Solution Manual For Microeconomics 16CE Campbell R. McConnell, Stanley L. Brue, Sean Masaki Flynn, T

Solution Manual For Microeconomics 16CE Campbell R. McConnell, Stanley L. Brue, Sean Masaki Flynn, Tom Barbiero Chapter 1-19

Chapter 01 - Limits, Alternatives, and Choices McConnell Brue Flynn, Barbiero Macro 16ce DISCUSSION QUESTIONS 1. What is an opportunity cost? How does the idea relate to the definition of economics? Which of the following decisions would entail the greater opportunity cost: Allocating a square block in the heart of Toronto for a surface parking lot or allocating a square block at the edge of a typical suburb for such a lot? Explain. LO1.2

Answer: An opportunity cost is what was sacrificed to do or acquire something else. The condition of scarcity creates opportunity cost. If there was no scarcity, there would be no need to sacrifice one thing to acquire another.

The opportunity cost would be much higher in Toronto as the alternative uses for that square block are much more valuable than for a typical suburban city block.

2. Cite three examples of recent decisions that you made in which you, at least implicitly, weighed marginal cost and marginal benefit. LO1.2

Answer: Student answers will vary, but may include the decision to come to class, to skip breakfast to get a few extra minutes of sleep, to attend college, or to make a purchase. Marginal benefits of attending class may include the acquisition of knowledge, participation in discussion, and better preparation for an upcoming examination.

Marginal costs may include lost opportunities for sleep, meals, or studying for other classes. In evaluating the discussion of marginal benefits and marginal costs, be careful to watch for sunk costs offered as a rationale for marginal decisions.

3. What is ―utility‖ and how does the idea relate to purposeful behaviour? LO1.2

Answer: ―Utility‖ refers to the pleasure, happiness, or satisfaction gained from engaging in an activity (eating a meal, attending a ball game, etc.). It is an important component of

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purposeful behaviour because people will allocate their scarce time, energy, and money in an attempt to gain the most utility possible.

4. What are the key elements of the scientific method and how does this method relate to economic principles and laws? LO1.3

Answer: The key elements include the gathering of data (observation), the formulation of possible explanations (hypothesis), testing the hypothesis, determining the validity of the hypothesis, and repeated testing of hypotheses that have appeared to be valid in prior tests.

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

5. Make (a) a positive economic statement of your choice, and then (b) a normative economic statement relating to your first statement. LO1.4

Answer: Student answers will vary. Example: (a) The unemployment rate is 6.8 percent; (b) the unemployment rate is too high. In general, we treat ―what is‖ statements as positive, ―what should be‖ as normative, but keep an eye out for statements like ―at full employment an increase in the production of pizzas should come at the cost of less robots.‖ Some students may incorrectly identify the statement as normative because of the term ―should.‖

6. How does the slope of a budget line illustrate opportunity cost and trade-offs? How does a budget line illustrate scarcity and the effect of limited incomes? LO1.5

Answer: Budget lines are always sloped downward. This downward slope shows an inverse relationship between the two goods, meaning that as you increase one, the other must decrease. This decrease is what you are giving up, or opportunity cost, of the good you are getting more of.

Budget lines illustrate scarcity in that they show you are limited by your income. Since they slope downward, they show you cannot keep getting more and more of both goods.

There is always a trade-off. The area beyond the budget line represents combinations of the goods that are beyond your income.

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7. What are economic resources? What categories do economists use to classify them? Why are resources also called factors of production? Why are they called inputs? LO1.6

Answer: Economic resources are the natural, human, and manufactured inputs used to produce goods and services. Economic resources fall into four main categories: labour, land (natural resources), real capital (machines, factories, buildings, etc.,) and entrepreneurs. Economic resources are also called factors of production because they are used to produce goods and services. They are called inputs because they go in to a production process (like ingredients go into a bowl to make a cake), with the resulting goods and services also being referred to as output.

8. Why is money not considered to be a capital resource in economics? Why is entrepreneurial ability considered a category of economic resource, distinct from labour? What are the major functions of the entrepreneur? LO1.6

Answer: Money is not considered a capital resource because money is not productive – it provides access to resources but itself does not directly contribute to the production of goods and services. Additionally, the quantity of money in circulation does not determine an economy‘s productive capacity, while the amount of capital and other resources does.

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

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

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

9. Specify and explain the typical shapes of marginal-benefit and marginal-cost curves. How are these curves used to determine the optimal allocation of resources to a particular product? If 1-3 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

current output is such that marginal cost exceeds marginal benefit, should more or fewer resources be allocated to this product? Explain. LO1.7

Answer: The marginal benefit curve is downward sloping; MB falls as more of a product is consumed because additional units of a good yield less satisfaction than previous units.

The marginal cost curve is upward sloping, MC increases as more of a product is produced since additional units require the use of increasingly unsuitable resource. The optimal amount of a particular product occurs where MB equals MC. If MC exceeds MB, fewer resources should be allocated to this use, as the additional cost is more than the additional benefit.

10. Suppose that, on the basis of a nation‘s production possibilities curve, an economy must sacrifice 10,000 pizzas domestically to get the 1 additional industrial robot it desires but that it can get the robot from another country in exchange for 9,000 pizzas. Relate this information to the following statement: ―Through international specialization and trade, a nation can reduce its opportunity cost of obtaining goods and thus ‗move outside its production possibilities curve.‘‖ LO1.8

Answer: The message of the production possibilities curve is that an individual nation is limited to the combinations of output indicated by its production possibilities curve.

International specialization means directing domestic resources to output which a nation is highly efficient at producing. International trade involves the exchange of these goods for goods produced abroad. Specialization and trade have the same effect as having more and better resources or discovering improved production techniques. The output gains from greater international specialization and trade are the equivalent of economic growth.

LAST WORD Starbucks has $1 billion to invest. It can either purchase a rival coffee shop chain or build additional Starbucks shops. If Starbucks chooses to purchase the rival chain, what does that say about the relative profitability of purchasing and owning the rival‘s existing shops versus building additional Starbucks shops? Explain.

Answer: If Starbucks made the decision to invest the $1 billion by purchasing a rival chain rather than building additional Starbucks shops, we can assume that Starbucks' management had made a careful comparison of the marginal costs and marginal benefits of each option and found that the net marginal benefit (or profitability) of purchasing the rival chain to be 1-4 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

higher. Of course, the management team also determined that expected marginal benefits exceeded marginal costs. Otherwise, it would not make sense to pursue either option because they would be unprofitable.

REVIEW QUESTIONS

1. Match each term with the correct definition. LO1.2 economics opportunity cost marginal analysis utility

a. The next-best thing that must be foregone in order to product one more unit of a given product. b. The pleasure, happiness, or satisfaction obtained from consuming a good or service. c. The social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity. d. Making choices based on comparing marginal benefits with marginal costs.

Answer: a. opportunity cost; b. utility; c. economics; d. marginal analysis

2. Indicate whether each of the following statements applies to microeconomics or macroeconomics: LO1.3 a. The unemployment rate in Canada was 5.9 percent in January 2018. b. A software firm discharged 15 workers last month and transferred the work to India. c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of oranges to rise. d. Canadian output, adjusted for inflation, increased by 3.0 percent in 2017. e. Last week ScotiaBank lowered its interest rate on business loans by one-half of 1 percentage point. f. The consumer price index rose by 1.7 percent from January 2017 to January 2018.

Answer: a. macro; b. micro; c. micro; d. macro; e. micro; f. Macro

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3. Suppose that you initially have $100 to spend on books or movie tickets. The books start off costing $25 each and the movie tickets start off costing $10 each. For each of the following situations, would the attainable set of combinations that you can afford increase or decrease?

LO1.5 a. Your budget increases from $100 to $150 while the prices stay the same. b. Your budget remains $100, the price of books remains $25, but the price of movie tickets rises to $20. c. Your budget remains $100, the price of movie tickets remains $10, but the price of a book falls to $15.

Answer: a. increase because a larger budget allows you to purchase not only the combinations that you could afford before but also new combinations that you could not afford before (for example, you can now afford to purchase 4 books and 5 movie tickets); b. decrease because certain combinations are no longer affordable (for example, you can no longer purchase 10 movie tickets with your $100 budget); c. increase because the lower price allows you to purchase combinations that you could not afford before (for example, you can now purchase 6 books and 1 movie ticket)].

4. Suppose that you are given a $100 budget at work that can be spent only on two items: staplers and pens. If staplers cost $10 each and pens cost $2.50 each, then the opportunity cost of purchasing one stapler is: LO1.5 a. 10 pens. b. 5 pens. c. zero pens. d. 4 pens.

Answer: 4 pens. You must forego purchasing 4 pens if you are to free up enough money (4 x $2.50 = $10) to purchase a stapler.

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5. For each of the following situations involving marginal cost (MC) and marginal benefit (MB), indicate whether it would be best to produce more, fewer, or the current number of units. LO1.5

a. 3,000 units at which MC = $10 and MB = $13. b. 11 units at which MC = $4 and MB = $3. c. 43,277 units at which MC = $99 and MB = $99. d. 82 units at which MC < MB. e. 5 units at which MB < MC. Answer: a. more because MB > MC -- the benefit of consuming one more unit exceed the opportunity costs (scarce resources used elsewhere) of producing that additional unit. b. fewer because MC > MB -- the opportunity costs (scarce resources used elsewhere) of producing one more unit exceed the benefit of consuming that additional unit. c. current amount because MB = MC -- there is no net gain in using scarce resources in producing and consuming one more unit. d. more because MB > MC -- see the explanation for part (a) e. fewer because MB < MC -- see the explanation for part (b) 6. Explain how (if at all) each of the following events affects the location of a country‘s production possibilities curve: LO1.7 a. The quality of education increases. b. The number of unemployed workers increases. c. A new technique improves the efficiency of extracting copper from ore. d. A devastating earthquake destroys numerous production facilities.

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

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7. What are the two major ways in which an economy can grow and push out its production possibilities curve? LO1.8 a. Better weather and nicer cars. b. Higher taxes and lower spending. c. Increases in resource supplies and advances in technology. d. Decreases in scarcity and advances in auditing.

Answer: c. The economy produces output from resource inputs like land, labour, and capital. So one major way for an economy to grow and push out its production possibilities curve is for it to obtain more resources.

The second major way is to develop new and better technologies so that the economy can produce more from any given amount of resources.

PROBLEMS

1. Potatoes cost Janice $1 per kilogram, and she has $5.00 that she could possibly spend on potatoes or other items. If she feels that the first kilogram of potatoes is worth $1.50, the second kilogram is worth $1.14, the third kilogram is worth $1.05, and all subsequent kilograms are worth $0.30, how many kilograms of potatoes will she purchase? What if she only had $2 to spend? LO1.2

Answer: 3; 2

Feedback: Janice will purchase potatoes until the value of potatoes is less than the cost of potatoes or until her income has been exhausted. For example, assume Janice has $5.00 to spend on potatoes or other items and the cost of a kilogram of potatoes is $1.

Now assume the first kilogram of potatoes is worth $1.50 to Janice. She will purchase this kilogram of potatoes since the value of the kilogram of potatoes ($1.50) is greater than the cost ($1). If the second kilogram is worth $1.14 and the third kilogram is worth a $1.05 then Janice will purchase these as well since the value exceeds the cost of $1. If all remaining kilograms are worth $0.30 then Janice will not purchase these because the value is less than the cost. So, Janice will purchase 3 kilograms of potatoes at total cost of $3.00.

Now assume Janice only has $2.00 to spend on potatoes. She will purchase the first kilogram because it is worth $1.50 to her and it only costs a $1. She will purchase the second kilogram because it is worth $1.14. She has now spent her entire income on 1-8 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

potatoes. She would like to purchase the third kilogram because the value of this kilogram of potatoes is $1.05, but she does not have the income to make this purchase.

So, Janice will purchase 2 kilograms of potatoes at a total cost of $2.00.

2. Pham can work as many or as few hours as she wants at the university bookstore for $9 per hour. But due to her hectic schedule, she has just 15 hours per week that she can spend working at either the bookstore or at other potential jobs. One potential job, at a café, will pay her $12 per hour for up to 6 hours per week. She has another job offer at a garage that will pay her $10 an hour for up to 5 hours per week. And she has a potential job at a daycare center that will pay her $8.50 per hour for as many hours as she can work. If her goal is to maximize the amount of money she can make each week, how many hours will she work at the bookstore? LO1.2

Answer: 4.

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

For example, assume Pham only has 15 hours per week that she can work and the wage rate at the bookstore is $9 per hour. She can also spend her time working at a café that will pay her $12 per hour for up to 6 hours per week, at a garage that will pay her $10 an hour for up to 5 hours per week, and at a daycare center that will pay her $8.50 per hour for as many hours as she can work.

She will choose to work at the café for the full 6 hours because the wage rate at the café is $12 per hour, which is greater than the wage rate at the bookstore of $9. This leaves her with 9 hours of work time remaining. Next, she will choose to work at the garage for the full 5 hours because the wage rate here is $10, which again is greater than the bookstore wage rate $9. After this decision she only has 4 hours of work time remaining. She will choose to work these last 4 hours at the bookstore because the bookstore wage rate of $9 exceeds the daycare center wage rate of $8.50.

3. Suppose you won $15 on a lotto ticket at the local 7-Eleven and decided to spend all the winnings on candy bars and bags of peanuts. Candy bars cost $0.75 each while bags of peanuts cost $1.50 each. LO1.6

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a. Construct a table showing the alternative combinations of the two products that are available. b. Plot the data in your table as a budget line in a graph. What is the slope of the budget line?

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

Answers: Part a: Consumption alternatives Goods

A

B

C

D

E

F

Candy bars

0

4

8

12

16

20

Bags of peanuts

10

8

6

4

2

0

Part b:

Bags of Peanuts

Slope 

 .75   .5 1.5

10

20

Candy Bars

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Feedback: The slope for the budget line above, with candy bars on the horizontal axis, is -0.5 (= -Pcb/Pbp). Note that the figure could also be drawn with bags of peanuts on the horizontal axis. The slope of that budget line would be -2.

The opportunity cost of one more candy bar is ½ of a bag of peanuts. The opportunity cost of one more bag of peanuts is 2 candy bars. These opportunity costs are constant.

They can be found by comparing any two of the consumption alternatives for the two goods.

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

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

Part d: Increased.

B ags of P eanuts Incom e = $ 15

20

Income = $30

10

20

40

Candy Bars

Feedback: The budget line at $30 would be preferable because it would allow greater consumption of both goods.

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4. Suppose that you are on a deserted island and possess exactly 20 coconuts. Your neighbour, Friday, is a fisherman, and he is willing to trade 2 fish for every 1 coconut that you are willing to give him. Another neighbour, Kwame, is also a fisherman, and he is willing to trade 3 fish for every 1 coconut. LO1.6 a. On a single figure, draw budget lines for trading with Friday and for trading with Kwame.

(Put coconuts on the vertical axis.) b. What is the slope of the budget line from trading with Friday? c. What is the slope of the budget line from trading with Kwame? d. Which budget line features a larger set of attainable combinations of coconuts and fish? e. If you are going to trade coconuts for fish, would you rather trade with Friday or Kwame?

Answers: Part a:

Part b: -1/2 Feedback: The slope of the budget line from trading with Friday equals -(1/2). This implies that for every coconut I give up, Friday must give up two fish. Or, for every fish that Friday gives up, I must give up (1/2) a coconut.

Part c: -1/3 Feedback: The slope of the budget line from trading with Kwame equals -(1/3). This implies that for every coconut I give up, Kwame must give up three fish. Or, for every fish that Friday gives up, I must give up (1/3) a coconut.

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Part d: The budget line from trading with Kwame Feedback: The budget line from trading with Kwame features a larger set of attainable combinations of coconuts and fish. Because Kwame is willing to give up more fish per coconut, I can consume more of both (assuming I make a trade). This implies that you would prefer to trade with Kwame.

Part e: Kwame Feedback: Because Kwame is willing to give up more fish per coconut, I can consume more of both (assuming I make a trade). This implies that you would prefer to trade with Kwame.

5. Below is a production possibilities table for consumer goods (automobiles) and capital goods (forklifts): LO1.7

a. Show these data graphically. Upon what specific assumptions is this production possibilities curve based? b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift?

Which characteristic of the production possibilities curve reflects the law of increasing opportunity costs: its shape or its length? c. If the economy characterized by this production possibilities table and curve were producing 3 automobiles and 20 forklifts, what could you conclude about its use of its available resources? d. Is production at a point outside the production possibilities curve currently possible? Could a future advance in technology allow production beyond the current production possibilities curve? Could international trade allow a country to consume beyond its current production possibilities curve?

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

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

Feedback: Consider the following example:

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

The cost of producing one more automobile can be found by moving to point D and calculating the number of forklifts given up for the 2 additional automobiles. At point D the economy is producing 12 forklifts, which is a loss of 9 forklifts (moving from C to D) for the 2 additional automobiles. Thus, the cost of 1 more automobile equals 9 (forklifts) divided by 2 (automobiles), or (9/2) = 4.5 forklifts.

The cost of producing one more forklift can be found in an equivalent fashion. First, we will move to point B (from point C). Here we must give up 2 automobiles to get 6

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forklifts. Thus, the cost of 1 more forklift equals 2 (automobiles) divided by 6 (forklifts), which is (2/6) = (1/3).

In review, take the cost (loss) and divide by the gain. If we were at point D, the cost of one more forklift equals 2 automobiles (loss) divided by 9 forklifts (gain). Thus, the cost of 1 more forklift at point B is (2/9) automobiles.

Increasing opportunity cost implies that we must give up more of a particular good to get an additional unit of a different good. This implies as we move along the production possibilities curve (from left to right) I must give up more automobiles to get an additional forklift. Thus, the SHAPE of the schedule captures the increasing opportunity cost concept.

Part c: Underutilizing.

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

Part d: No; Yes; Yes.

Feedback: No, the country cannot produce outside its PPC. Yes, a technological advance would shift the PPC outward allowing the country produce more with a given amount of inputs. Yes, by specializing in goods we have a comparative advantage producing we can trade to gain access to goods beyond our own PPC. 6. Look at Figure 1.3. Suppose that the cost of cheese falls, so that the marginal cost of producing pizza decreases. Will the MC curve shift up or down? Will the optimal amount of pizza increase or decrease? LO1.7

Answers: MC will shift down; the optimal amount of pizza will increase.

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Feedback: To think about cost schedules we must think about input costs. If the cost of cheese falls, then the cost of making pizza is cheaper for all pizzas. This implies that the marginal cost schedule will shift down reflecting the lower input cost. For a given demand schedule, the optimal amount of pizza produced and sold will increase and the equilibrium price would fall. The opposite story would apply if the cost of cheese were to increase.

7. Referring to the table in problem 5, suppose improvement occurs in the technology of producing forklifts but not in the technology of producing automobiles. Draw the new production possibilities curve. Now assume that a technological advance occurs in producing automobiles but not in producing forklifts. Draw the new production possibilities curve. Now draw a production possibilities curve that reflects technological improvement in the production of both goods. LO1.8 Answers: See figures below Technological advance in producing forklifts and not automobiles.

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Feedback: This implies we can produce more forklifts with the given resources, so the schedule will shift out along the horizontal axis.

Technological advance in producing automobiles and not forklifts.

Feedback: This implies we can produce more automobiles with the given resources, so the schedule will shift up along the vertical axis.

Technological in advance in producing automobiles and forklifts.

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

8. Because investment and capital goods are paid for with savings, higher savings rates reflect a decision to consume fewer goods for the present in order to be able to invest in more goods for the future. On average, households in China save 40 percent of their annual income each year, whereas households in Canada save less than 5 percent. Production possibilities are growing at roughly 9 percent annually in China and 3.5 percent in Canada. Use graphical analysis of present goods versus future goods to explain the differences in growth rates.

LO1.8 Answers: See figures below

Canada

China Future Goods

Future Goods

B A Present Goods 1-18 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Present Goods

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

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Chapter 01 Appendix McConnell Brue Flynn Barbiero Macro 16ce

APPENDIX DISCUSSION QUESTIONS

1. What is an inverse relationship? How does it graph? What is a direct relationship? How does it graph? LOA1.1

Answer: Graphs help us visualize relationships between key economic variables in the data. For example, the relationship between the price of oranges and the number of oranges purchased is likely to be an inverse relationship. An inverse relationship is one where we observe one variable increasing and the other variable decreasing as a result (moving in opposite directions). Thus, as the prices of oranges increase we would expect to see a decrease in the quantity of oranges purchased. Graphically, we represent this inverse relationship as follows.

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

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2. Describe the graphical relationship between ticket prices and the number of people choosing to visit amusement parks. Is that relationship consistent with the fact that, historically, park attendance and ticket prices have both risen? Explain. LOA1.1

Answer: There is likely an inverse relationship between ticket prices and the number of people visiting amusement parks. As ticket prices increase relative to other goods, people will spend their income on these other goods. For example, they may decide to go to the movies instead of visiting the now more expensive amusement park.

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

3. Look back at Figure A1.2, which shows the inverse relationship between ticket prices and game attendance at Informed University (IU). (a) Interpret the meaning of both the slope and the intercept. (b) If the slope of the line were steeper, what would that say about the amount by which ticket sales respond to increases in ticket prices? (c) If the slope of the line stayed the same but the intercept increased, what can you say about the amount by which ticket sales respond to increases in ticket prices? LOA1.1

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Answer:

Part a: The slope of this relationship tells us how much the price of a ticket must fall to induce someone to buy an additional ticket. In this case, the slope of -2.5 tells us that the price must fall by $2.50 to sell one more ticket (or to induce someone to buy one more ticket). The vertical intercept tells us the price at which no tickets will be sold. Here, this price is $50. Combining these two components tells us that if the initial price is $50 per ticket and the price falls to $40, then 4 tickets will be purchased (one for each reduction in price of $2.50, which is the slope).

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

Part c: If the vertical intercept increased this would imply that individuals are willing to purchase more tickets at every price. This will be an increase in the demand for tickets.

This will not affect the slope or the quantity response to a change in the price of tickets.

We still have the relationship that the price must fall by $2.50 to sell one more ticket (or to induce someone to buy one more ticket).

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APPENDIX REVIEW QUESTIONS 1. Indicate whether each of the following relationships is usually a direct relationship or an inverse relationship. LOA1.1 a. A sports team's winning percentage and attendance at its home games. b. Higher temperature and sweater sales. c. A person's income and how often they shop at discount stores. d. Higher gasoline prices and kilometers driven in automobiles.

Answer: Part a: direct relationship because winning reams are typically more popular.

Part b: inverse relationship because as higher temperatures people usually purchase fewer sweaters Part c: inverse relationship because as people get richer, they typically shop less often at discount stores.

Part d: inverse relationship because higher gas prices cause most people to cut back on their driving.

2. Erin grows pecans. The number of bushels (B) that she can produce depends on the number of centimetres of rainfall (R) that her orchards get. The relationship is given algebraically as follows: B = 3,000 + 800R. Match each part of this equation with the correct term. LOA1.1

Answer: B goes with dependent variable.

3,000 goes with vertical intercept.

800 goes with slope.

R goes with independent variable.

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APPENDIX PROBLEMS

1. Graph and label as either direct or indirect the relationships you would expect to find between (a) the number of centimeters of rainfall per month and the sale of umbrellas, (b) the amount of tuition and the level of enrollment at a college or university, and (c) the popularity of an entertainer and the price of her concert tickets. LOA1.1

Answer: Part a:

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

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Part b:

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

Part c:

Feedback: The popularity of an entertainer and the price of her concert tickets: There is likely a direct relationship between the popularity of an entertainer and the price of her concert tickets. The more popular the entertainer, the more people are willing to pay to see her in concert.

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2. Indicate how each of the following might affect the data shown in Figure A1.2 of this appendix: LOA1.1

a. IU‘s athletic director schedules higher-quality opponents. b. A National Basketball Association (NBA) team locates in the city where IU also plays. c. IU signs a contract to have all of its home games televised.

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

Feedback: Consider the three scenarios:

Part a: IU‘s athletic director schedules higher-quality opponents. By scheduling higher quality opponents there will be an increase in demand. That is, more tickets will be purchased at every price. The demand schedule will shift to the right.

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

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

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3. The following table contains data on the relationship between saving and income.

Rearrange these data into a logical order and graph them on the accompanying grid. What is the slope of the line? The vertical intercept? Write the equation that represents this line. What would you predict saving to be at the $12,500 level of income? LOA1.1

Answer: Income per Year

Saving per Year

0

-$500

$5,000

0

$10,000

$500

$15,000

$1,000

$20,000

$1,500

To rearrange the above data into a meaningful order, we start with the lowest income and saving pair. We then continue with sequentially higher values of both income and saving. The reason for this ordering is that economic theory (and data) suggests that as income increases so does saving. The data are reordered as follows (you could also reorder from highest to lowest, but this is less intuitive).

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

The slope of the saving line can be found by dividing the change in saving by the change in income between any two points. For example we have the entry (5000 (income), 0 (savings)) and the entry (10000 (income), 500 (savings)). This implies that the change in saving equals 500 minus zero (= 500) and the change in income equals 10000 minus 5000 (= 5000), therefore the slope equals (500/5000) or 0.10. That is, for every additional dollar an individual earns (net income) he or she will save 10 cents and consume 90 cents. The vertical intercept equals -$500. This implies that if the individual does not earn an income he or she either borrows $500 or reduces past savings (stock variable) by $500.

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

To find the predicted amount of saving for a given level of income we substitute the income level into the equation above. For example if income equals $12,500, then the predicted level of saving equals -$500 + 0.1×$12,500. Thus the predicted level of saving is $750 (= -$500 + $1250).

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4. Construct a table from the data shown on the graph below. Which is the dependent variable and which the independent variable? Summarize the data in equation form. LOA1.1

Answer: Study Time (hours)

Exam Score (points)

0

10

2

30

4

50

6

70

8

90

The dependent variable is Exam Score (points); Study Time (hours) is the independent variable. Thus, the equation representing this relationship is: Exam Score = 10 + 10 x Study Time.

Feedback: The dependent variable is Exam Score (points) because we assume Study Time (hours) influences your score. The more hours you spend studying will increase your exam score.

This means that Study Time (hours) is the independent variable.

The vertical intercept for this relationship is your exam score if you choose not to study (zero hours). From the table above this value is 10.

To find the slope we divide the change in your Exam Score by the change in Study Time for any two points. For example we have the entry (2 (study time), 30 (exam score)) and the entry (4, 50). This implies the slope equals (50-30) divided by (4-2), which equals 20/2 (= 10). For every additional hour you spend studying your exam score will increase by 10 point.

Thus, the equation representing this relationship is: 1-29 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Exam Score = 10 + 10 × Study Time 5. Suppose that when the interest rate on loans is 16 percent, businesses find it unprofitable to invest in machinery and equipment. However, when the interest rate is 14 percent, $5 billion worth of investment is profitable. At 12 percent interest, a total of $10 billion of investment is profitable. Similarly, total investment increases by $5 billion for each successive 2percentage-point decline in the interest rate.

Describe the relevant relationship between the interest rate and investment in a table, on a graph, and as an equation. Put the interest rate on the vertical axis and investment on the horizontal axis. In your equation use the form i = a + bI , where i is the interest rate, a is the vertical intercept, b is the slope of the line (which is negative), and I is the level of investment. LOA1.1

Answer: Interest rate (in percent) 16 14 12 10 8 6 4 2 0

Amount of investment (billions of dollars) $0 5 10 15 20 25 30 35 40

Equation: i = 16 - (2/5)I OR i = 16 – (0.4)I Feedback: When the interest rate is 16%, investment spending will be zero. When the interest rate is 14%, investment spending will be $5 billion. For each successive drop of 2 percentage points in the interest rate, investment spending will increase by $5 billion.

Using equation i  a  bI i  16  16  14  / 5  0 I 2  16    I 5  16  0.4 I

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Graphically we have the following relationship:

6. Suppose that C = a + bY , where C = consumption, a = consumption at zero income, b = slope, and Y = income. LOA1.1 a. Are C and Y positively related or are they negatively related? b. If graphed, would the curve for this equation slope upward or slope downward? c. Are the variables C and Y inversely related or directly related? d. What is the value of C if a = 10, b = .50, and Y = 200? e. What is the value of Y if C = 100, a = 10, and b = .25?

Answers: (a) positively related; (b) upward; (c) directly related; (d) C = 110; (e) Y = 360.

Feedback: (a) C and Y are positively related because the slope, b, is positive by assumption. As individual income increases the individual will spend some of this additional income on consumption.

(b) The curve would slope upward because the slope is positive.

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(c) C and Y are directly related because C and Y are positively related (move in the same direction).

(d) Consider the following values: If a = 10, b = .50, and Y = 200, then C = 110. If a = 10 and b = .50, then the consumption function takes the following form C = 10 + 0.50 x Y. If income equals 200, Y = 200, then consumption at this level of income equals C = 10 + 0.50 x 200 = 110.

(e) Consider the following values: Y if C = 100, a = 10, and b = .25, then Y = 360. If a = 10 and b = .25, then the consumption function takes the following form C = 10 + 0.25 x Y. We can solve for Y as a function of C. STEP 1: 0.25 x Y = C - 10 STEP 2: Y = (1/0.25) x C - (10/0.25) = 4 x C - 40 STEP 3: Substitute in the value of consumption given, C = 100. Y = 4 x 100 - 40 = 360.

7. The accompanying graph shows curve XX‘ and tangents at points A, B, and C . Calculate the slope of the curve at these three points. LOA1.1

Answer: Point A, slope = 4; Point B, slope = 0; Point C, slope = -4.

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Feedback: To calculate the slope of the function use the "rise-over-run" approach. The "rise" is the change in the variable on vertical axis as you move between entries (points) and the "run" is the change in the variable on the horizontal axis as you move between the SAME two entries (points).

Point A has a slope that equals 4. To see this we use the two entries (2,10) and (12,50).

The "rise" equals 50 - 10 = 40. The "run" equals 12 - 2 = 10. To find the slope we use the rule "(rise/run)", which equals (40/10) = 4.

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

Point C has a slope that equals -4. To see this we use the two entries (16,50) and (26,10).

The "rise" equals 10 - 50 = -40 (note that "rise" can be negative). The "run" equals 26 16 = 10. To find the slope we use the rule "(rise/run)", which equals (-40/10) = -4.

8. In the accompanying graph, is the slope of curve AA‘ positive or negative? Does the slope increase or decrease as we move along the curve from A to A‘? Answer the same two questions for curve BB‘. LOA1.1

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

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Feedback:

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

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

Chapter 02 - The Market System and the Circular Flow McConnell Brue Flynn Barbiero Macro 16ce

DISCUSSION QUESTIONS 1. Contrast how a market system and a command economy try to cope with economic scarcity.

LO 2.1 Answer: A market system allows for the private ownership of resources and coordinates economic activity through market prices. Participants act in their own self-interest and seek to maximize satisfaction or profit through their own decisions regarding consumption or production. Goods and services are produced, and resources are supplied by whoever is willing to do so. The result is competition and widely dispersed economic power.

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

2. How does self-interest help achieve society‘s economic goals? Why is there such a wide variety of desired goods and services in a market system? In what way are entrepreneurs and businesses at the helm of the economy but commanded by consumers? LO 2.2 Answer: The motive of self-interest gives direction and consistency to the economy. The primary driving force of the market system is self-interest. Entrepreneurs try to maximize their profits; property owners want the highest price for their resources; workers choose the job with the best wages, fringe benefits and working conditions. Consumers apportion their expenditures to maximize their utility, while seeking the lowest possible prices. As individuals express their free choice, the economy is directed to produce the most wanted goods at the lowest possible cost.

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Each individual consumer will choose a variety of goods and services that in combination will maximize his/her satisfaction (utility). There is a wide variety because individual wants are diverse. To maximize profits, producers must respond to the desires of the individual consumer.

Although producers are free to choose what products they will produce, if the producers are to maximize profits, these good and services must be what consumers desire. Entrepreneurs can drive the economic ship where they want (at least for a while), but the ship will run aground (businesses will fail) if entrepreneurs at the helm don‘t listen to the consumers that command them.

3. Why is private property, and the protection of property rights, so critical to the success of the market system? How do property rights encourage cooperation? LO 2.2 Answer: The ownership of private property and the protection of property rights encourages investment, innovation, and, therefore, economic growth. Property rights encourage the maintaining of the property and they facilitate the exchange of the property. However, the most important consequence of property rights is that they encourage people to cooperate by helping to ensure that only mutually agreeable economic transactions take place. Also property rights encourage owners to maintain or improve their property so as to preserve or increase its value.

4. What are the advantages of using capital goods in the production process? What is meant by the term ―division of labour‖? What are the advantages of specialization in the use of human and material resources? Explain why exchange is the necessary consequence of specialization. LO 2.2 Answer: Capital goods enable producers to operate more efficiently and to produce more output.

―Division of labour‖ means that workers perform those tasks that are best suited to their individual abilities and skills.

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

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

5. What problem does barter entail? Indicate the economic significance of money as a medium of exchange. What is meant by the statement ―We want money only to part with it‖? LO 2.2 Answer: Barter requires the ―double coincidence of wants.‖ If someone wants something, he/she will have to find someone who wishes to part with that good and at the same time wishes to exchange the good for something that the first party wishes to part with.

With money as a medium of exchange, one knows the purchase price of the item to be purchased and it relative price to other items. Money is a very convenient common denominator, a common measure of value that is also used as a medium of exchange.

Money also encourages specialization. Without money, workers and other resources could not be paid except in the output produced. All those who participated in the production of the good would have to collectively exchange it for all the goods and service desired by the resource owners.

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

6. Evaluate and explain the following statements: LO 2.2 a. The market system is a profit-and-loss system. b. Competition is the disciplinarian of the market economy.

Answer: a) The quotation is accurate. In a market system, producer decisions are motivated by the attempt to earn profits. Those products that enable a firm to earn at least a normal profit (minimum compensation for the entrepreneur for his/her time and talents) will be produced. If the product cannot be produced for a profit—in other words, if losses are involved in production—the capitalist firm will respond by seeking lower cost production methods and may halt the production of goods completely. Because profits and/or losses 1-36 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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

7. Some large hardware stores such as Canadian Tire boast of carrying as many as 20,000 different products in each store. What motivated the producers of those individual products to make them and offer them for sale? How did the producers decide on the best combinations of resources to use? Who made those resources available, and why? Who decides whether these particular hardware products should continue to be produced and offered for sale? LO 2.3 Answer: The quest for profit led firms to produce these goods. Producers looked for and found the least-cost combination of resources in producing their output. Resource suppliers, seeking income, made these resources available. Consumers, through their dollar votes, ultimately decide on what will continue to be produced.

8. What is meant by the term ―creative destruction‖? How does the emergence of self driving cars relate to this idea? LO 2.3 Answer: Creative destruction refers to the process by which the creation of new products and production techniques destroys the market positions of firms committed to producing only existing products or using outdated methods. The ability to download and store a large number of songs, and the superior quality of MP3 is causing a decline in the CD industry, just as CDs once replaced cassette tapes, which had previously replaced phonographs (records).

9. In a sentence, describe the meaning of the phrase ―invisible hand.‖ LO 2.3

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Answer: Market prices act as an ―invisible hand,‖ coordinating an economy by rationing what are scarce and providing incentives to produce the most desired goods and services.

10. In market economies, firms rarely worry about the availability of inputs to produce their products, whereas in command economies input availability is a constant concern. Why the difference? LO 2.4 Answer: In market economies, buyers of inputs know that sellers want to make resources available for sale because that is how they earn their profits. If there aren‘t enough resources available, prices will rise until suppliers come forth with the desired amounts. In command economies the availability of inputs depends on what was specified in the plan, and how well the plan was executed. There is no opportunity (at least not legally) to offer greater payments to get those resources provided.

11. Distinguish between the factor market and the product market in the circular flow model. In what way are businesses and households both sellers and buyers in this model? What are the flows in the circular flow model? LO 2.5 Answer: The factor, or resource, markets are where the owners of the resources (the households) sell their resources to the buyers of the resources (businesses). In the product markets, businesses sell the goods and services they have produced to the buyers of the goods and services, the households.

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

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

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

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12. How does shielding employees and suppliers from business risk help to improve economic outcomes? Who is responsible for managing business risks in the market system? LO2.6 Answer: This process allows the owners of a business to attract employees and suppliers. If some of the business risk was put on these groups, most of them would stay away. These groups' pay does not depend on the profitability of the business; and therefore, they should not incur any of the risk associated with it. In the same sense, all the business risk is put on the owners, due to the fact that they are the ones who will enjoy the profits, or suffer the losses, of the business. This gives them an incentive to manage the business wisely.

The LAST WORD Why are price ceilings during a hyperinflation problematic? What generalizations do you draw from Venezuela‘s economic collapse? Would a Venezuelan-style economic collapse be less likely in Canada? Explain

Answer: Price ceilings during hyperinflation are particularly problematic because the prices producers have to pay for their inputs keep increasing. However, the price ceilings prevent producers from charging higher prices to offset the increased costs of production. Soon the costs of production exceed the legal selling price and producers are forced to choose between going out of business or selling their products illegally. Since the Venezuelan government imposed severe penalties on those who sold at prices above the legal limit, many firms chose to go out of business.

In general, government attempts to control the major means of production in an economy are likely to end in failure because of the potential for incompetence and corruption. Bad economic decisions often lead to more bad economic decisions such as using excessive printing of money to try to make up for tax revenues lost from inefficient production or payoffs to corrupt officials.

An economic collapse would be less likely in Canada because businesses have a large degree of autonomy over what to produce. Also, government has less power to control industry, which reduces the likelihood of government officials harming production by engaging in corruption or by making poor decisions on a large scale. In addition, producers have incentives to produce efficiently because that boosts their profits.

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REVIEW QUESTIONS

1. Decide whether each of the following descriptions most closely corresponds to being part of a command system, a market system, or a laissez-faire system. LO2.1 a. A woman who wants to start a flower shop finds she cannot do so unless the central government has already decided to allow a flower shop in her area. b. Shops stock and sell the goods their customers want but the government levies a sales tax on each transaction in order to fund elementary schools, public libraries, and welfare programs for the poor. c. The only taxes levied by the government are to pay for national defence, law enforcement, and a legal system designed to enforce contracts between private citizens.

Answer: a. command system because there is central government planning of even minor things like how many flow shops can be in operation; b. market system because while the government is using its power to tax to promote public schools and welfare, it is mostly leaving markets alone so that they can be the dominant force in deciding what to produce, how to produce it and who will get it; c. laissez-faire system because the government restricts itself to only engaging in activities that protect private property and the operation of the market system.

2. Match each term with the correct definition. LO2.2

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a. An institution that brings buyers and sellers together. b. The right of private persons and firms to obtain, control, employ, dispose of, and bequeath land, capital, and other property. c. The presence in a market of independent buyers and sellers who compete with one another and who are free to enter and exit the market as they each see fit. d. The freedom of firms to obtain economic resources, decide what products to produce with those resources, and sell those products in markets of their choice. e. What each individual or firm believes is best for itself and seeks to obtain. f. Economic transactions willingly undertaken by both the buyer and the seller because each feels that the transaction will make him or her better off. g. The freedom of resource owners to dispose of their resources as they think best; of workers to enter any line of work for which they are qualified; and of consumers to spend their incomes in whatever way they feel is most appropriate.

Answer: a. Market; b. Private Property; c. Competition; d. Freedom of Enterprise; e.

Self-interest; f. Mutually Agreeable; g. Freedom of Choice

3. True or False: Money must be issued by a government for people to accept it. LO2.2

Answer: False Many things have been used as money without having been approved by or produced by governments. Examples included seashells, cattle, and cigarettes. Money is socially defined and whatever a society accepts as a medium of exchange is money.

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4. Assume that a business firm finds that its profit is greatest when it produces $40 worth of product A. Suppose also that each of the three techniques shown in the table below will produce the desired output. LO2.3 Resource Units Required Resource Price per unit $3 Labour $4 Land $2 Capital Entrepreneurial $2 ability

Technique #1 5 2 2

Technique #2 2 4 4

Technique #3 3 2 5

4

2

4

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a. With the resource prices shown, which technique will the firm choose? Why? Will production using that technique entail profit or loss? What will be the amount of that profit or loss? Will the industry expand or contract? When will that expansion or contraction end? b. Assume now that a new technique, technique 4, is developed. It combines 2 units of labour, 2 of land, 6 of capital, and 3 of entrepreneurial ability. In view of the resource prices in the table, will the firm adopt the new technique? Explain your answer. c. Suppose that an increase in the labour supply causes the price of labour to fall to $1.50 per unit, all other resource prices remaining unchanged. Which technique will the producer now choose? Explain. d. ―The market system causes the economy to conserve most in the use of resources that are particularly scarce in supply. Resources that are scarcest relative to the demand for them have the highest prices. As a result, producers use these resources as sparingly as is possible.‖ Evaluate this statement. Does your answer to part c, above, bear out this contention? Explain.

Answer: a. To calculate the cost of each technique, multiply the price per unit of resource by the amount of the resource employed by the technique and add these together. For example, the cost of technique 1 equals $3 × 5 (labour cost) + $4 × 2 (land cost) + $2 × 2 (capital cost) + $2 × 4 (entrepreneurial cost) = $15 + $8 + $4 + $8 = $35. The same process is applied to Techniques 2 and 3. The firm will choose technique 2 because it produces the output at the least cost ($34 compared to $35 for techniques 1 and 3). Economic profit will be $6 (= $40 - $34), causing the industry to expand. Expansion in this industry will continue until prices decline to where total revenue equals total cost of $34 and no additional firms will want to enter the industry. b. The firm will adopt technique 4 because its cost is now lowest at $32.

c. The firm will choose technique 1 because its cost is now lowest at $27.50.

d. The statement is logical. Increasing scarcity of a resource causes its price to rise. Firms ignoring higher resource prices will become high-cost producers. Firms switching to the less expensive inputs become lower-cost producers and earn higher profits than high-cost producers. The market system, therefore, forces producers to conserve on the use of highly scarce resources. Question 4c confirms this: Technique 1 was adopted because labour had become less expensive.

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5. Identify each of the following quotes as being an example of either: the coordination problem, the invisible hand, creative destruction, or the incentive problem. LO2.4 a. "If you compare a list of today‘s most powerful and profitable companies with a similar list from 30 years ago, you will see lots of new entries." b. "Managers in the old Soviet Union often sacrificed product quality and variety because they were being awarded bonuses for quantitative, not qualitative, targets." c. "Each day, central planners in the old Soviet Union were tasked with setting 27 million prices -- correctly." d. "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."

Answer: a. creative destruction because this quote is a reflection of how fast new technologies and new products destroy the market positions of even very powerful older firms. b. incentive problem because this quote reflects how the poorly designed financial incentives of the old Soviet Union often led to managers making decisions that were personally beneficial but socially destructive. c. coordination problem because this quote reflects the impossible complexity of centrally coordinating a large economy. d. invisible hand because this quote (from Adam Smith‘s book The Wealth of Nations) reflects the idea that producers end up doing things that their customers want not out of a sense of charity but rather in an attempt to further their own interests. The butcher, the brewer, and the baker do a good job at their respective tasks because they want their customers‘ money.

6. True or False: Households sell finished products to businesses. LO2.6

Answer: False. Households sell resources to businesses, which use those resources to produce goods and services that are in turn bought and consumed by households.

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7. Franklin, John, Henry, and Harry have decided to pool their financial resources and business skills in order to open up and run a coffee shop. They will share any profits or losses that the business generates and will be personally responsible for making good on any debt that their business undertakes. Their business should be classified as a: LO2.6 Answer: Partnership. The coffee shop that these guys are starting should be classified as a partnership because of the relatively few members involved and because each member is personally liable for any losses that the business generates Both sole proprietorships and partnerships share that same feature—that those who own and run them are personally responsible for any losses that their businesses generate and for any debts that their businesses owe.

By contrast, the owners of a corporation are not personally responsible for their firm‘s losses or debts. That is true because a corporation is its own legal entity, completely separate from its owners. Thus, any money that it owes to creditors is money owed by the corporation itself, and not by those who own the corporation.

8. Ted and Fred are the owners of a gas station. They invested $150,000 each and pay an employee named Lawrence $35,000 per year. This year revenues are $900,000, while costs are $940,000. Who is legally responsible for bearing the $40,000 loss? LO2.6 a. b. c. d. e.

Lawrence Ted Fred Ted and Fred Lawrence, Ted, and Fred

Answer: Ted and Fred. A firm‘s owners bear the firm‘s business risk, including the risk of running a loss (rather than breaking even or generating a profit.) So in this case, the loss will be borne

by Ted and Fred, since they are the owners. Lawrence, by contrast, is an employee and not legally bound to bear any business risk. So, he must be paid his salary on time and in full whether or not the firm is running a profit, a loss, or just breaking even.

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PROBLEMS

1. Table 2.1 contains information on three techniques for producing $15 worth of bar soap.

Assume that we specified ―$15 worth of bar soap‖ because soap costs $3 per bar and all three techniques produce 5 bars of soap ($15 = $3 per bar × 5 bars). So you know each technique produces 5 bars of soap. LO3 a. What technique will you want to use if the price of a bar of soap falls to $2.75? Which technique will you use if the price of a bar of soap rises to $4? To $5? b. How many bars of soap will you want to produce if the price of a bar of soap falls to $2.00? c. Suppose that the price of soap is again $3 per bar but that the prices of all four resources are now $1 per unit. Which is now the least-profitable technique? d. If the resource prices return to their original levels (those shown in the table) but a new technique is invented that can produce 3 bars of soap (yes, 3 bars, not 5 bars!) using 1 unit of each of the four resources, will firms prefer the new technique? Why or why not?

Answers: (a) Technique 2, Technique 2, Technique 2; (b) Zero—it is not profitable to produce bars of soap at this selling price; (c) Technique 3; (d) No, they will still prefer technique 2.

Feedback: Part a: If the price falls to $2.75 total revenue (price multiplied by units sold) equals $13.75 (= $2.75 × 5). This does not change the total cost of each technique, so the firm will continue to use the lowest cost technique 2. This logic also applies to the increase in the sale price to $4.00 and $5.00 respectively. This does not change the cost of each technique, so the firm will continue to employ the lowest cost technique 2.

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Part b: Here the answer is different (from that in part a) because total revenue equals $10.00 (= $2 × 5). Here it is unprofitable to produce any output because the least cost technique 2 is $13.

Part c: Here we must first calculate the cost incurred by the firm for each technique.

Since the price of each input is $1 per unit, the cost for each technique is just the sum of the inputs used. For example, the cost of technique 1 equals $7 [= $4 (labour) + $1 (land) +$1 (capital) + $1 (entrepreneurial ability)] Using the same procedure, the total cost of technique 2 equals $7 (= $2 + $3 + $1 + $1) and the total cost of technique 3 equals $8 (= $1 + $4 + $2 + $1). Thus, the least-profitable technique is technique 3.

Part d. The total revenue from this new technique equals $3 (price per bar) multiplied by 3 (units sold and produced), or $9. The total cost of this technique equals the sum of the resource prices, in the table above, because this technique employs one unit of each input. Thus, total cost equals $9 (+ $2 (labour) + $1 (land) + $3 (capital) + $3 (entrepreneurial ability)). Using this new technique economic profit is zero (= $9 (revenue) – $9 (cost)), whereas technique 2 continues to generate $2 of economic profit (= $15 (revenue) – $13 (cost)). Since economic profit is greater using technique 2 the firm will continue to employ this technique.

2. Suppose Natasha currently makes $50,000 per year working as a manager at a cable TV company. She then develops two possible entrepreneurial business opportunities. In one, she will quit her job to start a hand-made soap company. In the other, she will try to develop an Internet-based competitor to the local cable company. For the soap-making opportunity, she anticipates annual revenue of $465,000 and costs for the necessary land, labour, and capital of $395,000 per year. For the WiFi opportunity, she anticipates costs for land, labour, and capital of $3,250,000 per year as compared to revenues of $3,275,000 per year. (a) Should she quit her current job to become an entrepreneur? (b) If she does quit her current job, which opportunity would she pursue? LO 2.3

Answers: (a) Yes; (b) She should pursue the soap business.

Feedback: Natasha should quit her job only if the net revenue from the entrepreneurial business opportunity exceeds that of her current wage (net revenue equals revenue minus cost. This could also be defined as accounting profit).

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

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

The net revenue from WiFi company equals $3,275,000 (revenue) minus $3,250,000 (cost). This net revenue of $25,000 (= $3,275,000 - $3,250,000) is less than Natasha's current wage of $50,000, thus she should not develop this company and continue working for the TV company.

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

3. With current technology, suppose a firm is producing 400 loaves of banana bread daily. Also assume that the least-cost combination of resources in producing those loaves is 5 units of labour, 7 units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at prices of $40, $60, $60, and $20, respectively. If the firm can sell these 400 loaves at $2 per unit, what is its total revenue? Its total cost? Its profit or loss? Will it continue to produce banana bread? If this firm‘s situation is typical for the other makers of banana bread, will resources flow toward or away from this bakery good? LO 2.3

Answers: TR = $800; TC = $760; Profit = $40; Yes, it will continue to produce banana bread; Resources will flow toward this bakery good.

Feedback: Consider the following example. A firm is producing 400 loaves of banana bread daily. The least-cost combination of resources in producing those loaves is 5 units of labour, 7 units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at prices of $40, $60, $60, and $20, respectively. The firm can sell these 400 loaves at $2 per unit.

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

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

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

Since the firm in our example is earning positive economic profit it will continue to produce banana bread. However, if the firm were losing money (suffering a loss because total cost exceeds total revenue) the firm will stop producing banana bread.

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

4. Let‘s put dollar amounts on the flows in the circular flow diagram of Figure 2.2. LO 2.5 a. Suppose that businesses buy a total of $100 billion of the four resources (labour, land, capital, and entrepreneurial ability) from households. If households receive $60 billion in wages, $10 billion in rent, and $20 billion in interest, how much are households paid for providing entrepreneurial ability? b. If households spend $55 billion on goods and $45 billion on services, how much in revenues do businesses receive in the product market?

Answers: (a) $10 billion for entrepreneurial ability; (b) $100 billion in revenues.

Feedback: a. $10 billion for entrepreneurial ability (= $100 billion in total factor payments - $60 billion in wages - $10 billion in rent - $20 billion in interest) b. $100 billion (= $45 billion + $55 billion) because household expenditures equal business revenues.

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Chapter 03 - Demand, Supply, and Market Equilibrium McConnell Brue Flynn Barbiero Macro 16ce

DISCUSSION QUESTIONS

1. Explain the law of demand. Why does a demand curve slope downward? How is a market demand curve derived from individual demand curves? LO3.2

Answer: The Law of Demand says that, ceteris paribus. if the price drops, a larger quantity will be demanded; if the price rises, a lesser quantity will be demanded.

The demand curve slopes downward because of diminishing marginal utility, and the substitution and income effects. Because successive units of a good provide less additional utility than the previous units, buyers will only pay for these smaller amounts of utility if the price is lowered. When the price of a commodity decreases relative to that of substitutes, a buyer will substitute the now cheaper commodity for those whose prices have not changed.

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

By adding the quantities demanded by all consumers at each of the various possible prices, it can get from the individual demand to market demand. In the graphical summing procedure, at each price we sum horizontally the individual quantities demanded to obtain the total quantity demanded at that price; then plot the price and the total quantity demanded as one point of the market demand curve.

Thus, the market demand curve is the horizontal summation of the individual demand curves of all consumers in the market.

2. What are the determinants of demand? What happens to the demand curve when any of these determinants change? Distinguish between a change in demand and a change in the quantity demanded, noting the cause(s) of each. LO3.2

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Answer: The fundamental determinant of demand is the price of the commodity under consideration: a change in price causes movement along the commodity‘s demand curve.

This movement is called a change in quantity demanded. Decreased price leads to movement down the demand curve: There is an increase in quantity demanded. Increased price leads to movement up the demand curve: There is a decrease in quantity demanded.

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

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

3. Explain the law of supply. Why does the supply curve slope upward? How is the market supply curve derived from the supply curves of individual producers? LO 3.2

Answer: The law of supply is the principle that, other things equal, an increase in the price of a product will increase the quantity of it supplied, and conversely for a price decrease. As prices rise because of increased demand for a commodity, producers find it more and more profitable to increase the quantity they offer for sale; that is, the supply curve will slope upward from left to right. Clearly, firms would rather sell at a higher price than at a lower price. Moreover, it is necessary for firms to demand a higher price as they increase production. This comes about because as they produce more and more, they start to run up against capacity constraints and costs rise. At any given time, a plant has a given size. As production increases, the firm will need to add an extra shift and then a third shift, both perhaps at higher wages. It may run out of warehouse space and have to rent at higher cost from another firm. It may have to pay extra to get increasingly urgent raw material, and so on.

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

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4. What are the determinants of supply? What happens to the supply curve when any of these determinants changes? Distinguish between a change in supply and a change in the quantity supplied, noting the cause(s) of each. LO 3.3

Answer: The fundamental determinant of supply is the price of the commodity. As price increases, the quantity supplied increases. An increase in price causes a movement up a given supply curve. A decrease in price causes a movement down a given supply curve.

The non-price determinants of supply are: resource (input) prices, technology, taxes and subsidies, prices of other related goods, expectations, and the number of sellers. If one or more of these changes, there will be a change in supply and the whole supply curve will shift to the right or the left.

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

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

5. In 2001 an outbreak of foot-and-mouth disease in Europe led to the burning of millions of cattle carcasses. What impact do you think this had on the supply of cattle hides, hide prices, the supply of leather goods, and the price of leather goods? LO 3.5

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

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6. For each stock in the stock market, the number of shares sold daily equals the number of shares purchased. That is, the quantity of each firm‘s shares demanded equals the quantity supplied. So, if this equality always occurs, why do the prices of stock shares ever change?

LO 3.5

Answer: During any given stock trading session, there will be both prospective buyers and sellers, each willing to buy or sell a certain number of shares depending on price. If at the current price (e.g. the day‘s opening price) the quantity of shares demanded exceeds the quantity of shares supplied, buyers must increase their price offers to induce sellers to offer enough shares. This will cause share prices to rise until quantity demanded equals quantity supplied. Suppose that during the trading session there is a report of bad economic news.

Sellers may respond by trying to sell more shares than buyers are wanting at the current price.

In order to find enough willing buyers, sellers will have to offer their shares at lower prices.

On any given trading day, there will be multiple equilibrium prices, many of them not lasting for more than a few minutes (or even seconds).

7. What do economists mean when they say ―price floors and ceilings stifle the rationing function of prices and distort resource allocation‖? LO 3.6

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

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The LAST WORD Real (inflation-adjusted) tuition costs were nearly constant during the 1960s despite a huge increase in the number of college and university students as the very large Baby Boom generation came of age. What does this suggest about the supply of higher education during that period? When the much smaller Baby Bust generation followed in the 1970s, real tuition costs fell. What does that suggest about demand relative to supply during the 1970s?

Answer: As the large Baby Boom generation entered college and university, the demand for college education would increase (increase in the number of "consumers"). This would be shown in a shift to the right in the demand curve. For prices to remain nearly constant during this time, the supply of college education would need to increase by the same amount as demand.

As the smaller Baby Bust generation entered college, the demand for college education would decrease. As the demand curve shifts to the left, to have prices fall, the supply of college education must not have decreased along with demand.

