf decreases. Her cross elasticity of demand is −0.33. Tennis and golf are complements because the cross elasticity of demand is negative.

23.

Cindy loses her math tutoring job and the amount she has to spend on golf and tennis falls from $70 to $35 a month. With the price of an hour of golf at $10 and of tennis $5, calculate the change in the hours she spends playing golf. For Cindy, is golf a normal good or an inferior good? Is tennis a normal good or an inferior good?

With an income of $35, Cindy now plays golf for 2 hours and tennis for 3 hours to maximize her utility. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis. Golf is a normal good because the fall in income leads to a decrease in Cindy’s demand for hours spent playing golf from 5 hours to 2 hours.

Tennis is a normal good because the fall in income leads to a decrease in Cindy’s demand for hours spent playing tennis from 4 hours to 3 hours.

24.

Cindy takes a Club Med vacation, the cost of which includes unlimited sports activities. With no extra charge for golf and tennis, Cindy allocates a total of 4 hours a day to these activities. a. How many hours does Cindy play golf and how many hours does she play tennis?

Cindy plays golf for 3 hours and plays tennis for 1 hour.

b. What is Cindy‘s marginal utility from golf and from tennis?

Cindy’s marginal utility from golf and from tennis both equal 40.

c. Why does Cindy equalize the marginal utilities rather than the marginal utility per dollar from golf and from tennis?

Because the equipment is free, Cindy does not have to allocate her © 2018 Pearson Education, Inc.

120

CHAPTER 8

income between the two activities; instead, she allocates her time between the two activities because time is now the factor that limits her. Because each activity is in hour increments, Cindy equalizes the marginal utility per hour and thereby sets the marginal utilities equal to each other.

25.

Jim has made his best affordable choice of muffins and coffee. He spends all of his income on 10 muffins at $1 each and 20 cups of coffee at $2 each. Now the price of a muffin rises to $1.50 and the price of coffee falls to $1.75 a cup. a. Will Jim now be able to buy 10 muffins and 20 coffees?

Before the changes in price, Jim spent all his income on muffins and coffee. Therefore Jim’s income is (10 muffins) × ($1 each) + (20 cups of coffee) × ($2 each) = $50. After the change in prices, the cost of 10 muffins and 20 coffees is (10 muffins) × ($1.50 each) + (20 cups of coffee) × ($1.75 each), which is $50. Therefore Jim can buy 10 muffins and 20 coffees.

b. If Jim changes the quantities he buys, will he buy more or fewer muffins and more or less coffee? Explain your answer.

If Jim changes the quantities he buys, he will buy more coffee and fewer muffins. He will make these changes because coffee has fallen in relative price while muffins have risen in relative price.

26.

Ben spends $50 a year on 2 bunches of flowers and $50 a year on 10,000 gallons of tap water.

Ben is maximizing utility and his marginal utility from water is 0.5 unit per gallon. a. Are flowers or water more valuable to Ben? In total, water is more valuable to Ben because water has a (much!) higher total utility. On the margin, an additional bunch of flowers has larger marginal utility than does an additional 1,000 gallons of water.

b. Explain how Ben‘s expenditure on flowers and water illustrates the paradox of value.

Flowers are more expensive than water even though water is essential to life. The reason flowers are more expensive is because people, such as Ben, enjoy fewer flowers than they do water. Because Ben consumes so much water, its marginal utility is quite low even though its total utility is tremendous. Because so few flowers are enjoyed, their marginal utility is relatively high even though their total utility is small. Prices, though, reflect the marginal utility of the good and so flowers are more expensive than water.

Use the following news clip to work Problems 27 to 29.

Putting a Price on Human Life Researchers at Stanford and the University of Pennsylvania estimated that a healthy human life is worth about $129,000. Using Medicare records on treatment costs for kidney dialysis as a benchmark, the authors tried to pinpoint the threshold beyond which ensuring another ―quality‖ year of life was no longer financially worthwhile. The study comes amid debate over whether Medicare should start rationing health care on the basis of cost effectiveness.

Source: Time, June 9, 2008 27.

Why might Medicare ration health care according to treatment that is ―financially worthwhile‖ as opposed to providing as much treatment as is needed by a patient, regardless of costs? © 2018 Pearson Education, Inc.

UTILITY AND DEMAND121

Increasing the quantity of health care lowers the marginal utility from the last unit of health care. At some amount of health care the point is reached such that the marginal utility per dollar of health care is less than the marginal utility per dollar from other goods and services. At that point the quantity of health care being provided is too much and society would be better off with less health care.

© 2018 Pearson Education, Inc.

122

28.

CHAPTER 8

What conflict might exist between a person‘s valuation of his or her own life and the rest of society‘s valuation of that person‘s life?

The marginal utility that an individual places on another year of their own life likely approximates infinity. The marginal utility that the rest of society places on another year of the person’s life is not as high. Hence the individual’s valuation of their life is much higher than society’s valuation.

29.

How does the potential conflict between self-interest and the social interest complicate setting a financial threshold for Medicare treatments?

Each individual has a very high marginal utility from an additional year of life. Hence each individual’s marginal utility per dollar from extending their life is extremely high and so their selfinterested demand will be very high. But the rest of society’s marginal utility per dollar from an additional year of the person’s life is much lower and the socially interested demand will be much lower.

Economics in the News 30.

After you have studied Economics in the News (pp. 198–199), answer the following questions. a. If the price of an unlimited data plan increased, (i) How would the number of people who buy the service change?

As the law of demand demonstrates, the number of people who buy unlimited data plans would decrease.

(ii) How would the quantity of data used change for someone who keeps buying blocks of data?

For a user who keeps buying blocks of data the quantity of data used will not change because the rise in the price of an unlimited plan does not affect him or her.

b. If the price per GB of a Canadian data plan increased, (i) How would the number of people who buy a 1 GB plan change?

An increase in the price per GB increases the relative price of downloading data. People will move along their budget line, substituting other goods and services for data usage. This change leads to two effects on the number of people who buy a 1 GB plan. First, some people who had been buying more than 1 GB of data will decrease their usage of data in favor of other goods and move down to a 1 GB plan. This effect increases the number of people who buy a 1 GB plan. Second, some people who had been buying a 1 GB plan will stop buying any data download plan at all and instead consume more other goods and services. This effect decreases the number of people who buy a 1 GB plan. The net effect depends on which effect is larger. (ii) How would the quantity of data used by the average person change?

The increase in the price of a GB will decrease the quantity of data the average person uses.

© 2018 Pearson Education, Inc.

UTILITY AND DEMAND123

31.

Companies Are Racing to Add Value to Water Svalbardi, a water sourced from Norwegian icebergs that are up to 4,000 years old, sells for $99 a bottle. From extreme luxury to the ordinary, the market for bottled water is growing quickly as people switch from soft drinks and alcohol to healthier alternatives. Market researchers report that consumption of bottled water overtook that of sugary soft drinks in America in 2016.

Source: The Economist, March 25, 2017 a. Assuming that the price of an ordinary bottle of water is $1, what can we infer about the marginal utility of a bottle of ordinary water and the marginal utility of a bottle of Svalbardi for a person who buys one bottle of Svalbardi and 100 bottles of ordinary water per year?

To maximize his or her utility, the person will buy the quantity of Svalbardi water and ordinary water that sets (MUS/PS) = (MUO/PO) where MUS is the marginal utility of Svalbardi water, MUO is the marginal utility from ordinary water, PS is the price of a bottle of Svalbardi water, and PO is the price of a bottle of ordinary water.

The marginal utility per dollar condition can be rearranged to MUS = (PS/PO) × MUO. Because PS = $99 and PO = $1, the rearranged equation shows that MUS = 99 × MUO. In other words, the marginal utility from the first bottle of Svalbardi is 99 times the marginal utility of the 100th bottle of ordinary water.

b. Why might the marginal utility from a bottle of Svalbardi decrease more rapidly than the marginal utility from ordinary bottled water?

One of the major attributes of Svalbardi is the ―statement‖ it makes that the consumer is one of the few who can afford it. But typically a consumer carries around only one bottle of water. And once one bottle of Svalbardi is purchased, it is easily refillable and can be carried once more with no loss of status. For both reasons, the marginal utility of a second bottle of Svalbardi is quite low compared to the marginal utility of the first bottle. Ordinary bottled water, however, is purchased more for its hydrating properties than a fashion statement, so its marginal utility falls more slowly because its marginal utility is derived from its hydration.

32.

Money Can Buy Happiness, But Only to a Point They say money can‘t buy happiness. Of course, they‘re wrong. Research by economist David Clingingsmith at the Weatherhead School of Management shows that household income is positively related to emotional well-being and a person‘s evaluation of their own quality of life.

For people who earn less than $200,000 a year, getting a pay rise improves their emotional wellbeing. Above $200,000 the effects tail off.

Source: CNBC, December 14, 2015 Based on the research reported in the news clip, a. How does an increase in income for people who earn less than $200,000 a year influence total utility? ―Utility‖ and ―emotional well-being‖ may not be synonymous because utility is an arbitrary measure that tells how people value different consumption bundles at a point in time while emotional well-being presumably is a measure that tells how pleased or happy © 2018 Pearson Education, Inc.

124

CHAPTER 8

people are with their entire life. But, supposing they C h a p t e r measure the same thing, according to the research in the news clip, an increase in income for people who earn less than $200,000 increases their emotional well-being which means it increases their total utility.

b. How does an increase in income for people who earn less than $200,000 a year influence marginal utility?

If ―emotional well-being‖ is the same as utility, then the additional income increases total utility so that the marginal utility of additional income is positive.

Answers to the Review Quizzes Page 208 1.

What does a household‘s budget line show?

9

POSSIBILITES, PREFERENCES, AND CHOICES

The budget line plots combinations of goods that require all a household’s income and describes the limits to its consumption choices.

2.

How does the relative price and a household‘s real income influence its budget line?

The magnitude of the slope of the budget line equals the relative price of the good or service measured on the horizontal axis. A fall in the price of the good measured on the horizontal (vertical) axis © 2018 Pearson Education, Inc.

122

CHAPTER 9

decreases that good’s relative price and decreases (increases) the slope of the budget line. A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. An increase (decrease) in household income causes a parallel shift of the budget line rightward (leftward). The slope of the budget line does not change when income changes.

3.

If a household has an income of $40 and buys only bus rides at $2 each and magazines at $4 each, what is the equation of the household‘s budget line?

The budget equation states that a household’s spending must equal its income. The budget equation is derived for two goods, bus rides and magazines. The amount spent on bus rides is (Pbus ride)×(Qbus ride), the amount spent on magazines is (Pmagazine)×(Qmagazine), and the consumer’s income is y. We know that (Pmagazine)×(Qmagazine) + (Pbus ride)×(Qbus ride) = y. Rearrange this equality by subtracting the amount spent on bus rides from both sides to give (Pmagazine)×(Qmagazine) = y – (Pbus ride)×(Qbus ride). Finally, divide both sides by the price of magazine to give the budget equation Qmagazine = y/Pmagazine – (Pbus ride /Pmagazine)×(Qbus ride).

Substituting in our values, y = $40, P bus ride = $2 and P magazine = $4, gives Qmagazine = $40/$4 – ($2/$4)×(Qbus ride) which is equal to Qmagazine = 10 – 0.5 Qbus ride

4.

If the price of one good changes, what happens to the relative price and the slope of the household‘s budget line?

A relative price is the price of one good divided by the price of another good. For example, the magnitude of the slope of the budget line (Pmovie/Psoda) is the relative price of a movie in terms of soda. This relative price shows how many sodas must be forgone to see an additional movie. A fall in the price of the good on the horizontal (vertical) axis increases the total affordable quantity of that good, decreases its relative price, and decreases (increases) the magnitude of the slope of the budget line.

5.

If a household‘s money income changes and prices do not change, what happens to the household‘s real income and budget line?

A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. For example, the vertical intercept for a budget line measuring soda on the vertical axis is (y/Psoda), which is the consumer’s real income in terms of sodas. A change in a household’s money income changes the household’s real income in terms of both goods and causes a parallel shift of the budget line. If a household’s money income increases, its budget line shifts rightward and if a household’s money income decreases, its budget line shifts leftward.

© 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES123

Page 212 1.

What is an indifference curve and how does a preference map show preferences?

An indifference curve shows those combinations of goods for which a consumer is indifferent. The consumer has the same level of satisfaction for any combination on a given indifference curve. The family of indifference curves is the preference map. This map shows the person’s preferences because it shows how the person ranks each combination of goods. In particular, the person prefers combinations on higher indifference curves to combinations on lower indifference curves.

2.

Why does an indifference curve slope downward and why is it bowed toward the origin?

The downward slope of an indifference curve illustrates the tradeoff between two goods while maintaining the same level of total satisfaction. Since the consumer is indifferent among all points on an indifference curve, when moving along it any increase in satisfaction from gaining one good must be matched by an equal decrease in satisfaction from a loss in the other good. An indifference curve is bowed toward the origin because the more of good x that is consumed the less you are willing to give up of good y to get more of good x and remain indifferent.

3.

What do we call the magnitude of the slope of an indifference curve?

The magnitude of the slope of an indifference curve is called the marginal rate of substitution (MRS). The MRS measures the rate at which the consumer gives up one good to get more of another good, while remaining on the same indifference curve (keeping the consumer indifferent about the changes). The bowed-in shape of the indifference curve is due to the assumption of diminishing MRS.

4.

What is the key assumption about a consumer‘s marginal rate of substitution?

The key assumption about the marginal rate of substitution is that it is diminishing as a consumer moves down an indifference curve, creating the bowed-in shape.

Page 217 1.

When a consumer chooses the combination of goods and services to buy, what is she or he trying to achieve?

The consumer is trying to achieve the highest level of well being possible.

2.

Explain the conditions that are met when a consumer has found the best affordable combination of goods to buy. (Use the terms budget line, marginal rate of substitution, and relative price in your explanation.)

At the optimal consumption choice, the consumer’s consumption bundle is 1) on the budget line, 2) on the highest attainable indifference curve,

© 2018 Pearson Education, Inc.

124

CHAPTER 9

3) such that the slope of the budget line, which is the relative price of the two goods, equals the slope of the indifference curve, which is the MRS.

3.

If the price of a normal good falls, what happens to the quantity demanded of that good?

If the price of a normal good falls, the quantity demanded of that good increases because the substitution effect and the income effect both bring an increase in the quantity demanded.

4.

Into what two effects can we divide the effect of a price change?

A price change can be divided into a substitution effect and an income effect. The substitution effect is the effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new situation. The income effect is the effect of a change in income sufficient to get the consumer to the highest indifference curve that is affordable on the new budget line reflecting the price change.

5.

For a normal good, does the income effect reinforce the substitution effect or does it partly offset the substitution effect?

For a normal good the substitution effect and the income effect reinforce each other, and a decrease (increase) in the price of a good will always result in an increase (decrease) in the quantity of the good demanded.

© 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES125

Answers to the Study Plan Problems and Applications Use the following information to work Problems 1 to 2.

Sara‘s income is $12 a week. The price of popcorn is $3 a bag, and the price of a smoothie is $3.

1.

Calculate Sara‘s real income in terms of smoothies. Calculate her real income in terms of popcorn. What is the relative price of smoothies in terms of popcorn? What is the opportunity cost of a smoothie?

Sara’s real income is 4 smoothies. Sara’s real income in terms of smoothies is equal to her money income divided by the price of a smoothie. Sara’s money income is $12, and the price of a smoothie is $3. Sara’s real income is $12 divided by $3 a smoothie, which is 4 smoothies.

Sara’s real income is 4 bags of popcorn. Sara’s real income in terms of popcorn is equal to her money income divided by the price of a bag of popcorn, which is $12 divided by $3 a bag or 4 bags of popcorn.

The relative price of a smoothie is 1 bag of popcorn per smoothie.

The relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so the relative price of a smoothie is $3 divided by $3 a bag, which equals 1 bag of popcorn per smoothie.

The opportunity cost of a smoothie is 1 bag of popcorn. The opportunity cost of a smoothie is the quantity of popcorn that must be forgone to get a smoothie. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so to buy one smoothie Sara must forgo 1 bag of popcorn.

2.

Calculate the equation for Sara‘s budget line (with bags of popcorn on the left side). Draw a graph of Sara‘s budget line with the quantity of smoothies on the x-axis. What is the slope of Sara‘s budget line? What determines its value?

The equation that describes Sara’s budget line is QP = 4 – QS. Call the price of popcorn PP and the quantity of popcorn QP, the price of a smoothie PS and the quantity of smoothies QS, and income y. Sara’s budget equation is PPQP + PSQS = y. If we substitute $3 for the price of popcorn, $3 for the price of a smoothie, and $12 for the income, the budget equation becomes $3QP + $3QS = $12. Dividing both sides by $3 and subtracting QS from both sides gives QP = 4 – QS. To draw a graph of the budget line, plot the quantity of smoothies on the x-axis and the quantity of popcorn on the yaxis. The budget line is a straight line from 4 bags of popcorn on the y-axis to 4 smoothies on the x-axis.

The slope of the budget line, when smoothies are plotted on the x-axis, is minus 1. The magnitude © 2018 Pearson Education, Inc.

126

CHAPTER 9

of the slope is equal to the relative price of a smoothie. The slope of the budget line is ―rise over run.‖ If the quantity of smoothies decreases from 4 to 0, the quantity of popcorn increases from 0 to 4. The rise is 4 and the run is 4. Therefore the slope equals 4/4, which is 1.

© 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES127

Use the following data to work Problems 3 and 4.

Sara‘s income falls from $12 to $9 a week, while the price of popcorn is unchanged at $3 a bag and the price of a smoothie is unchanged at $3.

3.

What is the effect of the fall in Sara‘s income on her real income in terms of (a) smoothies and (b) popcorn? a. Sara’s real income falls from 4 smoothies to 3 smoothies. Sara’s real income in terms of smoothies is equal to her money income divided by the price of a smoothie. Sara’s money income is now $9 and the price of a smoothie is $3. Sara’s real income is now $9 divided by $3 a smoothie, which is 3 smoothies. b. Sara’s real income falls from 4 bags of popcorn to 3 bags of popcorn.

Sara’s real income in terms of popcorn is equal to her money income divided by the price of a bag of popcorn. Sara’s money income is now $9 and the price of a bag of popcorn is $3. Sara’s real income is now $9 divided by $3 a bag, which is 3 bags of popcorn.

4.

What is the effect of the fall in Sara‘s income on the relative price of a smoothie in terms of popcorn? What is the slope of Sara‘s new budget line if it is drawn with smoothies on the x-axis?

The relative price of a smoothie is 1 bag of popcorn per smoothie, the same relative price as before her income fell. The relative price does not depend on Sara’s income. Instead the relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so the relative price of a smoothie is $3 divided by $3 a bag. The relative price equals 1 bag per smoothie.

The slope of the budget line, when smoothies are plotted on the xaxis is minus 1, the same slope as before her fall in income. The magnitude of the slope of the budget line is equal to the relative price of a smoothie. The relative price does not change when Sara’s income decreases so the slope of the budget line does not change.

5.

Sara‘s income is $12 a week. The price of popcorn rises from $3 to $6 a bag, and the price of a smoothie is unchanged at $3. Explain how Sara‘s budget line changes with smoothies on the xaxis.

The budget line rotates inward around the unchanged x intercept. The magnitude of the slope of the budget line is equal to the relative price of a smoothie. The relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The rise in the price of a bag of popcorn lowers the relative price of a smoothie in terms of popcorn. The relative price has fallen so the magnitude of the slope of the budget line has fallen.

6.

Draw figures that show your indifference curves for the following pairs of goods. For each pair, are the goods perfect substitutes, perfect complements, substitutes, complements, or unrelated goods?  Right gloves and left gloves Figure 9.2A is to the right. Right gloves/left gloves are perfect complements. Because these are perfect

© 2018 Pearson Education, Inc.

128

CHAPTER 9

complements, the indifference curves are right angles.



Coca-Cola and Pepsi Figure 9.2B is to the right. These are, for most students, almost perfect substitutes. The indifference curves should either be linear (for perfect substitutes, as shown in Figure 9.2B) or nearly linear.



Desktop computers and laptop computers Figure 9.2C is to the right. These are substitutes, though not perfect substitutes. The indifference curves are bowed inward toward the origin.



Strawberries and ice cream Figure 9.2D is to the right. These are probably complements for many students, though not perfect complements. The indifference curves are not right angles, as they would be for perfect complements, but instead are bowed inward toward the origin. © 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES129

7.

Discuss the shape of the indifference curve for each of the following pairs of goods. Explain the relationship between the shape of the indifference curve and the marginal rate of substitution as the quantities of the two goods change.  Orange juice and smoothies Orange juice and smoothies are substitutes. They are not perfect substitutes, so the indifference curves are bowed in toward the origin. The marginal rate of substitution falls moving down along an indifference curve.



Baseballs and baseball bats These are complements but probably not perfect complements. The indifference curves should be significantly bowed inward. (If a student says these goods are perfect complements, the indifference curves should be right angles, such as those in Figure 9.2A.) If the indifference curves are not right angles, then the marginal rate of substitution falls rapidly moving down along an indifference curve.

(If the goods are perfect complements, the marginal rate of substitution does not change moving down along the indifference curve except when moving around the 90 degree point where it goes from infinity to zero.)



Left running shoe and right running shoe These are perfect complements so the indifference curves are right angles, as shown in Figure 9.2A. The marginal rate of substitution does not change moving down along the indifference curve except when moving around the 90 degree point where it goes from infinity to zero.



Eyeglasses and contact lenses The indifference curves should either be linear (for perfect substitutes, as shown in Figure 9.2B) or nearly linear as in Figure 9.2C. If the indifference curves are linear, then the marginal rate of substitution does not change moving down along the indifference curve; if the indifference curves are nearly linear, then the marginal rate of substitution falls slightly moving down along an indifference curve.

Use the following data to work Problems 8 and 9.

Pam has made her best affordable choice of cookies and granola bars. She spends all of her weekly income on 30 cookies at $1 each and 5 granola bars at $2 each. Next week, she expects the price of a cookie to fall to 50¢ and the price of a granola bar to rise to $5.

8. a. Will Pam be able to buy and want to buy 30 cookies and 5 granola bars next week?

Pam can still buy 30 cookies and 5 granola bars. When Pam buys 30 cookies at $1 each and 5 granola bars at $2 each, she spends $40 a © 2018 Pearson Education, Inc.

130

CHAPTER 9

week. Now that the price of a cookie is 50 cents and the price of a granola bar is $5, 30 cookies and 5 granola bars will cost $40. So Pam can still buy 30 cookies and 5 granola bars. But Pam will not want to buy 30 cookies and 5 granola bars because the marginal rate of substitution does not equal the relative price of the goods. Pam will move to a point on the highest indifference curve possible where the marginal rate of substitution equals the relative price.

b. Which situation does Pam prefer: cookies at $1 and granola bars at $2 or cookies at 50¢ and granola bars at $5?

Pam prefers cookies at 50 cents each and granola bars at $5 each because she can get onto a higher indifference curve than when cookies are $1 each and granola bars are $2 each. To see why Pam can move to a higher indifference curve, note that the new budget line and the old budget line both pass through the point 30 cookies and 5 granola bars. If granola bars are plotted on the x-axis, the marginal rate of substitution at this point on Pam’s indifference curve is equal to the relative price of a granola bar at the original prices, which is 2. The new relative price of a granola bar is $5/50 cents, which is 10. That is, the budget line is steeper than the indifference curve at 30 cookies and 5 granola bars. So Pam’s new equilibrium combination of cookies and granola bars must be on an indifference curve at a point steeper than the initial indifference curve. Because the new budget line is steeper and passes through the initial equilibrium combination, the new best affordable point must lie above the initial equilibrium point so it must be on a higher indifference curve.

9. a. If Pam changes how she spends her weekly income, will she buy more or fewer cookies and more or fewer granola bars?

Pam will buy more cookies and fewer granola bars. The new budget line and the old budget line pass through the point at 30 cookies and 5 granola bars. If granola bars are plotted on the x-axis, the marginal rate of substitution at this point on Pam’s indifference curve is equal to the relative price of a granola bar at the original prices, which is 2. The new relative price of a granola bar is $5/50 cents, which is 10. That is, the budget line is steeper than the indifference curve at 30 cookies and 5 granola bars. Pam will buy more cookies and fewer granola bars.

b. When the prices change next week, will there be an income effect, a substitution effect, or both at work?

There will be a substitution effect and an income effect. A substitution effect arises when the relative price changes and the consumer moves along the same indifference curve to a new point where the marginal rate of substitution equals the new relative price. An income effect arises when the consumer moves from one indifference curve to another, keeping the relative price constant.

Use the following information to work Problems 10 and 11.

Hamptons Glamour Finds a Humbler Home Lucy Martin collected and sold vintage clothing in the wealthy Hamptons, but in the recession of 2008, © 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES131

her sales fell. She eventually moved her shop to Tannersville, N.Y., where her expenses are 70 percent less than they were in the Hamptons.

Source: The New York Times, December 22, 2016 10. a. According to the news clip, is vintage clothing a normal good or an inferior good? If the price of vintage clothing falls and income remains the same, explain how the quantity of vintage clothing bought changes.

According to the article, the demand for vintage clothing decreased when the economy was in a downturn and incomes fell. Because the demand decreased when income decreased, vintage clothing is a normal good.

If the price of vintage clothing falls and income remains the same, the quantity of vintage clothing purchased increases.

b. Describe the substitution effect and the income effect that occur.

The price fall creates both a substitution effect and an income effect. The substitution effect leads to an increase in the quantity of vintage clothing demanded. The price decrease increases consumers’ real incomes. Because used clothing is a normal good, the income effect also leads to an increase in the quantity of vintage clothing purchased. The substitution effect and income both create an increase in the quantity of vintage clothing demanded when the price falls.

© 2018 Pearson Education, Inc.

132

11.

CHAPTER 9

Draw a graph of a person‘s indifference curves for vintage clothing and other goods. Then draw two budget lines to show the effect of a fall in income on the quantity of vintage clothing purchased.

In Figure 9.3, the fall in income shifts the budget line from BL1 to BL2. The quantity of vintage clothing purchased decreases, in the figure from 6 items per month to 4 items per month.

© 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES133

Answers to Additional Problems and Applications Use the following data to work Problems 12 to 15.

Marc has a budget of $20 a month to spend on root beer and DVDs. The price of root beer is $5 a bottle, and the price of a DVD is $10.

12.

What is the relative price of root beer in terms of DVDs and what is the opportunity cost of a bottle of root beer?

The relative price of root beer is 1/2 DVD. The relative price of root beer is the price of root beer divided by the price of a DVD. The price of root beer is $5 a bottle and the price of a DVD is $10, so the relative price of root beer is $5 a bottle divided by $10 a DVD, which equals 1/2 DVD per bottle. The opportunity cost of a bottle of root beer is 1/2 DVD. The opportunity cost of a bottle of root beer is the quantity of DVDs that must be forgone to obtain a bottle of root beer. The price of root beer is $5 a bottle and the price of a DVD is $10, so to buy one bottle of root beer Marc must forgo 1/2 DVD.

13.

Calculate Marc‘s real income in terms of root beer. Calculate his real income in terms of DVDs. Marc’s real income is 4 bottles of root beer. Marc’s real income in terms of bottles of root beer is equal to his money income divided by the price of a bottle of root beer. Marc’s money income is $20, and the price of root beer is $5 a bottle. Marc’s real income is $20 divided by $5 a bottle of root beer, which is 4 bottles of root beer.

Marc’s real income is 2 DVDs. Marc’s real income in terms of DVDs is equal to his money income divided by the price of a DVD, which is $20 divided by $10 a DVD or 2 DVDs.

14.

Calculate the equation for Marc‘s budget line (with the quantity of root beer on the left side).

The equation that describes Marc’s budget line is QR = 4 – 2QDVD. Call the price of a bottle of root beer PR and the quantity of root beer QR, the price of a DVD PDVD and the quantity of DVDs QDVD, and income y. Marc’s budget equation is PRQR + PDVDQDVD = y. If we substitute $5 for the price of a bottle of root beer, $10 for the price of a DVD, and $20 for income, the budget equation becomes $5QR + $10QDVD = $20.

Next, divide both sides by $5 to obtain QR + 2QDVD = 4. Finally subtract 2QDVD from both sides to give QR = 4 – 2QDVD.

15.

Draw a graph of Marc‘s budget line with the quantity of DVDs on the x-axis. What is the slope of Marc‘s budget line? What determines its value?

The budget line is illustrated in Figure 9.4. The slope of the budget line, when DVDs are plotted on the x-axis is 2. The magnitude of the slope is equal to the relative price of a DVD. The slope of the budget line is © 2018 Pearson Education, Inc.

134

CHAPTER 9

―rise over run.‖ If the quantity of DVDs decreases from 2 to 0, the quantity of root beer increases from 0 to 4 bottles. The rise is 4 and the run is 2. So the slope equals 4/2, which is 2.

© 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES135

Use the following data to work Problems 16 to 19.

Amy has $20 a week to spend on coffee and cake. The price of coffee is $4 a cup, and the price of cake is $2 a slice.

16.

Calculate Amy‘s real income in terms of cake. Calculate the relative price of cake in terms of coffee.

Amy’s real income in terms of cake is $20/($2 per slice), which is 10 slices. The relative price of cake in terms of coffee is ($2 per slice)/($4 per cup) = 0.5 cups of coffee per slice of cake.

17.

Calculate the equation for Amy‘s budget line (with cups of coffee on the left side).

The equation that describes Amy’s budget line is QCOFFEE = 5 – 0.5QCAKE. Call the price of a cup of coffee PCOFFEE and the quantity of coffee QCOFFEE, the price of a slice of cake PCAKE and the quantity of cake QCAKE, and income y. Amy’s budget equation is PCOFFEEQCOFFEE + PCAKEQCAKE = y. If we substitute $4 for the price of a cup of coffee, $2 for the price of a slice of cake and $20 for income, the budget equation becomes $4QCOFFEE + $2QCAKE = $20. Next, divide both sides by $4 to obtain QCOFFEE + 0.5QCAKE = 5. Finally subtract 0.5QCAKE from both sides to give QCOFFEE = 5 – 0.5QCAKE.

18.

If Amy‘s income increases to $24 a week and the prices of coffee and cake remain unchanged, describe the change in her budget line.

Amy’s budget line shifts outward and its slope does not change.

19.

If the price of cake doubles while the price of coffee remains at $4 a cup and Amy‘s income remains at $20, describe the change in her budget line.

Amy’s budget line rotates inward. If the quantity of cake is plotted on the horizontal axis, the budget line rotates inward around the unchanged vertical intercept (which is the maximum number of cups of coffee Amy can purchase) and becomes steeper.

© 2018 Pearson Education, Inc.

136

CHAPTER 9

Use the following news clip to work Problems 20 and 21.

Cheap Gas Fuels Summer Rush AAA is projecting 700,000 more than last year will travel on the Memorial Day weekend. Low gasoline prices are fueling the rush. But travelers pay more for hotels. In Miami hotel prices are up 23 percent.

Source: USA Today, May 27, 2016 20. a. Sketch a budget line for a household that spends its income on only two goods: gasoline and hotel rooms. Identify the combinations of the two goods that are affordable.

Figure 9.5 shows a budget line.

The combinations of gasoline and hotel room stays that lie on and inside the budget line are affordable. The combinations of gasoline and hotel room stays that lie beyond the budget line are unaffordable.

b. Sketch a second budget line to show how a fall in the price of gasoline and a rise in the price of hotel rooms changes the affordable and unaffordable combinations of gasoline and hotel rooms. Describe how the household‘s consumption possibilities change.

The fall in the price of gasoline rotates the budget outward while the rise in the price of hotel rooms rotates the budget line inward, as illustrated in Figure 9.6. Some initially affordable combinations of gasoline and hotel room stays have become unaffordable. The dark gray triangle shows these combinations. Other initially unaffordable combinations of gasoline and hotel room stays have become affordable. The light gray triangle shows these combinations.

© 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES137

21.

How does a fall in the price of gasoline change the relative price of a hotel room? How does a fall in the price of gasoline change real income in terms of hotel rooms? How does a simultaneous rise in the price of a hotel room change the answers to these questions?

The relative price of a hotel room equals the price of a hotel room divided by the price of gasoline. The fall in the price of gasoline raises the relative price of a hotel room. The fall in the price of gasoline does not change real income in terms of hotel rooms. The rise in the price of a hotel room raises the relative price of hotel rooms, so the net effect on the relative price of a hotel room is ambiguous. The rise in the price of a hotel room decreases real income in terms of hotel rooms, so while the change in the price of gasoline had no effect on this real income, the rise in the price of a hotel room definitely decreases it.

Use the following information to work Problems 22 and 23.

Rashid buys only books and CDs and Figure 9.7 shows his preference map.

22. a. If Rashid chooses 3 books and 2 CDs, what is his marginal rate of substitution?

Rashid’s marginal rate of substitution is 1 book per CD. Rashid’s marginal rate of substitution equals the magnitude of the slope of his indifference curve. If Rashid buys 3 books and 2 CDs, the slope of his indifference curve at this point is minus 1 book per CD.

b. If Rashid chooses 2 books and 6 CDs, what is his marginal rate of substitution?

Rashid’s marginal rate of substitution is 1/2. Rashid’s marginal rate of substitution equals the magnitude of the slope of his indifference curve. If Rashid buys 2 books and 6 CDs, the slope of his indifference curve at this point is minus 1/2 book per CD.

23.

Do Rashid‘s indifference curves display diminishing marginal rate of substitution? Explain why or why not.

Rashid’s indifference curves display diminishing marginal rate of substitution. When moving along either indifference curve the slope becomes smaller as the consumption of CDs increases, which means that Rashid has diminishing marginal rate of substitution of books for CDs.

© 2018 Pearson Education, Inc.

138

24.

CHAPTER 9

Happy Employees Want Raises and Respect at Work A survey of 600 employees reports that employee satisfaction is at its highest level in 10 years, but satisfaction with benefits, compensation, time off, and ―respectful treatment of employees‖ at work, is low.

Source: The Calgary Herald, May 7, 2016 An earlier survey found that trust in management is a big component of job satisfaction. Say you get a new boss and your trust in management goes up a bit (say, up 1 point on a 10-point scale).

That‘s like getting a 36-percent pay raise. In other words, that increased level of trust will boost your level of overall satisfaction in life by about the same amount as a 36-percent raise would. a. Measure trust in management on a 10-point scale, measure pay on the same 10-point scale, and think of them as two goods. Sketch an indifference curve (with trust on the x-axis) that is consistent with the news clip.

The clip implies that a 1 point increase in trust combined with a 3.6 point (which is 36 percent on a 10 point scale) decrease in income leaves the person indifferent. So, as illustrated in Figure 9.8, the indifference curve is linear showing the tradeoff between trust and income.

b. What is the marginal rate of substitution between trust in management and pay according to this news clip?

The news clip implies that the indifference curves are linear (as illustrated in Figure 9.8) which means that the marginal rate of substitution is constant and equal to 3.6 in the figure.

c. What does the news clip imply about the principle of diminishing marginal rate of substitution? Is that implication likely to be correct?

The news clip implies that the indifference curves are linear, as illustrated in Figure 9.8. Linear indifference curves mean that the marginal rate of substitution is constant, that is, the principle of diminishing marginal rate of substitution does not hold. This assumption is likely to be incorrect. Increasing trust in management from 0 to 1 is likely to be very worthwhile and the person will give up a large amount of income to gain this unit increase. But increasing trust in management from, say, 8 to 9 is probably not nearly so worthwhile because at 8 management is already highly trusted. So to gain this unit increase in trust, the person is likely willing to give up only a small amount of income. Hence, contrary to the article, increasing trust in management is subject to a diminishing rate of substitution.

Use the following information to work Problems 25 and 26.

Jim has made his best affordable choice of muffins and coffee. He spends all of his income on 10 © 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES139

muffins at $1 each and 20 cups of coffee at $2 each. Now the price of a muffin rises to $1.50 and the price of coffee falls to $1.75 a cup.

25. a. Will Jim now be able and want to buy 10 muffins and 20 coffees?

Jim is able to buy 10 muffins and 20 coffees because this combination remains affordable. Jim will not want to buy this combination, however, because the relative price of muffins and coffee has changed. At his consumer equilibrium, Jim’s MRS equals the relative price of muffins and coffee and because the relative price has changed, Jim’s MRS has changed so Jim will change his consumption point.

b. Which situation does Jim prefer: muffins at $1 and coffee at $2 a cup or muffins at $1.50 and coffee at $1.75 a cup?

Jim prefers the $1.50 per muffin/$1.75 per coffee prices because he can attain a higher indifference curve. The new budget line goes through the old budget line at the initial consumption point. But, with coffee measured along the horizontal axis, the new budget line is flatter than the old budget line and lies beyond the initial budget line at all points below the initial consumption point.

26. a. If Jim changes the quantities that he buys, will he buy more or fewer muffins and more or less coffee? Explain your answer.

Jim will buy more coffee and fewer muffins because the relative price of coffee has fallen and the relative price of a muffin has risen.

b. When the prices change, will there be an income effect, a substitution effect, or both at work?

Explain your answer.

Price changes can always be divided into an income effect and a substitution effect so there will always be both at work.

Use the following data to work Problems 27 to 29.

Sara‘s income is $12 a week. The price of popcorn is $3 a bag, and the price of cola is $1.50 a can. Figure 9.9 shows Sara‘s preference map for popcorn and cola.

27.

What quantities of popcorn and cola does Sara buy? What is Sara‘s marginal rate of substitution at the point at which she consumes?

Sara buys 6 cans of cola and 1 bag of popcorn. Sara’s budget line runs from 8 cans of cola on the x-axis to 4 bags of popcorn on the y-axis and is tangent to indifference curve I1 at 6 cans of cola and 1 bag of popcorn.

Sara’s marginal rate of substitution is ½. The marginal rate of substitution is the magnitude of the slope of the indifference curve at Sara’s consumption point, which equals the magnitude of the slope of the © 2018 Pearson Education, Inc.

140

CHAPTER 9

budget line. The slope of Sara’s budget line is ½ bag of popcorn per can of cola so the marginal rate of substitution is ½ bag of popcorn per can of cola.

28.

Suppose that the price of cola rises from $1.50 to $3.00 a can while the price of popcorn and Sara‘s income remain the same. What quantities of cola and popcorn does Sara now buy? What are two points on Sara‘s demand curve for cola? Draw Sara‘s demand curve.

Sara buys 2 cans of cola and 2 bags of popcorn. Sara buys the quantities of cola and popcorn that moves her onto the highest indifference curve, given her income and the (new) price of cola and price of popcorn. The budget line is tangent to indifference curve I0 at 2 cans of cola and 2 bags of popcorn.

Two points on Sara’s demand for cola are the following: At $3 a can of cola, Sara buys 2 cans of cola. At $1.50 a can of cola, Sara buys 6 cans. Her demand curve is downward sloping and, as Figure 9.10 shows, goes through these two points.

29.

Suppose that the price of cola rises to $3.00 a can and the price of popcorn and Sara‘s income remain the same. a. What is the substitution effect of this price change and what is the income effect of the price change?

The substitution effect is 1 can of cola. To divide the price effect into a substitution effect and an income effect, take enough income away from Sara and gradually move her new budget line back toward the original indifference curve until it just touches Sara’s first indifference curve I1. The point at which this budget line just touches indifference curve I1 is 5 cans of cola. The substitution effect is the decrease in the quantity of cola from 6 cans to 5 cans along the indifference curve I1. The substitution effect is 1 can of cola.

The income effect is 3 cans of cola. The income effect is the change in the quantity of cola from the price effect minus the change from the substitution effect. The price effect is 4 cans of cola (2 cans minus the initial 6 cans). The substitution effect is a decrease in © 2018 Pearson Education, Inc.

POSSIBILITIES, PREFERENCES, AND CHOICES141

the quantity of cola from 6 cans to 5 cans. So the income effect is 3 cans of cola.

b. Is cola a normal good or an inferior good? Explain.

Cola is a normal good for Sara because the income effect is positive.

Economics in the News 30.

After you have studied Economics in the News on pp. 218–219, answer the following questions. a. Dan is another student. In Fig. 2, draw Dan‘s budget line in 2017 if he faced the 2017 level of tuition but had a high enough income to be on indifference curve I1.