REVIEW QUESTIONS

1. What effect will each of the following have on the demand for small automobiles such as the Mini-Cooper and Fiat 500? LO3.2 a. Small automobiles become more fashionable. b. The price of large automobiles rises (with the price of small autos remaining the same). c. Income declines and small autos are an inferior good. d. Consumers anticipate that the price of small autos will greatly come down in the near future. e. The price of gasoline substantially drops.

Answer: Demand increases in (a), (b), and (c); decreases in (d). The last one (e) is ambiguous. As autos and gas are complements, one could argue that the decrease in gas prices would stimulate demand for all cars, including small ones. However, one could also argue that small cars are attractive to consumers because of fuel efficiency, and that a 1-54 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

decrease in gas prices effectively reduces the price of the ―gas guzzling‖ substitutes. That would encourage consumers to switch from smaller to larger cars (SUVs), and demand for small automobiles would fall. This presents a good illustration of the complexity of many of these changes.

2. True or False: A ―change in quantity demanded‖ is a shift of the entire demand curve to the right or to the left. LO3.2

Answer: False.

Be sure to distinguish properly between a change in quantity demanded and a change in demand. A change in quantity demanded is a movement from one point to another point along a fixed demand curve. A change in demand is a shift of the entire demand curve to the right or to the left. Note that these two types of changes have different causes. A change in quantity demanded (which is a movement along a fixed demand curve) is caused by a change in a good‘s own price. By contrast, a change in demand occurs because there has been a change in one or more of the determinants of demand (for example, a change in consumer tastes or a change in income).

3. What effect will each of the following have on the supply of auto tires? LO3.3 a. A technological advance in the methods of producing tires. b. A decline in the number of firms in the tire industry. c. An increase in the prices of rubber used in the production of tires. d. The expectation that the equilibrium price of auto tires will be lower in the future than currently. e. A decline in the price of the large tires used for semi-trucks and earth-hauling rigs (with no change in the price of auto tires). f. The levying of a per-unit tax on each auto tire sold. g. The granting of a 50-cent-per-unit subsidy for each auto tire produced.

Answer: a. Supply will increase because the technological advance allows the tire manufacturers to produce more tires using the same amount of inputs. b. Supply will decrease because there are fewer firms in the industry. c. Supply will decrease because the increase in the price of rubber results in an increase in production costs. Thus, each firm will need to charge a higher price at each level of output (or supply less at each price).

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d. Supply will increase because the expectation that the equilibrium price of auto tires will be lower in the future causes firms to sell their inventories today while the price is still high. e. Supply will increase because the decline in the price of large tires used for semi trucks and earth-hauling rigs (with no change in the price of auto tires) will cause firms to reduce production of large tires (now commanding a lower price) and produce more auto tires. These two goods are substitutes in production. f.

Supply will decrease because per-unit tax on each auto tire sold increases the cost of production since the tire manufacturers must now pay for input costs PLUS the per unit tax.

g. Supply will increase because the 50-cent-per-unit subsidy decreases the cost of production. The tire manufacturers receive the subsidy, which they can subtract from their input costs.

4. ―In the corn market, demand often exceeds supply and supply sometimes exceeds demand.‖ ―The price of corn rises and falls in response to changes in supply and demand.‖ In which of these two statements are the terms ―supply‖ and ―demand‖ used correctly? Explain. LO 3.3

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

Supply and/or demand can change (the entire curves can shift). Each time this happens, it will create a new intersection of the two curves that will lead to changes in the equilibrium quantity and price of corn. Thus, the terms ―supply‖ and ―demand‖ are used correctly in the second statement.

5. Suppose that in the market for computer memory chips, the equilibrium price is $50 per chip.

If the current price is $55 per chip, then there will be ______________ of memory chips.

LO3.4 a. A shortage. b. A surplus. c. An equilibrium quantity. d. None of the above.

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Answer: A surplus. At the equilibrium price of $50 per chip, the quantity demanded exactly equals the quantity supplied. At higher prices, the quantity supplied increases while the quantity demanded decreases. Thus, at the $55 price, the quantity supplied exceeds the quantity demanded. The result is a surplus of unsold chips because not all of the chips that producers are willing to supply at the $55 price will find buyers at that price. In fact, the equilibrium price of $50 is the only price at which the desires of suppliers with regard to how much they wish to sell are consistent with the desires of buyers with regard to how much they wish to purchase.

6. Critically evaluate: ―In comparing the two equilibrium positions in Figure 3.7b, I note that a smaller amount is actually demanded at a lower price. This refutes the law of demand.‖ LO3.5 Answer:

The key point here is that the second equilibrium occurs after demand has decreased, that is demand has shifted because of a change in determinants, which has caused buyers to want less at every price compared to the original D1 demand curve and schedule. Each equilibrium price refers to a different demand situation. Therefore, the fact that less is purchased at a lower price when demand decreases does not refute the law of demand. Note that on the second demand curve and schedule, less would still be purchased at a higher price.

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7. Label each of the follow scenarios with the correct combination of price change and quantity change. In some scenarios, it may not be possible from the information given to determine the direction of a particular price change or a particular quantity change. We will symbolize those cases as, respectively, ―P?‖ and ―Q?‖ LO3.5

P↓ Q: indeterminate P↑ Q: indeterminate P: indeterminate Q↓ P: indeterminate Q↑ a. On a hot day, both the demand for lemonade and the supply of lemonade increase. b. On a cold day, both the demand for ice cream and the supply of ice cream decrease. c. When Hawaii‘s Mt. Kiluea erupts violently, the demand on the part of tourists for sightseeing flights increases but the supply of pilots willing to provide these dangerous flights decreases. d. In a hot area of Arizona where they generate a lot of their electricity with wind turbines, the demand for electricity falls on windy days as people switch off their air conditioners and enjoy the breeze. But at the same time, the amount of electricity supplied increases as the wind turbines spin faster.

Answer: a. P: indeterminate, Q: increases The equilibrium quantity will definitely increase as the rightward shifts of both curves guarantee that their intersection point will also shift to the right. However, the change in price will depend on which curve shifts further to the right. If the demand curve shift horizontally further than the supply curve, the equilibrium price will rise (and visa versa).

b. P: indeterminate, Q: decreases With both curves shifting to the left, their intersection will also shift to the left. Thus, the equilibrium quantity will definitely decline. However, the direction of the price change will depend on which curve shifts further to the left. If the demand curve shifts further than the supply curve, then the intersection point will move down vertically, implying that the equilibrium price will fall. On the other hand, if the supply curve shifts further to the left, then the intersection point will be higher vertically, implying that the equilibrium price will rise.

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c. P: increases, Q: indeterminate With demand increasing and supply decreasing, the intersection point between the demand curve and the supply curve will have to be higher. Thus, the equilibrium price will definitely rise. However, the change in the equilibrium quantity is uncertain. It will depend on whether the horizontal rightward shift of the demand curve is bigger or smaller than the horizontal leftward shift of the supply curve. If the demand curve moves right more than the supply curve moves left, then the equilibrium quantity will increase. By contrast, if the supply curve moves to the left more than the demand curve moves to the right, the equilibrium quantity will fall.

d. P: decreases, Q: indeterminate With demand falling and supply increasing, the intersection point between the demand curve and the supply curve will definitely move down vertically. Thus, the equilibrium price will definitely decline. Whether the equilibrium quantity increases, or decreases will depend on which curve shifts further. If the rightward shift of the supply curve exceeds the leftward shift of the demand curve, then the equilibrium quantity will increase. By contrast, if the leftward shift of the demand curve exceeds the rightward shift of the supply curve, the equilibrium quantity will decrease.

8. Suppose the total demand for wheat and the total supply of wheat per month in the Winnipeg grain market are as shown in the table below. Suppose that the government establishes a price ceiling of $3.70 for wheat. What might prompt the government to establish this price ceiling?

Explain carefully the main effects. Demonstrate your answer graphically. Next, suppose that the government establishes a price floor of $4.60 for wheat. What will be the main effects of this price floor? Demonstrate your answer graphically. LO3.6

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

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

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

9. A price ceiling will result in a shortage only if the ceiling price is ____________ the equilibrium price. LO3.6 a. less than b. equal to c. greater than d. louder than

Answer: Less than.

If the ceiling price is set at a value below the equilibrium price, then a shortage will result because quantity demanded will exceed quantity supplied. By contrast, if the ceiling price is set higher than the equilibrium price, it will not affect anything because the equilibrium price will not be in violation of the legal ceiling price and all the market participants can proceed as they normally would. Finally, if the ceiling price happens to be just equal to the market 1-60 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

equilibrium price, then the market will behave as normal and reach the market equilibrium price because with the equilibrium price just equal to the ceiling price, nobody is violating the law and nobody has to change his or her behavior.

PROBLEMS

1. Suppose there are three buyers of candy in a market: Tex, Dex, and Rex. The market demand and the individual demands of Tex, Dex, and Rex for candy are given in the table below. LO 3.2 a. Fill in the table for the missing values. b. Which buyer demands the least at a price of $5? The most at a price of $7? c. Which buyer‘s quantity demanded increases the most when the price is lowered from $7 to $6? d. Which direction would the market demand curve shift if Tex withdrew from the market?

What if Dex doubled his purchases at each possible price? e. Suppose that at a price of $6, the total quantity demanded increases from 19 to 38. Is this a ―change in the quantity demanded‖ or a ―change in demand‖?

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Answers: (a) Row 1: 4; Row 2: 2; Row 3: 12; Row 4:4; Row 5: 36. (b) Dex, Tex. (c) Tex. (d) Left, Right. (e) ―A change in demand.‖

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

Part b: At a price of $5 Dex demands the least amount of goods, which equals 4. Tex demands 17, and Rex demands 6. At a price of $7 Tex demands the most amount of goods, which equals 8. Dex demands 2, and Rex demands 2.

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Part c: When the price is lowered from $7 to $6, Tex's demand increases by 4 (= 12 - 8), Dex's demand increases by 1 (= 3 - 2), and Rex's demand increases by 2 (= 4 - 2). Thus, Tex's demand increases the most when the price is lowered from $7 to $6.

Part d: If Tex withdrew from the market, there would be less demand at every price level.

This implies that the demand schedule would shift to the left. If Dex doubled his purchases at every price level, this would increase demand. This implies that the demand schedule would shift to the right.

Part e: Since the price is fixed in the statement, this is a change in demand. A change in the quantity demanded results from a change in price.

2. The figure below shows the supply curve for tennis balls, S1, for Drop Volley tennis, a producer of tennis equipment. Use the figure and the table below to give your answers to the following questions. LO 3.3

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

b. If production costs were to increase, the quantities supplied at each price would be as shown by the third column of the table (―S2 Quantity Supplied‖). Use that data to draw supply curve S2 on the same graph as supply curve S1. c. In the fourth column of the table, enter the amount by which the quantity supplied at each price changes due to the increase in product costs. (Use positive numbers for increases and negative numbers for decreases.) d. Did the increase in production costs cause a ―decrease in supply‖ or a ―decrease in quantity supplied‖?

Answers: (a) 15 balls at $3; 10 balls at $2, 5 balls at $1; (b) Draw in supply curve S2 using the data in column 3; (c) -11 balls at $3; -8 balls at $2; -5 balls at $1; (d) decrease in supply.

Feedback: Consider the following figure and values.

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

Price $3 2 1

S 1 Quantity supplied 15 10 5

S 2 Quantity supplied 4 2 0

Change in quantity supplied _______ _______ _______

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Part b: Graph

Part c: The increase in production costs cause supply to decrease at each price level. Supply falls from 15 to 4 for at the price of $3, thus the change is -11. Supply falls from 10 to 2 at the price of $2, thus the change is -8. Supply falls from 5 to 0 at the price of $1, thus the change is -5.

Part d: This is a decrease in supply because the schedule shifts left (less quantity supplied at every price).

3. Refer to the expanded table below from question 11. LO 3.4

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a. What is the equilibrium price? At what price is there neither a shortage nor a surplus? Fill in the surplus-shortage column and use it to confirm your answers. b. Graph the demand for wheat and the supply of wheat. Be sure to label the axes of your graph correctly. Label equilibrium price P and equilibrium quantity Q. c. How big is the surplus or shortage at $3.40? At $4.90? How big a surplus or shortage results if the price is 60 cents higher than the equilibrium price? 30 cents lower than the equilibrium price?

Answers: a) Equilibrium price = $4.00. There is neither a shortage nor a surplus at $4.00. Quantity demanded and quantity supplied are equal to each other when price is $4.00.

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

b)

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c) At $3.40, there is a shortage of 13 units (i.e., -13). At $4.90, there is a surplus of 21 units (i.e. +21). If the price increases by 60 cents from the equilibrium price, a surplus of 14 units (+14) results. If the price falls by 30 cents from the equilibrium price, a shortage of 7 units (-7) results.

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

4. How will each of the following changes in demand and/or supply affect equilibrium price and equilibrium quantity in a competitive market; that is, do price and quantity rise, fall, or remain unchanged, or are the answers indeterminate because they depend on the magnitudes of the shifts? Use supply and demand analysis to verify your answers. LO 3.5 a. Supply decreases and demand is constant. b. Demand decreases and supply is constant. c. Supply increases and demand is constant. d. Demand increases and supply increases. e. Demand increases and supply is constant. f. Supply increases and demand decreases. g. Demand increases and supply decreases. h. Demand decreases and supply decreases.

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(a) Price up; quantity down; (b) Price down; quantity down; (c) Price down; quantity up; (d) Price indeterminate; quantity up; (e) Price up; quantity up; (f) Price down; quantity indeterminate; (g) Price up, quantity indeterminate; (h) Price indeterminate and quantity down.

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

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

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

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Part d: The increase in supply and the increase in demand unambiguously increases the equilibrium quantity. This is because the increase in supply and the increase in demand both increase the equilibrium quantity. However, the change in equilibrium price is indeterminate because the increase in supply puts downward pressure on the equilibrium price and the increase in demand puts upward pressure on the equilibrium price. The figure below shows these effects when the demand effect dominates.

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

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

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

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Part h: The decrease in supply and the decrease in demand unambiguously decreases the equilibrium quantity. This is because the decrease in supply and the decrease in demand both decrease the equilibrium quantity. However, the change in equilibrium price is indeterminate because the decrease in supply puts upward pressure on the equilibrium price and the decrease in demand puts downward pressure on the equilibrium price. The figure below shows these effects when the supply effect dominates.

5. ADVANCED ANALYSIS Assume that demand for a commodity is represented by the equation P = 10 - .2Qd and supply by the equation P = 2 + .2Qs, where Qd and Qs are quantity demanded and quantity supplied, respectively, and P is price. Using the equilibrium condition Qs = Qd, solve the equations to determine equilibrium price. Now determine equilibrium quantity. LO 3.5

Answer: Equilibrium price is P = 6; equilibrium quantity is Q = 20 Feedback: Consider the following equations: demand for a commodity is P = 10 - .2Qd supply of the commodity is P = 2 + .2Qs To solve this system of equations we use the fact that the equilibrium price in both equations must be the same. Therefore we can equate the two (eliminate P from the system).

This gives us: 10 - .2Qd = 2 + .2Qs We now use the equilibrium condition for quantity: Qs = Qd= Q We substitute Q for Qd and Qs 1-72 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

This gives us: 10 - .2Q = 2 + .2Q Solving for Q: .2Q + .2Q = 8 or .4Q = 8 The equilibrium quantity is: Q = (8/.4) = 20 To find the equilibrium price we substitute the equilibrium quantity Q = 20 into either the demand function or supply function.

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

6. Suppose that the demand and supply schedules for rental apartments in the city of Gotham are as given in the table below. LO 3.6

a. What is the market equilibrium rental price per month and the market equilibrium number of apartments demanded and supplied? b. If the municipal government can enforce a rent-control law that sets the maximum monthly rent at $1500, will there be a surplus or a shortage? Of how many units?

And how many units will actually be rented each month? c. Suppose that a new government wants to keep out the poor. It declares that the minimum rent that can be charged is $2500 per month. If the government can enforce that price floor, will there be a surplus or a shortage? Of how many units? And how many units will actually be rented each month? d. Suppose that the government wishes to decrease the market equilibrium monthly rent by increasing the supply of housing. Assuming that demand remains unchanged, by how many units of housing would the government have to increase the supply of housing in order to get the market equilibrium rental price to fall to $1500 per month? To $1000 per month? To $500 per month?

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Answers: (a) 12,500 apartments at a rent of $2000 per month; (b) A shortage of 5,000 apartments per month, 10,000 apartments will actually be rented each month; (c) A surplus of 5,000 apartments per month, 10,000 apartments will actually be rented each month; (d) 2,500 more apartments, 5000 more apartments; 7,500 more apartments.

Feedback: Part a: The market equilibrium price is determined by the relationship quantity supplied equals quantity demanded. Thus, to find the equilibrium price we find the price where the quantities are equal, which occurs at the rent (price) of $2000. The equilibrium quantity at this price is 12,500 apartments.

Part b: If the government imposes a maximum rent of $1500 the quantity of apartments supplied equals 10,000 and the quantity of apartments demanded equals 15,000. Thus, there is a shortage of 5000 apartments (= 15,000 (demand) - 10,000 (supply)). The amount of apartments actually rented will be determined by supply here. There are only 10,000 available for rent, so only 10,000 will be rented.

Part c: If the government imposes a minimum rent of $2500 the quantity of apartments supplied equals 15,000 and the quantity of apartments demanded equals 10,000. Thus, there is a surplus of 5000 apartments (= 15,000 (supply) - 10,000 (demand)). The amount of apartments actually rented will be determined by demand here. There are only 10,000 households that want to rent, so only 10,000 will be rented.

Part d: If the government wants to reduce the market equilibrium rent to $1500 per month the government would need to increase the supply of apartments by 2500 units. To see this, start in equilibrium. Here the equilibrium rent is $2000 and the equilibrium quantity is 12,500 units. If the government adds 2500 units there will now be 15,000 unit for rent in the market. The equilibrium price is now $1500 (the rent desired by government) and the equilibrium quantity is 15,000.

If the government wanted to reduce the equilibrium rent to $1000 they would need to add 5000 units. This would result in 17,500 units on the market (12,500 already on the market plus the 5000 new apartments), which has an equilibrium rent of $1000.

If the government wanted to reduce the equilibrium rent to $500 they would need to add 7500 units. This would result in 20,000 units on the market (12,500 already on the market plus the 7500 new apartments), which has an equilibrium rent of $1000.

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Chapter 03 Appendix McConnell Brue Flynn Barbiero Macro 16e

APPENDIX DISCUSSION QUESTIONS

1. Why are shortages or surpluses more likely with pre-set prices, such as those on tickets, than flexible prices, such as those on gasoline? LOA3-1

Answer: Pre-set prices, rather than responding to demand conditions, attempt to predict the level of demand that will produce an equilibrium quantity. If these predictions are incorrect, there will be an imbalance between the quantity supplied and the quantity demanded.

Pre-set prices often apply to one-time-only events, versus something like gasoline that is sold regularly and repeatedly. Sellers can learn from experience how to adjust prices to best meet demand.

2. Most scalping laws make it illegal to sell—but not to buy—tickets at prices above those printed on the tickets. Assuming that is the case, use supply and demand analysis to explain why the equilibrium ticket price in an illegal secondary market tends to be higher than in a legal secondary market. LOA3-1

Answer: Ticket prices tend to be higher in illegal secondary markets because sellers face higher costs (thus reducing supply relative to what it would be in a legal secondary market).

The additional costs include the higher transactions costs (finding secret locations to transact, monitoring for law enforcement, screening clients, etc.) and compensation for the risk of getting caught (with the associated costs of legal services, fines, incarceration, etc.).

3. How high (or how low) are gasoline prices now? Go to gasbuddy.com and follow the links to find the current retail price of gasoline in your area. How does the current price of regular gasoline compare with the price a year ago? What must have happened to either supply, demand, or both to explain the observed price change? LOA3-1

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

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4. Suppose the supply of apples sharply increases because of perfect weather conditions throughout the growing season. Assuming no change in demand, explain the effect on the equilibrium price and quantity of apples. Explain why quantity demanded increases even though demand does not change. LOA3-1

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

5. Assume the demand for lumber suddenly rises because of a rapid growth of demand for new housing. Assume no change in supply. Why does the equilibrium price of lumber rise? What would happen if the price did not rise under the demand and supply circumstances described?

LOA3-1 Answer: Buyers are willing to purchase more new housing, causing price and quantity to increase in that market. In order to satisfy the increased demand for new housing, more lumber (and other building materials) is needed. The greater willingness to pay for housing implies a greater willingness to pay for the materials and labor needed to produce that housing. As the resources become increasingly scarce (because of a given supply and increasing demand), the price rises.

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

6. Assume that both the supply of bottled water and the demand for bottled water rise during the summer but that supply increases more rapidly than demand. What can you conclude about the directions of the impacts on equilibrium price and equilibrium quantity? LOA3-1

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

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7. When asked for investment advice, humorist Will Rogers joked that people should "Buy land. They ain't making any more of the stuff." Explain his advice in terms of the supply and demand model. LOA3-1

Answer: Since the supply of land (as a natural resource) is limited, the supply curve is a vertical line. As demand increases, price of land will increase, allowing you to earn money on your investment.

APPENDIX REVIEW QUESTIONS

1. Will the equilibrium price of orange juice increase or decrease in each of the following situations? LOA3-1 a. A medical study reporting that orange juice reduces cancer is released at the same time that a freak storm destroys half of the orange crop in Florida. b. The prices of all beverages except orange juice fall in half while unexpectedly perfect weather in Florida results in an orange crop that is 20 percent larger than normal.

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Answers: a. Increase. The medical study reporting that orange juice reduces cancer will cause the demand curve for orange juice to shift to the right. The storm that destroys half the orange crop in Florida will cause the supply curve for orange juice to shift to the left. With these two shifts occurring at the same time, the price of orange juice will increase. b. Decrease. When the prices of other beverages fall in half, demand for orange juice will fall as many people will drink less orange juice. Thus, the demand curve for orange juice will shift to the left. At the same time, the perfect weather that results in the bumper crop of oranges in Florida will cause the price of oranges to fall. Because oranges are the only ingredient in orange juice, the price of producing orange juice will also fall, thereby increasing the profits of orange juice makers and encouraging them to produce more orange juice. Thus, the supply curve for orange juice will shift to the right. These two shifts occurring at the same time will result in the price decreasing.

2. Consider the market for coffee beans. Suppose that the prices of all other caffeinated beverages go up 30 percent while at the same time a new fertilizer boosts production at coffee plantations dramatically. Can you tell what will happen to the equilibrium price? What about the equilibrium quantity? LOA3-1 a. Both the equilibrium price and the quantity will rise. b. The equilibrium price will rise but the equilibrium quantity will fall. c. The equilibrium price may rise or fall but the equilibrium quantity will rise for certain. d. Neither the price change nor the quantity change can be determined for certain. e. None of the above.

Answer: C; the equilibrium price may rise or fall but the equilibrium quantity will rise for certain.

Coffee and other caffeinated beverages are substitutes. Thus, when the prices of all other caffeinated beverages rise, people will substitute away from them and consume more coffee. That increase in demand for coffee shifts the coffee demand curve to the right. At the same time, the new fertilizer that boosts coffee production will cause the supply of coffee to increase, thereby shifting the supply curve for coffee to the right. With both the demand and supply curves for coffee shifting to the right, the equilibrium quantity will definitely increase. But it is unclear without knowing more information whether the equilibrium price with increase or decrease. If the demand curve shifts further to the right, the equilibrium price will rise. But if the supply curve shifts further to the right, the equilibrium price will fall.

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3. True or False. A price ceiling will result in a shortage only if the ceiling price is greater than the equilibrium price. LOA3-1

Answer: False. If the ceiling price is set at a value below the equilibrium price, then a shortage will result because quantity demanded will exceed quantity supplied. By contrast, if the ceiling price is set higher than the equilibrium price, it will not affect anything because the equilibrium price will not be in violation of the legal ceiling price and all the market participants can proceed as they normally would. Finally, if the ceiling price happens to be just equal to the market equilibrium price, then the market will behave as normal and reach the market equilibrium price because with the equilibrium price just equal to the ceiling price, nobody is violating the law, and nobody has to change their behaviour.

4. Suppose that you are the economic advisor to a municipal government that has to deal with a politically embarrassing surplus caused by a price floor that the government recently imposed. Your first suggestion is to get rid of the price floor, but the politicians don‘t want to do that. Instead, they present you with the following list of options that they hope will get rid of the surplus while keeping the price floor. Identify each one as either could work or can‘t work. LOA3-1 a. Restricting supply. b. Decreasing demand. c. Purchasing the surplus at the floor price.

Answer: a. Could work. There is currently a surplus because, at the floor price, quantity supplied exceeds quantity demanded. If the government can restrict supply, it will be able to reduce the size of the surplus. And if it can restrict supply and shift the supply curve to the left by exactly the amount of the surplus, it will be able to completely eliminate the surplus. Thus, the policy of restricting supply will work if implemented correctly. b. Can’t work. There is a surplus because quantity supplied exceeds quantity demanded.

This gap would only be made worse and increased if demand decreases. So decreasing demand won‘t work. In fact, the government might want to try the opposite, increasing demand. c. Could work. There is a surplus because the quantity that producers wish to supply at the floor price exceeds the quantity that consumers wish to purchase at the floor price. The government can get rid of the unsold surplus by purchasing it at the floor price. In essence, the surplus disappears because the government augments private demand with government demand. Together, the two sources or demand are enough to purchase the total amount supplied at the floor price. Thus, this policy could work if he government is willing to spend the money necessary to purchase the entire surplus at the floor price.

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5. Suppose both the demand for olives and the supply of olives decline by equal amounts over some time period. Use graphical analysis to show the effect on equilibrium price and quantity. LOA3-1

Answer: The supply and demand curves would shift left by an equal amount (supply shifts from S1 to S2 and demand shifts from D1 to D2 in the diagram below), reducing the equilibrium quantity and leaving the equilibrium price unchanged.

6. Governments can use subsidies to increase demand. For instance, the government can pay farmers to use organic fertilizers rather than traditional fertilizers. That subsidy increases the demand for organic fertilizer. Consider two industries, one in which supply is nearly vertical and the other in which supply is nearly horizontal. Assume that firms in both industries would prefer a higher market equilibrium price because a higher market equilibrium price would mean higher profits. Which industry would probably spend more resources lobbying the government to increase the demand for its output? (Assume that both industries have similarly sloped demand curves.)

LOA3-1 a. The industry with a nearly flat supply curve. b. The industry with a nearly vertical supply curve.

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Answer: b. The industry with a nearly vertical supply curve.

Any demand subsidy will shift the demand curve right. That will cause a larger increase in equilibrium price in the industry with the nearly vertical curve. Thus, the firms in that industry will have larger incentive to lobby the government to subsidize the demand for their output.

APPENDIX PROBLEMS

1. Demand and supply often shift in the retail market for gasoline. Here are two demand curves and two supply curves for litre of gasoline in the month of May in a small town in Maine.

Some of the data is missing. LOA3-1

a. Use the following facts to fill in the missing data in the table. If demand is D1 and Supply is S1, the equilibrium quantity is 7000 litres per month. When demand is D2 and supply is S1, the equilibrium price is $3.00 per litre. When demand is D2 and supply is S1, there is an excess demand of 4000 litres per month at a price of $1.00 per litre. If demand is D1 and supply is S2, the equilibrium quantity is 8000 litres per month. b. Compare two equilibriums. In the first, demand is D1 and supply is S1. In the second, demand is D1 and supply is S2. By how much does the equilibrium quantity change? By how much does the equilibrium price change?

c. If supply falls from S2 to S1 while demand simultaneously declines from D2 to D1, does the equilibrium price rise or fall or stay the same? What if only supply falls? What if only demand falls?

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d. Suppose that supply is fixed at S1 and that demand starts at D1. By how many litres per month would demand have to increase at each price level such that the equilibrium price per litre would be $3.00? $4.00?

Answers: (a) See the complete table below for the missing values; (b) equilibrium quantity increases by 1000 litres per month, the equilibrium prices falls by $1.00; (c) equilibrium price stays the same (at $2.00), equilibrium price rises (from $2.00 to $3.00), equilibrium price falls (from $2.00 to $1.00); (d) 2000 litres per month, 4000 litres per month.

Answers:

Part a: If demand is D1 and Supply is S1, the equilibrium quantity is 7000 litres per month. We can eliminate all rows except the third row in the table above because we actually have values for the first two rows for D1 and S1 and the fourth row has a value of 5000 for S1. In equilibrium S1 must equal D1, so the only row where this can hold is row 3. So the entry for row 3- D1 is 7000 and the entry for row 3-S1 is 7000 as well.

When demand is D2 and supply is S1, the equilibrium price is $3.00 per litre. Equilibrium for D2 and S1 occurs at a quantity of 8000. Therefore, the price in row 2 is $3.00.

When demand is D2 and supply is S1, there is an excess demand of 4000 litres per month at a price of $1.00 per litre. The excess demand of 4000 occurs in row 4 for D2 and S1.

This implies the price in row 4 is $1.00.

If demand is D1 and supply is S2, the equilibrium quantity is 8000 litres per month. Since the equilibrium quantity must equal 8000 for D1 and S2, and the only remaining missing quantity entries are in row 4 for D1 and S2, implies that the entries for D1 and S2 in row 4 (quantities) are 8000.

In summary, we have the following table:

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Part b: Compare two equilibriums. In the first, demand is D1 and supply is S1. In the second, demand is D1 and supply is S2. By how much does the equilibrium quantity change? By how much does the equilibrium price change?

The initial equilibrium for D1 and S1 is Q=7000 and P=$2.00. The second equilibrium for

D1 and S2 (an increase in supply) is Q=8000 and P=$1.00. Thus, the change in quantity is an increase of 1000 (=8000 - 7000) and the change in price is a decrease of $1.00 (=$2.00 - $1.00).

Part c: If supply falls from S2 to S1 while demand declines from D2 to D1, does the equilibrium price rise or fall or stay the same? What if only supply falls? What if only demand falls?

The initial equilibrium for S2 and D2 is Q=8500 and P=$2.00. The second equilibrium for S1 and D1 (both supply and demand fall) is Q=7000 and P=$2.00. The equilibrium price remains the same at P=$2.00. The third equilibrium for D2 and S1 (only supply falls) is Q=8000 and P=$3.00. Compared to the initial equilibrium price increases from $2.00 to $3.00. The fourth equilibrium for S2 and D1 (only demand falls) is Q=8000 and P=$1.00.

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

Part d: Suppose that supply is fixed at S1 and that demand starts at D1. By how many litres per month would demand have to increase at each price level such that the equilibrium price per litre would be $3.00? $4.00?

Since supply is fixed at S1 and demand starts at D1 the initial equilibrium is Q=7000 and P=$2.00. For the equilibrium price to increase to $3.00 (from $2.00) demand would need to increase by 2000. This would result in an equilibrium Q=8000 and P=$3.00 (D2 and S1). Note: the original demand at $3.00 is only 6000, so to support an equilibrium price of $3.00 demand would need to be 2000 higher. The same logic applies for the equilibrium price of $4.00. If demand is going to support the equilibrium price of $4.00, then demand will need to increase from 5000 (D1) to 9000 (D2). Thus, demand will need to increase by 4000 and the new equilibrium is Q=9000 and P=$4.00 (D2 and S1).

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

Suppose that Stromnord has exactly 65 pairs of this style of shoe in inventory at the start of the month of July and will not receive any more pairs of this style until at least August 1st.

LOA3-1

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

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

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

Part b: If the price of shoes is set at $75 for both July and August and demand will be D2 in July and D1 in August, then the total demand for these months is 66 pairs of shoes.

Since Stromnord has 65 pairs in inventory they will need to order 1 more pair to meet demand for both months. If the price is set at $55 total demand for both months will be 114. Here Stromnord will need to order 49 pairs (=114 - 65).

3. Use the table below to answer the questions that follow: LOA3-1 a. If this table reflects the supply of and demand for tickets to a particular World Cup soccer game, what is the stadium capacity? b. If the pre-set ticket price is $45, would we expect to see a secondary market for tickets?

Would the price of a ticket in the secondary market be higher than, the same as, or lower than the price in the primary (original) market? c. Suppose for some other World Cup game the quantities of tickets demanded are 20,000 lower at each ticket price than shown in the table. If the ticket price remains $45, would the event be a sellout? Explain why or why not.

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

Feedback: Part a: Stadium Capacity is 60,000. We can infer this from the constant supply independent of price.

Part b: If the pre-set ticket price is $45 we would expect to see a secondary market because there is a shortage of tickets at this price. The shortage of tickets, which equals 10,000, would allow individuals who have the tickets (or get to purchase the tickets) to resell them for a higher price. This is because the market would result in a higher equilibrium price of $65, which implies some individuals are willing to pay between $46 and $65 for the tickets. Thus, the price in the secondary market would be higher.

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

Chapter 04 - Market Failures: Public Goods and Externalities McConnell Brue Flynn Barbiero Macro 16ce

DISCUSSION QUESTIONS

1. Use the ideas of consumer surplus and producer surplus to explain why economists say competitive markets are efficient. Why are below- or above-equilibrium levels of output inefficient, according to these two ideas? LO4.1 1-86 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Answer: When the consumers‘ utility exceeds the price paid, consumer surplus is generated.

Likewise, when producers receive a price greater than marginal cost, producer surplus is created. By producing up to the point where MB = MC, the maximum potential consumer surplus and producer surplus is generated. Producing less than the equilibrium level means that potential surplus is left unrealized. Overproduction subtracts from the surplus because society values the use of the additional resources in other pursuits more than it values them in consumption of that good.

2. What divergences arise between equilibrium output and efficient output when (a) negative externalities and (b) positive externalities are present? How might government correct these divergences? Cite an example (other than the text examples) of an external cost and an external benefit. LO4.1

Answers: (a) When negative externalities are present, the equilibrium output will be greater than the efficient output. This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision.

(b) When positive externalities are present, the equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer‘s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must either aid the producer to encourage more output or engage in its own production of the item with the external benefits.

Government might correct external costs through regulation, which requires firms to internalize these external costs, or it might tax the externality until it becomes too expensive for the firm to incur these costs. This effectively shifts the supply curve to the left as costs of production rise, and the new equilibrium output will be less and closer to the efficient level. External benefits can be encouraged by government subsidies to the producers of these products or by government production. In either case, the supply curve shifts to the right which lowers the equilibrium price and leads to a greater equilibrium output level.

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

3. Why are spillover costs and spillover benefits also called negative and positive externalities?

Show graphically how a tax can correct for a negative externality and how a subsidy to producers can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to producers in correcting for a positive externality? LO4.2

Answers: Spillover costs are called negative externalities because they are external to the participants in the transaction and reduce the utility of affected third parties (thus ―negative‖).

Spillover benefits are called positive externalities because they are external to the participants in the transaction and increase the utility of affected third parties (thus ―positive‖). To show how taxes and subsidies can correct externalities, see Figures 4.6 and 4.7. Compare (b) and (c) in Figure 4.7.

A tax can correct for a negative externality because taxes will increase production costs and thus product price. As the price of the product rises, the externality is reduced because less output is produced. A subsidy to producers can correct for a positive externality by increasing market supply and thus equilibrium output.

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4. An apple grower‘s orchard provides nectar to a neighbour‘s bees, while the beekeeper‘s bees help the apple grower by pollinating his apple blossoms. Use Figure 4.5b to explain why this situation of dual positive externalities might lead to an under allocation of resources to both apple growing and beekeeping. How might this under allocation get resolved via the means suggested by the Coase theorem? LO4.2

Answers: Using Figure 4.5b in the text the following can be said: The market demand curves for apples and honey would not include the spillover benefits accruing to the production of the other good. Both of these outputs are greater than equilibrium outputs leading to an under allocation of resources to both apple-growing and beekeeping.

Using the Coase theorem, we note that it will be to the advantage of individual apple growers and beekeepers to negotiate so that beekeepers (whose hives can be moved) locate their 1-89 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

production in or near orchards. This negotiation will occur as long as property ownership is well defined, only a few people are involved, and bargaining costs are low. For example, an apple grower who owns an orchard could allow a beekeeper to use a portion of his or her land, charging below-market rents so that both parties gain from the agreement.

5. The LoJack car recovery system allows the police to track stolen cars. As a result, they not only recover 90 percent of LoJack-equipped cars that are stolen but also arrest many auto thieves and shut down many ―chop shops‖ that rip apart stolen vehicles to get at their used parts. Thus, LoJack provides both private benefits and positive externalities. Should the government consider subsidizing LoJack purchases? LO4.2

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

6. Explain why zoning laws, which allow certain land uses only in specific locations, might be justified in dealing with a problem of negative externalities. Explain why, in areas where buildings sit close together, tax breaks to property owners for installing extra fire prevention equipment might be justified in view of positive externalities. Explain why excise taxes on beer might be justified in dealing with a problem of external costs. LO4.3

Answers: Zoning could force businesses producing negative externalities to locate in regions where these costs would not spill over onto third parties, or where such costs would at least be reduced. Businesses wanting to locate in regions where external costs would cause the most damage (but where zoning restricts their location) would be forced to eliminate or reduce those external costs. In either case, a more efficient allocation of resources would result.

Tax breaks to property owners who install fire prevention equipment reduces the potential of fire spreading to nearby buildings. Thus, the fire prevention equipment will have positive externalities because of the additional benefit to the community. At the individual level the

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building owners take into account the benefits for their own business, which implies that fire prevention equipment will be underutilized without the tax break (which reduces direct cost).

7. Because medical records are private, an individual applying for private health insurance in Canada will know more about his own health conditions than will the insurance companies to which they are applying for medical services not covered by our national health care

system. Is this likely to increase or decrease the insurance premium that he will be offered? Why? LO4.4

Answer: This information asymmetry will likely increase the insurance premium because the buyers of the insurance policy have more information about their health status than the sellers (the insurance companies). Because of this asymmetric information problem, insurance companies will likely suffer losses if they charge an insurance premium based on the average health of the population. Only the unhealthy will purchase coverage at this "average" price.

These potential losses will force insurance companies to charge a higher premium, on average, than they would if they had complete information.

8. Why is it in the interest of new homebuyers and builders of new homes to have government building codes and building inspectors? LO4.4

Answer: The reason is related to the lack of information and education on the part of most new homebuyers and builders with regard to every aspect of home construction. To make sure that a new building conforms to adequate safety and construction standards, building codes have been created. The government inspectors provide impartial third-party expertise to assure the buyer that the codes have been met. Such inspections also provide information to builders about the electrical and plumbing installation that is usually done by subcontractors. Without building codes and inspections, the market for new homes might be severely hampered. Thus, builders also benefit from codes and inspectors.

9. Which of the following are moral hazard problems? Which are adverse selection problems?

LO4.4 a. A person with a terminal illness buys several life insurance policies through the mail.

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b. A person drives carelessly because they have automobile insurance. c. A person who intends to torch their warehouse takes out a large fire insurance policy. d. A professional athlete who has a guaranteed contract fails to stay in shape during the off season. e. A person who anticipates having a large family takes a job with a firm that offers exceptional child-care benefits.

Answers: a. Adverse selection problem: The buyer of the insurance policy has more information about his or her health than the seller when the contract is signed. b. Moral hazard problem: The person changes his or her behaviour after the insurance contract is signed. c. Adverse selection problem: The buyer of the insurance policy has more information about the likelihood of an intentional fire than the seller when the contract is signed. d. Moral hazard problem: The person changes his or her behavior after the insurance contract is signed. e. Adverse selection problem: The person has more information about her desired family size when the firm hires her.

The LAST WORD What information does a government need if it wants to attempt to reduce a widespread negative externality like air pollution? Who, typically, is actually in possession of that information? How do markets in tradeable emissions permits solve the asymmetric information problem affecting pollution abatement efforts?

Answers: If a government wants to reduce a widespread negative externality such as air pollution, it must know the costs of abatement for the different entities that are producing the negative externality (i.e., the polluters in the case of air pollution). Unfortunately, for the government, this information is usually known only to the polluters themselves because the government does not have detailed information about the internal cost structures of each individual polluter.

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Governments can use tradeable emissions permits ("cap and trade") to solve the asymmetric information problem affecting pollution abatement efforts by handing out permits even without a knowledge of whether they are going to emitters that have the lowest costs of abatement. Because the permits are tradeable, those polluters with higher costs of abatement will purchase permits from those with lower costs of abatement. The high-cost firms benefit because it is less expensive for them to buy permits to keep on polluting than it is to reduce their own pollution. And the lowcost firms benefit because they can make more money selling their permits than it will cost them to reduce their emissions (which they must do after they sell away their permits). Both sides win, the externality is reduced at the lowest cost, and society achieves the allocatively efficient level of pollution.

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REVIEW QUESTIONS

1. Draw a supply and demand graph and identify the areas of consumer surplus and producer surplus. Given the demand curve, what impact will an increase in supply have on the amount of consumer surplus shown in your diagram? Explain why. LO4.1

Answer: An increase in supply will lower the price and increase the amount of consumer surplus for a given demand curve. Any individual that was receiving consumer surplus before the change in supply will realize an increase in consumer surplus as the price falls and the difference between their maximum willingness to pay and the market price widens. See example below.

2. Assume that candle wax is traded in a perfectly competitive market in which the demand curve captures buyers‘ full willingness to pay while the supply curve reflects all production costs. For each of the following situations, indicate whether the total output should be increased, decreased, or kept the same in order to achieve allocative and productive efficiency. LO4.1 a. The maximum willingness to pay exceeds minimum acceptable price. b. Marginal Cost > Marginal Benefit. c. Total surplus is at a maximum. d. The current quantity produced exceeds the market equilibrium quantity.

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Answer: Part a) increased More candle wax should be produced and sold because doing so would increase allocative efficiency and help to ensure that society‘s limited supply of resources are being used to produce the products that consumers most highly desire. That is true because the minimum acceptable price demanded by producers takes into account the opportunity costs of everything else that they could possibly produce from the resources needed to make more candle wax. Thus, the fact that buyers have a maximum willingness to pay that exceeds the producers‘ minimum acceptable price means that the buyers value turning those resources into additional candle wax more than they would if the resources were turned into any other possible product. Therefore, increasing the production of candle wax would increase allocative efficiency.

Part b) decreased Output should be reduced in order to improve allocative efficiency. Because MC > MB at the current level of production, we know that the cost of producing the final unit of candle wax exceeds the benefit felt by consumers from consuming it. This implies that the resources currently being used to produce the final unit of candle wax could be put to better use producing other goods and services. This is true because the MC of the final unit of candle wax includes the opportunity cost of producing other products from the resources currently being used to produce the final unit of candle wax. Therefore, we can improve allocative efficiency by reducing the production of candle wax so that those resources can be freed up and directed toward the production of products that are more highly valued than the final unit of candle wax.

Part c) kept the same Production should be kept at the same level because the level of output that maximizes total surplus is also the level of output that guarantees allocative efficiency. The easiest way to see this is by nothing that both reducing production and increasing production will cause allocative inefficiencies. First consider a decrease in candle wax production. If fewer units are produced, total surplus will fall as units for which consumers‘ maximum willingness to pay exceeds producers‘ minimum acceptable price will no longer be produced. That implies a reduction in allocative efficiency because the resources that are freed up by the reduction in candle wax production will end up being used to produce units of other products that are not as highly valued as the foregone units of candle wax. Next consider an increase in candle wax production. If output is increased, total surplus will also fall because the increased production would involve units of candle wax for which consumers‘ maximum willingness to pay is less than producers‘ minimum acceptable price. That implies a reduction in allocative efficiency because the resources used to increase candle wax production could have gone 1-95 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

instead into the production of products that would have been more highly valued than the additional candle wax.

Part d). decreased The most amazing thing about equilibrium in competitive markets is that when demand curves fully reflect buyers‘ willingness to pay and supply curves fully reflect all production costs, the market equilibrium quantity will be the same as the unique level of output that is both allocatively and productively efficient. Thus, we know that any level of output in excess of the market equilibrium quantity will not be allocatively or productively efficient. We also know that the remedy would be to decrease production back down to the market equilibrium quantity.

3. Efficiency losses ____________________________. LO4.1 a. Are not possible if suppliers are willing to produce and sell a product. b. Can only result from underproduction. c. Can only result from overproduction. d. None of the above.

Answer: d; none of the above.

Feedback: Efficiency losses can result from either overproduction or underproduction. The fact that suppliers are willing to produce and sell a product does not by itself guarantee that the allocatively efficient amount of that product will be produced. In fact, it is possible for them to either underproduce or overproduce relative to the efficient output level. Either will cause an efficiency loss. Thus, answers a, b, and c are all incorrect.

4. Match each of the following characteristics or scenarios with either the term negative externality or the term positive externality. LO4.2 a. Overallocation of resources. b. Tammy installs a very nice front garden, raising the property values of all the other houses on her block. c. Market demand curves are too far to the left (too low). d. Under allocation of resources. e. Water pollution from a factory forces neighbours to buy water purifiers.

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Answers: Part a) negative externality Resources are overallocated to products that impose negative externalities on third parties. This happens because the firms imposing negative externalities on third parties fail to take into account the costs that would be needed to either prevent the negative externalities or compensate those who suffer from them. Not taking those costs into account renders the firms‘ profits artificially high—which leads them to overproduce. As they do so, resources are overallocated to the production of their products and taken away from the production of other products that would have produced greater net benefits for society. In terms of a supply and demand diagram, the negative externalities lower the polluting firms‘ MC curves and shift the market supply curve to the right. This results in an equilibrium quantity in excess of the optimal output level that would prevail if the firms MC curves correctly accounted for the negative externalities.

Part b) positive externality Tammy‘s garden provides a positive externality for her neighbours because while her main intent was to make herself happy by improving the look of her own property, she has also provided a free benefit to her neighbours. They receive higher property values without having to pay Tammy anything for them.

Part c) positive externality Positive externalities cause market demand curves to be too far to the left (too low) relative to total-benefit demand curves. The problem is that when there are positive externalities, the people receiving the positive externalities do not have to pay for the benefits that they receive. Thus, their willingness to pay for those benefits is not captured by the market demand curve. This causes the market demand curve to end up too far to the left, leading to a market equilibrium quantity that is less than the optimal output. And because output is less than optimal, resources that should have flowed to producing more of the good in question flow instead to the production of other products that are less valued by consumers.

Part d) positive externality Resources are under allocated to products that impose positive externalities on third parties. The problem is that when there are positive externalities, the people receiving the positive externalities do not have to pay producers for the benefits that they are receiving. This lowers producer profits and causes them to produce less than the socially optimal output. Because output is below the optimal level, resources that should have flowed to producing more of the goods in question flow instead to the production of other products that are less valued by consumers. In terms of a supply and demand diagram, the positive externality means that the demand curve is too far to the left (too low) relative to the total-benefit demand curve that includes the willingness to pay of the people receiving the positive externalities. With the demand curve shifted to the left in this way, the market equilibrium output ends up lower than the optimal output.

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Part e) negative externality The factory‘s water pollution imposes a negative externality on its neighbours because the factory does not take into account the costs that it imposes on them.

5. Use marginal cost/marginal benefit analysis to determine if the following statement is true or false: ―The optimal amount of pollution abatement for some substances, say, dirty water from storm drains, is very low; the optimal amount of abatement for other substances, say, cyanide poison, is close to 100 percent.‖ LO4.3

Answer: Reducing water flow from storm drains has a low marginal benefit, meaning the MB curve would be located far to the left of where it is in the text diagram. It will intersect the MC curve at a low amount of pollution abatement, indicating the optimal amount of pollution abatement (where MB = MC) is low. Any cyanide in public water sources could be deadly. Therefore, the marginal benefit of reducing cyanide is extremely high and the MB curve in the figure would be located to the extreme right where it would intersect the MC curve at or near 100 percent.

6. People drive faster when they have auto insurance. This example illustrates: LO4.4 a. adverse selection. b. asymmetric information problem. c. moral hazard.

Answer: Moral Hazard People driving faster when they have auto insurance is an example of moral hazard. This is true because moral hazard is the tendency of one party to a contract or an agreement to alter his or her behavior after the contract is signed in ways that could be costly to the other party.

In this case, drivers who have signed auto insurance contracts alter their driving behaviour in a way that is likely to be very costly to the insurance companies, who will have to pay for any increase in the number of accidents that is caused by their customers driving faster.

7. Government inspectors who check on the quality of services provided by retailers and government requirements for licensing in various professions are both attempts to resolve: LO4.4 a. the moral hazard problem. b. the asymmetric information problem.

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Answer: The asymmetric information problem: This is true because government inspectors and professional licensing are attempts to reassure consumers that they do not have to worry about the quality of the services they are buying. This reassurance helps to facilitate trade because without it, many consumers would refuse to purchase such services out of the fear that they would be dealing with an incompetent or dishonest seller.

8. True or False: A market may collapse and have relatively few transactions between buyers and sellers if buyers have more information than sellers. LO4.4

Answer: True: This statement is true because when buyers have more information than sellers, sellers must worry that buyers will take advantage of them. The standard example of this phenomenon is health insurance because individuals almost always have better information about their own health conditions than insurance companies. This causes a pricing problem for the insurance companies, who would like to keep the cost of insurance low so that it will be widely popular with all sorts of people. But the people that most likely want to buy health insurance are people who know that they are sicker than average and will very likely need a lot of costly treatments in the future. Taking that into consideration, the health insurance companies must raise the price of insurance so as to make sure that they will be collecting enough in premiums to be able to cover those high future costs. But as the price of insurance rises, a lot of healthy people will no longer find it worth their while to buy health insurance. As they drop out of the market, the group of people still buying insurance comes to be dominated by the people who privately know that they are more costly than average. As a result, the market may collapse as many who would have bought insurance at lower prices now choose to go without.

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PROBLEMS

1. Refer to Table 4.1. If the six people listed in the table are the only consumers in the market and the equilibrium price is $11 (not the $8 shown), how much consumer surplus will the market generate? LO4.1

Answer: $3 Feedback: Consider the following table as an example:

Using the values above, and assuming an equilibrium price of $11 (not the $8 shown), we first note that an individual will only purchase the good if his or her "maximum price willing to pay" is greater than or equal to the price of the product ($11). This implies that only Bob, Badel, and Bangshik are willing to purchase the good at the price of $11.

Now we can calculate the consumer surplus by adding up the difference between the "maximum price willing to pay" and the actual price paid.

Bob's consumer surplus is $2 (= $13 - $11) Badel's consumer surplus is $1 (= $12 - $11) Bangshik's consumer surplus is $0 (= $11 - $11) 1-100 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Thus, the total consumer surplus equals $3 (= $2 + $1 + $0)

2. Refer to Table 4.2. If the six people listed in the table are the only producers in the market and the equilibrium price is $6 (not the $8 shown), how much producer surplus will the market generate? LO4.1

Answer: $6 Feedback: Consider the following table as an example:

Using the values above, and assuming an equilibrium price of $6 (not the $8 shown), we first note that an individual will only sell the good if his or her "minimum acceptable price" is less than or equal to the price of the product ($6). This implies that only Carlos, Courtney, Constantine, and Carolina are willing to sell the good at the price of $6.

Now we can calculate the producer surplus by adding up the difference between the actual (equilibrium) price and the "minimum acceptable price".

Carlos's producer surplus is $3 (= $6 - $3) Courtney's producer surplus is $2 (= $6 - $4) Constantine's producer surplus is $1 (= $6 - $5) Carolina's Producer surplus is $0 (= $6 - $6)

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Thus, the total producer surplus equals $6 (=$3 + $2 + $1 + $0)

3. Look at Tables 4.1 and 4.2 together. What is the total surplus if Bob buys a unit from Carlos?

If Badal buys a unit from Courtney? If Bob buys a unit from Chad? If you match up pairs of buyers and sellers so as to maximize the total surplus of all transactions, what is the largest total surplus that can be achieved? LO4.2 Answers: $10 (= $13 - $3); $8 (= $12 - $4); $5 = ($13 - $8); $30.

Feedback: Consider the following tables as an example:

If Bob buys a unit of the good from Carlos, then the economic surplus is the difference between Bob's "maximum price willing to pay" and Carlos's the "minimum acceptable price." The economic surplus is $10 (= $13- $3) If Badal buys a unit form Courtney, then the economic surplus equals $8 (= $12 - $4).

If Bob buys a unit form Chad, then the economic surplus is $5 (= $13 - $8).

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If we match up buyers and sellers to maximize the total economic surplus, then we need to choose the pairs with the largest gap between "maximum price willing to pay" and the "minimum acceptable price."

This implies the following pairs (Bob, Carlos) with an economic surplus of $10, (Badal, Courtney) with an economic surplus of $8, (Bangshik, Constantine) with an economic surplus of $6, (Bart, Carolina) with an economic surplus of $4, (Bernis, Craig) with an economic surplus of $2, and (Betty, Chad) with an economic surplus of $0. Adding this up across all pairs gives us a total economic surplus of $30.

4. ADVANCED ANALYSIS Assume the following values for Figures 4.4a and 4.4b. Q1 = 20 bags. Q2 = 15 bags. Q3 = 27 bags. The market equilibrium price is $45 per bag. The price at a is $85 per bag. The price at c is $5 per bag. The price at f is $59 per bag. The price at g is $31 per bag. Apply the formula for the area of a triangle (Area = ½ × Base × Height) to answer the following questions. LO4.2 a. What is the dollar value of the total surplus (producer surplus plus consumer surplus) when the allocatively efficient output level is being produced? How large is the dollar value of the consumer surplus at that output level? b. What is the dollar value of the deadweight loss when output level Q2 is being produced? What is the total surplus when output level Q2 is being produced? c. What is the dollar value of the deadweight loss when output level Q3 is produced?

What is the dollar value of the total surplus when output level Q3 is produced?

Answers: (a) At output level Q1, total surplus is $800; consumer surplus at Q1 is $400. (b) The deadweight loss at Q2 is $50; the total surplus at Q2 is $750. (c) The deadweight loss at Q3 is $98; the dollar value of the total surplus at Q3 is $702.

Feedback: To answer this question, let us first find the mathematical representation of the supply and demand schedules. To help us accomplish this objective we us the following figures.

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Now consider the following values as an example. Assume the following values for Figures 4.4a and 4.4b: The equilibrium quantity Q1 = 20, the market equilibrium price is $45 per bag, the price at a is $85 per bag, the price at c is $5 per bag.

To derive the demand schedule (inverse demand schedule), we use the following ordered pairs: (20,45) equilibrium and (0,85) point a.

We know the form of the demand schedule will be P=C1 + C2Q where C1 and C2 are unknown constants. The intercept, C1, can be found by setting Q equal to zero. This is point a, so C1 equals 85. To find the slope, C2, we divide the change in quantity by the change in price using our two ordered pairs above (rise-over-run). This implies C2 equals (20 - 0) / (45 - 85) = -2.

Thus, we have the following demand schedule: P = 85 - 2Q

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To derive the supply schedule (inverse supply schedule), we use the following ordered pairs: (20,45) equilibrium and (0,5) point c.

We know the form of the supply schedule will also be P = C1 + C2Q where C1 and C2 are once again unknown constants. The intercept, C1, can be found by setting Q equal to zero. This is point c, so C1 equals 5. To find the slope, C2, we divide the change in quantity by the change in price using our two ordered pairs above (rise-over-run). This implies C2 equals (20 - 0) / (45 - 5) = 2.