Figure 9.11 shows the budget line that enables Dan to reach indifference curve I1 with the 2017 level of tuition. Dan will take 10 credits per semester and consume $8,000 of other goods and services—point B in the figure.

The price of 10 hours of credits is $5,000. Dan’s total income is $18,000.

b. What is Dan‘s substitution effect of the tuition rise?

Dan’s substitution effect from the tuition rise is to reduce the number of credits he takes each semester from 12 credits to 10 credits, so the substitution effect is 2 credits. In the figure, the substitution effect is the movement from point A to point B.

c. What is Dan‘s income effect of the tuition rise?

Presuming Dan has the same preferences as Jessica, the income effect from the rise in tuition is to is reduce the number of credits he takes each semester from (the hypothetical) 10 credits he takes in part b to 8 credits, so the income effect is 2 credits. In the figure, the income effect is the movement from point B to point C.

d. Identify Dan‘s best affordable point.

Presuming Dan has the same preferences and income as Jessica, his best affordable point is point C where he takes 8 credits per semester and consumes $6,000 worth of other goods and services.

© 2018 Pearson Education, Inc.

CXLII

C h a p t e r

10

ORGANIZING PRODUCTION

Answers to the Review Quizzes Page 230 1.

What is a firm‘s fundamental goal and what happens if the firm doesn‘t pursue this goal?

A firm’s fundamental goal is to maximize its profit. If the firm fails to maximize profit it is either eliminated or bought out by other firms maximizing profit.

2.

Why do accountants and economists calculate a firm‘s cost and profit in different ways?

Accountants and economists have different reasons for computing a firm’s costs. An accountant calculates a firm’s cost and profit to ensure that the firm pays the correct amount of income tax and to show its investors how their funds are being used. An economist calculates a firm’s cost and profit in a way that enables him or her to predict the firm's decisions.

3.

What are the items that make opportunity cost differ from the accountant‘s measure of cost?

A firm’s opportunity cost includes the cost of using resources bought in the market, owned by the firm and supplied by the firm's owner. Economists and accountants both include the price of resources bought in the market as costs. But accountants omit costs included by economists. For instance, use of a building the owner has already purchased has an opportunity cost that accountants do not include. Additionally the normal profit, interest foregone, and economic depreciation are other opportunity costs not recorded by an accountant.

4.

Why is normal profit an opportunity cost?

Normal profit is the return to a firm’s owner for the owner’s supply of entrepreneurial ability and labor to the firm’s production process. Using the owner’s ability to run the business implies that the owner could have received a return for using it in another capacity, such as running another firm. This cost is an opportunity cost for the firm because it is the cost of a forgone alternative, which is running another firm, and must be included in calculating the firm’s opportunity cost of production.

cxlii

138

5.

CHAPTER 10

What are the constraints that a firm faces? How does each constraint limit the firm‘s profit?

The three types of constraints a firm faces are technology constraints, information constraints, and market constraints.

Technology is any specific method of producing a good or service and it advances over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output. Information is never complete, for the future or the present. A firm is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information itself limits profit. Market constraints mean that what each firm can sell and the price it can obtain are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms. The resources that a firm can buy and the prices it must pay for them are limited by the willingness of people to work for and invest in the firm. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.

Page 232 1.

Is a firm technologically efficient if it uses the latest technology? Why or why not?

Technological efficiency occurs when a firm produces a given level of output using the least amount of inputs. Adopting the latest available technology does not necessarily imply that a firm’s production process is technologically efficient. As long as the firm is getting the maximum possible output for a given combination of inputs, it is technologically efficient.

2.

Is a firm economically inefficient if it can cut its costs by producing less? Why or why not?

Economic efficiency occurs when the firm produces a given level of output at the least cost. If a firm can decrease production costs by decreasing output, it is not necessarily economically inefficient.

If it is producing the new level of output at the least possible cost, it is achieving economic efficiency.

3.

Explain the key distinction between technological efficiency and economic efficiency.

The difference between technological and economic efficiency is that technological efficiency concerns the quantity of inputs used in production for a given level of output, whereas economic efficiency concerns the value of the inputs used. Economic efficiency requires technological efficiency, but technological efficiency does not require economic efficiency.

4.

Why do some firms use large amounts of capital and small amounts of labor while others use small amounts of capital and large amounts of labor?

The mix of resources used, such as large amounts of capital versus small amounts of capital, depends on economic efficiency. Economic efficiency is based on minimizing the value of the resources used, not the quantity. A firm will use the mix that produces output at © 2018 Pearson Education, Inc.

ORGANIZING PRODUCTION139

the lowest possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of capital decreases relative to the cost of other resources, capital-intensive production methods will become economically efficient and firms will avoid labor-intensive methods.

Page 236 1.

Explain the distinction between a command system and an incentive system.

A command system uses a managerial hierarchy, where commands pass downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management. Incentive systems use market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.

2.

What is the principal-agent problem? What are three ways in which firms try to cope with it?

The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. There are three ways of coping with this problem: Ownership, often offered to managers, gives the agents an incentive to maximize the firm’s profits, which is the goal of the owners, the principals; incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal; long-term contracts tie managers’ or workers’ long-term rewards to the longterm performance of the firm, encouraging the agents to work in the best long-term interests of the firm owners, the principals.

3.

What are the three types of firms? Explain the major advantages and disadvantages of each.

The three main ways of organizing a firm have both advantages and disadvantages:  Proprietorship. ADVANTAGES—easy to set up; managerial decisionmaking is simple and rapid; and profits are taxed only once.

DISADVANTAGES—bad decisions on the part of the owner are not subject to review; the owner’s entire wealth is at stake because of unlimited liability; the firm dies with the owner; and acquiring capital and labor is expensive.  Partnership. ADVANTAGES—easy to set up; has diversified decisionmaking so that more than one person’s expertise can be utilized; can survive the death or withdrawal of a partner; and profits are taxed only once. DISADVANTAGES—all the owners’ wealth is at risk because of unlimited liability; if there are many partners, gaining a consensus about managerial decisions may be difficult; the withdrawal of partner may create capital shortage; labor costs are high compared to corporations; and capital costs can be high.  Corporation. ADVANTAGES—perpetual life; limited liability for its owners; readily available, large-scale, and low-cost capital; can rely on professional managers rather than the talents of the owners; and reduced costs from long-term labor contracts. © 2018 Pearson Education, Inc.

140

CHAPTER 10

DISADVANTAGES—potentially complex management structure may lead to slow and expensive decision-making; and profits are taxed twice, once as corporate profit and once as income to the stockholders.

Page 241 1.

What are the four market types? Explain the distinguishing characteristics of each.

Economists identify four market types: 1. Perfect competition is a market with many firms, each selling an identical product. There are many buyers and no restrictions on entry of new firms. Firms and buyers are all well informed of prices and products of all firms in the industry.

2. Monopolistic competition is a market with many firms that produce similar but slightly different goods.

3. Oligopoly is a market in which a small number of firms compete and each firm may produce almost identical or differentiated goods.

4. Monopoly is a market in which only one firm produces the entire output of the industry. There are no close substitutes for the monopolist’s product and there are barriers to entry that protect the firm from competition of entering firms.

2.

What are the two measures of concentration? Explain how each measure is calculated.

Two measures of concentration have been developed and are in common use: the four-firm concentration ratio and the Herfindahl–Hirschman Index (HHI).

1. The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry.

2. The Herfindahl–Hirschman Index (HHI) equals the sum of the squared market shares of the 50 largest firms in the industry.

3.

Under what conditions do the measures of concentration give a good indication of the degree of competition in a market?

Concentration measures give a good indication of the degree of competition in a market if the following characteristics of the industry market are correct: 1. The industry market is national in scope, rather than local or international.

2. There are no concerns about over-stating or under-stating the extent of barriers to entry.

3. Firms are not misclassified with respect to their markets.

4.

Is the U.S. economy competitive? Is it becoming more competitive or less competitive?

The U.S. economy would be considered competitive since threequarters of the value of goods and services bought are in markets characterized as perfect competition or monopolistic competition.

The U.S. economy has become increasingly competitive over the decades.

© 2018 Pearson Education, Inc.

ORGANIZING PRODUCTION141

Page 243 1.

What are the two ways in which economic activity can be coordinated?

Firms and markets both coordinate resources.

2.

What determines whether a firm or markets coordinate production?

Firms coordinate resources when they can do so at lower cost than can a market.

1. Firms may reduce transactions costs, which are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled.

2. Firms can capture economies of scale, which occurs when the cost of producing a unit falls as its output rate increases.

3. Firms can capture economies of scope, where one firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise.

4. Firms can engage in team production, in which the individuals specialize in mutually supportive tasks.

Firms coordinate economic activity when they can perform a task more efficiently than markets can. In such a situation, it is profitable to set up a firm. If markets can perform a task more efficiently than a firm can, firms will use markets, and any attempt to set up a firm to replace such market coordination will be doomed to failure.

3.

What are the main reasons why firms can often coordinate production at a lower cost than markets can?

Firms can often coordinate production at a lower cost than can markets because firms lower transactions costs and achieve economies of scale, scope, and team production. These opportunities are not present when markets coordinate production.

© 2018 Pearson Education, Inc.

142

CHAPTER 10

Answers to the Study Plan Problems and Applications 1.

One year ago, Jack and Jill set up a vinegar-bottling firm (called JJVB). Use the following data to calculate JJVB‘s opportunity cost of production during its first year of operation:  Jack and Jill put $50,000 of their own money into the firm and bought equipment for $30,000.  They hired one worker at $20,000 a year.  Jack quit his old job, which paid $30,000 a year worked full-time for JJVB.  Jill kept her old job, which paid $30 an hour, but gave up 500 hours of leisure a year to work for JJVB.  JJVB bought $10,000 of goods and services.  The market value of the equipment at the end of the year was $28,000.  Jack and Jill have a $100,000 home loan on which they pay interest of 6 percent a year.

The wages paid, $20,000, and the goods and services bought from other firms, $10,000, are opportunity costs to JJVB. Other opportunity costs include the interest forgone on the $50,000 put into the firm, which could have been used to pay part of the mortgage, so the interest forgone is $3,000; the $30,000 income forgone by Jack not working at his previous job; $15,000, which is the value of 500 hours of Jill’s leisure; and the economic depreciation of $2,000 ($30,000 minus $28,000). JJVB’s total opportunity cost is the sum of all these opportunity costs and is $80,000.

2.

Joe, who has no skills, no job experience, and no alternative employment, runs a shoeshine stand. Other operators of shoeshine stands earn $10,000 a year. Joe pays rent of $2,000 a year, and his total revenue is $15,000 a year. Joe spent $1,000 on equipment, which he used his credit card to buy. The interest on a credit card balance is 20 percent a year. At the end of the year, Joe was offered $500 for his business and all its equipment. Calculate Joe‘s opportunity cost of production and his economic profit.

Joe’s opportunity costs are the $2,000 paid to the airport for the space; the $200 for the interest paid on the $1,000 credit card balance; the $10,000 of normal profit; and, the $500 for the depreciation of his equipment (which equals the $1,000 paid for the chair, polish, and brushes minus the $500 he was offered for this equipment). Joe’s total opportunity cost is the sum of these costs, which is $12,700. Joe’s economic profit is his total revenue, $15,000, minus his total opportunity cost, $12,700, for an economic profit of $2,300.

3.

Four ways of laundering 100 shirts are in the table. a. Which methods are technologically efficient?

All the methods are technologically efficient.

Labor Capital Method (hours) (machines) 1 10 A 5 8 B 20 4 C 50 1 D

© 2018 Pearson Education, Inc.

ORGANIZING PRODUCTION143

b. Which method is economically efficient if the hourly wage rate and the implicit rental rate of capital are: (i) Wage rate $1, rental rate $100?

Method D is economically efficient because the total cost is the least. Method D’s costs are 50  $1 + 1  $100, or $150.

(ii) Wage rate $5, rental rate $50?

Method D and Method C are economically efficient because the total cost is the least. Method C’s costs are 20  $5 + 4  $50, or $300 and Method D’s costs are 50  $5 + 1  $50, also $300.

(iii) Wage rate $50, rental rate $5?

Method A is economically efficient because the total cost is the least. Method A’s costs are 1  $50 + 10  $5, or $100.

4.

CEO Pay Is Rising Twice as Fast as Workers’ Income Executive compensation, in salary, stock, and other compensation, increased 8.5 percent in 2016 to a median of $11.5 million. It‘s the biggest CEO pay increase in three years.

Source: time.com/money, May 23, 2017 What is the economic problem that CEO compensation schemes are designed to solve? Would paying executives with stock align their interests with shareholders‘?

CEO compensation schemes are designed to overcome the principalagent problem. A CEO’s decisions can have large effects on the company’s profitability. The principals, the shareholders of the corporation, want the CEO, the agent, to carefully consider the decisions and make decisions that boost the firm’s profit. The CEO, however, has the incentive to shirk and to make decisions that boost his or her well-being rather than the company’s profit.

Paying executives with stock helps align their interests with shareholders. If the profit rises, then the company’s stock price will rise. If the CEO’s pay is largely determined by changes in the stock price, then the CEO’s decisions are directly linked to the company’s fortunes.

5.

Sales of the firms in the tattoo industry Calculate the four-firm concentration structure of the tattoo industry?

Firm

Sales (dollars per year) 450

are in the table. ratio. What is the

The four-firm concentration ratio is 60.49. The four-firm Bright concentration ratio equals the ratio of Spots the total sales of the largest four Freckles 325 firms to the total industry sales Love Galore 250 expressed as a percentage.

The total Native 200 sales of the largest four firms is Birds $450 + $325 + $250 + $200, which equals Other 15 800 $1,225. Total industry sales equal firms $1,225 + $800, which equals $2,025. The four-firm concentration ratio equals ($1,225/$2,025)  100, which is 60.49 percent.

This industry is highly concentrated because the four-firm concentration ratio exceeds 60 percent. © 2018 Pearson Education, Inc.

144

6.

CHAPTER 10

Walmart, Grocery, Target Top Personal Care Market Share A Personal Care Study conducted by TABS Analytics shows that Walmart has a 19.4 percent share of the $40 billion personal care market, while grocery stores Kroger and Publix have a 16.6 percent share, and Target, 12.8 percent.

Source: drugstorenews.com, March 23, 2017 Estimate a range for the four-firm concentration ratio and the HHI for the U.S. personal care market based on the data provided in this news clip.

Walmart has the largest market share, 19.4 percent, and Kroger and Publix are tied for the second largest market share, 16.6 percent.

Target is fourth with a market share of 12.8 percent. Consequently, the four-firm concentration ratio equals 19.4 + 16.6 + 16.6 + 12.8 which is ranges from 65.4 percent.

The HHI equals the sum of the squared market shares of the 50 2 largest firms. Wal-Mart’s contribution to the HHI is 19.4 which is 2 376.4; Kroger’s and Publix’s contributions to the HHI is each 16.6 2 which is 275.6; and, Target’s contribution is 12.8 which is 163.8.

If there are two other firms each with a market share of 12.7 percent and one other firm with a market share of 9.2 percent, the HHI attains its maximum of 1,498.6. If there are 36 other firms each 2 2 with a market share of 1 percent, the HHI 19.42 + 16.6 + 16.6 + 2 2 12.8 + 36×1 = 1127. So the HHI can range from about 1,127 to about 1,500.

7.

FedEx contracts with independent truck operators to pick up and deliver its packages and pays them on the volume of packages carried. Why doesn‘t FedEx buy more trucks and hire more drivers? What incentive problems might arise from this arrangement?

FedEx does not buy more trucks and hire more drivers because FedEx faces a principal-agent problem. In particular, it is not easy to monitor its drivers and insure that they are working hard to efficiently deliver packages. FedEx overcomes this problem by hiring independent contractors and then paying them based on the amount of packages they deliver. Essentially, FedEx uses a piecework method of payment.

FedEx pays its drivers based on the volume of packages they deliver.

This method of payment creates a few incentive potential problems for FedEx. First, FedEx must worry about the quality of its service.

In particular, unless FedEx bases part of the payment on quality, its drivers have an incentive to drop the package and race off to the next delivery with no concern for how the packages are handled.

Second, FedEx must take care that drivers do not attempt to select only packages that are close to the FedEx location and avoid packages that have a greater than average driving time. Finally, FedEx also must worry that its drivers do not take undue risks while driving in order to deliver as many packages as possible. If FedEx trucks were involved in too many accidents, FedEx would suffer bad publicity and, presumably, would lose some business.

© 2018 Pearson Education, Inc.

ORGANIZING PRODUCTION145

Answers to Additional Problems and Applications Use the following data to work Problems 8 and 9.

Lee is a computer programmer who earned $35,000 in 2016. But on January 1, 2017, Lee opened a body board manufacturing business. At the end of the first year of operation, he submitted the following information to his accountant:  He stopped renting out his cottage for $3,500 a year and used it as his factory. The market value of the cottage increased from $70,000 to $71,000.  He spent $50,000 on materials, phone, etc.  He leased machines for $10,000 a year.  He paid $15,000 in wages.  He used $10,000 from his savings account, which earns 5 percent a year interest.  He borrowed $40,000 at 10 percent a year.  He sold $160,000 worth of body boards.  Normal profit is $25,000 a year.

8.

Calculate Lee‘s opportunity cost of production and his economic profit.

Lee has costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; $3,500 of forgone rent for the cottage plus $1,000 for the ―depreciation‖ of the cottage (the cottage actually appreciated); $500 in forgone interest from the savings account; wages forgone of $35,000; and, $25,000 for normal profit. These give a total opportunity cost of $142,000. Lee’s economic profit is the total revenue, $160,000, minus the total opportunity cost, $142,000, for an economic profit of $18,000.

9.

Lee‘s accountant recorded the depreciation on his cottage during 2017 as $7,000. According to the accountant, what profit did Lee make?

Lee’s accountant will include costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; and, $7,000 of depreciation expense for a total opportunity cost of $86,000. The total profit according to the accountant will equal total revenue, $160,000, minus total cost, $86,000, for a profit of $74,000.

10.

In 2016, Toni taught music and earned $20,000. She also earned $4,000 by renting out her basement. On January 1, 2017, she quit teaching, stopped renting out her basement, and began to use it as the office for her new Web site design business. She took $2,000 from her savings account to buy a computer. During 2017, she paid $1,500 for the lease of a Web server and $1,750 for high-speed Internet service. She received a total revenue from Web site designing of $45,000 and earned interest at 5 percent a year on her savings account balance. Normal profit is $55,000 a year. At the end of 2017, Toni could have sold her computer for $500. Calculate Toni‘s opportunity cost of production and her economic profit in 2017.

Toni has costs of $1,500 for the lease of a Web server; $1,750 for high-speed Internet service; $55,000 for normal profit; $20,000 of forgone earnings from teaching; $4,000 of forgone rent from renting her basement; $100 of forgone interest from her saving account; and © 2018 Pearson Education, Inc.

146

CHAPTER 10

$1,500 for the depreciation of her computer (which equals the $2,000 paid for it minus the $500 for which she could have sold it). These various costs sum to a total opportunity cost of $83,850. Toni’s economic profit is her total revenue, $45,000, minus her total opportunity cost, $83,850, for an economic loss of $38,850.

11.

Starburst “All Pink” Packs Show Importance of Giving Customers What They Want Giving customers what they want, Starburst candy will produce limited edition bags of ―All Pink‖ Source: smallbiztrends.com, Mar 10, 2017 a. Does the news clip imply that Starburst‘s goal is customer satisfaction and not profit maximization?

Although the news clip talks about customer satisfaction, Starburst’s actual focus is on its profit. If Starburst produced products consumers did not want, no one would buy its candy so Starburst would shut down. By producing candy that customers want, Starburst will make a profit and stay in business.

b. What would happen to Starburst if it didn‘t focus on maximizing profit, but instead focused its production and pricing decisions to ―give customers what they want‖?

In general customers want very tasty, potentially very costly candy sold for an exceptionally low price. In particular, customers want to pay the lowest price possible regardless of the company’s profit.

If Starburst focused on only giving customers want they want, Starburst would incur a loss and ultimately would either close or be purchased by another company.

12.

Investing in Watches The values of premium second-hand watches have been rising and a Luxury Investment Index says they are expected to appreciate 68 percent over 10 years. But investing in watches is risky.

Their prices don‘t always rise.

Source: New York Times, September 29, 2015 a. What is the cost of buying a watch?

The (opportunity) cost of buying a watch is the loss of whatever else would have been purchased with the funds.

b. What is the opportunity cost of owning a watch?

The opportunity cost of owning a watch is the annual forgone return, such as the forgone interest from buying a watch rather than placing the funds in a savings account, and the depreciation of the watch.

c. Does owning a watch create an economic profit opportunity?

Yes, owning a watch creates an economic profit opportunity. If the watch appreciates at a rapid clip, so that the gain in the value of the watch over time exceeds the normal profit from the funds used to purchase the watch, then owning the watch has lead to an economic profit.

Use the following data to work Problems 13 and 14.

Four methods of completing a tax return and the time taken by each method are: with a PC, 1 hour; with a pocket calculator, 12 hours; with a pocket calculator and paper and pencil, 12 hours; and with a © 2018 Pearson Education, Inc.

ORGANIZING PRODUCTION147

pencil and paper, 16 hours. The PC and its software cost $1,000, the pocket calculator costs $10, and the pencil and paper cost $1.

13.

Which, if any, of the methods is technologically efficient?

All methods other than ―pocket calculator with paper and pencil‖ are technologically efficient. To use a pocket calculator with paper and pencil to complete the tax return is not a technologically efficient method because it takes the same number of hours as it would with a pocket calculator but it uses more capital.

14.

Which method is economically efficient if the wage rate is (i) $5 an hour?

The economically efficient method is the technologically efficient method that allows the task to be done at least cost. When the wage rate is $5 an hour, total cost with a PC is $1,005, total cost with a pocket calculator is $70, and total cost with paper and pencil is $81. Total cost is least with a pocket calculator.

(ii) $50 an hour?

When the wage rate is $50 an hour, total cost with a PC is $1,050, total cost with a pocket calculator is $610, and the total cost with paper and pencil is $801. The pocket calculator is economically efficient.

(iii) $500 an hour?

When the wage rate is $500 an hour, total cost with a PC is $1,500, total cost with a pocket calculator is $6,010, and total cost with pencil and paper is $8,001. The PC is economically efficient.

15.

Would You Let a Robot Perform Your Surgery?

A recent study showed that an autonomous robot can perform soft-tissue surgery, and do so better than a human surgeon.

Source: CNN, May 12, 2016 a. Assume that performing a surgery with a surgical robot requires fewer surgeons and nurses. Is using the surgical robot technologically efficient?

Using the surgical robot is technologically efficient because the production technique uses less labor (and more capital) than the non-robotic technique.

b. What additional information would you need to be able to say that switching to surgical robots is economically efficient for a hospital?

To determine if the production technique is economically efficient, information about the cost of the robot and the cost of the nurses and doctors and about the number of doctors and nurses each production technique uses is needed.

© 2018 Pearson Education, Inc.

148

16.

CHAPTER 10

Wal-Mart has more than 3,700 stores, more than one million employees, and total revenues of close to a quarter of a trillion dollars in the United States alone. Sarah Frey-Talley runs the family-owned Frey Farms in Illinois and supplies Wal-Mart with pumpkins and other fresh produce. a. How does Wal-Mart coordinate its activities? Is it likely to use mainly a command system or also to use incentive systems? Explain.

Wal-Mart is a huge organization. As such, it uses both command and incentive systems. At the lower, store level, command is the system that is most commonly used. (For instance, an associate is told that he or she will help unload a delivery and stack the packages against the South wall.) At the higher, corporate level, incentive is the system most commonly used. (For instance, regional directors have part of their income tied to their region’s performance.) However, even at the store level some incentive systems are used (associates can enroll in a profit sharing plan) and even at the corporate level some command systems are used (regional directors are told that they must report to their supervisors on a weekly basis).

b. How do you think Sarah Frey-Talley coordinates the activities of Frey Farms? Is she likely to use mainly a command system or also to use incentive systems? Explain.

Ms. Frey-Talley probably uses a command system significantly more often than an incentive system. Her farm has few employees and so it is easy to tell each employee what to do, when to do it, and where to do it. Possibly the only use of an incentive system might be if Ms. Frey-Talley has some higher-ranking family members on a profitsharing program.

c. Describe, compare, and contrast the principal–agent problems faced by Wal-Mart and Frey Farms. How might these firms cope with their principal–agent problems?

Wal-Mart faces many more principal-agent problems than does Ms. Frey-Talley. For Ms. Frey-Talley’s farm, it is relatively straightforward to monitor each employee so employees will find it difficult to shirk. Plus Ms. Frey-Talley owns the farm herself, and so there is no principal-agent problem associated with a difference between the owners and the managers. Wal-Mart, however, has more than one million employees. Each of these employees realizes that if he or she shirks, it will make little difference to Wal-Mart’s overall performance. So Wal-Mart’s managers must be constantly alert to this problem. Wal-Mart also faces the principal-agent problem that results because its owners are not its managers. As a result, the owners must try to create incentives for the managers to behave in the best interests of the owners. Wal-Mart has a number of ways that it can try to overcome the principal-agent problems it faces.

Its top management is given stock options. Regional managers, store managers, and top level store management are given profit-sharing packages that depend on the performance of the region or a particular store. Buyers for Wal-Mart—people employed by Wal-Mart to determine which products Wal-Mart will purchase—are often given profit-sharing packages that increase the buyer’s income depending on how well the products the buyer purchased perform in the stores. © 2018 Pearson Education, Inc.

ORGANIZING PRODUCTION149

All of these are designed to give the recipient the incentive to make decisions that boost Wal-Mart’s profit and thereby its stock price, which benefit the owners.

17.

Where Does Google Go Next?

Google gives its engineers one day a week to work on whatever project they want. A couple of colleagues did what many of the young geniuses do at Google: They came up with a cool idea.

At Google, you often end up with a laissez-faire mess instead of resource allocation.

Source: Fortune, May 26, 2008 a. Describe Google‘s method of organizing production with their software engineers.

In some sense Google is using a command system because Google ―orders‖ its engineers to use one day a week to work on their own projects. But in a larger sense Google is using an incentive system.

If one of the engineers comes up with a wildly profitable idea, the engineer will benefit by gaining stature and probably income within Google.

b. What are the potential gains and opportunity costs associated with this method?

The potential gain is that the creative people working for Google will apply their creativity to develop new and better products for Google. The potential drawback is the principal-agent problem. The engineers might use their time for on-the-job leisure rather than for new, cutting edge research.

18.

Market shares of chocolate makers are in the table.

Calculate the Herfindahl-Hirschman Index. What is the structure of the chocolate industry?

The Herfindahl-Hirschman Index is 1,800.

The Herfindahl-Hirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms.

The Herfindahl-Hirschman Index equals 2 2 2 2 2 2 15 + 10 + 20 + 15 + 25 + 15 , which equals 1,800.

This industry is moderately concentrated because the Herfindahl-Hirschman Index lies in the range 1,500 to 2,500.

Firm Truffles, Inc. Magic, Inc. Mayfair, Inc. All Natural, Inc. Gold, Inc. Bond, Inc.

Market share (percent) 25 20 15 15 15 10

Use the following information to work Problems 19 to 21.

Two leading design firms, Astro Studios of San Francisco and Hers Experimental Design Laboratory, Inc. of Osaka, Japan, worked with Microsoft to design the Xbox 360 video game console. IBM, ATI, and SiS designed the Xbox 360‘s hardware. Three firms—Flextronics, Wistron, and Celestica— manufacture the Xbox 360 at their plants in China and Taiwan.

19.

Describe the roles of market coordination and coordination by firms in the design, manufacture, and marketing of the Xbox 360.

Microsoft entered the market to hire various firms, Astro Studios and Hers Experimental Design Laboratory to design the Xbox 360 and then entered the market again to hire IBM, ATI, and SiS to design the hardware of the Xbox 360. Finally, Microsoft once again entered © 2018 Pearson Education, Inc.

150

CHAPTER 10

the market to hire Flextronics, Wistron, and Celestica to produce the Xbox 360. Once Microsoft had contracted with these firms, the design, manufacture, etc. takes place within the firm.

20. a. Why do you think Microsoft works with a large number of other firms, rather than performing all the required tasks itself?

Microsoft works with a large number of firms rather than doing everything in-house because it is less expensive for Microsoft to work with other firms. These other firms have specialized in various tasks and so have gained economies of scale that Microsoft does not possess. Therefore it is cheaper for Microsoft to enter the market and hire the expertise it needs than to do it all itself.

b. What are the roles of transactions costs, economies of scale, economies of scope, and economies of team production in the design, manufacture, and marketing of the Xbox?

Microsoft needed to determine what part of designing, building, and marketing the Xbox would take place inside of Microsoft and what would take place in other companies that Microsoft hired. Hiring other companies means that Microsoft incurs the transactions costs of using markets. However, other companies that specialized in different tasks have economies of scale, economies of scope, and/or economies of team production that lower the cost to Microsoft of hiring them. So Microsoft had to determine which parts of the Xbox 360 would be cheaper to undertake inside of Microsoft and which parts would be cheaper to enter the market to contract with other firms.

21.

Why do you think the Xbox is designed in the United States and Japan but built in China?

The Xbox is designed in America and Japan because America and Japan have a large number of highly-skilled workers who can successfully design the Xbox. With a large number of technically adept workers, it is less expensive to design the Xbox in these countries.

Manufacturing the Xbox, however, takes place in China because China has a large number of lower-skilled workers and so it is less expensive to build the Xbox in China.

Economics in the News 22.

After you have studied Economics in the News on pp. 244–245, answer the following questions. a. What products do Facebook and Google sell?

Facebook sells social networking services; that is, it allows its users to keep up with their friends. Google sells search services; that is, it helps its users search the Internet for the topics in which they are interested.

b. In what types of markets do Facebook and Google compete?

Both markets have other providers of similar services. But in each case there are a few that are much larger than the other competitors. So both markets are oligopolies.

c. How do social networks and Internet search providers generate revenue?

Both social network Internet sites and Internet search providers generate revenue from sale of advertisements.

© 2018 Pearson Education, Inc.

ORGANIZING PRODUCTION151

d. What is special about social network sites that make them attractive to advertisers?

Social network sites have millions of users. Users typically provide the social network site information about the user’s interests.

Therefore these sites are attractive to advertisers because an advertiser gains a large audience of people who have a tendency to be interested in the advertiser’s product.

e. What is special about Internet search providers that make them attractive to advertisers?

Users of Internet search providers often are searching for either a particular product or else a product to fill a particular need.

Often users are searching with an intention to buy. Advertisers are attracted to these web sites because they allow the advertiser to target an audience that is frequently going to purchase the product the advertiser has for sale.

f.

What technological changes might increase the profitability of social networks compared to Internet search providers?

Technological change that enables the social networking site to more precisely target the preferences of individual consumers—such as past buying history from the social networking website or better information about preferences via the consumer’s past web browsing on the social network site or on other web sites—would make Internet advertising on the social website more profitable because the ads would more precisely reflect the potential buyer's interests. This change would enable the social networking website to set a higher price for each advertisement, thereby increasing its profitability compared to Internet search providers.

23.

Effects of Merit Pay For Teachers An experiment that awarded teachers higher pay if their students‘ test results were higher suggests that the bonuses didn‘t simply lead teachers to teach to the test, but provided their students with knowledge and work habits that served them well later in life.

Source: The Washington Post, March 16, 2015 How does merit pay for teachers attempt to cope with the principal–agent problem in public education? Does the information in the news clip suggest that it works?

The principal-agent problem with teachers in public education is the concern that teachers will not work hard in the classroom. Teachers’ efforts are difficult to monitor and so teachers have the incentive to shirk by working less diligently and teaching their students less. Merit pay is an incentive system that links the teachers’ pay to their students’ achievement, in the case at hand, performance on standardized exams. With this linkage teachers will be paid more the better their students’ performance which gives the teachers the self-interested incentive to work diligently to instruct their students. According to the results from this experiment, merit pay worked because students gained knowledge and work habits that benefited them in later life.

© 2018 Pearson Education, Inc.

152

CHAPTER 10

C h a p t e r

11

OUTPUT AND COSTS

Answers to the Review Quizzes Page 252 1.

Distinguish between the short run and the long run.

The short run is a period of time during which the quantity of at least one factor of production is fixed and cannot be changed. The long run is a period of time long enough so that the quantities of all factors of production can be varied.

2.

Why is a sunk cost irrelevant to a firm‘s current decisions?

Sunk cost is irrelevant because it cannot be changed by any decision. It is already incurred and so must be paid. The only costs © 2018 Pearson Education, Inc.

152

CHAPTER 11

that concern the firm are costs that the firm can change with its current decisions.

Page 256 1.

Explain how the marginal product and average product of labor change as the labor employed increases (a) initially and (b) eventually.

Initially, as the quantity of labor is increases, the firm experiences increasing marginal returns, which means that the marginal product increases as more labor is employed. Increasing marginal returns occur because hiring additional workers allows the workers to specialize and become more productive. Eventually, the firm will experience diminishing marginal returns which means that the marginal product decreases as more labor is employed. Decreasing marginal returns occur because eventually the gains from specialization diminish and because more and more workers are working with the same fixed amount of capital. The average product of labor follows the marginal product of labor. Initially, when the marginal product of labor is increasing, the average product also increases. As long as the marginal product of labor exceeds the average product of labor, the average product continues to increase.

Eventually when the marginal product is falling it falls enough so that it is less than the average product, at which point the average product of labor decreases.

2.

What is the law of diminishing returns? Why does marginal product eventually diminish?

The law of diminishing returns states that as a firm uses more of a variable factor of production with a given quantity of fixed factors of production, the marginal product of the variable factor eventually diminishes. Diminishing marginal returns arises from the fact that ever more workers are using the same capital and working in the same space.

3.

Explain the relationship between marginal product and average product.

As the quantity of labor initially increases the firm experiences increasing marginal returns and the marginal product of labor increases. The marginal product of labor is greater than the average product over this range of labor, so the average product of labor increases when the quantity of labor increases. Eventually, diminishing marginal returns causes the marginal product of labor to fall. When the marginal product of labor falls below the average product, the average product decreases as the quantity of labor increases.

Page 263 1.

What relationships do a firm‘s short-run cost curves show?

The marginal cost (MC), average total cost (ATC) and average variable cost (AVC) curves are all related in the short run:  When the MC curve lies above (lies below) the AVC curve, the AVC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the AVC curve at its lowest © 2018 Pearson Education, Inc.

OUTPUT AND COSTS153

point.  When the MC curve lies above (lies below) the ATC curve, the ATC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the ATC curve at its lowest point.  As output increases, the ATC curve becomes vertically closer to the AVC curve.

2.

How does marginal cost change as output increases (a) initially and (b) eventually?

At small outputs, marginal cost decreases as output increases because of greater specialization and the division of labor, but as output increases further, marginal cost eventually increases because of the law of diminishing returns.

3.

What does the law of diminishing returns imply for the shape of the marginal cost curve?

The law of diminishing returns states: As a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes. The law of diminishing returns means that each additional worker produces a successively smaller addition to output. So to get an additional unit of output, ever more workers are required. The cost of an additional unit of output—marginal cost—is increasing, so the marginal cost curve eventually slopes upward.

4.

What is the shape of the AFC curve and why does it have this shape?

Average fixed cost (AFC) equals total fixed cost divided by total product. As the quantity produced increases, the fixed costs are spread over a larger and larger quantity of output so average fixed cost decreases. So the AFC curve slopes downward as the quantity produced increases.

5.

What are the shapes of the AVC curve and the ATC curve and why do they have these shapes?

The average variable cost (AVC), and average total cost (ATC) curves are both U-shaped.  The marginal cost (MC) curve shows how total cost changes when output increases by one unit. If the MC curve lies below the AVC curve, AVC is falling. Diminishing marginal returns means that eventually the MC curve slopes upward. At some point the MC curve lies above the AVC curve, and the AVC curve is upward sloping.  ATC is the sum of average fixed cost (AFC) and AVC. Initially the ATC curve falls as the quantity produced increases because the AFC is initially quite large, but drops rapidly as total fixed costs are spread over greater levels of output. However, eventually diminishing returns cause marginal product to fall below average product, and average product decreases. As a result AVC increases as the quantity produced increases. If AVC rises more quickly than AFC falls, then the ATC curve is upward sloping.

Page 267 1.

What does a firm‘s production function show and how is it related to a total product curve? © 2018 Pearson Education, Inc.

154

CHAPTER 11

A firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labor. The total product curve shows the maximum output that a given quantity of labor can produce for a given quantity of capital.

2.

Does the law of diminishing returns apply to capital as well as labor? Explain why or why not.

The law of diminishing returns applies to capital as well as labor.

The marginal product of capital is the change in the total product resulting from a one-unit increase in capital, holding the quantity of labor constant. As the quantity of capital increases for a given level of labor, the first units of capital will increase output substantially. But as capital continues to increase, eventually the increase in production starts to get smaller and diminishing returns to capital are occurring.

3.

What does a firm‘s LRAC curve show? How is it related to the firm‘s short-run ATC curves?

The long-run average cost curve (LRAC) shows the relationship between the lowest attainable ATC and output when both plant size and labor are varied. The LRAC curve reflects the minimum possible ATC the firm can attain for any given level of output. For any level of output the firm might choose to produce, the LRAC reflects the lowest possible ATC taken from an ATC curve that corresponds to a particular plant size. Once the firm has chosen that plant size, it will incur costs corresponding to the ATC curve associated with that plant size.

4.

What are economies of scale and diseconomies of scale? How do they arise? What do they imply for the shape of the LRAC curve?

Economies of scale are features of a firm’s technology that lead to falling long-run average cost (LRAC) as output increases. As plant size increases, the minimum attainable average total cost (ATC) for each plant size falls with output. Diseconomies of scale are features of a firm’s technology that lead to rising LRAC as output increases. As plant size increases, the minimum attainable ATC for each plant size rises with output. A firm initially experiences economies of scale up to some output level and over this range of output the LRAC curve is downward sloping as output increases.

Beyond that output level, it may move toward diseconomies of scale.

When there are diseconomies of scale, the LRAC slopes upward as output increases, resulting in a U-shaped LRAC curve.

5.

What is a firm‘s minimum efficient scale?

Minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. If the long-run average cost curve has the typical U shape, the minimum point of the LRAC identifies the level of output that represents the firm’s minimum efficient scale.

© 2018 Pearson Education, Inc.

OUTPUT AND COSTS155

Answers to the Study Plan Problems and Applications 1.

Macy’s Is Closing Another 100 Stores Macy‘s will close 15 percent of its department stores and employees at closed stores may be offered jobs in nearby stores. Premiere Macy‘s locations could be scaled back.

Walmart plans to shut down 269 stores.

Nearly 44,000 retail workers have been laid off in 2016.

Amazon and other online retailers are expanding.

Source: CNNMoney, August 11, 2016 Which of the items in the news clip involves a short-run decision and which involves a long-run decision? Explain.

Scaling back Macy’s Premiere locations and laying off 44,000 retail workers are short run decisions because they involved decreasing only one factor of production—labor—and all the other factors remained fixed.

Macy’s plans to close stores and not offer employees jobs in nearby stores is a long-run decision because it reduces the size of all of Macy’s factors of production, labor and the capital stock. So, too, are Walmart’s decision to shut down 269 stores and Amazon’s and other online retailors’ decisions Labor Output to expand because they also (workers (surfboards change the quantity of all of the factors of per per week) production.

Use the table to work Problems 2 to 6.

The table sets out Sue‘s Surfboards‘ total schedule.

2.

Draw the total product curve.

week) 1 2 3 4 5 6 7

30 70 120 160 190 210 220

product

To draw the total product curve measure labor on the x-axis and output on the y-axis. The total product curve is upward sloping and is illustrated in Figure 11.1.

3.

Calculate the average product of labor and draw the average product curve.

The average product of labor is equal to total product divided by the quantity of labor employed. For example, when 3 workers are employed, they produce 120 surfboards a week, so average product is 40 surfboards per worker. As Figure 11.2 (on the next page) shows, the average product curve is upward sloping when up to 3 workers are hired and then is downward sloping when more than 4 workers are hired.

4.

Calculate the marginal product of labor and draw the marginal product curve.

The marginal product of labor is equal to the increase in total product that results from © 2018 Pearson Education, Inc.

156

CHAPTER 11

a one-unit increase in the quantity of labor employed. For example, when 3 workers are employed, total product is 120 surfboards a week.

When a fourth worker is employed, total product increases to 160 surfboards a week. The marginal product of increasing the number of workers from 3 to 4 is 40 surfboards. We plot the marginal product at the halfway point, so at a quantity of 3.5 workers, the marginal product is 40 surfboards per worker per week. As Figure 11.2 shows, the marginal product curve is upward sloping when up to 2.5 workers a week are employed and it is downward sloping when more than 2.5 workers a week are employed.

5. a. Over what output range does Sue‘s Surfboards enjoy the benefits of increased specialization and division of labor?

The firm enjoys the benefits of increased specialization and division of labor over the range of output for which the marginal cost decreases. This range of output is the same range over which the marginal product of labor rises. For Sue’s Surfboards, the benefits of increased specialization and division of labor occur until 2.5 workers are employed.

b. Over what output range does the firm experience diminishing marginal product of labor?

The marginal product of labor decreases after the 3rd worker is employed.

c. Over what output range does the firm experience an increasing average product of labor but a diminishing marginal product of labor?

The marginal product of labor decreases and the average product of labor increases between 2.5 and 3.5 workers.

6.

Explain how it is possible for a firm to experience simultaneously an increasing average product but a diminishing marginal product.

As long as the marginal product of labor exceeds the average product of labor, the average product of labor rises. For a range of output the marginal product of labor, while decreasing, remains greater than the average product of labor, so the average product of labor rises. Each additional worker, while producing less than the previous worker hired is still producing more than the average worker.

Use the following data to work Problems 7 to 11.

Sue‘s Surfboards, in Problem 2, hires workers at $500 © 2018 Pearson Education, Inc.

OUTPUT AND COSTS157

a week and its total fixed cost is $1,000 a week.

7.

Calculate total cost, total variable cost, and total fixed cost of each output in the table. Plot these points and sketch the short-run total cost curves passing through them.

Total cost is the sum of the costs of all the factors of production that Sue’s Surfboards uses. Total variable cost is the total cost of the variable factors. Total fixed cost is the total cost of the fixed factors. For example, the total variable cost of producing 120 surfboards a week is the total cost of the workers employed, which is 3 workers at $500 a week, which equals $1,500. Total fixed cost is $1,000, so the total cost of producing 120 surfboards a week is $2,500. Figure 11.3 shows these total cost curves.

© 2018 Pearson Education, Inc.

158

8.

CHAPTER 11

Calculate average total cost, average fixed cost, average variable cost, and marginal cost of each output in the table. Plot these points and sketch the short-run average and marginal cost curves passing through them.

30

AFC (dollar s per surfboa rd) 33.33

AVC (dollar s per surfboa rd) 16.67

ATC (dollar s per surfboa rd) 50.00

70

14.29

14.29

28.58

120

8.33

12.50

20.83

160

6.25

12.50

18.75

190

5.26

13.16

18.42

210

4.76

14.29

19.05

220

4.55

15.91

20.46

Output (surfboar ds)

MC (dollar s per surfboa rd) 12.50 10.00 12.50 16.67 25.00 50.00

Average fixed cost is total fixed cost per unit of output. Average variable cost is total variable cost per unit of output. Average total cost is the total cost per unit of output. For example, take the case in which the firm makes 160 surfboards a week. Total fixed cost is $1,000, so average fixed cost is $6.25 per surfboard; total variable cost is $2,000, so average variable cost is $12.50 per surfboard; and, total cost is $3,000, so average total cost is $18.75 per surfboard. Marginal cost is the increase in total cost divided by the increase in output. For example, when output increases from 120 to 160 surfboards a week, total cost increases from $2,500 to $3,000, an increase of $500. This $500 increase in total cost means that the increase in output of 40 surfboards increases total cost by $500. Marginal cost is equal to $500 divided by 40 surfboards, which is $12.50 a surfboard. The table shows these data schedules and the curves are plotted in Figure 11.4.

© 2018 Pearson Education, Inc.

OUTPUT AND COSTS159

Illustrate the connection between Sue‘s AP, MP, AVC, and MC curves in graphs like those in Fig. 11.7.

9.

AP MP Labor Output (surfboards (surfboards (workers) (surfboards) per worker) per worker) 1

30

30.0

2

70

35.0

3

120

40.0

4

160

40.0

5

190

38.0

6

210

35.0

7

220

31.4

40.0 50.0 40.0 30.0 20.0 10.0 The table sets out the data used to draw the curves. Figure 11.5 shows the curves and the relationships.

When the AP curve rises the AVC curve falls and vice versa. When the MP curve rises the MC curve falls and vice versa.

10.

Sue‘s Surfboards rents a factory. If the rent rises by $200 a week and other things remain the same, how do Sue‘s Surfboards‘ short-run average cost curves and marginal cost curve change?

The rent is a fixed cost, so total fixed cost increases. The increase in total fixed cost increases total cost but does not change total variable cost. Average fixed cost is total fixed cost per unit of output. The average fixed cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve and average variable cost curve do not change.

11.

Workers at Sue‘s Surfboards negotiate a wage increase of $100 a week per worker. If other things remain the same, explain how Sue‘s Surfboards‘ short-run average cost curves and marginal cost curve © 2018 Pearson Education, Inc.

AVC MC (dollars (dollars per per surfboard) surfboard) 16.67 12.50 14.29 10.00 12.50 12.50 12.50 16.67 13.16 25.00 14.29 50.00 15.91

160

CHAPTER 11

change.

The increase in the wage rate is a variable cost, so total variable cost increases. The increase in total variable cost increases total cost but total fixed cost does not change. Average variable cost is total variable cost per unit of output. The average variable cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve shifts upward while the average fixed cost curve does not change.

Use the following data to work Problems 12 to 14.

Jackie‘s Canoe Rides rents canoes at $100 per Labor day and pays $50 per day for each canoe (workers per day) operator it hires. The table shows the firm‘s 10 production function.

20 12. Graph the ATC curves for Plant 1 and 30 Plant 2. Explain why these ATC curves 40 differ.

Canoes

Plant 1 20 40 65 75 10

To find the average total cost for each plant, at the different levels of output add the cost of the workers, $50 per worker, and the fixed cost, the cost of the canoes, $100 per canoe. So for plant 1, the total cost for 20 rides is $1,500; for 40 rides is $2,000; and, for 65 rides is $2,500. The average total cost is calculated by dividing the total cost by the quantity of rides. These average total costs are plotted in Figure 11.6. (The average total cost curve for one plant, ATC1, is the same as the thicker curve through the first 4 points.) The curves differ because the number of plants differs.

13.

Output (rides per day) Plant 2 Plant 3 40 55 60 75 75 90 85 100 20 30

Graph the ATC curves for Plant 3 and Plant 4. Explain why these ATC curves differ.

These are drawn in Figure 11.6. The curves differ because the number of plants differs.

14. a. On Jackie‘s LRAC curve, what is the average cost of producing 40, 75, and 85 rides a week?

The long-run average total cost curve is illustrated in Figure 11.6 as the thicker curve. It is comprised of the parts of the short-run average total cost curves that are the minimum average total cost for the different levels of output. From this curve, the average cost of producing 40 rides is $50; of producing 75 rides is $40; and the average cost of producing 85 rides is $47.06.

© 2018 Pearson Education, Inc.

Plant 4 65 85 100 110 40

OUTPUT AND COSTS161

b. What is Jackie‘s minimum efficient scale?

Jackie’s minimum efficient scale is the smallest quantity at which the long-run average cost is the lowest. Jackie’s minimum efficient scale is 65 canoe rides where, with one plant, the average total cost is $38.46.

c. Does Jackie‘s production function feature economies of scale or diseconomies of scale?

Jackie’s has both economies of scale for up to 65 canoe rides and then diseconomies of scale for more than 65 canoe rides.

© 2018 Pearson Education, Inc.

162

CHAPTER 11

Answers to Additional Problems and Applications 15.

Staples Closing Another 70 Stores as North American Sales Sink Staples closed 48 of its North American stores in 2016 and will close another 70 in 2017. The firm has expanded its e-commerce, and has focused on buying small business-to-business service providers beyond office supplies companies that employ 10 to 200 employees. It has added 1,000 people to its sales force.

Source: Fortune, March 9, 2017 a. Which of Staples‘ decisions described in the news clip is a short-run decision and which is a long-run decision?

Closing the stores in 2016 and 2017 as well as expanding its ecommerce and buying small business-to-business service providers are long-run decisions because they change the amount of all of Staple’s inputs including its input of capital. Adding the 1,000 additional sales people is a short-run decision.

b. Why is Staples‘ long-run decision riskier than its short-run decision?

Staple’s long-run decisions are riskier than its short-run decision because it is more difficult to change the long-run decisions. In particular if Staples decides to reverse its short-run decision to hire more sales people, it is straightforward to fire them. However to reverse the long-run decision of decreasing the number of its stores or expanding its e-commerce is more difficult and takes much longer to do.

16.

Sunk-Cost Bias: Is It Time To Call It Quits?

Author Margie Warrell recalls keeping on wearing a pair of designer shoes even though they made her feet ache because she had paid a lot for them. She says she was thinking ―I need to get my money‘s worth!‖ She tells this story as a warning against ―sunk-cost bias‖.

Source: Forbes, September 14, 2015 a. What type of cost is expenditure on shoes?

Once the pair of shoes is purchased, its cost is a sunk cost.

b. Why is the price paid for the shoes irrelevant to your decision about whether to keep on wearing a pair that cause pain?

The cost of the shoes is a sunk cost; that is, the cost of the shoes has already been incurred. Because the cost of the shoes is the same regardless if you wear them or not, their cost is irrelevant to your decision whether to wear them or not.

17.

Terri runs a rose farm. One worker produces 1,000 roses a week; hiring a second worker, doubles her total product; hiring a third worker doubles her output again; hiring a fourth worker increased her total product but by only 1,000 roses. Construct Terri‘s marginal product and average product schedules. Over what range of workers do marginal returns increase?

The easiest way to construct the marginal product and average product schedules is to use the total product schedule, in the table to the left. Then the average product of labor is equal to the

Labor (workers per week 1

Output (roses per week) 1,000

Average product (roses per week) 1,000

2

2,000

1,000

3

4,000

1,333

4

5,000

1,250

Marginal product (roses per week) 1,000

© 2018 Pearson Education, Inc.

2,000 1,000

OUTPUT AND COSTS163

output divided by the quantity of labor and the marginal product of labor is equal to the change in output divided by the change in the quantity of labor. Marginal returns increase over the range of 3 workers. After the third worker, the marginal product decreases as more workers are hired.

18.

Read the information about Staples‘ business decisions in the news clip in Problem 15. Explain how Staples‘ short-run decision will change its average variable cost and its short-run ATC curve. Explain how Staples‘ long-run decision will change its total fixed cost and its short-run ATC curve.

Staple’s long-run decision to decrease the size of its plant (the number of its stores) decreases its total fixed cost and, as it lays off workers, its total variable cost also decreases. However Staple’s decision to add 1,000 salespeople increases its variable cost. Staple’s long-run decisions to expand its e-commerce and buy small business-to-business service providers increase both its variable cost and its fixed cost because these initiatives use variable and fixed inputs. The effect on total variable cost is ambiguous—it will rise if the effects on the variable cost from adding sales people, expanding e-commerce, and buying business-tobusiness service providers exceed that from closing stores. In this case the average variable cost rises. Probably the effect on the total fixed costs from decreasing the number of retail stores is larger than the effect from expanding e-commerce and buying the business-to-business service providers, in which case Staple’s total fixed cost and average fixed cost decrease. The impact on the average total cost is ambiguous because the average fixed cost decreases while the average variable cost (probably) increases.

19.

Bill‘s Bakery has a fire and Bill his cost data. The bits of paper recovers after the fire provide information in the following cost numbers are dollars).

Bill asks you to come to his provide the missing data in the identified as A, B, C, D, and E.

TP 10

AFC 120

AVC 100

ATC 220

20

A

B

150

30

40

90

130

40

30

C

D

MC 80

loses some of that he the table (all the

90 130

rescue and five spaces

A is the average fixed E cost, AFC, when the output is 50 24 108 132 20. Average fixed cost equals total fixed cost divided by output, or AFC = TFC ÷ Q. Rearranging gives TFC = AFC × Q. So the total fixed cost for the problem equals $120 × 10, which is $1,200. A equals $1,200, TFC, divided by 20, Q, which is $60.

B is the average variable cost, AVC, when output is 20. Use the result that AFC + AVC = ATC by rearranging to give AVC = ATC  AFC, so average variable cost equals $150  $60, which is $90.

D is the average total cost, ATC, when output, Q, equals 40. Average total cost equals total cost divided by output, or ATC = TC ÷ Q. Rearranging gives TC = ATC × Q. So the total cost when 30 units are © 2018 Pearson Education, Inc.

164

CHAPTER 11

produced is $130 × 30, which is $3,900. Marginal cost, MC, equals the change in total cost divided by the change in quantity, or MC = TC ÷ Q. Rearranging gives TC = MC × Q, so the change in total cost between Q = 30 and Q = 40 is $130 × 10, or $1,300. Therefore the total cost when Q equals 40 is $3,900 + $1,300, or $5,200. The average total cost when Q is 40 is $5,200 ÷ 40, or $130.

C is the average variable cost, AVC, when output, Q, equals 40. Use the result that AFC + AVC = ATC by rearranging to give AVC = ATC  AFC. As a result, average variable cost equals $130  $30, or $100.

E is the marginal cost, MC, when output increases from 40 units to 50 units. Marginal cost, MC, equals the change in total cost divided by the change in quantity, or MC = TC ÷ Q. To calculate marginal cost, the total cost when output is 40 and the total cost when output is 50 are needed. Average total cost equals total cost divided by output, or ATC = TC ÷ Q. Rearranging gives TC = ATC × Q. So the total cost when 40 units are produced is $130 × 40, which is $5,200 and total cost when 50 units are produced is $132 × 50, which is $6,600. So the marginal cost equals ($6,600  $5,200) ÷ 10, which equals $140.

Use the following table to work Problems 20 and 21.

ProPainters hires students at $250 a week to paint houses. It leases equipment at $500 a week. The table sets out its total product schedule.

20.

If ProPainters paints 12 houses a week, calculate its total cost, average total cost, and marginal cost. At what output is average total cost a minimum?

Labor (students) 1 2 3 4 5 6

To paint 12 houses, ProPainters hires 4 students.

The total variable cost is $1,000 (paid to the students) and the total fixed cost is $500 (the leased equipment). Therefore the total cost is $1,500. The average total cost equals $1,500/12, which is $125 per house. The marginal cost of 10½ houses is $83.33 and the marginal cost of 13 houses is $125.00. These mean that the marginal cost of 12 houses is $104.17. Using the data in the table, the average total cost is at its minimum of $125 per house when 13 houses are painted.

21.

Explain why the gap between ProPainters‘ total cost and total variable cost is the same no matter how many houses are painted.

The gap between total cost and total variable cost is total fixed cost. Because the fixed cost is the same at all levels of output, the difference between the total cost and total variable cost is constant.

© 2018 Pearson Education, Inc.

Output (houses painted per week) 2 5 9 12 14 15

OUTPUT AND COSTS165

22.

Sushi Under Intense Price Pressure The price of flavored hake, used by sushi bars in place of crabmeat, has increased by 33 per cent over the past three years. Crabmeat is up about 50 per cent. Californian sushi rice has increased in price by about 25 per cent in the past two years. The wholesale price of sushi-grade sockeye salmon has fluctuated between $11 and $15 a kilogram. The price of avocados has fluctuated between $40 and $60 a case.

Source: The Vancouver Sun, May 28, 2015 a. How do fluctuations in the prices of items in the news clip influence a sushi bar‘s short-run cost curves?

All of the inputs mentioned in the news clip are variable inputs, so increases in any of them increase the bar’s variable costs, its average variable cost, its total cost, its total average cost, and its marginal cost. All of the curves shift upward when any of these prices rises.

b. Do the price fluctuations change a sushi bar‘s fixed cost, variable cost, or marginal cost?

All of the inputs are variable inputs, so they have no effect on the bar’s fixed cost. When any of them rise in cost, the bar’s variable costs and marginal cost both increase.

© 2018 Pearson Education, Inc.

166

CHAPTER 11

Use the table in Problem 20 and the following information to work Problems 23 and 24.

If ProPainters doubles the number of students it hires and doubles the amount of equipment it leases, it experiences diseconomies of scale.

23.

Explain how the ATC curve with one unit of equipment differs from that when ProPainters uses double the amount of equipment.

Because ProPainters experiences diseconomies of scale, when ProPainters doubles its inputs the minimum average cost is higher than when it uses the lesser quantities of inputs. Even so, at high levels of output the average total cost of producing the large level of output with the greater quantities of inputs is lower than the average total cost of producing this large level of output with the smaller quantities of inputs.

24.

Explain what might be the source of the diseconomies of scale that ProPainters experiences.

ProPainters might experience diseconomies of scale because when it gets larger the complexity of operating the business increases, which increases the costs of running the business and making decisions.

Use the following information to work Problems 25 to 27.

The table shows the Labor production function of (workers Bonnie‘s Balloon Rides. per day) Plant 1 Bonnie‘s pays $500 a day for 10 6 each balloon it rents and $25 20 10 a day for each balloon 30 13 40 15 operator it hires.

50 16 25. Graph the ATC curves Balloons 1 for Plant 1 and Plant 2.

Explain why these ATC curves differ.

Output (rides per day) Plant 2 Plant 3 10 13 15 18 18 22 20 24 21 25 2 3

Plant 4 15 20 24 26 27 4

To find the average total cost for each plant, at the different levels of output add the variable cost, which is the cost of the workers or $25 per worker, to the fixed cost, which is the cost of the balloons or $500 per balloon.

For Plant 1, the total cost for 6 rides is $750; for 10 rides is $1,000; for 13 rides is $1,250; for 15 rides is $1,500; and, for 16 rides is $1,750. The average total cost is calculated by dividing the total cost by the quantity of rides. These average total costs are plotted in Figure 11.7. The curves differ because the number of plants differs.

26.

Graph the ATC curves for Plant 3 and Plant 4. © 2018 Pearson Education, Inc.

OUTPUT AND COSTS167

Explain why these ATC curves differ.

Figure 11.7 shows these ATC curves. These curves differ because the number of plants differs.

27. a. On Bonnie‘s LRAC curve, what is the average cost of producing 15 rides and 18 rides a day?

The long-run average total cost curve is illustrated in Figure 11.7 as the darker line. The long-run average cost curve is comprised of the segments of the different short-run average total cost curves that have the minimum average total cost for the different levels of output. For 15 rides a day the average cost is $100 and for 18 rides a day the average cost is $97.22.

b. Explain how Bonnie‘s uses its long-run average cost curve to decide how many balloons to rent.

Bonnie’s will use its long-run average total cost curve by building the size of the plant that minimizes its long-run average cost at the number of balloon rides that Bonnie’s expects to produce.

Economics in the News 28.

After you have studied Economics in the News on pp. 268-269, answer the following questions. a. Explain the distinction between the short run and the long run and identify when IKEA would want to make each type of decision.

The short run is a time frame during which the quantity of at least one factor of production is fixed. The long run is a time frame in which the quantities of all factors of production can be varied.

IKEA will make changes that lower its costs. It will make a shortrun change when it wants to make an immediate change or when it wants to make a change that it will reverse in the near future. IKEA will make a long-run change when it wants to make a change that will be permanent.

b. Explain economies of scale. Does IKEA reap economies of scale in the example on p. 269?

Economies of scale occur when a firm’s average total cost falls as the firm’s output increases. As its output increases, the firm will employ more labor and capital. Increased specialization of labor and capital leads to economies of scale. Figure 2 shows that IKEA has economies of scale at least up to 1,400 customers per hour.

c. Amend the graph in Fig. 2 on p. 269 to illustrate IKEA‘s average total cost curves for its Memphis and Montreal stores.

Figure 11.8 shows IKEA’s longrun average total cost, LRAC. The average total cost curve for Memphis is ATCMem and the average total cost curve for Montreal is ATCMon.

29.

Self-Serve Beer Stations Cut Labor Costs A new technology lets beer drinkers draw their own taps, like the soda fountain at McDonald‘s. The technology can measure and charge by the sip. It costs $25,000 for a wallmounted, 20-tap system, plus a monthly © 2018 Pearson Education, Inc.

168

CHAPTER 11

maintenance fee.

Source: The Toronto Star, October 9, 2015 a. What is the total fixed cost of operating one self-serve system? What are its variable costs of providing self-serve beer?

The fixed costs are the cost of the machine itself, $25,000. The variable costs include the cost of the beer and the cost of maintaining the taps.

b. Explain how the fixed costs, variable costs, and total costs of beer served by a person differ from those of self-served beer.

The fixed cost of the automatic tap machine machine exceeds that of a beer served by a person. The variable cost of the beer served by a person exceeds that of the machine. The total cost of the automatic tap machine is probably higher than that of the person-served beer at lower levels of output and is probably lower at higher level of outputs.

c. Sketch the marginal cost and average cost curves implied by your answer to part (b).

Figure 11.9 shows the different marginal costs and average total cost curves. The costs with the person-served beer are labeled ―1‖ and the costs with the automatic tap machine are labeled ―2‖. The average total cost of the machine is higher than that of the person-served beer at low levels of output and is lower than the average total cost of the person-served beer at high levels of output. The marginal cost of the machine is lower than the marginal cost of the person-served beer,

Use the following news clip to work Problems 30 and 31.

Dollar General Targets Millennials With DGX Concept Stores Discount grocer Dollar General has the Millennial shopper in mind with a smaller-format 3,400square-foot DGX concept store. The idea of the smaller store concept is to better serve busy citydwellers in a convenient, easy-to-shop format.

Source: USA TODAY, February 3, 2017 30.

Thinking of a DGX store as a production plant, explain why Dollar General is opening smaller stores. Is Dollar General‘s decision a long-run decision or a short-run decision?

Dollar General believes that its stores are too large and that it is operating where it has diseconomies of scale. By reducing the size of its plant (its stores) Dollar General can slide down its LRAC curve and decrease its average cost. Dollar General’s decision is a long-run decision because it involves the size of the firm’s plant.

© 2018 Pearson Education, Inc.

OUTPUT AND COSTS169

31.

Is Dollar General expecting to benefit from economies of scale or does the firm C h a p t e r think there are diseconomies of scale? Explain your answer.

Dollar General believes that it is operating where there are diseconomies of scale. By opening a smaller, DGX store, Dollar General believes its average total cost of serving busy millennial shoppers will be lower than in its conventionalsized store.

32.

Draw a graph to illustrate the average total cost curves of a DGX store and regular Dollar General stores.

Figure 11.9 shows Dollar General’s long-run average cost curve (LRAC), its average total cost for a DGX store (ATCDGX), and a regular, conventional store (ATCCon). When serving the smaller number of millennial customers per day, 600 in the figure, the DGX store’s average total cost is less than $1 compared to $2 for a conventional store.

12

PERFECT COMPETITION

Answers to the Review Quizzes Page 277 1.

Why is a firm in perfect competition a price taker?

One firm’s output is a perfect substitute for another firm’s output and each firm is a small part of the market. These points imply that each firm cannot unilaterally influence the market price at which it can sell its good or service. It must accept, or ―take‖ the market equilibrium price—hence the term, price taker.

2.

In perfect competition, what is the relationship between the demand for the firm‘s output and the market demand?

The market demand curve for the goods and services in a perfectly competitive market is downward sloping. However, no single firm in this market can influence the price at which it sells its output. © 2018 Pearson Education, Inc.

166

CHAPTER 12

This point means a firm that is a price taker must take the equilibrium market price as given, and the firm faces a perfectly elastic demand.

3.

In perfect competition, why is a firm‘s marginal revenue curve also the demand curve for the firm‘s output?

A perfectly competitive firm’s demand curve is a horizontal line at the market price. This result means that the price it receives is the same for every unit sold. The marginal revenue received by the firm is the change in total revenue from selling one more unit, which is the constant market price. So a perfectly competitive firm’s demand curve is the same as its marginal revenue curve.

4.

What decisions must a firm make to maximize profit?

The firm has three decisions it must make. First it must determine how to produce at the minimum cost. Then it must determine how much to produce. Finally it must decide whether to enter or exit a market.

Page 281 1.

Why does a firm in perfect competition produce the quantity at which marginal cost equals price?

A firm’s total profit is maximized by producing the level of output at which marginal revenue for the last unit produced equals its marginal cost, or MR = MC. In a perfectly competitive market, MR is equal to the market price P for all levels of output. These points imply that a perfectly competitive firm will maximize profit by producing the quantity at P = MC.

2.

What is the lowest price at which a firm produces an output? Explain why.

The lowest price at which a firm will produce output is the price that equals the firm’s minimum AVC. At this price the firm has just enough total revenue to cover its total variable costs. The firm’s loss is equal to its fixed costs. At any lower market price the firm’s loss would be greater than its fixed costs. In this case the firm can avoid losses that are greater than its fixed cost by shutting down.

3.

What is the relationship between a firm‘s supply curve, its marginal cost curve, and its average variable cost curve?

The firm will produce output as long as the price is greater than the minimum AVC. It will choose the level of output where MC = P, which means the firm’s supply curve is the firm’s MC curve above minimum AVC and along the vertical axis, producing zero, below the minimum AVC.

Page 285 1.

How do we derive the short-run market supply curve in perfect competition?

The short-run market supply curve is the horizontal sum of each individual firm’s supply curve. That is, the amount supplied by the © 2018 Pearson Education, Inc.

PERFECT COMPETITION167

total market equals the sum of what each firm in the industry supplies at a given price.

2.

In perfect competition, when market demand increases, explain how the price of the good and the output and profit of each firm changes in the short run.

When market demand increases, the market price of the good rises, and the market quantity increases. Because price equals marginal revenue, the rise in the price means marginal revenue rises. As a result, each firm moves up its marginal cost curve and increases the quantity it produces. The firm’s economic profit rises (or its economic loss decreases). If the firm had been making a normal profit before the increase in demand, after the increase the firm makes an economic profit.

3.

In perfect competition, when market demand decreases, explain how the price of the good and the output and profit of each firm changes in the short run.

When market demand decreases, the market price of the good falls and the market quantity decreases. Because the price equals marginal revenue, the fall in the price means marginal revenue falls. As a result, each firm moves down its marginal cost curve so each firm decreases the quantity it produces. The firm’s economic profit falls (or its economic loss increases). If the firm had been making a normal profit before the decrease in demand, after the decrease the firm incurs an economic loss.

Page 288 1.

What triggers entry in a competitive market? Describe the process that ends further entry.

When firms in a competitive market make an economic profit, the economic profit serves as an inducement to other firms to enter the market. As the other firms enter, the supply increases and the price falls. The fall in the price eventually eliminates the economic profit, at which time entry stops.

2.

What triggers exit in a competitive market? Describe the process that ends further exit.

When firms in a competitive market are incurring an economic loss, some of the firms will exit the market. As these firms exit, the supply decreases and the price rises. The rise in the price eventually eliminates the economic loss, at which time exit stops.

Page 291 Describe what happens to output, price, and economic profit in the short run and in the long run in a competitive market following: 1.

An increase in demand.

An increase in demand increases the market quantity, and the market price rises above ATC for each firm. In the short run, firms in the market make an economic profit, attracting firms from outside the market to enter the market in the long run. This entry shifts the market supply curve rightward, lowering the price as the market quantity continues to increase. The fall in the price shrinks the © 2018 Pearson Education, Inc.

168

CHAPTER 12

firms’ economic profit until the price again equals the minimum point on each firm’s ATC curve. At this point, firms return to zero economic profit and entry stops. In the long run, the price returns to the original level, market output is larger than the original amount, the number of firms is larger, and economic profit for each firm returns to zero.

2.

A decrease in demand.

Starting from an initial point of long-run equilibrium, a permanent decrease in demand decreases the market quantity, and the price falls below the minimum ATC for each firm. In the short run, firms in the market incur an economic loss, which leads some firms to exit the market in the long run. This exit shifts the market supply curve leftward, raising the price and continuing to decrease the market quantity. The increase in the price shrinks the economic loss for each remaining firm. Exit continues until the price again equals the minimum point on each firm’s ATC curve. At this point, firms return to zero economic profit and exit stops. In the long run, the market price returns to the original level, market output is less than the original amount, the number of firms is less, and economic profit for each firm returns to zero.

3.

The adoption of a new technology that lowers production costs.

Technological advances result in lower costs for the firm that adopts them and initially these firms make an economic profit. Two actions occur in the market: i) firms from outside the market enter the market; ii) firms with old technology either exit the market or adopt the new technology. These two actions shift the market supply rightward, decreasing market price and increasing market quantity.

In the long run, all firms in the industry will be new technology firms, economic profit for each firm will return to zero, market quantity will increase, and market price will fall to the new minimum ATC for each firm.

Page 293 1.

State the conditions that must be met for resources to be allocated efficiently.

Resource use is efficient when the economy produces the goods and services that people value most highly. This situation requires that consumers are on their demand curves, thereby allocating their budgets to get the most possible value from their income. If the people who consume a good or service are the only ones who benefit from it, then the market demand curve measures the benefit to the entire society and is the marginal social benefit curve. Efficient resource use also requires that firms are on their supply curves, thereby getting the most value out of their resources. If the firms that produce a good or service bear all the costs of producing it, then the market supply curve measures the marginal cost to the entire society and the market supply curve is the marginal social cost curve. And resources are used efficiently when marginal social benefit equals marginal social cost. © 2018 Pearson Education, Inc.

PERFECT COMPETITION169

2.

Describe the choices that consumers make and explain why consumers are efficient on the market demand curve.

Consumers allocate their budgets so they get the most value from their budgets. When consumers are on their demand curves, they are getting the most value out of their resources and are efficient.

3.

Describe the choices that producers make and explain why producers are efficient on the market supply curve.

Competitive firms maximize profit. We derive the firm’s supply curve by finding the profit-maximizing quantity at each price, which means that firms are efficient and get the most value out of their resources at all points along their supply curve.

4.

Explain why resources are used efficiently in a competitive market.

Resources are used efficiently in a competitive market because the market demand curve is the same as the marginal social benefit curve and the market supply curve is the same as the marginal social cost curve. The equilibrium quantity, determined by where the demand and supply curves intersect, is the same quantity where the marginal social benefit and marginal social cost curves intersect, which is the efficient quantity.

© 2018 Pearson Education, Inc.

170

CHAPTER 12

Answers to the Study Plan Problems and Applications 1.

Lin‘s makes fortune cookies. Anyone can make and sell fortune cookies, so there are dozens of producers. All fortune cookies are the same and buyers and sellers know this fact. In what type of market does Lin‘s operate? What determines the price of fortune cookies? What determines Lin‘s marginal revenue?

Lin is operating in a perfectly competitive market. The equilibrium price is determined at the intersection of the market demand curve and the market supply curve. Lin’s marginal revenue equals the market price of a box of cookies.

Use the following table to work Problems 2 to 4.

Pat‘s Pizza Kitchen is a price taker and the table shows its costs of production.

2.

Calculate Pat‘s profit-maximizing output and economic profit if the market price is (i) $14 a pizza, (ii) $12 a pizza, (iii) $10 a pizza.

Output (pizzas per hour) 0 1 2 3 4 5

Total cost (dollars per hour) 10 21 30 41 54 69

(i) At $14 a pizza, Pat’s profit-maximizing output is 4 pizzas an hour and economic profit is $2 an hour.

Pat’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $14 a pizza. The marginal cost is the change in total cost when output is increased by 1 pizza an hour. The marginal cost of increasing output from 3 to 4 pizzas an hour is $13 ($54 minus $41). The marginal cost of increasing output from 4 to 5 pizzas an hour is $15 ($69 minus $54). So the marginal cost of the fourth pizza is half-way between $13 and $15, which is $14. Marginal cost equals marginal revenue when Pat produces 4 pizzas an hour. Economic profit equals total revenue minus total cost. Total revenue equals $56 ($14 multiplied by 4). Total cost is $54, so economic profit is $2. (ii) At $12 a pizza, Pat’s profit-maximizing output is 3 pizzas an hour and economic profit is $5. Pat’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. Marginal revenue equals price, which is $12 a pizza. The marginal cost of increasing output from 2 to 3 pizzas an hour is $11 ($41 minus $30). The marginal cost of increasing output from 3 to 4 pizzas an hour is $13. So the marginal cost of the third pizza is half-way between $11 and $13, which is $12. Marginal cost equals marginal revenue when Pat produces 3 pizzas an hour.

Economic profit equals total revenue minus total cost. Total revenue equals $36 ($12 multiplied by 3). Total cost is $41, so economic profit is $5. (iii) At $10 a pizza, Pat’s profit-maximizing output is 2 pizzas an hour and economic profit is $10. Pat’s maximizes its profit by producing the quantity at which marginal revenue equals © 2018 Pearson Education, Inc.

PERFECT COMPETITION171

marginal cost. Marginal revenue equals price, which is $10 a pizza. The marginal cost of increasing output from 1 to 2 pizzas an hour is $9 ($30 minus $21). The marginal cost of increasing output from 2 to 3 pizzas an hour is $11. So the marginal cost of the second pizza is half-way between $9 and $11, which is $10. Marginal cost equals marginal revenue when Pat produces 2 pizzas an hour. Economic profit equals total revenue minus total cost. Total revenue equals $20 ($10 multiplied by 2). Total cost is $30, so economic profit is $10.

3.

What is Pat‘s shutdown point and what is Pat‘s economic profit if it shuts down temporarily?

The shutdown point is the price that equals minimum average variable cost. To calculate total variable cost, subtract total fixed cost ($10—when output is zero, total variable cost is $0, so total cost at zero output equals total fixed cost) from total cost. Average variable cost equals total variable cost divided by the quantity produced. The average variable cost of producing 2 pizzas is $10 a pizza. Average variable cost is a minimum when marginal cost equals average variable cost. The marginal cost of producing 2 pizzas is $10. So Pat’s shutdown point is a price of $10 a pizza. When Pat shuts down the economic ―profit‖ is actually an economic loss equal to Pat’s fixed cost. In particular Pat’s economic loss is $10.

4.

Derive Pat‘s supply curve.

Pat’s supply curve is the same as the marginal cost curve at prices equal to or above $10 a pizza. The supply curve is the y-axis (0 pizzas) at prices below $10 a pizza.

5.

The market for paper is perfectly competitive and 1,000 firms produce paper. The first table sets out the market demand schedule for Price Quantity demanded paper. The second table sets out the (dollars (thousands of boxes costs of each producer of paper. per box) per week) Calculate the market price, the 3.65 500 market output, the quantity 5.20 450 produced by each firm, and the firm‘s 6.80 400 economic profit or loss.

8.40 350 The market price is $8.40 10.00 300 per box of paper. The 11.60 250 market price is the price 13.20 200 at which the quantity demanded equals the quantity supplied. The firm’s supply curve is the same as Output Marginal Average Averag its marginal cost curve (boxes cost variable e at prices above per (dollars cost total minimum average week) per cost variable cost. additional (dollars per Average variable box) box) cost is at its 200 6.40 7.80 12.80 minimum when marginal 250 7.00 7.00 11.00 cost equals average 300 7.65 7.10 10.43 variable cost.

350 8.40 7.20 400 10.00 7.50 Education, Inc. 8.00 450 © 2018 Pearson 12.40 500 20.70 9.00

10.06 10.00 10.22 11.00

172

CHAPTER 12

Marginal cost equals average variable cost at the quantity 250 boxes a week. So the firm’s supply curve is the same as the marginal cost curve for the outputs equal to 250 boxes or more. When the price is $8.40 a box, each firm produces 350 boxes and the quantity supplied by the 1,000 firms is 350,000 boxes a week. The quantity demanded at $8.40 is 350,000 a week.

The market output is 350,000 boxes a week.

Each firm produces 350 boxes a week.

Each firm incurs an economic loss of $581 a week. Each firm produces 350 boxes at an average total cost of $10.06 a box. The firm sells the 350 boxes for $8.40 a box. The firm incurs a loss on each box of $1.66 and incurs a total economic loss of $581 a week.

6

In Problem 5, the market demand and the demand schedule becomes the schedule shown in the table. If firms have the same costs set out in Problem 5, what is the market price and the firm‘s economic profit or loss in the short run?

Price (dollars per box) 2.95 4.13 5.30 6.48 7.65 8.83 10.00 11.18

Quantity demanded (thousands of boxes per week) 500 450 400 350 300 250 200 150

The market price is $7.65 a box, the equilibrium market quantity is 300,000 boxes a week, and each firm incurs an economic loss of $834 a week. When the price is $7.65 a box, each firm produces 300 boxes and the total quantity supplied by the 1,000 firms is 300,000 boxes a week. The market quantity demanded at $7.65 is 300,000 boxes a week. Each firm produces 300 boxes at an average total cost of $10.43 a box. The firm sells the 300 boxes for $7.65 a box. At this price and quantity the firm incurs a loss on each box of $2.78 and incurs an economic loss of $834 a week.

7.

In Problem 5, in the long run, what is the market price and the quantity of paper produced? What is the number of firms in the market?

In the long run, the price equals the minimum average total cost, $10 a box. The number of firms in the long run is 750. In the long run, as firms exit the industry, the price rises. In the long-run equilibrium the price will equal the minimum average total cost.

When output is 400 boxes a week, marginal cost equals average total cost and average total cost is a minimum at $10 a box. In the long run, the price is $10 a box. Each firm remaining in the industry produces 400 boxes a week. The quantity demanded at $10 a box is 300,000 boxes a week. The number of firms is 300,000 boxes divided by 400 boxes per firm, which is 750 firms. In the long run, the 750 firms together produce the equilibrium quantity of 300,000 boxes.

8.

If the market demand for paper remains the same as in Problem 6, calculate the market price, market output, and the economic profit or loss of each firm.

In the long run, the price equals the minimum average total cost, which is $10.00 a box, the equilibrium industry quantity is 200,000 boxes a week, and each firm makes zero economic profit.

© 2018 Pearson Education, Inc.

PERFECT COMPETITION173

9.

In perfect competition in the long-run equilibrium, can consumer surplus or producer surplus be increased? Explain your answer.

Once at the competitive equilibrium quantity, which is the same as the efficient quantity, the sum of consumer surplus plus producer surplus is as large as possible. If the price is lowered, consumer surplus increases but only at the expense of a larger decrease in producer surplus. And the lower price is not the long-run equilibrium price.

If the price is raised, producer surplus increases but only at the expense of a larger decrease in consumer surplus. And the higher price is not the long-run equilibrium price.

© 2018 Pearson Education, Inc.

174

CHAPTER 12

Answers to Additional Problems and Applications Use the following news clip to work Problems 10 to 12.

Money in the Tank Two gas stations stand on opposite sides of the road: Rutter‘s Farm Store and Sheetz gas station.

Rutter‘s doesn‘t even have to look across the highway to know when Sheetz changes its price for a gallon of gas. When Sheetz raises the price, Rutter‘s pumps are busy. When Sheetz lowers prices, there‘s not a car in sight. Both gas stations survive but each has no control over the price.

Source: The Mining Journal, May 24, 2008 10.

In what type of market do these gas stations operate? What determines the price of gasoline and the marginal revenue from gasoline?

These stations operate in a perfectly competitive market. The equilibrium price is determined at the equilibrium between the market demand and the market supply. The marginal revenue from a gallon of gasoline equals the market price of a gallon.

11.

Describe the elasticity of demand that each of these gas stations faces.

Each station’s elasticity of demand is very high. When one station raises its price even a bit, it loses a lot of customers to its competitors. And when one of the stations lowers its price, it gains a lot of customers from its competitor.

12.

Why does each of these gas stations have so little control over the price of the gasoline they sell?

These stations face a large amount of competition, not only from each other but also from all nearby gas stations. If a firm raises its price it loses a vast number of customers so each firm is severely limited in raising its price. And there is no need for a firm to lower its price much below the going price because the firm can already increase its sales drastically with only a slight lowering of its price.

13.