Thus, we have the following supply schedule: P = 5 + 2Q With these schedules we can now answer the following questions: Part (a): What is the dollar value of the total surplus (producer surplus plus consumer surplus) when the allocatively efficient output level is being produced? How large is the dollar value of the consumer surplus at that output level?

To calculate total surplus, we use the following formula for the area of a triangle (Area = ½ (Base × Height)).

The area between the demand schedule P = 85 - 2Q and the supply schedule P = 5 + 2Q for the quantity ranging from 0 to 20 is the total economic surplus. This is a triangle with a base of 80 (the price difference at Q = 0, or points a and c) and a height of 20 (the number of units purchased in equilibrium). Using these values, we have a total surplus = (1/2) × 80 × 20 = 800.

The consumer surplus is the area between the demand curve and the equilibrium price line. Here we have a base of 40 (the price difference between the demand schedule price at Q = 0, which is $85, and the equilibrium price of $45). The height of the triangle is once again 20 (the number of units purchased in equilibrium). Using these values, we have a consumer surplus = (1/2) × 40 × 20 = 400.

Consider the following additional values for the figures above: Q2 = 15 bags. Q3 = 27 bags, the price at f is $59 per bag, and the price at g is $31 per bag.

Part (b): What is the dollar value of the deadweight loss when output level Q2 is being produced? What is the total surplus when output level Q2 is being produced?

The first thing we need to do is calculate the price at Q2 = 15 for the supply and demand schedules. The price on the supply schedule is P = 5 + 2 × 15 = 35. The price on the demand schedule is P = 85 – 2 × 15 = 55. The difference between these two prices is our base, which equals 20. The height is the quantity difference between the equilibrium quantity Q1 = 20 and the underproduction quantity Q2 = 15 (= 5). Thus, the deadweight loss from underproduction is (1/2) × 20 × 5 = 50.

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The total surplus can be found by subtracting the deadweight loss from the original total surplus that maximized efficiency. This is 800 (maximum total surplus) - 50 (deadweight loss) = 750.

Part (c): What is the dollar value of the deadweight loss when output level Q3 is produced? What is the dollar value of the total surplus when output level Q3 is produced?

Here we follow the same procedure. We are given the price at point f is $59 and the price at point g is $31 (we do not need to calculate these prices using the demand and supply schedule). The quantity Q =27 represents over production (the marginal cost to society exceeds the marginal benefit to society) of 7 units. To calculate the deadweight loss from this overproduction we use the price difference as the base, which is 28 (= 59 - 31), and the amount of overproduction as the height, which is 7 (= 27 - 20). This results in a deadweight loss of 98 (= (1/2) × 28 × 7).

The total surplus can be found by subtracting the deadweight loss from the original total surplus that maximized efficiency. This is 800 (maximum total surplus) - 98 (deadweight loss) = 702. Note here that we capture all of the surplus from producing the equilibrium quantity, but we lose surplus from overproduction (inefficient use of resources).

5. Refer to Tables 4.1 and 4.2, which show, respectively, the willingness to pay and willingness to accept of buyers and seller of bags of oranges. For the following questions, assume that the equilibrium price and quantity depend on the following changes in supply and demand. Also assume that the only market participants are those listed by name in the two tables. LO4.2 a. What are the equilibrium price and quantity for the data displayed in the two tables? b. Instead of bags of oranges, assume that the data in the two tables deal with a good (such as fireworks displays) that can be enjoyed by free riders who do not pay for it. If all the buyers in the two tables free ride, what quantity will private sellers supply? c. Assume that we are back to talking about bags of oranges (a private good), but that the government has decided that tossed orange peels impose a negative externality on the public that must be rectified by imposing a $2-per-bag tax on sellers. What is the new equilibrium price and quantity? If the new equilibrium quantity is the optimal quantity, by how many bags were oranges overproduced before?

Answers: P* = $8 and Q* = 6 bags; Q* = 0; P* = $9 and Q* = 5 bags.

Feedback: Here we consider the tables from Problems 1 and 2.

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a. To determine the equilibrium price of oranges, we begin by comparing the highest willingness to pay with the lowest minimum acceptable price. Bob is willing to pay $13 and Carlos is willing to accept at minimum $3. This trade is made because Bob is willing to pay more than Carlos requires for the sale. We then move on to the trade between Badel and Courtney. This trade is also made because Badel is willing to pay $12 and Courtney only requires $4 to make the sale. This goes on until the "maximum willingness to pay" equals the "minimum acceptable price". This occurs for the trade between Betty and Chad. Betty's "maximum willingness to pay" is $8 and Chad's "minimum acceptable price" is also $8. Since the six purchasers (each purchase 1 unit) buy the 6 units produced by the six producers (each produces 1 unit), the equilibrium quantity is 6 at the equilibrium price of $8.

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b. If instead of bags of oranges, the data in the two tables dealt with a public good like fireworks displays, and all the buyers free ride, then the quantity supplied will be zero. Everyone will try to pay a zero price. c. If the government decides that tossed orange peels impose a negative externality on the public that must be rectified by imposing a $2-per-bag tax on sellers, then the "minimum acceptable price" will increase by the amount of the tax. The reason is that the producers must now pay an additional $2 on top production costs. This implies that the "minimum acceptable price" for Carlos is $5(= $3 + $2), Courtney $6, Constantine $7, Carolina $8, Craig $9, and Chad $10. Comparing this new "minimum acceptable price" schedule with the original "maximum willingness to pay" schedule we have the following new equilibrium.

Bob is willing to pay $13 and Carlos is willing to accept at minimum $5. This trade is made because Bob is willing to pay more than Carlos requires for the sale. We then move on to the trade between Badel and Courtney. This trade is also made because Badel is willing to pay $12 and Courtney only requires $6 to make the sale. This goes on until the "maximum willingness to pay" equals the "minimum acceptable price".

This occurs for the trade between Bernis and Craig now. Bernis' "maximum willingness to pay" is $9 and Craig's "minimum acceptable price" is also $9. The potential trade between Betty and Chad no longer takes place. Betty is only willing to pay $8 and Chad requires $10 to make the sale. Since only five purchasers (each purchase 1 unit) buy the 5 units produced by the five producers (each produces 1 unit), the new equilibrium quantity is 5 at the equilibrium price of $9.

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

6. Consider a used-car market with asymmetric information. The owners of used cars know what their vehicles are worth but have no way of credibly demonstrating those values to potential buyers. Thus, potential buyers must always worry that the used car they are being offered may be a low-quality ―lemon.‖ LO4.2 a. Suppose that there are equal numbers of good and bad used cars in the market and that good used cars are worth $13,000 while bad used cars are worth $5,000. What is the average value of a used car? b. By how much does the average value exceed the value of a bad used car? By how much does the value of a good used car exceed the average value? c. Would a potential seller of a good used car be willing to accept the average value as payment for her vehicle? d. If a buyer negotiates with a seller to purchase the seller‘s used car for a price equal to the average, is the car more likely to be good or bad?

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e. Will the used-car market come to feature mostly, if not exclusively, lemons? How much will used cars end up costing if all the good cars are withdrawn?

Answer: (a) $9,000; (b) By $4,000; $4,000; (c) No; (d) Bad; (e) Yes; $5,000 each

Feedback: a. Since there are an equal number of good and bad used cars in the market the likelihood of each type is 0.50 (or 50% good and 50% bad)). This implies the average value of a used car is $9000 (= 0.5 × $13,000 + 0.5 × $5,000). You can also find the average by adding together the two values ($13,000 + $5,000) and dividing by two = $18,000/2 = $9,000.

b. The average value of a used car exceeds the value of a bad used car by $4,000 (= $9,000 - $5,000).

The value of a good used car exceeds the average value a used car by $4,000 (= $13,000 - $9,000).

c. No, the typical buyer would NOT be willing to pay the average value as there is a 50 percent chance that they are not getting the full value of the car.

d. The car will likely be a bad used car with a value of $5,000. The seller of a good used car is unlikely to accept $9,000 (average value) for a car worth $13,000 (value of a good used car).

e. Yes, this market will come to feature mostly, if not exclusively, lemons. If all the good cars are withdrawn, the remaining bad cars should go for what they are worth, $5,000 each.

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Chapter 05 – Public Goods, Public Choice, and Government Failure McConnell Brue Flynn Barbiero Macro 16ce

DISCUSSION QUESTIONS 1. What are the two characteristics of public goods? Explain the significance of each for public provision as opposed to private provision. What is the free-rider problem as it relates to public goods? Is Canadian border patrol a public good or a private good? Why? What type of good is satellite TV? Explain. LO5.1

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

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

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

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

2. Explain how affirmative and negative majority votes can sometimes lead to inefficient allocations of resources to public goods. Use the information in Figures 5.2a and 5.2b to show how society might be better off if Garcia were allowed to buy votes. LO5.2

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Answer: The problem arises because the one-person one-vote rule does not allow voters to register the strength of their preferences. In the text‘s example, three people—Garcia, Johnson, and Lee—have preferences with regard to the benefits of national defense as follows: It is worth $700 to Garcia, $250 to Johnson, and $200 to Lee for a total of $1,150 worth of benefits. The national defense program would cost $900 to be borne by each voter equally, or $300 each. This program would lose a majority vote because neither Johnson nor Lee would be willing to pay $300 for it. However, the total benefit to society in this three-voter world would have been $1,150. A ―no‖ vote is therefore inefficient in the economic sense.

On the other hand, suppose the program was worth $100 to Garcia, but $350 each to Johnson and Lee for a total benefit of $800. In this case the program would win because both Lee and Johnson would vote for it, but Garcia would not. The $900 spending program would be approved even though it was worth only $800 to society. In this case a ―yes‖ vote is inefficient in the economic sense.

In Figure 5.2a, since Garcia would receive a net benefit of $400 ($700 value – $300 in additional taxes) from the public good, she would be willing to spend up to $400 to buy votes to help the measure pass. For example, if Garcia were to pay Johnson $60 to change his vote, it would be in Johnson's best interest to do so since he receives $250 of value from the public good and $60 from Garcia (which is greater than his cost of $300). The measure would pass, leading to a more efficient economic outcome. (Note that if Garcia spent more than $250 buying votes that would also lead to an inefficient economic outcome since the value of the public good to society would be less than the total cost.)

In Figure 5.2b, Garcia would incur a net loss of $200 if the measure passes, so it would be in her best interest to spend up to $200 to help defeat the measure. If she paid Johnson $60 to change his vote to "no," Johnson would receive more economic benefit by voting against the measure. The measure would fail, leading to a more efficient economic outcome. Note that buying votes in Canada is illegal. Even though it could lead to more efficient economic outcomes in some cases, other complicating factors need to be considered.

3. ―Majority voting ensures that government will produce only those public goods for which benefits exceed costs.‖ Discuss. LO5.2

Answer: The statement is incorrect. A number of government failures and voting paradoxes can lead to situations in which a government overprovides a public good and produces beyond the amount at which MB = MC. Inefficient voting outcomes and the paradox of voting may be to blame.

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4. ―The problem with our democratic institutions is that they don‘t correctly reflect the will of the people! If the people—rather than self-interested politicians or lobbyists—had control, we wouldn‘t have to worry about government taking actions that don‘t maximize allocative and productive efficiency.‖ Critique. LO5.2

Answer: The statement is false. Due to voter failure and the problem that economically inefficient policies are often very popular with the electorate.

5. Does traditional one-person-one-vote (1p1v) majority voting allow voters to directly express differences in strengths of preference? Does quadratic voting do any better? Discuss the differences and then explain which system you prefer, and why. LO5.2

Answer: Traditional one-person-one-vote (1p1v) majority voting does NOT allow voters to directly express differences in strengths of preference because a single voter's vote only counts once regardless of the strength of preference (or how much the voter stands to gain or lose from a public good).

Quadratic voting is an alternative voting mechanism that leads to fewer inefficient voting outcomes than 1p1v. Under quadratic voting, the winning side of an election (Yes or No) is still determined by the ―50 percent plus 1‖ majority voting rule that you are familiar with. But under a quadratic voting system, voters can purchase and then cast as many votes as they desire. Naturally, voters with strong preferences will wish to buy more votes because the outcome matters more for them than for people with weak preferences.

Under quadratic voting, the cost of purchasing votes is quadratic, meaning that it increases exponentially with the square of the number of votes purchased. With quadratic voting, each voter will purchase votes up to the point where the marginal benefit from purchasing additional votes equals the marginal cost of purchasing additional votes.

Thus, this system would yield more socially efficient outcomes than the one-person-onevote system, which does not enable voters to express the strength of their preferences.

6. Jean Baptiste Colbert was the Minister of Finance under King Louis XIV of France. He famously observed, ―The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.‖ How does his comment relate to the special-interest effect? LO5.3

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Answer: The logic above applies to special interests and collective action as well. In the case of special interest and collective action, the large gains to the smaller group motivates these individuals to be more active politically and financially than the larger group who faces small losses at the individual level. That is, the smaller group will extract resources from the larger group until it is no longer politically feasible.

7. What is rent seeking and how does it differ from the kinds of profit maximization and profit seeking that we discussed in previous chapters? Provide an actual or hypothetical example of rent seeking by firms in an industry, by a union, or by a professional association (for example, physicians, schoolteachers, or lawyers). Why do elected officials often accommodate rent-seeking behaviour, particularly by firms, unions, and professional groups located in their home states? LO5.3

Answer: Rent seeking is an appeal to the government for special benefits at taxpayers or someone else's expense. The term 'rent' refers to any payment is excess of the minimum amount that is necessary to keep the resource employed in its current use. Rent-seeking is different from profit maximization because rent-seeking attempts to influence the political process to gain increased profit or income. Standard profit maximization and profit seeking is driven by market forces, such as new products, cost minimization, etc.

Examples will vary. An industry may try to block imports explicitly or implicitly using tariffs and/or non-tariff barriers. Canada's beef producers might argue that they are concerned about mad-cow disease to block imports of U.S. beef. A union may restrict access to employment or negotiate as a block to keep wages higher than the market wage.

Professional associations may require certification and testing to actively participate in the market.

These groups tend to be politically more active and willing to spend resources supporting individuals who support their respective objectives. Thus, a politician is likely to support their activities.

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8. How does the problem of limited and bundled choice in the public sector relate to economic efficiency? Why are public bureaucracies possibly less efficient than firms? LO5.3

Answer: Limited and bundled choice in the political process tends to reduce economic efficiency because blocks of public goods and social programs are provided. That is, instead of evaluating each public good and social program on its respective costs and benefits the politician chooses all programs together. Some of these goods and programs may benefit society (positive net benefits), but others may hurt society (negative net benefits).

The private market is driven by profit. If a company continues to lose money or produces a good that society does not want it goes out of business. If the public sector, a bureaucracy, fails to use its resources efficiently then the market is not there to discipline it. In this case, the bureaucracy continues to operate inefficiently and may actually grow in size in an attempt to 'fix' the inefficiency.

However, we need to look carefully at the logic underlying this argument. Most bureaucratic operations do not provide private goods. They provide public goods and social services that correct potential market failures through regulation and direct provision. Thus, the market analogy may not apply.

9. Explain: ―Politicians would make more rational economic decisions if they weren‘t running for re-election every few years.‖ LO5.3

Answer: Because political officeholders must seek voter support every few years, they favor programs with immediate and clear-cut benefits and with vague or deferred costs. Conversely, politicians will reject programs with immediate and easily identifiable costs but with long term, less measurable benefits. Such biases can lead politicians to reject economically justifiable programs and to accept programs that are economically irrational. Politicians may make these and other irrational decisions in order to curry favor with the voters.

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10. Critique the following statement: ―Thank goodness we have so many government regulatory agencies. They keep Big Business in check.‖ LO5.3

Answer: Government regulatory agencies sometimes fall under the sway of the industries that they are supposed to be regulating. Those instances of ―regulatory capture‖ imply that this statement is overly confident in the ability of government regulatory agencies to keep powerful businesses in check. If regulatory capture occurs, the captured regulator ceases to be a truly independent watchdog looking out for the better interests of the public. Instead, it often imposes regulations that reduce competition and promote high levels of profit in the ―regulated‖ industry.

The LAST WORD What were some of the government failures at the start of the COVID-19 pandemic? Give one reason the virus spread more widely in the U.S. compared to Canada.

Answer: Some of the failures include: lack of preparedness in Canada‘s nursing homes, lack of personal protective equipment (PPE) for front-line healthcare workers, and lack of effective coordination for sharing information among Canadian provinces. A contributing factor to the virus spreading more quickly in the U.S.A. was the premature opening of economies in some parts of the country.

REVIEW QUESTIONS

1. Draw a production possibilities curve with public goods on the vertical axis and private goods on the horizontal axis. Assuming the economy is initially operating on the curve, indicate how the production of public goods might be increased. How might the output of public goods be increased if the economy is initially operating at a point inside the curve? LO5.1

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

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2. Use the distinction between the characteristics of private goods and public goods to determine whether the following should be produced through the market system or provided by government: (a) French fries, (b) airport screening, (c) court systems, (d) mail delivery, and (e) medical care. Explain your answers. LO5.1

Answer: a. French fries: Market system (rival and excludable) b. Airport screening: Government c. Court systems: Government d. Mail delivery: Combined market and government. The law gives the postal service a monopoly, but services such as package delivery have private competition. e. Medical care: Combined market and government. The mix of private and public production is a controversial topic addressed in the chapter on the economics of health care.

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3. We can apply voting paradoxes to the highway construction example of Table 5.2. Suppose there are only five people in a society, and each favours one of the five highway construction options listed in Table 5.2. (―No new construction‖ is one of the five options). Explain which of these highway options will be selected using a majority paired-choice vote. Will this option be the optimal size of the project from an economic perspective? LO5.2

Answer: Project B (new 2-lane highway) wins using a paired-choice vote. There is no paradox of voting here, and B is the preference of the median voter. The two voters who favor no new construction and widening, respectively, will prefer new 2-lane highways— project B—to new 4- or 6-lane highways. The two voters preferring new 4- and 6-lane highways will prefer a new 2-lane highway to widening or no new construction. The median voter‘s preference for B will prevail. However, the optimal size of the project from an economic perspective is C, as it would provide a greater net benefit to society than B.

4. True or False: The median voter model explains why politicians so often stake out fringe positions that appeal only to a small segment of the electorate. LO5.2

Answer: False The median voter model does NOT explain why politicians so often stake out fringe positions that appeal only to a small segment of the electorate. What it actually does is explain why politicians so often take positions that appeal to the median voter who prefers moderate positions.

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The motivation for politicians to appeal to the median voter and advocate moderate positions is a result of the procedure of majority voting itself. In order to win an election, a politician needs to get 50 percent plus one of the votes. That implies that she must win the vote of the median voter, the voter holding the middle position on the issues at stake in the election. Only if the politician can capture this person‘s support can she win the election.

Her attempt to capture the support of the median voter will also tend to draw in a lot of the voters on either side of the median voter. This is true because the extreme voters on either policy stance that would appeal to the other side‘s extreme voters. So, for this reason as well, politicians will tend to take positions that appeal to the median voter.

5. In Figure 5.2b, we saw that traditional one-person-one-vote (1p1v) majority voting results in an inefficient majority Yes vote (two in favor, one opposed). Let‘s see whether the outcome is better under quadratic voting. LO5.2 a. How much will Garcia be willing to spend on votes? b. How much each will Johnson and Lee be willing to spend on votes? c. How many votes will Garcia purchase? How many will Johnson and Lee each purchase? d. What is the total number of votes cast for No? For Yes? e. Approval of this project requires a 50-percent-plus-1 majority. Will the project be approved? f.

Does quadratic voting lead to the economically efficient outcome here?

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Answer: a. The proposed public project has a net value of –$200 to Garcia ($100 value – $300 in additional taxes). Therefore, Garcia would be willing to spend up to $200 on "no" votes to prevent the project from passing to avoid the $200 loss. b. The proposed public project has a net value of $50 each to Johnson and Lee ($350 value – $300 in additional taxes). Therefore, Johnson and Lee would be willing to spend up to $50 each on "yes" votes to help the project pass because that is the value of the public good to each of them individually. c. Because the net value of the public project to Garcia is –$200 (as explained in part a), she will buy 14 votes ($142 = $196). She would not buy 15 votes because the cost of 15 votes ($152 = $225) would exceed the value of avoiding the $200 loss. Because the net value of the public project to Johnson and Lee is $50 each (as explained in part b), they will each buy 7 votes ($72 = $49). They would not buy 8 votes each because the cost of 8 votes ($82 = $64) would exceed the $50 value of the project to each individual. d. The total number of "yes" votes cast will be 14 and the total number of "no" votes cast will be 14 (as explained in part c). e. If the project requires a 50-percent-plus-1 majority, the project will NOT be approved because the number of "yes" votes would not exceed the 50-percent threshold. f.

In this case, quadratic voting leads to an economically efficient outcome because the total cost of the project ($900 in additional taxes) exceeds the total value that the individual voters place on the project ($100 + $350 + $350 = $800).

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6. Tammy Hall is the mayor of a large Canadian city. She has just established the Office of Window Safety. Because windows sometimes break and spray glass shards, every window in the city will now have to pass an annual safety inspection. Property owners must pay the $5per-window inspection cost—and by the way, Tammy has made her nephew the new head of the Office of Window Safety. This new policy is an example of _____: LO5.3 a. political corruption b. rent seeking c. adverse selection

Answer: Rent-seeking. This new policy is an example of rent seeking.

By creating the new set of regulations, Mayor Hall has provided her nephew with a way to collect an economic rent, which by definition is a payment in excess of the minimum amount needed to keep an economic resource employed in its current use. In this case, all of the city‘s windows would have kept on being employed in their current use—as windows—even without the new window inspection fees. Thus, the entire $5-perwindow fee that is collected by her nephew will be an economic rent.

By contrast, the window-inspection policy is not an example of political corruption, earmarks, or adverse selection.

It is not an example of political corruption because what is being done here is perfectly legal. Nobody is bribing public officials to either do something illegal or to get them to perform a service that they should be providing to the public for free. The new policy is stupid, but Tammy‘s nephew will in fact be obeying the law when making inspections and demanding $5 for each one. So, there is no political corruption going on here.

Finally, this law has nothing to do with adverse selection because it has nothing to do with one party to a contract possessing more information than another party to the contract.

7. Suppose that total costs (TC) double for each project listed in Table 5.2. Which project(s) is (are) now economically viable? LO5.3

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a. Plan A only b. Plans C and D only c. Plans B and C d. Plans A and B only e.

None of the plans.

Answer: e

We answer this question by comparing the marginal cost of each project to the marginal benefit of each project. If the marginal benefit of a project exceeds the marginal cost, then the project is economically viable. In other words, if the net benefit (marginal benefit minus marginal cost) is positive, then the project is economically viable. In this case, if the total cost of each project doubles, the marginal benefit DOES NOT exceed marginal cost for any of the plans. Therefore, none of the plans are economically viable options.

8. Explain the paradox of voting through reference to the accompanying table, which shows the ranking of three public goods by voters Colbert, Fallon, and Kimmel: LO5.3

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Answer: The paradox is that majority voting does not always provide a clear and consistent picture of the public‘s preferences. Here the courthouse is preferred to the school (both Colbert and Fallon ranked the courthouse ahead of the school), and the park is preferred to the courthouse (both Colbert and Kimmel ranked the park ahead of the courthouse). Given this, we would surmise that the park is preferred to the school. But paired-choice voting would show that the school is preferred to the park (both Fallon and Kimmel ranked the school ahead of the park).

PROBLEMS

1. On the basis of the three individual demand schedules below, and assuming these are the only three people in the society, determine (a) the market demand schedule on the assumption that the good is a private good and (b) the collective demand schedule on the assumption that the good is a public good. LO5.1

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(a) Market demand schedule

Quantity Demanded

Price

1

$8

2

$7

4

$6

7

$5

10

$4

13

$3

16

$2

19

$1

(b) Collective demand schedule

Quantity 1 2 3 4 5 6 7 8

Amount Society is Willing to Pay $19 $16 $13 $10 $7 $4 $2 $1

Feedback: Part (a): Derive the market demand schedule on the assumption that the good is a private good. To accomplish we use the principle of horizontal summation. That is, we fix price and add up the quantities demanded by the individuals.

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

At a price of $8: individual 1 (I1) demands 0, individual 2 (I2) demands 1, and individual 3 (I3) demands 0. Thus, we have the following market demand ordered pair (1,8).



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



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



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



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



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



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



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

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



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



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



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



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

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

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



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



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



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

2. Use your demand schedule for a public good, determined in problem 1, and the following supply schedule to ascertain the optimal quantity of this public good. LO5.1

Answer: 4 units Feedback: Collective Demand Schedule:

Quantity 1 2 3 4 5

Amount Society is Willing to Pay $19 $16 $13 $10 $7

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6 7 8

$4 $2 $1

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

The optimal quantity can be found by finding the price where the willingness to pay equals price required by the firm to supply that last unit (basically the price that clears the market). For example, at $19 society demands one unit but firms are willing to supply 10 units. At $16 society demands 2 units but firms are willing to supply 8 units. This continues until we reach the price of $10 where society demands 4 units and firms are willing to supply 4 units. Thus, the optimal quantity is 4 units.

3. Look back at Figures 5.2a and 5.2b, which show the costs and benefits to voters Garcia, Johnson, and Lee of two different public goods that the government will produce if a majority of voters support them. Suppose that Garcia, Johnson, and Lee have decided to have one single vote at which the funding for both of those public goods will be decided simultaneously. LO5.2

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a. Given the $300 cost per person of each public good, what are Garcia‘s net benefits for each public good individually and for the two combined? Will she vote yes or no on the proposal to fund both projects simultaneously? b. What are Lee‘s net benefits for each public good individually and for the two combined?

Will she vote yes or no on the proposal to fund both projects simultaneously? c. What are Johnson‘s net benefits for each public good individually and for the two combined? Will he vote yes or no on the proposal to fund both projects simultaneously —or will he be indifferent? d. Who is the median voter here? Who will the two other voters be attempting to persuade?

Answer: a. Garcia‘s net benefit for the good in 5.2a is $400 (= $700 of benefit minus $300 of cost). Her net benefit for the public good in 5.2b is -$200 (= $100 of benefit minus $300 of cost). Thus, her combined net benefit for both projects is $200 (= $400 from the first project -$200 from the second project) and she will want to vote yes on funding both projects simultaneously.

b. Lee‘s net benefit for the public good in 5.2a is -$100 (=$200 of benefit minus $300 of cost). Her net benefit for the public good in 5.2b is $50 (= $350 of benefit minus $300 of cost). Thus, her combined net benefit for both projects is -$50 (= $100 from the first project + $50 from the second project) and she will want to vote no on funding both projects simultaneously.

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c.

Johnson‘s net benefit for the public good in 5.2a is -$50 (= $250 of benefit minus $300 of cost). His net benefit for the public good in 5.2b is $50 (= $350 of benefit minus $300 of cost). Thus, his combined net benefit for both projects is $0 (= -$50 from the first project + $50 from the second project) and he will be indifferent.

d. Johnson is the median voter whose preference is ―in the middle‖ and whose vote will decide the outcome. Thus, Garcia and Lee will put their efforts towards persuading Johnson to vote for their respective positions.

4. Political advertising is often directed at winning over so-called swing voters, whose votes might go either way. Suppose that two political parties—the Freedom Party and the Liberty Party—disagree on whether to build a new road. Polling shows that of 1000 total voters, 450 are firmly for the new road and 450 firmly against. Thus, each party will try to win over a majority of the 100 remaining swing voters. LO5.2 a. Suppose that each party spends $5,000 on untargeted TV, radio, and newspaper ads that are equally likely to reach any and all voters. How much per voter will be spent by both parties combined? b. Suppose that, instead, each party could direct all of its spending toward just the swing voters by using targeted social media ads. If all of the two parties‘ combined spending is targeted at just swing voters, how much will be spent per swing voter? c. Suppose that only the Freedom Party know how to target voters using social media. How much per swing voter will it be spending? If at the same time the Liberty Party is still using only untargeted TV, radio, and newspaper ads, what portion of its total spending is likely to be reaching the 100 swing voters? How much per swing voter does that portion amount to? d. Looking at your answers to part c, how much more per swing voter will the Freedom Party be spending than the Liberty Party? If spending per swing voter influences elections, which party is more likely to win?

Answer:

a.

The two parties combined will spend $10,000 (= $5,000 + $5,000). That amounts to $10 per voter (= $10,000 of total combined advertising spending divided by 1000 total voters).

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b. If all advertising could be targeted at just the swing voters, the parties would spend $100 per swing voter (= $10,000 of total combined advertising spending divided by 100 swing voters).

c. Thanks to knowing how to target just swing voters, the Freedom Party will spend $50 per swing voter (= $5,000 of targeted ad spending divided by 100 swing voters). By contrast, because the Liberty Party is using untargeted ads, only about $500 of its $5,000 of advertising spending will flow to swing voters (because swing voters constitute 100 out of 1000, or 10 percent of the total electorate). Thus, the Liberty Party will end up spending about $5 per swing voter (= $500 divided by 100 swing voters) as a result of using untargeted ads.

d. The Freedom Party will be spending about $45 more per swing voter (=$50 per swing voter by the Freedom Party minus $5 per swing voter by the Liberty Party) thanks to its sole use of targeted ads. If spending per swing voter influences elections, the Freedom Party is more likely to win.

5. Let‘s see whether quadratic voting can avoid the paradox of voting that arose in Table 5.3 when using 1p1v in a series of paired-choice majority votes. LO5.2

To reexamine this situation using quadratic voting, the nearby table presents the maximum willingness to pay of Garcia, Johnson, and Lee for each of the three public goods. Notice that each person‘s numbers for willingness to pay match her or his ordering of preferences (1st choice, 2nd choice, 3rd choice) presented in Table 5.3. Thus, Garcia is willing to spend more 1-129 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

on her 1st choice of national defense ($400) than on her second choice of a road ($100) or her third choice of a weather warning system ($0). LO5.2

a. Assume that voting will be done using a quadratic voting system and that Garcia, Johnson, and Lee are each given $500 that can only be spent on purchasing votes (i.e., any unspent money has to be returned). How many votes will Garcia purchase to support national defense? How many for the road? Place those values into the appropriate blanks in the table below and then do the same for the blanks for Johnson and Lee.

b. Across all three voters, how many votes are there in favor of national defense? The road?

The weather warning system? c. If a paired-choice vote is taken of national defense versus the road, which one wins? d. If a paired-choice vote is taken of the road versus the weather warning system, which one wins? e. If a paired-choice vote is taken of national defense versus the weather warning system, which one wins? f.

Review your answers to parts c, d, and e. Has quadratic voting eliminated the paradox of voting that we found when using 1p1v?

Answer: a. Under a quadratic voting system, each rational voter would be willing to purchase votes up to the point where the marginal benefit from purchasing an additional vote equals the 1-130 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

marginal cost of purchasing an additional vote. For example, if Garcia places a $400 value on national defense, it would be rational for her to pay up to $400 to buy votes in favor of national defense. This is the point where MB = MC (for this example, we assume there are no additional costs beyond the cost of purchasing votes). Since the total cost of buying votes is the number of votes squared, we can find the number of votes by taking the square root of the marginal benefit of each public good for each individual voter. If Garcia spends $400 on votes for national defense, she can buy = 20 votes. Since she places a $100 value on the road, she will buy = 10 votes. Similarly, Johnson will spend up to $50 to buy votes for national defense, so he will buy = 7.07 or 7 votes. (We truncate the decimal places since we assume votes must be purchased in whole numbers.) He will also spend up to $150 to buy 12 votes (= 12.247). We follow the same procedure to calculate that Lee will buy 10 votes for the road and 15 for the weather warning system.

Note that it would also be valid to argue that Johnson might buy 8 votes for national defense and Lee might buy 16 votes for the weather warning system. In these cases, the marginal costs would slightly exceed the marginal benefits. However, since the voters have to return any unspent money and they have enough of the $500 remaining to buy the additional vote, one could argue that it could be in their interest to do so since it is not actually their money. b. We can find the total number of votes for each project simply by adding together the numbers in each row. Doing so, we get the following results: Votes for national defense = 20 + 7 + 12 = 39. Votes for road = 10 + 17 + 10 = 37. Votes for weather warning system = 0 + 12 + 15 = 27. c. In a paired-choice vote between national defense and the road, national defense would win with a 2-to-1 vote because national defense is a higher preference for both Garcia and Lee. d. In a paired-choice vote between the road and the weather warning system, the road would win with a 2-to-1 vote because it is a higher preference than the weather warning system for both Garcia and Johnson. e. In a paired-choice vote between national defense and the weather warning system, the weather warning system would win with a 2-to-1 vote because it is a higher preference for both Johnson and Lee.

6. Consider a corrupt provincial government in which each housing inspector examines two newly built structures each week. All the builders in the province are unethical and want to

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increase their profits by using substandard construction materials, but they can‘t do that unless they can bribe a housing inspector into approving a substandard building. LO5.3 a. If bribes cost $1,000 each, how much will a housing inspector make each year in bribes?

(Assume that each inspector works 52 weeks a year and gets bribed for every house they inspect.) b. There is a provincial construction supervisor who gets to hire all of the housing inspectors. He himself is corrupt and expects his housing inspectors to share their bribes with him. Suppose that 20 inspectors work for him and that each passes along half the bribes collected from builders. How much will the construction supervisor collect each year? c. Corrupt officials may have an incentive to reduce the provision of government services to help line their own pockets. Suppose that the provincial construction supervisor decides to cut the total number of housing inspectors from 20 to 10 in order to decrease the supply of new housing permits. This decrease in the supply of permits raises the equilibrium bribe from $1,000 to $2,500. How much per year will the construction supervisor now receive if he is still getting half of all the bribes collected by the 10 inspectors? How much more is the construction supervisor getting now than when he had 20 inspectors working in part (b)? Will he personally be happy with the reduction in government services? d. What would happen if reducing the number of inspectors from 20 to 10 only increased the equilibrium bribe from $1,000 to $1,500? In this case, how much per year would the construction supervisor collect from his 10 inspectors? How much less is the construction supervisor getting than when he had 20 inspectors working in part (b)? In this case, will the construction supervisor be happy with the reduction in government services? Will he want to go back to using 20 inspectors?

Answer: a. $104,000 (=52 weeks times 2 bribes per week times $1,000 per bribe). b. $1,040,000 (=20 inspectors times one half times each inspector‘s annual total bribe amount of $104,000). c. $1,300,000 (=10 inspectors times one half times each inspector‘s new annual total bribe amount of $260,000). That annual total bribe amount of $260,000 = $2,500 per bribe times two bribes per week times 52 weeks per year. The construction supervisor will personally be happy with this reduction in government services because it substantially increases his personal income. d. $780,000 (=10 inspectors times one half times each inspector‘s new annual total bribe amount of $156,000.) The construction supervisor will not be happy with this reduction in government services. He will want to go back to using 20 inspectors 1-132 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

because he personally received a higher income from bribes when there were 20 inspectors.

Chapter06 - Elasticity McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Explain why the choice between 1, 2, 3, 4, 5, 6, 7, and 8 movie tickets or 1000, 2000, 3000, 4000, 5000, 6000, 7000, and 8000 movie tickets makes no difference in determining elasticity in Table 6.1. LO6.1

Answer: Price elasticity of demand is determined by comparing the percentage change in price and the percentage change in quantity demanded. The percentage change in quantity will remain the same regardless of whether the difference is between 1 unit and 2 units or 1000 units and 2000 units.

To see this note that the percentage change between 1 and 2 equals ((2-1)/1) × 100 = 100%. The percentage change between 1000 and 2000 equals ((2000-1000)/1000) × 100=100%. Since these are the same for a given percentage change in price the elasticities will be the same.

This is also true if you use the midpoints formula. In this case, that the percentage change between 1 and 2 equals ((2-1)/((1+2)/2)) × 100(1/1.5) × 100 = 67%. The percentage change between 1000 and 2000 equals ((2000-1000)/((1000+2000)/2) × 100 = (1000/1500) × 100 = 67%.

2. What effect would a rule stating that university students must live in university dormitories have on the price elasticity of demand for dormitory space? What impact might this in turn have on room rates? LO6.1

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

3. The income elasticities of demand for movies, dental services, and clothing have been estimated to be +3.4, +1.0, and +0.5, respectively. Interpret these coefficients. What does it mean if an income elasticity coefficient is negative? LO6.5 Answer: All are normal goods—income and quantity demanded move in the same direction. These coefficients reveal that a 1 percent increase in income will increase the quantity of movies demanded by 3.4 percent, of dental services by 1.0 percent, and of clothing by 0.5 percent. A negative coefficient indicates an inferior good— income and quantity demanded move in the opposite direction.

4. Research has found that an increase in the price of beer would reduce the amount of marijuana consumed. Is cross elasticity of demand between the two products positive or negative? Are these products substitutes or complements? What might be the logic behind this relationship? LO6.5 Answer: If the cross elasticity is negative, this implies that an increase in the price of one good results in a decrease in the quantity purchased of another good. This implies that the goods are compliments; as the price of one good increases, it reduces the consumption of other goods (purchased less). The cross elasticity of the two products above is negative. Thus, the products appear to be complementary. As one drinks beer, one also smokes marijuana.

5. What is the tax incidence of a sales tax when demand is highly inelastic? Highly elastic? What effect does the elasticity of supply have on the incidence of a sales tax?

LO6.6 Answer: The incidence of a sales tax is likely to be primarily on consumers when demand is highly inelastic and primarily on producers when demand is elastic. The more elastic the supply, the greater the incidence of a sales tax on consumers and the less on producers.

The LAST WORD What is the purpose of charging different groups of customers different prices?

Supplement the three broad examples in the Last Word with two additional examples of your own. Hint: Think of price discounts based on group characteristics or time of purchase.

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Answer: The primary purpose for charging different prices is to increase revenue and, in turn, profits. Other examples include student and senior citizen discounts (group characteristics based on age or activity), and movies and golf courses (discounts for consumption during ―off-peak‖ times in order to spread out consumption and increase revenue).

REVIEW QUESTIONS 1. Suppose that the total revenue received by a company selling basketballs is $600 when the price is set at $30 per basketball and $600 when the price is set at $20 per basketball. Without using the midpoint formula, can you tell whether demand is elastic, inelastic, or unit elastic over this price range. LO6.1 Answer: Since revenue does not change between these two price points, demand over this range is unit elastic. Thus, the midpoint formula would yield a value of 1.

2. What are the major determinants of price elasticity of demand? Use those determinants and your own reasoning in judging whether demand for each of the following products is probably elastic or inelastic: (a) bottled water; (b) toothpaste; (c) Crest toothpaste; (d) ketchup; (e) diamond bracelets; (f) Microsoft‘s Windows operating system. LO6.1 Answer: The key determinants of price elasticity are substitutability, proportion of income; luxury versus necessity, and time. The larger the number of substitutes available, the more elastic the demand. The higher the price of a good is relative to a consumer's income, the more elastic the demand. Generally, goods seen as luxury items have a more elastic demand. The longer time duration, the more elastic the demand. a. Bottled water. This good is likely elastic because there are a number of substitutes (water fountains, cans of soda, etc...) b. Toothpaste. This good is likely inelastic because there aren't many substitutes and it is a necessity (in economic terms). c. Crest toothpaste. This specific brand of the good is likely elastic. There are a number of substitutes for this specific brand of the good. d. Ketchup. This good is likely inelastic. There aren't many substitutes for ketchup (for people who like ketchup) and it makes up a small percentage of income. e. Diamond bracelets. This good is likely elastic because it is a luxury good and may make up a large fraction of income (more than ketchup).

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f. Microsoft's Windows operating system. This good is likely inelastic because there aren't many substitutes for this good and it has become a necessity in a number of workplaces.

3. Calculate total-revenue data from the demand schedule given below. Graph total revenue below your demand curve. Generalize about the relationship between price elasticity and total revenue. LO6.2

Answer:

To calculate total revenue, multiply price and quantity. At the price of $5 one unit is sold. Thus, total revenue is $5×1 = $5. At the price of $2 total revenue is $4×2 = 8, at $3 total revenue is $3×3 = 9, at $4 total revenue is $4×2 = 8, and at $1 total revenue is $1×5 = 5.

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When demand is elastic, price and total revenue move in the opposite direction.

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

4. How would the following changes in price affect total revenue? That is, would total revenue increase, decrease, or remain unchanged? LO6.2 a. Price falls and demand is inelastic. b. Price rises and demand is elastic. c. Price rises and supply is elastic. d. Price rises and supply is inelastic. e. Price rises and demand is inelastic. f. Price falls and demand is elastic. g. Price falls and demand is of unit elasticity.

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

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

Using these rules, we have the following answers. a. Total revenue decreases (As the price falls individuals purchase more of the good.

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

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5. In 2017, Leonardo Da Vinci‘s painting Salvador Mundi sold for $450 million. Portray this sale in a demand and supply diagram and comment on the elasticity of supply.

Comedian George Carlin once mused, ―If a painting can be forged well enough to fool some experts, why is the original so valuable?‖ Provide an answer. LO6.4 Answer: The supply is perfectly inelastic—vertical—at a quantity of 1 unit. The $137.5 million price is determined where the downward sloping demand curve intersected this supply curve.

If more than one picture were available (all but one having to be a copy), the demand would likely decrease enormously.

6. Suppose the cross elasticity of demand for products A and B is +3.6 and for products C and D it is -5.4. What can you conclude about how products A and B are related?

Products C and D? LO6.5 Answer: The cross elasticity relates the percentage change in quantity to the percentage change in price of a different good. If the cross elasticity is positive this implies that and increase in the price of one good results in an increase in the quantity purchased of another good. This implies the goods are substitutes, as the price of one good increases substitute into the other good (purchase more).

This implies that goods A and B are substitutes and that goods C and D are compliments.

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

7. True or false. The incidence of property taxes that are levied on rented houses and apartments is high—meaning that they are paid almost entirely by the landlords, who are billed by the government for those taxes. LO6.6 Answer: false. The incidence of property taxes levied on rented properties is in fact low—meaning that very little is paid by the landlords who are billed by the government.

This is true because the landlords simply pass the property taxes on to their tenants by boosting rents.

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PROBLEMS 1. Look at the demand curve in Figure 6.2a. Use the midpoint formula and points a and b to calculate the elasticity of demand for that range of the demand curve. Do the same for the demand curves in Figures 6.2b and 6.2c using, respectively, points c and d for Figure 6.2b and points e and f for Figure 6.2c. LO6.1 Answers: 9/5 = 1.8; 5/9 = .5556; 1.

Feedback: Consider the following figures taken from the textbook (Figures 6.2a, 6.2b, and 6.2c).

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

Given the two points in Figure 6.2a (10,2) and (40,1), note that the ordered pair is (Q, P), we can calculate the elasticity. ( ) (

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Given the two points in Figure 6.2b (10,4) and (20,1), we can calculate the elasticity.

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( (

)

(

)⁄ ) (

(

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(

(

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Given the two points in Figure 6.2c (10,3) and (30,1), we can calculate the elasticity.

(Note this approximates the nonlinear schedule.) ( (

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2. Investigate how demand elasticities are affected by increases in demand. Shift each of the demand curves in Figures 6.2a, 6.2b, and 6.2c to the right by 10 units. For example, point a in Figure 6.2a would shift rightward from location (10 units, $2) to (20 units, $2) while point b would shift rightward from location (40 units, $1) to (50 units, $1). After making these shifts, apply the midpoint formula to calculate the demand elasticities for the shifted points. Are they larger or smaller than the elasticities you calculated in Problem 1 for the original points? In terms of the midpoint formula, what explains the change in elasticities? LO6.1 Answers: 1.29; 1/3 = .3333; 2/3 = .6667; smaller; everything in the midpoint formula stays the same except the reference point for quantity, which increases—that increase reduces the elasticity.

Feedback: Once again, consider the following figures taken from the textbook (Figures 6.2a, 6.2b, and 6.2c).

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Here everything remains the same, but the quantity units in the ordered pairs (Q,P) increase by 10 units.

Given the initial two points in Figure 6.2a (10,2) and (40,1), we now have the two points (20,2) and (50,1). ( (

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Given the two points in Figure 6.2b (10,4) and (20,1), we now have (20,4) and (30,1). ( (

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→

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Given the two points in Figure 6.2c (10,3) and (30,1), we now have (20,3) and (40,1).

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( (

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If we compare the elasticities in this problem to those found in problem 1, we can see that an increase in quantity at every price (shift the demand schedule to the right) reduces the elasticity. The percentage change in quantity is smaller given the higher quantity purchased at every price.

3. Graph the demand data given below, and then use the midpoint formula for Ed to determine price elasticity of demand for each of the four possible $1 price changes.

What can you conclude about the relationship between the slope of a curve and its elasticity? Explain why demand is elastic in the northwest segment of the demand curve and inelastic in the southeast segment. LO6.2

Answer: The graph of the data is:

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To calculate the elasticity, we use the midpoint formula.

First, we calculate the percentage change in quantity. Second, we calculate the percentage change in price. Then we divide the percentage change in quantity by the percentage change in price. To report the values as positive numbers we then take the absolute value of the answer. For example, we have the following elasticities as we move down the demand schedule (demand elasticities are reported as positive values).

Moving from $5 to $4: ( ) (

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Moving from $4 to $3: ( (

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The same process applies to further reductions in price (and increase in quantity): As we move from $3 to $2 the elasticity is 0.714. As we move from $2 to $1 the elasticity is 0.333.

This demand curve has a constant slope of -1 (= -1/1), but elasticity declines as we move down the curve. When the initial price is high and initial quantity is low, a unit change in price is a low percentage while a unit change in quantity is a high percentage change. The percentage change in quantity exceeds the percentage change in price, making demand elastic. When the initial price is low and initial quantity is high, a unit change in price is a high percentage change while a unit change in quantity is a low percentage change. The percentage change in quantity is less than the percentage change in price, making demand inelastic.

4. Danny ―Dimes‖ Donahue is a neighbourhood‘s 9-year-old entrepreneur. His most recent venture is selling homemade brownies that he bakes himself. At a price of $1.50 each, he sells 100. At a price of $1.00 each, he sells 300. Is demand elastic or inelastic over this price range? If demand had the same elasticity for a price decline from $1.00 to $0.50 as it does for the decline from $1.50 to $1.00, would cutting the price from $1.00 to $0.50 increase or decrease Danny‘s total revenue? LO6.2 Answers: Elastic; cutting price would increase Danny‘s total revenue.

Feedback: The total revenue rule implies that demand is elastic when revenue and price move in opposite directions. In other words, a decrease in price results in an increase in total revenue. We can use this rule to answer this question.

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

Total revenue at the price $1.50 and the quantity of 100 equals $150 (= $1.50×100 ).

Danny then decreases his price to $1.00 and sells 300 brownies now. Total revenue at this new price equals $300 (= $1.00x300). Since total revenue increased after Danny decreased his price we know from the rule above that demand is elastic over this range.

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

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

5. What is the formula for measuring the price elasticity of supply? Suppose the price of apples goes up from $20 to $22 a box. In direct response, Goldsboro Farms supplies 1,200 boxes of apples instead of 1,000 boxes. Compute the coefficient of price elasticity (midpoints approach) for Goldsboro‘s supply. Is its supply elastic, or is it inelastic? LO6.4 1-144 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Answers: elasticity of supply = percentage change in quantity supplied percentage change in price Es = 1.91; supply is elastic Feedback: The formula for measuring the elasticity of supply is the same as the formula for measuring the elasticity of demand. Divide the percentage change in quantity by the percentage change in price. The only difference is that we do not need to take absolute value here because the price and quantity will move in the same direction (implying the elasticity is already positive).

Consider the following values: Suppose the price of apples goes up from $20 to $22 a box. In direct response, Goldsboro Farms supplies 1200 boxes of apples instead of 1000 boxes. Here we have two ordered pairs (1000, 20) and (1200, 22), note the form is (Q, P). ( ) (

(

)⁄ ) ( (

(

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

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

(Hint: Apply the midpoints approach to the elasticity of supply.) LO6.4 Answers: 200 per day in the short run; 300 per day in the long run.

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

(

)⁄ ) (

(

(

) )⁄ )

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

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

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)⁄ ) (

(

(

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This implies, ( (

(

)

(

)

( )(

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Solving for Q2 we have the following: ( )

( )(

)

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

(

)⁄ ) (

( This implies: ( ) (

(

(

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

7. Ariya likes to play golf. The number of times per year that she plays depends on both the price of playing a round of golf as well as Ariya‘s income and the cost of other types of entertainment—in particular, how much it costs to go see a movie instead of playing golf. The three demand schedules in the table below show how many rounds of golf per year Ariya will demand at each price under three different scenarios. In scenario D1, Ariya‘s income is $50,000 per year and movies cost $9 each. In scenario 1-146 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

D2, Ariya‘s income is also $50,000 per year, but the price of seeing a movie rises to $11. And in scenario D3, Ariya‘s income goes up to $70,000 per year while movies cost $11. LO6.5

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

Is golf an inferior good?

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

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

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

Here we use the same formula: ( (

(

)⁄ ) (

(

(

)

)

(

)

(

)

)⁄ )

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

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( (

)

(

)⁄ ) (

(

(

(

)

(

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) )⁄ )

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

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)

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

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

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

Thus, our answer is golf and movies are complements.

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

Finally, two goods are independent if the cross elasticity is zero. A price change in one good does not change the quantity of the other good.

Part (b): To calculate the income elasticity we use a similar approach. Here we divide the percentage change in quantity by the percentage change in income. We do this at every price for the good.

For our golf example we have the following income elasticities.

At the price of $50 for a golf game (hold constant for this calculation because we are looking at how golf games respond to a change in income) we have the following 1-148 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

ordered pairs (10, 50000) and (15, 70000). Note that the ordered pair is (golf games, income). ( (

(

) )⁄ )

( (

( )

(

)

(

)

)⁄ )

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

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( (

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

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( )

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) )

)⁄ )

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

To determine if golf is a normal good or inferior good, we have the following rule.

If the income elasticity is positive, then the good is a normal good. The higher an individual's income the more of the good they consume.

Thus, golf is a normal good.

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

8. ADVANCED ANALYSIS Suppose the equation for the demand curve for some product X is P = 8 ‐ 0.6Q and the supply curve is P = 2 + 0.4Q. What are the 1-149 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

equilibrium price and quantity? Now suppose an excise tax is imposed on X such that the new supply equation is P = 4 + 0.4Q. How much tax revenue will this excise tax yield the government? LO6.6 Answer: To determine the equilibrium quantity we equate the supply schedule with the demand schedule (in equilibrium the price must be the same for both schedules).

8 ‐ 0.6Q = 2 + 0.4Q or 8 - 2 = 0.6Q + 0.4Q, thus Q*=6 We can solve for the equilibrium price by substituting the equilibrium quantity back into the supply or demand schedule.

Supply: P = 2+.4×6 = 4.4 (or $4.40) Demand: P = 8 -0.6x6 = 4.4 (or $4.40) If the government imposes an excise tax on the firm of $2 the new supply schedule will be P = 4 + 0.4Q. The firm must now charge an additional $2 per unit to cover the cost of the tax. Thus, the additional $2 shows up in the intercept.

Again, to determine the equilibrium quantity we equate the NEW supply schedule with the demand schedule.

8 ‐ 0.6Q = 4 + 0.4Q or 8 - 4 = 0.6Q + 0.4Q, thus Q*=4 We can solve for the equilibrium price by substituting the equilibrium quantity back into the NEW supply or demand schedule.

Supply: P = 4+0.4×4 = 5.6 (or $5.60) Demand: P = 8 -0.6×4 = 5.6 (or $5.60) Since the government collects $2 per unit sold, government revenue equals $8 (=$2×4).

Chapter 07 - Consumer Choice and Utility Maximization McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Complete the following table and answer the questions below: LO7.1

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a. At which rate is total utility increasing: a constant rate, a decreasing rate, or an increasing rate? How do you know? b. ―A rational consumer will purchase only 1 unit of the product represented by these data since that amount maximizes marginal utility.‖ Do you agree? Explain why or why not. c. ―It is possible that a rational consumer will not purchase any units of the product represented by these data.‖ Do you agree? Explain why or why not.

Answer: Missing total utility data, top – bottom: 18; 33. The missing total utility for the second unity can be found by adding the marginal utility (change in utility) to the total utility for the first unit. By consuming the second unit, 8 more units of utils are added; thus total utility is 18 (= 10 + 8). Missing marginal utility data, top – bottom: 7; 5; 1. The missing marginal utility values are found by subtracting the total utility for the previous unit consumed from the total utility of the unit with the missing value (the change in utility).

The marginal utility for the third unit is 7, which equals 25 (total utility for the third unit) minus 18 (total utility for the second unit). a. A decreasing rate; because marginal utility is declining. b. Disagree. The marginal utility of a unit beyond the first may be sufficiently great (relative to product price) to make it a worthwhile purchase. Consumers are interested in maximizing total utility, not marginal utility. c. Agree. This product‘s price could be so high relative to the first unit‘s marginal utility that the consumer would buy none of it.

2. Mrs. Simpson buys loaves of bread and quarts of milk each week at prices of $1 and 80 cents, respectively. At present she is buying these products in amounts such that the marginal utilities from the last units purchased of the two products are 80 and 70 utils, respectively. Is she buying the utility-maximizing combination of bread and 1-151 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

milk? If not, how should she reallocate her expenditures between the two goods?

LO7.2 Answer: Mrs. Wilson is not buying the utility-maximizing combination of bread and milk because the marginal utility per cent spent on each good is not equal. The marginal utility per cent of bread is 0.8 (= 80 utils/100 cents); the utility per cent of milk is 0.875 (= 70 utils/80 cents). Mrs. Wilson should buy more milk and less bread.

3. How can time be incorporated into the theory of consumer behaviour? Explain the following comment: ―Want to make millions of dollars? Devise a product that saves Canadians lots of time.‖ LO7.2 Answer: Time is money. This expression is a time-saving way of making the point that for a person who can make so much per hour, every hour spent not working is so much money not made. A person can be said to ―consume‖ a ball game or an evening at the theater. If the ball game costs $10 and the theater $20, at first sight one could say the ball game is a better deal. But if the person makes $20 an hour and is forgoing this in taking the time off, then we must take into account the time spent at the ball game or at the theater. If the ball game goes into extra innings and takes 4 hours, then its total cost is $90 (= $10 + $80). If the theater takes 3 hours, its total cost is $80 (= $20 + $60). Assuming the marginal utility of the ball game and attending the theater are the same, the theory of consumer behaviour (with time taken into account) would therefore have this consumer going to the theater.

4. Explain what is meant by the following statements: LO7.2 a. Before economic growth, there were too few goods; after growth, there is too little time. b. It is irrational for an individual to take the time to be completely rational in economic decision making. c. Telling your spouse where you would like to go out to eat for your birthday makes sense in terms of utility maximization.

Answers: a. Before economic growth, most people lived at the subsistence level. By practically anyone‘s definition, this implies ―too few goods.‖ After economic growth, goods are in relative abundance. To make (or consume) more takes time, but the relative abundance of goods means that there are already many goods to enjoy. So, now there is a clash between the use of time to make more goods and the use of time to relax and enjoy the goods one already has. There just isn‘t enough time.