Figure 12.1 shows the costs of Quick Copy, one of many copy shops near campus. If the market price of copying is 10¢ a page, calculate Quick Copy‘s a. Profit-maximizing output.

Quick Copy’s profit-maximizing quantity is 80 pages an hour.

Quick Copy maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is 10 cents a page. Marginal cost is 10 cents a page when Quick Copy produces 80 pages an hour.

b. Economic profit.

Quick Copy’s economic profit is $2.40 an hour. Economic profit equals total revenue minus total © 2018 Pearson Education, Inc.

PERFECT COMPETITION175

cost. Total revenue equals $8.00 an hour (10 cents a page multiplied by 80 pages). The average total cost of producing 80 pages is 7 cents a page, so total cost equals $5.60 an hour (7 cents multiplied by 80 pages). So economic profit equals $8.00 minus $5.60, which is $2.40 an hour.

Price (dollars per smoothie) 1.90 2.00 2.20 2.91 4.25 5.25 5.50

Quantity demanded (smoothies per hour) 1,000 950 800 700 550 400 300

© 2018 Pearson Education, Inc.

176

14.

CHAPTER 12

The market for smoothies is perfectly competitive and the market demand schedule is in the first table. Each of the 100 producers of smoothies has the costs given in the second table when it uses its least-cost plant. a. What is the market price of a smoothie?

The market price is the price at which the market quantity demanded equals the market quantity supplied. The firm’s supply curve is the same as its marginal cost curve at prices above minimum average variable cost. Average variable cost is a minimum when marginal Output Marginal cost Average Averag cost equals average variable (smooth (dollars per variable e cost. Marginal cost equals ies additional cost total average variable cost at the per smoothie) cost quantity 7 smoothies an hour. So hour) (dollars per the firm’s supply curve is the smoothie) same as the marginal cost curve 3 2.50 4.00 7.33 for outputs greater than and 4 2.20 3.53 6.03 equal to 7 smoothies. When the 5 1.90 3.24 5.24 price is $2.91 a smoothie, each 6 2.00 3.00 4.67 firm produces 7 smoothies and 7 2.91 2.91 4.34 the market quantity supplied by 8 4.25 3.00 4.25 the 100 firms is 700 smoothies 9 8.00 3.33 4.44 an hour. The market quantity demanded at $2.91 is 700 smoothies an hour so the market price is $2.91

b. What is the market quantity of smoothies?

The market quantity of smoothies is 700 smoothies an hour.

c. How many smoothies does each firm sell?

Each firm sells 7 smoothies an hour.

d. What is the economic profit made or economic loss incurred by each firm?

Each firm incurs an economic loss. Each firm produces 7 smoothies at an average total cost of $4.34 a smoothie. The firm sells the 7 smoothies for $2.91 each. The firm incurs a loss on each smoothie of $1.43 and incurs a total economic loss of $10.01 an hour.

15.

GM Plant Closures Could Signal Trouble for U.S. Auto Industry General Motors will temporarily idle five U.S. assembly plants that build sedans and coupes, such as the Chevrolet Cruze, Cadillac CTS, and Chevy Camaro, as American motorists by the millions shift from passenger cars to utility vehicles and other light trucks.

Source: MSNBC, December 19, 2016 a. Explain how the shutdown decision will affect GM‘s TFC, TVC, and TC. The shutdown decision has no effect on GM’s TFC. It will lower GM’s TVC and TC.

b. Under what conditions would this shutdown decision maximize GM‘s economic profit (or minimize its loss)? Explain your answer.

GM will shut down its plant when the price of a sedan or coupe is less than its average variable cost, that is, when P < AVC. By shutting down, GM incurs an economic loss equal to its total fixed cost, which is the minimum loss that it can incur in this situation. © 2018 Pearson Education, Inc.

PERFECT COMPETITION177

c. Under what conditions will GM start producing the Chevy Volt again? Explain your answer.

GM will start producing the sedans and coupes again when their price exceeds their average variable cost, that is, when P > AVC. In this case, even if GM is still incurring an economic loss, its loss will be less if it produces than if it shuts down.

16.

Dark Clouds Loom for Farmers as Corn Price Languishes Global corn acreage expanded by 18 percent over the past 10 years and Minnesota farms are producing a near-record amount of corn at a time when its price is low.

Source: Star Tribune, August 1, 2016 Why did the price of corn fall in 2016? Draw a graph to show the short-run effect on an individual farmer‘s economic profit.

The price of corn fell in 2016 because the supply of corn increased. The increase in the supply of corn drives the price of corn lower. Figure 12.2 shows the effect of the lower price on the economic profit of an individual farmer. The price of a bushel of corn falls from $4 per bushel to $2 per bushel. The farmer’s marginal revenue curve therefore falls from MR0 to MR1.

When the price was $4 per bushel, the firm produced 70,000 bushels per year and made an economic profit (because P > ATC). After the price falls to $2 per bushel, the firm produces 45,000 bushels per year and incurs an economic loss (because P < ATC).

17.

In Problem 14, do firms enter or exit the market for smoothies in the long run? What is the market price and the equilibrium quantity in the long run?

The firms are incurring economic losses, so some firms exit the market. As firms exit the market, the market supply decreases so that in the long run the price rises to equal the minimum average total cost, $4.25 per smoothie. When the price is $4.25 for a smoothie, the equilibrium quantity is 550 smoothies per hour.

18.

In Problem 15, under what conditions would GM stop producing the Cadillac CTS and exit the market for sedans. Explain your answer.

GM will permanently shut down and exit the market in the long run if the price of a Cadillac CTS is less than GM’s average total cost. In this situation, if it remained open GM would incur an economic loss

© 2018 Pearson Education, Inc.

178

CHAPTER 12

but if it exited the market it would no longer incur an economic loss.

19.

Mitsubishi to Close U.S. Auto Plant Mitsubishi Motors will close its production plant in Normal, Illinois. Dwindling sales in North America have brought a loss in the region of $200 million in the current year. The plant ended production of its Outlander Sport SUV model in November, laying off 1,000 workers.

Source: Reuters, January 7, 2016 a. Is Mitsubishi making a shutdown or exit decision in the automobile market?

Mitsubishi is making an exit decision. It is permanently leaving the market.

b. Under what conditions will this decision maximize Mitsubishi‘s economic profit?

This decision maximizes Mitsubishi’s economic profit if Mitsubishi’s operations are incurring an economic loss with the price less than the average total cost. In this case by closing its plant, Mitsubishi increases its economic profit.

c. How might Mitsubishi‘s decision affect the economic profit of other auto producers?

Mitsubishi’s exit will decrease the number of plants producing automobiles. This decrease in the number of plants decreases the supply and raises the market price of automobiles. As a result of the higher market price the other auto producers’ profits rise.

20.

4K Ultra HD TV Begins to Hit its Stride; Consumers Enjoy Picture Quality, Boosting Disc Sales As the average price of a 4K Ultra HD television fell below $1,000, the quantity bought increased. About 9 million were bought between 2012 and 2015, 10 million in 2016, and an anticipated 15 million in 2017. Increases in content from streaming services have also boosted 4K TV sales. Sales of movie discs and 4K Ultra HD Blu-ray Disc players have increased.

Source: USA TODAY, January 4, 2017 a. Explain how the advance in TV technology will influence the markets for streaming services and Blu-ray discs and players in the short run and in the long run. Illustrate your explanation with a graph.

The markets for all three products will respond in the same way to the advance in TV technology: The demand for streaming services, Blu-ray discs, and Blu-ray players all increase. In the short run, the price of, say, a Blu-ray player rises. As Figure 12.3 shows with the increase in demand from D0 to D1, the price rises from $180 to $240 per player along supply curve S0. The higher price increases the profit of the firms producing Blu-ray players, so new firms enter the market. The © 2018 Pearson Education, Inc.

PERFECT COMPETITION179

supply of Blu-ray players increases, shifting the supply curve rightward, in the figure from S0 to S1. The increase in the supply lowers the price back to $180 per player. The quantity increases from 10 million per year ultimately to 30 million per year.

b. Explain how the markets for streaming services and Blu-ray discs and players will influence the market for 4K HD TVs. As the popularity of streaming services, Blu-ray discs, and players increases and their prices fall, the demand for 4K HD TVs will increase. The increase in the demand for these televisions raises their price, so that the firms producing them make an economic profit. The economic profit, however, attracts entry by new firms, which increases the supply and then lowers the price.

21.

In a perfectly competitive market, each firm maximizes its profit by choosing only the quantity to produce and regardless of whether the firm makes an economic profit or incurs an economic loss, the short-run equilibrium is efficient. Is the statement true? Explain why or why not.

The statement is true. A perfectly competitive firm is a price taker and so it has no choice about what price it will charge. If there are no external benefits or external costs, then when a competitive market is in equilibrium, it is efficient. Regardless of the firms’ profits, as long as they are producing along their supply curves they are producing efficiently and obtaining the most value for their resources.

Economics in the News 22.

After you have studied Economics in the News on pp. 294–295, answer the following questions. a. What are the features of the market for apps that make it competitive?

The market for apps is highly competitive because there are many producers and buyers of apps, there are no restrictions on entry, established app sellers have no advantages over new sellers, and sellers and buyers of apps are well informed about prices.

b. Does the information provided in the news article suggest that the app market is in long-run equilibrium? Explain why or why not.

The market is not in long-run equilibrium. Developers are constantly entering the market, which indicates the presence of economic profit.

c. How would you expect Apple‘s plan to train more developers to change the market supply and the developer‘s marginal revenue, marginal cost, average total cost, and economic profit?

Apple’s plan will lower developers’ costs, thereby increasing the market supply, which lowers the market price. Developers’ marginal revenue is equal to the market price, so the fall in the price lowers the marginal revenue. Because they no longer need to pay for Apple’s curriculum, the developers’ marginal cost and average total cost and the marginal cost and average total cost curves shift downward. Because firms maximize their profit by producing so that marginal revenue equals marginal cost, the marginal revenue © 2018 Pearson Education, Inc.

180

CHAPTER 12

decreases. In the short run, the firms using the ―free‖ curriculum make an economic profit. But in the long run, more developers will enter the market. In the long run, the price falls so that the firms make zero economic profit.

d. Illustrate your answer to part (c) with an appropriate graphical analysis.

Figure 12.4a shows the market for apps; Figure 12.4b shows an individual app developer. Before Apple’s plan, the market supply curve is S0 and the price is $5 per app and 100 million apps are bought and sold in a year. The app developer illustrated in Figure 12.4b initially produces 15,000 apps per year and makes zero economic profit. After Apple’s plan lowers the cost of producing apps, the developer’s average total cost curve and marginal cost curve shift downward from ATC0 and MC0 to ATC1 and MC1. The market supply increases and the market supply curve shifts rightward.

Eventually after new developers have entered the market, the supply curve shifts to S1. The price of an app falls to $1.50 and at this price the app developers now make zero economic profit.

23.

China’s Phone Makers Look to India for Growth China produces smartphones, and hundreds of millions of Chinese have bought one. With intense competition among more than 150 brands, China‘s smartphone producers are looking to capture the Indian market.

Source: The New York Times, May 12, 2015 a. Explain the effects of the increase in Indian demand for smartphones on the market for smartphones and on an individual smartphone producer in the short run.

The market demand for smartphones increases. In the short run, the price of a smartphone rises and the market equilibrium quantity increases. Because the market price rises, individual smartphone

© 2018 Pearson Education, Inc.

PERFECT COMPETITION181

producers increase the quantity they produce and make an economic profit.

b. Draw a graph to illustrate your explanation in part (a).

Figure 12.5 shows the short-run outcome. Figure 12.5a shows the market equilibrium. In the market, demand increases and the demand curve shifts rightward from D0 to D1. In the short run the supply curve remains S0. As a result of the increase in demand the market price rises to $250 a smartphone and the market quantity increases to 1,200 million. Figure 12.5b shows the situation at a representative firm. The rise in the market price raises the firm’s demand and marginal revenue curve from MR0 to MR1. The firm responds by increasing the quantity it produces from 200 million smartphones a year to 225 million smartphones a year. It makes an economic profit because the price exceeds the firm’s average total cost.

c. Explain the long-run effects of the increase in global demand for smartphones on the market for smartphones.

In the long run the economic profit attracts entry into the market.

The market supply increases which drives the price down. The market equilibrium quantity increases. The fall in the price decreases and, in the long run, eliminates the firms’ economic profits so the firms make zero economic profit.

© 2018 Pearson Education, Inc.

CLXXXII

C h a p t e r

14

MONOPOLISTIC COMPETITION

Answers to the Review Quizzes Page 329 1.

What are the distinguishing characteristics of monopolistic competition?

The distinguishing characteristics of monopolistic competition are: i) a large number of firms, each producing a differentiated product than its competitors, ii) firms compete on quality, price, and marketing, and iii) there are no barriers to entry into the industry.

2.

How do firms in monopolistic competition compete? clxxxii

198

CHAPTER 14

Firms in monopolistic competition compete in three areas: Quality— the physical attributes of a product, including the product’s design and reliability, the service provided with the product, and the ease of access to the product; price—because the firms produce differentiated products, each firm faces a downward-sloping demand curve for its own product; and marketing—firms must make consumers aware of the quality of their differentiated products through advertising and packaging.

3.

Provide some examples of industries near your school that operate in monopolistic competition (excluding those given on the text page in the figure).

Hamburger restaurants, coffee shops, and juice bars are examples of firms competing in their own respective industry, each industry being a market described by monopolistic competition.

Page 333 1.

How does a firm in monopolistic competition decide how much to produce and at what price to offer its product for sale?

A firm that has already decided the quality of its product and its marketing program produces the output at which its marginal revenue equals its marginal cost (MR = MC) because this output maximizes profit. The price is determined from the demand curve for the firm’s product and is the highest price the firm can charge for the profitmaximizing quantity.

2.

Why can a firm in monopolistic competition make an economic profit only in the short run?

A firm in monopolistic competition can make an economic profit only in the short-run because economic profit induces entry, which decreases the demand for the firm’s product, lowers its profitmaximizing output, price, and economic profit. In long-run equilibrium, when entry ends, each firm makes zero economic profit.

3.

Why do firms in monopolistic competition operate with excess capacity?

A firm’s capacity output is the output at which average total cost is at its minimum. In monopolistic competition in the long run, MR = MC and P = ATC. At the long run equilibrium, it is the case that MC < ATC, which means that ATC is falling in this range and so production occurs at an output level that is less than capacity output.

4.

Why is there a price markup over marginal cost in monopolistic competition?

A firm’s markup is the amount by which price exceeds marginal cost.

There is a markup in monopolistic competition because P > MR at all levels of output. Since the firm produces the quantity at which MR = MC, the fact that P > MR means that P > MC, so that there is a markup.

5.

Is monopolistic competition efficient?

Monopolistic competition is not efficient by the requirement for allocative efficiency MSB = MSC. The price equals the consumer’s willingness to pay, which is the marginal social benefit and the firm’s marginal cost is the marginal social cost. Product differentiation in monopolistic competition means that P > MR, which © 2018 Pearson Education, Inc.

MONOPOLISTIC COMPETITION199

implies that P > MC at the quantity where MR = MC. Because P = MSB and MC = MSC, the result is that MSB > MSC, which signals inefficiency. However, when compared to the perfectly competitive alternative that all goods are identical, the variety offered by monopolistic competition makes monopolistic competition potentially efficient.

Page 337 1.

How, other than by adjusting price, do firms in monopolistic competition compete?

The two main ways firms in monopolistic competition compete other than by adjusting price is through product development and advertising.

2.

Why might product development be efficient and why might it be inefficient?

Product development might be efficient if the development represents actual improvements to the product and not simply the perception of improvement. The value of these new innovations to the consumer is the marginal benefit or the extra amount consumers are willing to pay to have the new product. If the marginal benefit to the consumer is equal to the marginal cost of product development, then development is efficient.

3.

Explain how selling costs influence a firm‘s cost curves and its average total cost.

Selling costs increase a firm’s fixed cost, which increase the firm’s total cost. This means that an increase in selling costs shifts the average fixed cost (AFC) curve and the average total cost (ATC) curve upward. Variable costs do not change, so the marginal cost (MC) and average variable cost (AVC) curves remain unchanged.

4.

Explain how advertising influences the demand for a firm‘s product.

If a firm’s advertising program is successful, it will shift the firm’s demand curve rightward in the short run. But if this shift in demand increases economic profit, it will attract firms to enter the industry, shifting each existing firm’s demand curve back leftward as they each lose some market share. In the long run, each firm makes zero economic profit, and demand for the firm’s product will not increase through advertising.

5.

Are advertising and brand names efficient?

Advertising and brand names can increase consumer information about product differences and quality. This information increases consumers’ wellbeing and increases efficiency. But advertising and creating a brand name also are costly endeavors. If the MSB from the advertising and brand names is greater than the MSC of the advertising and brand names, then advertising and brand names increase efficiency. But if the MSB from the advertising and brand names is less than the MSC of the advertising and brand names, then advertising and brand names decrease efficiency. Basically, if the additional benefit that consumer’s gain from advertising and brand names exceed the costs, then advertising and brand names have a surplus for society and should be increased until their marginal social benefit equals their marginal social cost. © 2018 Pearson Education, Inc.

200

CHAPTER 14

Answers to the Study Plan Problems and Applications 1.

Which of the following items are sold by firms in monopolistic competition? Explain your selections.  Cable television service The cable television market is not an example of monopolistic competition because at any locale, there are not a lot of firms competing.



Wheat The wheat market is not an example of monopolistic competition because the many competing firms each produce an identical product.



Athletic shoes The athletic shoe market is an example of monopolistic competition.

There are several producers of athletic shoes, with extensive product differentiation and competition on quality, price, and marketing.



Soda The soda market is not an example of monopolistic competition because there are only two producers who together have a very large market share.



Toothbrushes The toothbrush market is an example of monopolistic competition.

There are many producers of toothbrushes, with extensive product differentiation and competition on quality, price, and marketing.



Ready-mix concrete The ready-mix concrete market is not an example of monopolistic competition.

2.

The four-firm concentration ratio for audio equipment makers is 30 and for electric lamp makers it is 89. The HHI for audio equipment makers is 415 and for electric lamp makers is 2,850.

Which of these markets is an example of monopolistic competition?

The audio equipment market is an example of monopolistic competition.

Use the following information to work Problems 3 and 4.

Sara is a dot.com entrepreneur who has established a Web site at which people can design and buy sweatshirts. Sara pays $1,000 a week for her Web server and Internet connection. The sweatshirts that her customers design are made to order by another firm, and Sara pays this firm $20 a sweatshirt. Sara has no other costs. The table sets out the demand schedule for Sara‘s sweatshirts.

3.

Calculate Sara‘s profit-maximizing output, price, and economic profit.

Price (dollars per sweatshirt) 0 20 40 60 80 100

Quantity demanded (sweatshirts per week) 100 80 60 40 20 0

Sara produces the quantity that sets her marginal cost equal to her marginal revenue. Sara’s marginal cost is $20. Between the quantity of 20 and 40 sweatshirts, Sara’s marginal revenue is $40. Between 40 and 60 sweatshirts, Sara’s marginal revenue is $0. So at the quantity of 40 sweatshirts © 2018 Pearson Education, Inc.

MONOPOLISTIC COMPETITION201

Sara’s marginal revenue is $20. To maximize her profit, Sara produces 40 sweatshirts. When Sara produces 40 sweatshirts, the price from the demand schedule is $60 per sweatshirt. Sara’s total revenue is $2,400. Her total cost is $1,000 (fixed cost) plus $800 (variable cost), or $1,800. Sara’s economic profit equals $2,400  $1,800 or $600.

4. a. Do you expect other firms to enter the Web sweatshirt business and compete with Sara?

Sara is making an economic profit so other firms will enter the Web sweatshirt business and compete with Sara.

© 2018 Pearson Education, Inc.

202

CHAPTER 14

b. What happens to the demand for Sara‘s sweatshirts in the long run? What happens to Sara‘s economic profit in the long run?

As new firms enter the Web sweatshirt industry, the demand for Sara’s sweatshirts will decrease. In the long run Sara’s economic profit is zero—a normal profit.

Use Figure 14.1, which shows the situation facing Flight Inc., a producer of running shoes, to work Problems 5 to 8.

5.

What quantity does Flight produce, what price does it charge, and what is its economic profit?

To maximize profit, Flight produces the quantity at which marginal revenue equals marginal cost, so it produces 100 pairs a week. Flight charges the highest price that enables it to sell the 100 pairs of shoes. As read from the demand curve, Flight charges $80 a pair. Economic profit equals total revenue minus total cost. The price is $80 a pair and the quantity sold is 100 pairs, so total revenue is $8,000.

Average total cost is $60 a pair, so total cost equals $6,000.

Economic profit equals $8,000 minus $6,000, so Flight makes an economic profit of $2,000 a week.

6.

In the long run, how does Flight change its price and the quantity it produces? What happens to the market output of running shoes?

The price of a pair of Flight’s running shoes falls and the quantity decreases in the long run. Flight is making an economic profit and this profit attracts entry into the market so the number of firms increases. As new firms enter the market, the demand for Flight’s shoes decreases. The decrease in demand leads to the price of Flight’s running shoes falling and the quantity of running shoes decreasing. The quantity of running shoes in the market as a whole increases in the long run. As new firms enter, each existing firm decreases its output a bit. But the new firms produce more shoes and, on net, the quantity of shoes in the entire market increases.

7.

Does Flight have excess capacity in the long run? If it has excess capacity in the long run, why doesn‘t it decrease its capacity?

In the long run, monopolistically competitive firms produce less output than the amount which minimizes the average total cost, which means that in the long run they have excess capacity. Flight produces at the average total cost that is the minimum average total cost for the quantity it produces. If Flight decreased its capacity it would shift its average total cost curve upward. This shift would increase its average total cost for its profit-maximizing quantity and Flight would incur an economic loss. © 2018 Pearson Education, Inc.

MONOPOLISTIC COMPETITION203

8.

Is the market for running shoes efficient or inefficient in the long run? Explain your answer.

Based on the allocative efficiency criterion of producing the quantity at which MSB = MSC, the market for running shoes is not efficient. Producing at the allocatively efficient quantity P (which equals MSB) equals MC (which equals the MSC). But a monopolistically competitive industry produces so that P > MC and therefore is not allocatively efficient. However based on a broader measure of efficiency the market might be efficient. In particular due to the monopolistically competitive nature of the market there are a variety of running shoes produced. People value variety and if consumers’ benefit from the product variety equals the cost of producing this variety then, in this broader sense, the market is efficient.

9.

Suppose that Tommy Hilfiger‘s marginal cost of a jacket is a constant $100 and the total fixed cost at one of its stores is $2,000 a day. This store sells 20 jackets a day, which is its profitmaximizing number of jackets. Then the stores nearby start to advertise their jackets. The Tommy Hilfiger store now spends $2,000 a day advertising its jackets, and its profit-maximizing number of jackets sold jumps to 50 a day. a. What is this store‘s average total cost of a jacket sold (i) before the advertising begins and (ii) after the advertising begins?

Before the advertising begins, the average total cost of a jacket is $200. The average total cost equals the total cost divided by the quantity. The fixed cost is $2,000. Because the marginal cost is $100 per jacket, the total variable cost is $2,000. So the total cost is the $2,000 fixed cost plus the $2,000 variable cost, which is $4,000. So the average total cost is $4,000/20, which is $200.

After the advertising begins, the average total cost of a jacket is $180. The average total cost equals the total cost divided by the quantity. The fixed cost is $4,000. Because the marginal cost is $100 per jacket, the total variable cost is $5,000. So the total cost is the $4,000 fixed cost plus the $5,000 variable cost, which is $9,000. The average total cost is $9,000/50, which is $180.

b. Can you say what happens to the price of a Tommy Hilfiger jacket, Tommy‘s markup, and Tommy‘s economic profit? Why or why not?

If the advertising has decreased the demand and made it more elastic, which is likely the case if all firms advertise, then the price will fall. However, if the advertising has increased the demand and made the demand less elastic, then the price will rise.

If the price falls, then the makeup falls; if the price rises, then the markup rises.

It is not possible to determine the effect on the profit in the short run. In the long run, however, the economic profit will equal zero as it does for all monopolistically competitive firms in the long run.

© 2018 Pearson Education, Inc.

204

CHAPTER 14

Answers to Additional Problems and Applications 10.

Which of the following items are sold by firms in monopolistic competition? Explain your selection.  Orange juice There are many firms that produce orange juice and they produce many different varieties. Orange juice is an example of monopolistic competition.



Canned soup While there are many different varieties of canned soup, a few very large firms have a very large market share. Canned soup is an example of an oligopoly.



Tablet computers There are many firms that produce tablet computers and they produce many different varieties. Tablet computers are an example of monopolistic competition.



Chewing gum While there are many different varieties of chewing gum, two firms— Wrigley and Cadbury—dominate the industry. Chewing gum is an example of an oligopoly.



Breakfast cereals While there are many different varieties of breakfast cereals, the four largest firms have a four-firm concentration of over 80.

Breakfast cereal is an example of an oligopoly.



Corn There are many producers of corn, but each producer produces an identical product. Because corn is not a differentiated product, the market for corn is perfect competition.

11.

The HHI for motorcycles is 4,672, for sporting goods it is 373, for light bulbs it is 3,395, and for jewelry it is 550. Which of these markets is an example of monopolistic competition?

Sporting goods and jewelry are examples of monopolistically competitive markets.

Use the following information to work Problems 12 and 13.

Lorie teaches singing. Her fixed costs are $1,000 a month, and it costs her $50 of labor to give one class. The table shows the demand schedule for Lorie‘s singing lessons.

12.

Calculate Lorie‘s profit-maximizing output, price, and economic profit.

Price (dollars per lesson) 0 50 100 150 200 250

Quantity demanded (lessons per month) 250 200 150 100 50 0

Lorie produces the quantity of singing lessons that sets her marginal cost equal to her marginal revenue. Lorie’s marginal cost is $50. Between the quantity of 50 and 100 lessons, Lorie’s marginal revenue is $100. Between 100 and 150 lessons, Lorie’s marginal revenue is $0. So at the quantity of 100 lessons Lorie’s marginal revenue is $50. To maximize her profit, Lorie sells 100 lessons. When Lorie sells 100 lessons, the price from her demand © 2018 Pearson Education, Inc.

MONOPOLISTIC COMPETITION205

schedule is $150 per lesson. Lorie’s total revenue is $15,000. Her total cost is $1,000 (her fixed cost) plus $5,000 (her variable cost), which is $6,000. Lorie’s economic profit equals $15,000  $6,000, which is $9,000.

13. a. Do you expect other firms to enter the singing lesson business and compete with Lorie?

Lorie is making an economic profit so other firms will enter the singing-lesson industry to compete with Lorie.

b. What happens to the demand for Lorie‘s lessons in the long run? What happens to Lorie‘s economic profit in the long run?

As new firms enter the singing-lesson industry, the demand for Lorie’s lessons will decrease. In the long run Lorie’s economic profit is eliminated and Lorie makes zero economic profit—a normal profit.

Use Figure 14.2, which shows the situation facing Mike‘s Bikes, a producer of mountain bikes, to work Problems 14 to 18. The demand and costs of other mountain bike producers are similar to those of Mike‘s Bikes.

14.

What quantity does the firm produce and what is its price? Calculate the firm‘s economic profit or economic loss.

Mike’s Bikes produces 100 mountain bikes per week because this is the quantity at which MR = MC. The price of a mountain bike is $250 per bike because this is the highest price that people are willing to pay at the profit-maximizing quantity of 100 bikes.

Mike’s Bikes incurs an economic loss. The average total cost of a bike is $300 and the price of a bike is $250. So Mike’s Bikes’ economic loss is equal to ($300  $250)  100 bikes, which is an economic loss of $5,000.

15.

What will happen to the number of firms producing mountain bikes in the long run?

The firms are incurring an economic loss, so some firms exit the market. In the long run, the number of firms producing mountain bikes decreases.

16. a. How will the price of a mountain bike and the number of bikes produced by Mike‘s Bikes change in the long run?

As long as Mike’s Bikes is a survivor, the demand for Mike’s Bikes increases. When demand increases, the marginal revenue also increases so Mike’s Bikes increases the quantity of bikes it produces.

© 2018 Pearson Education, Inc.

206

CHAPTER 14

b. How will the quantity of mountain bikes produced by all firms change in the long run?

In the long run the price of a mountain bike rises, so in the long run the quantity of mountain bikes demanded (and the quantity produced) in the entire market decreases.

17.

Is there any way for Mike‘s Bikes to avoid having excess capacity in the long run?

If Mike’s Bikes maximizes its profit, it will have excess capacity.

If Mike’s Bikes increases its production so that it produces at the minimum of its average total cost, it will incur an economic loss.

18.

Is the market for mountain bikes efficient or inefficient in the long run? Explain your answer.

Based on the strict requirement for allocative efficiency, MSB=MSC, the market is definitely not efficient. In monopolistic competition the price of a mountain bike, which is the MSB of a mountain bike, is greater than the marginal cost of a mountain bike, which is the MSC of a mountain bike. However, viewed more widely the mountain bike market might be efficient. There are a variety of mountain bike producers, each producing a differentiated mountain bike. This large variety of different mountain bikes benefits consumers because it is more likely that each consumer will be able to find a mountain bike he or she likes.

Use the following news clip to work Problems 19 and20.

“The Lunatic Fringe of Extreme Beer” Now Available in Dayton Samuel Adams Utopias is an ultra-rich, port-like beer, which is meant to be sipped and not guzzled. It has a high 28 percent alcohol content. Its price tag is $199 for a ceramic decanter containing 24 ounces.

This volume is the equivalent of two cans of beer, or a bit less than a standard-sized (750-ml) bottle of wine.

Source: dayton.com, November 18, 2016 19. a. Explain how Samuel Adams has differentiated its Utopias to compete with other beer brands in terms of quality, price, and marketing.

Samuel Adams differentiated Utopias by bottling it in a unique ceramic decanter and brewing the beer to have a high 28 percent alcohol content. It has also set its price much higher than other beers.

b. Predict whether Samuel Adams produces Utopias at, above, or below the efficient scale in the short run.

In the short run Samuel Adams might produce at, above, or below its efficient scale; it is not possible to predict which.

c. Predict whether Samuel Adams produces Utopias at, above, or below the efficient scale in the long run.

Because Samuel Adams is a monopolistic competitor, in the long run it will produce below its efficient scale.

20. a. Predict whether the $199 price tag on the Utopias is at, above, or below marginal cost (i) in the short run In the short run the price exceeds the marginal cost. For a monopolistically competitive firm, P > MR. And to maximize its profit, the firm produces so that MR = MC. Combining these results shows P > MC. © 2018 Pearson Education, Inc.

MONOPOLISTIC COMPETITION207

(ii)

in the long run

In the long run the price will exceed the marginal cost. For a monopolistically competitive firm, P > MR. And to maximize its profit, the firm produces so that MR = MC. Combining these results shows P > MC.

b. Do you think that Samuel Adams‘ Utopias makes the market for beer inefficient? b. Do you think that Samuel Adams Utopias makes the market for beer inefficient?

Samuel Adams Utopias possibly makes the beer market inefficient. On the one hand, allocative efficiency requires that MSB=MSC. The price of a Utopias beer, which is its MSB, is greater than its marginal cost, which is the MSC. So production of Utopias is not allocatively efficient. On the other hand, viewed more widely the beer market might be more efficient with Utopias. Utopias adds to the variety of beers available so that it is more likely that some consumers will be able to find a beer, such as Utopias, that they like.

Use the following news clip to work Problems 21 and 22.

Women’s Golf Clubs A quarter of golfers today are women and the number keeps growing. And golf club manufacturers are paying attention and developing women‘s clubs. Callaway and 14 other firms compete in this market.

Source: Thoughtco.com, February 20, 2017 21. a. How are golf club manufacturers attempting to maintain economic profit?

Manufacturers are innovating by creating golf clubs for women.

They expect that the demand for women’s clubs will be high and so they will be able to (temporarily) make an economic profit.

b. Draw a graph to illustrate Callaway‘s cost and revenue curves in the market for women‘s golf clubs.

Figure 14.3 shows the situation at Callaway. The firm produces 200,000 golf clubs per year and sets a price of $140 per club.

c. Show on your graph in part (b) Callaway‘s short-run economic profit.

The economic profit equals the area of the darkened rectangle labeled A in Figure 14.3.

22. a. Explain why the economic profit that Callaway makes on women‘s golf clubs is likely to be temporary.

The economic profit is temporary because there are no barriers to entry. If Callaway is indeed able to make an economic profit other firms will enter the market by producing women’s golf clubs. As more firms produce the clubs the demand for Callaway clubs will decrease.

As a result the quantity and price of Callaway clubs will decrease, © 2018 Pearson Education, Inc.

208

CHAPTER 14

which lowers its economic profit. In the long run, entry will eliminate the economic profit.

b. Draw a graph to illustrate Callaway‘s cost and revenue curves in the market for women‘s golf clubs in the long run. Mark the firm‘s excess capacity.

Figure 14.4 shows the long-run equilibrium for Callaway. The firm produces 150,000 golf clubs and sets a price of $130 per club. The firm makes zero economic profit (a normal profit) because its price equals its average total cost. The firm’s excess capacity is 150,000 golf clubs, shown in the figure by the length of the grey arrow between the quantity the firm produces and the quantity that minimizes the firm’s average total cost.

Use the following information to work Problems 23 to 25.

Bianca bakes delicious cookies. Her total fixed cost is $40 a day, and her average variable cost is $1 a bag. Few people know about Bianca‘s Cookies, and she is maximizing her profit by selling 10 bags a day for $5 a bag. Bianca thinks that if she spends $50 a day on advertising, she can increase her market share and sell 25 bags a day for $5 a bag.

23.

If Bianca‘s advertising works as she expects, can she increase her economic profit by advertising?

If additional advertising enables sales to increase so that total revenue increases more than total cost, she can increase economic profit. In the case at hand, her total revenue will increase by $75 and her total cost will increase by $50 plus whatever is the increase in her variable cost of producing the cookies. Because her AVC when she produces 10 bags is only $1, it is likely that her variable costs will increase by less than $25, which means that advertising will be profitable.

24.

If Bianca advertises, will her average total cost increase or decrease at the quantity produced?

Before she advertised, Bianca’s total variable cost was $10 and her total fixed cost was $40, so her total cost was $50. With this total cost and production of 10 bags of cookies, Bianca’s average total cost was $5 a bag. After she advertises, if her average variable © 2018 Pearson Education, Inc.

MONOPOLISTIC COMPETITION209

cost remains $1 a bag, her total variable costs become $25, her total fixed costs are $90 (the initial fixed costs of $40 plus her advertising costs of $50) so her total cost is $115. With this total cost and production of 25 bags a day, Bianca’s average total cost is $4.60 a bag.

25.

If Bianca advertises, will she continue to sell her cookies for $5 a bag or will she change her price?

In the short run, presuming that advertising raises her demand, Bianca will raise the price of her cookies. In the long run Bianca’s price will equal her average total cost. If her average total cost remains below $5 a bag, in the long run her price will be forced down below $5 a bag.

Use the following news clip to work Problems 26 and 27.

How Uniqlo Will Conquer U.S. Consumerism Uniqlo‘s marketing seeks to associate the brand with sustainable quality for all activities and differentiate it from fast-fashion competitors. Uniqlo launched its first global marketing campaign last year costing $6.1 million. The firm‘s fall collection is built around a series of technological improvements to enhance comfort and make cold weather enjoyable.

Source: Advertising Age, March 29, 2017 26. a. What is the main objective of Uniqlo‘s marketing plan?

Uniqlo’s marketing plan is attempting to differentiate its products from those of its competitors. It is trying to have consumers perceive the brand as creating quality products that enhance their comfort and make cold weather more enjoyable.

b. Is Uniqlo‘s marketing expenditure of $6.1 million a fixed cost or a variable cost?

Uniqlo’s marketing expenditure is a fixed cost.

27.

How does Uniqlo‘s marketing change the firm‘s cost and revenue curves and its economic profit? Does average total cost at the profit-maximizing output increase or decrease?

Uniqlo’s marketing increases Uniqlo’s fixed cost and hence its total cost, thereby shifting its average total cost curve upward. It has no effect on Uniqlo’s marginal cost curve. If the marketing works, it increases the demand, thereby increasing Uniqlo’s total revenue.

Uniqlo’s demand and marginal revenue curves shift rightward. It is not possible to determine if Uniqlo’s average total cost at the profit-maximizing output increases or decreases.

© 2018 Pearson Education, Inc.

210

28.

CHAPTER 14

Amazon May be Sprinting into Athletic Apparel People increasingly wear their workout clothes outside the gym and athletic clothing sales in the United States increased by 15 percent in 2015 and 12 percent in 2016. Amazon wants to get this $44 billion market, which is currently dominated by Nike and Under Armour.

Source: CBS News, January 4, 2017 How will Amazon‘s entry into the athletic clothing market influence Nike and Under Armour?

Illustrate your answer with a graph.

Amazon’s entry into the athletic clothing market will decrease the demand for Nike’s and Under Armour’s clothing. As Figure 14.5 shows, their demand and marginal revenue curves will shift leftward, from D0 to D1 and MR0 to MR1, respectively. Nike’s and Under Armour’s price will fall from $100 per item to $60 per item and the quantity they each produce will decrease from 100,000 units of clothing per week to 50,000. They were making an economic profit before Amazon entered (which is why Amazon entered the market) but Amazon’s entry decreased their economic profit.

Economics in the News 29.

After you have studied Economics in the News on pp. 339–339, answer the following questions. a. Why did Apple improve the cameras and the battery in iPhone 7?

Apple is innovating and improving its iPhone to maximize its profit, thereby differentiating its smartphone from those of its rivals.

b. How would Apple‘s cost curves (MC and ATC) have been different if they had not made improvements in iPhone 7?

Improving the iPhone’s camera and battery life increased Apple’s marginal cost and average total cost, thereby shifting Apple’s marginal cost and average total cost curves upward.

c. How do you think the launch of a new iPhone influences the demand for other firms‘ smartphones?

When Apple launches a new iPhone, the demands for other firms’ smartphones decrease.

d. Explain the effects of the introduction of a new iPhone on Samsung and other firms in the © 2018 Pearson Education, Inc.

MONOPOLISTIC COMPETITION211

market for smartphones.

When Apple introduces a new iPhone, the effect on Samsung is similar to the effect on all the other firms in the market. The demand for Samsung’s smartphones decreases. The price of a Samsung smartphone and the quantity produced both decrease. If Samsung was making an economic profit before the introduction, Samsung’s economic profit decreases.

© 2018 Pearson Education, Inc.

212

CHAPTER 14

e. Draw a graph to illustrate your answer to part (d). Explain your answer.

The impact of the iPhone on Samsung is representative of the impact on all other producers. Figure 14.6 shows the effect the introduction of a new iPhone has on Samsung.

The demand for Samsung’s smartphone decreases and, as the figure shows, the demand curve for Samsung’s smartphone shifts leftward. The demand for Samsung’s smartphone decreases from D0 to D1 because some consumers who otherwise would have purchased a Samsung smartphone instead switch to the new iPhone because they prefer the iPhone’s features. The quantity produced decreases from 10,000 smartphones per week to 5,000 and the price falls from $1,000 per smartphone to $600. Samsung’s economic profit decreases from the area of the light gray rectangle plus the dark gray rectangle to just the dark gray rectangle.

f.

What do you predict will happen to the markup on smartphones?

There will be entry into the market for smartphones. As more firms enter, the demand for the incumbent firms’ smartphones decreases. As the demand decreases, the price falls so that the markup between the marginal cost and the price decreases.

g. What do you predict will happen to the excess capacity in the market for smartphones? Explain your answer.

In the long run, similar to all firms in monopolistic competition, the producers of smartphones will have excess capacity. In the short run, however, the firms might not have excess capacity. Indeed, in the short run it is possible for the manufacturers to produce at a point beyond their capacity output.

© 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?CCXIII

C h a p t e r

15

OLIGOPOLY

Answers to the Review Quizzes Page 347 1.

What are the two distinguishing characteristics of oligopoly?

Oligopoly has two distinguishing characteristics: Natural or legal barriers prevent the entry of new firms, and a small number of firms compete in the industry.

2.

Why are firms in oligopoly interdependent?

Firms in oligopoly are interdependent because each firm has a large market share and so each firm’s decisions have a major influence on its competitors’ profits.

3.

Why do firms in oligopoly face a temptation to collude?

Firms in oligopoly face the temptation to collude because if they can successfully collude, they can boost their economic profit.

4.

Can you think of some examples of oligopolies that you buy from?

The market for graphic accelerator cards is close to an oligopoly; the market for long-distance land-based telephone service is close to an oligopoly; the market for soft drinks is an oligopoly; and, the market for beer is an oligopoly.

Page 355 1.

What are the common features of all games?

All games share four common features: rules, strategies, payoffs, and outcome.

2.

Describe the prisoners‘ dilemma game and explain why the Nash equilibrium delivers a bad outcome for both players.

In the prisoners’ dilemma game, each prisoner faces two strategies: confess or deny. There are four outcomes: i) Both prisoners confess and each receives more years in prison than if they both did not confess, ii) both prisoners deny, iii) prisoner A confesses and prisoner B denies, and iv) prisoner B confesses and prisoner A denies. In these last two outcomes, the confessing prisoner gets a lower sentence than if both confessed and lower than if they both denied. The dominant strategy for both prisoners is to confess.

Regardless of what the other prisoner does, the best strategy for each prisoner is to confess, and both prisoners confess. This ccxiii

210

CHAPTER 15

outcome is worse for both prisoners than if they each denied the crime, which creates the dilemma.

3.

Why does a collusive agreement to restrict output and raise price create a game like the prisoners‘ dilemma?

Each firm has the possibility of sharing monopoly profits with other members of the cartel if each firm complies with the agreement. But each firm has an incentive to cheat on the collusive agreement in a cartel. If they all cheat, the outcome for each firm is worse than if they had all held to the agreement.

4.

What creates an incentive for firms in a collusive agreement to cheat and increase output?

All firms in a collusive agreement face the same optimal strategies: their payoff is high if they all comply, but the payoff to any one firm that cheats is even higher if all the other firms comply. This motivates each firm to cheat on the agreement.

5.

What is the equilibrium strategy for each firm in a duopolists‘ dilemma and why do the firms not succeed in colluding to raise the price and profits?

Each firm sees that its own profit is higher if it cheats on the agreement, and this strategy is best regardless of how any of the other firms act. This motivates all firms to cheat, and they all suffer an outcome that is far less profitable than if they all had complied with the agreement.

6.

Describe the payoffs for an R&D game of chicken and contrast them with the payoffs in a prisoners‘ dilemma.

In the R&D game of chicken, a firm can use the R&D if either it conducts the R&D or if its competitor conducts the R&D. So if one firm conducts the R&D, it bears the cost and reaps the reward but the other firm reaps only the reward because it pays none of the costs. In a game of chicken, neither firm ―wants‖ to do the R&D—both firms would prefer that the other conduct the R&D. In the prisoners’ dilemma R&D game, a firm can use the R&D only if it conducts R&D. If one firm conducts R&D, the firm incurs the costs of the R&D but then it alone reaps the rewards of the R&D. In this situation, both firms have the incentive to cheat on any agreement to restrict R&D because each firm knows that if it, and it alone cheats, its profit will increase.

Page 359 1.

If a prisoners‘ dilemma game is played repeatedly, what punishment strategies might the players employ and how does playing the game repeatedly change the equilibrium?

Two strategies for motivating compliance in a repeated prisoner’s dilemma game are: i) a tit-for-tat strategy, where cheating by one firm in the current period is punished by the other firm cheating in the next period, but compliance by one firm in the current period is rewarded by compliance in the next period, ii) a trigger strategy, where cheating by one firm in the current period is punished by cheating by the other firm in all subsequent periods. Both strategies may create a cooperative equilibrium where all players share in the maximum possible benefit. © 2018 Pearson Education, Inc.

OLIGOPOLY211

2.

If a market is contestable, how does the equilibrium differ from that of a monopoly?

A contestable market occurs when the firms in a market face potential entry from other firms due to low barriers to entry. While a monopoly free from the threat of entry will charge a high price and maximize economic profit, the firm or firms in a contestable market will keep price low and quantity produced high to deter potential entry by other firms outside the market. This benefits consumers, who enjoy near-competitive levels of output and a competitive market price.

Page 363 1.

What are the two main antitrust laws and when were they enacted?

The two acts of Congress that make up our main antitrust law and the years of their enactment are: a. The Sherman Act of 1890 b. The Clayton Act of 1914

2.

When is price fixing not a violation of the antitrust laws?

Price fixing among competitors always is a violation of antitrust law, whether or not the act was found to be harmful to consumers. If the Justice Department can prove the existence of price fixing, a defendant can offer no acceptable excuse. Price fixing between a supplier and a reseller is not illegal as long as it is not anticompetitive.

3.

What is an attempt to monopolize an industry?

In theory, attempts to monopolize an industry mean a firm is trying to become a monopoly. In practice, attempts to monopolize an industry are more difficult to define and are a matter of interpretation by the courts. The ―rule of reason‖ seemed to say that size alone doesn’t constitute an attempt to monopolize as in the 1920 U.S. Steel case. But the ―rule of reason‖ was overturned when size did matter as in the 1945 Alcoa case. Even in more recent cases, it is difficult to predict what the court will define as an attempt to monopolize. Decisions continue to be divided in this area of the law.

4.

What are resale price maintenance, tying arrangements, and predatory pricing?

Resale price maintenance occurs when a manufacturer agrees with a distributor about the minimum price at which the product will be resold. Resale price maintenance agreements are illegal only if they are anticompetitive. Resale price maintenance can create inefficiency if it allows the manufacturer to set the monopoly price for its product. However it can create efficiency when it enables manufacturers to induce retail sellers to give the efficient level of sales service for the product.

Tying arrangements occur when the seller agrees to sell one product to a buyer only if the buyer also buys another, different product.

Tying can sometimes allow the producer to price discriminate and increase its profit. Tying arrangements can be illegal under the Clayton Act. © 2018 Pearson Education, Inc.

212

CHAPTER 15

Predatory pricing is setting a low price to drive competitors out of business to then set a high, monopoly price when the competition has gone. If predatory pricing occurs, it can lead to monopoly but economists are skeptical that it occurs often because the firm trades off a sure loss for an uncertain future profit.

5.

Under what circumstances is a merger unlikely to be approved?

A merger is likely to be approved by the Justice Department as long as the pre-merger HHI is less than 1,500. If the pre-merger HHI is between 1,500 and 2,500, the merger would be challenged if it raises the HHI by 100 or more points. If the pre-merger HHI is greater than 2,500, the merger generally would be blocked if it raises the HHI index by 200 or more points.

© 2018 Pearson Education, Inc.

OLIGOPOLY213

Answers to the Study Plan Problems and Applications 1.

Intel and Advanced Micro Devices make most of the chips that power a PC. What makes the market for PC chips a duopoly? Sketch the market demand and cost curves that describe the situation in this market and that prevent other firms from entering.

The market for PC chips, in particular the processor, is a natural oligopoly, most likely a natural duopoly. There are only two firms in the market, Intel and AMD, and there are no legal barriers to entry which limit the number of firms to two. Because other firms could enter the market but do not do so supports the idea that this industry is a natural duopoly. The cost curves and demand curve for this market would be similar to those in Figure 15.1, which shows the situation for a market in which two firms can satisfy the market demand. In this situation if a new firm entered the market it would be at a significant cost disadvantage compared to Intel and AMD and would likely incur an economic loss. Such a prospect deters entry by new competitors.

2.

Energizer Versus Duracell In the year to March 2017, Duracell‘s share of the battery market fell from 47.7 percent to 44.5 percent and Energizer‘s share grew from 29.6 percent to 32.9 percent.

Source: Seeking Alpha, April 27, 2017 In what type of market are batteries sold? Explain your answer.

Batteries are sold in an oligopolistic market. There are two major sellers of batteries: Duracell and Energizer. The 4-firm concentration ratio is approximately 90%.

3.

Restrictions on Telecom Industry Eased A law change will make it easier for broadband providers to charge higher prices for connections to the main arteries of their networks. Another law change will ease the limit on how many stations a broadcast television company can own.

Source: The New York Times, April 20, 2017 a. Explain why the news clip implies that the broadband and broadcast television markets are not perfectly competitive.

The news clip implies that there is not free entry into the telecom industry because the law limits the number of stations a broadcast © 2018 Pearson Education, Inc.

214

CHAPTER 15

television can own. In addition, the clip also implies that the firms in this market are not price takers because they will be able to charge higher prices for certain connections to their networks.

b. What barriers to entry might limit competition and allow a broadband provider to influence the price?

A legal barrier to entry exists when competition and entry are restricted by the granting of a public franchise, government license, patent, or copyright are legal barriers to entry limiting entry into the telecom market. In the broadband and broadcast television markets, a legal barrier to entry exists. In addition, with the limited number of firms, the providers are able to reap economies of scale, so a natural barrier is created.

c. How would the law changes described in the news clip change the barriers to entry in the broadband and broadcast television markets?

By increasing the number of stations a broadcast company can own, the change in the law will make it easier for firms to act more like a monopoly.

4.

Consider a game with two players who cannot communicate, and in which each player is asked a question. The players can answer the question honestly or lie. If both answer honestly, each receives $100. If one player answers honestly and the other lies, the liar receives $500 and the honest player gets nothing. If both lie, then each receives $50. a. Describe the strategies and payoffs of this game.

The game has 2 players (A and B), and each player has 2 strategies: to answer honestly or to lie. There are 4 payoffs: Both answer honestly and both receive $100; both lie and both receive $50; A lies, and B answers honestly and A receives A‘s strategies $500 and B receives $0; Honest Lie and B lies, and A answers honestly and A $100 $500 receives $0 and B Honest receives $500. $100 $0 b. Construct the payoff matrix.

B‘s The payoff matrix has strategies the following cells: Both answer honestly: A $0 $50 gets $100, and B gets Lie $100; both lie: A gets $500 $50 $50, and B gets $50; A lies and B answers honestly: A gets $500, and B gets $0; B lies and A answers honestly: A gets $0, and B gets $500. The payoff matrix is to the right.

c. What is the equilibrium of this game?

The equilibrium is that each player lies and gets $50. If B answers honestly, the best strategy for A is to lie because he would get $500 rather than $100. If B lies, the best strategy for A is to lie because he would get $50 rather than $0. So A’s best strategy is to © 2018 Pearson Education, Inc.

OLIGOPOLY215

lie, no matter what B does. Repeat the exercise for B. B’s best strategy is to lie, no matter what A does.

d. Compare this game to the prisoners‘ dilemma. Are the two games similar or different? Explain.

The game is the same as a prisoners’ dilemma. In this game, as in the prisoners’ dilemma game, both players get the jointly worse equilibrium outcome because they cannot trust the other player to cooperate. If the players could cooperate, they would achieve a better result.

5.

Soapy Inc. and Suddies Inc., the only laundry detergent producers, collude and agree to share the market equally. If neither firm cheats, each makes $1 million profit. If one firm cheats, it makes $1.5 million, while the complier incurs a loss of $0.5 million. If both cheat, they break even.

Neither firm can monitor the other‘s actions. a. What are the strategies in this game? Construct the payoff matrix for this game.

Each firm has two strategies: to comply with the agreement or to cheat on the agreement.

The payoff matrix has the following cells: Both comply by the agreement: Soapy makes $1 million profit, and Suddies makes $1 million profit; both cheat: Soapy makes $0 profit, and Suddies makes $0 profit; Soapy cheats and Suddies complies with the agreement: Soapy makes $1.5 million profit, and Suddies incurs a $0.5 million loss; Suddies cheats and Soapy complies with the agreement: Suddies makes $1.5 million profit, and Soapy incurs $0.5 million loss. These payoffs are shown, in Soapy‘s strategies millions of dollars, in the matrix to the Comply Cheat right.

b. If the game is played only once what is the equilibrium?

Is it a dominant-strategy equilibrium? Explain.

$1 M

Comply Suddie‘s strategies

$1 M

$1.5 M $.5 M

The equilibrium is that both firms cheat 0 $.5 M and each makes normal Cheat profit.

The equilibrium is a $1.5 M 0 dominant strategy equilibrium because for each firm, regardless of the opponent’s choice, the best strategy is to cheat. If Suddies complies with the agreement, the best strategy for Soapy is to cheat because it would make a profit of $1.5 million rather than $1 million. If Suddies cheats, the best strategy for Soapy is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $0.5 million.

So Soapy’s best strategy is to cheat, no matter what Suddies does.

Repeating the exercise for Suddies shows that Suddies’s best strategy also is to cheat, no matter what Soapy does.

© 2018 Pearson Education, Inc.

216

6.

CHAPTER 15

If You Hate Flying Now, Just Wait After the airline industry was deregulated, a series of mergers created a four-carrier oligopoly with an 85 percent market share. Reduced competition brought worse service and higher fares.

With Washington‘s refusal to rein in the unfettered airline industry, flying is going to get more uncomfortable.

Source: The Washington Post, May 3, 2017 a. Explain how airline mergers might (i) increase fares or (ii) lower airline production costs. (i)

Mergers can allow the firms to cut capacity, which will decrease supply and raise the price of air travel. If some routes wind up being served by only a handful of airlines and become oligopolistic in nature, a price-boosting cartel might emerge and persist. (ii) The merged firms might be able to enjoy economies of scale from the increased production. For instance, they might be able to eliminate duplicate services (such as advertising agencies and accounting departments). It might also be able to gain some economies of scale, perhaps because the larger air fleet allows its mechanics to specialize in servicing particular types of planes.

b. Explain how lower costs might be passed on to travelers or boost airlines‘ profits. What does the news clip say happened and how would you explain that outcome?

If, after the mergers and cut in capacity, the market remains competitive, competition forces the price down toward the (lower) average total cost. Hence competition can lead to the cost savings being passed along to consumers. On the other hand, if the merger and cut in capacity makes the market significantly less competitive, it becomes more likely that the airlines will be able to form a cartel (or reach an implicit agreement) to keep their prices high and thereby increase their profits. According to the news clip, it is the latter outcome that occurred: Higher prices and worse service. This outcome results if the mergers decreased competition and created an oligopolistic industry.

7.

If Soapy Inc. and Suddies Inc. play the game in Problem 5 repeatedly, on each round of play: a. What strategies might each firm might adopt?

Each firm can adopt a tit-for-tat strategy or a trigger strategy, strategies that were not possible in a one-time game.

b. Can the firms adopt a strategy that gives the game a cooperative equilibrium?

The game has a cooperative equilibrium. If the firms employ a trigger strategy or a tit-for-tat strategy, they can reach the cooperative comply/comply outcome. Take the case of the tit-for-tat strategy. If both firms comply for, say, three periods, both firms make $3 million profit. If a firm cheats in the first period while its opponent complies, the cheater makes a $1.5 million profit. In the second period, the opponent cheats, so if the first firm complies, it losses $0.5 million. In the third period the opponent will comply so the first firm can again cheat and make $1.5 million.

However, in these three periods the total profit is only $2.5 million, so the cooperative equilibrium is possible.

© 2018 Pearson Education, Inc.

OLIGOPOLY217

c. Would one firm still be tempted to cheat in a cooperative equilibrium? Explain your answer.

If the firms employ a trigger strategy or a tit-for-tat strategy, they can reach the cooperative comply/comply outcome. In these cases, the long-run profit from complying with the agreement exceeds that from cheating and so the cooperative equilibrium is likely. But a firm’s short-run profit would be larger if the firm (and that firm alone) cheated. So each firm still has an incentive to cheat because each firm can temporarily increase its profit.

8.

A federal judge ruled that a $37 billion merger between the health insurers Aetna and Humana would not be in the interest of its consumers and should not be permitted.

Source: The New York Times, January 23, 2017 What are the guidelines used by the FTC when deciding cases like the one in the news clip?

The FTC uses guidelines based on the Herfindahl-Hirschman Index (HHI). A market in which the HHI is less than 1,500 is regarded as competitive and mergers will not be challenged. A market with an index between 1,500 and 2,500 is considered moderately concentrated, so a merger in this market that would increase the index by 100 points is challenged by the FTC. Finally, a market with an index above 2,500 is a concentrated market, and a merger in this market that would increase the index by 200 points is usually blocked.

© 2018 Pearson Education, Inc.

218

CHAPTER 15

Answers to Additional Problems and Applications 9.

Monster Hopes for Jump From NASCAR Deal Red Bull and Monster, the two main players in the $8.3-billion U.S. energy drink market, invest heavily in sponsoring motor racing. And Monster has now signed a multiyear deal to name the Monster Energy NASCAR Cup Series. Red Bull has a 38 percent market share and Monster a 27 percent share. Overall market growth is expected to be 3.1 percent a year over the next five years Source: Los Angeles Times, January 4, 2017 a. Describe the structure of the energy-drink market.

The structure of the energy-drink market is an oligopoly. The two largest firms, Red Bull and Monster, together have a market share of 65 percent.

b. What might be the reason why two firms dominate the energy drinks market?

These two firms might dominate the energy drinks market because large economies of scale may make them a natural oligopoly. The large (fixed) cost of advertising can mean that the average cost of new entrants is higher than that of Red Bull and Monster so that Red Bull and Monster are able to set lower prices than are new entrants.

Use the following data to work Problems 10 and 11.

Bud and Wise are the only two producers of aniseed beer, a New Age product designed to displace root beer. Bud and Wise are trying to figure out how much of this new beer to produce. They know: (i) If they both produce 10,000 gallons a day, they will make the maximum attainable joint economic profit of $200,000 a day, or $100,000 a day each. (ii) If either firm produces 20,000 gallons a day while the other produces 10,000 a day, the one that produces 20,000 gallons will make an economic profit of $150,000 and the other will incur an economic loss of $50,000. (iii) If both produce 20,000 gallons a day, each firm will make zero economic profit.

10. Construct a payoff matrix for the Bud‘s strategies game that Bud and Wise must Limit Expand play.

The payoff matrix has four cells: Both limit $100 $150 Limit production: Bud makes $100,000 profit, and $100 $50 Wise makes $100,000 Wise‘s profit; both expand strategies production: Bud makes 0 $50 $0 profit, and Wise Expand makes $0 profit; Bud limits production and $150 0 Wise expands production: Bud incurs an economic loss of $50,000, and Wise makes an economic profit of $150,000; Bud expands production and Wise limits production: Bud makes an economic profit of $150,000, and Wise incurs an economic loss of $50,000. These payoffs, in thousands of dollars, are shown in the payoff matrix. © 2018 Pearson Education, Inc.

OLIGOPOLY219

11.

Find the Nash equilibrium of the game that Bud and Wise play.

The Nash equilibrium is for both Bud and Wise to expand production.

From Bud’s perspective, if Wise limits production Bud’s profit is larger if it expands production. If Wise expands production then Bud’s profit is larger if Bud expands production. For Bud ―expand production‖ is a dominant strategy. Wise’s situation is similar, so Wise, too, has a dominant strategy of ―expand production.‖

12.

Cartel Flexes Maple Syrup Muscle Quebec is the world‘s largest maple syrup producer, and in the spring of 2017, its production increased by 4 million pounds over the previous year to 152.2 million pounds. The Federation of Quebec Maple Syrup Producers regulates how much farmers can sell and it increased production quotas in a bid to restore market share lost to the U.S. producers in the past decade. Quebec farmers oppose the federation‘s quota on output, and some producers exceed their quotas and sell on a black market. U.S. producers increased their share of the world market with a 23 percent increase in output in 2016.

Source: Bloomberg News, June 1, 2017 a. If the Quebec and U.S. maple syrup producers become a profit-maximizing colluding oligopoly, explain how they would influence the price of maple syrup.

To maximize their profit, the producers would decrease the quantity of maple syrup they produce and raise its price. Similar to any monopoly, they would produce the quantity of maple syrup so that the marginal cost equals the marginal revenue and then use the demand curve to determine the highest price that enables them to sell the profit-maximizing quantity.

b. Draw a graph to illustrate your answer to (a).

Figure 15.2 shows the outcome of this cartel in the market for maple syrup. Before the oligopoly organized, suppose the maple syrup market was competitive. The equilibrium price and quantity were determined by the intersection of the market demand and market supply. In the figure the competitive market supply curve is MC, so before the oligopoly the equilibrium price was $4.50 per pound of maple syrup and 300 million pounds were produced. After the oligopoly organized, the equilibrium quantity decreases to 200 million pounds and the price of a pound of maple syrup rises to $6.00 per pound.

© 2018 Pearson Education, Inc.

220

CHAPTER 15

c. Why is it difficult for the Quebec cartel to act like a monopoly? Use the ideas of game theory to explain.

The Quebec cartel finds it difficult to successfully collude for two reasons. First, as is the case in any successful cartel, the incentive is for each producer to cheat on the collusive agreement by producing more syrup. This incentive lowers the likelihood that the cartel will succeed. In addition, the members of the cartel are not the only maple syrup producers. Maple syrup is also produced in the United States and as the price of maple syrup rises, U.S. producers increase their production, which will drive the price back down.

13.

Suppose that Mozilla and Microsoft each develop their own versions of an amazing new Web browser that allows advertisers to target consumers with great precision. Also, the new browser is easier and more fun to use than existing browsers. Each firm is trying to decide whether to sell the browser or to give it away. What are the likely benefits from each action? Which action is likely to occur?

The more people use a particular browser, the more advertisers are willing to pay. And charging for a browser also generates profit. If the browser is given away and the competitor charges, likely the one given away gains market share and that company makes a large economic profit. The other company incurs an economic loss. If both browsers are given away, both companies probably make a comparable economic profit. And if both browsers are sold, both companies probably make the largest economic profit because they collect from both advertisers and consumers.

A payoff matrix is to the right that reflects Microsoft‘s strategies this analysis. The Free Charge numbers in the matrix are the economic profit in millions of dollars. $300 $100 Free Microsoft’s profits are in the grey upper $100 $700 Mozilla‘s triangles and Mozilla’s strategies profits are in the white lower triangles. $900 $700 The fact that for any Charge given situation $500 Microsoft’s profits are $300 larger than Mozilla’s is realistic but does not affect the analysis. The joint profit is the largest when the browser is sold and is the smallest when the browser is given away.

With the profits in the payoff matrix, the Nash equilibrium is to give the browsers away for free.

© 2018 Pearson Education, Inc.

OLIGOPOLY221

14.

Why do Coca-Cola and PepsiCo spend huge amounts on advertising? Do they benefit? Does the consumer benefit? Explain your answer by constructing a game to illustrate the choices CocaCola and PepsiCo make.

Coca-Cola and PepsiCo Coca-Cola‘s strategies are engaged in an Do not advertise Advertise advertising game. In an advertising game, two $100 firms can advertise or $100 Advertise not advertise.

Advertising is costly $100 $500 Pepsi‘s but if one firm strategies advertises and the other does not, the one not $500 $300 advertising loses market Do not share and profit while advertise $300 $100 the one advertising gains market share and profit. Both firms would be better if neither advertised but the Nash equilibrium is that both firms advertise. The game to the right is a possibility. Both companies have the choice of whether to advertise or not. Coke’s economic profits, in millions of dollars, are in the grey triangles and Pepsi’s profits, also in millions of dollars, are in the white triangles. If both advertise, each makes a profit of $100 million; if one advertises but the other does not, the one advertising makes a profit of $500 million and the one not advertising incurs a loss of $100 million; and if neither advertise, each makes a profit of $300 million. The Nash equilibrium of this game is for each firm to advertise.

Consumers benefit if the advertising gives them new information, for example information about a new drink. They also benefit if the advertising allows the firms to increase their production and enjoy economies of scale that allow lower prices. At one time in history, it is likely that consumers benefited from lower prices due to the increased economies of scale as Coca-Cola and PepsiCo drove smaller firms from the market. Today, however, most of the advertising does not convey new information and there are probably not many economies of scale left to exploit. It is likely that consumers are generally harmed by the advertising because the price of the product is higher.

Use the following news clip to work Problems 15 and 16.

Who’s Winning Console Wars?

Sony, Microsoft, and Nintendo dominate the video game console market. Nintendo has a new hybrid handheld and home console called the Switch. Sony has a new PlayStation VR headset. Microsoft plans to launch a more powerful Xbox One.

© 2018 Pearson Education, Inc.

222

CHAPTER 15

Source: USA TODAY, April 28, 2017 15. a. Thinking about competition in game consoles as a game, describe the firms‘ strategies.

Strategies are all the possible actions of each of the players. The news clip shows that the current strategy in the game between Sony, Microsoft, and Nintendo is based on technology with the strategies of innovating new types of consoles or technologies and marketing current technologies.

b. What, based on the information provided, turned out to be the equilibrium of the game?

The equilibrium turned out to that all the firms developed new technology. Nintendo and Sony innovated new types of consoles (Nintendo, with its switch and Sony, with its VR headset). Microsoft developed a more powerful console (its new Xbox One).

16.

Can you think of reasons why the three consoles are different?

The consoles are so different because the firms also are competing, in large part, in innovation and technology. In particular, each manufacturer is innovating in a way that it expects will most appeal to consumers.

17.

If Bud and Wise in Problems 10 and 11 play the game repeatedly, what is the equilibrium of the game?

If the game is played repeatedly, then Bud and Wise might be able to reach the cooperative equilibrium (both limit production) if they use a tit-for-tat or trigger strategy.

© 2018 Pearson Education, Inc.

OLIGOPOLY223

18.

Agile Airlines‘ profit on a route on which it has a monopoly is $10 million a year. Wanabe Airlines is considering entering the market and operating on this route. Agile warns Wanabe to stay out and threatens to cut the price so that if Wanabe enters it will make no profit. Wanabe determines that the payoff matrix for the game in which it is engaged with Agile is shown in the table. Does Wanabe believe Agile‘s assertion?

Does Wanabe enter or not? Explain.

Agile‘s strategies Low price

High price 7

Enter Wanabe‘s strategies

5

1 0

10 Do not enter

0

5 0

Wanabe does not believe Agile’s assertion. If Wanabe does not enter, Agile’s best strategy is to set a high price. And, even if Wanabe enters the market, Agile’s best strategy is to set a high price because Agile has a larger payoff from setting a high price, 7, than by setting a low price, 1. So Wanabe has no reason to believe Agile’s assertion.

Wanabe enters the market. If Wanabe does not enter, Wanabe receives a payoff of 0. If Wanabe enters, Agile sets a high price and so Wanabe receives a payoff of 5.

19.

Swatch is Taking on Silicon Valley Swatch, Switzerland‘s largest watchmaker, is developing an alternative to Apple‘s iOS and Google‘s Android operating systems for smartwatches. Swatch says its technology will need less battery power and will protect data better.

Source: The Toronto Star, March 17, 2017 What type of market does the news clip imply best describes the markets for smartwatches and their operating systems?

The market for smartwatches is monopolistic competition. In monopolistic competition, a large number of firms compete with each other on product quality, price, and marketing, and each firm produces a differentiated product. The news clip implies that the market for smartwatches is a monopolistic competition because many different smartwatches are produced by many different firms.

The market for smartwatch operating systems is an oligopoly. An oligopoly is a market structure in which a small number of firms compete. Each firm's actions influence the profits of all the other firms, so the firms are interdependent. The news clip implies that the market for smartwatch operating systems is best described as an oligopoly because Swatch, Apple, and Google are the only producers and these firms are interdependent.

Use the following news clip to work Problems 20 and 21.

Generic Drugmakers Facing Antitrust Inquiry Over Rising Prices A congressional inquiry report says the price of doxycycline, a generic antibiotic used to treat acne (and other things), rose more than 8,000 percent in 2013–2014. Doxycycline is made by Mylan, one of © 2018 Pearson Education, Inc.

224

CHAPTER 15

several generic drug manufacturers that are under investigation by the Justice Department because their list prices of many older medications have risen in lockstep in recent years.

Source: NPR, November 4, 2016 20. Which sections of the antitrust laws might have been violated by Mylan and other generic drugs producers?

If Mylan and the other generic producers agreed to raise the prices on generic drugs, they violated Section 1 of the Sherman Act because agreeing on prices is per se illegal.

21.

Why might the price increases described in the news clip be against the social interest and benefit only the producer?

The price increases create a deadweight loss, which harms society because less than the allocative efficient quantities of the drugs are sold. The producers benefit because the higher prices increase their economic profits.

Economics in the News 22.

After you have studied Economics in the News on pp. 364–365, answer the following questions. a. What are the strategies of T-Mobile and Verizon in the market for cellphone service?

The strategies of T-Mobile and Verizon are to offer an unlimited plan at a relatively lower price or offer an unlimited plan at a relatively higher price.

b. Why, according to the news article, is it that Verizon and T-Mobile are in a fierce battle?

Verizon and T-Mobile are in a fierce battle because Verizon has the largest cellphone service market share and T-Mobile is attempting to cause Verizon customers to switch to T-Mobile. T-Mobile fired the first shot by offering unlimited data plans at relatively low prices and Verizon responded by also offering unlimited plans but keeping its prices relatively higher.

c. Why wouldn‘t Verizon stick with its high price and leave T-Mobile to incur the cost of setting a lower price?

If T-Mobile improves the value of its plans by offering unlimited data and relatively lower prices, Verizon’s profit is larger if it cuts the price of its plans and also offers unlimited plans. If Verizon had kept its price high, its sales would suffer and its profit would be significantly smaller.

d. Could T-Mobile do something that would make it the market leader? Would that action maximize T-Mobile‘s profit?

T-Mobile could further slash the price it charges for its (enhanced) plans and win market share away from Verizon. But by so doing TMobile could suffer a loss on each plan it sold and therefore TMobile would not be maximizing its profit.

© 2018 Pearson Education, Inc.

OLIGOPOLY225

23.

After a Surge in Orders, Airlines Balk at Big Jets Boeing and Airbus are the main producers of commercial airplanes and dominate the markets for wide-bodied super jumbos and for smaller planes. Passenger traffic is predicted to create a demand for 9,000 new smaller and more fuel-efficient wide-bodied planes over the next 20 years.

Source: The New York Times, June 19, 2017 a. In what type of market are commercial airplanes sold?

There are only two sellers of big airplanes, so this market is an oligopoly.

b. Thinking of competition between Boeing and Airbus as a game, what are the strategies and the payoffs?

Boeing and Airbus are playing the duopolists’ game. They can set either low prices or high prices. If both Boeing and Airbus set low prices, then they will both make a smaller profit, perhaps even zero economic profit. If they both set high prices, then both will make a large economic profit. However, if one sets a low price and the other sets a high price, then the one with the low price will make a very large economic profit and the one with the high price will incur an economic loss.

© 2018 Pearson Education, Inc.

226

CHAPTER 15

c. Set out a hypothetical payoff matrix for the game you‘ve described in part (b). What is the equilibrium of the game?

The payoff matrix is to the right. In it the profits are in millions of dollars. The equilibrium is the prisoners’ dilemma equilibrium, that is, both firms set low prices and both make zero economic profit.

Boeing‘s strategies High price $700

High price Airbus‘s strategies

Low price $1,000 ─$200

$500

─$100 Low price

$800

$0 $0

d. Do you think the market for commercial airplanes is efficient? Explain and illustrate your answer.

The market for big airplanes is probably not efficient. It is efficient only if Boeing and Airbus compete against each other as if they were in perfect competition. But this outcome is unlikely. More likely is an outcome in which Boeing and Airbus together operate a monopoly or, if not precisely as a monopoly, then approaching that status. This outcome is especially likely because Boeing and Airbus will be playing a repeated game in which they (potentially) compete with each other for over two decades. In that situation, the repeated game makes it more likely that they will reach the cooperative equilibrium in which they operate together as a monopoly.

Figure 15.3 shows the range of outcomes. If the two firms compete with each other, the equilibrium will be the competitive equilibrium, where they sell a total of 300 planes per year at a price of $15 million per plane. This outcome is the efficient outcome. However if Boeing and Airbus attain the cooperative © 2018 Pearson Education, Inc.

OLIGOPOLY227

equilibrium in which they act together to reach C h a p t e r the monopoly outcome, then a total of 200 planes per year is sold and the price is $20 million per plane. In this case the outcome is inefficient and a deadweight loss results.

16

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

Answers to the Review Quizzes Page 377 1.

List the economic functions of governments.

Governments exist to establish and maintain property rights, to provide nonmarket ways of allocating resources, and to create methods that redistribute income and wealth.

2.

Describe the political marketplace. Who are the participants, what do they do, and what is a political equilibrium?

Voters, firms, politicians, and bureaucrats interact in the political marketplace. Voters and firms demand policies. Voters provide votes and/or funds while firms supply funds and other help to politicians or political parties that supply the policies they want. Politicians and political parties supply the policies and in exchange receive votes and/or contributions from voters and firms.

Politicians attempt to supply proposals that attract enough votes to be elected and then reelected. Bureaucrats are in charge of implementing the policies.

The political equilibrium is a situation in which no one has the incentive to change their efforts or their policies.

3.

Distinguish among public goods, private goods, common resources, and natural monopoly goods.

Public goods are nonexcludable and nonrival. As a result, anyone can consume the good whether or not he or she paid for it and one person’s use of the good does not decrease the amount available for other people. Private goods are excludable and rival. As a result, only the person who pays for the good can consume it and one © 2018 Pearson Education, Inc.

224

CHAPTER 16

person’s use decreases the amount available for others. Common resources are nonexcludable and rival. As a result, anyone can consume the good whether or not he or she paid for it and one person’s consumption decreases the amount available for other people’s consumption. Natural monopoly goods are nonrival and excludable. Potential users of the good can be excluded if they do not pay but once having paid their use of the good is nonrival.

4.

Why are healthcare and education not public goods and why do governments play a large role in the markets for these services?

Healthcare and education are not public goods because they are rival and excludable. But governments play a major role in the market for these services because a majority of voters want these goods provided to people regardless of the people’s ability to pay for them. Because of this view, public choices are used to determine the quantity of healthcare and education services provided.

Page 381 1.

What is the free-rider problem? Why do free riders make the private provision of a public good inefficient?

If a firm were to provide a public good, it would suffer from the free-rider problem, which arises when non-paying consumers consume the public good without paying, enjoying a ―free ride.‖ Public goods are, in part, characterized by inability to exclude nonpaying consumers. A private firm would not receive a sufficient level of revenue to provide the efficient level of the public good.

2.

Under what conditions will competition among politicians for votes result in an efficient provision of a public good?

Competition in the political marketplace will provide the efficient quantity of a public good only if the voters are well informed and are motivated to carefully evaluate the alternative policies that the politicians propose.

3.

How do rationally ignorant voters and budget maximizing bureaucrats prevent the political marketplace from delivering the efficient quantity of a public good?

If the marginal benefit to the voter of becoming well informed about a particular policy issue is much smaller than the marginal cost of becoming well informed, the voter is likely to remain rationally ignorant about the policy and the level of any related public goods provision. The marginal benefit of providing public goods is very high to both bureaucrats and the contractors who are employed to produce and distribute the public goods. So they have a concentrated interest in lobbying politicians to direct the bureaucrats to provide more than the efficient quantity of the public good, even to where the net benefit to the economy is zero.

4.

Explain why public choices might lead to the overprovision rather than the underprovision of a public good.

Rational ignorance of voters, combined with lobbying by public goods contractors and bureaucrats, causes the political equilibrium to provide public goods at a higher level than is economically © 2018 Pearson Education, Inc.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE225

efficient. In this case, it is in the self-interest of the politicians to provide more than the efficient quantity of the public good because they reap benefits from the lobbyists and bureaucrats while suffering little or no loss from voters.

Page 387 1.

What is special about healthcare that makes it a good provided by the government?

The government provides healthcare services because the marginal social benefit of healthcare exceeds the marginal benefit perceived by its consumers, Consumers underestimate the benefit of healthcare because they underestimate the health risks they face. They also underestimate their future needs for healthcare. And some people cannot afford the healthcare they need. For these reasons the majority of voters want healthcare to be available on need rather than on the ability and willingness to pay

2.

Why would the market economy produce too little healthcare?

The markets for healthcare will produce less than the efficient quantity because consumers of healthcare take account of only the benefits that accrue to them. They ignore the marginal social benefit that exceeds their perceived marginal benefit. Therefore the consumers’ demand for healthcare is less than the marginal social benefit from healthcare so the quantity of healthcare services produced is less than the efficient quantity.

3.

How do Canada and the United Kingdom deliver healthcare and what is the problem left unresolved?

Canada and the United Kingdom provide healthcare using a universal coverage, single payer system. Everyone is covered by health insurance and the government pays for all healthcare services. The government’s public choice determines the quantity of healthcare services provided. Consumers pay little or nothing for any healthcare service. Consequently the quantity of healthcare services demanded exceeds the quantity provided by the government which creates a problem: There often is a long waiting period until a patient receives services.

4.

What are the problem with Medicare and Medicaid?

The government expenditure on Medicare and Medicaid are determined by the quantity of healthcare demanded, not by a fixed government budget. The scale of expenditure on Medicare and Medicaid in the United States is much than that in other rich nations. The U.S. population is aging. Older people demand more healthcare services than do younger people. Consequently, without changes in the Medicare and Medicaid programs, the expenditure on these programs, already huge, will increasingly grow.

5.

What is the problem that Obamacare seeks to solve and how does the solution work?

The Patient Protection and Affordable Care Act, or Obamacare, attempts to overcome the problem of too many people who do not have health insurance. It seeks to make quality, affordable, private © 2018 Pearson Education, Inc.

226

CHAPTER 16

health-insurance plans available for those currently uninsured and to stop insurance companies from denying coverage of pre-existing conditions, This act created a Health Insurance Market in which subsidized health insurance is provided. On the supply-side of the market are private healthcare insurance companies. On the demandside are individuals. Many of the consumers qualify for subsidies which lower the cost to them of the healthcare insurance. By reducing the price, the act increases the number of people with healthcare insurance.

© 2018 Pearson Education, Inc.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE227

Answers to the Study Plan Problems and Applications 1.

Classify each of the following items as excludable, nonexcludable, rival, or nonrival. Explain your answer.  A Big Mac A Big Mac is excludable and rival. It’s excludable because a person must pay for a Big Mac to consume it. It’s rival because one person’s consumption decreases the quantity available for others to consume.



Brooklyn Bridge The Brooklyn Bridge is nonexcludable (because there is no toll for using it) and rival (especially when it is crowded).



A view of the Statue of Liberty Viewing the Statue of Liberty is nonexcludable and nonrival. It is nonexcludable because a person cannot be prevented from viewing the statue and it is nonrival because one person’s view does not decrease people’s views.



A hurricane warning system A hurricane warning system is nonexcludable and nonrival. It is nonexcludable because once a warning is sounded, everyone can learn of it and nonrival because one person learning of the warning does not limit other people’s use of the warning.

2.

Classify each of the following items as a public good, a private good, a natural monopoly good, or a common resource. Explain your answer.  Highway control services Highway control services are nonexcludable and nonrival so they are a public good.



Internet service Internet service is a natural monopoly good. Internet service is excludable because a consumer must pay for the service or else he or she does not receive it. But once access is granted, use of Internet service is nonrival.



Fish in the Atlantic ocean Fish in the ocean are a common resource because they are nonexcludable and rival.



UPS courier service UPS is rival (a carrier cannot deliver a package to my house and your house simultaneously) and excludable (a user must pay) so it is a private good.

3.

For each of the following goods, explain why a free-rider problem arises or how is it avoided.  July 4th fireworks display The fireworks display is a public good so there is a potential freerider problem. Area residents might be taxed to finance the display, but visitors to the area, who don’t pay local taxes, are free riders.



Interstate 81 in Virginia Interstate 81 potentially has a free rider problem. However if the state of Virginia uses the gas tax revenue it receives from the sale © 2018 Pearson Education, Inc.

228

CHAPTER 16

of gasoline near the interstate to pay to maintain the freeway, then users of the Interstate pay for the road. In this case there is no free rider problem.



Wireless Internet access in hotels Wireless Internet access in hotels can avoid the free rider problem if the hotel limits access to guests staying at the hotel.



The public library in your city The public library has a free rider problem because people can use the library even if they pay no taxes to support it. Potentially the free rider problem can be mitigated if the library charges a fee for its services.

4.

The table sets out the benefits that Terri and Sue receive from on-campus police at night. Suppose that Terri and Sue are the only students on the campus. Draw a graph to show the marginal social benefit from the police at night.