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b. To be completely rational in economic decision making, provided one does not take time into consideration, one has to take account of every factor. This would take a great deal of time. One could not, for example, make any purchase without first searching the classifieds to see whether a better deal could be had, rather than simply heading for the nearest store. However, this would be most irrational, for time does have value. While making an extensive search before making any deal, one would be forgoing the income to make this or any deal. For every penny saved to make the perfect deal, one would be losing dollars in income because of the time spent in making the perfect deal. c. There is little time sacrificed in making a request to your spouse for the restaurant where you eat on your birthday. If you eat there, the benefit will likely exceed the cost. It also reduces the probability of eating at a restaurant where the market value (purchase price) exceeds the utility to the recipient.

5. In the last decade or so there has been a dramatic expansion of small retail convenience stores (such as Mac‘s, 7 Eleven, and Circle K, etc.), although their prices are generally much higher than prices in large supermarkets. What explains the success of the convenience stores? LO7.2 Answer: These stores are selling convenience as well as the goods that are purchased there. Because of their small size and convenient locations, they save busy consumer‘s time. In an era when most consumers are working at least 40 hours per week, their time is valuable, and when only a few items are needed, the time saved must be worth the additional cost one pays for shopping at these convenience stores.

(You seldom, if ever, see anyone buying a week‘s worth of groceries at such shops.)

6. Many apartment-complex owners are installing water meters for each apartment and billing the occupants according to the amount of water they use. This is in contrast to the former procedure of having a central meter for the entire complex and dividing up the collective water expense as part of the rent. Where individual meters have been installed, water usage has declined 10 to 40 percent. Explain that drop, referring to price and marginal utility. LO7.3 Answer: The way we pay for a good or service can significantly alter the amount purchased. An individual living in an apartment complex who paid a share of the water expense measured by a central meter would have little incentive to conserve.

Individual restraint would not have much impact on the total amount of water used.

Suppose there were 10 apartments in the complex; each apartment would be billed for one-tenth of the cost of the water. A single gallon of water would carry a price equal to one-tenth the amount charged by the water district. The very low price per gallon 1-153 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

would encourage the use of water until the marginal utility of an additional gallon was correspondingly low. If the tenants paid separately for their own water, the full market price of water would be considered when making their consumption choices.

7. Using the utility-maximization rule as your point of reference, explain the income and substitution effects of an increase in the price of product B, with no change in the price of product A. LO7.4 Answer: The utility-maximization rule compares the marginal utilities per dollar of goods under consideration (in this case A and B). An increase in the price of product B would reduce the marginal utility per dollar of B. This would discourage consumption of B, and with a pure income effect, would not alter consumption of A. If the increased price of B caused the marginal utility per dollar of the last unit of B to fall below the MU/$ of the next unit of A, we would expect the consumer to substitute A for B in consumption (substitution effect).

8. ADVANCED ANAYLSIS A ―mathematically fair bet‖ is one in which the amount won will on average equal the amount bet, for example when a gambler bets, say, $100 for a 10 percent chance to win $1,000 ($100 = .10 × $1,000). Assuming diminishing marginal utility of dollars, explain why this is not a fair bet in terms of utility. Why is it even a less fair bet when the ―house‖ takes a cut of each dollar bet? So is gambling irrational? LO7.4 Answer: Because the marginal utility of money diminishes the more you have, the utility of the $100 used to make the bet is greater than the $900 that you might gain ($1,000 - $100) if you win the bet.

It is even less of a ―fair bet‘ when the ―house‖ takes its cut, because the $100 bet has the possibility of yielding less than $900 in winnings.

Is gambling irrational? Maybe. The activity of gambling may provide enough extra utility to offset the poor utility odds of winning.

9. Rank each of the following three gift possibilities in terms of how much utility they are likely to bring and explain your reasoning. A store-specific gift card worth $15, a $15 item from that specific store, and $15 of cash that can be spent anywhere. LO7.5 Answer: From the highest to lowest likely utility, we would rank the options as follows: Cash, gift card, specific item. Even though the price of each option is the same, we don't know how the recipient will value them as such. The $15 specific item may not be something the recipient likes, meaning he may value it less than $15. The gift card may be for a store that the recipient won't like, but it gives him the flexibility to select the item. The cash gives him the ability to select how the money is spent, and he can therefore purchase the item he values the most. The more say that the recipient has on how the money is spent, the more likely the option will have a higher utility.

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The LAST WORD In what way is criminal behaviour similar to consumer behaviour? Why do most people obtain goods via legal behaviour as opposed to illegal behaviour? What are society's main options for reducing illegal behaviour?

Answer: Both the lawful consumer and the criminal try to maximize their total utility. (Answers may vary.)

Most people choose legal behaviour because they see the price of illegal behaviour to be greater than the marginal benefit. The costs include guilt, direct costs (supplies and tools), loss of freedom, and the forgone income earned through legal behaviour.

Society's main option to reduce illegal behaviour is to increase the cost of engaging in it.

They can do this many ways. Guilt costs can be increased through family, educational, and religious efforts. They can get better locks and alarms forcing the criminal to spend more money on better tools. They can provide higher incomes for legal behaviour, increasing the opportunity cost. They can increase policing to make it more likely the criminal will be caught.

REVIEW QUESTIONS 1. True or false. The law of diminishing marginal utility predicts the consumption behaviour of addicts quite well. LO7.1 Answer: false.

The law of diminishing marginal utility does not predict the consumption behaviour of addicts well at all. That is because the law predicts that, other things equal, successive units will be less and less valuable to a person. Thus, people should not keep on consuming additional units relentlessly. But an alcoholic, for instance, will often purse a 15th drink on a given day with as much intensity as he pursued his first drink that day. And a gambling addict will often bet his final dollar with as much alacrity as he bet his first. Those suffering from addiction appear to behave as if the marginal utility of the drug or behaviour to which they are addicted remains high no matter how much of the drug or behaviour they engage in.

2. Frank spends $75 on 10 magazines and 25 newspapers. The magazines cost $5 each and the newspapers cost $2.50 each. Suppose that his MU from the final magazine is 1-155 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10 utils while his MU from the final newspaper is also 10 utils. According to the utility-maximizing rule, Frank should: LO7.2 a. Reallocate spending from magazines to newspapers. b. Reallocate spending from newspapers to magazines. c. Be satisfied because he is already maximizing his total utility. d. None of the above.

Answer: a, reallocate spending from magazines to newspapers Frank is not currently maximizing the utility that he could get from his $75 budget and should reallocate spending from magazines to newspaper in order to increase the total utility that he receives from his budget.

This can be seen by examining the MU per dollar that he is currently getting from the last magazine and the last newspaper. The MU per dollar from the last magazine is 10/$5 = 2 utils per dollar. The MU per dollar from the last newspaper is 10/$2.50 = 4 utils per dollar. Thus, Frank could gain more total utils if he spent less on newspapers and more on dollars.

As an example, imagine that Frank cut his purchases of magazines by one, reducing them from 10 purchased to only 9 purchased. That would free up $5 that he could spend on newspapers. Since newspapers cost $2.50 each, he could purchase two newspapers. Now, look at what happens to his total utility as he makes that change in consumption. He will lose 10 utils by consuming one fewer magazine (because the MU of magazines is 10). But he will gain more than 10 utils by consuming two additional newspapers (because the MU of an additional newspaper is 10 utils and he will be consuming two additional newspapers). Thus, by reallocating his spending from the product with the lower MU per dollar to the product with the higher MU per dollar, Frank will be able to increase the total utility that he receives from his budget.

3. Demand curves slope downward because _________, other things held equal, LO7.3 a. An increase in a product‘s price lowers MU. b. A decrease in a product‘s price lowers MU. c. A decrease in a product‘s price raises MU per dollar and makes consumers wish to purchase more units. d. An increase in a product‘s price raises MU per dollar and makes consumers wish to purchase more units.

Answer: c, A decrease in a product’s price raises MU per dollar and makes consumers wish to purchase more units.

Rational consumers decide how to spend their limited budgets by comparing the marginal utilities per dollar that they can get from various products. If the prices of all other products stay the same while the price of product X falls, then the MU per dollar of money spent on product X will increase. That will mean that any money spent purchasing units of product X will get the consumer more MU than previously.

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Thus, consumers interested in getting as much utility as possible when spending their limited budges will want to spend more of their limited budgets on product X. This behaviour explains the downward slope of demand curves because a decrease in the price of product X leads to an increase in the quantity demanded of product X. 4. Jermaine spends his money on cucumbers and lettuce. If the price of cucumbers falls, the MU per dollar of cucumbers will ______________ and Jermaine will _______________ cucumbers for lettuce. LO7.4 a. Fall; substitute b. Rise; substitute c. Fall; supply d. Rise; demand Answer: b, rise; substitute When the price of cucumbers falls, the MU per dollar of cucumbers will rise. As a result, each dollar spent on cucumbers will now bring more marginal utility than it did previously. Cucumbers thus become relatively more attractive than they were previously and so Jermaine will switch, or substitute, some of his spending away from lettuce and towards cucumbers in order to maximize his utility given the new, lower price of cucumbers.

5. Tammy spends her money on lemonade and iced tea. If the price of lemonade falls, it is as though her income __________________. LO7.4 a. increases b. decreases c. stays the same Answer: a, increases.

A person‘s income is not same thing as their budget. Rather, their income is the amount of goods and services that they can purchase with their budget. Thus, when the price of something that they purchase falls, their income rises because they can now purchase more goods and services than they did before.

Consider the following example. Suppose that Tammy originally has a $6 budget and maximizes utility by purchasing 2 glasses of lemonade for $2 each and 2 glasses of iced tea for $1 each. So her income of goods and services is 2 glasses of lemonade and 2 glasses of iced tea. Then suppose that the price of iced tea falls in half, to only $1 per glass. Her budget of $6 remains unchanged, but she will now be able to purchase more total items and thereby enjoy a higher income due to the lower price of lemonade.

This can be seen most directly by noting that her old income of 2 glasses of lemonade and 2 glasses of iced tea will now only cost $4—which means that she has $2 left over to increase her consumption of either iced tea or lemonade. The price reduction allows her to consume more overall, which is the same as saying that her income of goods and services has increased.

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PROBLEMS 1. Mylie‘s total utility from singing the same song over and over is 50 utils after one repetition, 90 utils after two repetitions, 70 utils after three repetitions, 20 utils after four repetitions, -50 utils after five repetitions, and -200 utils after six repetitions.

Write down her marginal utility for each repetition. Once Mylie‘s total utility begins to decrease, does each additional singing of the song hurt more than the previous one or less than the previous one? LO7.1 Answers: 50, 40, -20, -50, -70, -150; More than the previous one.

Feedback: Consider the following values: Mylie‘s total utility from singing the same song over and over is 50 utils after one repetition, 90 utils after two repetitions, 70 utils after three repetitions, 20 utils after four repetitions, -50 utils after five repetitions, and -200 utils after six repetitions.

Mylie's marginal utility can be found by calculating the change in total utility as she sings the song one more time. The utility from singing the song the first time is 50, which is the total utility of singing the song the first time, 50, minus the total utility of not singing the song at all, 0. The utility from singing the song the second time is 40, which is the total utility from singing the song the second time, 90, minus the total utility from singing the song the first time, 50. Apply the same procedure to following repetitions of the song. The marginal utility of the third time is -20 (= 70 - 90). The fourth time, -50 (= 20 - 70), the fifth time, -70 (= -50 - 20). The sixth time, -150 (= 200 - (-50) = -200 + 50).

Once Mylie's total utility begins to decrease, each additional song hurts more than the previous one because she is becoming worse in terms of utility (which is a measure of individual welfare). As we can see above, after the second repetition, Mylie is actually worse off. Also, the decline in utility increases after the second repetition.

2. John likes Coca-Cola. After consuming one Coke, John has a total utility of 10 utils.

After two Cokes, he has a total utility of 25 utils. After three Cokes, he has a total utility of 50 utils. Does John show diminishing marginal utility for Coke or does he show increasing marginal utility for Coke? Suppose that John has $3 in his pocket. If Cokes cost $1 each and John is willing to spend one of his dollars on purchasing a first can of Coke, would he spend his second dollar on a Coke, too? What about the 1-158 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

third dollar? If John‘s marginal utility for Coke keeps on increasing no matter how many Cokes he drinks, would it be fair to say that he is addicted to Coke? LO7.1 Answers: Increasing; Yes; Yes. Feedback: John's marginal utility equals the change in total utility as he consumes an additional unit. Thus, his marginal utility from the first Coke is 10 (= 10 - 0), his second Coke is 15 (= 25 - 10), and his third Coke is 25 (= 50 -25). Since his marginal utility is increasing at an increasing rate he shows increasing marginal utility for Coke.

If John consumes the first can of Coke, we know that his marginal utility per dollar was sufficient to induce the purchase. Since his marginal utility increases as he consumes more Coke, his marginal utility per dollar will also increase (price does not change). This implies that he will purchase the second Coke because it provides even more marginal utility per dollar than the first Coke did. The same is true for the third can of Coke. He will spend his entire income on Coke, thus it is fair to say he is addicted to Coke.

3. Suppose that Omar‘s marginal utility for cups of coffee is constant at 1.5 utils per cup, no matter how many cups he drinks. On the other hand, his marginal utility per doughnut is 10 for the first doughnut he eats, 9 for the second he eats, 8 for the third he eats, and so on (that is, declining by 1 util per additional doughnut). In addition, suppose that coffee costs $1 per cup, doughnuts cost $1 each, and Omar has a budget that he can spend only on doughnuts, coffee, or both. How big would that budget have to be before he would spend a dollar buying a first cup of coffee? LO7.2 Answer: $10.

Feedback: To answer this question, we first need to calculate the marginal utility per dollar for doughnuts. Recall that the marginal utility per dollar for a good is the marginal utility divided by the price of the good (=MU/P). For the first doughnut we have 10 (=10/$1), the second doughnut 9 (=9/$1), third 8, fourth 7, fifth 6, sixth 5, seventh 4, eighth 3, ninth 2, and tenth 1.

The marginal utility per dollar for every cup of coffee is 1.5 (=1.5/$1).

To determine how big the budget would have to be before John would spend a dollar buying his first cup of coffee, we compare the marginal utility per dollar values. John will purchase the first doughnut before he buys a cup of coffee because the marginal utility per dollar for the doughnut is greater than the marginal utility per dollar for the cup of coffee (10>1.5). The same is true for the second through the ninth doughnut.

This implies John will buy 9 doughnuts at the price of $1 before he buys his first cup of coffee. Therefore, his budget will need to $10 before he buys his first cup of coffee, $9 on the doughnuts and $1 for the cup of coffee.

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4. Columns 1 through 4 in the table below show the marginal utility, measured in utils, that Ricardo would get by purchasing various amounts of products A, B, C, and D. Column 5 shows the marginal utility Ricardo gets from saving. Assume that the prices of A, B, C, and D are, respectively, $18, $6, $4, and $24 and that Ricardo has an income of $106. LO7.2

a. What quantities of A, B, C, and D will Ricardo purchase in maximizing his utility? b. How many dollars will Ricardo choose to save? c. Check your answers by substituting them into the algebraic statement of the utility-maximizing rule (verify that all of the income has been exhausted between the various goods and savings).

Answer: (a) 4 units of good A, 3 units of good B, 3 units of good C, zero units of good D; (b) $4; (c) $106 (= $18x4 + $6x3 +$4x3 + $24x0 + $4) Feedback: The first step is to convert the marginal utility values into marginal utility per dollar values. Recall this is MU/P.

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Marginal Marginal Marginal Marginal Marginal Marginal Marginal Marginal Utility Utility Utility Utility Utility Utility Utility Utility units per dollar per dollar per dollar per dollar per dollar per dollar per dollar per dollar unit 1 unit 2 unit 3 unit 4 unit 5 unit 6 unit 7 unit 8 Column 1 Good A Column 2 Good B Column 3 Good C Column 4 Good D Column 5 Saving

4.00

3.00

2.50

2.00

1.50

1.00

0.83

0.67

4

4.00

2.50

2.00

1.50

1.17

0.83

0.33

0.17

3

3.75

3.00

2.00

1.75

1.25

1.00

0.88

0.75

3

1.50

1.25

1.00

0.75

0.54

0.29

0.17

0.08

0

5.00

4.00

3.00

2.00

1.00

0.50

0.25

0.13

4

The table above reads across rows (for example, the first row labeled 'Column 1-Good A' is marginal utility per dollar for good A). The columns represent the marginal utility per dollar for the different goods for each unit consumed and saving (for example, column 1 ―Marginal Utility per dollar unit 1‖ tells us the marginal utility per dollar for the first unit of every good and savings). This will make the comparison a little easier.

To determine the optimal amount of goods that Ricardo will purchase, we choose the goods with the highest marginal utility per dollar as we move from left to right. We continue to do this until income is exhausted. We see that the first unit of savings ($1) provides $5.00 worth of utility per dollar, so Ricardo makes this choice. Next, he purchases one unit of good A and good B with a marginal utility per dollar of 4 He will also save the second dollar (an additional $1) because the marginal utility per dollar is 4.

The next decision leads Ricardo to purchase the first unit of good C with a marginal utility per dollar of 3. Then he moves on to purchase the second unit of good A, the second unit of good B, and he saves an additional dollar because the marginal utility per dollar is 3for these goods. After these purchases, he has an income left of $53. Since he has income left, he continues to buy more goods using the approach above.

In conclusion, Ricardo will consume 4 units of good A, 3 units of good B, 3 units of good C, zero units of good D, and saves $4. This will exhaust his income $106 (= $18 × 4 + $6 × 3 +$4 × 3 + $24 × 0 + $4).

5. You are choosing between two goods, X and Y, and your marginal utility from each is as shown in the table below. If your income is $9 and the prices of X and Y are $2 and $1, respectively, what quantities of each will you purchase to maximize utility?

What total utility will you realize? Assume that, other things remaining unchanged, the price of X falls to $1. What quantities of X and Y will you now purchase? Using the two prices and quantities for X, derive a demand schedule (prices and quantities demanded table) for X. LO7.3

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Answer: X = 2 units, Y = 5 units; total utility = 48; X = 4, Y = 5; Demand schedule = Price Demanded Quantity Demanded 2 2 1 4 Feedback: The first step is to convert the marginal utility values into marginal utility per dollar values. Recall this is MU/P. See the table below.

Marginal Marginal Marginal Marginal Marginal Marginal Utility per Utility per Utility per Utility per Utility per Utility per dollar unit dollar unit dollar unit dollar unit dollar unit dollar unit Unit 1 2 3 4 5 6 s Good Y (first price) Good X (first price) Good Y (second price) Good X (second price)

8.00

7.00

6.00

5.00

4.00

3.00

5

5.00

4.00

3.00

2.00

1.50

1.00

2

8.00

7.00

6.00

5.00

4.00

3.00

5

10.00

8.00

6.00

4.00

3.00

2.00

4

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The first two rows define the marginal utility per dollar for goods X and Y when the price of good X is $2 and the price of Good Y is $1. Each column is the marginal utility for the unit consumed (Marginal utility per dollar for unit 1 is for the first unit consumed, Marginal utility per dollar for unit 2 is for the second unit consumed, etc...).

To determine the optimal number of goods to purchase we choose the goods with the highest marginal utility per dollar as we move from left to right. We continue to do this until income is exhausted.

First, we only consider the first two rows for Goods X and Y for the first price of good X (price of X is $2). We purchase the first unit of good Y with a marginal utility per dollar of 8. Next, we purchase the second unit of good Y with a marginal utility per dollar of 7.

Followed by the third unit of good Y with a marginal utility per dollar of 6. Continuing on, we purchase the fourth and fifth unit of Good Y and the first and second unit of good X 5 and 4 marginal utility per dollar). Thus, we purchase 5 units of good Y and 2 units of good X. The total cost is $9 (= $5 × 5 + $2 × 2), which exhausts income.

The total utility is then found by adding up the marginal utility values for the goods consumed using the values in the original table. The total utility from good Y is 30 (=8 + 7 + 6 + 5 + 4) and the total utility from good X is 18 (=10 + 8). The sum of these two values is the total utility, which equals 48 (=30 + 18).

Now we consider the case where the price of good X falls to $1.

Here, we only consider the last two rows for Goods X and Y for the second price of good X. Here our first purchase is the first unit of good X with a marginal utility per dollar of 10. Next we purchase the second unit of good X and the first unit of good Y with a marginal utility per dollar of 8.00. We continue this process until income is exhausted.

The optimal consumption level for good X is 4 and for good Y is 5.

This gives us the ordered pairs for good X: (P = 2, Q = 2) and (P = 1, Q = 4). We can use these ordered pairs to graph the demand schedule (not required).

6. ADVANCED ANAYLSIS Let MUA = z = 10 - x and MUB = z = 21 - 2y, where z is marginal utility per dollar measured in utils, × is the amount spent on product A, and y is the amount spent on product B. Assume that the consumer has $10 to spend on A and B—that is, x + y = 10. How is the $10 best allocated between A and B? How much utility will the marginal dollar yield? LO7.3 Answer: $7 on good B; $3 on good A; MUA = 7, MUB = 7.

Feedback: To solve this system of equations we set the MUA=MUB. This is required if we are maximizing utility. This leaves with only × and y to solve for using the individual's budget constraint.

Consider the following equations: Let MUA = z = 10 - X and MUB = z = 21 - 2y, where z is marginal utility per dollar measured in utils, X is the amount spent on product A, and y is the amount spent on product B. Also, assume that the consumer has $10 to spend on A and B—that is, x+ y = 10.

We know from our optimization rule that MUA=MUB, which implies 10 - x = 21 - 2y.

Or, after some rearranging, 2y - x = 11. Combining this equation with our budget constraint, x + y =10, we have two equations and two unknowns (x and y).

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Use the budget constraint to solve x, or x = 10 - y. Substitute x from this equation into our optimality rule (2y - x = 11), which gives us 2y - (10 -y) = 11. Again, after some rearranging, we have 2y - 10 + y = 11, or 3y = 21. Thus, we spend $7 on good B. Using our budget constraint 9x + y =10), this implies we spend $3 on good A. To check our answer, substitute these values into the marginal utility equations: MUA= 10 - x, or MUA = 10 -3 = 7 and MUB = 21 - 2y = 21 -2×7 = 7. Thus, MUA=MUB., and the marginal dollar will yield 7 utils.

7. Suppose that with a budget of $100, Deborah spends $60 on sushi and $40 on bagels when sushi costs $2 per piece and bagels cost $2 per bagel. But then, after the price of bagels falls to $1 per bagel, she spends $50 on sushi and $50 on bagels. How many pieces of sushi and how many bagels did Deborah consume before the price change?

At the new prices, how much money would it have cost Deborah to buy those same quantities (the ones that she consumed before the price change)? Given that it used to take Deborah‘s entire $100 to buy those quantities, how big is the income effect caused by the reduction in the price of bagels? LO7.4 Answers: 30 pieces of sushi and 20 bagels; $80 (= (30 × $2) + (20 × $1)); $20.

Feedback: This information in the question prompt implies that Deborah bought 30 pieces of Sushi (=$60/$2) and she bought 20 bagels (=$40/2) before the price change.

If Deborah purchased the same quantities of Sushi and bagels with the new prices it would only cost her $80. She still spends $60 on Sushi because the price hasn't changed (still $2) and she was consuming 30 pieces. However, the cost of the 20 bagels has fallen to $20 because the price of the bagel is only $1 now.

This implies Deborah has an additional $20 to spend as a result of the price decrease on bagels (= $100 (original cost) - $80 (new cost)).

Chapter 07B - Behavioural Economics McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Suppose that Joe enjoys and repeatedly does stupid things like getting heavily into debt and insulting police officers. Do these actions constitute systematic errors? If he gets what he wants each time, are his stupid actions even considered to be errors by economists? Explain. LO7B.1 Answer: Joe‘s stupid behaviours do not constitute systematic errors because the way the word ―error‖ is used by economists, an error only occurs if a person behaves in a way that reduces the likelihood of getting what he or she wants. Because Joe actually wants to do these stupid things, the fact that he is achieving them implies that he is not making any errors.

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2. Why do behavioural economists consider it helpful to base a theory of economic behaviour on the actual mental processes that people use to make decisions? Why do neoclassical economists not care about whether a theory incorporates those actual mental processes? LO7B.1 Answer: Behavioural economists do consider it helpful to base economic theories about behaviour on the actual mental processes that people use to make decisions.

They have that preference because those sorts of theories tend to offer better practical advice for improving outcomes. This is true because any systematic errors that are being made are very likely to be the result of the actual mental processes that are being used to make decisions. In those sorts of situations, any possible improvements in outcomes will be the result of either adjusting or circumventing those error-prone mental processes.

Neoclassical economists do not care about whether a theory incorporates the actual mental processes used to make decisions because they only care about whether a theory makes accurate predictions about observed behaviour. Put slightly differently, neoclassical economists are not interested in improving outcomes. This is because the neoclassical tradition assumes that people never make systematic errors. That belief rests on the contention that people are rational and can figure out for themselves what the best behaviours are to achieve any particular goal. Under that assumption, there is no reason to worry about improving people‘s behaviour because people are already behaving optimally. Thus, the only thing a theory needs to do is correctly predict the current behaviour that is assumed by neoclassical economists to be optimal.

3. Economist Gerd Gigerenzer characterizes heuristics as ―fast and frugal‖ ways of reaching decisions. Are there any costs to heuristics being ―fast and frugal‖? Explain and give an example of how a fast and frugal method for doing something in everyday life comes at some costs in terms of other attributes forgone. LO7B.2 Answer: While heuristics are fast and frugal, they are not perfect. In particular, they achieve high speed and low energy use at the cost of precision and accuracy. The brain could employ other methods for reaching decisions that would on average reach better results-but those methods would run more slowly and use more energy.

As an example of how a fast and frugal method for doing something comes at some cost in terms of other attributes forgone, consider a bartender checking ID‘s. A short glance at a driver‘s license and the person offering it will allow him to quickly and easily detect obvious fakers. But if he wants to raise his accuracy rate and be able to detect and reject more sophisticated fakers, he will have to carefully examine the ID and ask the person offering it several questions to see if they seem legit. Doing so will take up both more and more energy. It is slower and more costly than just giving ID‘s a quick glance.

4. ―There‘s no such thing as bad publicity.‖ Evaluate this statement in terms of the recognition heuristic. LO7B.2 1-165 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Answer: When people apply the recognition heuristic, they assume that if an option is more easily recognized, it is probably more important or more highly ranked.

Therefore, to the extent that even bad publicity increases recognition, it will make the people who see the bad publicity more likely to assume that the person or product receiving the bad publicity is of high value. Be cautious, though. The recognition heuristic is not the only process that people utilize when ranking people or products.

Thus, to the extent that bad publicity might cause negative emotions, bad publicity could indeed be bad for whoever or whatever receives that bad publicity.

5. For each of the following cognitive biases, come up with at least one example from your own life. LO7B.2 a. Confirmation bias. b. Self-serving bias. c. The overconfidence effect. d. Hindsight bias. e. The availability heuristic. f. The planning fallacy. g. Framing effects.

Answer: Answers will vary. See definition of each bias.

6. Suppose that Amir is loss averse. In the morning, Amir‘s stockbroker calls to tell him that he has gained $1,000 on his stock portfolio. In the evening, his accountant calls to tell him that he owes an extra $1,000 in taxes. At the end of the day, does Amir feel emotionally neutral since the dollar value of the gain in his stock portfolio exactly offsets the amount of extra taxes he has to pay? Explain. LO7B.3 Answer: If Amir is loss averse he will feel losses more intensely than gains. This implies that the increase in taxes of $1,000 will cause a greater level of disutility than the gain in utility Amir derives from the $1,000 increase in his stock portfolio. In effect, because Amir is loss averse, he worse off in terms of utility. If we use the intensity figure from the textbook, the $1,000 loss is felt 2.5 more intensely than the $1,000 gain.

7. You just accepted a campus job helping to raise money for your school‘s athletic program. You are told to draft a fund-raising letter. The bottom of the letter asks recipients to write down a donation amount. If you want to raise as much money as possible, would it be better if the text of that section mentioned that your school is ranked third in the nation in sports or that you are better than 99 percent of other schools at sports? Explain. LO7B.3 Answer: The framing effect suggests that we might raise more revenue by stating that the school is better in sports than 99 percent of other schools. This is because the 1-166 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

value 99 serves as an "anchor" number and may increase the size of the donation.

That is, if an individual has been exposed to a larger number prior to making the donation they will likely use this number as a reference point. If, on the other hand, we stated the school was ranked third in sports, the donations might be lower because people will use 3 as their reference number or "anchor."

8. In the early 1990‘s, New Jersey and Pennsylvania both reformed their automobile insurance systems so that citizens could opt for either a less-expensive policy that did not allow people to sue if they got into accidents or a more-expensive policy that did allow people to sue if they got into accidents. In New Jersey, the default option was the less-expensive policy that did not allow suing. In Pennsylvania, the default option was the more-expensive policy that did allow suing. Given those options, which policy do you think most people in New Jersey ended up with? What about in Pennsylvania? Explain. LO7B.3 Answer: Status quo bias caused the majority of people in both New Jersey and Pennsylvania to stay with the default option that was presented to them. As a result, most people in New Jersey ended up with the less-expensive policy that did not allow suing while most people in Pennsylvania ended up with the more-expensive policy that did allow suing.

9. Give an example from your own life of a situation where you or someone you know uses a pre-commitment to overcome a self-control problem. Describe why the precommitment is useful and what it compensates for. Avoid any pre-commitment that was mentioned in the book. LO7B.4 Answer: Answers will vary. See the definition of a pre-commitment.

10. What does behavioural economics have to say about each of the following statements? LO7B.5 a. ―Nobody is truly charitable-they just give money to show off.‖ b. ―America has a ruthless capitalist system. Considerations of fairness are totally ignored.‖ c. ―Selfish people always get ahead. It‘s like nobody even notices!‖ Answer: Answers will vary. a. Behaviour economics would say that people often act in their own self-interests; however, not exclusively. Economic transactions are heavily influenced by moral and ethical factors.

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b. Behavioural economics has studied moral and ethical factors that affect economic behaviour and fairness is among the most important. There is both field and experimental evidence that fairness has a strong effect on people's behaviour. Examples: giving to charity, obeying the law, and the outcomes of experimental games. c. Experiments have shown that people are not exclusively selfish, and when people are treated unfairly, they react very strongly.

11. Do people playing the dictator game show only self-interested behaviour? How much divergence is there in the splits given by dictators to the other player? LO7B.5 Answer: Most people playing the dictator game show a concern for others. In particular, most dictators give at least some of the money to the other player even though the game is fully anonymous and the other player has no way of retaliating. There is a wide range of generosity seen among dictators. About 5 percent give everything to the other player. On the other hand, about one-third of all dictators keep everything for themselves while 17 percent of dictators split the money perfectly evenly between themselves and the other player.

12. Evaluate the following statement. ―We shouldn‘t generalize from what people do in the ultimatum game because $10 is a trivial amount of money. When larger amounts of money are on the line, people will act differently.‖ LO7B.5 Answer: This statement is inconsistent with experimental evidence. When hundreds or even thousands of dollars are on the line, the strong preference that responders have for being treated fairly still remains. As a result, the responders reject unfair offers at the same rates whether large or small amounts of money are at stake.

The LAST WORD What do you think of the ethics of using unconscious nudges to alter people‘s behaviour?

Before you answer, consider the following argument made by economists Richard Thaler and Cass Sunstein, who favour the use of nudges. They argue that in most situations we couldn‘t avoid nudging even if we wanted to because whatever policy we choose will contain some set of unconscious nudges and incentives that will influence people. Thus, they say, we might as well choose the wisest set of nudges.

Answer: Answers will vary.

The argument by Thaler and Sunstein is correct. For example, if the default option is not to enroll in a company's retirement plan, then the 'nudge' is not to enroll. However, if the default option is to enroll in the retirement plan, then the 'nudge' is to enroll. In either case there is a 'nudge'; it is just a matter of direction. Why not choose the direction that is 1-168 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

best for society? Or is this question and answer just a 'nudge' to get you to think the way we do? The question and answer obviously include a bit of ‗framing‘.

REVIEW QUESTIONS 1. Which of the following are systematic errors? LO7B.1 a. A colour-blind person who repeatedly runs red lights. b. An accountant whose occasional math errors are sometimes on the high side and sometimes on the low side. c. The tendency many people have to see faces in clouds. d. Miranda paying good money for a nice-looking apple that turns out to be rotten inside. e. Elvis always wanting to save more but then spending his whole paycheque, month after month.

Answers: a. Yes, the colorblindness causes the driver to systematically (routinely and repeatedly and predictably) make the error of running red lights. b. Because these errors are randomly high and low, there is no systematic (routine, repeated, and predictable) tendency to them. They are all errors, but they do not constitute a systematic error. c. The tendency to see faces in clouds is a systematic (routine, repeated, and predictable) error because there obviously are no faces in clouds. The tendency to see faces in clouds arises from the fact that the brain has many error-prone heuristics for attempting to judge emotion and feelings from other people‘s faces.

Those heuristics are so overly eager to quickly discern emotions and facial expressions from visual information that they ―see‖ faces even where there are none. d. Because Miranda has only made this error one time, it is not a systematic error. In addition, there is no way to avoid this type of bad outcome by looking at the external features of an apple. Thus, Miranda made no avoidable error in judgment when she selected the apple that turned out to be bad. Put slightly differently, Miranda suffered from bad luck. What happened to her was not the result of engaging in an action that would predictably lower her chances of getting what she wants.

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e. Each month, Elvis‘s spending of his entire paycheck causes him to fail to achieve his goal of saving more. Thus, his spending behaviour is a systematic error in that it routinely, repeatedly, and predictably prevents him from achieving his goal.

2. Identify each statement as being associated with neoclassical economics or behavioural economics. LO7B.1 a. People are eager and accurate calculators. b. People are often selfless and generous. c. People have no trouble resisting temptation. d. People place insufficient weight on future events and outcomes. e. People only treat others well if doing so will get them something they want.

Answer: See Table 7B.1 below. a. Neoclassical economics b. Behavioural economics c. Neoclassical economics d. Behavioural economics e. Neoclassical economics

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3. Label each of the following behaviours with the correct bias or heuristic. LO7B.3

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a. Your uncle says that he knew all along that the stock market was going to crash in 2008. b. When Fred does well at work, he credits his intelligence. When anything goes wrong, he blames his secretary. c. Ellen thinks that being struck dead by lightning is much more likely than dying from an accidental fall at home. d. The sales of a TV that is priced at $999 rise after another very similar TV prices at $1,300 is placed next to it at the store. e. The sales of a brand of toothpaste rise after new TV commercials announce that the brand ―is preferred by 4 out of 5 dentists.‖ Answers: a. Hindsight bias. People engage in hindsight bias when they retroactively believe that they were able to predict past events. b. Self-serving bias. This refers to people‘s tendency to attribute their success to personal effort or character traits while attributing failures to factors outside their control. c. Availability heuristic. This causes people to base their estimates about the likelihood of an event on how quickly they come to mind, not on objective facts. d. Framing effect. Occurs when a change in context causes people to react differently. e. Status quo bias. The tendency that people have to favour any option that is presented to them as the default option.

4. Erik wants to save more, but whenever a paycheque arrives, he ends up spending everything. One way to help him overcome this tendency would be to: LO7B.4 a. Teach him about time inconsistency. b. Tell him that self-control problems are common. c. Have him engage in pre-commitments that will make it difficult for his future self to over-spend.

Answer: c; Have him engage in pre-commitments that will make it difficult for his future self to overspend.

Pre-commitments are effective in helping people to overcome the self-control problems associated with myopia and time inconsistency. By contrast, simply 1-172 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

informing people that they are time inconsistent or that they are prone to self-control problems does little good because those tendencies are deeply wired into the brain.

5. Many proposers in the ultimatum game offer half to the responder with whom they are paired. This behaviour could be motivated by (select as many as might apply): LO7B.5 a. Fear that an unequal split might be rejected by a fair-minded responder. b. A desire to induce the responder to reject the offer. c. A strong sense of fairness on the part of the proposers. d. Unrestrained greed on the part of the proposers.

Answer: a. and c.

Proposers who offer half to their responders are likely motivated by either of two desires. The first is that they are genuinely fair-minded and wish to share equally.

The second is that they are not fair-minded but still offer half in order to avoid offending the sense of fairness of the responders with whom they are paired. The nice thing about the Dictator Game is that it removes the possibility of rejection.

Thus, if we see dictators offering half, we know that they must be truly fair-minded because they do not have to worry about the possibility of rejection.

PROBLEMS 1. One type of systematic error arises because people tend to think of benefits in percentage terms rather than in absolute dollar amounts. As an example, Samir is willing to drive 20 minutes out of his way to save $4 on a grocery item that costs $10 at a local market. But he is unwilling to drive 20 minutes out of his way to save $10 on a laptop that costs $400 at a local store. In percentage terms, how big is the savings on the grocery item? On the laptop? In absolute terms, how big is the savings on the grocery item? On the laptop? If Samir is willing to sacrifice 20 minutes of his time to save $4 in one case, shouldn‘t he also be willing to sacrifice 20 minutes of his time to save $10? LO7B.2 Answer: The percentage savings on the grocery item is 40 percent [= ($4/$10) ×100].

The percentage savings on the laptop is 2.5 percent [= ($10/$400) ×100]. In absolute terms, the savings on the grocery item is $4 and the savings on the laptop is $10.

Yes, if Samir is willing to sacrifice 20 minutes of his time to save $4 in one case, he should be more than happy to get $10 for sacrificing 20 minutes in the other case. In terms of economic terminology, his behaviour in the first case indicates that saving $4 exceeds the opportunity cost of whatever else he could be doing with 20 minutes‘ worth of time. If that is so, then $10 will also exceed that same opportunity cost.

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Samir‘s decision, however, is not based on rationally comparing the absolute amount that can be saved with the opportunity cost of 20 minutes‘ worth of time. Rather, he bases his decision on whether a given amount saved seems big in percentage terms.

If it does, he is willing to sacrifice 20 minutes. If not, he will shop locally and pay more.

2. Anne is a bargain-minded shopper. Normally, her favourite toothpaste costs the same at both of her local supermarkets, but the stores are having competing sales this week.

At one store, there is a bonus offer: buy 2, get 1 free. At the other store, toothpaste is being sold at 40 percent off. Anne instantly opts for the first offer. Was that really the less-expensive choice? (Hint: Is ―buy 2, get 1 free‖ the same as 50 percent off?)

LO7B.2 Answer: Anne made the wrong choice because she - like most consumers erroneously believes that ―buy 2, get 1 free‖ is equivalent to a 50 percent discount.

To see what‘s going on, assume a price of $1 per tube of toothpaste. In that case, ―buy 2, get 1 free‖ implies that Anne would pay $2 for three tubes. That comes out to 67 cents per tube (=$2 divided by three tubes), which implies that ―buy 2, get 1 free‖ is the same as a 33 percent discount (because 67 cents per tube is 33 percent less than $1 per tube). By contract, the other store‘s offer of ―40 percent off‖ would mean that the tubes that normally sell for $1 each are now only 60 cents each. So, it would definitely be better to for ―40 percent off‖ rather than ―buy 2, get 1 free‖.

3. The coffee shop near the local university normally sells 250 grams of roasted coffee beans for $10. But the shop sometimes puts the beans on sale. During some sales, it offers ―33 percent more for free‖. Other weeks, it takes ―33 percent off‖ the normal price. After reviewing the shop‘s sales data, the shop‘s manager finds that ―33 percent more for free‖ sells a lot more coffee than ―33 percent off.‖ Are the store‘s customers making a systematic error? Which is actually the better deal? LO7B.2 Answer: The store‘s customers are indeed making a systematic error because ―33 percent off‖ is actually a much better deal than ―33 percent more for free.‖ To see why, start with ―33 percent off.‖ Since the price of 250 grams is normally $10, 33 percent off would mean that 250 grams would cost just $6.70. That implies that the coffee will cost just 0.027 cents per gram (=$6.70 per 250 grams divided by 250 grams). By contrast, getting 33 percent more for free would mean that $10 would purchase 332.50 grams (=the 250 original grams plus an extra 82.5 grams). That implies that the coffee will cost 0.030 cents per gram (=$10 per 332.5 grams divided 332.5 grams). So ―33 percent off‖ actually implies a much lower cost per ounce than does ―33 percent more for free.‖ Behavioural economists believe that people prefer the ―33 percent more for free‖ option to the ―33 percent off‖ option because they have a shopping heuristic based on the word free. According to this hypothesis, people‘s brains are enthusiastically 1-174 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

biased towards any offer that contains the word ―free‖ because people assume that obtaining anything for free will definitely improve their utility. That assumption would be true here in this example if the whole package of coffee were free. But because customers have to pay for the first 10 ounces, the entire package is not freeand indeed has a higher cost per ounce than when the store is offering ―33 percent off‖. But that reality is overlooked because the ―free heuristic‖ biases people.

4. Angela owes $500 on a credit card and $2,000 on a student loan. The credit card has a 15 percent annual interest rate and the student loan has a 7 percent annual interest rate. Her sense of loss aversion makes her more anxious about the larger loan. As a result, she plans to pay it off first-despite the fact that professional financial advisors always tell people to pay off their highest-interest-rate loans first. Suppose Angela has only $500 at the present time to help pay down her loans and that this $500 will be the only money she will have for making debt payments for at least the next year.

If she uses the $500 to pay off the credit card, how much interest will accrue on the other loans over the coming year? On the other hand, if she uses the $500 to pay off part of the student loans, how much in combined interest will she owe over the next year on the remaining balances on the two loans? By how many dollars will she be better off if she uses the $500 to completely pay off the credit card that than partly paying down the student loans? (Hint: If you owe X dollars at an annual interest rate of Y percent, your annual interest payment will be X×Y, where the interest rate, Y, is expressed as a decimal.) LO7B.3 Answer: Angela would be better off following the expert advice and paying down the higher-interest-rate loan first.

If she uses the $500 to pay off her credit card debt, she will only have to pay interest on her student loan. That interest will come to $140 (=$2,000×0.07).

By contrast, if she uses the $500 to pay down part of her student loan, she will still have two debts outstanding, the $500 she owes on her credit card plus the $1,500 (=$2,000 minus her $500 payment) she will still owe on her student loan. Over the next year, the $500 balance on the credit card will accrue $75 (=$500×0.15) of interest while the remaining $1,500 balance on the credit card will accrue $105 (=$1,500×0.07) in interest. Thus, if Angela uses the $500 to pay off part of her student loan rather than all of her credit card debt, she will end up accruing a total of $180 (=$75 + $105) in interest over the next year.

That $180 in interest is substantially more than the $140 in interest she would accrue is she ignored her loss-aversion instincts and used the $500 to pay off the higherinterest credit card debt first.

5. ADVANCED ANALYSIS In the algebraic version of prospect theory, the variable × represents gains and losses. A positive value for × is a gain, a negative value for × is a loss, and a zero value for × represents remaining at the status quo. The so-called 1-175 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

value function, v(x), has separate equations for translating gains and losses into, respectively, positive values (utility) and negative values (disutility). The gain or loss is typically measured in dollar while the resulting value (utility or disutility) is measured in utils. A typical person values gains (x > 0) using the function v(x) = x0.88 and losses (x < 0) using the function v(x) = -2.5×(-x)0.88. In addition, if she stays at the status quo (x = 0), then v(x) = 0. First use a scientific calculator and the typical person‘s value functions for gains and losses to fill out the missing spaces in the nearby table. Then answer the questions below. LO7B.3

Gain or Loss -3 -2 -1 0 1 2 3

Total Value of Gain or Loss -6.57 -2.5 0

Marginal Value of Gain or Loss -2.1 -2.5 1

1.84 0.79

a. What is the total value of gaining $1? Of gaining $2? b. What is the marginal value of going from gaining $0 to gaining $1? Of going from gaining $1 to gaining $2. Does the typical person experience diminishing marginal utility from gains? c. What is the marginal value of going from losing $0 to losing $1? Of going from losing $1 to losing $2? Does the typical person experience diminishing marginal disutility from losses? d. Suppose that a person simultaneously gains $1 from one source and loses $1 from another source. What is the person‘s total utility after summing the values from these two events? Can a combination of events that leaves a person with the same wealth as they started with be perceived negatively?

Does this shed light on status quo bias? e. Suppose that an investor has one investment that gains $2 while another investment simultaneously loses $1. What is the person‘s total utility after summing the values from these two events? Will an investor need to have

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gains that are bigger than her losses just to feel as good as she would is she did not invest at all and simply remained at the status quo?

Answer: The completed table should look like this: Total Marginal Gain or Value of Value of Loss Gain or Gain or Loss Loss -3 -6.57 -1.97 -2

-4.60

-2.10

-1

-2.50

-2.50

0

0.00

0.00

1

1.00

1.00

2

1.84

0.84

3

2.63

0.79

The total value of gaining $1 is 1.00 utils. The total value of gaining $2 is 1.84 utils.

The marginal value of going from gaining $0 to gaining $1 is 1.00 utils (= 1.00 – 0.00 utils). The marginal value of going from gaining $1 to gaining $2 is 0.84 utils (= 1.84 utils – 1.00 utils). Thus, the typical person does experience diminishing marginal utility for gains.

The marginal value of going from losing $0 to losing $1 is -2.50 utils (=2.50 utils – 0.00 utils). The marginal value of going from losing $1 to losing $2 is -2.10 utils (= 4.60 utils – (-2.50 utils)). Thus, the typical person does experience diminishing marginal disutility for losses.

The person‘s combined total utility from the two events will be -1.50 utils (= 1.00 util from the gain of $1 – 2.50 utils from the loss of $1). Thus, a combination of events that leaves a person with the same amount of wealth as they held initially can leave the person feeling worse off. This is one explanation for the origin of status quo bias.

People don‘t want to make changes because losses feel so much worse than gains that even ending up back where they started can feel worse than if they had simply stayed at the status quo.

This investor‘s total utility will be -1.50 utils (= 1.00 utils from gaining $1 –s.50 utils from losing $1). So, yes, an investor will have to have gains that exceed her losses by a substantial amount if she wants to end up feeling better than if she had done nothing and remained at the status quo.

6. Ted has always had difficulty saving money. So on June 1st, he enrolls in a Christmas savings program at his local bank and deposits $750. That money is totally locked away until December 1st so that Ted can be certain that he will still have it once the holiday shopping season begins. Suppose that the annual rate of interest is 10 percent on ordinary savings accounts (that allow depositors to withdraw their money at any 1-177 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

time). How much interest is Ted giving up by pre-committing his money into the Christmas savings account for six months instead of depositing it into an ordinary savings account? (Hint: If you invest X dollars at an annual interest rate of Y percent, you will receive interest equal to X × Y, where the interest rate Y is expressed as a decimal.) LO7B.4 Answer: Ted is giving up $37.50 in interest over the six-month period. To see why, note that because he put his $750 into an ordinary savings account for a year, he would receive interest totaling $75 (= 10 percent per year times $750). Since $75 is the amount of interest he would receive for one year, he would receive half of that amount, or $37.50 for six months (= half a year).

Chapter 08 – The Firm and the Costs of Production McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Distinguish between explicit and implicit costs, giving examples of each. What are

some explicit and implicit costs of attending college? LO8.1 Answer: Explicit costs are payments the firm must make for inputs to non-owners of the firm to attract them away from other employment, for example, wages and salaries to its employees. Implicit costs are non-expenditure costs that occur through the use of self-owned, self-employed resources, for example, the salary the owner of a firm forgoes by operating his or her own firm and not working for someone else.

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

2. Distinguish between accounting profit, economic profit, and normal profit. Does

accounting profit or economic profit determine how entrepreneurs allocate resources between different business ventures? Explain. LO8.1 ANSWER: ACCOUNTING PROFIT EQUALS SALES REVENUE MINUS EXPLICIT COSTS, SUCH AS MATERIAL, THE WAGES OF EMPLOYEES, ETC… NORMAL PROFIT EQUALS THE ACCOUNTING PROFIT YOU COULD HAVE POTENTIALLY EARNED IN A DIFFERENT (OR ALTERNATIVE) BUSINESS VENTURE. THIS GIVES US A TRUE MEASURE OF THE OPPORTUNITY COST OF THE CURRENT BUSINESS VENTURE. Economists classify normal profits as

costs, since in the long run the owner of a firm would close it down if a normal profit were not being earned. Since a normal profit is required to keep the entrepreneur operating the firm, a normal profit is a cost.

Economic profit equals the accounting profit minus the additional implicit costs of the business. This includes entrepreneurial ability, forgone interest, forgone labour income, etc...

Economic profit determines how entrepreneurs allocate resources between different business ventures. If economic profit is greater zero this implies the business venture 1-178 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

is earning above average normal profits (more than other alternative business ventures on average), thus more resources will flow towards this activity. The opposite is true when economic profit is negative.

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

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

product is diminishing, marginal cost is rising. Illustrate and explain graphically. LO8.2 ANSWERS:

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Inputs of Labour

Total Product

Marginal Product

Average Product

0 1 2 3 4 5 6 7 8

0 15 34 51 65 74 80 83 82

NA 15 19 17 14 9 6 3 -1

NA 15 17 17 16.25 14.8 13.33 11.86 10.25

MP is the slope—the rate of change—of the TP curve. When TP is rising at an increasing rate, MP is positive and rising. When TP is rising at a diminishing rate, MP is positive but falling. When TP is falling, MP is negative and falling. AP rises when MP is above it; AP falls when MP is below it.

MP first rises because the fixed capital gets used more productively as added workers are employed. Each added worker contributes more to output than the previous worker because the firm is better able to use its fixed plant and equipment. As still more labour is added, the law of diminishing returns takes hold. Labour becomes so abundant relative to the fixed capital that congestion occurs and marginal product 1-180 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

falls. At the extreme, the addition of labour so overcrowds the plant that the marginal product of still more labour is negative—total output falls.

Because labour is the only variable input and its price (its wage rate) is constant, MC is found by dividing the wage rate by MP. When MP is rising, MC is falling; when MP reaches its maximum, MC is at its minimum; when MP is falling, MC is rising.

4. Why can the distinction between fixed costs and variable costs be made in the short run? Classify the following as fixed or variable costs: advertising expenditures, fuel, interest on company-issued bonds, shipping charges, payments for raw materials, real estate taxes, executive salaries, insurance premiums, wage payments, sales taxes, and rental payments on leased office machinery. ―There are no fixed costs in the long run; all costs are variable.‖ Explain. LO8.3 Answer: The distinction can be made because there are some costs that do not vary with total output. These are the fixed costs that, fundamentally, are related to the scale or size of the plant. In the short run, by definition, the scale of the plant cannot change: The firm cannot bring in more machinery or move to a larger building. All costs that are related to the scale of the plant—costs that continue to be incurred even though the firm‘s output may be zero—are fixed costs. On the other hand, the firm can increase its output by using its plant—its fixed capital—more intensively, that is, by hiring more labor, or by using more materials. But by doing so, it will increase its operating costs, its variable costs.

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

Real estate taxes: fixed costs. Executive salaries: fixed costs. Insurance premiums: fixed costs. Wage payments: variable costs. Depreciation and obsolescence charges: fixed costs. Sales taxes: variable costs. Rental payments on leased office machinery: fixed costs (although it is possible that short-term lease arrangements on some types of office equipment may rise or fall with output).

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

5. List several fixed and variable costs associated with owning and operating an

automobile. Suppose you are considering whether to drive your car or fly 2,000 kilometres for spring break. Which costs—fixed, variable, or both—would you take into account in making your decision? Would any implicit costs be relevant? Explain.

LO8.3

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Answer: Fixed costs associated with owning and operating an automobile include the price of the car (probably monthly payments); insurance; driver‘s license; car license; and depreciation.

Variable costs associated with owning and operating an automobile include gasoline, oil, lubricants; repairs; car wash; and depreciation, which is also in part a variable cost since the more the car is driven, the more it depreciates.

The costs of driving are the same variable costs (including depreciation) listed above.

Going by plane, the variable cost is the cost of the ticket. It would probably be cheaper to drive but this would leave out the relevant implicit cost—my time and the wear and tear on myself of driving there and back. The plane would be faster. How much is it worth to me to arrive sooner and stay longer and be fresher on arrival? On the other hand, maybe I‘d find the car useful when on spring break, and having one‘s own car saves the variable cost of renting if one flies.

6. Use the concepts of economies and diseconomies of scale to explain the shape of a firm‘s long-run ATC curve. What is the concept of minimum efficient scale? What bearing can the shape of the long-run ATC curve have on the structure of an industry?

LO8.4 Answer: The long-run ATC curve is U-shaped. At first, long-run ATC falls as the firm expands and realizes economies of scale from labour and managerial specialization and the use of more efficient capital. The long-run ATC curve later turns upward when the enlarged firm experiences diseconomies of scale, usually resulting from managerial inefficiencies.

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

THE LAST WORD

Suppose that minimum efficient scale for producing items with a 3-D printer is 100 times what a typical family would consume in a year. Would you expect each family to have its own 3-D printer? What sort of industry structure might arise?

Answer: Suppose that the average family could be expected to 3-D print 100 objects per year, or about two objects per week. If the minimum efficient scale for 3-D printing is to print 100 times that amount, or 10,000 objects per year, then a business that prints for local customers would have a cost advantage relative to individual families doing their own printing. This would provide entrepreneurs with a business opportunity. If they can figure out how to make the business model profitable (after paying for all the necessary land, labor, capital, and entrepreneurship), then you would expect most families to lean toward outsourcing 3-D printing since having local firms printing at minimum efficient scale would lead to cheaper per-unit costs for printed objects.

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We might arrive at a 3-D printing industry whose industry structure consists of a large number of small local businesses doing 3-D printing for local families REVIEW QUESTIONS 1. Linda sells 100 bottles of homemade ketchup for $10 each. The cost of the ingredients and the bottles and the labels was $700. In addition, it took her 20 hours to make the ketchup and to do so she took time off from a job that paid her $20 per hour. Linda‘s accounting profit is _____________ while her economic profit is ______________. LO8.1 a. $700; $400 b. $300; $100 c. $300; negative $100 d. $1,000; negative $1,100 Answer: e; $300; negative $100.

Linda‘s revenue is $1,000 (=100 bottles of ketchup sold at $10 each). Linda‘s explicit costs for ingredients, bottles, and labels are $700. Thus, her accounting profit (which subtracts explicit costs from revenue) is $300 (=$1,000 of revenue minus $700 of explicit costs).

Linda‘s implicit cost is the opportunity cost of the 20 hours of labour that she put into making the ketchup. Because she gave up making $20 per hour for each of those 20 hours of labour, the implicit cost of her labour is $400 (=$20 per hour times 20 hours). Thus her economic profit (which subtracts both explicit costs and implicit costs from revenue) is negative $100 (=$1,000 in revenue minus $700 in explicit costs minus $400 in implicit costs).

2. Which of the following are short-run and which are long-run adjustments? LO8.1 a. Wendy‘s builds a new restaurant. b. Scotiabank hires 200 more workers. c. A farmer increases the amount of fertilizer used on his corn crop. d. An Alcan aluminum plant adds a third shift of workers.

ANSWER:

a. Long-Run. This is a capital investment, which takes time to become productive. b. Short-Run. The new labourers can work immediately. c. Short-Run. Although this takes time via the growing process, this is still a shortrun adjustment. It influences the growth of current crops immediately. d. Short-Run. The new labourers can work immediately.

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3. A firm has fixed costs of $60 and variable costs as indicated in the table at the bottom

of this page. Complete the table and check your calculations by referring to problem 4 at the end of Chapter 9. LO8.3

a. Graph total fixed cost, total variable cost, and total cost. Explain how the law of diminishing returns influences the shapes of the variable-cost and total-cost curves. b. Graph AFC, AVC, ATC, and MC. Explain the derivation and shape of each of these four curves and their relationships to one another. Specifically, explain in nontechnical terms why the MC curve intersects both the AVC and the ATC curves at their minimum points. c. Explain how the location of each curve graphed in question 3b would be altered if (1) total fixed cost had been $100 rather than $60 and (2) total variable cost had been $10 less at each level of output.

Answer: See the completed table below: Total Total Total fixed variable product cost cost

Total cost

Average Average Average Margina fixed variable total l Cost cost cost cost

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0

$60

$0

$60

-

-

-

-

1

60

45

105

$60

$45

$105

$45

2

60

85

145

30

42.5

72.50

$40

3

60

120

180

20

40

60

$35

4

60

150

210

15

37.5

52.50

$30

5

60

185

245

12

37

49

$35

6

60

225

285

10

37.5

47.50

$40

7

60

270

330

8.6

38.6

47.14

$45

8

60

325

385

7.5

40.6

48.13

$55

9

60

390

450

6.7

43.3

50

$65

10

60

465

525

6

46.5

52.50

$75

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

b. See the graph below. AFC (= TFC/Q) falls continuously since a fixed amount of capital cost is spread over more units of output. The MC (= change in TC/change in Q), AVC (= TVC/Q), and ATC (= TC/Q) curves are U-shaped, reflecting the 1-185 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

influence of first increasing and then diminishing returns. The ATC curve sums AFC and AVC vertically. The ATC curve falls when the MC curve is below it; the ATC curve rises when the MC curve is above it. This means the MC curve must intersect the ATC curve at its lowest point. The same logic holds for the minimum point of the AVC curve.

c. (1) If TFC has been $100 instead of $60, the AFC and ATC curves would be higher—by an amount equal to $40 divided by the specific output. Example: at 4 units, AVC = $25.00 [= ($60 + $40)/4]; and ATC = $62.50 [= ($210 + $40)/4].

The AVC and MC curves are not affected by changes in fixed costs.

(2) If TVC has been $10 less at each output, MC would be $10 lower for the first unit of output but remain the same for the remaining output. The AVC and ATC curves would also be lower—by an amount equal to $10 divided by the specific output.

Example: at 4 units of output, AVC = $35.00 [= $150 - $10)/4], ATC = $50 [= ($210 - $10)/4]. The AFC curve would not be affected by the change in variable costs.

4. Indicate how each of the following would shift the (1) marginal-cost curve, (2) average-variable-cost curve, (3) average-fixed-cost curve, and (4) average-total-cost curve of a manufacturing firm. In each case specify the direction of the shift. LO8.3 a. A reduction in business property taxes. b. An increase in the nominal wages of production workers. c. A decrease in the price of electricity. d. An increase in insurance rates on plant and equipment. e. An increase in transportation costs.

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Answer: a. This is a change in the fixed cost. This implies there will be no change in MC or AVC. Since this is a decrease in fixed cost AFC shifts down and ATC shifts down (sum of AVC and AFC). b. This is a change in variable cost. Since wages are now higher, MC shifts up, AVC shifts up, and ATC shifts up. There is no change in AFC. c. This is a change in variable cost. The lower price of electricity implies MC shifts down, AVC shifts down, and ATC shifts down. There is no change in AFC. d. This is a change in the fixed cost. This implies there will be no change in MC or AVC. Since this is an increase in fixed cost AFC shifts up and ATC shifts up. e. This is a change in variable cost. Since transportation costs are now higher, MC shifts up, AVC shifts up, and ATC shifts up. There is no change in AFC.

5. True or false. The U shape of the long-run ATC curve is the result of diminishing returns. LO8.4 Answer: False The long-run ATC curve's U shape cannot be explained by diminishing returns. That is because the definitions of short run and long run that are used in microeconomics imply that diminishing returns can only take place in the short run.

To see why, recall that the short run is a period of time that is too brief for a firm to alter its plant capacity while the long run is a period long enough for a firm to adjust the quantities of all the resources that it employs, including plant capacity. The difference between those definitions matters because diminishing returns applies only when one productive resources or input is held constant. Thus, it cannot happen in the long run when, by definition, firms have had enough time to adjust all their inputs, including plant capacity.

So what does cause the U shape of the long-run ATC curve? The answer is economics and diseconomies of scale related to factors such as labour specialization and capital efficiency.

6. Suppose a firm has only three possible plant-size options, represented by the ATC

curves shown in the accompanying figure. What plant size will the firm choose in producing (a) 50, (b) 130, (c) 160, and (d) 250 units of output? Draw the firm‘s longrun average-cost curve on the diagram and describe this curve. LO8.4

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

The firm's long run average total cost curve will be the lower sections of the different plant size ATC schedules. Specifically, to the left of 80 units ATC1 will be the first section of the long run ATC. Between 80 and 240 ATC2 will make up the second section of the long run ATC. Finally, to the right of 240 ATC3 will make up the rest of the firm's long run ATC. PROBLEMS 1. Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72,000.

Calculate the accounting profit and the economic profit for Gomez‘s pottery firm.

LO8.1 Answer: Accounting profit = $35,000; Economic profit = $13,000.

Explicit costs are the direct costs incurred from production: $37,000 (= $12,000 for the helper + $5,000 of rent + $20,000 of materials).

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

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Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs) Economic profit = $13,000 (= $72,000 - $37,000 of explicit costs - $22,000 of implicit costs) 2. Imagine you have some workers and some hand-held computers that you can use to take inventory at a warehouse. There are diminishing returns to taking inventory. If one worker uses one computer, he can inventory 100 items per hour. Two workers can together inventory 150 items per hour. Three workers can together inventory 160 items per hour. And four or more workers can together inventory fewer than 160 items per hour. Computers cost $100 each and you must pay each worker $25 per hour. If you assign one worker per computer, what is the cost of inventorying a single item? What if you assign two workers per computer? Three? How many workers per computer should you assign if you wish to minimize the cost of inventorying a single item? LO8.2 Answer: 1.25; 1.00; 1.09; 2 If you assign one worker per computer, the cost of inventorying a single item is $1.25. You incur the cost of the computer, $100, and the cost of employing one worker, $25, which is divided by the number of units inventoried, 100 (= ($100 + $25) / 100)).

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

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

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

3. You are a newspaper publisher. You are in the middle of a one-year rental contract for your factory that requires you to pay $500,000 per month, and you have contractual labour obligations of $1 million per month that you can‘t get out of. You also have a marginal printing cost of $0.25 per paper as well as a marginal delivery cost of $0.10 per paper. If sales fall by 20 percent from 1 million papers per month to 800,000 papers per month, what happens to the AFC per paper, the MC per paper, and the minimum amount that you must charge to break even on these costs? LO8.3 Answers: 1-189 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

AFC per paper rises from $1.50 per paper to $1.88 per paper; MC does not change; and the minimum amount that the paper must charge to break even rises from $1.85 per paper (= $1.5 million in fixed costs divided by 1 million papers plus $0.35 per paper in marginal costs) to $2.23 per paper (= $1.5 million in fixed costs divided by 800,000 papers plus $0.35 per paper in marginal costs).

Here Marginal Cost (MC) is constant, which implies that Average Variable Cost (AVC) is constant and equals MC. This does not imply Average Total Cost (ATC) is constant or has to equal MC. Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC) Divide through by the quantity Q, which implies TC/Q = FC/Q + VC/Q. This gives us ATC = AFC + AVC. Now, since MC is constant (each unit of output costs MC to produce), thus we have MC × Q = Variable Cost (VC). Note this is variable cost (VC) because we do not have to produce.

Divide this by Q, which implies that MC = VC/Q = AVC Substituting this result into the ATC equation, we have ATC = AFC + MC (or AVC).

Thus, MC and AVC are the same in this set-up.

The original average fixed cost (AFC) was $1.50, which equals the total fixed cost $1.5 million divided by the number of papers sold (1 million, the original amount).

Note here that labour is treated as a fixed cost because of the contractual obligation (you must pay even if production stops, assuming the company does not file for bankruptcy) (=$1,500,000/1,000,000).

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

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

The marginal printing and marginal delivery costs are still the same; therefore, marginal costs do not change.

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

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

4. There are economies of scale in ranching, especially with regard to fencing land.

Suppose that barbed-wire fencing costs $10,000 per kilometre to set up. How much would it cost to fence 1 property whose area is 1 square kilometre if that property also happens to be perfectly square, with sides that are each 1 kilometre long? How much would it cost to fence exactly 4 such properties, which together would contain 4 square kilometres of area? Now consider how much it would cost to fence 4 square kilometres of ranch land if, instead, it comes as 1 large square that is 2 kilometres 1-190 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

long on each side. Which is more costly—fencing the 4 one-square-kilometre properties or the 1 four-square-kilometre property? LO8.4 Answers: $40,000 for the single one-square-kilometre property; $160,000 for four of the one-square-kilometre properties; $80,000 for the single four-square-kilometre property that is two-kilometres on each side; it is cheaper to fence in a single foursquare-kilometre property than four, one-square kilometre properties.

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

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

Now, consider how much it would cost to fence in four square kilometres of ranch land if, instead, it comes as a single large square that is two-kilometres long on each side.

Here, we only need to fence the outside perimeter in the diagram below. First, recognize that each side of the square below is twice as long as the problem above (separate properties), which implies it is going to cost $20,000 to fence each side (2 kilometres long). There are four sides, so the total cost of fencing this area is $80,000 (= 4 × $20,000).

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

Chapter 9 - Perfect Competition in the Short Run McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS Briefly state the basic characteristics of perfect competition, perfect monopoly, monopolistic competition, and oligopoly. Under which of these market classifications does each of the following most accurately fit? (a) a supermarket in your hometown; (b) the steel industry; (c) a Saskatchewan wheat farm; (d) the chartered bank in which you or your family has an account; (e) the automobile industry. In each case justify your classification. LO9.1 Answer: Perfect competition: very large number of firms; standardized products; no control over price: price takers; no obstacles to entry; no non-price competition.

Monopoly: one firm; unique product: with no close substitutes; much control over price: price maker; entry is blocked; mostly public relations advertising.

Monopolistic competition: many firms; differentiated products; some control over price in a narrow range; relatively easy entry; much non-price competition: advertising, trademarks, brand names.

Oligopoly: few firms; standardized or differentiated products; control over price circumscribed by mutual interdependence: much collusion; many obstacles to entry; much non-price competition, particularly product differentiation. a. Hometown supermarket: oligopoly. Supermarkets are few in number in any one area; their size makes new entry very difficult; there is much non-price competition. However, there is much price competition as they compete for market share, and there seems to be no collusion. In this regard, the supermarket acts more like a monopolistic competitor. Note that this answer may vary by area.

Some areas could be characterized by monopolistic competition while isolated small towns may have a monopoly situation.

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b. Steel industry: oligopoly within the domestic production market. Firms are few in number; their products are standardized to some extent; their size makes new entry very difficult; there is much non-price competition; there is little, if any, price competition; while there may be no collusion, there does seem to be much price leadership. c. Saskatchewan wheat farm: perfect competition. There are a great number of similar farms; the product is standardized; there is no control over price; there is no nonprice competition. However, entry is difficult because of the cost of acquiring land from a present proprietor. Of course, government programs to assist agriculture complicate the purity of this example. d. Chartered bank: monopolistic competition. There are many similar banks; the services are differentiated as much as the bank can make them appear to be; there is control over price (mostly interest charged or offered) within a narrow range; entry is relatively easy (maybe too easy!); there is much advertising. Once again, not every bank may fit this model—smaller towns may have an oligopoly or monopoly situation. e. Automobile industry: oligopoly. There are the Big Three automakers, so they are few in number; their products are differentiated; their size makes new entry very difficult; there is much non-price competition; there is little true price competition; while there does not appear to be any collusion, there has been much price leadership. However, imports have made the industry more competitive in the past two decades, which has substantially reduced the market power of the North American automakers.

Strictly speaking, perfect competition is relatively rare. Then why study it? LO9.2 Answer: Thank of perfect competition as a benchmark. It can be shown that perfect competition results in low-cost production (productive efficiency)—through long-run equilibrium occurring where P equals minimum ATC—and allocative efficiency— through long-run equilibrium occurring where P equals MC. Given this, it is then possible to analyze real world examples to see to what extent they conform to the ideal of plants producing at their points of minimum ATC and thus producing the most desired commodities with the greatest economy in the use of resources. ―Even if a firm is losing money, it may be better to stay in business in the short run.‖ Is this statement ever true? Under what condition(s)? LO9.5

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Answer: Yes, a firm may want to stay in business even if it is losing money. For example, assume the firm has a fixed cost of $1,000 which it must pay even if it stops production. Now assume that average variable cost is $10 per unit and price of the product is $15 per unit. Finally assume that output equals 100 units using the MR=MC rule. This implies total revenue equals $1,500, variable cost equals $1,000, and total cost equals $2,000 (the sum of variable and fixed cost). The firm is losing money because profit equals -$500 (=$1500 - $2000). However, this loss is less than the fixed cost it would incur in the short run if it shut down, which equals a $1,000.

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

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

Consider a firm that has no fixed costs and that is currently losing money. Are there any situations in which it would want to stay open for business in the short run? If a firm has no fixed costs, is it sensible to speak of the firm distinguishing between the short run and the long run? LO9.5 Answer: No, the firm will want to shut down. This follows because the firm is losing money, but there are no fixed costs. Since there are no fixed costs, only variable cost, revenue must be less than total variable cost or price is less than average variable cost (the shut-down rule). In other words, the firm can shut down and lose nothing because there are no fixed costs or it can keep producing and earn a negative profit.

In a more general sense, a firm with no fixed cost is really in the long run. By definition, the short run implies there are fixed cost present that the firm cannot get of paying either implicitly or explicitly. The long run implies all factors and costs can adjust to the economy.

Why is the equality of marginal revenue and marginal cost essential for profit maximization in all market structures? Explain why price can be substituted for marginal revenue in the MR = MC rule when an industry is perfectly competitive.

LO9.5 Answer: If the last unit produced adds more to costs than to revenue, its production must necessarily reduce profits (or increase losses). On the other hand, profits must increase (or losses decrease) so long as the last unit produced—the marginal unit—is adding more to revenue than to costs. Thus, so long as MR is greater than MC, the production of one more marginal unit must be adding to profits or reducing losses (provided price is not less than minimum AVC). When MC has risen to precise equality with MR, the production of this last (marginal) unit will neither add nor reduce profits.

In perfect competition, the demand curve is perfectly elastic; price is constant regardless of the quantity demanded. Thus, MR is equal to price. This being so, P can be substituted for MR in the MR = MC rule. (Note, however, that it is not good 1-194 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

practice to use MR and P interchangeably, because in imperfectly competitive models, price is not the same as marginal revenue.) ―That segment of a competitive firm‘s marginal-cost curve that lies above its averagevariable-cost curve constitutes the short-run supply curve for the firm.‖ Explain using a graph and words. LO9.6 Answer: The firm will not produce if P < AVC. When P > AVC, the firm will produce in the short run at the quantity where P (= MR) is equal to its increasing MC. Therefore, the MC curve above the AVC curve is the firm‘s short-run supply curve, it shows the quantity of output the firm will supply at each price level. See Figure 9.6 (below) for a graphical illustration.

The LAST WORD You are given an old car by your uncle, who wants you to keep it in working condition so that you can hand it off to your younger brother in three years. It will cost you $1,500 per year to keep it in working condition for your brother. If you skip maintenance altogether, the car will die after two years, but you can pocket the maintenance costs. What will you be tempted to do? Would higher maintenance costs make you more or less likely to do what your uncle wants? Explain.

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Answer: The marginal cost of keeping the car for the third year is $1,500, whereas the marginal benefit is the value you place on a year of the car use. The marginal cost of not doing any maintenance is monetarily zero, but you would be disappointing your uncle.

The marginal benefit of not doing any maintenance is $3,000. So, it is tempting to not do the maintenance. Higher maintenance costs would make it less likely that you would want to do what your uncle wants.

REVIEW QUESTIONS 1. Suppose that the paper clip industry is perfectly competitive. Also assume that the market price for paper clips is 2 cents per paper clip. The demand curve faced by each firm in the industry is: LO9.3

a. b. c. d.

A horizontal line at 2 cents per paper clip.

A vertical line at 2 cents per paper clip.

The same as the market demand curve for paper clips.

Always higher than the firm‘s MC curve.

Answer: a. A horizontal line at 2 cents per paper clip.

In any perfectly competitive industry, the demand curve faced by an individual firm is a horizontal line at the market equilibrium price. This is because in a perfectly competitive industry each firm's output is too small to affect the overall market equilibrium price. Thus, each firm can sell as many or as few units of output as it pleases without affecting the market equilibrium price.

In the case of the paper clip industry used in this question, each firm can sell as many or as few paper clips as it wishes at the market equilibrium price of 2 cents per paper clip. That is equivalent to each firm perceiving demand to be a horizontal line at a price of 2 cents per paper clip because whether the firm produces one paper clip or many, it will always be able to see the amount it produces for 2 cents per paper clip. Thus, from the perspective of each individual firm, there is no trade-off between the amount it wishes to sell and the price at which it can sell. The demand curve perceived by each individual firm will be horizontal.

By contrast, the overall market demand curve will still be downward sloping, so that there will still be an inverse relationship between the total amount that the industry produces and the price of paper clips. For the overall market demand curve, the more firms produce, the lower the price per paper clip. That is, the overall market demand curve will be downward sloping.

2.

Use the following demand schedule to determine total revenue and marginal revenue for each possible level of sales: LO9.3

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a. What can you conclude about the structure of the industry in which this firm is operating? Explain. b. Graph the demand, total-revenue, and marginal-revenue curves for this firm. c. Why do the demand and marginal-revenue curves coincide? d. ―Marginal revenue is the change in total revenue associated with additional units of output.‖ Explain verbally and graphically, using the data in the table.

Answer: See completed table below: Product Price Quantity ($) Demanded 2 0 2 1 2 2 2 3 2 4 2 5

Marginal Revenue ($) NA 2 2 2 2 2

Total Revenue ($) 0 2 4 6 8 10

a. The industry is perfectly competitive—this firm is a ―price taker.‖ The firm is so small relative to the size of the market that it can change its level of output without affecting the market price. b. See graph. c. The firm‘s demand curve is perfectly elastic; MR is constant and equal to P.

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d. True. When output (quantity demanded) increases by 1-unit, total revenue increases by $2. This $2 increase is the marginal revenue. The change in TR is measured by the slope of the TR line, 2 (= $2/1 unit).

3. A perfectly competitive firm whose goal is to maximize profit will choose to produce the amount of output at which: LO9.4 a. TR and TC are equal. b. TR exceeds TC by as much as possible. c. TC exceeds TR by as much as possible. d. None of the above.

Answer: b. TR exceeds TC by as much as possible.

A perfectly competitive firm that wishes to maximize profit will choose to produce the amount of output at which TR exceeds TC by as much as possible. That is because profit is the difference between TR and TC. Stated algebraically, Profit = TR – TC. Consequently, a competitive firm‘s profit will be maximized when TR exceeds TC by as much as possible. Note, however, that it is possible that a firm facing difficult circumstances could find itself in the very unfortunate position of never being able to make a profit. That can happen if TR < TC at every possible output level. In such situations, the firm will always lose money. But it will attempt to lose as little money as possible. That will be done by choosing the output level at which the loss is as small as possible. As explained in this section, it will either shut down production and produce zero units of output (if the price is less than minimum AVC) or produce the amount of output at which MR = MC (if price exceeds minimum AVC). It will undertake whichever of those two options produces the smaller loss.

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4. If it is possible for a perfectly competitive firm to do better financially by producing rather than shutting down, then it should produce the amount of output at which: LO9.5

a. b. c. d.

MR < MC. MR = MC. MR > MC. none of the above.

Answer: b. MR = MC. First, keep in mind that depending upon its circumstances; it may be better for a firm to shut down production and produce zero units of output than for it to produce a positive amount of output. This will be true in cases where the firm is facing losses AND those losses would be smaller if it shut down production than if it produced a positive amount of output.

In such situations, the firm that shuts down production will lose only the amount of its fixed costs. By contrast, in such situations, the firm would lose even more if it produced a positive amount of output. That is why, in such situations, the firm will prefer to shut down and produce nothing and thereby only lose the value of its fixed costs rather than producing a positive amount of output and losing even more money.

On the other hand, it may be possible for a firm facing better circumstances to either make a positive profit or generate a loss that is smaller than the fixed-cost loss that it would incur if it shut down production. In such situations, the firm will do as well as it possibly can if it chooses to produce the amount of output at which MR = MC. That amount of output will either maximize the firm‘s profit (if it is possible for the firm to make a profit) or minimize the firm‘s loss (if the firm must make a loss).

5. A perfectly competitive firm that makes car batteries has a fixed cost of $10,000 per month.

The market price at which it can sell its output is $100 per battery. The firm‘s minimum AVC is $105 per battery. The firm is currently producing 500 batteries a month (the output level at which MR = MC). This firm is making a _____________ and should _______________ production. LO9.5

a. b. c. d.

profit; increase profit; shut down loss; increase loss; shut down

Answer: d. loss; shut down.

This firm is making a loss and should shut down production. We know that it is making a loss because the market price at which it can sell its batteries is less than the minimum AVC. That implies that its revenue per battery is not even high enough to cover the variable cost of producing its output. But the situation is even worse because each month the firm has $10,000 in fixed costs. So if the firm produces output, not only will it be failing to cover the variable cost of producing output, it will also be failing to cover its fixed cost of producing output.

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The firm should shut down immediately and produce nothing because producing nothing will minimize the size of its loss. That is because if it produces nothing, it will only lose $10,000 per month, the value of its fixed cost. By contrast, if it continues to produce output, it will lose not only its fixed cost but also an additional amount because its revenues are not even high enough to cover the variable cost of producing output. Thus, it would lose less money if it shut down production than if it continued producing output. Better to lose just the fixed-cost amount of $10,000 per month rather than an even larger amount!

6. Consider a profit-maximizing firm in a competitive industry. For each of the following situations, indicate whether the firm should shut down production or produce where MR = MC. LO9.5

a. P < minimum AVC. b. P > minimum ATC. c. Minimum AVC < P < minimum ATC. Answers: a. The firm should shut down production because in this price range (P < minimum AVC) the firm would always lose less money by shutting down than by producing output. This is true because shutting down would result in a loss equal to the firm‘s fixed cost while producing any positive amount of output would lose the firm even more money. b. The firm should produce where MR = MC because in this price range (P > minimum ATC) the firm will maximize profits by choosing to produce the amount of output at which MR = MC. Note that with the price higher than minimum ATC, the firm is guaranteed to make a profit. The only question is how much output to produce in order to maximize that profit. The answer is given by the MR = MC rule, which tells us that in any situation in which producing is preferable to shutting down, a competitive firm will do as well as it possibly can if it produces where MR = MC. c. The firm should produce where MR = MC because in this price range (minimum AVC < P < minimum ATC) the firm will minimize its loss by producing where MR = MC. To see why this is the case, first note that because the price is less than minimum ATC, the firm will be forced to make a loss. But we know that because price exceeds minimum AVC, the firm will not want to shut down. The question then is how much to produce. The answer is given by the MR = MC rule, which tells us that in any situation in which producing is preferable to shutting down, a competitive firm will do as well as it possibly can if it produces where MR = MC. 1-200 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

In this case where the firm will be forced to take a loss, the size of that loss will be minimized by producing the amount of output at which MR = MC.

PROBLEMS 1. A perfectly competitive firm finds that the market price for its product is $20. It has a fixed cost of $100 and a variable cost of $10 per unit for the first 50 units and then $25 per unit for all successive units. Does price exceed average variable cost for the first 50 units? What about for the first 100 units? What is the marginal cost per unit for the first 50 units? What about for units 51 and higher? For each of the first 50 units, does MR exceed MC? What about for units 51 and higher? What output level will yield the largest possible profit for this perfectly competitive firm? (Hint: Draw a graph similar to Figure 9.2 using data for this firm.) LO9.5

Answer: Yes; Yes; the MC per unit is $10 per unit for the first 50 units; the MC per unit is $25 per unit for subsequent units; Yes, MR > MC; For units 51 and up, MR < MC; Producing 50 units will maximize profit.

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

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

What is the marginal cost per unit for the first 50 units? What about for units 51 and higher? For each of the first 50 units, does MR exceed MC? What about for units 51 and higher? The MC is $10 per unit for the first 50 units and the MC is $25 per unit for subsequent units. For each of the first 50 units, MR > MC since $20 > $10 and for units 50 and up, MR < MC since $20 < $25.

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

2. A perfectly competitive wheat farmer can sell any wheat they grow for $10 per bushel. Their five hectares of land show diminishing returns because some are better suited for wheat production than others. The first hectare can produce 1000 bushels of wheat, the second 900, the third 800, and so on. Draw a table with multiple columns to help you answer the following questions. LO9.5

a. How many bushels will each of the farmer‘s five hectares produce?

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b. How much revenue will each hectare generate? c. What are the TR and MR for each hectare? d. If the marginal cost of planting and harvesting a hectare is $7,000 per hectare for each of the five hectares, how many hectares should the farmer plant and harvest?

Answers: The student should end up constructing a table similar to the following.

The farmer should plant and harvest four hectares.

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

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

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

Using our MC=MR rule, the farmer should plant and harvest 4 hectare. Marginal revenue for the fourth acre equals $7,000 and the marginal cost equals $7,000.

3. Karen runs a print shop that makes posters for large companies. It is a very competitive business. The market price is currently $1 per poster. She has fixed costs of $250. Her variable costs are $1,000 for the first thousand posters, $800 for the second thousand, and then $750 for each additional thousand posters. What is her AFC per poster (not per thousand!) if she prints 1,000 posters? 2,000? 10,000? What is her ATC per poster if she prints 1,000? 2,000? 10,000? If the market price fell to 70 cents per poster, would there be any output level at which Karen would not shut down production immediately? LO9.5 1-202 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Answers: AFC per poster is $0.25 for 1,000; $0.125 for 2,000; $0.025 for 10,000.

ATC per poster is $1.25 for 1,000 posters; $1.025 for 2,000 posters; and $0.805 for 10,000. Shutdown is determined by AVC. The AVC per poster for more than 2,000 posters is $0.75 per poster, so Karen will shut down if the price falls to 70 cents per poster.

Feedback: What is her AFC per poster (not per thousand!) if she prints 1,000 posters? 2,000?

10,000?

To calculate average fixed cost (AFC) divide total fixed cost by the number of posters being produced (=Total Fixed Cost / # of posters).

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

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

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

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

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

AVC for 10,000 posters is $0.78. This is the total variable cost of 7,800; $1000 for the first 1,000; $800 for the second 1,000; and $6,000 for the next 8,000 ($750 per 1,000 or 8x$750), divided by 10,000 posters (=$7,800/10,000).

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

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

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

4. Assume the following cost data are for a perfectly competitive producer: LO9.5

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a. At a product price of $56, will this firm produce in the short run? If it is preferable to produce, what will be the profit-maximizing or loss-minimizing output? What economic profit or loss will the firm realize per unit of output? b. Answer the questions of 4a assuming product price is $41. c. Answer the questions of 4a assuming product price is $32. d. In the table below, complete the short-run supply schedule for the firm (columns 1 and 2) and indicate the profit or loss incurred at each output (column 3).

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e. Now assume that there are 1,500 identical firms in this competitive industry; that is, there are 1,500 firms, each of which has the cost data shown in the table.

Complete the industry supply schedule (column 4). f. Suppose the market demand data for the product are as follows:

What will be the equilibrium price? What will be the equilibrium output for the industry? For each firm? What will profit or loss be per unit? Per firm? Will this industry expand or contract in the long run?

Answers: (a) Yes; 8 units; the total economic profit equals $62.96. (b) Yes; 6 units; the total economic profit (loss) equals -$39.00. (c) The firm will not produce; the firm shuts down and incurs the loss of $60.00 (fixed cost). (d) and (e) See completed table below: (2) (4) Quantity (3) Quantity (1) supplied, single Profit (+) or supplied, 1500 Price firm loss (-) firms $26 0 -$60 0 32 0 -60 0 38 5 -55 7,500 41 6 -39 9,000 46 7 -7.98 10,500 56 8 62.96 12,000 66 9 144 13,500 (f) $46; 10,500; 7 units; per-unit loss is -$1.14; the loss per firm is -$7.98; industry will contract.

Feedback:

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Part a: The rule is to produce at the level of output where Marginal Revenue equals (or is greater than if we are using integers) Marginal Cost as long as revenue is sufficient to cover fixed cost (Price is greater than Average Fixed Cost).

In the case above the market is competitive so Marginal Revenue equals the price of $56.

From the table above we see that the marginal cost for the 8th unit is $55 and the marginal cost of 9th unit is $65. The firm will want to produce 8 units where the marginal revenue of $56 is greater than the marginal cost of $55. For the 9th unit of output this is not the case.

We also need to verify that price exceeds average variable cost at this level of production.

The answer is yes, average variable cost is $40.63 which is less than the price of $56.

At this level of production, the firm will earn a positive economic profit per unit of $7.87 (= $56 (price of product) - $48.13 (average total cost for the 8th unit). The total economic profit equals $62.96 (=8 (number of units sold) × $7.87 (profit per unit)).

Part b: The same process is applied here.

The price of $41, which is marginal revenue, is greater than the marginal cost of the 6th unit in the table above. Beyond this level of production marginal cost exceeds marginal revenue. Thus, the firm will produce 6 units as long as price covers average variable cost.

The average variable cost for 6 units is $37.50, which is less than the price. The firm will produce the 6 units of output.

At this level of production, the firm will earn a negative economic profit per unit or loss per unit of -$6.50 (= $41 (price of product) - $47.50 (average total cost for the 6th unit).

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The total economic profit (loss) equals -$39.00 (=6 (number of units sold) × (-$6.50) (loss per unit)).

Part c: We could go through the same exercise here. However, by recognizing that the price of $32 is below average variable cost at all levels of production the firm will not produce. Thus, the firm shuts down and incurs the loss of $60.00 (fixed cost).

Part d and e: (1) Price

(2) Quantity supplied, single firm

(3) Profit (+) or loss (-)

(4) Quantity supplied, 1500 firms

$26 32 38 41 46 56 66

0 0 5 6 7 8 9

-$60 -60 -55 -39 -7.98 62.96 144

0 0 7,500 9,000 10,500 12,000 13,500

Part f: To determine the equilibrium price we look at the total quantity demanded schedule and the total quantity supplied schedule (for the 1,500 firms above) to find the price where quantity demanded equals quantity supplied.

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

Note that at prices below $46 quantity demanded exceeds quantity supplied and at prices above $46 quantity supplied exceeds quantity demanded.

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

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

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

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

Chapter 10 - Perfect Competition in the Long Run McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Explain how the long-run differs from the short-run in perfect competition. LO10.1

Answer: The entry and exit of firms in our market models can only take place in the long-run. In the short-run, the industry is composed of a specific number of firms, each with a plant size that is fixed and unalterable in the short-run. Firms may shut 1-207 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

down in the sense that they can produce zero units of output in the short-run, but they do not have sufficient time to liquidate their assets and go out of business.

In the long-run, by contrast, the firms already in an industry have sufficient time to either expand or contract their capacities. More important, the number of firms in the industry may either increase or decrease as new firms enter or existing firms leave.

2. Use the concept of opportunity costs to explain why profits encourage entry into perfectly competitive industries and how losses encourage exit from perfectly competitive industries.

LO10.2

Answer: Remember that normal profit is our measure of opportunity cost. Entry or exit will continue until the market price generates a normal profit for firms in the industry. With firms earning a normal profit, there will be no incentive to either enter or exit the industry. This situation constitutes long-run equilibrium in a perfectly competitive industry.

3. How do the entry and exit of firms in a perfectly competitive industry affect resource flows and long‐run profits and losses? LO10.2

Answer: Entry and exit help to improve resource allocation. Firms that exit an industry due to low profits release their resources to be used more profitably in other industries. Firms that enter an industry chasing higher profits bring with them resources that were less profitably used in other industries. Both processes increase allocative efficiency.

In the long-run, the market price of a product will equal the minimum average total cost of production. Thus, long-run economic profits are zero.

4. In long‐run equilibrium, P = minimum ATC = MC. Of what significance for economic efficiency is the equality of P and minimum ATC? The equality of P and MC? Distinguish between productive efficiency and allocative efficiency in your answer. LO10.4

Answer: The equality of P and minimum ATC means the firms is achieving productive efficiency; it is using the most efficient technology and employing the least costly combination of resources. The equality of P and MC means the firms is achieving allocative efficiency; the industry is producing the right product in the right amount based on society‘s valuation of that product and other products.

5. The basic model of perfect competition reviewed in this chapter finds that in the long-run all firms in a perfectly competitive industry will earn normal profits. If all firms will only earn a normal profit in the long-run, why would any firms bother to develop new products or lower‐ cost production methods? Explain. LO10.5

Answer: Competition involves the never-ending attempts by entrepreneurs and managers to earn above-normal profits by either creating new products or developing 1-208 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

lower-cost production methods for existing products. These efforts cause creative destruction, the financial undoing of the market positions of firms committed to existing products and old ways of doing business by new firms with new products and innovative ways of doing business. That is, if firms can innovate they can earn economic profit in the short-run.

6. ―Ninety percent of new products fail within two years—so you shouldn‘t be so eager to innovate.‖ Do you agree? Explain why or why not. LO10.5

Answer: If your firm happens to be one of the 10% that succeed you can capture short-run economic profits. You may even qualify for a patent on your product which allows you to act as a monopolist for a given amount of time. So, if you can capture enough expected economic profit in the short-run to cover your initial investment then it is worthwhile to innovate. (This argument ignores risk. If you add risk to the investment story, then you will need to receive additional expected economic profit to undertake the investment to innovate.)

The LAST WORD What is systems engineering and how has Elon Musk applied systems engineering to cut costs and increase profits? Are Musk's innovations subject to competition, copycats, and creative destruction? Over the long-run, how can Musk continue to generate economic profits?

Answer: "Systems engineering" is an approach to developing new business methods and new technologies. Systems engineers study complex production systems, looking for places where resources can be used more effectively or where new processes or techniques can cut costs or eliminate entire steps in a production process. As a concrete example, consider Musk's major innovation at SpaceX, the reusable space rocket. The key stumbling block to Musk's long-term goal is to colonize Mars is launch costs. One of the key reasons launch costs are so high is because the standard technology for decades had involved booster rockets that were not reusable. Musk directed SpaceX's engineers to figure how to safely land a booster rocket vertically on a landing pad after it had done its job of helping to boost a payload into space. They succeeded in 2015 and SpaceX is now the leading private space launch company in the world, not only launching private satellites but also under contract with agencies like NASA to fly government payloads into space, too.

These sorts of cost-cutting innovations have given Musk's firms a strong financial position within their respective industries. This chapter's analysis suggests that the good times will not last indefinitely. Rivals are free to enter and many of Musk's systems engineering innovations are not patentable—anyone, for instance, can build their own reusable booster rocket or build their own bricks onsite as they are digging a tunnel. Tesla is already under substantial pressure. Every major car maker in the world, including Ford and Toyota, now has its own electric car technology as well as its own version of the selfdriving technology that Tesla also helped to popularize. Musk's other firms also face new entrants. Solar City is now only the second biggest installer and leaser of solar panels after facing stiff competition from Sunrun and Vivint Solar.

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This flood of new competitors is exactly what we expect in long-run competition. And unless Musk can figure out new ways of staying one-step ahead and operating at lower costs than his rivals, his firms' outsized profits will not last.

REVIEW QUESTIONS 1. When discussing perfect competition, the term long-run refers to a period of time long enough to allow: LO10.1 a. Firms already in an industry to either expand or contract their capacities. b. New firms to enter or existing firms to leave. c. Both a and b. d. Neither of the above.

Answer: c. Both a and b.

When discussing perfect competition, the term long-run refers to a period of time long enough for existing firms to expand or contract their capacities AND for the overall number of firms to increase or decrease as new firms enter or existing firms exit.

For intuition, note that the long-run is the amount of time necessary for both existing and potential firms to react to profit incentives. High profits will tend to cause existing firms to expand capacity while also attracting new firms to enter the industry.

Low profits or losses will tend to cause existing firms to reduce capacity or exit the industry. They will also discourage any new firms from entering the industry.

2. Suppose that the pen-making industry is perfectly competitive. Also suppose that each current firm and any potential firms that might enter the industry all have identical cost curves, with minimum ATC = $1.25 per pen. If the market equilibrium price of pens is currently $1.50, what would you expect it to be in the long-run?

LO10.2 a. $0.25. b. $1.00. c. $1.25. d. $1.50.

Answer: c, $1.25.

We would expect the long-run market equilibrium price of pens to be equal to the minimum ATC of $1.25 per pen.

To understand why, note that the current market equilibrium price of $1.50 is higher than minimum ATC. This implies that each firm in the industry will be making a positive economic profit because the $1.50 price at which a firm can sell a pen exceeds the average total cost of producing that pen.

These positive economic profits will attract new firms to enter the industry. As each new firm enters, it will increase the total supply of pens. That increase in supply decreases the market equilibrium price of pens and, consequently, the profits earned by each firm in the industry.

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Firms will continue to enter the industry as long as profits are positive. Thus, they will continue to enter as long as the market is greater than the minimum ATC of $1.25 per pen. Entry will only stop once the number of firms has increased industry supply so much that the market equilibrium price drops down to the minimum ATC of $1.25 per pen. Thus, in the long-run, we would expect the market price of pens to be $1.25.

3. Suppose that as the output of mobile phones increases, the cost of touch screens and other component parts decreases. If the mobile phone industry features perfect competition, we would expect the long-run supply curve for mobile phones to be: LO10.3 a. Upward sloping. b. Downward sloping. c. Horizontal. d. U-shaped.

Answer: b. Downward sloping.

This is a decreasing-cost industry because the cost of mobile-phone components declines as output increases. These decreases in input costs will lower the ATC curves of every firm in the industry. The result will be that as output increases, the equilibrium price of mobile phones will decrease. This implies that the industry‘s long-run supply curve will be downward sloping as increases in output lead to decreases in price.

4. Using diagrams for both the industry and a representative firm, illustrate competitive long‐run equilibrium. Assuming constant costs, employ these diagrams to show how (a) an increase and (b) a decrease in market demand will upset that long‐run equilibrium. Trace graphically and describe verbally the adjustment processes by which long‐run equilibrium is restored. Now rework your analysis for increasing‐ and decreasing‐cost industries and compare the three long‐run supply curves. LO10.3 Answer: See Figures 10.1 and 10.2 (below) and their legends for the answers to (a) and (b) above. See figure 9.4 for the supply curve for an increasing cost industry and figure 10.5 for the supply curve for a decreasing cost industry.

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5. Suppose that perfectly competitive firms producing cashews discover that P exceeds MC. Will their combined output of cashews be too little, too much, or just right to achieve allocative efficiency? In the long-run, what will happen to the supply of cashews and the price of cashews? Use a supply and demand diagram to show how that response will change the combined amount of consumer surplus and producer surplus in the market for cashews. LO10.4 Answer: The combined output is too little to achieve allocative efficiency. The marginal benefit of producing more cashews (as measured by P) exceeds the cost of the resources necessary to produce them.

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

The increase in supply will unambiguously increase the combined area under the demand curve and above the supply curve (consumer surplus and producer surplus, respectively). See figure 10.6b for reference.

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1. A firm in a perfectly competitive industry has a typical cost structure. The normal rate of profit in the economy is 5 percent. This firm is earning $5.50 on every $50 invested by its founders. What is its percentage rate of return? Is the firm earning an economic profit? If so, how large? Will this industry see entry or exit? What will be the rate of return earned by firms in this industry once the industry reaches long-run equilibrium? LO10.2 Answers: Percentage rate of return is 11 percent (= $5.50/$50); Yes, it is earning an economic profit; It‘s economic profit is 6 percent (= 11 percent – 5 percent); This industry will see entry; Once the industry reaches equilibrium, firms in the industry will earn the economy‘s normal rate of profit, 5 percent.

Feedback: Since the firm is earning $5.50 on every $50 invested, the percentage rate of return is 11% (= ($5.50 / $50) × 100).

Yes, the firm is earning an economic profit of 6%, which equals the difference between the actual percentage rate of return and the normal rate of profit in the economy (=11%-5%).

This industry will see entry because the rate of return is greater than the normal rate of profit (economic profit is positive) resources could earn on average in other industries.

In the long-run firms in this industry will earn the normal rate of profit. This is when entry of new firms stops.

2. A firm in a perfectly competitive industry is currently producing 1,000 units per day at a total cost of $450. If the firm produced 800 units per day, its total cost would be $300, and if it produced 500 units per day, its total cost would be $275. What are the firm‘s ATC per unit at these three levels of production? If every firm in this industry has the same cost structure, is the industry in long‐run competitive equilibrium? From what you know about these firms‘ cost structures, what is the highest possible price per unit that could exist as the market price in long‐run equilibrium? If that price ends up being the market price and if the normal rate of profit is 10 percent, then how big will each firm‘s accounting profit per unit be? LO10.4 Answers: The firms‘ ATC per unit at 1,000 units per day is $0.45 (= $450/1,000); at 800 units per day it is $0.38 (= $300/800); and at 500 units per day it is $0.55 = ($275/500). This industry is not in long-run equilibrium because the firms in the industry are not producing at the minimum point on their ATC curves—they are producing at an output level higher than minimum ATC. From what we know of these three output levels, the highest that the long-run equilibrium price could be is $0.38 since that is the lowest of the three ATC per unit that we know and in long-run equilibrium firms must be producing at the lowest possible ATC per unit. If $0.38 ends up being the market equilibrium price in the long-run and if the normal profit rate that must hold in long-run equilibrium is 10%, then the firm must be earning a normal profit of 3.8 cents per unit (= 10% × $0.38).

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Feedback: The average total cost (ATC) is found by dividing total cost by the number of units being produced. ATC for 1,000 units is $0.45 (=$450 / 1,000). ATC for 800 units is $0.375 (=$300 / 800). ATC for 500 units is $0.55 (=$250 / 550).

If every firm in this industry has the same cost structure, is the industry in long‐run competitive equilibrium? No, because the firm is producing 1,000 (as stated in the question) this industry cannot be in long-run equilibrium because it is not producing at the lowest ATC (ATC at 1,000 units is greater than ATC at 800 units).

The highest possible price that could be supported in the long-run is the lowest ATC in the industry. Given the information above this is $0.375 or $0.38 after rounding.

Since the normal rate of profit is 10% and the firm will charge $0.38 for each unit in the long-run, the accounting profit will be $0.038 (3.8 cents per unit). This is 10% of the price (=.10 × $0.38).

3. There are 300 perfectly competitive farms in the local dairy market. Of the 300 dairy farms, 298 have a cost structure that generates profits of $24 for every $300 invested.

What is their percentage rate of return? The other two dairies have a cost structure that generates profits of $22 for every $200 invested. What is their percentage rate of return? Assuming that the normal rate of profit in the economy is 10 percent; will there be entry or exit? Will the change in the number of firms affect the two that earn $22 for every $200 invested? What will be the rate of return earned by most firms in the industry in long‐run equilibrium? If firms can copy each other‘s technology, what will be the rate of return eventually earned by all firms? LO10.4 Answers: The 298 dairies earn an 8 percent (= $24/$300) rate of return while the two other dairies earn an 11 percent (= $22/$200) rate of return. Because the normal rate of return of 10% is higher than the 8 percent earned by the 298 dairies, there will be exit. The exit will not affect the two dairies that are earning 11 percent returns because they are earning above-normal returns and thus do not have any incentive to exit. In long-run equilibrium, most firms (the ones that remain from the original 298) will earn the normal 10% rate of return. If firms can copy the technology used by the two more efficient firms, then all firms will end up earning the normal 10% rate of return after all firms have copied the better technology and expanded output until the increase in market supply brings down the market price low enough that all firms in the industry are earning the normal profit.

Feedback: The percentage rate of return for the firms is found by dividing profits by the amount invested. This is multiplied by 100 to convert into percentage form. The percentage rate of return for the 298 firms is 8% (= ($24 / $300) × 100). The percentage rate of return for the 2 firms is 11% (= ($22 / $200) × 100).

There will be exit in this industry because the normal rate of profit is 10% and the 298 firms are only earning a return of 8%. That is, firms will exit this industry and invest their resources in other industries which, on average, are earning 10%. This will not affect the 2 firms that are earning an 11% rate of return on their investment.

To stop the exit of firms from this industry, the firms will need to earn a 10% rate of return. This equals the normal rate of profit in the economy.

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If firms can copy the technology used by the two more efficient firms, then all firms will end up earning the normal 10% rate of return after all firms have copied the better technology and expanded output until the increase in market supply brings down the market price low enough that all firms in the industry are earning the normal profit.

Chapter 11 -Monopoly McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. ―No firm is completely sheltered from rivals; all firms compete for consumer dollars.

If that is so, then monopoly does not exist.‖ Do you agree? Explain. How might you use Chapter 6‘s concept of cross elasticity of demand to judge whether a monopoly exists? LO11.1 Answer: Though it is true that ―all firms compete for the dollars of consumers,‖ it is playing on words to hold that monopoly does not exist. If you wish to send a first-class letter, it is the postal service or nothing. Of course, if the postal service raises its rate to $10 to get a letter across town in two days, you will use a courier, or the phone, or you will fax it. But within sensible limits, say a doubling of the postal rate, there is no alternative to the postal service at anything like it at a comparable price.

The same case can be made concerning the monopoly enjoyed by the local electricity company in any town. If you want electric lights, you have to deal with a single company. It is a monopoly in that regard, even though you can switch to oil or natural gas for heating. Of course, you can use oil, natural gas, or kerosene for lighting too—but these are hardly convenient options.

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

2. Discuss the major barriers to entry into an industry. Explain how each barrier can foster either monopoly or oligopoly. Which barriers, if any, do you feel give rise to monopoly that is socially justifiable? LO11.2 Answer: Economies of scale are a barrier to entry because of the need for new firms to start big to achieve the low production costs of those already in the industry.

However, not all industries need techniques of production that require large scale. In many industries the minimum efficient scale is only a small percentage of domestic consumption.

Natural monopolies give rise to monopoly that is socially justifiable. The economies of scale are sometimes such that having two or more firms serving the market would 1-216 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

increase costs unreasonably. Two telephone companies, or gas companies, or water companies, or electricity companies in the same city would be highly inconvenient and costly as long as transmission requires wires and pipes. In such instances, it makes sense for government to grant exclusive franchises and then regulate the resulting monopoly to ensure the public interest is protected.

Patents and licenses are legal barriers to entry that also, to some extent, are justifiable.

If inventions were not protected at all from immediate copying by those who bore none of the costs, the urge to invent and innovate would be lessened and the costly secrecy that is enforced already would have to be much greater and more costly.

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

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

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

3. How does the demand curve faced by a monopolistic seller differ from that confronting a competitive firm? Why does it differ? Of what significance is the difference? Why is the monopolist‘s demand curve not perfectly inelastic? LO11.3 Answer: The demand curve facing a monopolist is downward sloping; that facing the perfectly competitive firm is horizontal, perfectly elastic. This is so for perfect competition because the firm faces a multitude of competitors, all producing perfect substitutes. In these circumstances, the perfectly competitive firm may sell all that it wishes at the equilibrium price, but it can sell nothing for even so little as one cent higher. The individual firm‘s supply is so small a part of the total industry supply that it cannot affect the price.

The monopolist, on the other hand, is the industry and therefore is faced by a normal downward sloping industry demand curve. Being the entire industry, the monopolist‘s supply is big enough to affect prices. By decreasing output, the monopolist can force the price up. Increasing output will drive it down.

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

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4. Assume that a monopolist and a perfectly competitive firm have the same unit costs.

Contrast the two with respect to (a) price, (b) output, (c) profits, (d) allocation of resources, and (e) impact on income transfers. Since both monopolists and competitive firms follow the MC = MR rule in maximizing profits, how do you account for the different results? Why might the costs of a competitive firm and those of a monopolist be different? What are the implications of such a cost difference?

LO11.5 Answer: With the same costs, the monopolist will charge a higher price, have a smaller output, and have higher economic profits in both the short run and the long run than the perfect competitor. As a matter of fact, the perfect competitor will have no economic profits in the long run even though it might have some in the short run.

Because the monopolist does not produce at the point of minimum ATC and does not equate price and MC, its allocation of resources is inferior to that of the perfect competitor. Specifically, resources are under allocated to monopolistic industries.

Since a monopolist is more likely than the perfect competitor to make economic profits in the short run and is, moreover, the only one of the two able to make economic profits in the long run, the distribution of income is more unequal with monopoly than with competition.

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

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

Economies of scale may be such as to ensure that one large firm can produce at lower cost than a multitude of small firms. This is certainly the case with most public utilities. And in such industries as basic steelmaking and car manufacturing, competition would involve a very high cost. On the other hand, monopolies may suffer from X-inefficiency, the inefficiency that a lack of competition allows.

Monopolies may also incur non-productive costs through ―rent-seeking‖ expenditures. For example, they may try to influence legislation that protects their monopoly powers.

5. Critically evaluate and explain each statement: LO11.5 a. Because they can control product price, monopolists are always assured of profitable production by simply charging the highest price consumers will pay. b. The monopolist seeks the output that will yield the greatest per‐unit profit.

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c. An excess of price over marginal cost is the market‘s way of signaling the need for more production of a good. d. The more profitable a firm, the greater its monopoly power. e. The monopolist has a pricing policy; the competitive producer does not. f. With respect to resource allocation, the interests of the seller and of society coincide in a competitive market but conflict in a monopolized market.

Answer: a. The statement is false. If the monopolist charged the highest price consumers would pay, it would sell precisely one unit! (Conceivably, it might sell a little more than one if more than one consumer made matching bids for the first unit offered.) It is highly unlikely that the sale of one unit (or a very few) would cover the very high AFC of one or a very few units. And even a monopolist that does produce sensibly where MR = MC may still suffer a loss: P can be below ATC at all levels. b. The statement is false. The monopolist seeks the output that will yield the greatest profit. The profit equation is Q(P - ATC). It is not (P - ATC). If the monopolist sells one unit for $100 when ATC is $60, then its profit per unit and total profit is $40 (= $100 - $60). Nice, but if the same monopolist can sell 1,000 units for $40 when ATC is $39, then, though its per unit profit is a mere $1 (= $40 - $39), its total profit is $1,000 [= 1,000($40 - $39)]. This is much better than $40. c. The statement is true. Price is the value society sets on the last item produced.

Marginal cost is the value to society of the alternative production forgone when the last item is produced. When P>MC, society is willing to pay more than the opportunity cost of the last item‘s production. d. This statement can be true and probably is in many cases. Large profits allow expansion to gain economies of scale and thus prevent the late entry of smaller rivals. Large profits also enable the firm to price below cost, to engage (illegally) in a price war. Moreover, large profits in the short run are often associated with monopoly power. In the long run, only a firm with monopoly power can gain economic profits; in perfect competition such profits would invariably be competed away by new entry. e. The statement is true. The monopolist must equate MR and MC. Having determined at what quantity this equality occurs, the monopolist simultaneously sets price. This price differs at each output because the demand curve is downward sloping. The perfect competitor accepts the price given by total 1-219 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

industry supply and demand. Knowing this externally given price, the competitor then equates it with the firm‘s MC and produces the amount determined by this equality. f. The statement is true. In perfect competition, P = MC. This means that the value society sets on the last item produced (its price) is equal to the cost of the alternative commodities that are not produced. This is because producing the last item of the commodity in question is its MC. In monopoly, P>MC. This means that society values the last item produced more than its cost.

6. Assume a monopolistic publisher has agreed to pay an author 10 percent of the total revenue from the sales of a text. Will the author and the publisher want to charge the same price for the text? Explain. LO11.5 Answer: The publisher is a monopolist seeking to maximize profits. This will occur at the quantity of output where MC = MR. (See Figure 11.4 below)

The author who will receive 10% of the total revenue will maximize his payment if the book is priced where MR = 0. This will occur where the price elasticity of demand is equal to 1 and total revenue is maximum. (See Figure 11.3 below)

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The author would prefer a lower price than the publisher. Consult Key Graph 11.4 and compare the price charged where MC = MR and the price that would be necessary to maximize total revenue when MR = 0. This is a highly unlikely outcome since the publisher, whether economically literate or not, is certain to recognize the revenue maximizing price as disadvantageous.

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7. U.S. pharmaceutical companies charge different prices for prescription drugs to buyers in different nations, , including Canada, depending on elasticity of demand and government-imposed price ceilings. Explain why these companies, for profit reasons, oppose laws allowing re-importation of drugs to the United States. LO11.6 Answer: U.S. pharmaceutical companies are price discriminating based in part on the different elasticities of demand in different nations. Re-importation allows reselling of the goods, making it more difficult to price discriminate. To the extent they could still charge different prices, the difference in prices would have to be small enough so that re-importation was not profitable. Prohibition of re-importation would allow pharmaceutical companies to charge the profit-maximizing price in each nation, without fear of being undercut back in the U.S. by those in nations where the drugs are cheaper.

8. Explain verbally and graphically how price (rate) regulation may improve the performance of monopolies. In your answer distinguish between (a) socially optimal (marginal‐cost) pricing and (b) fair‐return (average‐total‐cost) pricing. What is the ―dilemma of regulation‖? LO11.7 Answer: Monopolies that are natural monopolies are normally subject to regulation.

Because of extensive economies of scale, marginal cost is less than average total cost throughout the range of output. An unregulated monopolist would produce at Qm when MC = MR and enjoy an economic profit. Society would be better off with a larger quantity. Output level Qr would be socially optimal because MC = Price and allocative efficiency would be achieved. However, the firm would lose money producing at Qr since ATC exceeds the price. In order for the firm to survive, public subsidies out of tax revenue would be necessary. Another option for regulators is to allow a fair-return price that would allow the firm to break even economically (cover all costs including a normal profit). Setting price equal to ATC would deliver Qf output and only partially solve the under allocation of resources. Despite this dilemma regulation can improve on the results of monopoly from the social point of view. Price regulation (even at the fair-return price) can simultaneously reduce price, increase output, and reduce the economic profits of monopolies.

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9. It has been proposed that natural monopolists should be allowed to determine their profit-maximizing outputs and prices and then government should tax their profits away and distribute them to consumers in proportion to their purchases from the monopoly. Is this proposal as socially desirable as requiring monopolists to equate price with marginal cost or average total cost? LO11.7 Answer: No, the proposal does not consider that the output of the natural monopolist would still be at the suboptimal level where P > MC. Too little would be produced and there would be an under allocation of resources. Theoretically, it would be more desirable to force the natural monopolist to charge a price equal to marginal cost and subsidize any losses. Even setting price equal to ATC would be an improvement over this proposal. This fair-return pricing would allow for a normal profit and ensure greater production than the proposal would.

The LAST WORD Using Big Data to set personalized prices cannot be done with 100 percent precision. What would happen if personalized prices were set higher than customers' reservation prices? Would this possibility reduce the incentive to set the highest possible personalized prices? How can consumers protect themselves from personalized prices?