The marginal social benefit at every number of police officers equals Terri’s marginal benefit plus Sue’s marginal benefit. Figure 16.1 shows the marginal social benefit curve.

Police officers on duty (number per night) 1 2 3 4 5

© 2018 Pearson Education, Inc.

Marginal benefit Terri Sue (dollars per police officer) 18 14 10 6 2

22 18 14 10 6

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE229

Use the data on a mosquito control program in the table to work Problems 5 and 6.

5.

What quantity of spraying would a private firm provide? What is the efficient quantity of spraying? In a single-issue election on mosquito spraying, what quantity would the winner provide?

Quantity (square miles sprayed per day) 1 2 3 4 5

Marginal Marginal social social cost benefit (thousands of dollars per day) 2 10 4 8 6 6 8 4 10 2

Mosquito spraying is a public good and subject to free riding. As a result, a private mosquito would supply no spraying. The efficient quantity of spraying is 3 square miles a day, which is the quantity at which marginal social cost equals marginal social benefit. In a single issue election, the outcome will be that each party eventually proposes spraying 3 square miles per day and the election outcome will be the efficient quantity of spraying.

6.

If the government appoints a bureaucrat to run the program, would mosquito spraying most likely be underprovided, overprovided, or provided at the efficient quantity?

With the bureaucratic department in charge of spraying, mosquito spraying likely would be overprovided.

© 2018 Pearson Education, Inc.

230

CHAPTER 16

Use the following figure, which shows the marginal benefit from health insurance and the willingness and ability to pay for it, to work Problems 7 to 10.

The marginal cost of insurance is a constant $6,000 per family per year. Marginal social benefit from insurance exceeds the willingness and ability to pay by a constant $4,000 per family per year.

7.

With no public health insurance market, how many families buy insurance, what is the premium, and is the coverage efficient?

With a private and competitive health insurance market, the price of health insurance equals the marginal cost, or $6,000 per year. At this price, 10 million families buy insurance. The coverage is not efficient because the marginal social benefit exceeds the marginal (private) benefit. When 10 million families are insured the marginal social benefit is $10,000, which exceeds the marginal cost of the insurance. Accordingly insurance is underprovided by the private market.

8.

If the government provides healthcare to achieve the efficient coverage, how many families are covered and how much must taxpayers pay?

The efficient quantity of health insurance is 50 million families covered. At this quantity, the marginal social benefit equals the marginal benefit of $2,000 plus $4,000, or $6,000. Therefore the marginal social benefit equals the marginal cost, so 50 million families covered is the efficient quantity.

With 50 million families insured, the demand curve shows that consumers will pay $2,000 per family. The marginal cost of this quantity of policies is $6,000 so the taxpayers must subsidize each family by an amount of $6,000 − $2,000, or $4,000. Therefore the total subsidy taxpayers must pay is $4,000 per family multiplied by 50 million families, or $200 billion.

9.

If the government subsidizes private insurers, what subsidy will achieve the efficient coverage?

To insure 50 million families, the insurers’ total cost equals $6,000 per family multiplied by 50 million, or $300 billion. With 50 million families covered, the demand curve shows that a family is willing to pay $2,000 per policy. Accordingly families will pay 50 million × $2,000, or $100 billion. Therefore the government must provide a subsidy of $200 billion to private insurers.

10.

If the government gave coverage to everyone what problems would arise in the related market for healthcare services?

If the government gave everyone coverage, then 70 million families— the quantity of insurance policies demanded at a price of $0—will be insured. This larger quantity of insured households means that the © 2018 Pearson Education, Inc.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE231

quantity of healthcare services will be larger. Unless the government is going to provide additional healthcare services, there will be a long wait until a patient can receive treatment, at least for non-life threatening ailments.

© 2018 Pearson Education, Inc.

232

CHAPTER 16

Answers to Additional Problems and Applications 11. 

Classify each of the following items as excludable, nonexcludable, rival, or nonrival.

Homeland security Homeland security is nonrival (the use of homeland security by one person does not decrease the quantity available for someone else) and nonexcludable (it is impossible to prevent anyone from benefiting from it).



A Starbucks coffee



A view of the Liberty Bell

A Starbucks coffee is rival and excludable.

A view of the Liberty Bell is nonexcludable and nonrival.



The Appalachian Trail The Appalachian Trail is nonexcludable. It is generally nonrival except in areas where is becomes very crowded.



A google Search A google search is nonexcludable because anyone can search for the same item and is nonrival because one person’s search does not decrease the searches available to anyone else.

12.

Classify each of the following items as a public good, a private good, a natural monopoly good, or a common resource. Explain your answer.  Measles vaccinations Measles vaccination is a private good. It is excludable and rival.



Tuna in the Pacific Ocean Tuna in the ocean are a common resource because they are nonexcludable and rival.



Air service in the United States Airline flights are a private good because they are excludable and rival.



Local storm-water system The local storm water system is a natural monopoly good because it is excludable but once access is granted, use of it is nonrival.

13.

Classify each of the following goods as either a private good, a public good, a natural monopoly good, or none of the above.  Chewing gum Chewing gum is excludable and rival so it is a private good.



Cable TV Cable TV is a natural monopoly good. It is excludable because a consumer must pay for access. But once access is granted, use of the cable TV system is nonrival.



The New York City subway The subway is a private good because it is excludable and, when crowded, is rival.



A skateboard A skateboard is a private good.

© 2018 Pearson Education, Inc.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE233



The Santa Monica beach The beach at Santa Monica is nonexcludable and rival so it is none of the above. (It is a common resource.)

© 2018 Pearson Education, Inc.

234

14.

CHAPTER 16

The table sets out the marginal benefits that Sam and Nick receive from the town‘s street lighting: a. Is the town‘s street lighting a private good or a public good?

It is a public good.

b. Suppose that Sam and Nick are the only residents of the town. Draw a graph to show the marginal social benefit from the town‘s street lighting.

Number of street lights 1 2 3 4 5

Marginal benefit Sam Nick (dollars per street light) 10 12 8 9 6 6 4 3 2 0

Figure 16.3 shows the marginal social benefit curve. The marginal social benefit at every quantity equals Sam’s marginal benefit plus Nick’s marginal benefit.

15.

What is the principle of diminishing marginal benefit? In Problem 14, does Sam‘s, Nick‘s, or the society‘s marginal benefit diminish faster?

The principle of declining marginal benefit asserts that as the quantity of the good or service consumed increases, the marginal benefit of an additional unit decreases. Society’s marginal benefit decreases more rapidly than does Sam’s marginal benefit or Nick’s marginal benefit. For every additional street light, Sam’s marginal benefit decreases by $2, Nick’s marginal benefit decreases by $3, and society’s marginal benefit decreases by $5.

Use the following news clip to work Problems 16 and 17.

New Jersey May Increase Famously Low Gas Tax The American Society of Civil Engineers says more than 550 of New Jersey‘s bridges need major repairs. With the state‘s roads and bridges falling apart, and with its transportation trust fund running dry, New Jersey lawmakers are considering raising the gas tax from 14.5 cents per gallon, the secondlowest in the country, to 37.5 cents a gallon, bringing it closer to that of New York and other neighboring states.

Source: The New York Times, June 23, 2016 16. Why might an increase in the gas tax to finance transportation infrastructure be a political equilibrium?

In a political equilibrium, the choices of voters, firms, politicians, and bureaucrats are all compatible and no group can see a way of improving its position by making a different choice. If © 2018 Pearson Education, Inc.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE235

voters believe that repairing bridges and roads is worth the increase in the gas tax, they will vote for politicians who support these policies. The bureaucrats in charge of the transportation policies and as well as the firms that build and repair roads and bridges will support these policies, so the political equilibrium is for politicians to also support them.

17.

Roads and bridges are constructed by private engineering companies yet are public goods.

Distinguish between public production and public provision. Give three other examples that illustrate the distinction.

The difference between private provision of a public good and public provision hinges around who—the private sector or the public sector— actually produces the public good. For instance, many local governments contract with private agencies to provide street sweeping services, a public good. For another example, some states have contracted with private companies for the day-to-day running of parks. Finally, some states, such as Texas, have allowed private firms to produce toll roads.

18.

Threatened by Free Riders Some parents refuse to get their children vaccinated against infectious diseases like measles and preventable infectious disease is returning to the developed world. A measles outbreak that began at California‘s Disneyland has health officials warning of worse to come. Parents who don‘t vaccinate are free riders.

Source: Washingtonpost.com, February 3, 2015 a. Explain why someone in a rich country who has not opted out on medical or religious grounds and refuses to be vaccinated is a ―free rider.‖ The person who has not been vaccinating is free riding because he or she is benefiting from the people who have been vaccinated. The people who have been vaccinated will not spread the disease to others. The people who have not been vaccinated are enjoying a free ride because they are not providing the same disease prevention benefit to others.

b. The measles vaccine is highly effective. Were the people who got measles at Disneyland ―free riders‖? Should vaccinations be compulsory? Explain your answer.

The people who got measles were attempting to free ride since they were counting on not catching the disease because other people were vaccinated. Consequently they were attempting to benefit from the people who had been vaccinated. Compulsory vaccination would eliminate free riding and might make the market more efficient.

However, it would also infringe on some people’s religious beliefs.

19.

Obamacare 2017 Enrollment Hits Record Nearly 6.4 million Americans selected Obamacare policies through the federal exchange for coverage during 2016 and it is expected that a total of 13.8 million people will sign up for plans through both the federal and state exchanges by the end of the enrollment period.

Source: CNNMoney, December 21, 2016

© 2018 Pearson Education, Inc.

236

19.

CHAPTER 16

Obamacare Hits Enrollment Goal A last-minute enrollment surge enabled the White House to meet its 7 million sign-up target for the Affordable Care Act. President Barack Obama said on Tuesday that 7.1 million people had signed up on federal or state exchanges for coverage under the healthcare law.

Source: CNN, April 1, 2014 a. If the Obamacare enrollment is the efficient quantity of families, how would that quantity have been determined?

The target would be the quantity of families that sets the marginal social benefit of healthcare insurance equal to the marginal cost.

© 2018 Pearson Education, Inc.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE237

b. Draw a graph to illustrate the health insurance market and illustrate how the Obamacare subsidy influences the number of families covered.

Figure 16.4 shows the market for health insurance. In the absence of any subsidy, the price of a health insurance policy is $4,000 per year and 30 million families buy a policy. The subsidy under Obamacare increases the quantity of families buying health insurance. Presuming that the subsidy brings about the efficient outcome, the figure shows that the subsidy is $4,000 per family. With this subsidy, 50 million families will buy insurance because the price paid for a policy falls to $2,000. In the figure, Obamacare has increased the number of families insured from 30 million to 50 million.

c. How would the demand for health insurance change if the penalty for not signing up for Obama care were abolished? Draw a graph to illustrate the outcome The penalty increases the demand for health insurance. In Figure 6.5, with the penalty the demand curve for health insurance is DPenalty and the $4,000 subsidy per family leads to the efficient quantity of families insured, 50 million. But if the penalty is abolished, the demand curve for insurance is D = MB. In this case, the same $4,000 subsidy leads to only 40 million families being insured. There is a deadweight loss because the quantity of insured families is less than the efficient quantity.

To reach the efficient quantity, in the absence of the penalty the subsidy needs to be increased to $6,000 per family.

© 2018 Pearson Education, Inc.

238

CHAPTER 16

Use the following information and figure to work Problems 20 and 22.

The marginal cost of health insurance is a constant $8,000 a year and the figure shows the marginal benefit and willingness and ability to pay curve. Suppose that the marginal social benefit of insurance exceeds the willingness and ability to pay by a constant $2,000 per family per year.

20.

If all health insurance is private and the market for insurance is competitive, how many families are covered, what is the premium, and what is the deadweight loss created?

If the market is private and competitive, the price of health insurance is $8,000 a year. As Figure 16.7 (on the next page) shows, the equilibrium quantity of policies is 10 million families insured. The efficient quantity, however, is 20 million quantities because that is the quantity that sets the marginal social benefit, MSB, equal to the marginal cost, MC. When only 10 million families are insured, the deadweight loss is the grey triangle in the figure. The area of this triangle is the amount of the deadweight loss and is equal to ½ × 10 million × $2,000 = $10 billion.

© 2018 Pearson Education, Inc.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE239

21.

If the government decides to provide public health insurance (like Canada), what healthcare fee does it charge to achieve an efficient coverage? How much will taxpayers have to pay?

If the government provides public health insurance as does Canada, Canada will insure 20 million families. The cost of insuring each family is $8,000. Canada uses a single payer method of health care, which means that the Canadian government pays for all health care expenditures. Therefore Canadian taxpayers must pay for the entire cost of the insurance, $8,000 × 20 million or $160 billion.

22.

If the government decides to subsidize health insurance (like Obamacare), what subsidy will achieve the efficient coverage?

The subsidy must lead to insuring 20 million families because that is the efficient quantity that sets the marginal social benefit equal to the marginal cost. The demand and marginal benefit curve, D = MB, shows that the price of an insurance policy must be $6,000 per year to have 20 million families enrolled. The subsidy per family equals $8,000 − $6,000, or $2,000 per family.

Economics in the News 23.

After you have studied Economics in the News on pp. 388–389, answer the following questions: a. What is the source of revenue for constructing and maintaining the transportation infrastructure?

The gasoline tax is the main source of funds for constructing and maintaining the transportation capital.

b. Why has that revenue source not grown fast enough to deliver an efficient scale of infrastructure provision?

As cars become more fuel efficient, they use less gasoline, thereby generating less gasoline tax revenue.

c. What other revenue sources can you suggest that could provide a solution to underprovision?

General tax revenue could be used to maintain the infrastructure.

More tolls could be established for using bridges and freeways, with the funds generated devoted to the infrastructure. Drivers might be taxed for the miles they drive rather than the gasoline they use, which could generate additional funds.

d. How would you expect population growth to influence the marginal social benefit of highways © 2018 Pearson Education, Inc.

240

CHAPTER 16

and bridges?

Population growth increases the marginal social benefit of highways and bridges.

e. Illustrate your answer to (d) by drawing a version of the figure on p. 389 that shows the effect of an increase in population.

Figure 16.8 shows how the marginal social benefit curve shifts rightward to MSB1. As a result, the efficient number of bridges to repair increases from 6,000 per year to 8,000 per year.

24.

Trump Confronts NATO’s Free Riders NATO is a 28-nation defense alliance that regards an attack on one member as an attack on every member. To provide the agreed level of mutual support, NATO members commit to spending at least 2 percent of their gross domestic product on defense. But only the U.S., Britain, Poland, Estonia, and Greece beat 2 percent. France, Germany, and Canada fall short.

Source: The Chicago Tribune, February 16, 2017 a. Explain the free-rider problem described in this news clip.

The free rider problem is that most NATO nations rely on the United States, Britain, Poland, Estonia, and Greece to provide defense services against aggression. These nations meet their NATO pledge to spend at least 2 percent of their gross domestic product on defense while other NATO nations fall short.

b. Does the free-rider problem in international defense mean that the world has too little defense against aggression?

Free riding because of the public goods aspect of defense means that the world has too little defense against aggression.

c. How do nations try to overcome the free-rider problem among nations?

Nations can sign treaties that either obligate them to cut their weapons systems or jointly develop new weapon systems. By cutting weapons, less additional defense spending is required, which limits the total amount of free riding that occurs. By jointly developing new weapon systems the nations eliminate free riding because all the nations who signed the treaty help pay for the weapons system. © 2018 Pearson Education, Inc.

WHAT IS ECONOMICS?CCXLI

C h a p t e r

EXTERNALITIES

17

Answers to the Review Quizzes Page 396 1.

What are the four types of externality?

Externalities can be: a negative production externality, a positive production externality, a negative consumption externality, or a positive consumption externality.

2.

Provide an example of each type of externality that is different from the ones described above. ccxli

238

CHAPTER 17

Dumping dangerous chemicals in river while producing paper is an example of a negative production externality. Baking bread and the resulting odor enjoyed by by-passers is an example of a positive production externality. Littering while hiking is an example of a negative consumption externality. Planting a beautiful bamboo garden that by-passers enjoy is an example of a positive consumption externality.

Page 404 1.

What is the distinction between private cost and social cost?

A private cost of production is the cost of producing a good or service that is borne only by the producer. A social cost of production includes the private costs of production as well as the external costs of production borne by people other than the producer.

2.

How do external costs prevent a competitive market from allocating resources efficiently?

External costs create a marginal social cost (MSC) that exceeds the marginal private cost (MC) for producing or consuming a good or service. That is, with an external cost, MSC > MC. When the firm produces a good or service with an external cost, it chooses to produce the quantity at which marginal cost equals marginal benefit, MC = MB. Marginal benefit equals marginal social benefit, MSB. In this case, the firm produces the quantity at which MC = MSB. This level of production exceeds the level at which MSC = MSB. Too much of the good or service is produced, resulting in an inefficient allocation of resources.

3.

How can external costs be eliminated by assigning property rights?

The existence of a negative externality means some group must bear some of the costs of a production or consumption activity for which they are not involved. The Coase theorem implies that assigning a property right to either the group generating the externality or the group bearing the externality costs will eliminate the inefficient allocation of resources. The Coase theorem applies if the number of parties involved is small and if transactions costs are low.

4.

How do taxes, pollution charges, and cap-and-trade work to reduce emissions?

An emissions tax or pollution charge on the producers of the activities that generate pollution or other negative externality will force these producers, when deciding about their level of production, to take account of the external costs they impose on society. Producers' costs increase and, in response, they decrease their production, which decreases pollution emissions. For cap-andtrade, the regulating agency first determines the total amount of pollution to be allowed. Each firm that might potentially pollute is then assigned a permitted amount of pollution to be emitted per period and is allocated sufficient permits to allow this amount of pollution. For any firm to exceed this amount, it must buy permits held by another firm. Each firm faces an opportunity cost for selling its emissions permits, namely the cost of cleaning up its pollution. The price of buying an extra permit will reflect the © 2018 Pearson Education, Inc.

EXTERNALITIES239

opportunity cost of the firm that sells the permits. Those firms with lower costs of cleaning pollution will sell their permits to those firms with higher costs. The total amount of pollution emitted will equal the total amount allowed.

Page 409 1.

What is the tragedy of the commons? Give two examples, including one from your state.

The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. The private market place will not produce the efficient quantity of a common resource. Some examples include the congestion of traffic during rush hour, the congestion near a college football stadium whenever a major game is played, or the free Internet access computer at the local library.

2.

Describe the conditions under which a common resource is used efficiently.

A common resource is used efficiently when the marginal social benefit equals the marginal social cost at the quantity produced.

3.

Review three methods that might achieve the efficient use of a common resource and explain the obstacles to efficiency.

There are three different methods that government can use to obtain the efficient allocation of resources in the event of a common resource: 

Property Rights are assigned to private property, which is a resource that someone owns and has an incentive to use in a way that maximizes its value. However, assigning property rights to resources is not always feasible, such as with the fish that migrate over the vast depths of the oceans.



Production Quotas can be set for total catch and divided among harvesting consumers so that the marginal social benefit from harvesting equals the marginal social cost of harvesting.

However, it is in every harvester’s best interest to cheat on the quota, because marginal private benefit from exceeding the quota allotment is greater than the marginal cost of harvesting.



An Individual Transferable Quotas (ITQ) is a production limit that is assigned to an individual harvester who is free to transfer the quota to someone else.

Page 413 1.

Why would the market economy produce too little education?

The markets for education will produce less than the efficient quantity because consumers of education take account of only the benefits that accrue to them. They ignore the marginal external benefit that others gain. Therefore the consumers’ demand for education is less than the marginal social benefit from education.

2.

How might governments achieve an efficient provision of education?

© 2018 Pearson Education, Inc.

240

CHAPTER 17

Governments could use public provision, private subsidies, or vouchers to achieve efficiency in the market for education. Public provision: The government could determine the efficient amount of education and create public colleges. This method is the primary method used for K-12 education. Private subsidies: The government could offer subsidies to private colleges. Vouchers: The government would give vouchers to students. Pell grants are an example of vouchers.

3.

What are the key differences among public production, private subsidies, and vouchers?

Public production means that the government is the producer of the product. Private subsidies, however, are given to private producers of the product. Both public production and private subsidies affect the supply-side of the market. Vouchers, however, are given to households to help pay for the product. Vouchers therefore affect the demand-side of the market.

4.

Why do economists generally favor vouchers to achieve an efficient outcome?

Economists generally favor vouchers because they allow for competition and they limit the opportunity for overproduction.

First, a voucher gives the consumer of the good the buying power, which forces producers to compete for business. Vouchers allow for competition between public producers and private producers. Second, vouchers can also limit overproduction because setting the value of the vouchers and the total voucher budget is transparent so that bureaucrats have less ability to pad their budgets. In addition, vouchers spread the spending over millions of consumers so no one consumer has the incentive to lobby for increased spending.

© 2018 Pearson Education, Inc.

EXTERNALITIES241

Answers to the Study Plan Problems and Applications 1.

Describe three consumption activities that create external costs.

Wearing heavy perfume creates an external cost; littering fast-food containers or soda cans creates an external cost; and, a drunk at a bar creates an external cost.

2.

Describe three production activities that create external benefits.

Presuming people like the smell of baking bread, a bakery creates an external benefit; basic research creates an external benefit; and recycling at a business has an external benefit because it decreases the harm created by waste disposal sites.

Use Figure 17.1, which illustrates the market for cotton, to work Problems 3 and 4. Suppose that the cotton growers use a chemical to control insects and waste flows into the town‘s river. The marginal social cost of producing the cotton is double the marginal private cost.

3.

If no one owns the river and the town takes no action to control the waste, what is the quantity of cotton and the deadweight loss created?

400 tons of cotton is produced.

In Figure 17.2, the deadweight loss that is created is equal to the area of the grey triangle. So the deadweight loss is equal to ½ × ($100 per ton − $50 per ton) × 100 tons, which is $2,500.

4.

If the town owns the river and taxes cotton growers so that the efficient quantity is grown.

How much tax revenue does the town receive? Is the quantity of waste zero? Explain your answer.

The tax is equal to the marginal external cost at the efficient quantity, $37.50 per ton of cotton. The efficient quantity of cotton is produced, 300 tons.

Therefore the town receives $37.50 per ton × 300 tons, which is $11,250. The quantity of waste is not zero because 300 tons of cotton are produced. But the quantity produced is the efficient amount, so the marginal social benefit from the last ton of cotton produced equals the marginal social cost, which includes the external cost. © 2018 Pearson Education, Inc.

242

CHAPTER 17

Use Figure 17.3 to work Problems 5 and 6.

The figure illustrates the market for North Atlantic tuna.

5. a. What is the quantity of tuna that fishers catch and the price of tuna? Is the tuna stock being used efficiently? Explain why or why not.

When the market is unregulated, the quantity of fish caught and their price is determined by the equilibrium between supply and demand. The demand curve is the same as the MSB curve so Figure 17.3 shows that the equilibrium quantity of tuna is 80 tons and the equilibrium price is $100 per ton. The tuna stock is not being used efficiently, The efficient quantity of tuna is determined by the intersection of the MSC curve and the MSB curve. Figure 17.3 shows that the efficient quantity of tuna is 40 tons. Tuna, a common resource, is overfished.

b. What would be the price of tuna, if the stock of tuna were used efficiently?

If tuna were used efficiently, 40 tons per month would be caught and the price would be $150 per ton.

6.

With a quota of 40 tons a month for the tuna fishing industry, what is the price of tuna and the quantity caught? Does overfishing occur?

With a quota of 40 tons per month, the quantity of tuna caught will be 40 tons and the price will be $150 per ton. As long as the quota is enforced so that fishers cannot cheat on their allocation, the equilibrium with the 40-ton quota is efficient. Tuna is not overfished.

Use Figure 17.4, which shows the demand for college education, to work Problems 7 to 9.

The marginal cost is a constant $6,000 per student per year. The marginal external benefit from a college education is a constant $4,000 per student per year.

7.

What is the efficient number of students? If all © 2018 Pearson Education, Inc.

EXTERNALITIES243

colleges are private, how many people enroll in college and what is the tuition?

The efficient number of students is 50,000 because this quantity is the number of students that sets the marginal social benefit equal to the marginal cost. If all colleges are private, then 30,000 students enroll in college because this quantity is the number that sets the marginal benefit equal to the marginal cost.

8.

If the government provides public colleges, what tuition will achieve the efficient number of students? How much will taxpayers have to pay?

The tuition will be $2,000 because this tuition will lead 50,000 students to enroll. The taxpayers must pay $4,000 per student (the $6,000 marginal cost minus the $2,000 tuition) for 50,000 students, so the taxpayers will pay $200,000,000 in total.

9.

If the government offers students vouchers, what is the value of the voucher that will achieve the efficient number of students?

The efficient number of students is 50,000. The value of the voucher must be $4,000 a student. The private colleges charge tuition of $6,000 per student and, of this tuition, students pay $2,000 so 50,000 students enroll.

© 2018 Pearson Education, Inc.

244

CHAPTER 17

Answers to Additional Problems and Applications 10.

What externalities arise from smoking tobacco products and how do we deal with them?

There are at least two externalities from smoking. First, many people who do not smoke find the smell of smoking offensive. Second, tobacco smoke can pose a health risk for non-smokers. To deal with these external costs, many locations ban smoking. For example, smoking on airplanes is illegal. Many states have banned smoking in restaurants. Some college campuses and most hospitals have gone ―smoke free‖ by prohibiting smoking while on their premises.

11.

What externalities arise from beautiful and ugly buildings and how do we deal with them?

Beautiful buildings create external benefits from the pleasure that people get from observing them. For ugly buildings, it is the reverse: They create external costs from the displeasure people get from observing them. To try to create more beautiful buildings, some locations require architectural review in which the planned building must pass inspection. Buildings of significant historical value are given heritage designations. People who pile trash around their buildings are fined.

12.

Betty and Anna work at the same office in Philadelphia and they have to attend a meeting in Pittsburgh. They decide to drive to the out-of-town meeting together. Betty is a cigarette smoker and her marginal benefit from smoking a package of cigarettes a day is $40. Cigarettes are $6 a pack. Anna dislikes cigarette smoke, and her marginal benefit from a smoke-free environment is $50 a day. What is the outcome if a. Betty drives her car with Anna as a passenger?

If Betty drives her car, Betty has the property right to the air in her car. Anna can offer to pay Betty some amount more than $34 and less than $50 to not smoke. Betty will accept and will not smoke on the trip. Betty’s net benefit from smoking is $34 (the net benefit equals the marginal benefit, $40, minus the price of the pack, $6) so for any amount greater than $34 she is willing to not smoke. Anna values a smoke-free environment at $50, so Anna is willing to pay any amount less than $50 for a smoke-free environment.

b. Anna drives her car with Betty as a passenger?

If Anna drives her car, Anna has the property right to the air in her car. Betty will not smoke because she will not offer Anna a high enough price to allow Betty to smoke.

Use the following data and Figure 17.5, which illustrates the market for a pesticide with no government intervention, to work Problems 13 to 16.

When factories produce pesticide, they also create waste, which they dump into a lake on the outskirts of the town. The marginal external cost of the waste is equal to the marginal private cost of producing the pesticide (that is, the marginal social cost of producing the pesticide is double the marginal private cost).

13.

What is the quantity of pesticide produced if no © 2018 Pearson Education, Inc.

EXTERNALITIES245

one owns the lake and what is the efficient quantity of pesticide?

If no one owns the lake the equilibrium quantity of pesticide produced is determined at the intersection of the demand curve and supply curve, 30 tons per week. The efficient quantity is determined at the intersection of the marginal social benefit curve and the marginal social cost curve. The marginal social benefit curve is the same as the demand curve. But the marginal social cost curve differs from the supply curve because of the external cost. The efficient quantity of pesticide is 20 tons per week because at this quantity the marginal social benefit, $100 per ton, equals the marginal social cost, also $100 per ton.

14.

If the town owns the lake, what is the quantity of pesticide produced and how much does the town charge the factories to dump waste?

Assuming that the transactions costs are low so that the Coase theorem applies, if the residents of the town own the lake, the efficient quantity of pesticide is produced, 20 tons per week. The residents charge the pesticide companies $50 per ton to dump their waste in the lake.

15.

If the pesticide factories own the lake, how much pesticide is produced?

Assuming that the transactions costs are low so that the Coase theorem applies, if the pesticide companies own the lake, 20 tons of pesticide is produced. In this case the residents pay the company to limit the dumping of waste.

16.

If no one owns the lake and the government levies a pollution tax, what is the tax that achieves the efficient outcome?

The tax is equal to the marginal external cost at the efficient quantity, which is $50 per ton of pesticide.

Use the following table to work Problems 17 to 19.

The first two columns of the table show the Quantity demand schedule for electricity from a coalPrice demanded burning utility; the second and third columns (cents (kilowatts show the utility‘s cost of producing electricity. per per day) The marginal external cost of the pollution kilowatt) created equals the marginal cost.

4 500 8 400 17. With no government action to control 12 300 pollution, what is the quantity of 16 200 electricity produced, the price of 20 100 electricity, and the marginal external cost of the pollution generated?

Marginal cost (cents per kilowatt) 10 8 6 4 2

With no pollution control, the quantity of electricity produced is 400 kilowatts per day, the price of electricity is 8¢ per kilowatt, and the marginal external cost of the pollution generated is 8¢ per kilowatt.

© 2018 Pearson Education, Inc.

246

18.

CHAPTER 17

With no government action to control pollution, what is the marginal social cost of the electricity generated and the deadweight loss created?

With 400 kilowatts of electricity being produced, the marginal social cost is 16¢ per kilowatt. To calculate the deadweight loss, it is necessary to determine the efficient quantity of electricity.

That quantity is 300 kilowatts per day because that is the quantity at which the marginal social cost, 12¢ per kilowatt, equals the marginal social benefit (the price from the demand curve, also 12¢).

The deadweight loss then equals the area of the triangle with a base equal to the difference between the efficient quantity and the equilibrium quantity, 100 kilowatts, and a height equal to the marginal external cost at the equilibrium quantity, 8¢ per kilowatt.

The deadweight loss equals ½ × 100 kilowatts per day× 8¢ per kilowatt, which is $4 per day.

19.

If the government levies a pollution tax such that the utility produces the efficient quantity, what is the price of electricity, the tax levied, and the government‘s tax revenue per day?

The tax will equal the amount of the marginal external cost at the efficient quantity, 6¢ per kilowatt. The quantity of electricity generated is 300 kilowatts per day and the price of electricity is 12¢ per kilowatt. The government collects as revenue 6¢ per kilowatt × 300 kilowatts per day, which is $18 per day.

20.

Deep Trouble Humans abuse the oceans. It is predicted that by 2050, overfishing, dumping waste, and heat from greenhouse-gas emissions will have destroyed most of the coral reefs and resulted in the oceans containing more plastic than fish. Without defined property rights, self-interest wins and the social interest loses.

Source: The Economist, May 27, 2017 Explain why the abuse of the oceans is a tragedy of the commons and how the assignment and enforcement of property rights in the oceans could improve the use of this natural resource.

Because no one owns the ocean, everyone is free to use it as desired. So when someone dumps waste in the ocean or overfishes, they do not pay all of the costs of their actions. For example, when dumped waste destroys coral reefs, all the fishers and divers who otherwise would use the reefs incur the cost of the destroyed reefs.

Because the people dumping waste, creating greenhouse gas emissions, and overfishing do not pay all the costs of their actions, they have the incentive to overuse the ocean. The external costs of dumping waste, emitting greenhouse gases, and overfishing mean that the ocean is being used unsustainably.

If property rights to the ocean could be assigned and enforced, the owners then have the incentive to charge the dumpers, greenhouse gas emitters, and overfishers the complete cost of their action so that there are no external costs. Essentially, the owners have the incentive to ensure that the ocean is used sustainably so that their asset—the ocean—is not destroyed.

© 2018 Pearson Education, Inc.

EXTERNALITIES247

Use Figure 17.6 to work Problems 21 to 23.

A spring runs under a village. Everyone can sink a well on her or his land and take water from the spring.

Figure 17.6 shows the marginal social benefit from and the marginal cost of taking water.

21.

What is the quantity of water taken and what is the private cost of the water taken?

With no government intervention, the quantity of water taken is 400 gallons per day, determined in the figure by where the marginal social benefit and the marginal private cost curves intersect. The marginal private cost of this quantity of water is 20¢ per gallon.

22.

What is the efficient quantity of water taken and the marginal social cost at the efficient quantity?

The efficient quantity of water taken is 200 gallons per day, determined in the figure by where the marginal social benefit and the marginal social cost curves intersect. The marginal social cost of this quantity of water is 30¢ per gallon.

23.

If the village council sets a quota on the total amount of water such that the spring is used efficiently, what would be the quota and the market value of the water taken per day?

The quota would be set at 200 gallons per day. This quantity of water would sell for a price of 30¢ per gallon, so the market value of this quantity of water is 200 gallons × 30¢ per gallon, which is $60.

24.

If hikers and other visitors were required to pay a fee to use the Appalachian Trail, a. Would the use of this common resource be more efficient?

The Appalachian Trail, or AT, is a common resource because it is nonexcludable and rival. As those who have hiked the AT know, this resource is over utilized; the natural beauty is adversely affected by the number of hikers. If there was a fee to hike the trail, its use would be more efficient

b. Would it be even more efficient if the most popular spots along the trail had the highest prices?

It would be even more efficient if the fee to use the trail was higher in more popular areas, such as Annapolis Rock, because these areas are even more over-utilized than the less popular areas.

c. Why do you think we don‘t see more market solutions to the tragedy of the commons?

It is probably the case that fees are not imposed because politicians resist imposing fees that their constituents must pay on goods and services that had previously been ―free.‖

© 2018 Pearson Education, Inc.

248

CHAPTER 17

Use the following data to work Problems 25 to 28.

The table shows the demand for college education.

The marginal cost of educating a student is a constant $4,000 a year and education creates an external benefit of a constant $2,000 per student per year.

25.

If all colleges are private and the market for education is competitive, calculate the number of students, the tuition, and the deadweight loss.

Price (dollars per student) 6,000 5,000 4,000 3,000 2,000

Quantity (students per year) 10,000 20,000 30,000 40,000 50,000

The equilibrium number of students will be 30,000 and the tuition will be $4,000. To calculate the deadweight loss, Figure 17.7 is helpful. The efficient quantity of students is 50,000. Therefore deadweight loss is equal to the area of the grey triangle in the figure, which is $20 million.

26.

If all colleges are public colleges, calculate the tuition that will achieve the efficient number of students. How much will taxpayers have to pay?

The efficient quantity of students is 50,000. To have 50,000 students attending college, the tuition must be $2,000. The marginal cost of educating a student is $4,000 so taxpayers must pay $2,000 per student. The total amount paid by taxpayers equals $2,000 per student × 50,000 students, which is $100 million.

27.

If the government decides to subsidize private colleges, what subsidy will achieve the efficient number of college students?

The subsidy must equal to the marginal external benefit at the efficient quantity, or $2,000 per student,

28.

If all colleges are private and the government offers vouchers to those who enroll at a college, calculate the value of the voucher that will achieve the efficient number of students.

The subsidy must equal to the marginal external benefit at the efficient quantity, or $2,000 per student,

Economics in the News 29.

After you have studied Economics in the News on pp. 414–415, answer the following questions: a. What are the marginal private costs of and marginal private benefits from using carbon-free resources to generate electricity?

The marginal private cost of using carbon-free resources is the cost paid by the utilities for these resources. The marginal private benefits from using carbon-free resources is the same as that from using other carbon-emitting resources, namely the marginal private © 2018 Pearson Education, Inc.

EXTERNALITIES249

benefits from electricity.

b. What are the marginal social costs of and marginal social benefits from using carbon-free resources to generate electricity?

The marginal social cost of using carbon-free resources is the marginal private cost of the fuel (the price paid by the utilities for the fuel) plus the marginal external cost from the (smaller amount of) carbon dioxide emitted. The marginal social benefits from using carbon-free resources is the same as that from using carbonemitting resources, namely the marginal social benefits from electricity.

c. How will California‘s cap-and-trade scheme change the price that households pay for electricity?

California’s cap-and-trade scheme will raise the price that households pay for electricity.

d. How will California‘s cap-and-trade scheme change the efficiency of electricity production?

California’s cap-and-trade scheme will increase the efficiency of electricity production. Currently burning coal creates an external cost that is not paid by the power utilities and the ultimate users.

The external cost creates a deadweight loss. California’s scheme will raise the price of coal, which decreases the amount of coal power utilities use to produce electricity and thereby decreases the deadweight loss.

30.

How San Francisco Is Leading the Way Out of Bottled Water Culture San Francisco led the movement to ban plastic shopping bags and is now proposing to ensure people have access to safe high-quality tap water and ban bottled water. A supporter of the ban says ―The city is reinforcing water as a public good rather than a commodity that can be bought and sold by corporations.‖ Source: The Guardian, June 28, 2017 a. What is the externality that arises from drinking bottled water?

Littering used plastic bottles could be an externality from drinking bottled water. Additionally, if the production of the plastic bottles creates pollution or accumulates in landfills, this could be another externality from drinking bottled water.

b. What methods other than a ban are available for dealing with the bottled-water externality?

Bottled water could be taxed. Alternatively the government could require users to recycle their bottles.

c. Is it likely that banning bottled water is efficient? Explain your answer.

Banning bottled water would not be efficient. There are instances when water has a very high marginal benefit, for example, thirsty tourists or thirsty outdoor workers. Neither of these groups has easy access to tap water, so the marginal cost of using tap water for them is quite high. The marginal cost of bottled water, however, is much lower, so that it would be efficient for these people to drink bottled water.

© 2018 Pearson Education, Inc.

CCL

C h a p t e r

Answers to the Review Quizzes Page 424 1.

What are the factors of production and their prices?

The factors of production and their prices are: labor, which is paid a wage rate for labor services; capital, which is paid a rental rate for capital services; land, which is paid a rental rate for land services; and entrepreneurship, which receives a profit or bears a loss that results from business decisions.

18

2.

MARKETS FOR FACTORS OF PRODUCTION

What is the distinction between capital and the services of capital?

Capital is the actual tools, instruments, machines, buildings, and constructions that have been produced in the past and that businesses now use to produce goods and services. Capital services are the services of the unit of capital. For example, a copy machine at a local Quik Print is capital but the copying performed by the machine is the service of that particular unit of capital.

3. ccl

What is the distinction between the price of capital equipment and the rental rate of capital?

250

CHAPTER 18

The price of a unit of capital is how much must be paid to acquire the piece of capital equipment. The rental rate of capital is the amount that must be paid to use the unit of capital equipment. For instance, the copy machine at the local Quik Print has a price of $10,000 but its services can be rented from the Quik Print for $50 per hour.

Page 427 1.

What is the value of marginal product of labor?

The value of marginal product of labor is the value to the firm of hiring one more unit of labor. The value of marginal product of labor, VMP, is the change in total revenue from employing an additional unit of labor.

2.

What is the relationship between the value of marginal product of labor and the marginal product of labor?

VMP is equal to the price of a unit of the output, P, multiplied by the marginal product of labor, MP. So VMP = P  MP.

3.

How is the demand for labor derived from the value of marginal product of labor?

The demand for labor is determined by the value of marginal product of labor. To maximize its profit a firm hires the number of workers that sets the wage rate equal to the value of marginal product of labor. When the wage rate changes, the firm changes the quantity of labor it demands so that the (new) wage rate equals the value of marginal product. So when the wage rate changes, the firm moves along its value of marginal product of labor curve to determine the quantity of labor demanded, thereby making its value of marginal product of labor curve its demand for labor curve.

4.

What are the influences on the demand for labor?

Factors that influence the demand for labor are the wage rate, the price of the firm’s output, the prices of other factors of production, and technology. A lower wage rate increases the quantity of labor demanded. A rise in the price of a substitute for labor or a fall in the price of a complement for labor increases the demand for labor. A new technology or new capital that increases the marginal product of labor increases the demand for labor.

Page 434 1.

What determines the amount of labor that households plan to supply?