Answer: If personalized prices are set higher than a customer's reservation price, two things could happen. If the company is truly a monopoly, the customer may not purchase the product, due to the destruction of the customer surplus. If there is competition in the market, the high personalized price may push the consumer to shop around, and ultimately buy the product from a competing seller.

This possibility does reduce the incentive to set the highest possible personalized price because the seller doesn't want to scare away the consumers. They want to preserve some consumer surplus and therefore give the consumer incentive to purchase the item from them and not bother shopping around.

The more competitive the market, the bigger the consumer surplus. If the consumer doesn't shop around, she is creating a monopoly situation. The easiest way for consumers 1-223 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

to protect themselves is to compare prices with multiple companies to ensure they aren't paying a monopoly-like price.

REVIEW QUESTIONS 1. Which of the following could explain why a firm is a monopoly? Select one or more answers from the choices shown. LO11.2 a. Patents b. Economies of scale. c. Inelastic demand. d. Government licences. e. Downward-sloping market demand.

Answer: Patents, Economics of scale, and Government licenses.

A firm is a monopoly when it is the only firm in its industry. A firm may be the only firm in its industry for a variety of reasons. These include holding patents that legally prevent any other firm from duplicating its products; having economics of scale that allow the firm to produce at a lower cost than potential rivals; and enjoying government licenses that make it the sole legal producer of a product in a given area.

2. The MR curve of perfectly competitive firm is horizontal. The MR curve of monopoly firm is: LO11.3 a. Horizontal, too. b. Upward-sloping. c. Downward-sloping. d. It depends.

Answer: c. Downward-sloping.

The MR curve of a monopoly firm is downward sloping because the only way for a monopoly firm to increase the amount of output that it sells is by lowering the price it charges in order to move down along its downward sloping demand curve. But the monopolist must lower the price not just on additional units but also on earlier units, too. As a result, the MR that the firm collects declines with each successive unit that it wishes to sell. Graphically, this implies that the MR curve is downward sloping, as MR declines with output.

3. Use the demand schedule below to calculate total revenue and marginal revenue at each quantity. Plot the demand, total‐revenue, and marginal-revenue curves, and explain the relationships between them. Explain why the marginal revenue of the fourth unit of output is $3.50, even though its price is $5. Use Chapter 6‘s total‐ revenue test for price elasticity to designate the elastic and inelastic segments of your graphed demand curve. What generalization can you make as to the relationship between marginal revenue and elasticity of demand? Suppose the marginal cost of 1-224 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

successive units of output was zero. What output would the profit‐seeking firm produce? Finally, use your analysis to explain why a monopolist would never produce in the inelastic region of demand. LO11.3

Answer: To calculate Total Revenue, multiply price (P) by Quantity Demanded (Q): TR = P × Q. To calculate Marginal Revenue, find the change in total revenue for each unit demanded: MR = Δ TR = TR (i+1) - TR(i).

See table below.

Price (P) $7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50

Quantity Demanded (Q) 0 1 2 3 4 5 6 7 8 9

Total Revenue (TR) $0 6.50 12.00 16.50 20.00 22.50 24.00 24.50 24.00 22.50

Marginal Revenue (MR) NA $6.50 5.50 4.50 3.50 2.50 1.50 0.50 -0.50 -1.50

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

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

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

When MR is negative, demand is inelastic.

If MC is zero, the monopolist should produce 7 units where MR is also zero. It would never produce where demand is inelastic because MR is negative there while MC is positive.

The graph below summarizes the analysis discussed above.

4. How often do perfectly competitive firms engage in price discrimination? LO11.6 a. Never. b. Rarely. c. Often. d. Always.

Answer: a. Never.

Note that this question asks about perfectly competitive firms, not monopolies!

Perfectly competitive firms never engage in price discrimination because they have no way of charging different prices to different consumers.

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This is true because perfectly competitive firms are price takers who have no influence over the market price. Each and every unit that they produce must be sold in the market at the market price. As a result, they have no ability to charge different prices to different consumers - as must be done when engaging in price discrimination.

5. Suppose that a monopolist can segregate his buyers into two different groups to which he can charge two different prices. In order to maximize profit, the monopolist should charge a higher price to the group that has: LO11.6 a. The higher elasticity of demand. b. The lower elasticity of demand. c. Richer members.

Answer: b. the lower elasticity of demand.

In order to maximize profit, the monopolist should charge a higher price to the group that has the lower elasticity of demand.

This is true because a lower elasticity implies that a given increase in price will lead to a smaller decline in quantity demanded. Thus, it will be more profitable to assign the higher price to the group with the lower elasticity because the quantity that they demand will fall off less if the higher price were assigned to the group with the higher elasticity of demand.

6. The socially optimal price (P = MC) is socially optimal because: LO11.7 a. It reduces the monopolist‘s profit. b. It yields a normal profit. c. It minimizes ATC. d. It achieves allocative efficiency.

Answer: d. It achieves allocative efficiency The socially optimal price is socially optimal because it achieves allocative efficiency. This is true because the socially optimal price is determined be where the downward sloping demand curve intersects the Upward sloping MC curve, thereby causing the regulated monopoly to produce every unit for which benefits exceed costs.

7. The main problem with imposing the socially optimal price (P = MC) on a monopoly is that the socially optimal price: LO11.7 a. May be so low that the regulated monopoly can‘t break even. b. May cause the regulated monopoly to engage in price discrimination. c. May be higher than the monopoly price.

Answer: a. May be so low that the regulated monopoly can‘t break even.

The main problem with imposing the socially optimal price (P = MC) on a monopoly is that the socially optimal price may be so low that the regulated monopoly can't 1-227 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

break even. In such situations, alternatives must be found in order to prevent the monopoly from going bankrupt and thereby denying society the chance to purchase the good or service made by the monopoly. These alternatives include providing a public subsidy to make up for the firm's losses or switching to fair return pricing, which would guarantee that the regulated monopoly could make a normal profit and thereby remain in business.

PROBLEMS 1. Suppose a monopolist is faced with the demand schedule shown below and the same cost data as the competitive producer discussed in problem 4 at the end of Chapter 9.

Calculate the missing total‐revenue and marginal‐revenue amounts and determine the profit‐maximizing price and profit‐maximizing output for this monopolist. What is the monopolist‘s profit? Verify your answer graphically and by comparing total revenue and total cost. LO11.4

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Answer:

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

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

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

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

Profit-maximizing price = $63; profit-maximizing quantity = 4 units; monopolist‘s profit = $42.

The graph should have the general shape of Figure 11.4 as shown below:

Feedback: To calculate Total Revenue, multiply price (P) by Quantity Demanded (Q): TR = P × Q 1-229 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

To calculate Marginal Revenue find the change in total revenue for each unit demanded: MR = Δ TR = TR (i+1) – TR (i). See table below.

Quantity Total Marginal Demanded Revenue Revenue Price (P) (Q) (TR) (MR) $115 0 $0 NA 100 1 100 100 83 2 166 66 71 3 213 47 63 4 252 39 55 5 275 23 48 6 288 13 42 7 294 6 37 8 296 2 33 9 297 1 29 10 290 -7 To determine profit‐maximizing price and profit‐maximizing output for this monopolist use the cost data in the table below (from Problem 4 Chapter 9).

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

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

The profit maximizing price is the price associated with the profit maximizing quantity, 4 units. Thus, the profit maximizing price is $63.

The monopolist's profit equals total revenue minus total cost. Total revenue equals $252 at 4 units of output. We still need total cost. From the 'cost data' table we see that average 1-230 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

total cost (ATC) equals $52.50. Since ATC equals total cost divided by quantity we can determine total cost from the ATC cost data.

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

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

Either approach above will work.

The graph should have the general shape of Figure 11.4 as shown below:

2. Suppose that a price‐discriminating monopolist has segregated its market into two groups of buyers. The first group described by the demand and revenue data that you developed for Problem 1. The demand and revenue data for the second group of buyers is shown in the accompanying table. Assume that MC is $13 in both markets and MC = ATC at all output levels. What price will the firm charge in each market?

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Based solely on these two prices, which market has the higher price elasticity of demand? What will be this monopolist‘s total economic profit? LO11.6

Answer: Price in market 1 = $48; price in market 2 = $33; the second market has the higher price elasticity of demand; total economic profit = $330.

Feedback: Let's start with the second market. Marginal cost is $13 for all output levels.

The marginal revenue from producing the 6th unit is $13 (=$198- $185), so this is the last unit produced by the firm for this market.

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

The price the firm charges in this market is $33, which is the price associated with the 6th unit.

The firm‘s profit in this market can be found using the following relationship (see problem 1 in this chapter for derivation).

Profit Market 2 = Q (P - ATC) = 6($33 - $13) = 6 × $20 = $120.

The first market is found in Problem 1 (Table reproduced below):

Price (P) $115 100 83 71

Quantity Demanded (Q) 0 1 2 3

Total Revenue (TR) $0 100 166 213

Marginal Revenue (MR) NA 100 66 47

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63 55 48 42 37 33 29

4 5 6 7 8 9 10

252 275 288 294 296 297 290

39 23 13 6 2 1 -7

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

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

The price the firm charges in this market is $48, which is the price associated with the 6th unit.

The firm‘s profit in this market can be found using the following relationship (see problem 1 in this chapter for derivation).

Profit Market 1 = Q (P - ATC) = 6($48 - $13) = 6 × $35 = $210.

The combined profit from both markets gives us total profit.

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

3. Assume that the most efficient production technology available for making vitamin pills has the cost structure given in the following table. Note that output is measured as the number of bottles of vitamins produced per day and that costs include a normal profit. LO11.6

a. What is ATC per unit for each level of output listed in the table?

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b. Is this a decreasing‐cost industry? (Answer yes or no). c. Suppose that the market price for a bottle of vitamins is $2.50 and that at that price the total market quantity demanded is 75,000,000 bottles. How many firms will there be in this industry? d. Suppose that instead the market quantity demanded at a price of $2.50 is only 75,000. How many firms do you expect there to be in this industry? e. Review your answers to parts b, c, and d. Does the level of demand determine this industry‘s market structure?

Answers: a. ATC per bottle is $4 per bottle at 25,000 bottles, $3 per bottle at 50,000 bottles, $2.50 per bottle at 75,000 units, and $2.76 per bottle at 100,000 units. b. No. c. There will be 1000 firms in this industry. d. There will be one firm in this industry. e. Yes.

Feedback: a. To find Average Total Cost (ATC) divide Total Cost by Output (Quantity).

ATC = Total Cost / Output Output 25,000 50,000 75,000 100,000

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

MC $0.50 1.00 2.50 3.00

ATC $4.00 $3.00 $2.50 $2.76

b. No, the ATC cost does NOT decline for all levels of output. c. Since $2.50 is minimum ATC, firms will produce at this level of output. Any firm that deviated from this level would incur a higher ATC and would be unprofitable at the market price of $2.50. d. The total number of firms can be found by dividing the market quantity demanded by output produced by a firm at the ATC of $2.50, which is 75,000.

Number of Firms = Market Quantity Demanded / Output Minimum ATC = 75,000,000/75,000 =1000.

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

4. A new production technology for making vitamins is invented by a university professor who decides not to patent it. Thus, it is available for anybody to copy and put into use. The TC per bottle for production up to 100,000 bottles per day is given in the following table. LO11.6

a. What is ATC for each level of output listed in the table? b. Suppose that for each 25,000‐bottle per day increase in production above 100,000 bottles per day, TC increases by $5,000 (so that, for instance, 125,000 bottles per day would generate total costs of $85,000 and 150,000 bottles per day would generate total costs of $90,000). Is this a decreasing‐cost industry? c. Suppose that the price of a bottle of vitamins is $1.33 and that at that price the total quantity demanded by consumers is 75,000,000 bottles. How many firms will there be in this industry? d. Suppose that instead the market quantity demanded at a price of $1.33 is only 75,000. How many firms do you expect there to be in this industry? e. Review your answers to parts b, c, and d. Does the level of demand determine this industry‘s market structure? f. Compare your answer to part d of this question with your answer to part d of problem 3. Do both production technologies show constant returns to scale?

Answers:

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a. ATC per bottle is $2.00 per bottle for 25,000 bottles, $1.40 per bottle for 50,000 bottles, $1 per bottle for 75,000 bottles, and $0.80 per bottle for 100,000 bottles. b. Yes, this is a decreasing cost industry. c. Only one firm since this is a natural monopoly situation. d. Only one firm since this is a natural monopoly situation. e. No, the level of demand does not determine this market‘s structure. f. No, the new technology of this problem shows economies of scale and this industry is therefore a decreasing-cost industry.

Feedback: a. To find Average Total Cost (ATC) divide Total Cost by Output (Quantity).

ATC = Total Cost / Output Output 25,000 50,000 75,000 100,000

TC $50,000 70,000 75,000 80,000

ATC $2.00 $1.40 $1.00 $.0.80

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

Output 25,000 50,000 75,000 100,000 125,000 150,000

TC $50,000 70,000 75,000 80,000 $85,000 $90,000

ATC $2.00 $1.40 $1.00 $.0.80 $0.68 $0.60

From this additional information we can conclude this is a decreasing cost industry because ATC falls as output increases at all levels. c. Since this is a decreasing cost industry there will only be one firm. d. Again, since this is a decreasing cost industry there will only be one firm. e. No. Since this is a decreasing cost industry there will only be one firm regardless of demand. f. No, the second technology (this problem) has an increasing returns to scale technology.

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5. Suppose you have been tasked with regulating a single monopoly firm that sells 50‐ kilogram bags of concrete. The firm has fixed costs of $10 million per year and a variable cost of $1 per bag no matter how many bags are produced. LO11.7 a. If this firm kept on increasing its output level, would ATC per bag ever increase?

Is this a decreasing‐cost industry? b. If you wished to regulate this monopoly by charging the socially optimal price, what price would you charge? At that price, what would be the size of the firm‘s profit or loss? Would the firm want to exit the industry? c. You find out that if you set the price at $2 per bag, consumers will demand 10 million bags. How big will the firm‘s profit or loss be at that price? d. If consumers instead demanded 20 million bags at a price of $2 per bag, how big would the firm‘s profit or loss be? e. Suppose that demand is perfectly inelastic at 20 million bags, so that consumers demand 20 million bags no matter what the price is. What price should you charge if you want the firm to earn only fair rate of return? Assume as always that TC includes a normal profit.

Answers: a. ATC will never increase. This is a decreasing cost industry. b. Charge $1 per bag. At that price, the firm would lose its $10 million fixed costs.

This firm would be losing money and will want to exit the industry. c. The firm will break even (no profit or loss). d. The firm will make an economic profit of $10 million. e. You should charge $1.50 per bag if you want this firm to earn a fair rate of return.

Feedback: a. ATC will never increase. This is a decreasing cost industry. The intuition is that FC get distributed over more and more units so that ATC will fall asymptotically towards the $1 per bag marginal cost. b. Charge $1 per bag since the MC of all bags is $1 per bag. At that price, the firm would lose its $10 million fixed costs (since the price is just enough to cover variable costs). This firm would be losing money and will want to exit the industry. c. The firm's revenue equals $20,000,000 (= $2 (price) × 10,000,000 (quantity)).

The firm's Fixed Cost equals $10,000,000 (given above).

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The firm's Total Variable Cost equals $10,000,000 (= $1 (variable cost of producing each bag) × 10,000,000 (quantity)).

The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $20,000,000 (=$10,000,000 (Total Fixed Cost) + $10,000,000 (Total Variable Cost)).

The firm's profit equals $0 (= $20,000,000 (revenue) - $20,000,000 (total cost)).

The firm breaks even. d. The firm's revenue equals $40,000,000 (= $2 (price) × 20,000,000 (quantity)).

The firm's Fixed Cost equals $10,000,000 (given above).

The firm's Total Variable Cost equals $20,000,000 (= $1 (variable cost of producing each bag) × 20,000,000 (quantity)).

The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $30,000,000 (=$10,000,000 (Total Fixed Cost) + $20,000,000 (Total Variable Cost)).

The firm's profit equals $10,000,000 (= $40,000,000 (revenue) - $30,000,000 (total cost)). e. The fair rate of return is where economic profit is zero (Total Cost above includes normal profit).

The first step is to find Total Cost.

The firm's Fixed Cost equals $10,000,000 (given above).

The firm's Total Variable Cost equals $20,000,000 (= $1 (variable cost of producing each bag) × 20,000,000 (quantity)).

The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $30,000,000 (=$10,000,000 (Total Fixed Cost) + $20,000,000 (Total Variable Cost)).

The second step is to find revenue (here the price is not known).

Revenue = Price (unknown) × 20,000,000.

The final step is to use the definition of profit to solve for the unknown price.

Profit = Revenue - Total Cost = Price × 20,000,000 - $30,000,000 We can also set profit to zero (fair rate of return requirement): Price × 20,000,000 - $30,000,000 = 0 or Price × 20,000,000 = $30,000,000 which gives us, Price = $30,000,000 / 20,000,000 = $1.50.

Thus, the firm should charge $1.50 per bag to earn a fair rate of return.

Chapter 12 - Monopolistic Competition McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS How does monopolistic competition differ from perfect competition in its basic characteristics? From monopoly? Explain fully what product differentiation may involve. Explain how the entry of firms into its industry affects the demand curve 1-238 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

facing a monopolistic competitor and how that, in turn, affects its economic profit.

LO12.1 Answer: In monopolistic competition there are many firms but not the very large numbers of perfect competition. The products are differentiated, not standardized.

There is some control over price in a narrow range, whereas the purely competitive firm has none. There is relatively easy entry; in perfect competition, entry is completely without barriers. In monopolistic competition, there is much non-price competition, such as advertising, trademarks, and brand names. In perfect competition, there is no non-price competition.

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

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

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

Compare the elasticity of a monopolistic competitor‘s demand with that of a perfect competitor and a monopolist. Assuming identical long-run costs, compare graphically the prices and outputs that would result in the long run under perfect competition and under monopolistic competition. Contrast the two market structures in terms of productive and allocative efficiency. Explain: ―Monopolistically competitive industries are populated by too many firms, each of which produces too little.‖ LO12.2 Answer: The monopolistic competitor‘s demand curve is less elastic than a perfect competitor and more elastic than a monopolist. Your graphs should look like Figure 9.6 (perfect competition) and Figure 12.1 (monopolistic competition). Price is higher and output lower for the monopolistic competitor. Perfect competition: P = MC (allocative efficiency); P = minimum ATC (productive efficiency). Monopolistic competition: P > MC (allocative inefficiency) and P > minimum ATC (productive inefficiency). Monopolistic competitors have excess capacity; meaning that fewer firms operating at capacity (where P = minimum ATC) could supply the industry output.

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―Monopolistic competition is monopolistic up to the point at which consumers become willing to buy close-substitute products and competitive beyond that point.‖ Explain.

LO12.2 Answer: As long as consumers prefer one product over another regardless of relative prices, the seller of the product is a monopolist. But in monopolistic competition this happy state is limited because there are many other firms producing similar products.

When one firm‘s prices get ―too high‖ (as viewed by consumers), people will switch brands. At this point, our firm has entered the competitive zone unwillingly, which is why monopolistically competitive firms are forever trying to find ways to differentiate their products more thoroughly and thus to gain more monopoly price-setting power. ―Competition in quality and service may be just as effective as price competition in giving buyers more for their money.‖ Do you agree? Why? Explain why monopolistically competitive firms frequently prefer non-price competition to price competition. LO12.2 Answer: This can certainly be true. It depends on how much consumers value quality and service and if they are willing to pay for it through higher product prices. In a monopolistically competitive market, the consumer can buy a substitute brand for a lower price, if the consumer prefers a lower price to better quality and service.

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

Non-price competition, on the other hand, if successful, results in more monopoly power: The firm‘s product has become more differentiated from now less-similar competitors in the industry. This increase in monopoly power allows the firm to raise its price with less fear of losing customers. Of course, the firm must still follow the MR = MC rule, but its success in non-price competition has shifted both the demand and MR curves upward to the right. This results in simultaneously a larger output, a higher price, and more economic profits.

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Critically evaluate and explain the following statements: LO12.2 a. In monopolistically competitive industries, economic profits are competed away in the long run; hence, there is no valid reason to criticize the performance and efficiency of such industries. b. In the long run, monopolistic competition leads to a monopolistic price but not to monopolistic profits.

Answers: a. The first part of the statement may well be true, but it does not lead logically to the second part. The criticism of monopolistic competition is not related to the profit level but to the fact that the firms do not produce at the point of minimum ATC and do not equate price and MC. This is the inevitable consequence of imperfect competition and its downward sloping demand curves. With P > minimum ATC, productive efficiency is not attained. The firm is producing too little at too high a cost; it is wasting some of its productive capacity. With P > MC, the firm is not allocating resources in accordance with society‘s desires; the value society sets on the product (P) is greater than the cost of producing the last item (MC). b. The statement is often true since competition of close substitutes tends to compete price of the average firm down to equality with ATC. Thus, there is no economic profit. However, the firm is producing where its (moderately) monopolistically downward-sloping demand curve is tangent to the ATC curve, short of the point of minimum ATC and thus at a higher than purely competitive price. In other words, it is at a ―monopolistic‖ price.

The LAST WORD What would you expect to happen to the proportion of big chain restaurants relative to mom-and-pop restaurants in a town that lowered its minimum wage? Will the proportion change due to exits or entrances? Which type of restaurant will see more in the way of exits or entrances? Why? Answer: In a restaurant market that contains both large chain restaurants and "mom and pop" restaurants, both types will be making zero economic profit. Due to the chain restaurant being fairly highly capitalized, a lower minimum wage won't impact their cost curves very much. However, "mom and pop" restaurants will have their cost curves impacted by much more due to them being more labour intensive. This could in turn cause more "mom and pop" restaurants to enter the market, causing the proportion of big chain restaurants to fall. Due to the lowering of labour costs, the "mom and pop" restaurant is the type we would expect to see entrances. Due to the capital-intensive structure of the big chain restaurant, we wouldn't expect to see much in the way of exits or entrances.

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REVIEW QUESTIONS 1. There are 10 firms in an industry, and each firm has a market share of 10 percent. The industry‘s Herfindahl index is: LO12.1

a. 10. b. 100. c. 1,000. d. 10,000.

Answer: 1,000.

This industry‘s Herfindahl index is 1,000. To understand why, begin by recalling that the Herfindahl index is used by economists to measure the degree to which an industry‘s output is concentrated and that the index is the sum of the squared percentage market shares of all firms in the industry.

In this question, there are 10 firms in the industry and each firm has a market share of 10 percent. Thus, the squared market share of each firm in the industry will be 100 (= 10^2). And the sum of the squared market shares will be 1,000 (= 100 + 100 + 100 + 100 + 100 + 100 + 100 + 100 + 100 + 100). As a result, the industry‘s Herfindahl index is 1,000.

2. In the small town of Geneva, there are 5 firms that make watches. The firms‘ respective output levels are 30 watches per year, 20 watches per year, 20 watches per year, 20 watches per year, and 10 watches per year. The four-firm concentration ratio for the town‘s watchmaking industry is: LO12.1

a. b. c. d.

5.

70.

90.

100.

Answer: 90.

The four firm concentration ratio for the town‘s watch making industry is 90. To see why, recall that the four firm concentration ratio is the percentage expression of the ratio of the output of the four largest firms in an industry relative to total industry output.

Here, the total industry output is 100 watches per year (= 30+20+20+20+10) and the output of the four largest firms is 90 watches per year (= 30+20+20+20). So the four firm concentration ratio is 90, because the ratio (= 90/100) is 90 when expressed as a percentage.

3. Which of the following best describes the efficiency of monopolistically competitive firms?

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a. Allocatively efficient by productively inefficient. b. Allocatively inefficient but productively efficient. c. Both allocatively efficient and productively efficient. d. Neither allocatively efficient nor productively efficient.

Answer: d. Neither allocatively efficient nor productively efficient.

Monopolistically competitive firms are neither allocatively efficient nor productively efficient. Both types of inefficiency have the same cause: product differentiation.

That is true because it is product differentiation that gives each firm in a monopolistically competitive industry its small share of monopoly power. With that monopoly power comes a downward sloping MR curve that when intersected with the firm‘s upward sloping MC curve results in a profit-maximizing output level that is inefficiently low. Productive efficiency is when the firm produces where price = minimum ATC. Due to product differentiation these firms produce at a lower quantity. Allocative efficiency is when the firm produces where P = MC. Due to the downward sloping MC curve, price will be higher than MC. PROBLEMS 1. Suppose that a small town has seven burger shops whose respective shares of the local hamburger market are (as percentages of all hamburgers sold): 23%, 22%, 18%, 12%, 11%, 8%, and 6%. What is the four‐firm concentration ratio of the hamburger industry in this town? What is the Herfindahl index for the hamburger industry in this town? If the top three sellers combined to form a single firm, what would happen to the four‐firm concentration ratio and to the Herfindahl index? LO12.1

Answers: The four-firm concentration ratio is 75%; the Herfindahl Index is 1702 (= 529 + 484 + 324 +144 + 121 + 64 + 36); The new four-firm concentration ratio would be 94%; the new Herfindahl Index would be 4334 = (3969 + 144 +121 + 64 + 36).

Feedback: The four-firm concentration ratio is found by adding together the top four firm's percentage of sales. For the values above, the four-firm concentration ratio equals 75% (= 23% + 22% + 18% + 12%).

The Herfindahl index is found by squaring the percentages for all of the firms in the industry (not the decimal form) and then adding these values together. For the values above, the Herfindahl index equals 1702 (= 232 + 222 +182 +122 + 112 + 82 + 62 = 529 + 484 + 324 + 144 + 121 + 64 + 36).

If the top three sellers combine to form a single firm, this combined firm will control 63% of the market (= 23% + 22% + 18%). Thus, we now have five firms in the industry whose respective shares of the local hamburger market are now 63%, 12%, 11%, 8%, and 6%.

The new four-firm concentration ratio is 94% (= 63% + 12% + 11% + 8%).

The new Herfindahl index is 4334 (= 632 + 122 + 112 + 82 + 62 = 3969 + 144 + 121 + 64 + 36).

2. Suppose that the most popular car dealer in your area sells 10 percent of all vehicles. If all other car dealers sell either the same number of vehicles or fewer, what is the largest value that the Herfindahl index could possibly take for car dealers in your area? In that same situation, what would the four‐firm concentration ratio be? LO12.1 1-243 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Answers: To maximize the Herfindahl Index means to have an industry with as much concentration as possible. That calls for firms that are as big as possible. With the largest firm controlling only 10%, the way to have the rest of the industry be as concentrated as possible would be for there to be 9 other firms that each also controlled 10% of the market (for a total of 10 firms each controlling 10%). In that situation, the Herfindahl index would be 1000 (= 10×(102)) and the four-firm concentration ratio would be 40% (= 4×10%).

Feedback: Given that the maximum number of firms in the market equals 10, at a maximum concentration share of 10% for all firms, the largest Herfindahl index possible is 1000 (=10 (number of firms) × 102 (percentage squared for each firm)).

This logic also implies that the four-firm concentration ratio (largest possible) is 40% (= 4 (largest four firms, could be any of the ten) × 10% (share of the market)).

3. Suppose that a monopolistically competitive restaurant is currently serving 230 meals per day (the output where MR = MC). At that output level, ATC per meal is $10 and consumers are willing to pay $12 per meal. What is the size of this firm‘s profit or loss? Will there be entry or exit? Will this restaurant‘s demand curve shift left or right? In long‐run equilibrium, suppose that this restaurant charges $11 per meal for 180 meals and that the marginal cost of the 180th meal is $8. What is the size of the firm‘s profit? Suppose that the allocatively efficient output level in long-run equilibrium is 200 meals. Is the deadweight loss for this firm greater than or less than $60? LO12.2, LO12.3

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

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

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

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

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

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

Chapter 13 – Oligopoly and Strategic Behaviour McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Why do oligopolies exist? List five or six oligopolists whose products you own or regularly purchase. What distinguishes oligopoly from monopolistic competition?

LO13.1 Answer: Oligopolies exist for several reasons, the most common probably being economies of scale. If these are substantial, as they are in the automobile industry, for example, only very large firms can produce at minimum average cost. This makes it virtually impossible for new firms to enter the industry. A small firm could not produce at minimum cost and would soon be competed out of the business; yet to start at the required very large scale would take far more money than an unestablished firm is likely to be able to raise before proving it will be profitable.

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

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

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

2. What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent?

LO13.1 Answer: A four-firm concentration ratio of 60 percent means the largest four firms in the industry account for 60 percent of sales; a four-firm concentration ratio of 90 percent means the largest four firms account for 90 percent of sales (just add the percentage of sales for the largest four firms).

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3. Explain the general meaning of the following profit payoff matrix for oligopolists X and Y. All profit figures are in thousands. LO13.2

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

Answer: a. X and Y are interdependent because their profits depend not just on their own price, but also on the other firm‘s price. Note that, as indicated by the colours in the figure, within each of the cells A, B, C and D, X's profits are in the upper corner and Y's profits are in the lower corner. b. Likely outcome: Both firms will set price at $35. If either charged $40, it would be concerned the other would undercut the price and its profit by charging $35.

For example, if firm X chooses a price of $40 and firm Y chooses a price of $40 then firm X's profits are $57,000 and firm Y's profits are $60,000. However, if firm Y chooses to charge $35 it can increase its profit to $69,000. In effect, firm Y has an incentive to deviate from the price of $40. The same logic applies to firm X. If firm X deviates from the price of $40 it can increase profits to $59,000.

The catch is that both firms recognize this incentive structure and realize that if they continue to charge $40 and the other firm deviates from this price their profits will fall (If firm X continues to charge $40 and firm Y charges $35, rather 1-246 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

than $40, to capture higher profits then firm X's profits will fall to $50,000. If firm X also charged $35 its profits would be $55,000, which is better than $50,000). Thus, both firms charge a price $35; X‘s profit is $55,000, Y‘s, $58,000. c. Through price collusion—agreeing to charge $40—each firm would achieve higher profits (X = $57,000; Y = $60,000). But once both firms agree on $40, each sees it can increase its profit even more by secretly charging $35 while its rival charges $40, which was discussed above.

4. Why might price collusion occur in oligopolistic industries? Assess the economic desirability of collusive pricing. What are the main obstacles to collusion? Speculate as to why price leadership is legal in Canada, whereas price-fixing is not. LO13.3 Answer: Price wars are a form of competition that can benefit the consumer but can be highly detrimental to producers. As a result, oligopolists are naturally drawn to the idea of price-fixing among themselves, i.e., colluding with regard to price. In a recession, it is nice to know whether one‘s rivals will cut prices or quantity, so that a mutually satisfactory solution can be reached. It is also convenient to be able to agree on what price to set to bankrupt any would-be interloper in the industry.

From the viewpoint of society, collusive pricing is not economically desirable. From the oligopoly‘s viewpoint it is highly desirable since, when entirely successful, it allows the oligopoly to set price and quantity as would a profit-maximizing monopolist.

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

Price leadership is legal because although the firms may follow the dominant firm‘s price, they are not compelled to. Also, the tacit agreement on price does not include an agreement to control quantity and to divide up the market. Price-fixing is illegal in Canada, because it destroys competition. This is what our antitrust laws protect against.

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5. Why is there so much advertising in monopolistic competition and oligopoly? How does such advertising help consumers and promote efficiency? Why might it be excessive at times? LO13.4 Answer: Two ways for monopolistically competitive firms to maintain economic profits are through product development and advertising. Also, advertising will increase the demand for the firm‘s product. The oligopolist would rather not compete on a basis of price. Oligopolists can increase their market share through advertising that is financed with economic profits from past advertising campaigns. Advertising can operate as a barrier to entry.

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

Advertising may result in manipulation and persuasion rather than information. An increase in brand loyalty through advertising will increase the producer‘s monopoly power. Excessive advertising may create barriers to entry into the industry.

6. ADVANCED ANALYSIS Construct a game-theory matrix involving two firms and their decisions on high versus low advertising budgets and the effects of each on profits. Show a circumstance in which both firms select high advertising budgets even though both would be more profitable with low advertising budgets. Why won‘t they unilaterally cut their advertising budgets? LO13.4 Answer: Consider the following example, where Firm B's profits are in the lower corner and Firm A's profits are in the upper corner:

Profits from each advertising strategy appear in the cells above.

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

The payoff matrix suggests that both firms should have high advertising budgets, but if both choose to do so, they will both be worse off relative to if they both had low budgets. Neither firm will reduce its budget because if it does and its rival doesn‘t, the firm reducing will lose profits to the other firm. Unless they collude, the firms will both end up with large advertising budgets and reduced profits. (This argument is similar to the one found in problem 8b and 8c.)

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

The restrictions are $X > $Q > $Z > $Y. 7. Is the game shown by Figure 13.2 a zero-sum game or is it a positive-sum game?

How can you tell? Are there dominant strategies in this game? If so, what are they?

Which cell represents a Nash equilibrium and why? Explain why it is so difficult for Uptown and RareAir to achieve and maintain a more favourable cell than the Nash equilibrium in this single-period pricing game. LO13.6 Answer: This is a positive-sum game since the sum of the payoffs for each firm is positive. Yes, the dominant strategy is for both firms to use a low-price strategy. This strategy will provide the highest payoff regardless of what the other firm does. The Nash equilibrium is for both firms to play the low-price strategy (low-low cell) since neither firm has an incentive to deviate from this strategy given the strategy of the competing firm.

The more favourable outcome would be for both firms to collude and use the high price strategy. Both firms would earn a profit of $12 rather than $8 in this case. The problem is that both firms have an incentive to deviate from this strategy given that the other firm is playing the high price strategy. By pricing low, given the other firm is pricing high, profits increase to $15 (rather than $12 through cooperation).

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8. Refer to the payoff matrix in Discussion Question 3. First, assume this is a one-time game. Explain how the $60/$57 outcome might be achieved through a credible threat.

Next, assume this is a repeated game (rather than a one-time game) and that the interaction between the two firms occurs indefinitely. Why might collusion with a credible threat not be necessary to achieve the $60/$57 outcome? LO13.6 Answer: Either firm could threaten to flood the market to induce the other firm to choose the $40 pricing strategy. This threat is likely to be credible since both firms benefit from the $40 pricing strategy. In a repeated game setting this threat may not be necessary since the present value of cooperation may exceed the one-time gains from deviating from the $40-$40 pricing strategy. Thus, each firm may have incentive not to deviate from the $40-$40 strategy out of fear of lower profits in the future.

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9. Refer to the payoff matrix below. LO13.6

Assuming this is a sequential game with no collusion, what is the outcome if Firm A moves first to build a new type of commercial aircraft? Explain why first-mover strategies in the real-world are only as good as the profit projections on which they are based. How could a supposed ―win‖ from moving first turn out to be a big loss, whereas the ―loss‖ of being pre-empted turn out to be a blessing in disguise?

Answer: The dominant strategy for firm B is to build. The payoff from this buildstrategy is greater than the alternative not to build, regardless of what firm A does.

Since firm A will recognize this strategy, they will choose not to build, thus minimizing their losses. Thus, even as a first mover firm A will choose not to build.

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A ‗win‘ for firm B may not materialize if the projections about profits are incorrect.

For example, if there is a global downturn that reduces the demand for aircraft and firm B has already built the aircraft, then this may result in a loss for firm B. The LAST WORD Why have tech firms near monopolies in their own sectors sought to compete with tech firms that have extremely strong, near-monopoly positions in other sectors?

Answer: Firms with near-monopoly power in their own sector has very little to gain unless they expand their market. The only source for more profit is another sector.

REVIEW QUESTIONS 7. Which of the following apply to oligopoly industries? Select one or more answers from the choices shown. LO13.1

a. b. c. d.

A few large producers.

Many small producers.

Strategic behaviour.

Price taking.

Answer: A few large producers, Strategic behaviour.

Oligopoly industries feature markets dominated by a few large producers that engage in strategic behaviour. These firms may sell homogeneous or differentiated products. Bu because of their fewness, the producers in an oligopolistic industry are not price takers.

Rather, each firm controls a large enough fraction of industry that it can influence its own price by how much it decides to produce.

That, though, implies that the firms in an oligopoly industry are involved in a strategic situation in which there is mutual interdependence. As an example, note that the decision by one firm to increase its own output would lower its own price and draw customers away from rival firms. But those rival firms are large enough to retaliate by increasing their own outputs and driving down their own prices in a bid to steal customers back. This interdependence implies that each firm must consider the possible reactions of its rivals to its own pricing, output, and advertising decisions.

8. Consider an oligopoly industry whose firms have identical demand and cost conditions. If the firms decide to collude, then they will want to collectively produce the amount of output that would be produced by: LO13.3

a. A monopolistic competitor. b. A perfect competitor. c. A monopolist. d. None of the above.

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Answer: c. A monopolist.

Each of these colluding oligopoly firms with identical demand and cost conditions will want to produce the same amount of output as if it were a monopolist. That is because the monopoly output level would maximize each firm‘s profit.

What is more, the fast that the firms all face identical demand and cost conditions implies that they will all end up charging the same price and thereby not competing with each other. This is true because their identical demand and cost conditions imply that they will each be facing identical situations. Thus, they will each choose the same monopoly output and set the same monopoly price.

This is important to understand because it shows how much collusion depends upon firms having identical or highly similar demand and cost conditions. If, by contrast, firms had very different demand or cost conditions, then each firm‘s preferred monopoly output and price would vary depending on the specific demand and cost conditions that it itself is facing. As a result, firms will find it very hard to collude as it will no longer be the case that all firms want to set the exact same price. Instead, significant price competition is likely to break out after each firm attempts to set its own price.

9. In an oligopoly, each firm‘s share of the total market is typically determined by: LO13.4 a. Scarcity and competition. b. Payoff matrices. c. Homogeneous products and import competition. d. Product development and advertising.

Answer: d. Product development and advertising.

In an oligopoly, each firm‘s share of the total market is typically determined by product and development and advertising. This is true because there is relatively little price competition in oligopoly industries. That leaves two major methods by which oligopoly firms can increase their share of the total market. The first is to develop new products that are more appealing than existing alternatives. The second is to use advertising to steal market share away from rival firms. Oligopolistic firms often use both methods quite aggressively.

10. Some analysts consider oligopolies to be potentially less efficient than monopoly firms because at least monopoly firms tend to be regulated. Arguments in favour of a more benign view of oligopolies include: LO13.5

a. Oligopolies are self-regulating. b. Oligopolies can be kept in line by foreign competition. c. Oligopolistic industries may promote technological progress. d. Oligopolies may engage in limit pricing to keep out potential entrants.

Answer: Oligopolies are self-regulating.

They often attempt collusion in order to collectively earn the monopoly profit. On the other hand, to the extent that a domestic oligopoly industry faces substantial foreign competition, it will have to lower prices, increase output, and behave more efficiently 1-253 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

from society‘s standpoint. Oligopolistic industries may also promote society‘s interests if they promote technological progress by funneling some of their economic profits back into R&D. And to the extent that oligopolies are worried about new entrants, they may engage in limit pricing, a policy that would reduce their prices and increases their output levels up toward socially efficient levels. Limit pricing, however, is illegal in many countries. This pricing strategy is used to eliminate competition within a market or prevent it from entering at all.

11. Collusive agreements can be established and maintained by: LO13.6

a. Credible threats. b. One-time games. c. Empty threats. d. First-mover advantage.

Answer: Credible threats.

Collusive agreements can be established and maintained by credible threats. This is true because credible threats that are made by a strong enforcer can help to prevent cheating and thereby maintain the group discipline required for collusion to succeed in driving up prices and reducing output.

12. True or false. Potential rivals may be more likely to collude if they view themselves as playing a repeated game rather than a one-time game. LO13.6

Answer: True.

Potential rivals may indeed be more likely to collude if they view themselves as playing a repeated game rather than a one-time game. This is true because repeated games allow firms to engage in reciprocity. In particular, the firms can take turns in doing nothing to interfere as the other firm pursues a highly profitable business venture such as launching a new product. Then, the next period, the firms switch roles, with the other firm now pursuing a highly profitable business venture while its rival does nothing to interfere. This sort of mutually beneficial alternation is only possible if the firms view themselves as playing a repeated game. Repeated games also allow for a firm to punish the other firm if they try to cheat in the game. This gives them more confidence that they will both follow through with the plan. If they think of themselves as playing a one-time game, then they will be less likely to collude as it is not possible to take turns and engage in reciprocity or to punish the other firm.

13. Property developers who build shopping malls like to have them ―anchored‖ with the outlets of one or more famous national retail chains, like Hudson Bay Company or Canadian Tire.

Having such ―anchors‖ is obviously good for the mall developers because anchor stores bring in a lot of foot traffic that can help generate sales for smaller stores that lack well-known national brands. But what‘s in it for the national retail chains? Why become an anchor?

Choose the best answer from the following list. LO13.6 1-254 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

a. The anchor stores want to make a credible threat against the developer. b. The anchor stores may feel there is a first-mover advantage to becoming one of only a few anchor stores at a new mall. c. The property developers are making empty threats to smaller stores. d. The smaller stores face a negative-sum game.

Answer: b. The anchor stores may feel there is a first-mover advantage to becoming one of only a few anchor stores at a new mall.

The famous national retail chains know that there are only a limited number of good spots in new malls. So, to displace their rivals, they compete to get outlets placed into new malls that look to be successful.

PROBLEMS 7. Consider a ―punishment‖ variation of the two-firm oligopoly situation shown in Figure 13.2 in the chapter. Suppose that if one firm sets a low price while the other sets a high price, then the firm setting the high price can fine the firm setting the low price. Suppose that whenever a fine is imposed, X dollars is taken from the low-price firm and given to the high-price firm.

What is the smallest amount that the fine X can be such that both firms will want to always set the high price? LO13.6

Answer: $3 million and one cent (also accept $3 million as an answer here).

Feedback: Let's look at the following example.

From the above figure we can see if one firm deviates from the high price while the other maintains the high price the firm that deviates will earn an extra $3 million in profits (If the firm continued with the high price, it would earn $12 million and if the firm deviates it will earn $15 million).

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Given this potential for additional profit the fine will need to be equal to or greater than this value. If the fine is set at $3 billion (plus one cent) it is in the firm's interest to maintain the high price because the fine (penalty) is greater than the gain.

8. Consider whether the promises and threats made toward each other by duopolists and oligopolists are always credible (believable). Look at the figure 13-2 below. Imagine that the two firms will play this game twice in sequence and that each firm claims the following policy. Each says that if both it and the other firm choose the high price in the first game, then it will also choose the high price in the second game (as a reward to the other firm for cooperating in the first game). LO13.6

a. As a first step toward thinking about whether this policy is credible, consider the situation facing both firms in the second game. If each firm bases its decision on what to do in the second game entirely on the payouts facing the firms in the second game, which strategy will each firm choose in the second game? b. Now move backward in time one step. Imagine that it is the start of the first game and each firm must decide what to do during the first game. Given your answer to part a, is the publicly stated policy credible? (Hint: No matter what happens in the first game, what will both firms do in the second game?) c. Given your answers to a and b, what strategy will each firm choose in the first game?

Answers: a. Each firm will choose the low-price strategy in the second game.

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b. No. c. Each firm will choose the low-price strategy in the first game.

Feedback: a. Each firm will choose the low-price strategy in the second game. The reason is that there can be no penalty after this stage of the game because the game ends. Here the low-price strategy strictly dominates the high price strategy for both firms. If Uptown air plays low, they are better off than if they played high regardless of the choice made by RareAir. If RareAir plays high, then Uptown Air receives $15 (which is greater than $12). If RareAir plays low, then Uptown Air receives $8 (which is greater than $6).

The same logic applies to the choice made by RareAir. Thus, the choice is low-low at this stage of the game. b. The policy is not credible because firms will not follow through on promises to play the high price strategy in the second game. Because both firms will base their decisions in the second game on the payouts in the second game, they will always choose the low-price strategy in the second game. c. Each firm will choose the low-price strategy in the first game. This is because they know that nothing, they do in the first game will affect the decisions that each of them will make to play the low-price strategy in the second game.

Thus, they base their decision about the first game solely on the payouts from the first game. Doing so leads both firms to choose the low-price strategy in the first game.

9. ADVANCED ANALYSIS Suppose you are playing a game in which you and one other person each pick a number between 1 and 100, with the person closest to some randomly selected number between 1 and 100 winning the jackpot. (Ask your instructor to fund the jackpot.) Your opponent picks first.

What number do you expect her to choose? Why? What number would you then pick? Why are the two numbers so close? How might this example relate to why Home Depot and Lowes, Rexall and Shoppers Drug Mart, McDonald‘s and Burger King, and other major pairs of rivals locate so close to each other in many well-defined geographical markets that are large enough for both firms to be profitable? LO13.6

Answer: As the first player it is optimal to choose 50. The reasoning is that your opponent could choose a number that significantly reduces your chances of winning if you didn‘t choose 50. For example, if you choose 1, the next player could choose 2.

Thus, the only way you win is if the number 1 is drawn. How about picking 25? Your 1-257 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

opponent would pick 26. Thus, you only have a 25 percent chance of winning. How about 49? The same logic applies.

The logic applies to companies that market similar (identical products). All of these companies choose a central location to maximize their share of costumers, assuming consumers base their behavior on distance alone. But even if this isn‘t a valid assumption the theory still applies for a homogeneous population. Assuming your opponent selected their location to optimize their exposure to consumers, by locating close by, you are putting yourself in the best position to gain their consumers.

Chapter 14 - Technology, R&D, and Efficiency McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. What is technological advance, as broadly defined? How does technological advance enter into the definition of the very long run? Which of the following are examples of technological advance, and which are not: an improved production process; entry of a firm into a profitable perfectly competitive industry; the imitation of a new production process by another firm; an increase in a firm‘s advertising expenditures?

LO14.1 Answer: Technological advance is broadly defined as new and better goods and services and new and better ways of producing or distributing them. There is a distinction between the ―long run‖ and the very ―long run‖: In the long run, technology is constant but firms can change their plant sizes and are free to enter or exit industries. In contrast, the very long run is a period in which technology can change and in which firms can introduce entirely new products. a. b. c. d.

An improved production process; Yes (innovation) Entry of a firm into a profitable perfectly competitive industry; No The imitation of a new production process by another firm; Yes (Diffusion) An increase in a firm‘s advertising expenditures; No

2. Contrast the older and the modern views of technological advance as they relate to the economy. What is the role of entrepreneurs and other innovators in technological advance? How does research by universities and government affect innovators and technological advance? Why do you think some university researchers are becoming more like entrepreneurs and less like ―pure scientists‖? LO14.2 Answer: The older view of technological advance was that it was external to the economy; a random outside force to which the economy adjusted. Scientific and technological advances were fortuitous and helpful but largely external to the market system. Most contemporary economists have a different view. They see capitalism itself as the driving force of technological advance. In this view, invention, 1-258 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

innovation, and diffusion occur in response to incentives provided by the market.

The motivation to seek new products and processes is driven by the expectation of new profit opportunities.

An entrepreneur is an initiator, innovator, and risk bearer—the catalyst who combines, land, labour and capital resources in new and unique ways to produce new goods and services. Historically, these were individuals. In today‘s more technologically complex economy, this role is just as likely to be carried out by entrepreneurial teams. Unlike entrepreneurs, other innovators do not bear personal financial risk. These people include key executives, scientists, and other salaried employees engaged in commercial R&D activities.

New scientific knowledge is highly important to technological advance, but scientific principles, as such, cannot be patented. For this reason, entrepreneurs actively study the scientific output of university and government laboratories to find discoveries with commercial applications, obtaining information without paying for its development. Although, firms increasingly help fund university research that relates to their products, scientists increasingly realize their work may have commercial value.

3. Consider the effect that corporate profit taxes have on investing. Look back at Figure 14.3. Suppose that the r line is the rate of return a firm earns before taxes. If corporate profit taxes are imposed, the firm‘s after-tax returns will be lower (and the higher the tax rate, the lower the after-tax returns). If the firm‘s decisions about R&D spending are based on comparing after-tax returns with the interest-rate costs of funds, how will increased corporate profit taxes affect R&D spending? Does this effect modify your views on corporate profit taxes? Discuss. LO14.3 Answer:

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If corporate profit taxes are imposed on the firm this will reduce the after-tax return at each level of investment. This will cause the expected rate of return schedule (after tax return) to shift left reducing investment.

For example, if the tax rate is 50% the firm only keeps 50% of the before tax return.

In the diagram above the equilibrium level of R&D expenditure (investment) is $60 million at an interest rate and before tax rate of return of 8%. However, with a tax rate of 50% the firm only keeps half of the 8% return, which equals 4%. Thus, this is no longer the equilibrium because the firm's after-tax return of 4% is less than the 8% interest rate.

The firm will reduce investment until the after-tax rate of return equals the interest rate of 8%. This occurs at the investment level of $20 million. The before tax rate of return equals 16% and the after-tax rate of return equals 8% (which equals the interest rate).

In conclusion the implementation (or increase) in the corporate profit tax will reduce R&D expenditure because the firm considers the after-tax return, not the before tax return, when undertaking investment projects since this is what determines the profitability.

This will likely cause the student to modify their views about corporate profit taxes if they originally thought they should be higher. However, they may not change their beliefs if they are considering equality and distribution issues.

4. Answer the following lettered questions on the basis of the information in this table: LO14.3

a. If the interest-rate cost of funds is 8 percent, what will be the optimal amount of R&D spending for this firm? b. Explain why $20 million of R&D spending will not be optimal. c. Why won‘t $60 million be optimal either?

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a. $50 million, where the interest-rate cost of funds equals the expected rate of return. b. at $20 million in R&D, the expected rate of return of 14 percent exceeds the interest-rate cost of funds of 8 percent, thus there would be an under allocation of R&D funds; c. at $60 million, the expected rate of return of 6 percent is less than the interest-rate cost of funds of 8 percent, thus there would be an over allocation of R&D funds.

5. Explain: ―The success of a new product depends not only on its marginal utility but also on its price.‖ LO14.4 Answer: A new product may have a high level of marginal utility per unit consumed.

However, if this product also has a high price the marginal utility per dollar may still be low.

For example, assume that you are already consuming good A. The marginal utility of the last unit consumed is 6 and price of the good is $2. The marginal utility per dollar for good A (last unit consumed) equals 3 (=6/$2).

Now assume a different firm comes out with a new good B. The marginal utility for first unit consumed of good B equals 100 and the price is $50. The marginal utility per dollar for good B (last unit consumed) equals 2 (=100/$50).

Given the choice of consuming good A or switching to a unit of good B the consumer will choose to continue to purchase good A and NOT to consume good B even though the marginal utility is higher. Individuals compare marginal utility per dollar not the marginal utility alone when making consumption choices.

The same logic applies to the case where the price is low for the product and marginal utility is low as well.

6. Learning how to use software takes time. So once customers have learned to use a particular software package, it is easier to sell them software upgrades than to convince them to switch to new software. What implications does this have for expected rates of return on R&D spending for software firms developing upgrades versus firms developing imitative products? LO14.5 Answer: Expenditures on R&D carry a great deal of risk. Upgrading an existing product is likely to be less risky than developing an imitated product. Consumers value their time as well as money and are likely to prefer products that are familiar.

Imitating a successful product may save the cost of R&D for development, but there are significant protections that may end up costing the ―copy cat‖ firm dearly.

Patents, copyrights, and brand name recognition all contribute to give the original innovator a major marketing advantage.

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7. Why might a firm making a large economic profit from its existing product employ a fast-second strategy in relationship to new or improved products? What risks does it run in pursuing this strategy? What incentive does a firm have to engage in R&D when rivals can imitate its new product? LO14.5 Answer: A dominant firm that is making large profits from its existing products may let smaller firms in the industry incur the high costs of product innovation while it closely monitors their successes and failures. In using this ―fast, second strategy,‖ the dominant firm counts on its own product improvement abilities, marketing prowess, or economies of scale to prevail.

A firm that attempts to imitate the new products of rival firms may encounter a variety of roadblocks. Patent rights for a secret process may stop the effort cold or lead to costly lawsuits.

Developing new products can be very profitable and there are several protections, and advantages to taking the lead including: patent protection, copyrights and trademarks, lasting brand name recognition, benefits from trade secrets and learning by doing, high economic profits during the lag time between a product's introduction and its imitation, and the possibility of lucrative buyout offers from larger firms‘.

8. Do you think the overall level of R&D would increase or decrease over the next 20 to 30 years if the lengths of new patents were extended from 20 years to, say, ―forever‖?

What if the duration were reduced from 20 years to 3 years? LO14.5 Answer: If patent rights were extended indefinitely the motivation to spend on R&D could increase for two reasons. First the extended patent rights would add to their potential value and second, perpetual patent rights would provide an additional incentive to find a way around these rights. Firms would be motivated to seek other products and processes not covered by the endless patent restrictions.

If the restriction were reduced to a much shorter period of three years, the spending on R&D would be likely to decrease. The short period of protection would make it difficult to recover the costs of development.

9. Make a case that neither perfect competition nor monopoly is conducive to a great deal of R&D spending and innovation. Why might oligopoly be more favorable to R&D spending and innovation than either perfect competition or monopoly? What is the inverted-U theory of R&D, and how does it relate to your answers to these questions? LO14.6 Answer: For a perfectly competitive firm, the expected rate of return on R&D may be low or even negative. Because of easy entry, its profit rewards from innovation may quickly be competed away by existing or entering firms that also produce the 1-262 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

new product or adopt the new technology. The small size of the firm makes it difficult to finance the R&D as well.

The monopoly market structure may provide the least incentive to engage in R&D. Absolute barriers prevent competition. The only incentive for R&D expenditures would be defensive, to reduce the risk of some new product or process that could destroy the monopoly.

The oligopoly market structure has many characteristics that are conducive to technological advance. First, the large size enables them to finance the often very expensive R&D costs associated with major product or process innovation. The typical firm in oligopoly is likely to realize ongoing economic profits, which provides a ready source of funds. The existence of barriers to entry gives some assurance that any economic profits earned from innovation can be maintained. The large volume of sales allows the firm to spread the cost of R&D over a great many units of output.

The large size of the firms in oligopoly also makes it easier to absorb the inevitable losses from ―misses‖ while waiting for compensation from the ―hits.‖ The inverted-U theory suggests that R&D expenditures as a percentage of sales rise with industry concentration until the four-firm concentration ratio reaches about 50%.

Further increases in industry concentrations are associated with lower relative R&D expenditures. (See figure 14-4 below) The inverted-U theory reiterates the assessment made above regarding likely R&D spending and market structure.

The LAST WORD How can patents speed up the rate of creative destruction? How can patents slow down the rate of creative destruction? How do differences in manufacturing costs affect which industries would be most likely to be affected by the removal of patents?

Answer: Patents create a very large profit incentive. This incentive encourages firms to constantly innovate and come up with something new. This increased innovation speeds up the process of creative destruction.

Patents also eliminate the threat of competition for the life of the patent. This may make the firm less eager to research and innovate, slowing down the process of creative destruction. Patents also prevent other firms from copying the patent holder. This means 1-263 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

the other companies cannot come out with their version of the patented product, thereby slowing the process of creative destruction.

Industries with high costs need the high profit incentive that a patent supplies to give them an opportunity to recover those costs. These industries would be greatly affected by the removal of patents, as the company‘s profit would be greatly reduced if it faced competition right away.

REVIEW QUESTIONS 1. Listed below are several possible actions by firms. Write ―INV‖ beside those that reflect invention, ―INN‖ beside those that reflect innovation, and ―DIF‖ beside those that reflect diffusion. LO14.1 a. An auto manufacturer adds ―heated seats‖ as a standard feature in its luxury cars to keep pace with a rival firm whose luxury cars already have this feature. b. A television production company pioneers the first music video channel. c. A firm develops and patents a working model of a self-erasing whiteboard for classrooms. d. A light bulb firm is the first to produce and market lighting fixtures with LEDs (light emitting diodes). e. A rival toy maker introduces a new Stacey doll to compete with Mattel‘s Barbie doll.

Answer: a. DIF: Another firm was already using heated seats in their automobiles b. INN: A new way of using existing technology c. INV: A new product d. INN: A new way of using existing technology e. DIF: Another firm was already producing a doll using a given technology 2. A firm is considering three possible one-year investments, which we will name X, Y, and Z. Investment X would cost $10 million now and would return $11 million next year, for a net gain of $1 million.

Investment Y would cost $100 million now and would return $105 million next year, for a net gain of $5 million.

Investment Z would cost $1 million now and would return $1.2 million next year, for a net gain of $200,000.

The firm currently has $150 million of cash on hand that it can loan out at 15 percent interest. Which of the three possible investments should it undertake? LO14.3 a. X only. b. Y only. c. Z only. d. X and Y. 1-264 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

e. X and Z. f. X, Y, and Z. Answer: Z only.

This firm should only invest in Z. This is true because only investment Z has an expected rate of return that exceeds the rate that the firm could get by lending out its each at 15 percent interest.

To see this, note that investment Z has an expected rate of return of 20 percent (=$200,000 net gain divided by $1 million initial investment). Because that rate of return exceeds the 15 percent that the firm could earn by lending its cash, the firm would be better off investing $1 million in investment Z than it would be if it lent out that money at 15 percent.

By contrast, the firm would be better off lending out cash than investing in either investment X or Y. That is because both of those investments have expected rates of return that are less than the 15 percent that the firm could earn lending out its cash.

3. An additional unit of Old Product X will bring Cindy an MU of 15 utils; an additional unit of New Product Y will bring Cindy an MU of 30 utils; and an additional unit of New Product Z will bring Cindy an MU of 40 utils. If a unit of Old Product X costs $10, a until of New Product Y costs $30, and a unit of New Product Z costs $20, which product will Cindy prefer to spend her money on? LO14.4 a. Old Product X. b. New Product Y. c. New Product Z. d. More information is required.

Answer: New Product Z. Cindy will prefer to spend her money on New Product Z. Her preference is based on the fact that New Product Z has the highest MU per dollar of any of the three options.

To see this, note that purchasing an additional until New Product Z costs $20 but brings with it a MU of 40 utils. Thus, the MU per dollar is 2 utils per dollar (= 40 utils divided by $20).

By contrast, Old Product X only offers an MU per dollar of 1.5 (= 15 utils divided by $10) while New Product Y offers an MU per dollar of just 1 (= 30 utils divided by $30).

4. The inverted-U theory suggests that R&D expenditures as a percentage of sales __________ with industry concentration after the four-firm concentration ratio exceeds about 50 percent. LO14.6 1-265 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

a. Rise. b. Fall. c. Fluctuate. d. Flat-line.

Answer: Fall.

The correct answer is that the inverted-U theory suggests that R&D expenditures as a percentage of sales fall with industry concentration after the four-firm concentration ratio exceed about 50 percent.

According to the theory, this decline is the result of the firms in highly concentrated industries losing their motivation to fund R&D activities. This happens because the more concentrated an oligopolistic an industry becomes, the less likely there is to be robust price competition. In fact, it is likely that the firms will collude to restrict output and maintain a high monopoly price. If they do so, they will have little incentive to engage in R&D because they will already be making high monopoly profits.

5. Which statement about market structure and innovation is true? LO14.7 a. Innovation helps only dominant firms. b. Innovation keeps new firms from ever catching up with leading firms. c. Innovation often leads to creative destruction and the replacement of established firms by new firms. d. Innovation always leads to entrenched monopoly power.

Answer: Innovation often leads to creative destruction and the replacement of established firms by new firms.

Innovation can be done by both established firms and by new firms. Because successful innovations that win popularity with consumers help firms to grow, it is the case that innovation often leads to creative destruction and the replacement of established firms by new firms.

PROBLEMS 1. Suppose a firm expects that a $20 million expenditure on R&D in the current year will result in a new product that can be sold next year. Selling that product next year would increase the firm‘s revenue next year by $30 million and its costs next year by $29 million. LO14.3 a. What is the expected rate of return on this R&D expenditure? b. Suppose the firm can get a bank loan at 6 percent interest to finance its $20 million R&D project. Will the firm undertake the project?

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c. Now suppose the interest-rate cost of borrowing, in effect, falls to 4 percent because the firm decides to use its own retained earnings to finance the R&D. Will this lower interest rate change the firm‘s R&D decision? d. Now suppose that the firm has savings of $20 million—enough money to fund the R&D expenditure without borrowing. If the firm has the chance to invest this money either in the R&D project or in government bonds that pay 3.5 percent per year, which option should it choose? e. What option should the company choose if the government bonds pay 6.5 percent per year rather than 3.5 percent per year?

Answers: (a) 0.05; (b) No; (c) Yes; (d) Invest in R&D; (e) Invest in bonds.

Feedback: a. The expected rate of return equals the (expected) profit from the R&D divided the expenditure. b. Expected rate of return = profit/expenditure = $1/$20 = 0.05 (or 5% = 0.05×100) c. The firm will not borrow at a rate greater than the expected rate of return. Since the bank loan has a 6% rate of interest, which exceeds the expected rate of return, the firm will not undertake this project. d. The firm will borrow at a rate less than the expected rate of return. Since the bank loan now has a 4% rate of interest, which is less than the expected rate of return, the firm will undertake this project. e. The firm will invest its savings where the return is the highest. Since government bonds pay 3.5% per year and the expected rate of return on the R&D project is 5%, the firm should invest in the R&D project. f. If government bonds pay 6.5% per year and the expected rate of return on the R&D project is 5%, the firm should invest in government bonds (not undertake the project).

2. ADVANCED ANALYSIS A firm faces the following costs. Its total cost of capital = $1,000; its price paid for labour = $12 per labour unit; and its price paid for raw materials = $4 per raw-material unit. LO14.4 a. Suppose the firm can produce 5,000 units of output this year by combining its fixed capital with 100 units of labour and 450 units of raw materials. What are the total cost and average total cost of producing the 5,000 units of output? b. Now assume the firm improves its production process so that it can produce 6,000 units of output this year by combining its fixed capital with 100 units of labour and 450 units of raw materials. What are the total cost and average total cost of producing the 6000 units of output?

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c. If units of output can always be sold for $1 each, then by how much does the firm‘s profit increase after it improves its production process? d. Suppose that implementing the improved production process would require a onetime-only cost of $1,100. If the firm only considers this year‘s profit, would it implement the improved production process? What if it considers its profit not just this year but in future years as well?

Answers: a. b. c. d.

The TC = $4,000 so that the ATC = $0.80.

The TC is unchanged at $4,000, but ATC = $0.67.

Profits are $1,000 higher.

No; Yes.

Feedback: a. Total cost equals the total cost of capital plus the total cost of labour (price per labour unit × units of labour) plus the total cost of raw materials (price per raw material unit × units of raw material).

Total cost = $1,000 + $1,200 ($12 × 100) + $1,800 ($4 × 450) = $4,000 Average total cost equals the total cost divided by the number of units produced.

Average total cost = $4,000/5,000 = $0.80 per unit b. The total cost does not change after the improvement in the production process.

Total cost = $1,000 + $1,200 ($12 × 100) + $1,800 ($4 × 450) = $4,000 However, since the firm can produce more units with the same amount of inputs the average total cost will fall.

Average total cost = $4,000/6,000 = $0.67 per unit. c. The firm's profit equals total revenue (price × units produced and sold) minus total cost.

Prior to the improvement of the production process: profit = $5,000 - $4,000 = $1,000 After to the improvement of the production process: profit = $6,000 - $4,000 = $2,000 Thus, the change (increase) in profits after the improvement of the production process equals $1,000 (= $6,000 - $5,000). d. If the firm only considers this year‘s profit, the firm will choose not to implement the improved production process. The firm will only increase profit by $1,000 for the year, which is less than the $1,100 one-time-only cost.

If the firm considers its profit not just this year, but in future years as well, it will implement the improved production process under any reasonable scenario. The firm will earn $1,000 for the life of the project (every year) and it will only have a 1-268 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

one-time-only cost of $1,100. Even after two years the profit generated will exceed the cost unless the discount rate (interest rate) is excessively high.

Chapter15 - Competition Policy and Regulation McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Both competition policy and industrial policy deal with monopoly. What distinguishes their approaches? How does government decide to use one form of remedy rather than the other? LO15.1 Answer: One of the goals of government in a market economy is to promote competition as a way of achieving efficiency. One approach is to maintain competition by using antitrust laws to discourage the creation of excess monopoly power such as through mergers or by taking action against a firm that is abusing its monopoly power. The other approach, particularly in cases where there is a natural monopoly, is for the government to regulate the firm. The government will choose an approach by analyzing the structure of the industry, the cost structure of the firm, the impact of the firm‘s actions on its competitors and customers, industry technology, and the likelihood of new competitors entering the industry.

2. Explain how strict enforcement of competition laws might conflict with (a) promoting exports to achieve a balance of trade, and (b) encouraging new technologies. Do you see any dangers in using selective competition enforcement as part of a broader policy to increase exports? LO15.1 Answer: Strict enforcement of competition laws could mean that a merger of two large firms would be prohibited or a dominant manufacturer in an industry might be broken up. (a) The targeted firms could be weakened, which might reduce their ability to compete successfully with strong foreign firms in sales abroad. This in turn conflicts with the goal of expanding Canadian exports. (b) Major mergers involving companies in banking, telecommunications, computer manufacturers, and software producers have led to questions of how strict competition laws enforcement should be in these industries, where emerging technology may benefit from industry restructuring. Hastening the development of the ―information superhighway‖ could also benefit Canadian exports of these services, which would strengthen our trade balance.

Selective enforcement of competition laws is a type of government industrial policy that interferes with the market process to the extent that it favours some industries by easing the way for concentration in some industries and strictly limiting consolidation in others. Such a selective policy can be dangerous when one considers the 1-269 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

opportunities for public sector failure discussed in Chapter 18. Selective enforcement encourages rent seeking and self-interest lobbying efforts, which may dictate policy more than the technological merits warrant.

3. Suppose a proposed merger of firms would simultaneously lessen competition and reduce unit costs through economies of scale. Do you think such a merger should be allowed? Explain. LO15.1 Answer: Abstracting from other issues (for example, the relative sizes of the two firms in the market), such a merger should only be allowed if it can be shown that price reductions associated with the decrease in unit costs will outweigh the probable increase in price associated with the reduced level of competition in the industry.

4. In the 1980s, PepsiCo Inc., which then had 28 percent of the soft‐drink market, proposed to acquire the Seven‐Up Company. Shortly thereafter the Coca‐Cola Company, with 39 percent of the market, indicated it wanted to acquire the Dr. Pepper Company. 7‐Up and Dr. Pepper each controlled about 7 percent of the market.

In your judgment, was the government‘s decision to block these mergers appropriate?

LO15.1 Answer: The government‘s decision was justified. Each of the proposed merged companies would have resulted in a Herfindahl index of well over 1800, the guideline used by the federal government for horizontal mergers. Furthermore, the mergers would have significantly increased the level of concentration in the soft-drink industry, with only two firms effectively controlling four-fifths of the market.

Proponents of the merger might argue that economies of scale in the industry necessitate the formation of large firms such as Pepsico and Coca-Cola, but this is unlikely. (Note: Later Dr. Pepper and 7-Up merged and in 1995 were in turn purchased by a Canadian firm.)

5. ―The competition laws serve to penalize efficiently managed firms.‖ Do you agree?

Why or why not? LO15.2 Answer: Opponents of competition legislation contend that by restricting the operations of those firms that are most successful in a particular market, these laws reduce efficiency, penalizing well-managed firms and allowing for the continued existence of badly managed companies. Proponents of competition legislation argue that firms subject to the laws still have a strong incentive to produce efficiently—the profit motive. Furthermore, firms with monopoly power inefficiently allocate resources by restricting output below the point where marginal benefits to society equal marginal costs. By reducing monopoly power, competition laws therefore enhance economic efficiency. Correctly applied, competition legislation probably serves to increase efficiency overall.

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6. ―The social desirability of any particular firm should be judged not on the basis of its market share but on the basis of its conduct and performance.‖ Make a counterargument, referring to the monopoly model in your statement. LO15.2 Answer: Market share is a good indication of a firm‘s monopoly power. A firm with substantial monopoly power will likely use the power to restrict output, charge high prices, generate excessive profits, and act in predatory ways toward competitors and potential competitors. The mere fact that a firm has significant monopoly power is a strong indication that it is violating competition laws. Even if it is not, the inefficiencies of monopoly firms warrant action against them.

7. What types of industries, if any, should be subjected to industrial regulation? What specific problems does industrial regulation entail? LO15.2 Answer: Industries composed of firms with natural monopolies conditions are most likely to be subjected to industrial regulation. Regulation based on ―fair-return‖ prices creates disincentives for firms to minimize costs since cost reductions lead regulators to force firms to change a lower price. Regulated firms may also use ―creative‖ accounting to boost costs and hide profits. Because regulatory commissions depend on information provided by the firms themselves, and commission members are often recruited from the industry, the agencies may in effect be controlled by the firms they are supposed to oversee. Also, industrial regulation sometimes is applied to industries that are not, or no longer are, natural monopolies.

Regulation may lead to the conditions of a cartel, conditions that are illegal in an unregulated industry.

8. In view of the problems involved in regulating natural monopolies, compare socially optimal (marginal‐cost) pricing and fair‐return pricing by referring again to Figure 11-10. Assuming that a government subsidy might be used to cover any loss resulting from marginal‐cost pricing, which pricing policy would you favour? Why? What problems might such a subsidy entail? LO15.2 Answer: Many of the regulatory problems associated with fair-return pricing also apply to a policy of marginal-cost pricing. In the unlikely case that a marginal-cost pricing policy does not entail public subsidies, it is subject to fewer regulatory problems. While there is an incentive for firms to artificially inflate marginal-cost estimates, there is no disincentive to contain costs and efficiency-enhancing substitutions of capital for labour are not encouraged. Some of these conclusions do not hold in the more likely case where public subsidies are required.

Because marginal-cost pricing fosters allocative efficiency, it is preferable to fair-return pricing. However, if the firm requires public subsidies to produce at the socially optimal point, the same disincentive exists to minimize actual and estimated unit costs as with fair-return pricing, since cost reductions will simply lead to a lower subsidy. Efficiency-enhancing substitutions of capital for labour are not encouraged, since regulators are not attempting to enforce a stipulated rate of return. While public 1-271 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

subsidies to ensure allocative efficiency can be worthwhile from an economic perspective, they are usually politically unpopular, since voters are reluctant to provide large monopolistic firms with scarce public funds.

9. How does social regulation differ from industrial regulation? What types of benefits and costs are associated with social regulation? LO15.3 Answer: Industrial regulation is concerned with prices, output, and profits in specific industries, whereas social regulation deals with the broader impact of business on consumers, workers, and third parties. Benefits: increased worker and product safety, less environmental damage, reduced economic discrimination. Two types of costs: administrative costs, because regulations must be administered by costly government agencies, compliance costs, because firms must increase spending to comply with regulations.

10. Use economic analysis to explain why the optimal amount of product safety may be less than the amount that would totally eliminate risks of accidents and deaths. Use automobiles as an example. LO15.3 Answer: To produce an automobile that would totally eliminate the risk of accidents and death would be extremely expensive in terms of materials. Additionally, the cost of operating such a vehicle would likely be expensive because of the weight of the car. As additional design changes are considered, engineers should balance the marginal cost of providing the extra units of safety with the expected marginal benefit received from the design change.

The LAST WORD On what basis were U.S. airlines found guilty of violating antitrust laws in the Airline Tariff Publishing case? What was the remedy? By contrast, why might it be hard to prosecute algorithmic collusion, which also uses prices posted electronically?

Answer: The U.S. airlines in the Airline Tariff Publishing Case were accused of using prices posted to an electronic bulletin board to collude and fix prices. The remedy was a 1-272 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

behavioural remedy: any air fares posted online would have to become available to consumers immediately, rather than being tentatively posted by one airline in the hopes of other airlines matching those prices and thereby colluding to fix prices. By contrast, it would be harder to prosecute algorithmic collusion because computer software cannot act with intent. Under current law, two parties must explicitly intend to collude in order to be found guilty of price fixing. But software cannot act with intent. So it would be hard to prosecute software for collusion.

REVIEW QUESTIONS 1. How would you expect the Competition Bureau to react to each of the following?

LO15.1 a. A proposed merger of Ford and General Motors. b. Evidence of secret meetings by contractors to rig bids for highway construction projects. c. A proposed merger of a large shoe manufacturer and a chain of retail shoe stores. d. A proposed merger of a small life‐insurance company and a regional candy manufacturer. e. An automobile rental firm that charges higher rates for last‐minute rentals than for rentals reserved weeks in advance.

Answers: a. They would block this horizontal merger (violation of Section 7 of the Clayton Act). b. They would charge these firms with price fixing (violation of Section 1 of the Sherman Act). c. They would allow this vertical merger, unless both firms had very large market shares and the resultant merger substantially lessens competition. d. They would allow this conglomerate merger. e. They would not interfere with this price discrimination.

2. How would you expect antitrust authorities to react to the following? LO15.2 a. A proposed merger of Ford and General Motors. b. Evidence of secret meetings by contractors to rig bids for highway construction projects.

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c. A proposed merger of a large shoe manufacturer and a chain of retail shoe stores. d. A proposed merger of a small life-insurance company and a regional candy manufacturer. e. An automobile rental firm that charges higher rates for last-minute rentals than for rentals reserved weeks in advance.

Answers: a. They would block this horizontal merger. b. They would charge these firms with price fixing. c. They would allow this vertical merger, unless both firms had very large market shares and the resultant merger substantially lessens competition. d. They would allow this conglomerate merger. e. They would not interfere with this price discrimination.

3. When confronted with a natural monopoly that restricts output and charges monopoly prices, the two methods that governments have for promoting better outcomes are: LO15.2 a. Public ownership and public regulation. b. Sole proprietorships and public goods. c. Antitrust law and horizontal mergers. d. Creative destruction and laissez-faire.

Answer: a. Public ownership and public regulation.

The two methods that governments have for promoting better outcomes when confronting a natural monopoly are public ownership and public regulation.

Under public ownership, the government purchases and then runs, the natural monopoly. Because the government is not interested in maximizing profit, it sets a lower price and produces a higher output than the natural monopoly would if it were allowed to continue as a private, profit maximizing firm.

Under public regulation, the natural monopoly remains a private company but is placed under a government regulator who specifies how much the firm can charge and how much it should produce. This method also fixes the problem of high price and low output that exist when a profit maximizing natural monopoly remains unregulated.

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4. Which of the following is the correct name for the idea that certain firms prefer government regulation because regulation shields them from the pressures of competition and, in effect, guarantees them a regulated profit? LO15.2 a. The public interest theory of regulation. b. The structuralists‘ theory of monopoly. c. The legal cartel theory of regulation. d. The public regulation theory of natural monopoly.

Answer: c. The legal cartel theory of regulation.

The idea that some regulated firms may prefer being regulated is known as the legal cartel theory of regulation.

The basic idea is that when the government regulates an industry, it will set up a committee that oversees the industry. The committee will typically set the prices charged by firms in the industry. These fixed prices imply that price competitions effectively eliminated. In addition, the committee will generally set prices high enough that each firm can make a normal profit. Thus, in effect, the regulation of the industry leads to a situation where firms do not have to compete but still earn a normal profit.

It does not take much imagination to see why such a situation would be more appealing to many firms than unregulated competition in which each firm stands a chance of going bankrupt.

5. True or false. Economists believe that social regulation is an exception to the MB = MC rule because social regulation should in every case extend as far as possible in order to ensure safe products, less pollution, and improved working conditions.

LO15.3 Answer: False.

This statement is false because what economists actually believe is that the optimal amount of social regulation is determined by where MB = MC. In particular, social regulation should only be increased if the marginal benefit exceeds the marginal cost.

Economists argue for the MB = MC level of regulation because any smaller level of regulation leaves room for additional net benefits while any greater level of regulation results in net losses.

The key factor to keep in mind is that regulation is costly. Significant resources in terms of time and labour must be devoted to both developing and enforcing a particular social regulation. If the benefits of that particular social regulation do not exceed its costs, it will not make sense to take resources away from the production of other goods and services in order to devote them to the creation and enforcement of that particular social regulation.

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So while we all like safe products, less pollution, and improved working conditions, we must in each instance judge whether a specifics social regulation‘s marginal benefit exceeds its marginal cost.

PROBLEMS 1. Carrot Computers and its competitors purchase touch screens for their handheld computers from several suppliers. The six makers of touch screens have market shares of, respectively, 19 percent, 18 percent, 14 percent, 16 percent, 20 percent, and 13 percent. LO15.2 a. What is the Herfindahl index for the touch screen manufacturing industry? b. By how much would a proposed merger between the two smallest touch screen makers increase the Herfindahl index? Would the government be likely to challenge that proposed merger? c. If Carrot Computers horizontally merges with its competitor Blueberry Handhelds, by how much would the Herfindahl index change for the touch-screen industry?

Answers: a. 1,706 b. The Herfindahl index would rise by 364; yes, the government would likely challenge the proposed merger. c. Zero Feedback: Part a: The Herfindahl index for an industry is found by squaring the market share of each firm in the industry and adding these together.

The Herfindahl index for the firms above equals 1,706 (= 192 + 182 + 142 + 162 + 202 +132).

Part b: The two smallest firms make up 13% and 14%, thus if they merge, they will make up 27% of the market.

The Herfindahl index after the merger is 2,070 (=192 + 182 +162 + 202 +(13 + 14)2) The increase in the Herfindahl index is 364 (= 2,070 (after merger - 1706 (prior to merger)) The government would likely challenge this merger because a Herfindahl index above 1800 suggests that the market is too concentrated.

Part c: The answer is zero (no change) because the market shares for the touch screen industry have not changed, therefore the Herfindahl index won‘t change for the touch screen industry.

Chapter 16 - The Demand for Resources McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1-276 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

1. What is the significance of factor pricing? Explain how the determinants of factor demand differ from those underlying product demand. Explain the meaning and significance of the fact that the demand for a factor is a derived demand. Why do factor demand curves slope downward? LO16.1 Answer: All factors that enter into production are owned by someone, including the most important factor of all for most people, self-owned labour. The most basic significance of factor pricing is that it largely determines people‘s incomes. Factor pricing allocates scarce factors among alternative uses. Firms take account of the prices of factors in deciding how best to attain least cost production.

Finally, factor pricing has a great deal to do with income inequality and the debate as to what government should or should not do to lessen this inequality. It is here that the factors that determine factor demand are most different from those that determine demand for products. Demand for products is a question of income and tastes. But factor demand is more passive in the sense that it is derived from the demand for the products the factor can produce. If a factor can‘t be used in production of a desired product, there will not be any demand for it. Additionally, factors are often less mobile than products, so their geographic location relative to demand for the output they produce may be an important factor determining demand for factors in particular geographic areas.

Factors of production are not hired or bought because their employer or buyer desires them for themselves. The demand for factors is entirely derived from what the firm believes the factors can produce. If there were no demand for output, there would be no demand for input.

The demand for a factor depends, then, on how productive it is in producing output and on the price of the output. The demand for a factor is downward sloping because of the diminishing marginal product of the factor (because of the law of diminishing returns) and, in imperfectly competitive markets, also because the greater the output, the lower its price.

2. In 2018 General Motors (GM) announced that it would reduce employment by 14,000 workers. What does this decision reveal about how GM viewed its marginal revenue product (MRP) and marginal resource cost (MFC)? Why didn‘t GM reduce employment by more than 14,000 workers? By fewer than 14,000 workers? LO16.3 Answer: GM‘s decision suggests that the MFC of those 14,000 workers was greater than the MRP. GM didn‘t reduce employment further because the MRP of the remaining workers exceeded the MFC. Reducing employment by less than 14,000 workers would have left GM with some employees for whom the MFC exceeded the MRP, reducing the company‘s profits.

3. What are the determinants of the elasticity of factor demand? What effect will each of the following have on the elasticity or the location of the demand for factor C, which is being used to produce commodity X? Where there is any uncertainty as to the outcome, specify the causes of that uncertainty. LO16.4 1-277 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

a. An increase in the demand for product X. b. An increase in the price of substitute factor D. c. An increase in the number of factors substitutable for C in producing X. d. A technological improvement in the capital equipment with which factor C is combined. e. A decline in the price of complementary factor E. f. A decline in the elasticity of demand for product X due to a decline in the competitiveness of product market X. Answer: Elasticity of demand for a factor is determined by: (1) ease of factor substitutability; (2) elasticity of product demand; and (3) ratio of factor costs to total costs. a. Increase in the demand for factor C. b. Uncertainty relative to the change in demand for factor C; answer depends upon which is larger – the substitution effect or the output effect. c. Increase in the elasticity of factor C. d. Increase in the demand for factor C. e. Increase in the demand for factor C. f. Decrease in the elasticity of factor C

4. In each of the following four cases, MRPL and MRPC refer to the marginal revenue products of labour and capital, respectively, and PL and PC refer to their prices.

Indicate in each case whether the conditions are consistent with maximum profits for the firm. If not, state which factor(s) should be used in larger amounts and which factor(s) should be used in smaller amounts. LO16.5 a. MRPL = $8; PL = $4; MRPC = $8; PC = $4 b. MRPL = $10; PL = $12; MRPC = $14; PC = $9 c. MRPL = $6; PL = $6; MRPC = $12; PC = $12 d. MRPL = $22; PL = $26; MRPC = $16; PC = $19 Answer: To answer this question use the profit maximization rule MRPL/PL = MRPK/PK =1. a. Use more of both; capital: $8/$4 =2 (more capital) Labour: $8/$4=2 (more labour) b. Use less labour and more capital; capital: $14/$9 =1.56 (more capital) Labour: $10/$12=0.83 (less labour) c. Maximum profits obtained; capital: $12/$12 =1 (optimal capital); Labour: $6/$6=1 (optimal labour) d. Use less of both; capital: $16/$19 =0.84 (less capital); Labour: $22/$26=0.85 (less labour) 1-278 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

5. Florida citrus growers say that the recent crackdown on illegal immigration is increasing the market wage rates necessary to get their oranges picked. Some are turning to $100,000 - $300,000 mechanical harvesters known as ―trunk, shake, and catch‖ pickers, which vigorously shake oranges from the trees. If widely adopted, what will be the effect on the demand for human orange pickers? What does that imply about the relative strengths of the substitution and output effects? LO 16.5 Answer: The effect of the adoption of the mechanical pickers will be to decrease the demand for human pickers. If this occurs, the substitution effect will have been greater than the output effect.

The LAST WORD To save money, some fast-food chains are now having their customers place their orders at computer kiosks. Will the kiosks necessarily reduce the total number of workers employed in the fast-food industry?

Answer: Yes, ceteris paribus. Assuming demand is unchanged, replacing workers with kiosks is an attempt to set the ratio of the marginal product of capital to its price equal to the ratio of the marginal product of labour to its price. Effectively, the kiosks (which are capital) offer a higher marginal product than labour does, and so the firm is able to more cheaply take orders using the kiosks than it would by paying workers.

In other words, before the kiosks were implemented, it must have been that MPL/PL < MPC/PC. To correct this imbalance, the company replaced workers with capital. Less workers increases the MPL and more capital increases MPC. The replacement of workers by capital eventually stops with MPC/PL=MPC/PC.

REVIEW QUESTIONS 1. Cindy is a baker and runs a large cupcake shop. She has already hired 11 employees and is thinking of hiring a 12th. Cindy estimates that a 12th worker would cost her $100 per day in wages and benefits while increasing her total revenue from $2,600 per day to $2,750 per day. Should Cindy hire a 12th worker? LO16.2 a. Yes. b. No. c. You need more information to figure this out.

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Answer: a. Cindy should hire a 12th worker because the MRP exceeds the MFC for that 12th worker.

The MRP of a 12th worker is $150 per day: = Total revenue with the additional 12th worker – Total revenue with the 11th worker = $2,750 per day – $2,600 per day = $150.

The MFC of the 12th worker would be $100 per day. So, Cindy‘s profits would increase by $50 per day with the 12th worker: = MRP of the 12th worker – MFC of the 12th worker = $150 – $100 = $50 (since this number is positive, it indicates that the profits would increase).

Thus, Cindy should hire a 12th worker if she wants to increase her profits.

2. Complete the following labour demand table for a firm that is hiring labour competitively and selling its product in a competitive market. LO16.2 a. How many workers will the firm hire if the market wage rate is $27.95? $19.95?

Explain why the firm will not hire a larger or smaller number of units of labour at each of these wage rates. b. Show in schedule form and graphically the labour demand curve of this firm. c. Now re-determine the firm‘s demand curve for labour, assuming that it is selling in an imperfectly competitive market and that, although it can sell 17 units at $2.20 per unit, it must lower product price by $0.05 to sell the marginal product of each successive labour unit. Compare this demand curve with that derived in part b. Which curve is more elastic? Explain.

Answer: Table:

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Units of Labour

Total Product

0 1 2 3 4 5 6

0 17 31 43 53 60 65

Marginal Product -

17 14 12 10 7 5

Product Price

Total Revenue

$2 2 2 2 2 2 2

$0 34 62 86 106 120 130

Marginal Revenue Product -

$34 28 24 20 14 10

Two workers at $27.95 because the MRP of the first worker is $34 and the MRP of the second worker is $28, both exceeding the $27.95 wage. Four workers at $19.95 because workers 1 through 4 have MRPs exceeding the $19.95 wage. The fifth worker‘s MRP is only $14 so he or she will not be hired.

The demand schedule consists of the first and last columns of the table:

New Table: Units of Labour

Total Product

0 1 2 3 4 5 6

0 17 31 43 53 60 65

Marginal Product -

17 14 12 10 7 5

Product Price

Total Revenue

$2 2.2 2.15 2.1 2.05 2 1.95

$0 37.4 66.65 90.3 108.65 120 126.75

Marginal Revenue Product -

$37.40 $29.25 $23.65 $18.35 $11.35 $6.75

The new labour demand is less elastic. Here, MRP falls because of diminishing returns and because product price declines as output increases. A decrease in the wage rate will produce less of an increase in the quantity of labour demanded, because the output from the added labour will reduce product price and thus MRP.

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3. Alice runs a shoemaking factory that utilizes both labour and capital to make shoes.

Which of the following would shift the factory‘s demand for capital? You can select one or more answers from the choices shown. LO16.3 a. Many consumers decide to walk barefoot all the time. b. New shoemaking machines are twice as efficient as older machines. c. The wages that the factory has to pay its workers rise due to an economy-wide labour shortage.

Answer: All three of the choices offered in this question would in fact shift the shoemaking factory‘s demand for capital. That‘s because they are specific examples of the three general things that can shift a resource's demand curve: changes in product demand, changes in the productivity of the resource, and changes in the prices of other inputs. The decision by many consumers to walk barefoot reduces the demand for the factory‘s output. As a result, the factory‘s derived demand for capital also declines.

The fact that new shoemaking machines are twice as efficient as older machines increases the factory‘s demand for capital. This happens because the increased efficiency causes an increase in capital‘s MRP. If capital‘s MFC stays the same, this rightward shift in the factory‘s MRP curve will cause it to employ more shoemaking machines. Finally, the increase in wages caused by the labour shortage will also affect the factory‘s demand for capital. But this time we cannot tell without more information whether the increased price of labour will lead to an increase or a decrease in the demand for capital. That will depend on whether capital and labour are substitutes or complements in production. But either way, the increased price of labour will definitely cause some shift in the factory‘s demand for capital.

4. FreshLeaf is a commercial salad maker that produces ―salad in a bag‖ that is sold at many local supermarkets. Its customers like lettuce but don‘t care so much what type of lettuce is included in each bag of salad, so you would expect FreshLeaf‘s demand for iceberg lettuce to be: LO16.4 a. Elastic. b. Inelastic. c. Unit elastic. d. All of the above.

Answer: a. Elastic. We would expect FreshLeaf‘s demand for iceberg lettuce to be highly elastic and therefore highly responsive to changes in price. That is because the relaxed preferences of FreshLeaf‘s customers allow it to easily substitute between different varieties of lettuce when the price of iceberg lettuce changes. As an example, consider what would happen if the price of iceberg lettuce fell. FreshLeaf would save money and increase profits by substituting iceberg lettuce for other varieties whose prices had stayed the same. As a result, FreshLeaf‘s quantity demanded of iceberg lettuce will be highly sensitive to price—which is the same thing as saying that its demand for lettuce will be highly elastic.

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5. Suppose the productivity of capital and labour are as shown in the accompanying table. The output of these factors sells in a perfectly competitive market for $1 per unit. Both capital and labour are hired under perfectly competitive conditions at $3 and $1, respectively. LO16.5

a. What is the least‐cost combination of labour and capital the firm should employ in producing 80 units of output? Explain. b. What is the profit‐maximizing combination of labour and capital the firm should use? Explain. What is the resulting level of output? What is the economic profit?

Is this the least costly way of producing the profit‐maximizing output?

Answer: a. To answer this question, we begin by finding the ratios of the marginal product of each input to their respective prices for the first unit of each input.

Capital (unit 1): 24/3=8 Labour (unit 1): 11/1=11 Since the ratio is larger for labour, we employ the first unit of labour giving us 11 units of output.

The next step is to calculate the marginal product of labour to price ratio for the second unit of labour and compare this with the first unit of capital (which we did not select in the first step).

Capital (unit 1): 24/3=8 Labour (unit 2): 9/1=9

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Since the ratio is once again larger for labour we employ the second unit of labour giving us an additional 9 units of output and a total of 20 (=11 (for the first unit of labour) + 9 (for the second unit of labour)) .

We continue the process comparing the third unit of labour with the first unit of capital.

Capital (unit 1): 24/3=8 Labour (unit 3): 8/1=8 Here they are equal so we could choose either, or in this case both, to increase output.

Since we now employ the first unit of capital, we add 24 units to our total and the third unit of labour adds 8. This gives is a total of 52 (= 20 (from above) + 24 +8).

Since we are still not at 80 units of output, we continue on down the marginal product of labour and capital schedules choosing inputs based on the algorithm above.

We will end up employing 2 units of capital and 4 units of labour (the next step in the process above).

Capital (unit 2): 21/3=7 Labour (unit 4): 7/1=7 Total output is 80 (=52 (from above) + 21 (unit 2 of capital) +7 (unit 4 of labour)) Thus, the least-cost combination is found by equating the marginal product of each input to their respective prices. Or, employ the product that costs less per unit of output.

b. To determine the profit maximizing combination of inputs we use the same process above, except we now need to calculate total cost, total revenue, and profit.

The first step gave us 1 unit of labour and 0 units of capital with 11 units of output.

Total revenue equals $11 and total cost equals $1, which gives us $10 in profit.

Step 2 gave us 2 units of labour and 0 units of capital with 20 units of output. Total revenue equals $20 and total cost equals $2, which gives us $18 in profit.

Step 3 gave us 3 units of labour and 1 unit of capital with 52 units of output. Total revenue equals $52 and total cost equals $6 (=$3 (capital) + $3 (3 units of labour)), which gives us $46 in profit.

Continuing on, Step 4 gives us 4 units of labour and 2 units of capital with 80 units of output. Total revenue equals $80 and total cost equals $10, which gives us $70 in profit.

This process will continue until we reach 7 units of labour and 7 units of capital with 142 units of output. Total revenue equals $142 and total cost equals $28, with a profit of $114. You can verify that profit falls adding one more unit of capital or labour.

A less time intensive approach is to recognize that the Marginal Revenue Product (MRP) for labour and capital equal their respective Marginal Product schedules since the price of each unit of output is $1. Profit maximization occurs where the Marginal Factor Cost (MFC) equals Marginal Revenue Product (MRP). Since the MFC is $3 for capital and $1 for labour, equate these values with the MRP for capital and labour.

This occurs at 7 units of capital (MRP=$3=MFC) and 7 units of labour (MRP=$1=MFC). This rule is MRPL/PL = MRPK/PK =1.

Finally, since MPL/PL = MPL/PL for profit maximization the least-cost rule also applies.

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6. A software company in Silicon Valley uses programmers (labour) and computers (capital) to produce apps for mobile devices. The firm estimates that when it comes to labour, MPL = 5 apps per month while PL = $1,000 per month. And when it comes to capital, MPC = 8 apps per month while PC = $1,000 per month. If the company wants to maximize its profits, it should: LO16.5 a. Increase labour while decreasing capital. b. Decrease labour while increasing capital. c. Keep the current amounts of capital and labour just as they are. d. None of the above.

Answer: If this firm wants to maximize its profits, it should decrease labour while increasing capital. This is true because spending additional dollars on capital would yield a larger increase in output than would spending additional dollars on labour. To see why, let‘s first look at labour. The firm‘s estimates are that the MPL = 5 apps per month while PL = $1,000 per month. Those numbers imply that an extra (marginal) $1,000 per month spent hiring additional labour would yield an extra (marginal) 5 apps per month in output. By comparison, the firm‘s estimates for capital are that the MPC = 8 apps per month while PC = $1,000 per month. So, an additional $1,000 spent on capital would yield an extra 8 apps per month in output.

If we now compare the number of extra apps the firm could get by spending on either labour or capital, we see that it should spend its money on capital rather than labour because an extra $1,000 spent on capital will yield 8 extra apps while an extra $1,000 spent on labour will yield only 5 extra apps. The best way for the firm to take advantage of this knowledge is by cutting spending on labour in order to increase spending on capital. That is because $1,000 transferred from labour to capital will result in a net increase of 3 apps (= 8 apps gained by spending an extra $1,000 on capital – 5 apps lost by spending $1,000 less on labour). More generally, the firm should continue to reallocate its spending from labour to capital until MPL/PL = MPC/PC because at that point there will be no further gains from reallocating spending.

PROBLEMS 1. A delivery company is considering adding another vehicle to its delivery fleet, all the vehicles of which are rented for $100 per day. Assume that the additional vehicle would be capable of delivering 1500 packages per day and that each package that is delivered brings in ten cents ($0.10) in revenue. Also assume that adding the delivery vehicle would not affect any other costs. LO16.2 a. What is the MRP? What is the MFC? Should the firm add this delivery vehicle?

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b. Now suppose that the cost of renting a vehicle doubles to $200 per day. What are the MRP and MFC? Should the firm add a delivery vehicle under these circumstances? c. Next suppose that the cost of renting a vehicle falls back down to $100 per day, but due to extremely congested freeways, an additional vehicle would only be able to deliver 750 packages per day. What are the MRP and MFC in this situation? Would adding a vehicle under these circumstances increase the firm‘s profits?

Answers: a. The MRP = $150/1 since 1,500 packages at ten cents each will yield $150 per day in revenue. The MFC = $100/1 since renting the van will add $100 per day to total costs. Since MRP > MFC, the firm should add this vehicle. b. The MRP = $150/1; the MFC = $200/1; the firm should not add this vehicle because MRP < MFC. c. The MRP = $75/1; the MFC = $100/1; the firm should not add a vehicle because MRP < MFC.

Feedback: Part a: To find the Marginal Revenue Product (MRP) of an additional truck, calculate the additional revenue this truck will generate for the company. Since the truck delivers 1500 packages and each package generates $0.10 in revenue, the truck generates $150.00 (= $0.10 × 1500) in total revenue. Thus, the MRP of the truck is $150.00. The Marginal Factor Cost is the cost of renting the truck for the day, which is $100.00.

Given that the MRP = $150.00 and the MFC = $100.00 (MRP>MFC) you should add this delivery vehicle.

Part b:Since the cost of renting the vehicle has doubled, the MFC = $200. The MRP has not changed and equals $150.00. The company should not add the vehicle (MRP<MFC).

Part c:Since the cost of renting the vehicle is $100.00 again, the MFC = $100.00.

However, the truck only delivers 750 packages per day now and each package delivered still brings in ten cents ($0.10) in revenue. Thus, the truck generates $75.00 (= $0.10 × 750) in total revenue. Here the MRP = $75.00. This is less than the MFC so adding the truck would reduce profits.

2. Suppose that marginal product tripled while product price fell by one‐half in Table 16.1. What would be the new MRP values in Table 16.1? What would be the net impact on the location of the factor demand curve in Figure 16.1? LO16.2 1-286 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Answer: MRP values equal: $21, $18, $15, $12, $9, $6, $3; factor demand schedule to shift to the right.

Feedback: Consider the following scenario: Suppose that marginal product tripled while product price fell by one‐half in Table 16.1.

New Table: Marginal Total Marginal Revenue Units of Product Product Product Total Product Factor (Output) (MP) Price Revenue (MRP)

0 0 $1 0 1 21 21 $1 $21 $21 2 39 18 $1 $39 $18 3 54 15 $1 $54 $15 4 66 12 $1 $66 $12 5 75 9 $1 $75 $9 6 81 6 $1 $81 $6 7 84 3 $1 $84 $3 Relative to the original factor demand schedule the new demand schedule will lie to the right. That is, the scenario above will cause the factor demand schedule to shift to the right because the Marginal Revenue Product is higher for each unit of the factor.

3. Suppose that a monopoly firm finds that its MR is $50 for the first unit sold each day, $49 for the second unit sold each day, $48 for the third unit sold each day, and so on.

Further suppose that the first worker hired produces 5 units per day, the second 4 units per day, the third 3 units per day, and so on. LO16.3 a. What is the firm‘s MRP for each of the first five workers?

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b. Suppose that the monopolist is subjected to rate regulation and the regulator stipulates that it must charge exactly $40 per unit for all units sold. At that price, what is the firm‘s MRP for each of the first five workers? c. If the daily wage paid to workers is $170 per day, how many workers will the unregulated monopoly demand? How many will the regulated monopoly demand?

Looking at those figures, will the regulated or the unregulated monopoly demand more workers at that wage? d. If the daily wage paid to workers falls to $77 per day, how many workers will the unregulated monopoly demand? How many will the regulated monopoly demand?

Looking at those figures, will the regulated or the unregulated monopoly demand more workers at that wage? e. Comparing your answers to parts (c) and (d), does regulating a monopoly‘s output price always increase its demand for factors?

Answers: The answers for parts (a) and (b) are included in the following table.

(c) At a daily wage of $170, the unregulated firm will demand 2 workers while the regulated firm will demand 1 worker. So, at that wage, the unregulated firm will demand more workers. (d) At a daily wage of $77, the unregulated firm would demand 3 workers while the regulated firm would demand 4 workers. So, at that wage, the regulated firm will demand more workers (e) No; the effect depends on factor prices Feedback: Parts a and b:

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To find the Marginal Revenue Product for the first unit of labour in the unregulated economy we need to add up the marginal revenue for each sequential worker given that the first unit can be sold for $50, the second for $49, and so on.

Since the first worker can produce 5 units and each of these sequential units sell for $50, $49, $48, $47, and $46, the MRP for the first worker is $240 (=$50+$49+$48+$47+$46).

The second worker can produce 4 units and each of these sequential units sell for $45, $44, $43, and $42, the MRP for the first worker is $174 (=$45+$44+$43+$42).

The same procedure is applied to the next 3 workers, where the third worker produces 3 units, the fourth 2 units, and the fifth 1 unit. Be sure to reduce the price by $1 for each additional unit sold.

To find the Marginal Revenue Product for the first unit of labour in the regulated economy we just multiply the regulated wage, $40, by the number of units this worker produces, which is 5. Thus, the MRP for this worker is $200.00 (=$40 × 5).

The second worker has an MRP=$160 (=$40 × 4), the third's MRP=$120 (=$40 × 3), and so on.

All of the values are in the table above for the unregulated and regulated economy.

Part c: Now assume the daily wage rate is $170.00. The firm will employ additional workers as long as the Marginal Revenue Product (MPL) is greater than or equal to the Marginal Factor Cost (MFC). The MFC in this case is $170.00, the wage rate.

Based on this MFC, the unregulated firm will employ the first worker where the MRP=$240 and the second worker where MRP = $174. This unregulated firm will not employ the third worker because the MRP = $120. The unregulated firm will demand 2 workers.

We can apply the same process to the regulated firm (price regulated at $40). The regulated firm will employ the first worker where MRP=$200.00 but will not employ the second worker because MRP = $160.00. The regulated firm will demand 1 worker.

Thus, the unregulated firm will demand more workers.

Parts d and e: Now assume the daily wage rate is $77. Using the same logic applied in part c we see that the unregulated firm will employ the first 3 workers where MRP>MFC=$77. The regulated firm will employ the first 4 workers where MRP>MFC=$77. In this case the regulated firm will employ more workers. So, we can conclude that regulating a 1-289 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

monopoly does NOT always increase the demand for factors. The direction will depend on the resource price.

4. Consider a small landscaping company run by Mr. Viemeister. He is considering increasing his firm‘s capacity. If he adds one more worker, the firm‘s total monthly revenue will increase from $50,000 to $58,000. If he adds one more tractor, monthly revenue will increase from $50,000 to $62,000. Additional workers each cost $4000 per month while an additional tractor would also cost $4000 per month. LO16.5 a. What is the marginal product of labour? The marginal product of capital? b. What is the ratio of the marginal product of labour to the price of labour (MPL/PL)?What is the ratio of the marginal product of capital to the price of capital (MPK/PK)? c. Is the firm using the least costly combination of inputs? d. Does adding an additional worker or adding an additional tractor yield a larger increase in total revenue for each dollar spent?

Answers: (a) The MPL = $8,000. The ((MPK = $12,000. (b) MPL/PL = $8,000/$4,000 = 2. (MPK/PK = $12,000/$4,000 = 3. (c) No because (MPK/PK > MPL/PL. (d) Because 3 > 2, total revenue is increased more by spending money on an additional tractor rather than an additional worker.

Feedback Part a: The marginal (revenue) product of labour is $8,000. This is the increase in total revenue generated by the additional worker (=$58,000-$50,000).

The marginal product of capital can be found the same way. The change in total revenue generated by the additional tractor is $12,000 (=$62,000-$50,000), which equals the Marginal Product of Capital.

So, we have: MPL=$8,000 and MPK=$12,000 Part b: The ratio of the Marginal Product of Labour to the price of labour is: MPL/PL = $8,000/$4,000 = 2 The ratio of the Marginal Product of Capital to the price of labour is: PK/PK = $12,000/$4,000 = 3 Part c: Since MPK/PK = 3 > MPL/PL = 2, this is not the least-cost combination of inputs.

Part d: The landscaping firm should invest in an additional tractor. This will generate more revenue per dollar (compared to labour) 1-290 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 17 - Wage Determination McConnell Brue Flynn Barbiero 16ce DISCUSSSION QUESTIONS 1. Explain why the general level of wages is high in Canada and other industrially advanced countries. What is the single most important factor underlying the long‐run increase in average real‐wage rates in Canada? LO 17.1 Answer: The general level of wages is higher in Canada and other industrially advanced nations because of the high demand for labour in relation to supply. Labour productivity is high in Canada and other industrially advanced countries because: (1) capital per worker is very high; (2) natural resources are abundant relative to the size of the labour force particularly in Canada; (3) technology is advanced in Canada and other industrially advanced countries relative to much of the rest of the world; (4) labour quality is high because of health, vigor, training, and work attitudes; (5) other factors contributing to high Canadian productivity are the efficiency and flexibility of Canadian management; the business, social, and political environment that greatly emphasizes production and productivity; and the vast domestic market, which facilitates the gaining of economies of scale.

2. Why is a firm in a perfectly competitive labour market a wage taker? What would happen if that firm decided to pay less than the going market wage rate? LO17.2 Answer: A firm in a perfectly competitive labour market is a wage taker because there are a large number of firms wanting to buy the labour services of the workers in that market and a large number of workers with identical skills wanting to sell their labour services. As a result, the individual firm has no control over the price of labour. If a firm attempted to pay a wage below the going wage, no workers would offer their services to that firm.

3. Describe wage determination in a labour market in which workers are unorganized and many firms actively compete for the services of labour. Show this situation graphically, using W1 to indicate the equilibrium wage rate and Q1 to show the number of workers hired by the firms as a group. Show the labour supply curve of the individual firm and compare it with that of the total market. Why are there differences? In the diagram representing the firm, identify total revenue, total wage cost, and revenue available for the payment of non-labour resources. LO17.2 Answer: The labour market is made up of many firms desiring to purchase a particular labour service and of many workers with that labour service. The market demand curve is downward sloping because of diminishing returns and the market supply curve is upward sloping because a higher wage will be necessary to attract additional workers into the market. Whereas the individual firm‘s supply curve is 1-291 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

perfectly elastic because it can hire any number of workers at the going wage, the market supply curve is upward sloping.

For the graphs, see Figure 17.3 below.

4. Suppose the formerly competing firms in Question 3 form an employers‘ association that hires labour as a monopsonist would. Describe verbally the effect on wage rates and employment. Adjust the graph you drew for Question 3, showing the monopsonistic wage rate and employment level as W2 and Q2, respectively. Using this monopsony model, explain why hospital administrators sometimes complain about a shortage of nurses. How might such a shortage be corrected? LO17.3 Answer: The equilibrium wage in the monopsonistic market declines from the competitive market‘s Wl rate to W2. The employment level in this market will decline from Q1 to Q2. See Figure 17.4 (wage falls from Wc to Wm and the employment level falls from Qc to Qm).

If there are only one or two hospitals in an area, there exists a monopsonistic market for nurses. Their wages would be less than those for nurses where there is competition among employers (numerous hospitals and/or clinics). Because hospitals prefer to hire more nurses at a wage W2, they view the difference between Q3 and Q2 as a shortage. However, since their profits are maximized at W2, they are unwilling to raise wages voluntarily. The hospital administrator might offer a higher wage, but this wage would not be profit maximizing. Another solution would be for nurses to organize and demand higher wages. This would allow nurses to earn wages closer to their MRP and as wages rise toward W1, the shortage would disappear.

5. Assume a monopsonistic employer is paying a wage rate of Wm and hiring Qm workers, as indicated in Figure 17.8. Now suppose an industrial union is formed that forces the employer to accept a wage rate of Wc. Explain verbally and graphically 1-292 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

why in this instance the higher wage rate will be accompanied by an increase in the number of workers hired. LO17.5

Answer: The union wage rate Wc becomes the firm‘s MFC, which would be shown as a horizontal line to the left of the labour supply curve in Figure 17.8. Each unit of labour now adds only its own wage rate to the firm‘s costs. The firm will employ Qc workers, the quantity of labour where MRP = MFC (= Wc); Qc is greater than the Qm workers it would employ if there were no union and if the employer did not have any monopsonistic power, i.e., more workers are will to offer their labour services when the wage is Wc than Wm. 6. Have you ever worked for the minimum wage? If so, for how long? Would you favour increasing the minimum wage by a dollar? By two dollars? By five dollars?

Explain your reasoning. LO17.6 Answer: Student answers will vary. Those students that have worked for minimum wage probably didn‘t stay at that job for long and would probably describe their performance and that of their co-workers as relatively unproductive (an absence of efficiency wages). Support for an increase will depend on factors such as their perception of how much employment would be lost versus the income gains of those retaining employment.

7. ―Many of the lowest‐paid people in society—for example, short‐order cooks— also have relatively poor working conditions. Hence, the notion of compensating wage differentials is disproved.‖ Do you agree? Explain. LO17.7 Answer: Short-order cooks generally need few specific skills, i.e., practically anyone is thought to be capable of flipping burgers. Since the supply of unskilled workers is high relative to the demand for them, their wages are low. In this case, the concept of 1-293 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

compensating wage differentials is swamped by the excess supply of low-wage workers.

8. What is meant by investment in human capital? Use this concept to explain (a) wage differentials and (b) the long‐run rise of real wage rates in Canada. LO17.7 Answer: Investment in human capital is educational activity that improves individual productivity. a. Wage differentials are explainable to some extent through the concept of human capital investment. There is a strong positive correlation between time spent acquiring a formal education and lifetime earnings. Of course, it can be said that the brain surgeon who spent over twenty years in training, starting in grade 1, had the qualities to succeed in the labour market without spending over twenty years in school. Though this counter-argument has some merit, the point still is that this highly-skilled individual would never have become a brain surgeon without the over twenty years in school and might not have achieved the particular high income that goes with being a medical specialist. b. The long-run rise in real wage rates in Canada is positively correlated to investment in human capital. Without the increase in education and training of the Canadian labour force that has occurred over the years, productivity (output per person per hour) would still have risen because of the investment in real capital, improved technology, and our abundant natural resource base. But the real wage would undoubtedly now be very much lower, because an unskilled labour force could not possibly have made efficient use of the material resources and advancing technology of the economy.

9. What is the principal‐agent problem? Have you ever worked in a setting where this problem has arisen If so, do you think increased monitoring would have eliminated the problem? Why don‘t firms simply hire more supervisors to eliminate shirking?

LO17.8 Answer: The principal-agent problem is usually associated with the possible differences in the interests of corporate shareholders (principals) and the executives (agents) they hire. Business owners who hire workers because they are needed to help produce the goods or services of the firm face the dilemma of the principal-agent problem. Workers are the agents; they are hired to promote the interests of the firm's owners (the principals). Owners and workers both have a common goal in the survival of the firm, but their interests are not identical. A principal- agent problem arises when those interests diverge. Workers may seek to increase their utility by shirking their responsibilities and providing less than the agreed upon effort. Owners 1-294 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

of firms have a profit incentive to reduce or eliminate shirking. Hiring more supervisory personnel can be costly and there is no guarantee that it will eliminate the problem.

The LAST WORD Do you think exceptionally high pay to CEOs is economically justified? Why or why not?

Answer: Student answers will vary. Supporters will point to the important decisions made by CEOs and their effect on overall firm productivity. High pay provides an incentive not only for current CEOs, but also for aspiring CEOs, further enhancing productivity. Critics argue that while pay gaps are necessary, they are excessive relative to the productivity differences. They further argue that stockholders are hurt because high CEO pay reduces company profits.

REVIEW QUESTIONS 1. Brenda owns a construction company that employs bricklayers and other skilled tradespeople. Her firm‘s MRP for bricklayers is $22.25 per hour for each of the first seven bricklayers, $18.50 for an eighth brick layer, and $17.75 for a ninth bricklayer.

Given that she is a price taker when hiring bricklayers, how many bricklayers will she hire if the market equilibrium wage for bricklayers is $18.00 per hour? LO17.2 Answer: Eight.

Firms that are price takers in a competitive labor market will hire all units of labor for which MRP exceeds the equilibrium wage. Thus, Brenda will hire exactly eight bricklayers because each of their MRPs exceeds the equilibrium wage of $18.00 per hour.

By contrast, she would not hire a ninth bricklayer because the ninth bricklayer‘s MRP of $17.75 per hour is less than the $18.00 per hour that she would have to pay him.