When households decide how much labor to provide in the labor market, they compare the market wage rate to the value of the lost leisure that supplying labor would entail. If the market wage rate exceeds the individual’s reservation wage rate, the individual forgoes leisure and supplies labor to the labor market. The quantity of labor the person supplies depends on the wage rate. At most wage rates the substitution effect dominates the income effect so that a person increases the quantity of labor supplied if the wage rate rises. But at high wage rates the income effect dominates the

© 2018 Pearson Education, Inc.

MARKETS FOR FACTORS OF PRODUCTION251

substitution effect so that a person decreases the quantity of labor supplied if the wage rate increases.

2.

How are the wage rate and employment determined in a competitive labor market?

In a competitive labor market, the wage rate and employment are determined at the intersection of the demand for labor curve and the supply of labor curve.

3.

How do labor unions influence wage rates?

Unions increase their members’ wage rates by increasing the demand for their members’ labor and decreasing the supply of labor. In particular, to increase the demand for their members’ labor, unions: increase the value of marginal product of union members by sponsoring training schemes and apprenticeship programs; encourage import restrictions so that consumers must buy goods and services produced by union members; and, support minimum wage laws to raise the wage of a substitute for their members’ labor. Unions also try to restrict the supply of labor, say by supporting immigration restrictions to decrease the supply of low-skilled labor. By decreasing the supply of low-skilled labor, the wage rate paid lowskilled labor rises, which increases the demand for high-skilled union labor.

4.

What is a monopsony and why is a monopsony able to pay a lower wage rate than a firm in a competitive labor market?

A monopsony is a market with a single buyer. A monopsony uses its market power to force down the price it pays for what it buys in a similar way to how a monopoly uses its market power to force upward the price of the good it sells. Compared to a competitive labor market, a monopsony in a labor market hires fewer workers. Because it hires fewer workers, it pays a lower wage rate.

5.

How is the wage rate determined when a union faces a monopsony?

When a monopoly seller, such as union, bargains with a monopsony buyer, such as a large firm, the situation is called bilateral monopoly. The wage rate will be lower than the union’s monopoly wage rate and higher than the buyer’s monopsony wage rate. Within this range, the actual wage rate depends on the cost that each party can inflict on the other. Everything else the same, the more cost that one party can inflict on the other, the closer the actual wage rate will be to that party’s desired wage rate.

6.

What is the effect of a minimum wage law in a monopsony labor market?

A minimum wage rate can increase employment in a monopsony market.

Over a range of employment, a minimum wage can lower the cost of hiring additional workers for a monopsony. In the absence of the minimum wage, the marginal cost of labor, MCL, curve exceeds the wage rate because hiring another worker requires that the firm must boost the pay of all its workers. With a minimum wage, hiring another worker at this wage rate requires that the firm pay this worker the minimum wage but the firm does not raise the wage rate paid its others workers because they, too, are paid the minimum wage. As a result, in this range of employment, a monopsony’s cost © 2018 Pearson Education, Inc.

252

CHAPTER 18

of hiring another worker is lower with a minimum wage. The lower cost of hiring workers leads the monopsony to increase its employment.

Page 439 1.

What determines demand and supply in rental markets for capital and land?

The demand for capital depends on the value of marginal product of capital; the demand for land depends on the value of marginal product of land. The higher the marginal product of capital or land, the greater the demand for capital or land. Additionally the demand for capital depends on the rental rate of capital and the demand for land depends on the rental rate of land. The higher the rental rates, the lower the quantities demanded. The supply of capital depends on the rental rate of capital. The higher the rental rate of capital, the greater is the quantity of capital supplied. The supply of land, however, is perfectly inelastic because its quantity is fixed.

2.

What determines the demand for a nonrenewable natural resource?

The demand for a nonrenewable natural resource depends on the resource’s value of marginal product and the expected future price of the resource.

3.

What determines the supply of a nonrenewable natural resource?

The supply of a nonrenewable natural resource depends on the total known amount, such as the known oil reserves in the market for oil.

It also depends on the scale of current production facilities, which determines the marginal cost of producing the resource. For instance, when more oil wells are sunk, the supply of oil increases.

The expected future price also affects the supply. The higher the future expected price, the smaller the present supply of the resource.

4.

What is the market fundamentals price and how might it differ from the equilibrium price?

The market fundamentals price is the price determined by the fundamental determinant of demand, the value of marginal product, and the fundamental determinant of supply, the marginal cost of extraction. When people’s expectations of the price differ from the market fundamentals price, then the demand and supply are affected by the expected price. At this point the equilibrium price, determined in part by people’s expectations, differs from the market fundamentals price.

5.

Explain the Hotelling principle.

The Hotelling principle is the result that the price of a nonrenewable natural resource is expected to rise at a rate equal to the interest rate. Only when this situation exists can the market be in equilibrium. For example, if the price is expected to rise more rapidly than the interest rate, supply decreases and demand increases, and the present price rises. Supply will continue to decrease, demand will continue to increase, and the present price will continue to rise until the percentage increase from the present © 2018 Pearson Education, Inc.

MARKETS FOR FACTORS OF PRODUCTION253

price to the future expected price equals the interest rate. At that point, which is the situation outlined by the Hotelling principle, the market is in equilibrium because supply stops decreasing and demand stops increasing.

© 2018 Pearson Education, Inc.

254

CHAPTER 18

Answers to the Study Plan P roblems and Applications 1.

Tim is opening a new online store. He plans to hire two workers at $10 an hour. Tim is also considering buying or leasing some new computers. The purchase price of a computer is $900 and after three years it is worthless. The annual cost of leasing a computer is $450. a. In which factor markets does Tim operate?

Tim is operating in the labor market when he hires his workers. Tim also is operating in the capital market when he buys or leases his computers. Tim, himself, is an entrepreneur.

b. What is the price of the capital equipment and the rental rate of capital?

The price of the capital equipment—Tim’s computer—is $900. The rental rate of capital is $450.

Use the following data to work Problems 2 to 6.

Wanda‘s is a fish store that hires students to pack the fish. Students can pack the amounts of fish shown in the table. The fish market is competitive and the price of fish is 50¢ a pound. The market for packers is competitive and their market wage rate is $7.50 an hour.

2.

Calculate the value of marginal product of labor and draw the value of marginal product curve.

Number of students 1 2 3 4 5 6 7 8

Quantity of fish (pounds) 20 50 90 120 145 165 180 190

The value of marginal product of labor is the increase in total revenue that results from hiring one additional student. For example, if Wanda hires 4 students, they produce 120 pounds of fish. Wanda sells the fish for 50¢ a pound, so total revenue is $60. If Wanda increases the number of students hired from 4 to 5, total product increases to 145 pounds and total revenue increases to $72.50. The value of marginal product when the number of students increases from 4 to 5 is $12.50 ($72.50 minus $60). Alternatively, the value of marginal product equals marginal product multiplied by price. The value of marginal product when the number of students increases from 4 to 5 is $12.50, which is the marginal product of 25 pounds of fish multiplied by the price of 50¢ a pound. The value of marginal products calculated in this problem are plotted midway between the two levels of employment. Figure 18.1 shows the value of marginal product when the number of students increases from 4 to 5 as well as the other value of marginal products.

© 2018 Pearson Education, Inc.

MARKETS FOR FACTORS OF PRODUCTION255

3. a. Find Wanda‘s demand for labor curve.

The demand for labor curve is the same as the value of marginal product curve.

b. How many students does Wanda employ?

Wanda hires the number of students that makes the value of marginal product equal to the wage rate of $7.50 an hour. When Wanda increases the number of students from 6 to 7, marginal product is 15 pounds of fish an hour, which Wanda sells for 50¢ a pound. The value of marginal product is $7.50—the same as the wage rate. The value of marginal product is plotted at the mid-point between 6 and 7 students a day, so Wanda hires 6.5 students a day.

Use the following additional information to work Problems 4 and 5.

The market price of fish falls to 33.33¢ a pound, but the packers‘ wage rate remains at $7.50 an hour.

4.

How does the students‘ marginal product change? How does the value of marginal product of labor change?

The marginal product does not change. For instance, if Wanda hires 5.5 students a day, the marginal product is still 20 pounds of fish.

The value of marginal product decreases. For instance, if Wanda hires 5.5 students a day, the marginal product is 20 pounds of fish.

When Wanda now sells the fish for 33.33¢, the value of marginal product falls to $6.67, down from $10.00 when the price was 50¢ a pound.

5.

How does Wanda‘s demand for labor change? What happens to the number of students that Wanda employs?

Wanda’s demand for labor decreases because her value of marginal product decreases at each quantity of labor and her demand for labor curve shifts leftward.

Wanda hires fewer students. At the wage rate of $7.50, the number of students Wanda hires decreases as the demand for labor curve shifts leftward.

6.

At Wanda‘s fish store, packers‘ wages increase to $10 an hour, but the price of fish remains at 50¢ a pound. a. What happens to the value of marginal product of labor?

The value of marginal product does not change. For example, if Wanda hires 5.5 students an hour, the marginal product is 20 pounds of fish, which she sells at 50¢ a pound. So, just as before, the value of marginal product remains at $10.00.

b. What happens to Wanda‘s demand for labor curve?

Wanda’s demand for labor and her demand for labor curve remain the same because the value of marginal product has not changed.

c. How many students does Wanda employ?

Wanda hires fewer students. At the wage rate of $10 an hour, Wanda hires the number of students that makes the value of marginal product equal to $10 an hour. Wanda now hires 5.5 students an hour— down from 6.5 students an hour. The marginal product of 5.5 students is 20 pounds of fish an hour, and Wanda sells this fish for 50¢ a pound. The value of marginal product is $10 an hour. © 2018 Pearson Education, Inc.

256

CHAPTER 18

Use the following news clip to work Problems 7 to 9.

Theater Jobs Skew White and Male, Study Finds Equity (The Actors‘ Equity Association) is a labor union that represents live-theater actors and stage managers. A study by the union shows that women and minorities get fewer jobs and lower pay than white men. Equity recently hired its first diversity director and will try to diversify its own organization as well as meet with producers, writers, and others to discuss challenges facing the industry.

Source: The New York Times, June 26, 2017 7.

What is the goal of Equity?

Equity has the general goals of increasing its members’ employment and wages. It has also taken on the goals of increasing the diversity of its members as well as increasing the employment of its female and minority members.

8.

Why is Equity seeking greater diversity?

Equity is seeking greater diversity because that will increase its membership, thereby giving it more market power to negotiate higher wage rates and better working conditions for tis members.

9.

How can Equity try to change the demand for female and minority labor?

Equity can try to increase demand for female and minority labor by creating training programs to boost their skills. They can also suggest to producers that females and minorities are suitable for roles that do not require a specific gender or race and they can urge their female and minority members to try out for such roles.

10.

Land Prices Reflect Farm Incomes Bank CEOs predict that farmland prices will fall by 3.1 percent over the next 12 months. Lower farm income resulted in tighter restrictions on bank loans to farmers.

Source: Today’s Producer, June 21, 2017 a. Why does the price of farmland reflect farm incomes? In your answer include a discussion of the demand for and supply of land.

Because of lower farm incomes and tighter bank loan restrictions, the demand for farmland has decreased. The supply is perfectly inelastic and has not changed. As the loan restrictions increasingly take effect, the demand decreases and, with no change in supply, the price of farmland falls.

b. Use a graph to show why the price of farmland is expected to fall.

Figure 18.2 shows the market for farmland. The supply is perfectly inelastic so the supply curve is vertical. Initially, the demand curve was D0 and the price is $6,000 per acre. As the loan restrictions decrease the demand, the new demand curve is D1 and the price falls to $2,000 per acre.

© 2018 Pearson Education, Inc.

MARKETS FOR FACTORS OF PRODUCTION257

c. Is the supply of farmland perfectly inelastic?

The supply of land is perfectly inelastic.

© 2018 Pearson Education, Inc.

258

CHAPTER 18

Answers to Additional Problems and Applications 11.

Venus is opening a tennis school. She plans to hire a marketing graduate to promote and manage the school at $20 an hour. Venus is also considering buying or leasing a new tennis ball machine. The purchase price of the machine is $1,000 and after three years it is worthless. The annual cost of leasing the machine is $500. a. In which factor markets does Venus operate?

Venus is operating in the labor market when she hires her marketing graduate and administrator. If she buys or leases a tennis ball machine, Venus is operating in the capital market. Venus, herself, is an entrepreneur.

b. What is the price of the capital equipment and the rental rate of capital?

The price of Venus’s capital equipment is $1,000; the rental rate of her capital is $500 per year.

Use the following data to work Problems 12 to 15.

Kaiser‘s Ice Cream Parlor hires workers to produce milk shakes. The market for milk shakes is perfectly competitive, and the price of a milk shake is $4.

The labor market is competitive, and the wage rate is $40 a day. The table shows the workers‘ total product schedule.

12.

Number of workers

Calculate the marginal product of hiring the fourth worker and the fourth worker‘s value of marginal product.

1 2 3 4 5 6

Quantity produced (milk shakes per day) 7 21 33 43 51 55

By hiring the 4th worker the number of milk shakes increases by 10 milk shakes (43 milk shakes – 33 milk shakes). So the marginal product of this worker is 10 milk shakes. The value of the marginal product of the 4th worker equals the price of a milk shake, $4, multiplied by the worker’s marginal product, 10 milk shakes, so the value of marginal product is $40.

13.

How many workers will Kaiser‘s hire to maximize its profit and how many milk shakes a day will Kaiser‘s produce?

Kaiser’s will hire 3.5 workers. The value of marginal product of 3.5 workers is $40 which equals the wage rate.

14.

If the price of a milk shake rises to $5, how many workers will Kaiser‘s hire?

If the price rises to $5 a milk shake, Kaiser’s will hire 4.5 workers. The value of marginal product of 4.5 workers is the marginal product, 8 milk shakes, multiplied by the price, $5 a milk shakes, or $40, which equals the wage rate.

15.

Kaiser‘s installs a new machine for making milk shakes that increases the productivity of workers by 50 percent. If the price of a milk shake remains at $4 and the wage rises to $48 a day, how many workers does Kaiser‘s hire?

Kaiser’s hires 4.5 workers because this is the quantity of workers that sets the value of marginal product equal to the wage rate. With the old machine, the marginal product of 4.5 workers was 8 milk shakes. The new machine increases the marginal product by 50 percent to 12 milk shakes. The price of a milk shake is $4. The value of marginal product equals the marginal product multiplied by the © 2018 Pearson Education, Inc.

MARKETS FOR FACTORS OF PRODUCTION259

price, so the value of marginal product of 4.5 workers is 12 milk shakes × $4 a milk shake, or $48 which equals the wage rate.

16.

Tesla $350 Million Gigafactory Hiring 500 Workers Tesla has partnered with Panasonic to increase production of lithium-ion batteries and drivetrains for its mass-market Model 3 car in a massive factory in Nevada. The electric carmaker will spend $350 million and hire 500 workers. The Model 3 will be priced at $35,000.

Source: Business Insider, January 18, 2017 a. Explain how the price of an electric car influences the market for factory labor in Nevada.

Technological advances are lowering the price of electric cars, which increases the quantity demanded of electric cars. Because electric cars use lithium-ion batteries, the increase in the quantity of electric cars increases the demand for lithium-ion batteries. The increase in demand for lithium-ion batteries increases the value of marginal product of workers in Nevada making these batteries, so the demand for these factory workers increases.

b. Draw a graph to illustrate the effects of an increase in the demand for electric cars on the market for factory labor in Nevada.

Figure 18.3 shows the impact in the market for factory labor. The demand for factory labor increases so the demand for labor curve shifts rightward from D0 to D1. The supply does not change.

The wage rate rises from $30 per hour to $40 per hour and the quantity of factory workers employed increases from 4,000 to 5,000.

Use the following news clip to work Problems 17 and 18.

New Labor Laws in Chile Embolden Striking Miners Workers at BHP Billiton‘s Escondida mine in Chile, the world‘s largest copper mine, have been strengthened by new labor laws and are striking for higher pay. This strike and another at the world‘s second largest mine in Indonesia have sent the price of copper to a 20-month high.

Source: Reuters, February 15, 2017

© 2018 Pearson Education, Inc.

260

17.

CHAPTER 18

How would the wage rate and employment for the Escondida miners be determined in a competitive market?

In a competitive labor market, the wage rate and employment are determined by the supply of labor and the demand for labor. The equilibrium wage rate is the wage rate that sets the quantity of labor demanded equal to the quantity of labor supplied and equilibrium employment is equal to that quantity of labor.

18. a. Explain how it is possible that the mine workers are being paid less than the wage that would be paid in a competitive labor market.

The mine provides a large fraction of total employment in the region. Hence BHP Billiton, the owner of the mine, might have monopsony power in the labor market. If BHP Billiton is a monopsonist, it will maximize its profit by hiring the quantity of labor that sets its marginal cost of labor equal to the value of the marginal product. This quantity of labor is less than the equilibrium quantity in a competitive labor market. Then BHP Billiton will pay the lowest wage rate for which that quantity of labor will work. This wage rate is lower than the equilibrium wage rate in a competitive labor market.

b. Explain how the Escondida miners‘ union might be able to raise their wage rate.

Escondida miners’ union will bargain with BHP Billiton. This situation is a bilateral monopoly: a monopoly seller of labor services (the union) bargains with a monopsony buyer of labor services (BHP Billiton). In this case the wage rate depends on the relative strengths of the two and will lie between the monopsony wage BHP Billiton will offer and the wage the union wants. In order to increase the demand for its workers, and thereby their wage rates, the union also might organize training that increases the miners’ value of marginal product.

Use the following news clip to work Problems 19 to 22.

Walmart Ups Pay Well Above Minimum Wage Walmart announced it will pay 500,000 workers at least $9 an hour from April 2015 and at least $10 an hour from February 2016. The union-backed group OUR Walmart took credit for the company‘s announcement, but a leader of the group said the improved wages fell short of what was needed. Black Friday protesters were demanding $15 an hour.

Source: CNNMoney, February 19, 2015 19. a. Assuming that Walmart has market power in a labor market, explain how the firm could use that market power in setting wages.

Walmart can use its market power to act as a monopsony: It hires the quantity of labor that sets the marginal cost of labor equal to the value of marginal product of labor and then pays the minimum wage that people are willing to accept. Consequently it decreases the wage rate it pays and decreases the number of workers it hires.

b. Draw a graph to illustrate how Walmart might use labor market power to set wages.

© 2018 Pearson Education, Inc.

MARKETS FOR FACTORS OF PRODUCTION261

Figure 18.4 shows Walmart’s situation if it has a monopsony in the labor market. Walmart’s demand curve is the same as its value of marginal product curve and is labeled D = VMP in the figure. The labor supply curve is upward sloping and is labeled S in the figure. Walmart’s marginal cost of labor exceeds the wage rate it pays so the marginal cost of labor curve, labeled MCL, lies above the labor supply curve.

Walmart’s profit-maximizing quantity of labor is determined at the intersection of the D = VMP curve and the MCL curve and is 500,000 workers. Walmart determines the wage rate from the labor supply curve as the lowest wage rate it can pay and hire its profit-maximizing quantity of labor. In the figure the wage rate is $10 dollars per hour.

20. a. Explain how OUR Walmart would attempt to counteract Walmart‘s wage offers in a bilateral monopoly.

OUR Walmart will bargain with Walmart. If Walmart faces a union, such as OUR Walmart, the situation is a bilateral monopoly: a monopoly seller of labor services (the union) bargains with a monopsony buyer of labor services (Walmart). OUR Walmart can attempt to increase the wage rate by threatening to shutdown Walmart with a strike.

b. Explain how the wage rate would be determined if the market were a bilateral monopoly.

In this case the wage rate depends on the relative strengths of the two and will lie between the monopsony wage Walmart offers, $10 per hour in Figure 18.4, and the wage the union wants, which is the value of marginal product, $15 per hour in Figure 18.4.

21.

Based upon evidence presented in this article, does Walmart function as a monopsony in labor markets, or is the market for retail labor competitive? Explain.

The key piece of evidence in the news clip is the point that Walmart raised its wage from $9 an hour to $10 an hour. If Walmart had significant monopsony power, it would probably not raise its wage so drastically. The large increase in the wage rate indicates that it competes in a competitive labor market.

22.

If the market for retail labor is competitive, explain the effect of OUR Walmart on the wage rate and employment at Walmart. Draw a graph to illustrate your answer.

© 2018 Pearson Education, Inc.

262

CHAPTER 18

Figure 18.5 shows the effect of OUR Walmart in a competitive labor market. The union decreases the supply of labor and the supply of labor curve shifts leftward from S0 to S1.

The union increases the demand for labor and the demand for labor curve shifts rightward from D0 to D1. The wage rate rises, in the figure from $10 per hour to $15 per hour. If the change in the supply of labor is the same as the change in demand, the case illustrated in the figure, employment does not change, starting at 700,000 workers and remaining at 700,000 workers.

23.

New technology has allowed oil to be pumped from much deeper offshore oil fields than before.

For example, 28 deep-ocean rigs operate in the deep waters of the Gulf of Mexico. a. What effect do you think deep ocean sources have had on the world oil price?

The deep ocean oil fields increased the supply of oil and have kept oil prices from rising higher than they would have otherwise.

b. Who will benefit from drilling for oil in the Gulf of Mexico? Explain your answer.

The people benefiting from the new technology are the owners of the oil rigs and the firms selling this oil. Consumers also benefit because the price of oil is lower.

24.

Water is a natural resource that is plentiful in Canada but not plentiful in Arizona. a. If Canadians start to export bulk water to Arizona, what do you predict will be the effect on the price of bulk water?

If Canadians export bulk water, the supply of bulk water increases.

The increase in the supply lowers the price of bulk water.

b. Will Canada eventually run out of water?

Water is a renewable resource in Canada so it will not run out.

c. Do you think the Hotelling Principle applies to Canada‘s water? Explain why or why not.

The Hotelling Principle does not apply to Canada’s water because the Hotelling Principle applies to nonrenewable natural resources.

Canadian water is a renewable resource.

© 2018 Pearson Education, Inc.

MARKETS FOR FACTORS OF PRODUCTION263

25.

Land Rush in Permian Basin, Where Oil Is Stacked Like a Layer Cake The Permian Basin, which straddles Texas and New Mexico, is hot. Oil companies spent more than $25 billion buying into it during the second half of 2016. The reason: Its geology is ideal for hydraulic fracturing, and well served with pipelines. Its oil shale fields are profitable even when oil sells for only $40 a barrel.

Source: The New York Times, January 17, 2017 a. Explain why the demand for land in the Permian basin increased.

The demand for land increased because of the discovery of oil that can be extracted using hydraulic fracturing. Hydraulic fracturing is a new technology that allows more oil to be produced from wells. The value of marginal product of the land, which equals the price of oil multiplied by the marginal product of the land in producing oil, increased so the demand for the land increased.

b. When an oil company buys land and the right to its oil reserves, what is its assumption about the future price of oil?

When an oil company buys land and the right to its oil reserves, the company assumes that the price of oil will rise at the same rate as the interest rate.

c. What could cause the price of oil to fall in the future?

Technological change that decreases the demand for oil can lead the price to fall in the future. Lower prices for substitutes for oil, such as coal or natural gas, will lower the demand for oil and lead to a lower price for oil. Discoveries of large new reserves of oil will lead to a lower price for oil.

Economics in the News 26.

After you have studied Economics in the News on pp. 440–441, answer the following questions: a. How is the demand for self-employed Uber drivers determined?

The demand for self-employed Uber drivers depends on the demand for rides, the Uber technology, and the wage rate paid Uber drivers.

b. How is the demand for regular wage-employed taxi drivers determined?

The demand for regular wage-employed taxi drivers is a derived demand based on the demand for taxi rides. The demand for regular wage drivers is the same as the value of marginal product for drivers, so it depends on the marginal product of a driver and the price of a taxi ride.

c. Which of the influences on the demand for self-employed drivers changed when Uber arrived to increase demand?

When Uber arrived, its technology better matched Uber rides and people needing a ride, so the demand for self-employed Uber drivers increased as people needing a ride switched from taxi companies to Uber rides.

d. Which of the influences on the demand for wage-employed drivers changed when Uber arrived to decrease demand?

When Uber arrived, because its technology better matched rides and people needing a ride, the people needing a ride switched from taxi companies to Uber rides. This substitution decreased the demand for © 2018 Pearson Education, Inc.

264

CHAPTER 18

taxi rides and thereby decreased the value of marginal product of regular wage-employed drivers, which lowered the wage paid these drivers.

e. Explain the two possible reasons why a decrease in the demand for wage-employed drivers can result in an increase in their level of employment.

The decrease in demand for wage-employed taxi drivers can increase their employment for two potential reasons. First, the supply of these taxi drivers could be backward bending, so the lower wage rate increases the quantity of labor supplied, which will lead to an increase in equilibrium employment. Second, the entrance of Uber, which decreases the demand for wage-employed drivers, also increased awareness of this sort of job, thereby increasing the supply of wage-employed taxi drivers and leading to an increase in equilibrium employment.

f.

Illustrate with a graph the backward-bending supply curve explanation for the fall in the wage rate and increase in employment of wage-employed drivers.

Figure 18.6 shows the market for wage-employed taxi drivers when their supply curve is backward bending. In the figure, before Uber enters the market the demand is given by demand curve D0 so that the equilibrium is a wage rate of $18 per hour and 400,000 hours of labor. After Uber enters, the demand curve for wage-employed drivers shifts leftward from D0 to D1. The equilibrium wage rate falls to $12 per hour and the equilibrium employment increases to 500,000 hours per day.

© 2018 Pearson Education, Inc.

MARKETS FOR FACTORS OF PRODUCTION265

27.

Keshia is opening a new bookkeeping service. She is considering buying or C h a p t e r leasing some new laptop computers. The purchase price of a laptop is $1,500 and after three years it is worthless. The annual lease rate is $550 per laptop. The value of marginal product of one laptop is $700 a year. The value of marginal product of a second laptop is $625 a year. The value of marginal product of a third laptop is $575 a year. And the value of marginal product of a fourth laptop is $500 a year. a. How many laptops will Keshia lease or buy?

Keshia will lease or buy 3 laptops. The fourth laptop’s value of marginal product is less than the annual lease rate, so Keisha will never lease the fourth laptop. And the present value of the value of marginal products for the fourth laptop is always less than $1,500 regardless of the interest rate. (The value of marginal products sum to $1,500 when not discounted, so when discounted they must sum to less than $1,500.) Keisha will never rent nor buy the fourth laptop because it is not profitable to do so. For each year the value of marginal product for the third laptop always exceeds the annual lease rate, so leasing that laptop will be profitable. Therefore Keisha will always be willing to lease the third laptop.

b. If the interest rate is 4 percent a year, will Keshia lease or buy her laptops?

Keshia compares the present value of leasing the laptops to the price of buying the laptops. When the interest rate is 4 percent, $550 $550 $550 the present value of leasing the laptops is   $1,526 .

1.04 (1.04 )2 (1.04 )3 The present value of leasing the laptops exceeds the price of buying the laptops, so Keisha buys the laptops.

c. If the interest rate is 6 percent a year, will Keshia lease or buy her laptops?

Keshia again compares the present value of leasing the laptops to the price of buying the laptops. When the interest rate is 6 percent, the present value of leasing the laptops is $550 $550 $550   $1,470. The present value of leasing the laptops is 2 1.06 (1.06 ) (1.06 )3 less than the price of buying the laptops, so Keisha leases the laptops.

Answers to Review

19

ECONOMIC INEQUALITY

© 2018 Pearson Education, Inc.

the

262

CHAPTER 19

Quizzes Page 456 1.

Which is distributed more unequally, income or wealth? Why? Which is the better measure?

The distribution of wealth is more unequally distributed than income. Wealth is distributed more unequally than income because wealth data do not include the value of human capital, while the income data measure income from all wealth, including human capital.

That is why income is a better measure for economic inequality than wealth.

2.

How has the distribution of income changed in the past few decades?

From 1970 economic inequality in the United States has increased.

The share of income received by the richest quintile (20 percent) of the population has increased and this is the major change in the distribution of income.

3.

What are the main characteristics of high-income and low-income households?

There are four major characteristics that influence the amount of income earned by an individual: i) Education: The more education attained by a person the higher the human capital that person has, and the more income that person enjoys; ii) Type of household: Married couples earn more, on average, than single people living alone, especially females living alone; iii) The age of householder: The oldest and youngest households have lower incomes than middle age households; and iv) Race: Individuals living in households headed by an Asian person have the highest incomes, followed by white households, Hispanic households, and then black households.

4.

What is poverty and how does its incidence vary across the races?

Poverty is a situation in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. Poverty is a relative concept. Minorities have historically been over-represented among those households living in poverty in the United States. In particular, 13 percent of white households live in poverty while 26 percent of Hispanic-origin households and 27 percent of black households lived in poverty.

5.

How much mobility has there been through the income quintiles since 2007?

There is some mobility but not a vast amount, particularly in the lowest and highest quintiles. In both these quintiles, about 70 percent of households remained in the same quintile. In the other three quintiles, somewhere between 45 percent and 50 percent of households remained in the same quintile. But there was some mobility. In the bottom four quintiles, about 25 percent of household moved up a quintile. (It is impossible for a household in the top quintile to move up.) Similarly, in the top four quintiles, about 25 percent of household moved down a quintile. (It is impossible for a household in the bottom quintile to move down.) A few household also moved up and down by more than one quintile.

© 2018 Pearson Education, Inc.

ECONOMIC INEQUALITY263

Page 458 1.

In which countries are incomes distributed most unequally and least unequally?

Brazil and South Africa have the most unequally distributed incomes.

Finland and Sweden and some other European nations have the most equally distributed incomes.

2.

Which income distribution is more unequal and why: the income distribution in the United States or in the entire world?

The world Gini ratio is larger than the U.S. Gini ratio which means that the distribution of world income is less equally distributed than in the United States. The world income distribution ranges from extremely poor individuals living on less than $2.50 per day to the very wealthy living in the United States and other advanced countries.

3.

How can incomes become more unequally distributed within countries and less unequally distributed across countries?

Income within nations generally has become distributed less equally.

However because the average income within the poorest nations has been rising more rapidly than average income within richer nations, the world distribution of income has become more equally distributed.

Page 462 1.

What role does human capital play in accounting for income inequality?

In general acquiring human capital is a costly endeavor so the supply of workers with a lot of human capital is less than the supply of workers with little human capital. The difference in supply means that the more human capital an individual attains, the more income that individual will likely earn, other things remaining the same. Greater variation in human capital across the population of households increases the degree of income inequality among households. While the level of human capital attained varies across households, this factor alone does not completely explain the observed variation in income across households in the United States

2.

What role might discrimination play in accounting for income inequality?

If the levels of VMP of labor for a racial group or one sex are perceived to be higher than that of another racial group or the other sex, then the equilibrium wages earned will vary across these groups, despite the fact that the two groups have equal ability.

Economists disagree to the extent that discrimination pervades the labor market. One line of reasoning states that those firms that practice race or sex discrimination in the labor market face higher production costs (pay higher wages for the same value of marginal product) than those firms that do not. If this line of reasoning is correct, the profit margins for the firms practicing discrimination will be lower and the market price of their goods and services would be higher than non-discriminating firms. Either way, the market pressures increase the opportunity cost to firms (and the consumers

© 2018 Pearson Education, Inc.

264

CHAPTER 19

who buy their goods) for practicing race or sex discrimination, eventually eliminating these practices.

3.

What role might contests among superstars play in accounting for income inequality?

Contests can explain why the super-rich have incomes that have increased greatly over the years. With increased globalization, the pool of ―contestants‖ has increased dramatically. With the larger number of conspiracy, each contestant’s probability of winning has shrunk. So contests need to have larger differences in payouts for the winners versus the losers so as to induce larger efforts to win the contest. The result is that the contest winners—be they sports stars, entertainment stars, of CEOs—nowadays have much larger incomes than the vast number of losers.

4.

How might technological change and globalization explain trends in the distribution of income?

Technological change and globalization have both changed the distribution of income so that the ―rich get richer and the poor get poorer.‖ More specifically, technological change has increased the demand for high-skilled workers and increased their wage rates and incomes. It also has decreased the demand for low-skilled workers and decreased their wage rates and their income. Globalization also has increased the demand for high-skilled workers and decreased the demand for low-skilled workers in the United States. Globalization has made contests worldwide, so the prizes for the best superstars— be they athletes or business managers—have increased with the increase in the size of the market.

5.

Does inherited wealth make the distribution of income less equal or more equal?

An inheritance from older to a younger generations can only increase wealth and can never decreases wealth within a family, which helps make the distribution of wealth more unequal over time, all else equal. However if a generation is ―lucky‖ and earns a high income and then passes some of it along as an inheritance to more typical less lucky lower-income generations, then inherited wealth makes the distribution of income more equal.

Page 465 1.

How do governments in the United States redistribute income?

The governments in the U.S. use three main ways to redistribute income and reduce, to some degree, economic inequality: i) Income taxes: Taxes on household income are charged by the U.S. federal government and by many state governments,; ii) Income maintenance programs: There are three major types of programs that provide direct payments to individuals; and iii) Subsidized services: A great deal of income redistribution takes the form of subsidized services, where people other than those who pay for services consume the services provided.

2.

Describe the scale of redistribution in the United States.

In the United States, income redistribution increases the share of total income received by the lowest 60 percent of households and decreases the share of total income received by the highest 40 © 2018 Pearson Education, Inc.

ECONOMIC INEQUALITY265

percent of households. Specifically, the poorest 20 percent of households receive only 0.9 percent of total market income earned in the United States, but receive 4.6 percent of income after taxes and benefits. The richest 20 percent of households receive 55.6 percent of total market income earned in the United States, but receive only 46.7 percent of income after taxes and benefits.

3.

What is one of the major welfare challenges today and how is it being tackled in the United States?

The major welfare challenge is households headed by single mothers The poorest people in the United States are young, minority women who have not completed high school, have one or more dependent children, and live without a spouse. The Temporary Assistance for Needy Families (TANF) program is the current attempt to meet this challenge. TANF is a block grant paid to the states, which administer payments to individuals. It is not open-ended. Adults receiving assistance must work or perform community service. There is a five-year limit for assistance.

© 2018 Pearson Education, Inc.

266

CHAPTER 19

Answers to the Study Plan Problems and Applications 1.

What is money income? Describe the distribution of money income in the United States in 2012.

Money income equals market income (wages, interest, rent, and profit earned in factor markets, before paying income taxes) plus cash payments from the government. The distribution of money income in the United States is unequal. While the median household income was $51,017, the poorest 20 percent of household received less than 4 percent of the total income and the richest 20 percent of household received slightly more than 50 Households Money income percent of the total income.

2.

The table shows money income shares in the United States in 2001.

Draw a U.S. Lorenz curve in 2001. Was the U.S. distribution of income more equal in 2001 than in 2012 (see p. 447)? Explain your answer.

(quintile) Lowest Second Third Fourth Highest

(percentage of total) 3.5 8.8 14.5 23.1 50.1

The Lorenz curve is illustrated in Figure 19.1. To draw it, plot the cumulative percentage of households on the x-axis and the cumulative percentage of income on the yaxis. The Lorenz curve will pass through the following points: 20 percent on the x-axis and 3.5 percent on the y-axis; 40 percent on the x-axis and 12.3 percent on the y-axis; 60 percent on the xaxis and 26.8 percent on the yaxis; 80 percent on the x-axis and 49.9 percent on the y-axis; and 100 percent on the x-axis and 100 percent on the y-axis. The Lorenz curve for the U.S. economy in 2001 lies closer to the Line of equality than does the Lorenz curve in 2012, which means the distribution of money income was more equal in 2001. In 2001, the lowest `quintile received a greater percentage of income than in 2012 and the highest quintile received a smaller percentage of income than in 2012.

© 2018 Pearson Education, Inc.

ECONOMIC INEQUALITY267

3.

Households (percentage) Lowest 20 Second 20 Middle 20 Next highest 20 Highest 20

United Canada United States Kingdom (percentage of total income) 3 7 3 8 13 5 15 18 14 23 25 25 50

37

53

Incomes in China and India are a small fraction of U.S. income, but incomes in China and India are growing at

more than twice the rate of U.S. incomes. a. Explain how economic inequality in China and India is changing relative to that in the United States.

Inequality between people in China and India and people in the United States is lessening. Income for the typically poorer people in China and India is increasing more rapidly than income for the typically richer people in the United States, so the fraction of world income going to the people in China and India is growing.

b. How is the world Lorenz curve and world Gini ratio changing?

The world Lorenz curve is moving closer to the line of equality and the Gini ratio is falling in value.

Use the table to work Problems 4 and 5. The table shows the income shares in the United States, Canada, and the United Kingdom in 2009.

4.

Draw the Lorenz curves for the United States and Canada. In which country was money income less equally distributed in 2009?

To draw the Lorenz curve for Canada, Canada it is necessary to calculate Cumulative the cumulative percentage of Households percentage households and cumulative percentage (quintile) of income of income. The table to the right Lowest 7 has these data.

Second 20 Figure 19.2 shows the Lorenz Third 38 curve for the United States and Fourth 63 Canada. Income is distributed Highest 100 less equally in the States.

United

© 2018 Pearson Education, Inc.

268

5.

CHAPTER 19

Draw the Lorenz curves for the United States and the United Kingdom. In which country was income less equally distributed in 2009?

United Kingdom To draw the Lorenz curve for Cumulative Canada, it is necessary to Households percentage calculate the cumulative percentage (quintile) of income of households and cumulative percentage of income. The table to Lowest 3 the right has these data.

Second 8 Figure 19.3, shows the Lorenz curve Third 22 for the United States and the Fourth 47 United Kingdom. Income is Highest 100 distributed less equally in the United Kingdom.

6.

Figure 19.4 shows the market for low-skilled labor. The value of marginal product of highskilled workers is $16 an hour greater than that of low-skilled workers at each quantity of labor. The cost of acquiring human capital adds $12 an hour to the wage that must be offered to attract high-skilled labor.

Compare the equilibrium wage rates of lowskilled labor and high-skilled labor. Explain why the difference between these wage rates equals the cost of acquiring human capital.

The wage rate adjusts to make the quantity of labor demanded © 2018 Pearson Education, Inc.

ECONOMIC INEQUALITY269

equal to the quantity supplied. Figure 19.4 shows that the wage rate of low-skilled labor is $12 an hour. The value of marginal product of high-skilled labor at each employment level is $16 greater than the value of marginal product of low-skilled labor, so firms are willing to pay high-skilled labor a higher wage rate than they are willing to pay low-skilled labor. For example, the demand curve for low-skilled labor tells us that firms are willing to hire 4,000 hours of low-skilled labor at a wage rate of $8 an hour. Because the value of marginal product of high-skilled labor is $16 greater than the value of low-skilled labor, firms are willing to hire 4,000 hours of high-skilled labor at a wage rate of $24 an hour. The demand curve for high-skilled labor lies above the demand curve for low-skilled labor such that at each quantity of labor the wage rate paid high-skilled labor is $16 greater than that paid low-skilled labor. The Before-tax Plan A Plan B Plan C tax supply income tax tax (dollars) curve of (dollars) (dollars) (dollars) high10,000 1,000 1,000 2,000 skilled 20,000 2,000 4,000 2,000 labor lies 30,000 3,000 9,000 2,000 above the supply curve of low-skilled labor such that the vertical distance between the two supply curves equals the cost of acquiring the human capital—$12 an hour. That is, high-skilled labor will supply any amount of labor a day if the wage rate is $24 an hour. Equilibrium in the labor market for high-skilled labor occurs at a wage rate of $24 an hour.

The wage rate increases by exactly the cost of acquiring the skill because the supply of labor is perfectly elastic. High-skilled labor is willing to supply any amount of labor at a wage rate of $24 an hour. They will supply no labor at wage rates below $24 an hour.

Use the table to work Problems 7 and 8.

The table shows three redistribution schemes.

7.

Which scheme has (i) a proportional tax? (ii) a regressive tax? (iii) a progressive tax?

Tax Plan A is a proportional tax. At each level of income, 10 percent of income is paid in taxes.

Tax Plan C is regressive. When income is $10,000, 20 percent of income is paid in taxes; when income is $20,000, 10 percent of income is paid in taxes; and, when income is $30,000, 6.67 percent of income is paid in taxes.

Tax Plan B is progressive. When income is $10,000, 10 percent of income is paid in taxes; when income is $20,000, 20 percent of income is paid in taxes; and, when income is $30,000, 30 percent of income is paid in taxes. © 2018 Pearson Education, Inc.

270

8.

CHAPTER 19

Which scheme will (i) increase economic inequality? (ii) reduce economic inequality? (iii) have no effect on economic inequality?

Tax Plan C increases inequality. The poor pay 20 percent of their income as tax while the rich pay only 6.7 percent.

Tax Plan B decreases inequality. The poor pay only 10 percent of their income as tax while the rich pay 30 percent.

Tax Plan A has no effect on inequality because all income groups pay 10 percent of their income as tax.

© 2018 Pearson Education, Inc.

ECONOMIC INEQUALITY271

Answers to Additional Problems and Applications Use the table to work Problems 9 and shows the distribution of market United States in 2007.

9. a. What is the definition of income?

Households (quintile) Lowest Second Third Fourth Highest

Market income (percentage of total) 1.1 7.1 13.9 22.8 55.1

10. The table income in the market

Market income is the before-tax income earned by factors of production in the marketplace. Labor earns wages, capital earns interest, land earns rent, and entrepreneurship earns profit.

b. Draw the Lorenz curve for the distribution of market income.

Figure 19.5 shows the distribution of market income.

To draw this Lorenz curve, plot the cumulative percentage of households on the x-axis and the cumulative percentage of market income on the yaxis. Make the scale on the two axes the same. The Lorenz curve will pass through the following points: 20 percent on the x-axis and 1.1 percent on the y-axis; 40 percent on the x-axis and 8.2 percent on the y-axis; 60 percent on the x-axis and 22.1 percent on the y-axis; 80 percent on the xaxis and 44.9 percent on the y-axis; and 100 percent on the x-axis and 100 percent on the y-axis.

10.

Compare the distribution of market income with the distribution of money income shown in Fig. 19.3 on p. 445. Which distribution is more unequal and why?

U.S. money income is distributed more equally than market income in 2016. The Lorenz curve for U.S. money income in 2016 lies closer to the line of equality than does the Lorenz curve for U.S. market income. Money income is distributed more equally than market income because money income includes cash payments to poor households, which increases their income.

© 2018 Pearson Education, Inc.

272

CHAPTER 19

Use the table to work Problems 11 to 13. The table shows shares of income in Australia.

11.

Draw the Lorenz curve for the income distribution in Australia and in Brazil and South Africa (use the data in Fig. 19.6 on p. 453). Is income distributed more equally or less equally in Brazil and South Africa than in Australia?

Figure 19.6 shows these Lorenz curves. Income is distributed less equally in Brazil and South Africa.

12.

Households (quintile) Lowest Second Third Fourth Highest

Is the Gini ratio for Australia larger or smaller than that for Brazil and South Africa? Explain your answer.

The Gini coefficient is smaller in Australia because the distribution of income is more equally distributed in Australia.

13.

What are some reasons for the differences in the distribution of income in Australia and in Brazil and South Africa?

In both Brazil and South Africa there are wealthy citizens descended from European settlers and poorer citizens descended from large indigenous native populations. The income disparity between these two relatively large groups creates an unequal distribution of income in Brazil and South Africa. In Australia the indigenous native population is smaller, so the population is comprised mainly of citizens descended from European settlers.

Because there is not a large pool of low-income indigenous natives, the distribution of income is more equal in Australia.

14.

Figure 19.7 shows the market for a group of workers who are discriminated against.

Suppose that other workers in the same industry are not discriminated against and their value of marginal product is perceived to be twice that of the workers who are discriminated against. Suppose also that the supply of these other workers is 2,000 hours per day less at each wage rate. a. What is the wage rate of the workers who are discriminated against?

The wage rate of workers who are discriminated against is $10 an hour.

b. What is the quantity of workers employed © 2018 Pearson Education, Inc.

Market income (percent of total) 7 13 18 24 38

ECONOMIC INEQUALITY273

who are discriminated against?

Firms employ 5,000 hours of labor per day from workers facing discrimination.

c. What is the wage rate of the workers who do not face discrimination?

Because the value of marginal product of workers not facing discrimination is perceived to be twice the value of marginal product of the other workers, firms are willing to pay the workers not facing discrimination twice the wage rate that they are willing to pay the workers who face discrimination. For example, the demand curve for the workers being discriminated against tells us that firms are willing to hire 6,000 hours of these workers at a wage rate of $8 an hour. So with workers not facing discrimination perceived to be twice as productive as the other workers, firms are willing to hire 6,000 hours of labor from the non-discriminated group at $16 an hour. The demand curve for labor for the workers not facing discrimination lies above the demand curve for workers facing discrimination such that at each quantity of workers the wage rate for workers not facing discrimination is double that of workers facing discrimination. The supply curve of workers not facing discrimination lies to the left of the supply curve of workers facing discrimination by 2,000 hours of labor. The vertical distance between the two supply curves is $4 an hour. That is, workers not facing discrimination will supply 6,000 hours a day if the wage rate is $16 an hour. The equilibrium wage rate of workers who do not face discrimination is $16 an hour.

d. What is the quantity of workers employed who do not face discrimination?

Firms employ 6,000 hours of labor per day from workers not facing discrimination.

15.

White House Pays Women 80 Cents for Every Dollar Paid to Men CNN has calculated the White House‘s gender gap from data provided in the White House‘s annual report to Congress. CNN says the average salary of men working in the White House, at $104,000, is $21,000 higher than the $83,000 that White House women earn on average. Men fill higher-ranking jobs than women. About 47 percent of the 359 regular employees are women.

The White House gender pay gap is more than double the gap for the federal government.

Source: CNN, July 3, 2017 a. Explain why the White House gender pay gap might be caused by discrimination and why it might not be caused by discrimination.

The pay gap might be caused by discrimination against women. This discrimination could reflect either paying women less than men in comparable positions or by hiring men for higher-pay positions rather than comparably qualified women. The pay gap might also not be caused by discrimination. For the high-paying positions, there may be few suitably qualified women, so men fill more of the highpaying positions than do women.

© 2018 Pearson Education, Inc.

274

CHAPTER 19

b. Draw a graph to illustrate how discrimination can result in female workers getting paid less than male workers for some jobs.

Figure 19.8 shows a labor market in which women are discriminated against in favor of men. With the discrimination, the value of marginal product of men exceeds that of women. As a result, the value of marginal product curve for males, labeled VMPM, lies above the value of marginal product curve for females, labeled VMPF. In the figure the supply of male labor is the same as that of females, so the supply curve is labeled SM = SF. The figure shows that the wage rate paid men, $100,000 per year, exceeds the wage rate paid women, $80,000 per year.

c. If women are discriminated against in the White House, what is the mechanism that is being used?

If high-level public officials prefer dealing with a man than a woman, then men’s value of marginal product remains permanently higher than women’s value of marginal product so the wage rate paid men remains permanently higher than the wage rate paid women. For a competitive, profit seeking firm, market forces will operate to help eliminate this discrimination. (In particular, rather than higherpaid men, managers would hire lower-paid, equally productive women and thereby lower their firm’s cost and increase its profit. The increase in demand for women raises their wages and the decrease in demand for men lowers their wages, countering the effect from discrimination.) But market forces will not operate to eliminate the discrimination in the White House because the White House is not a profit-seeking firm.

Use the following information to work Problems 16 and 17.

In 2016, 12.8 million Americans had management jobs that paid an average of $71,240 a year while 1.8 million Americans had retail sales jobs that paid an average of $32,400 a year. Managers require a high school certificate while retail sales people don‘t but they undergo training.

Source: Bureau of Labor Statistics 16.

Explain why managers are paid more than retail salespeople.

Managers have more human capital than retail salespeople. Their higher human capital means that their value of marginal product is higher, so the demand for managers exceeds that of retail salespeople. Additionally the cost of acquiring their human capital means that the supply of managers is less than the supply of retail salespeople. The higher demand for managers combined with the lower

© 2018 Pearson Education, Inc.

ECONOMIC INEQUALITY275

supply of managers means that their salaries exceed those of retail salespeople.

17.

If the online shopping trend continues, how do you think the market for salespeople will change in coming years?

Shopping on-line decreases the demand for in-person salespeople. If on-line shopping continues to increase in importance, the decrease in demand for salespeople will lower the salary and decrease the quantity of salespeople. If, in response to the lower salary, the supply of salespeople also decreases, then the employment definitely decreases but the effect on the salary becomes ambiguous.

18.

Use the information provided in Problem 9 and in Fig. 19.3 on p. 451. a. What is the percentage of total income that is redistributed from the highest income group?

Redistribution lowers the highest income group’s share by 3.9 percent of total income. The highest income group receives 55.1 percent of total market income and 51.2 percent of total money income. So redistribution lowers the highest income group’s share by 3.9 percent of total income.

b. What percentages of total income are redistributed to the lower income groups?

Redistribution raises the lowest income group’s share by 2.0 percent of total income. The lowest income group receives 1.1 percent of market income and 3.1 percent of total money income. So redistribution raises the lowest income group’s share by 2.0 percent of total income.

19.

Describe the effects of increasing the amount of income redistribution in the United States to the point at which the lowest income group receives 15 percent of total income and the highest income group receives 30 percent of total income.

If the highest income group’s share falls from 55.1 to 30 percent of total income, redistribution takes 25.1 percent of income from this group. If the lowest income group’s share rises from 1.1 to 15 percent, redistribution raises this group’s share by 13.9 percent of total income. The other 11.2 percent (25.1 minus 13.9 percent) would be distributed to other groups.

This redistribution scheme would require a tax on the highest groups of 45.5 percent— (25.1/55.1)  100 percent. Such a large increase in the tax rate and redistribution might create the big tradeoff effect. The highly taxed people might choose to do less work and if they do, total income decreases.

Use the following news clip to work Problems 20 and21.

The Massive Tax Cuts for the Rich Inside the GOP Healthcare Plan The Republicans‘ healthcare bill would see the richest households paying an average of $200,000 less tax. The bill would also replace health insurance subsidies based on income with subsidies based on age. It would probably make Medicaid health insurance for the poor less generous.

Source: The Washington Post, March 7, 2017 20.

Explain why you would expect lower subsidies for healthcare to benefit the rich the most.

In a progressive tax system, the wealthy pay a larger fraction of their income as tax than others. With this type of tax system, lower © 2018 Pearson Education, Inc.

276

CHAPTER 19

subsidies that allow for tax cuts must favor the wealthy because it is the wealthy that pay the vast majority of taxes.

21.

How would the changes in the news clip change the distribution of income across the quintiles and how would the Lorenz curve change?

The distribution of income would change so that the highest quintile would have a larger percentage of the total income and the lower quintiles would have smaller percentages. The Lorenz curve would shift away from the line of equality.

Economics in the News 22.

After you have studied Economics in the News on pp. 466–467, answer the following questions. a. What information in the news article is consistent with the view that computer and robot technology is a source of increased inequality?

One consistent bit of information in the article is that the gap between the highest- and lowest-income households expanded the most in high-tech hubs, such as San Jose, Austin, and Seattle. These are the areas where we can expect that computers and robots are first introduced, thereby lowering the demand for low-skilled labor. The decrease in demand for low-skilled labor lowers the wage rate paid low-skilled labor and thereby increases the wage gap between highskilled, high-income workers and low-skilled, low-income workers.

b. If college tuition was free and more people got degrees in engineering, how would the wage gap between engineers and retail sales clerks change?

The supply of engineers would increase, which lowers the wage paid engineers. The wage gap between engineers and retail-sales clerks would shrink.

c. Draw a graph to illustrate your answer to (b).

In Figure 19.9, the supply of engineers increases so that the supply curve shifts rightward from S0 to S1. The increase in the supply lowers the wage rate from $80,000 per year to $60,000.

This decrease in the wage paid engineers decreases the wage gap between engineers and retail clerks.

© 2018 Pearson Education, Inc.

ECONOMIC INEQUALITY277

23.

The Best and Worst Graduate Degrees for Jobs in 2016 Average tuition for a master‘s degree ranges from $30,000 at public universities to $40,000 at private schools. But a graduate degree can be a good investment. PayScale‘s numbers for the median salary earned with its pick for the best five graduate degrees are master‘s in biostatistics, $105,900; master‘s in statistics, $113,700; Ph.D. in computer science, $147,400; Ph.D. in economics, $125,800; and a master‘s in applied math, $124,900. The median salaries for PayScale‘s five worst graduate degrees are $46,600 with a master of fine arts, $48,700 in early childhood education, $59,900 in divinity and elementary education, and $58,200 in reading and literacy.

Source: Fortune, March 21, 2016 a. Why do people with different graduate degrees have different salaries?

The differences in salaries are the result of differences in the demand for and supply of people with different degrees. Different degrees require different skill sets and different amounts of human capital. These differences mean that the value of marginal product and therefore the demand for people with the different degrees can be substantially different. In addition different numbers of students receive degrees in the different subjects because some degrees are high-cost (in terms of time and/or effort) while others are lower cost. This difference means that the supply of people with the different degrees will not be the same.

© 2018 Pearson Education, Inc.

278

CHAPTER 19

b. Draw a graph of the labor C h a p t e r childhood educators to differences in the salaries of these two groups.

markets for Ph.D. economists and early illustrate your explanation of the

Ph.D. economists likely have more human capital and more marketable skills than do Ph.D early childhood educators, so the demand for Ph.D. economists is greater than the demand for Ph.D. early childhood educators. There may be more students receiving Ph.Ds in early childhood education than in economics, in which case the supply of Ph.D. early childhood educators exceeds the supply of Ph.D. economists.

Both these differences are illustrated in Figure 19.10. In the figure the demand curve for Ph.D. economists is labeled DE and lies to the right of the demand curve for Ph.D early childhood educators, labeled DCE. Also in the figure the supply curve of Ph.D early childhood educators, labeled SCE, lies to the right of the supply curve of Ph.D. economists, labeled SE. These different demand and supply curves result in a salary for Ph D. economists of $125,800 and for Ph.D early childhood educators of $48,700.

20 © 2018 Pearson Education, Inc.

UNCERTAINTY AND INFORMATION

276

CHAPTER 20

Answers to the Review Quizzes Page 476 1.

What is the distinction between expected wealth and expected utility?

Expected wealth is the money value of what a person expects to own at a point in time. Expected utility is the utility value of what a person expects to own at a point in time. These concepts both measure the value of what a person expects to own at a point in time but they differ because expected wealth is the money value and expected utility is the utility value.

2.

How does the concept of utility of wealth capture the idea that pain of loss exceeds the pleasure of gain?

The utility of wealth has diminishing marginal utility. Diminishing marginal utility means that the decrease in utility from a dollar decrease in wealth, that is, the pain of loss, is greater than the increase in utility from a dollar increase in wealth, that is, the pleasure of gain.

3.

What do people try to achieve when they make a decision under uncertainty?

When making decisions under uncertainty people maximize their expected utility.

4.

How is the cost of risk calculated when making a decision with an uncertain outcome?

A decision made with uncertainty has an expected wealth and an expected utility that depend on the probability, wealth, and utility associated with the different outcomes. Because people are risk averse, the amount of certain wealth that creates the utility equal to the expected utility in the uncertain case is less than the expected wealth in the uncertain case. The difference between the expected wealth in the uncertain case and the certain wealth that creates the same level of utility is the cost of risk.

Page 479 1.

How does insurance reduce risk?

Insurance reduces the risk any individual faces because insurance pools risks. Everyone pays into the pool but only the small fraction of people who suffer a loss are paid from the pool. Essentially people reduce the risk of a large adverse financial outcome in exchange for the small, certain payment to the insurance company.

2.

How do we determine the value (willingness to pay) for insurance?

The amount that someone would be willing to pay to avoid risk is measured using the person’s utility of wealth schedule or curve. The important feature of the curve is that the marginal utility of wealth diminishes as wealth increases. The rate at which the marginal utility of wealth declines determines the degree of the individual’s risk aversion, that is, how much he or she is willing to pay to avoid risk.

© 2018 Pearson Education, Inc.

UNCERTAINTY AND INFORMATION277

Suppose a person faces the risky situation of receiving wealth of W1 (with utility of U 1 ) or a smaller amount, W 2 (with utility of U 2 ).

The expected wealth from this situation is EW, and the expected utility is EU. This risky situation has the same utility as receiving some amount of certain wealth, W. The difference in wealth between the risky high level of wealth and the sure case, W1 – W, measures the value of insurance in this situation to this individual. The more rapidly the marginal utility of wealth declines, the more risk averse is the person because the more wealth the individual is willing to give up to guarantee a certain (albeit lower) amount of wealth. That is, the more concave the utility of wealth curve, the less is the certain wealth that has the same utility as the expected utility from an uncertain, risky outcome.

3.

How can an insurance company offer people a deal worth taking? Why do both the buyers and the sellers of insurance gain?

Insurance companies work by pooling risks so that everyone pays into the pool but only the (small) fraction of people who suffer a loss are paid from the pool. Although the likelihood of a bad occurrence is small for each individual, for a large enough group the total number and total amount of losses can be estimated very closely. The insurance company can calculate the size of the pool required to cover losses. From this calculation the company can compute the amount of the premium each person must pay into the pool to cover all the anticipated losses and other costs the company incurs.

People buy insurance because they are risk averse; they want to avoid unwanted outcomes. Insurance is worth buying because people are willing to give up a relatively small amount of income all the time to guarantee that they do not face the uncommon occurrence of having to give up a large amount of income since this deal increases their expected utility. An insurance company will always try to take in more in premiums paid than claims paid out to claimants so that their owners receive at minimum a normal profit.

4.

What kinds of risks can‘t be insured?

Insurance works because the risks of adverse outcomes are independent, that is, one person suffering a loss does not affect the likelihood that other people will suffer similar losses. If the losses from an event are not independent, so that ―everyone‖ suffers a loss at the same time, then the risk of loss cannot be insured.

Page 484 1.

How does private information create adverse selection and moral hazard?

Both moral hazard and adverse selection are the result of private information. Moral hazard occurs when, after an agreement has been reached, one of the parties to the agreement has the incentive to gain additional benefits at the expense of the other party. Adverse selection refers to people who accept certain contracts and have private information that allows them to benefit from the contract

© 2018 Pearson Education, Inc.

278

CHAPTER 20

while harming the other party. Both moral hazard and adverse selection can affect negatively the way in which markets function.

2.

How do markets for cars use warranties to cope with private information?

Warranties serve to limit the adverse selection and moral hazard problems in the market for cars. Essentially, warranties (and guarantees in general) are signals provided to potential buyers that the product under consideration has been examined by experts and is a high-quality item. Without the existence of these signals, the lemon problem, whereby only low-quality products are offered for sale, may occur because buyers realize that all sellers claim that they are selling high-quality goods but that adverse selection implies that the goods sold are of low quality.

3.

How do markets for loans use signaling and screening to cope with private information?

Lenders in the loans market want to separate high-risk borrowers from low-risk borrowers so that they can charge high-risk borrowers a high interest rate and low-risk borrowers a low interest rate.

They use signals and screens to help them do so. They screen borrowers by asking for information that helps them assess the riskiness of the loan and the borrower. If the borrower does not reveal the information requested, the lender has screened the borrower into the high-risk category. The information requested will provide signals about the borrower’s riskiness. For instance, if a borrower has defaulted on debt in the past this fact signals that the borrower is a high-risk individual.

4.

How do markets for insurance use no-claim bonuses to cope with private information? ―No-claim‖ bonuses are commonly used in auto insurance. One of the most important pieces of information a person can give an auto insurance company is his or her propensity to drive safely and avoid accidents. However, this information is only believable to the extent that driving records really do differentiate good drivers from bad drivers. Driving records cover only a short period of time and, randomly, some bad drivers will establish good records. So a good driving record is not a guarantee that the driver is a safe driver. The screening device that insurance companies use to overcome this potential problem is the ―no-claim‖ bonuses that drivers accumulate when they do not make an insurance claim.

Presumably, having not made a claim means that you were a good driver and did not need to make a claim!

Page 485 1.

Thinking about information as a good, what determines the information people are willing to pay for?

People are willing to pay for information so long as the marginal cost is less than or equal to its marginal benefit. For instance, consumers are willing to purchase information that has a marginal benefit to them that exceeds the price they must pay. Consumers might be willing to purchase information about the price(s) of large-ticket goods and services that are of interest. Workers might well be interested in buying information about salaries paid in © 2018 Pearson Education, Inc.

UNCERTAINTY AND INFORMATION279

occupations that interest them or salaries paid their co-workers.

Employers are willing to buy information about the average salary offer given to college graduates with different majors.

2.

Why is it inefficient to be overinformed?

Information is costly to obtain. If the marginal cost of obtaining the information exceeds its marginal benefit, the individual would be better off by not obtaining the information. It is inefficient to acquire the information because the marginal benefit from the information does not make up for the marginal cost of obtaining it.

3.

Why are some of the markets that provide information likely to be dominated by monopolies?

Objective information about, say, the quality of a good or service or the risk associated with a particular activity is costly to obtain. Once it is obtained, however, the marginal cost of disseminating it is low. With the low marginal cost, the firm can enjoy significant economies of scale, so these markets might be close to natural monopolies, that is, a market in which one firm can meet the demand at lower cost than could two or more firms.

© 2018 Pearson Education, Inc.

280

CHAPTER 20

Answers to the Study Plan Problems a nd Applications 1.

The figure shows Lee‘s utility of wealth curve. Lee is offered a job as a salesperson in which there is a 50 percent chance that she will make $4,000 a month and a 50 percent chance that she will make nothing. a. What is Lee‘s expected income from taking this job?

Lee’s expected income is (0.5  $4,000) + (0.5  $0) = $2,000 a month.

b. What is Lee‘s expected utility from taking this job?

When Lee’s income is $4,000, her utility is 100. When Lee’s income is $0, her utility is 0.

So Lee’s expected utility is (0.5  100) + (0.5  0) = 50.

c. How much would another firm have to offer Lee with certainty to persuade her not to take the risky sales job?

Lee would have to be offered about $1,250 a month with certainty to persuade her not to take the risky job. Lee would have to be offered the income that would give her with certainty 50 units of utility.

This income, $1,250, is read from the graph at the 50 units on the y-axis.

d. What is Lee‘s cost of risk?

Lee’s cost of risk is the difference between Lee’s expected income, $2,000, and the certain income that gives her the same total utility, $1,250. Lee’s cost of risk is $750.

Use the following news clip to work Problems 2 and 3.

Larry lives in a neighborhood in which 20 percent of the cars are stolen every year. Larry‘s car, which he parks on the street overnight, is worth $20,000. (This is Larry‘s only wealth.) The table shows Larry‘s utility of wealth schedule.

2.

If Larry cannot buy auto theft insurance, what is his expected wealth and his expected utility?

Larry’s expected wealth is $20,000 × 0.80 + $0 × 0.20, which is $16,000. Larry’s expected utility is 400 × 0.80 + 0 × 0.20, or 320.

3.

Wealth (dollars) 20,000 16,000 12,000 8,000 4,000

Utility (units) 400 350 280 200 110 0

0

High-Crime Auto Theft, an insurance company, offers to sell Larry insurance at $8,000 a year and promises to provide Larry with a replacement car worth $20,000 if his car is stolen. Is Larry willing to buy this insurance? If not, is he willing to pay $4,000 a year for such insurance?

If Larry buys the insurance for $8,000 his wealth will be $12,000 with no risk. This amount of wealth gives him utility of 280. This © 2018 Pearson Education, Inc.

UNCERTAINTY AND INFORMATION281

amount of utility is less than what his utility would be if he did not buy insurance, so Larry will not buy the insurance for $8,000.

If Larry buys the insurance for $4,000 his wealth will be $16,000 with no risk. This amount of wealth gives him utility of 350. This amount of utility is more than what his utility would be if he did not buy insurance, so Larry will buy the insurance for $4,000.

4.

Suppose that there are three national soccer leagues: Time League, Goal Difference League, and Bonus for Win League. The leagues are of equal quality, but the players are paid differently.

Players in the Time League are paid by the hour for time spent practicing and playing. Players in the Goal Difference league are paid an amount that depends on the goals scored by the team minus the goals scored against it. Players in the Bonus for Win League are paid one wage for a loss, a higher wage for a tie, and the highest wage of all for a win. a. Describe the predicted differences in the quality of the games played by each of the leagues.

In the Time League, players have no incentive to play hard or to win the game. In this league the games are likely to be dull, drawn out, low quality affairs with players not playing particularly hard. In the Goal Difference League, the players have the incentive to play as hard as possible throughout the game to score as many goals as possible. These games are likely to be action-oriented, high quality games. In the Bonus for Win League the players have an incentive to play hard but not as hard as in the Goal Difference League. For instance, if one team is ahead by a couple of points near the end of the game, the players on that team have the incentive to shirk as long as the other team does not tie or win the game. So these games will be medium quality.

b. Which league is the most attractive to players?

Assuming that the average salaries are the same, if players are risk averse then the Time League is most attractive.

c. Which league will generate the largest profits?

If fans like action packed games and if the average salary is the same in all leagues, then the Goal Difference League will attract the most fans and be the most profitable.

5.

You can‘t buy insurance against the risk of being sold a lemon. Why isn‘t there such a market?

How does the market provide a buyer with some protection against being sold a lemon? What are the main ways in which markets overcome the lemons problem?

There is not a market for ―lemon insurance‖ for several reasons.

Defining a ―lemon‖ is far from clear cut. The definition would need to be specified in the contract. But that leads to a moral hazard problem because a buyer with a car close to meeting the requirements for a lemon will behave in a way that increases the probability that the car will be deemed a lemon. Moral hazard also arises once the insurance is purchased but before the car is bought. Once the customer has the insurance, he or she will no longer search for a ―non-lemon,‖ a creampuff. So it is likely that many of the cars purchased by people with the insurance will be lemons. These reasons combine to make it impossible for an insuring company to offer the insurance at a price that customers will pay and that allows the © 2018 Pearson Education, Inc.

282

CHAPTER 20

insurance firm to make a profit. Adverse selection also enters because people who are less likely to spend time searching for a high-quality car are more likely to buy the lemon insurance.

Even without insurance, the market does give protection against lemons. Warranties are designed to help cope with the moral hazard and adverse selection problems on cars. Warranties signal that the car is not a lemon because if the car is a lemon servicing the car would be costly. The fact that the seller, who is the person with the private information, is willing to offer a warranty signals that the car is not a lemon.

6.

When You Find Out a Coworker Makes More Money than You Do In most organizations, pay information is private information. But sometimes a person stumbles on information about the amount a colleague is paid and might be able to use that information skillfully to get a bigger pay raise.

Source: Harvard Business Review, March 7, 2016 Explain why a worker might be willing to pay for the salary information of other workers.

A worker could demand a higher salary by comparing his or her pay with that of a (perceived) less valuable colleague. The worker would be willing to pay for the salary information if the marginal cost of obtaining the information is less than or equal to the marginal benefit from obtaining it.

© 2018 Pearson Education, Inc.

UNCERTAINTY AND INFORMATION283

Answers to Additional Problems and Applications Use the table, which shows Jimmy‘s and Zenda‘s utility of wealth schedules, to work Problems 7 to 9.

7.

What are Jimmy‘s and Zenda‘s expected utilities from a bet that gives them a 50 percent chance of having a wealth of $600 and a 50 percent chance of having nothing?

Jimmy’s expected utility is (0.5 393) + (0.5  0) = 196.5. Zenda’s expected utility is (0.5  683) + (0.5  0) = 341.5.

8. a. Calculate Jimmy‘s and Zenda‘s marginal utility of wealth schedules.

The table to the right sets out their marginal utility of wealth schedules.

b. Who is more risk averse, Jimmy or Zenda? How do you know?

Wealth 0

Jimmy’s utility 0

100

200

200

300

300

350

400

375

500

387

Wealth 0 100 200 300 400 500 600 700

Jimmy’s utility 0 200 300 350 375 387 393 396

Zenda’s utility 0 512 640 672 678 681 683 684

Jimmy’s Zenda’s marginal Zenda’s marginal utility utility utility 0 2.00 5.12 512 1.00 1.28 640 0.50 0.32 672 0.25 0.06 678 0.12 0.03 681 0.06 0.02 683 0.03 0.01 684

Zenda is more 600 393 risk averse because her 700 396 marginal utility of wealth decreases more quickly as wealth increases than does Jimmy’s marginal utility of wealth.

9.

Suppose that Jimmy and Zenda each have $400 and are offered a business investment opportunity that involves committing the entire $400 to the project. The project could return $600 (a profit of $200) with a probability of 0.85 or $200 (a loss of $200) with a probability of 0.15. Who goes for the project and who hangs on to the initial $400?

Jimmy puts his money into the project, but Zenda does not. Jimmy maximizes his expected utility. If Jimmy puts his money into the project and it makes a profit, his utility is 393; if Jimmy puts his money into the project and it fails, his utility is 300. So Jimmy’s expected utility from the project is (0.85  393) + (0.15  300), which equals 379. If Jimmy keeps his $400 and does not join the project, his utility is 375. Jimmy will choose to join the project because joining gives him greater utility. Zenda maximizes her expected utility. If Zenda puts her money into the project and it © 2018 Pearson Education, Inc.

284

CHAPTER 20

makes a profit, her utility is 683; if Zenda puts her money into the project and it fails, her utility is 640. So Zenda’s expected utility from the project is (0.85  683) + (0.15  640), which equals 677. If Zenda keeps her $400 and does not join the project, her utility is 678. Zenda will choose not to join the project because not joining gives her greater utility.

© 2018 Pearson Education, Inc.

UNCERTAINTY AND INFORMATION285

Use the following information to work Problems 10 to 12.

Two students, Jim and Kim, are offered summer jobs managing a student house-painting business.

There is a 50 percent chance that either of them will be successful and end up with $21,000 of wealth to get them through the next school year. But there is also a 50 percent chance that either will end up with only $3,000 of wealth.

Each could take a completely safe but back-breaking job picking fruit that would leave them with a guaranteed $9,000 at the end of the summer. The table shows Jim‘s and Kim‘s utility of wealth schedules.

10.

Does anyone take the painting job? If so, who takes it and why? Does anyone take the job picking fruit?

If so, who takes it and why?

Wealth 0 3,000 6,000 9,000 12,000 15,000 18,000 21,000

Jim’s utility 0

Kim’s utility 0

100 200 298 391 482 572 660

200 350 475 560 620 660 680

Jim will take the painting job. If Jim takes the job managing the house painters, his expected utility is 0.5 × 660 + 0.5 × 100, which is 380. If Jim takes the job picking fruit, his expected (and actual) utility is 298. Jim will take the job managing the house painters because his expected utility from that job is larger than his expected utility from picking fruit.

Kim will take the fruit-picking job. If Kim takes the job managing the house painters, her expected utility is 0.5 × 680 + 0.5 × 200, which is 440. If Kim takes the job picking fruit, her expected (and actual) utility is 475. Kim will take the picking fruit because her expected utility from that job is larger than her expected utility from managing the house painters.

11.

In Problem 10, what is each student‘s maximized expected utility? Who has the larger expected wealth? Who ends up with the larger wealth at the end of the summer?

Jim’s expected utility is 380; Kim’s expected utility is 475. Jim has higher expected wealth. Jim’s expected wealth is $12,000; Kim’s expected (and actual) wealth is $9,000. It is not possible to determine who has the actual larger wealth because Jim’s wealth is uncertain.

12.

In Problem 10, if one of the students takes the risky job, how much more would the fruit-picking job have needed to pay to attract that student?

Jim takes the risky job. His expected utility with the risky job is 380. The fruit picking job must offer pay that gives Jim utility of more than 380. If the fruit picking job paid $12,000, Jim’s utility would be 391 and he would take the fruit picking job. So to entice Jim to take the fruit picking job, it would need to pay $3,000 more than its current payment of $9,000.

© 2018 Pearson Education, Inc.

286

CHAPTER 20

Use the table, which shows Chris‘s utility of wealth schedule, to work Problems 13 and 14.

Chris‘s wealth is $5,000 and it consists entirely of her share in a risky ice cream business. If the summer is cold, the business will fail, and she will have no wealth. Where Chris lives there is a 50 percent chance each year that the summer will be cold.

13.

If Chris cannot buy cold-summer insurance, what is her expected wealth and what is her expected utility?

Wealth (dollars) 5,000 4,000 3,000 2,000 1,000 0

Utility (units) 150 140 120 90 50 0

Chris’s expected wealth is $5,000 × 0.50 + $0 × 0.50, which is $2,500. Her expected utility is 150 × 0.50 + 0 × 0.50, which is 75.

© 2018 Pearson Education, Inc.

UNCERTAINTY AND INFORMATION287

14.

Business Loss Recovery, an insurance company, is willing to sell Chris cold-summer insurance at a price of $3,000 a year and promises to pay her $5,000 if the summer is cold and the business fails. Is Chris willing to buy this loss insurance? If she is, is she willing to pay $4,000 a year for it?

If Chris buys the insurance for $3,000 her wealth will be $2,000 with no risk. This amount of wealth gives her utility of 90, which is more than what her utility would be if she did not buy insurance.

Chris will buy the insurance for $3,000.

If Chris buys the insurance for $4,000 her wealth will be $1,000 with no risk. This amount of wealth gives her utility of 50, which is less than what her utility would be if she did not buy insurance.

Chris will not buy the insurance for $4,000.

Use the following information to work Problems 15 to 17.

Larry has a good car that he wants to sell; Harry has a lemon that he wants to sell. Each knows what type of car he is selling. You are looking at used cars and plan to buy one.

15.

If both Larry and Harry are offering their cars for sale at the same price, from whom would you most want to buy, Larry or Harry, and why?

If you know that Larry’s car is a good car and Harry’s car is a lemon, you most want to buy from Larry. If you do not know that Larry’s car is a good car and Harry’s car is a lemon, you are indifferent between the two.

16.

If you made an offer of the same price to Larry and Harry, who would sell to you and why?

Describe the adverse selection problem that arises if you offer the same price to Larry and Harry.

The price offered will be the price for which a lemon sells. Harry, who has a lemon, will be willing to sell at that price; Larry, who has a good car, will not be willing to sell. The adverse selection problem that arises is that only sellers with lemons are willing to sell their cars at the going (lemon) price.

17.

How can Larry signal that he is selling a good car so that you are willing to pay Larry the price that he knows his car is worth, and a higher price than what you are willing to offer Harry?

Larry can offer a warranty on his car. For instance, Larry might offer to pay any repair bills (aside from accidents!) that come about for the next 6 months.

18.

Pam is a safe driver and Fran is a reckless driver. Each knows what type of driver she is, but no one else knows. What might an automobile insurance company do to get Pam to signal that she is a safe driver so that it can offer her insurance at a lower premium than it offers to Fran?

One possibility is to offer insurance with a higher deductible at a lower cost. Pam knows that she is less likely to need the insurance, so she is willing to accept the higher deductible to save on the insurance premiums. Fran knows that she is more likely to use the insurance, so she is not interested in a high deductible. Fran is more likely to pay the higher insurance premiums to have the low deductible.

19.

Why do you think it is not possible to buy insurance against having to put up with a low-paying, © 2018 Pearson Education, Inc.

288

CHAPTER 20

miserable job? Explain why a market in insurance of this type would be valuable to workers but unprofitable for an insurance provider and so would not work.

Insurance against a low-paying job is not available because of moral hazard and adverse selection. In particular, the moral hazard exists that once someone purchased this type of insurance, the person could then take a low-paying job that he or she, for some reason, enjoyed.

The person could then easily document that the job is low-paying and could also (falsely) assert the job was miserable and thereby collect on the insurance. Adverse selection also makes the insurance unlikely because the people most likely to wind up with low-paying jobs are the most likely to buy the insurance, whereas people who are most likely to wind up with high-paying jobs are least likely to buy the insurance.

Use the following news clip to work Problems 20 and 21.

Why We Worry About the Things We Shouldn’t … and Ignore the Things We Should We pride ourselves on being the only species that understands the concept of risk, yet we have a confounding habit of worrying about mere possibilities while ignoring probabilities, building barricades against perceived dangers while leaving ourselves exposed to real ones: 20% of all adults still smoke; nearly 20% of drivers and more than 30% of backseat passengers don‘t use seat belts; two thirds of us are overweight or obese. We dash across the street against the light and build our homes in hurricane-prone areas—and when they‘re demolished by a storm, we rebuild in the same spot.

Source: Time, December 4, 2006 20.

Explain how ―worrying about mere possibilities while ignoring probabilities‖ can result in people making decisions that not only fail to satisfy social interest, but also fail to satisfy selfinterest.

By ―worrying about mere possibilities while ignoring probabilities,‖ society sometimes devotes its scarce resources in ways that do not make people as well off as possible. In particular resources devoted to preventing mad cow pathogen might be better utilized to fight cholesterol. Similarly individuals can make decisions that do not advance their well being. For instance, a person’s decision to eat less beef to reduce the chances of catching mad cow disease while continuing to smoke and not use seat belts ignores the probabilities of these latter two actions while focusing on the probability of the first decision.

21.

How can information be used to improve people‘s decision making?

Information can improve people’s decision making by providing them with data about the potential outcomes of their decisions. With this information readily at hand, the marginal benefit and marginal cost of actions can be more readily determined. Related to the news clip, with more information people might worry less about mere possibilities and pay more attention to probabilities, thereby making better decisions so that society is more efficient.

© 2018 Pearson Education, Inc.

UNCERTAINTY AND INFORMATION289

Economics in the News 22.

After you have studied Economics in the News on pp. 486–487, answer the following questions. a. What information do accurate grades provide that grade inflation hides?

Accurate grades provide valuable information about the student’s productivity and the extent of the student’s skill base. High grades would be correlated with high skills and high ability so that these students would be sorted into higher paying jobs immediately upon graduation. Of course, this result also means that students with lesser skills are sorted in lower paying jobs immediately upon graduation.

b. With grade inflation being widespread in high schools, colleges, and universities, what new arrangements do you predict are providing better information about student ability?

A student’s class ranking, for instance, 23rd out of a class of 300, can become more important. Standardized tests administered across groups of students also can gain in importance.

c. Do you think grade inflation is in anyone‘s self-interest? Explain who benefits and how they benefit from grade inflation.

The people who benefit from grade inflation are the students who first received inflated grades. At this time potential employers and graduate schools were unaware that higher grades were commonplace and so assigned more informational content to the high grades than was justified.

d. How do you think grade inflation might be controlled?

Grade inflation could be controlled if the university put limits on the number of high grades that can be assigned in a class.

23.

How to Get Paid What You’re Worth To get paid what you are worth you must be able and willing to stand up for your value, break away from the HR wall chart, break free from low pre-set annual pay increases, negotiate, be willing to say ‗no‘, and quit. To get hired and paid what you‘re worth, first compare your pay with that on Salary.com and Payscale.com, but remember these data are averages of what employers are paying people who share your job title. Your real key to success is to discover what is paining the hiring manager and let her or him talk about the pain. Talk about him or her and his or her problems! That‘s how you‘ll get the hiring manager‘s attention.

Source: Forbes, August 7, 2015 a. Explain the role of asymmetric information in the situation described in the news clip.

The point that the worker does not know the maximum a hiring agent is willing to pay is an important piece of asymmetric information.

The news clip offers advice about how a worker can negotiate a wage that is higher, up to the maximum the firm is willing to offer.

b. What adverse selection problem exists in the advice given in the news clip?

The essential advice of the news clip is to be empathetic and attempt to befriend the hiring manager. If the job seeker succeeds, the hiring manager is more likely to offer the person a wage that is closer to the highest that the firm will pay or perhaps even tell him or her the maximum and then offer it. This result reflects a potential adverse selection problem for the firm. The firm wants to © 2018 Pearson Education, Inc.

290

CHAPTER 20

hire productive workers, not necessarily sympathetic or friendly workers. But if workers take the advice in the news clip, the firm will be more likely to hire empathetic workers regardless of their productivity.

c. How would public information about everyone‘s wage rate change the adverse selection that arises?

With public information about everyone’s wages, job seekers can better infer the maximum a firm will pay and so no longer need to attempt to befriend the hiring manager to gain this important bit of information. Additionally, the hiring manager knows that if he or she pays a high wage to a particularly friendly but low productivity worker, this fact will quickly become known, which may cost the hiring manager his or her position. Both of these effects diminish the adverse selection problem that the hiring manager will offer high wages to particularly sympathetic job seekers.

© 2018 Pearson Education, Inc.