Stated a bit less formally, she would not hire a ninth bricklayer because doing so would lose her $0.25 per hour (= the $18.00 per hour cost of hiring the ninth bricklayer - the $17.75 per hour that his output would increase total revenues).

2. Because a perfectly competitive employer‘s MFC curve is ______________, it will hire ____________ workers than would a monoposony employer with the same MRP curve. LO17.3 a. Upward-sloping; more b. Upward-sloping; fewer c. Flat; more d. Flat; fewer e. Downward-sloping; more f. Downward-sloping; fewer 1-295 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Answer: c. flat; more.

The wage that is paid to employers is determined for both perfectly competitive employers and monopsony employers by the intersection of MFC and MRP. The difference between the two types of employers is that monoposony employers have upsloping MFC curves whereas perfectly competitive employers have horizontal MFC curves.

This difference is due to the fact that perfectly competitive employers are able to hire as many workers as they please at the market equilibrium wage. By contrast, a monopsony employer faces the upsloping market supply curve for labour, which implies that the only way for the monopsony employer to increase the number of workers it employs is by raising wages.

The fact that it must raise wages to hire additional workers will make it less willing to hire additional workers than the perfectly competitive firm that can hire as many workers as it pleases at the fixed market equilibrium wage. This difference in MFCs will cause the monopsony employer to hire fewer workers than would a perfectly competitive firm with the same MRP curve.

3. True or false. When a labour market consists of a single monopsony buyer of labour interacting with a single monopoly seller of labour (such as a trade union), the resulting quantity of labour that is hired will always be inefficiently low. LO17.5 Answer: false.

This assertion is false because the interaction of a monopsony buyer and a monopoly seller may in fact lead to a negotiated wage that happens to be very close to the market equilibrium wage that would prevail if this were a perfectly competitive labour market. If that happens, the monoposony seller will end up employing as many workers as would be hired in a competitive market—which would mean that this market between a monopoly seller and a monposony buyer would in this case end up delivering an efficient outcome with respect to the number of workers employed.

But be careful. There is no guarantee that the negotiated wage will be near the competitive level. If it ends up really low (as would be the preference of the monoposony buyer) or really high (as would be the preference of the monopoly seller), the number of workers employed will be significantly less than the efficient number that would be hired in a perfectly competitive labour market. For more, see Figure 17.8.

4. The market equilibrium wage is currently $12 per hour among hairdressers. At that wage, 17,323 hairdressers are currently employed in the province. The provincial legislature then sets a minimum wage of $11.50 per hour for hairdressers. If there are no changes to either the demand or supply for hairdressers when that minimum wage is imposed, the number of hairdressers employed in the state will be: LO17.6 a. Fewer than 17,323. b. Still 17,323. c. More than 17,323.

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d. This is a bilateral monopsony so you can‘t tell.

Answer: b. Still 17,323.

The province‘s minimum wage of $11.50 per hour for hairdressers is below the current market equilibrium wage of $12 per hour. So it will affect neither the behaviour of demanders or suppliers. Thus, the wage will continue to be determined by the intersection of the demand and supply curves—which implies that the market equilibrium will not change and that the equilibrium wage and the equilibrium number of hairdressers employed will stay the same (at 17,323).

Another way to see this is to realize that minimum wages are price floors below which wages are not allowed to fall. But since the market equilibrium wage is already above the $11.50 per hour price floor that the provincial legislature is imposing, it will not be affected. Thus, the market equilibrium is unchanged and the same number of hairdressers are employed (17,323).

5. On average, 50-year old workers are paid several times more than workers in their teens and twenties. Which of the following options is the most likely explanation for that huge difference in average earnings? LO17.7 a. Older workers have more human capital and higher MRPs. b. Employers engage in widespread discrimination against younger workers. c. Young people lack information about the existence of the high-paying jobs occupied by older workers. d. Older workers receive compensating differences because they do jobs that are more risky than the jobs done by younger workers.

Answer: a. Older workers have more human capital and higher MRPs. The best explanation is that older workers have more human capital and higher MRPs than younger workers.

To begin with, we know that this is in fact true. It takes many decades of training and job experience to become a top manager, a top surgeon, or a top engineer. Only a very small fraction of young workers possess the skills and experience needed to succeed at those sorts of high-paying jobs.

There is also little evidence for widespread discrimination against younger workers.

In fact, aged-based discrimination is illegal and punishable by large fines and even jail time.

Next, there is little evidence that young people lack information about the highpaying jobs occupied by older workers. The media regularly presents TV shows and movies with characters occupying such jobs and, in addition, a quick trip to any Internet jobs site will present younger people with employment ads for those sorts of positions.

Finally, there is little evidence that older workers are paid more because they do jobs that are more risky. On the contrary, young people do most of society‘s most dangerous jobs, including serving in the military, working as police officers and fire fighters, and occupying other high-risk jobs in logging, construction, and sanitation.

Very few of these jobs are done by 50-year olds.

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6. Manny owns a local fast-food franchise. Angel runs it for him. So in this situation, Manny is the ____________ and Angel is the ________________. LO17.8 a. Free rider; entrepreneur. b. Agent; principal. c. Principal; agent. d. Producer; consumer.

Answer: c. Principal; agent.

Manny and Angel are engaged in a principal-agent relationship. Manny is the principal in the relationship. As owner, he wishes to maximize profits and has hired Angel to run the business for him with that goal in mind. Angel is therefore the agent, the person whose job it is to execute on the goals set by the principal.

As pointed out in this section, however, labour markets feature many examples of the principal-agent problem in which agents such as Manny pursue their own agendas to the detriment of the goals set out by their respective principals.

7. A principal is worried that her agent may not do what she wants. As a solution, she should consider: LO17.8 a. Commissions. b. Bonuses. c. Profit sharing. d. All of the above.

Answer: d. All of the above.

The correct answer is ―all of the above‖ because commissions, bonuses, and profit sharing are all methods by which a principal can encourage her agent to act in a manner consistent with the principal‘s goal of profit maximization.

That is true because the size of an agent‘s commission, bonus, or profit share depends upon the size of his firm‘s profit. The larger the profit, the larger the agent‘s commission, bonus, or profit share. Thus, each of these three incentive pay plans helps to encourage agents to act in a manner consistent with the principal‘s goal of profit maximization.

PROBLEMS 1. Workers are compensated by firms with ―benefits‖ in addition to wages and salaries.

The most prominent benefit offered by many firms is health insurance. Suppose that, in 2010, workers at one steel plant were paid $20 per hour and in addition received health benefits at the rate of $4 per hour. Also suppose that, by 2020, workers at that plant were paid $21 per hour but received $9 in health insurance benefits. LO17.1 a. By what percentage did total compensation (wages plus benefits) change at this plant from 2010 to 2020? What was the approximate average annual percentage change in total compensation?

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b. By what percentage did wages change at this plant from 2010 to 2020? What was the approximate average annual percentage change in wages? c. If workers value a dollar of health benefits as much as they value a dollar of wages, by what total percentage will they feel that their incomes have risen over this time period? What if they only consider wages when calculating their incomes? d. Is it possible for workers to feel as though their wages are stagnating even if total compensation is rising?

Answers: a. Total compensation rose from $24 in 2010 to $30 in 2020. This is a 25% increase.

Dividing that number by 10 we see that the average annual growth rate was approximately 2.5% per year. b. Wages went up by 5% over this time period (= $1/$20). Dividing that number by the number of years (10), we see that the approximate average annual growth rate of total compensation was 0.5% per year. c. If workers value health benefits as much as wages, then they will feel that their incomes have risen by 25%. If they exclude health benefits and focus only on wages, they will feel that their incomes went up 5%. (d) Yes, this is possible. See answers to part c.

Feedback Part a: Total compensation in 2010 was $24 (=$20 (wage rate) + $4 (health benefits)) and in 2020 total compensation is $30 (=$21 + $9).

The percentage increase in total compensation is (30-24)/24 = 6/24 = 0.25 (or 25%).

This implies the approximate average annual percentage change in total compensation is 0.25/10 = 0.025 (or 2.5%).

Part b: The percentage increase in wages alone is (21-20)/20 = 1/20 = 0.05 (or 5%). This implies the approximate average annual percentage change in wages is 0.05/10 = 0.005 (or 0.5%).

Part c: If workers value a dollar of health benefits as much as they value a dollar of wages, they feel that their incomes have risen by 25% (part a) over this time period.

If they only consider wages when calculating their incomes they feel that their incomes have risen by 5% (part b) over this time period.

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Yes, if workers only look at their wages they may feel as if their wages are stagnating.

2. Complete the following labour supply table for a firm hiring labour competitively: LO17.2

a. Show graphically the labour supply and marginal factor (labour) cost curves for this firm. Are the curves the same or different? If they are different, which one is higher? b. Plot the labour demand data of Review Question 2 in Chapter 16 on the graph used in part (a) above. What are the equilibrium wage rate and level of employment?

Answers: (a) The supply curve and the MFC are the same.

Units of Labour 0 1 2

Wage Rate 14 14 14

3 4 5 6

14 14 14 14

Total Labour Cost

Marginal Factor (Labour) Cost

$0 14 28 42 56 70 84

$14 14 14 14 14 14

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(b)

Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labour.

Feedback: The labour supply curve and MFC curve coincide as a single horizontal line at the market wage rate of $14. The firm can employ as much labour as it wants, each unit costing $14; wage rate = MFC because the wage rate is constant to the firm.

Units of Labour 0 1 2

Wage Rate 14 14 14

3 4 5 6

14 14 14 14

Total Labour Cost

Marginal Factor (Labour) Cost

$0 14 28 42 56 70 84

$14 14 14 14 14 14

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Graph: equilibrium is at the intersection of the MRP and MFC curves. Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labour. From the tables: MRP exceeds MFC for each of the first four units of labour, but MRP is less than MFC for the fifth unit.

Table from Review Question 2, Chapter 16: Units of Labour

Total Product

0 1 2 3 4 5 6

0 17 31 43 53 60 65

Marginal Product -

17 14 12 10 7 5

Product Price

Total Revenue

$2 2 2 2 2 2 2

$0 34 62 86 106 120 130

Marginal Revenue Product -

$34 $28 $24 $20 $14 $10

3. Assume a firm is a monopsonist that can hire its first worker for $6 but must increase the wage rate by $3 to attract each successive worker (so that the second worker must be paid $9, the third $12, and so on). LO17.3 Draw the firm‘s labour supply and marginal resource cost curves. Are the curves the same or different? If they are different, which one is higher?

On the same graph, plot the labour demand data of Question 2 in Chapter 13. What are the equilibrium wage rate and level of employment?

Compare these answers with those you found in problem 2. By how much does the monopsonist reduce wages below the competitive wage? By how much does the monopsonist reduce employment below the competitive level?

Answers: (a) Graph: (approximate shape below. Also note that the discreet nature of the problem requires that the marginal revenue product (MRP) be greater than or equal to the marginal factor cost (MFC)):

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The curves are different; the MFC curve is higher than the labour supply curve. (b) The firm will employ three workers in this situation. Here the MRP = $24 is greater than the MFC = $18. For the fourth worker the MRP = $20 and the MFC = $24. (c) The monopsonist reduces the wage by $2 (from $14 to $12) and reduces employment by two workers (from 5 to 3).

Feedback: Parts a and b: Table for part a and table for part b (from question 2 in Chapter 13 and problem 2 above).

Units of Labour

Total Product

0 1 2 3 4 5 6

0 17 31 43 53 60 65

Marginal Product -

17 14 12 10 7 5

Product Price

Total Revenue

$2 2 2 2 2 2 2

$0 34 62 86 106 120 130

Marginal Revenue Product -

$34 $28 $24 $20 $14 $10

Graph: (approximate shape below. Also note that the discreet nature of the problem requires that the marginal revenue product (MRP) be greater than or equal to the marginal resource cost (MFC)).

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The MFC schedule lies above the labour supply schedule because employing the next worker requires a higher wage in this market and you must pay all workers this higher wage.

The firm will employ three workers in this situation. To see this, look at the MRP and MFC columns in the table above. The first worker will generate a MRP = $34 and will have a MFC = $6, thus the firm will employ this worker (the marginal revenue product for this worker is greater than his or her marginal cost). For the second worker we have MRP = $28 and MFC = $12, so we employ this worker. For the third worker we have MRP = $24 is greater than the MFC = $18, so we employ this worker as well. For the fourth worker we have MRP = $20 and the MFC = $24. In this case the marginal cost of this worker is greater than the worker's marginal revenue product, so we do not employ this worker.

Part c: The monopsonist decreases employment by 2 units and the equilibrium wage rate is $2 less than the competitive wage.

4. Suppose that low‐skilled workers employed in clearing woodland can each clear one hectare per month if they are each equipped with a shovel, a machete, and a chainsaw.

Clearing one hectare brings in $1000 in revenue. Each worker‘s equipment costs the worker‘s employer $150 per month to rent and each worker toils 40 hours per week for four weeks each month. LO17.6 a. What is the marginal revenue product of hiring one low‐skilled worker to clear woodland for one month? b. How much revenue per hour does each worker bring in? c. If the minimum wage were $6.20, would the revenue per hour in part (b) exceed the minimum wage? If so, by how much per hour?

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d. Now consider the employer‘s total costs. These include the equipment costs as well as a normal profit of $50 per hectare. If the firm pays workers the minimum wage of $6.20 per hour, what will the firm‘s economic profit or loss be per hectare? e. At what value would the minimum wage have to be set so that the firm would make zero economic profit from employing an additional low‐skilled worker to clear woodland?

Answers: a. $1000. b. $6.25 (= $1000/160 hours). c. Yes, exceeds by $0.05 per hour. d. The firm‘s loss per hectare will be -192.00 dollars (= $1000 in revenue - $150 in rental cost for equipment - $50 in normal profit - $992 in wages for 160 hours at $6.20 per hour). e. If X is the firm‘s labour cost per worker for one month to clear one hectare, then we need $1000 - $150 - $50 – X = 0.

Solving this equation for X yields X = $800. Dividing X by 160 hours yields a minimum wage of $5 per hour as what would be needed for the firm to earn zero profit.

Feedback: Consider the following example. Clearing one hectare brings in $1000 in revenue. Each worker‘s equipment costs the worker‘s employer $150 per month to rent and each worker toils 40 hours per week for four weeks each month.

Part a: The marginal revenue is $1000. This is the revenue each worker can generate for the firm by clearing one hectare.

Part b: Since the worker generates $1000 per month and works a total of 160 hours (40 hours per week for 4 weeks), revenue per hour equals $6.25 (= $1000/160).

Part c: If the minimum wage were $6.20, revenue per hour in part b exceeds the minimum wage by 5 cents per hour (=$6.25-$6.20).

Part d: Now consider the employer‘s total costs. These include the equipment costs as well as a normal profit of $50 per hectare. The total explicit cost for the firm per hectare equals $150. Thus, the economic profit per worker at the minimum wage equals $1000 (revenue) - $150 (explicit cost) - $50 (normal profit) - 160×$6.20 (hour of labour multiplied by the minimum wage = $992) = -$192. The firm suffers a loss per hectare.

Part e: To determine the minimum wage necessary for the firm to break-even (earn zero economic profit, we first calculate the revenue left over for labour after accounting for normal profit and explicit cost. The revenue left over after these components have been removed is $800 (=$1000 - $150 -$50). This leaves $800 left to pay each unit of labour for the month (clears one hectare). Since each worker 1-305 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

works 160 hours a month, the highest the break-even wage can be is $5 (=$800/160).

This is the highest the minimum wage can be set in the industry without exit.

5. Suppose that a car dealership wishes to see if efficiency wages will help improve its salespeople‘s productivity. Currently, each salesperson sells an average of one car per day while being paid $20 per hour for an eight‐hour day. LO17.8 a. What is the current labour cost per car sold? b. Suppose that when the dealer raises the price of labour to $30 per hour the average number of cars sold by a salesperson increases to two per day. What is now the labour cost per car sold? By how much is it higher or lower than it was before? Has the efficiency of labour expenditures by the firm (cars sold per dollar of wages paid to salespeople) increased or decreased? c. Suppose that if the wage is raised a second time to $40 per hour the number of cars sold rises to an average of 2.5 per day. What is now the labour cost per car sold? d. If the firm‘s goal is to maximize the efficiency of its labour expenditures, which of the three hourly salary rates should it use: $20 per hour, $30 per hour, or $40 per hour? e. By contrast, which salary maximizes the productivity of the car dealer‘s workers (cars sold per worker per day)?

Answers: a. b. c. d. e.

$160 $120 per vehicle; $40 less per vehicle; increased. $128 per vehicle. $30 per hour $40 per hour.

Feedback: The current labour cost per car is $160 (= $20 per hour times eight hours per day divided by 1 car sold per day on average). (b) The labour cost per hour falls to $120 per vehicle. It is now $40 less per vehicle. Efficiency has increased. (c) The labour cost per car is now $128 per vehicle. (d) The dealer should pay $30 per hour if it wants to maximize the efficiency of labour expenditures. (e) If the dealer wants to maximize output per worker per day, it should pay $40 per hour.

Chapter18 - Rent, Interest, and Profit McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1-306 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

1. How does the economist‘s use of the term ―rent‖ differ from everyday usage?

Explain: ―Though rent need not be paid by society to make land available, rental payments are very useful in guiding land into the most productive uses.‖ LO18.1 Answer: In everyday usage, ―rent‖ is the term used to describe the payment that must be paid for the legal borrowing of some good or service. One pays rent for the use of a house or apartment; or one rents a tool from the equipment rental company. When paying this rent one is paying for part of the capital cost of the commodity, plus its maintenance, plus a share of the taxes on it, plus profit to the owner.

An economist defines rent much more restrictively: Economic rent is the price paid for the use of land and other natural resources which are completely fixed in total supply.

Land is completely fixed in total supply. No matter how high the rent, no more can be brought into use. Thus, rent serves no incentive function; the same amount of land will be available no matter how high the rent. But the resulting argument that rent is a surplus that could be eliminated without reducing the supply is to look at it from the viewpoint of society only.

2. Explain why economic rent is a surplus payment when viewed by the economy as a whole, but is a cost of production from the standpoint of individual firms and industries. Explain: ―Land rent performs no incentive function for the overall economy.‖ LO18.1 Answer: Land is completely fixed in total supply. As population expands and the demand for land increases, rent first appears and then grows. From society‘s perspective this rent is a surplus payment unnecessary for ensuring that the land is available to the economy as a whole. If rent declined or disappeared, the same amount of land would be available. If it increased, no more land would be forthcoming. Thus, rent does not function as an incentive for adding land to the economy.

But land does have alternative uses. To get it to its most productive use, individuals and firms compete and the winners are those who pay the highest rent. To the high bidders, rent is a cost of production that must be covered by the revenue gained through the sale of the commodities produced on that land.

3. If money is not an economic resource, why is interest paid and received for its use?

What considerations account for the fact that interest rates differ greatly on various types of loans? Use those considerations to explain the relative sizes of the interest rates on the following: LO18.2 a. A 10‐year $1000 government bond b. A $20 pawnshop loan c. A 30‐year mortgage loan on a $175,000 house 1-307 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

d. A 24‐month $12,000 bank loan to finance the purchase of an automobile e. A 60‐day $100 loan from a personal finance company Answer: Though money is not in itself productive, it is useful for acquiring resources that are productive. In borrowing money, businesses get the use of it to buy factories, machines, and equipment that are productive and with which the businesses hope to make a profit. Thus, it makes economic sense to pay for the use of money. It would make no economic sense to lend money without charging interest, for the lender has the alternative of buying productive real capital or consumer goods with it.

There are many considerations involved in the fact that interest rates differ greatly on various types of loans. (1) Risk: The greater the chance the borrower will not repay, the higher the interest rate. (2) Maturity: The longer the term of the loan, the higher the interest rate to compensate the lender for the risk of being without the use of the money for an extended period of time. (3) Loan size: The smaller the loan, the higher the interest rate because the administrative costs of large and small loans are about the same absolute amounts. (4) Taxability: The interest payments on certain state and municipal bonds being non-taxable, the interest that lenders require as payment is lower.

A 10-year $1000 government bond will have a relatively low rate of interest because it is risk-free: The Federal government cannot default (since its promise to repay is in currency that the government can have printed). However, the term to maturity normally would lead to a higher interest rate than a shorter-term government bond.

The loan size is irrelevant here because the government pays the same interest regardless of the bond‘s denomination.

A $20 pawnshop loan will have a high rate of interest. There‘s good chance the good pawned will not be redeemed but, in this case, the pawnbroker is not really at risk.

The pawned article undoubtedly has a resale value greater than $20. The high interest rate in fact helps ensure that the good will not be redeemed—to the pawnbroker‘s benefit. The high interest rate also compensates for the small size of the loan.

Mortgages are generally large loans at a relatively low interest rate. The loan is for a very long term and the house is pledged as collateral. Under certain circumstances, the loan may qualify for a government-subsidized mortgage insurance program, which insures the lender against default. Additionally, the borrower may deduct the interest from his/her taxable income. These contrasting considerations result in a lower interest rate than most types of long-term loans.

A 24-month $12,000 bank loan to finance the purchase of an automobile will certainly have a higher interest rate than a government bond, but its risk is reduced by the fact that the automobile serves as collateral for the loan. However, the bank would rather get its money back than a used car, so the bank certainly does not consider the loan risk-free. The loan is of a relatively large size; this will tend to lower the interest rate. The outcome of these conflicting considerations is an interest rate lower than for a straight, unsecured, consumer loan but higher than for a loan to a well-established business.

A 60-day $100 loan from a personal finance company will have the highest rate of all, except possibly for the pawnshop loan. Though it is very short term, it is considered relatively high risk, because otherwise the borrower would have gotten the loan from a bank; and the loan size is very small, making the administrative costs high in 1-308 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

relation to the loan size. Also, the fact that it is a personal loan implies there is no collateral like a car or home to back it up.

4. Why is the supply of loanable funds slope upward? Why is the demand for loanable funds slope downward? Explain the equilibrium interest rate. List some factors that might cause it to change. LO18.3 Answer: The supply of loanable funds is upward sloping because savers will make more funds available at higher interest rates than lower interest.

The demand for loanable funds is downward sloping because there are few investment and R&D projects that yield a high rate of return and many more that will yield a lower rate of return.

The equilibrium interest rate is determined where the interest rate (cost of borrowing the funds) is equal to the expected rate of return (the expected benefit from borrowing the funds and engaging in the investment or R&D project).

The supply of loanable funds may change because of a change in households‘ attitudes about saving (tax policies, macroeconomic conditions) or changes in Bank of Canada policies relative to the money supply. The demand for loanable funds could change as a result a change in technology or a change in the demand for the final product. If there is either a change in supply of or demand for loanable funds, the interest rate will change.

5. Here is the deal: You can pay your college or university tuition at the beginning of the academic year or the same amount at the end of the academic year. You either already have the money in an interest‐bearing account or will have to borrow it. Which situation would you choose? Explain your financial reasoning. Relate your answer to the time value of money, present value, and future value. LO18.4 Answer: The answer is you pay at the end of the academic year in both cases. For demonstrative purposes consider the following values: Tuition is $10,000 and the interest rate over the academic year is 10% (not an annual rate). If you already have the $10000 and you put it in an interest bearing account you will have $11000 (=1.10×$10000) at the end of the academic year. You pay the $10000 in tuition and pocket $1000. If you paid at the $10000 tuition at the beginning of the year you would lose this $1000 (The future value of the $10000 is $11000).

On the other hand, if you had to borrow the $10000 to pay your tuition you would still pay at the end of the academic year. Using the values as above, you borrow the $10000 today and put in an interest bearing account, which give you $11000 at the end of the academic year. You pay your tuition of $10000, which leaves you $1000 additional dollars. If you paid at the beginning of the academic year you would once again lose this $1000. This implies you could reduce your remaining debt burden to $9000 (assuming a government financed interest free student loan) by using the $1000 in interest to pay down the principal on the original loan.

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6. What are the major economic functions of the interest rate? How might the fact that many businesses finance their investment activities internally affect the efficiency with which the interest rate performs its functions? LO18.5 Answer: There are two major economic functions of the interest rate: 1) Interest rates affect the level of domestic output as the monetary authorities deliberately vary them by changing the money supply. Low interest rates encourage investment, and this tends to expand the economy. High interest rates discourage investment and this tends to restrain inflation or contract the economy.

2) Interest rates allocate capital to its most productive uses. When interest rates are, say, at 10 percent, a project that expects to earn 8 percent after the payment of all costs will not be undertaken, because the cost of the borrowed money is greater than the return expected on it. This is true even if the firm is using its own money. Why make 8 percent on the project with the firm‘s money when lending it will earn 10 percent? On the other hand, all projects that are expected to return more than the interest rate will be undertaken. The interest rate thus allocates money capital to those investments that are most productive, that is, which have the highest rate of return.

To the extent that firms truly are profit maximizers, the internal financing of investment should make no difference to the investment decision. One invests if the expected rate of return is greater than the rate of interest; one does not if the rate of interest is greater. However, firms are probably somewhat less anxious about what happens to money that they do not have to pay back. In other words, the efficiency with which the interest rate performs its functions is probably lessened the more firms finance their investments internally.

7. Distinguish between nominal and real interest rates. Which is more relevant in making investment and R&D decisions? If the nominal interest rate is 12 percent and the inflation rate is 8 percent, what is the real rate of interest? LO18.5 Answer: The nominal interest rate is the interest rate stated in dollars of current value (unadjusted for inflation). The real interest rate is the nominal interest rate adjusted for inflation (or deflation). The real interest rate is more relevant for making investment decisions—it reflects the true cost of borrowing money. It is compared to the expected return on the investment in the decision process. Real interest rate = nominal interest rate – inflation rate. Real interest rate = 4 percent (= 12 percent - 8 percent).

8. How do the concepts of accounting profit and economic profit differ? Why is economic profit smaller than accounting profit? What are the three basic sources of economic profit? Classify each of the following according to those sources: LO18.6 1-310 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

a. A firm‘s profit from developing and patenting a new medication that greatly reduces cholesterol and thus diminishes the likelihood of heart disease and stroke b. A restaurant‘s profit that results from the construction of a new highway past its door c. The profit received by a firm due to an unanticipated change in consumer tastes Answer: Accounting profit is what remains of a firm‘s total revenues after it has paid for all the factors of production employed by the firm (its explicit costs) but not for the use of the resources owned by the business itself. Economists also take into consideration implicit costs—the payment the owners could have received by using the resources they own in some other way. The economist adds these implicit costs to the accountant‘s explicit costs to arrive at total cost. Subtracting the total cost from total revenue results in a smaller profit (the economic profit) than the accountant‘s profit.

Sources of economic profit: (1) creating popular new products; (2) reduce production costs below rivals' costs; and (3) create and maintain a profitable monopoly.

Profit from creating a popular new product, as well as monopoly profit from the patent.

Creating and maintaining a monopoly as a result of its locational advantage.

Profit from creating a popular 'new' product. Note here that the change in consumer preferences has made the good 'popular'. The term 'new' is relative, it may have been around for awhile, but people just did not want to buy it in the quantities they now do.

9. Why is the distinction between insurable and uninsurable risks significant for the theory of profit? Carefully evaluate the following statement: ―All economic profit can be traced to either uncertainty or the desire to avoid it.‖ What are the major functions of economic profit? LO18.6 Answer: An insurable risk does not fatally affect the profit and loss of a firm. The firm insures against fire and theft and so on and then goes about its business, secure in the knowledge that it cannot suffer an irreparable loss if one of the insured-against events occurs.

Economic profit (and serious loss) occurs when the firm takes uninsurable risks.

Such risks relate to uncontrollable and unpredictable changes in demand and supply conditions. An insurance company is most unlikely to insure against a serious recession occurring in the next year or so or against the price of oil skyrocketing—or, if one did, the premium the insurance company would demand would be greater than the profit a firm could expect to make by forecasting these events correctly. Thus, firms must risk that the demand for their products in the future will give them adequate revenue to cover their future costs that, too, they must take the risk of estimating. If the firms are successful, they have earned their economic profits.

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―All economic profits can be traced to either uncertainty or the desire to avoid it.‖ A considerable amount of economic profits can be traced to either uncertainty or the desire to avoid it, but not all. There is clearly uncertainty in trying to estimate future demand and supply conditions. A firm cannot be sure what it will get for its output, what the input will cost, and the consequent economic profit or loss. There is also much uncertainty with regard to innovation. Will it fly, literally, or figuratively in the sense of being able to convince people to buy the new or redesigned product? Or will all of the revenue needed to pay back the development costs be gained before freeloading copiers come on the market with their versions?

However, though monopoly economic profits may be the product of the same types of uncertainty just discussed, they are by no means entirely so. It is De Beers‘ tight control of the supply of diamonds that has ensured its continuing economic profits, not favorable changes in the public‘s demand for diamonds. The major functions of profits include providing an incentive for entrepreneurial initiative in combining resources to produce a good or service; for innovation in the form of new products or production processes; and for taking the risks which the entrepreneur bears by operating in a dynamic and uncertain environment. Profits also allocate resources among alternative lines of production. Entrepreneurs seek profits and shun losses, which means industries will expand as long as they experience economic profits and contract when they experience losses.

The LAST WORD Assume that you borrow $5000 and pay back the $5000 plus $250 in interest at the end of the year. Assuming no inflation, what is the real interest rate? What would the interest rate be if the $250 of interest had been discounted at the time the loan was made? What would the interest rate be if you were required to repay the loan in 12 equal monthly installments?

Answer: Simple interest in the first case is 5 percent.

$250 / $5000100

In the second case the amount received at the time of borrowing would be $4750, so the interest rate is slightly higher at 5.26% (($250/$4750) × 100).

If you repaid the loan in twelve monthly installments and the interest payments still were equal to $250, then you have repaid $5250 total, but you have repaid part of the principal each month. Therefore, you did not borrow the entire $5000 for the whole year. Without having the exact equation to solve this problem, you could estimate that you borrowed on average $2500 for the whole year, since you would have paid back about half by the sixth month and reduced the principal by about 1/12 for every month thereafter. This means that the $250 is about 10 percent of the average amount borrowed.

REVIEW QUESTIONS 1. When using a supply-and-demand model to illustrate how land rents are set, economists typically draw the supply curve as a vertical line because: LO18.1 1-312 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

a. b. c. d.

The supply of land is fixed.

The supply of land is perfectly inelastic.

The quantity supplied of land does not increase when rents go up.

All of the above.

Answer: d. All of the above.

The correct answer to this question is ―all of the above‖ because the three choices offered are all true: the supply of land is fixed; the supply of land is perfectly inelastic; and the quantity supplied of land does not increase when rents go up.

To begin with, the supply of land is indeed fixed. As the old joke goes: ―Invest in land; they ain‘t makin‘ more of it!‖ Next, land‘s fixed supply implies that the supply of land is perfectly inelastic, meaning that the quantity supplied of land completely insensitive to price changes. To see this, note that the fixed supply of land implies that changes in rent—the price of land—will not affect the quantity of land that is supplied. Whether rents are high or low, the amount of land will always be the same.

Finally, the fact that the supply of land is fixed also obviously implies that rents have no effect on how much is supplied. The total quantity of land is always the same no matter what rents are.

2. In the 1980s land prices in Japan surged upward in a ―speculative bubble.‖ Land prices then fell for 11 straight years between 1990 and 2001. What can we safely assume happened to land rent in Japan over those 11 years? Use graphical analysis to illustrate your answer. LO18.1 Answer: Given that the supply of land is perfectly inelastic, the drop in prices must have resulted from decreased demand for land. The demand for land would fall if there were less of a return on the land (i.e. rent), so we can safely assume that land rent fell in Japan between 1990 and 2001. The shifts from D1 to D2 to D3 in Figure 18.1 demonstrate graphically what happened in Japan.

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3. Angela puts $1,000 in a savings account that pays 3 percent per year. What is the future value of her money one year from now? LO18.4 a. $970. b. $1,000. c. $1,003. d. $1,030.

Answer: d. $1,030.

The future value one year from now of the $1,000 that Angela invests today at 3 percent interest is $1,030. That is because her present value of $1,000 will grow into $1,030 in one year‘s time if it is invested at 3 percent interest. This is true because 3 percent of $1,000 is $30. So next year Angela will have the amount she invested ($1,000) plus an additional $30 of interest, or $1,030 in total.

Note, however, that future values depend upon the time horizon and the interest rate.

For instance, while the one-year-from-now future value of Angela‘s money is $1,030 if it is invested at 3 percent, the two-years-from-now future value would be $1,060.90 if it is invested at 3 percent because that is how much money in total Angela would have in her savings account if she allowed her initial deposit of $1,000 to compound for two full years at 3 percent interest.

In a similar fashion, a higher interest rate would also change the future value. For instance, future value of $1,000 in one year is $1,030 if invested at 3 percent but $1,060 if invested at 6 percent. Thus, the relationship between present values and future values depends crucially on the interest rate.

4. As shown in Table 18.2, $1,000 invested at 10 percent compound interest will grow into $1,331 after three years. What is the present value of $2,662 in three years if it is discounted back to the present at a 10 percent compound interest rate? (Hint: $2,662 is twice as much as $1,331.) LO18.4 Answer: $2000.

The correct answer to this question is $2,000 because $2,000 invested at 10 percent compound interest will grow into $2,662 after three years.

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The easiest way to get the answer is to realize that twice as much invested today should yield twice as much in three years. Thus, with $1,000 today growing into $1,331 after three years, twice as much invested today should grow into twice as much in three years. Plugging in numbers, this logic implies that $2,000 invested today should become $2,662 in three years. It thus becomes clear that the present value of $2,662 in three years is exactly $2,000 today.

5. Entrepreneurs are the residual claimants at their respective firms. This means that they: LO18.6 a. Only get paid if there is any money left over after all the other factors of production have been paid. b. Must bear the financial risks of running their firms. c. Receive whatever accounting profits or losses their firms generate. d. All of the above.

Answer: d. All of the above.

These statements about entrepreneurs as residual claimants are all true. Consequently, ―all of the above‖ is the correct answer.

To understand why, recall that as residual claimants, entrepreneurs will only get paid if there is any money left over after paying all of the other factors of production. As an example, wages and salaries have to be paid first. So does the rent. And so do any loan repayments due to creditors.

Only if there is any money left over after paying everyone else to whom the firm owes money will the entrepreneurs receive anything. And sometimes, of course, firms lose money because payments to resource providers exceed revenues. In those cases, it is the entrepreneurs who lose money. As a result, it is also the entrepreneurs who ultimately bear the financial risks of running their firms.

PROBLEMS 1. Suppose that you own a 10‐hectare plot of land that you would like to rent out to wheat farmers. For them, bringing in a harvest involves $30 per hectare for seed, $80 per hectare for fertilizer, and $70 per hectare for equipment rentals and labour. With these inputs, the land will yield 40 bushels of wheat per hectare. If the price at which wheat can be sold is $5 per bushel and if farmers want to earn a normal profit of $10 per hectare, what is the most that any farmer would pay to rent your 10 hectares?

What if the price of wheat rose to $6 per bushel? LO18.1 Answers: At a wheat price of $5 per hectare, the revenue from the land would be $200 per hectare (= 40 bushels per hectare times $5 per bushel) or $2000 for all 10 hectares. The cost including a normal profit would be $190 per hectare (= $30 + $80 + $70 + $10) or $1,900 for all 10 hectares. Thus, the most anyone would pay to rent the land would be $10 per hectare (= $200 per hectare - $190 per hectare) or $100 for 1-315 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

all 10 hectares. At a wheat price of $6 per hectare, the revenue from the land would be $240 per hectare (= 40 bushels per hectare times $6 per bushel) or $2400 for all 10 hectares. Since the costs will remain unchanged at $190 per hectare, the most anyone would pay to rent the land would be $50 per hectare (= $240 per hectare - $190 per hectare) or $500 for all 10 hectares.

Feedback: To answer this question, we begin by calculating the revenue generated per hectare. A bushel of wheat sells for $5 and each hectare produces 40 bushels of wheat. Thus, revenue per hectare equals $200 (=$5 × 40). Since there are 10 hectares of land on the farm total revenue equals $2000 (=10 × $200).

The total cost per hectare equals $190 (=$30+$80+$70+$10), which is the sum of the seed cost, fertilizer cost, equipment rental, and normal profit respectively. Thus, the total cost for 10-hectare farm is $1900 (=10 × $190).

To find the most any farmer would pay to rent the 10-hectare farm (land) we subtract the total cost from total revenue. This equals $100 (=$2000 (revenue) - $1900 (cost)).

So, the most the farmer would be willing to pay to rent the land is $100 since anything more would result in a loss (negative economic profit). Finally, since there are 10 hectares of land, the most the farmer would be willing to pay per hectare in rent is $10 (=$100/10).

If the price of wheat increased to $6 a bushel then total revenue per hectare would equal $240 (=$6 × 40). Total revenue for the farm would equal $2400 (=10 × $240).

The total cost remains the same, $1900. This implies $500 remains for potential land payment (=$2400-$1900), which is the most any farmer would be willing to pay to rent the land. Again, since there are 10 hectares of land the most any farmer would pay per hectare is $50 (=$500/10).

2. Suppose that the demand for loanable funds for car loans in the Vancouver area is $10 million per month at an interest rate of 10 percent per year, $11 million at an interest rate of 9 percent per year, $12 million at an interest rate of 8 percent per year, and so on. If the supply of loanable funds is fixed at $15 million, what will be the equilibrium interest rate? LO18.3 Answers: The equilibrium interest rate is 5 percent per year.

Feedback: Interest rate Demand for Supply of on Loan Loanable Funds Loanable Funds 10% $10 million $15 million 9%

$11 million

$15 million

8%

$12 million

$15 million

7%

$13 million

$15 million

6%

$14 million

$15 million

5%

$15 million

$15 million

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4%

$16 million

$15 million

3%

$17 million

$15 million

2%

$18 million

$15 million

1%

$19 million

$15 million

The table above demonstrates that the demand for loanable funds increases by $1 million for every 1% reduction in the interest rate.

The equilibrium interest rate occurs where the demand for loanable funds equals the supply of loanable funds. This occurs at the interest rate of 5%.

3. ADVANCED ANALYSIS To fund its wars against Napoleon, the British government sold consol bonds. They were referred to as ―perpetuities‖ because they would pay £3 every year in perpetuity (forever). If a citizen could purchase a consol for £25, what would its annual interest rate be? What if the price were £50? £100?

Bonds are known as ―fixed income‖ securities because the future payments that they will make to investors are fixed by the bond agreement in advance. Do the interest rates of bonds and other investments that offer fixed future payments vary directly or inversely with their current prices? Explain. LO18.4 Answers: 12 percent; 6 percent; 3 percent; inversely.

Feedback: To calculate the price of a perpetuity we use the formula, price = (payment/interest rate), or to calculate the interest rate we use the formula, interest rate = (payment/price).

Given the following payments (example): If a citizen could purchase a consol for £25, what would its annual interest rate be? What if the price were £50? £100? Assume a payment of £3 every year in perpetuity (forever). consol for £25: interest rate = (£3/£25) = 0.12 (12%). consol for £50: interest rate = (£3/£50) = 0.06 (6%) consol for £100: interest rate = (£3/£100) = 0.03 (3%) The interest rates vary inversely with current prices (see formulas above).

4. Suppose that the interest rate is 4 percent. What is the future value of $100 four years from now? How much of the future value is total interest? By how much would total interest be greater at a 6 percent interest rate than at a 4 percent interest rate? LO18.4 Answers: $116.99; $16.99; $9.26 Feedback: Consider the following example. Assume that the interest rate is 4 percent. What is the future value of $100 four years from now? How much of the future value is total interest? By how much would total interest be greater at a 6 percent interest rate than at a 4 percent interest rate?

To calculate the future value of $100 four years from we compound the interest for the four years. The future value for each successive year is: Year 1: $100 × (1.04) = $104 (carry this amount forward to year two) 1-317 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Year 2: $104 × (1.04) = $108.16 (carry this amount forward to year three) Year 3: $108.16 × (1.04) = $112.49 (carry this amount forward to year four) Year 4: $112.49 × (1.04) = $116.99 (future value in four years) Note that this answer could also be found via substitution back to Year 1, which gives us the formula: Future value = initial amount × (1+interest rate)t, where t is the number of years of compounding.

For the values above we have Future value = $100 × (1.04)4 = $100 × 1.1699 = $116.99.

To calculate the future value of total interest, subtract the principal (the initial amount) from total future value. This is $16.99 (=$116.99 - $100).

To find out how much greater total interest would be at a 6 percent interest rate than at a 4 percent interest rate, first find the future value at the 6% interest rate. Using the formula above, future value = $100 × (1.06)4 = $100 × 1.2625 = $126.25.

Second, find the future value of total interest. This is $26.25 (=$126.25 - $100).

Finally, subtract the total interest at the 4% rate from the total interest at the 6% rate.

This equals $9.26 (= $26.25 - $16.99).

5. You are currently a worker earning $60,000 per year but are considering becoming an entrepreneur. You will not switch unless you can expect to earn an accounting profit that is on average at least as great as your current salary. You look into opening a small grocery store. Suppose that the store has annual costs of $150,000 for labour, $40,000 for rent, and $30,000 for equipment. There is a 50 percent probability that revenues will be $200,000 and a 50 percent probability that revenues will be $400,000. LO18.6 a. In the low‐revenue situation, what will your accounting profit or loss be? In the high‐revenue situation? b. On average, how much do you expect your revenue to be? Your accounting profit? Your economic profit? Will you quit your job and try your hand at being an entrepreneur? Explain. c. Suppose the government imposes a 25 percent tax on accounting profits. This tax is only levied if a firm is earning positive accounting profits. What will your aftertax accounting profit be in the low‐revenue case? In the high‐revenue case? What will your average after‐tax accounting profit be? What about your average after‐ tax economic profit? Will you now want to quit your job and try your hand at being an entrepreneur? d. Other things equal, does the imposition of the 25 percent profit tax increase or decrease the supply of entrepreneurship in the economy?

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Explicit costs are $220,000 (= $150,000 + $40,000 + $30,000). Thus accounting profits in the lower-revenue case are -$20,000 (= $200,000 - $220,000) while accounting profits in the higher-revenue case are $180,000 (= $400,000 - $220,000).

On average, revenues will be $300,000 per year (= 0.5×$400,000 + 0.5×$200,000).

Thus, on average, accounting profits will be $80,000 per year (= $300,000 in average revenue - $220,000 in explicit costs). This means that on average economic profits will be $20,000 per year (= $80,000 of average accounting profits - $60,000 opportunity costs of foregone wages). You WILL want to quit your job to become an entrepreneur.

In the low-revenue case, the after-tax accounting profit will be the same since the firm is making a loss of - $20,000 and the tax is only applied if the firm is making a profit. In the high-revenue case, the after-tax accounting profit will be $135,000 (= 0.75× $180,000).

Given those numbers, the average after-tax accounting profit will be $57,500 (= 0.5×[-$20,000] + 0.5×$135,000). The average after-tax economic profit will be $2,500 (= $57,500 in average after-tax accounting profit - $60,000 in foregone wages). You will NOT want to quit your job and become an entrepreneur.

The profit tax decreases the supply of entrepreneurship in the economy.

Feedback: Part a: The accounting profit in each scenario equals revenue minus explicit costs.

The explicit costs in both cases (independent of state) equal $220,000 (= $150,000 (labour) + $40,000 (rent) + $30,000 (equipment)).

Scenario 1 (low revenue case, Revenue equals $200,000): Here the accounting profit is -$20,000 (= $200,000 - $220,000).

Scenario 2 (high revenue case, Revenue equals $400,000): Here the accounting profit is $180,000 (= $400,000 - $220,000).

Part b: The average revenue will be a weighted average of the two cases above, where the weights are the probabilities of each case. Here we assume that each case, or scenario, is equally likely (probability of 0.5 for each).

Average revenue equals $300,000 (= 0.5×$200,000 + 0.5×$400,000).

Average profit will equal $80,000 (= $300,000 (average revenue) - $220,000 (explicit cost)). Note that the explicit cost is the same in both scenarios.

You will quit your job because the average profit of $80,000 exceeds your current income of $60,000. (NOTE, we ignore risk here.)

Part c: If the government were to impose a 25% tax on all accounting profits this would only affect scenario 2. The government does not subsidize losses.

Scenario 1 (low revenue case, Revenue equals $200,000): Here the accounting profit is -$20,000 (= $200,000 - $220,000).

Scenario 2 (high revenue case, Revenue equals $400,000): Here the accounting profit is $180,000 (= $400,000 - $220,000). With the 25% tax the net revenue equals $135,000 (= 0.75×$180,000). This is the percentage of the accounting profit the firm receives after paying taxes.

Here, we calculate the firm's average profit by taking a weighted average of the 'aftertax' profits for the two scenarios. Average after-tax profits equal $57,500 (= 0.5×($20,000) + 0.5×$135,000).

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You will not quit your job because the average profit of $57,500 is less than your current income of $60,000. (NOTE, we ignore risk here.)

Part d: Yes, the reduction in after-tax profits induces some individuals not to undertake investments or decisions that are pre-tax profitable.

Chapter18B - Income Inequality, Poverty, and Discrimination McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Use quintiles to briefly summarize the degree of income inequality in Canada. What criticisms have been made of standard data on income inequality? How and to what extent does government contribute to income equality? LO18B.1 Answer: The income share received by the highest 20 percent was 44.2 percent in 2011, which is almost ten times the 4.8 percent received by the lowest 20 percent.

The middle three quintiles receive under 50 percent of the total before-tax income.

The top two quintiles receive twice as much as the bottom three quintiles combined.

2. Assume Al, Beth, Carol, David, and Ed receive incomes of $500, $250, $125, $75, and $50 respectively. Construct and interpret a Lorenz curve for this five-person economy. What percentage of total income is received by the richest and by the poorest quintiles? LO18B.1 Answer: See the figure below.

In this simple economy each person represents a complete income quintile—20 percent of the total population. The richest quintile (Al) receives 50 percent of total income; the poorest quintile (Ed) receives 5 percent.

This follows from the calculations below.

Total Income equals $1000 (= $500 + $250 + $125 + $75 + $50).

The lowest quintile (Ed) is 5% of total income (=$50/$1000) 1-320 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

The second quintile (David) is7.5% of total income (=$75/$1000) The third quintile (Carol) is 12.5% of total income (=$125/$1000) The fourth quintile (Beth) is 25% of total income (=$250/$1000) The upper quintile (Al) is 50% of total income (=$500/$1000) 3. How does the Gini ratio relate to the Lorenz curve? Why can‘t the Gini ratio exceed 1? What is implied about the direction of income inequality if the Gini ratio declines from 0.42 to 0.35? How would one show that change of inequality in the Lorenz diagram? LO18B.1 Answer: The Gini ratio is the numerical measurement of the inequality depicted by the Lorenz curve. It is calculated by dividing the area between the curve and the diagonal by the total area below the diagonal.

The Gini ratio can‘t exceed 1 because if the Lorenz curve is as far as possible from the diagonal (line of equality), the area between the curve and the diagonal will equal the total area below the diagonal. The equality will result in a Gini ratio of 1.

A decline in the Gini ratio implies less income inequality; and it would be graphically depicted by moving the Lorenz curve closer to the diagonal.

4. Why is the lifetime distribution of income more equal than the distribution in any given year? LO18B.1 Answer: The disparity of incomes in a single year reflects the income distribution at a point in time. Of course, the very young and very old will receive lower incomes, and the middle-aged tend to receive higher incomes, giving a picture of great inequality. However, if we view these same groups over time, there is considerable mobility both up and down the income scale, suggesting that income is more equally distributed over a five-, ten-, or twenty-year period for these same households.

5. Briefly discuss the major causes of income inequality. With respect to income inequality, is there any difference between inheriting property and inheriting a high IQ? Explain. LO18B.2 Answer: The reasons for income inequality are: differences in abilities and talents among individuals, differences in the amount of education and training an individual obtains, labour market discrimination, differences in tastes and preferences toward work and job attributes, inequality in the distribution of wealth, the ability to use market power to transfer income to oneself, luck, connections, and misfortune.

A high IQ normally does not lead to high income unless it is combined with personal initiative and favourable social circumstances. Inherited property—as long as it is competently managed—provides income irrespective of one‘s character and personal attributes. Both factors are largely a matter of luck to the recipient.

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6. Should a nation‘s income be distributed to its members according to their contributions to the production of that total income or to members‘ needs? Should society attempt to equalize income or economic opportunities? Are the issues of ―equity‖ and ―equality‖ in the distribution of income synonymous? To what degree, if any, is income inequality equitable? LO18B.3 Answer: The answer to this question is inextricably tied to value judgments, but most of us probably favour a combination of the two types of income distribution. A purely capitalist system, in which incomes are determined exclusively by the market mechanism, would mean that those who, for whatever reason, are unable to contribute to production would have to depend exclusively on private charity for their livelihood. A (hypothetical) communist state also leads to a seemingly intractable problem: If income is to be distributed purely on the basis of need, why would anyone engage in production? Most modern societies represent attempts to seek a compromise of one sort or another between these two extremes. The compromise that is actually found often differs markedly from what prevailing political rhetoric in that society might suggest. Socialist economies historically exhibited large differences in income, and wide-ranging government transfer programs are a seemingly permanent fixture in most capitalist economies.

Conservatives contend that because of the trade-off between equality and efficiency, society should content itself with attempting to ensure equality of opportunity.

Liberals argue that income redistribution is essential since equality of economic opportunity is impossible in an economy with wide differences in income, especially when these differences are related to the inheritance of property.

Income equity refers to how fairly income is distributed. One can argue that some inequality of income is not only necessary for reasons of efficiency but is fairer than an equal distribution of income, since those who produce more deserve to be rewarded for their efforts. But unequal incomes are not necessarily related to differences in individual ability or effort. It is difficult to defend the inequalities that result from market power and discrimination as being equitable. The justness of inherited wealth is also questionable. Liberals argue that because it creates inequality of opportunity, property inheritance is inherently unjust. Conservatives contend that allowing individuals to pass on wealth to whom they wish is much fairer than having wealth appropriated by the government.

7. Do you agree or disagree with the following statement? Explain your reasoning. ―There need be no trade-off between equality and efficiency. An ‗efficient‘ economy which yields an income distribution which many regard as unfair may cause those with meagre income rewards to become discouraged and stop trying. Hence, efficiency is undermined. A fairer distribution of rewards may generate a higher average productive effort on the part of the population, thereby enhancing efficiency.

If people think they are playing a fair economic game and this belief causes them to

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try harder, an economy with an equitable income distribution may be efficient as well.‖ LO18B.3 Answer: It is hard to imagine that the disincentive effects on both high- and low-income earners of income redistribution will be swamped by an increased interest on the part of some of the poor in ―playing the economic game.‖ Without the prospect of higher incomes, few individuals in an economy—including the poor— would choose to increase their productivity. What would increase individual effort and hence aggregate efficiency is the perception that opportunities for all are equal in every respect. In other words, it is not so much an unequal distribution of income that causes some members of society to become discouraged and stop participating in the market, but rather the wide-ranging perception that the deck is stacked against them.

Many feel they can never earn incomes commensurate with their abilities and efforts because of a lack of financial resources, restricted access to education, or barriers in the workplace.

8. Comment on or explain the following: LO18B.4 a. ―To endow everyone with equal income will make for very unequal enjoyment and satisfaction.‖ b. ―Equality is a ‗superior good‘; the richer we become, the more of it we can afford.‖ c. ―The mob goes in search of bread, and the means it employs is generally to wreck the bakeries.‖ d. ―Some freedoms may be more important in the long run than freedom from want on the part of every individual.‖ e. ―Capitalism and democracy are really a most improbable mixture. Maybe that is why they need each other—to put some rationality into equality and some humanity into efficiency.‖ f. ―The incentives created by the attempt to bring about a more equal distribution of income are in conflict with the incentives needed to generate increased income.‖ Answer: No distribution of income can ensure equal enjoyment. It can be argued that by equating incomes in a society we maximize the probability of maximizing total utility for all individuals.

The lessening of poverty provides a host of indirect benefits to affluent members of society—social peace, physical security, and perhaps the intangible satisfaction of living in a more equitable society. The better off the affluent become, the more they are willing to spend in order to purchase these benefits.

Mobs commonly exhibit a marked preference for present over future consumption.

Many conservatives contend that the income redistribution schemes resulting from democratic decision-making suffer from a similar failing in that they decrease the incentive to accumulate capital in order to provide present consumption to the poor. Is 1-323 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

this view valid? Perhaps. Does this mean that such redistribution schemes are misguided? Not necessarily.

This is a common conservative view, that civil and political liberties are more important than the universal eradication of poverty. Liberals are likely to contend that ensuring universal freedom from want does not necessarily detract from these fundamental freedoms.

The principles underlying the two systems can be summarized as follows: Each dollar has a vote in the marketplace, and each person has a vote at the ballot box. These principles are similar enough that the presence of one often leads to the other. They are dissimilar enough that the type of society that arises from a combination of the two represents a workable social compromise.

Incentives created in the attempt to bring about more equal distribution of income may cause a trade-off in decreased economic efficiency. Higher marginal taxes may reduce the efforts of those at the top to work harder and produce more. Greater benefits to those at the bottom may reduce their incentive to do the same as they receive benefits without the productive effort. Insofar as this trade-off occurs, there will be a reduction in economic growth and, therefore, damage to incentives leading to increased incomes.

9. Statistical discrimination implies that discrimination can persist indefinitely, while the taste-for-discrimination model suggests that competition might reduce discrimination in the long run. Explain the difference. LO18B.6 Answer: Statistical discrimination occurs when people are judged on the basis of the average characteristics of the group to which they belong. Insurance companies base auto insurance premiums on the statistical information available, and the consequent discrimination will continue as long as there is a difference in accident rates by gender in this age group.

The taste-for-discrimination model suggests that competition will reduce discrimination in the long run. Firms that do not discriminate will have lower actual wage costs per unit of output and lower average total costs than will the firms that discriminate. These lower costs will allow non-discriminating firms to charge lower prices. This should eventually drive the discriminating firms out of the market.

10. Use a demand and supply model to explain the impact of occupational segregation or ―crowding‖ on the relative wage rates and earnings of men and women. Who gains and who loses from the elimination of occupational segregation? Is there a net gain or net loss to society? Explain. LO18B.6 Answer: See Figure 18B-4 below. Discrimination against women in two of the three occupations will crowd women into the third occupation. Labour supply in the ―men‘s occupations‖ (X and Y) decreases, making them high-wage occupations.

Labour supply in the ―women‘s occupation‖ (Z) increases creating a low-wage occupation.

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Eliminating occupational segregation would entice women into the high-wage occupations, increasing labour supply there and reducing it in the low-wage occupation. The wage rates in the three occupations would converge to B. Women would gain, men would lose. Society would gain because the increase in output in the expanding occupations would exceed the loss of output in the contracting occupation. .

The Last Word How do poor people describe ―well-being‖ and ―ill-being‖?

Answer: Well-being was described by the following: happiness, harmony, peace, freedom from anxiety, and peace of mind. ―Ill-being‖ was described as lack of material things, as bad experiences, and as bad feelings about oneself.

REVIEW QUESTIONS 1. Suppose that Canada has a Gini ratio of 0.41 while Sweden has a Gini ratio of 0.31.

Which country has a more equal distribution of income? LO18B.1 a. Canada. b. Sweden. c. They are actually equal.

Answer: b. Sweden The higher the Gini ratio the more unequal a country‘s income distribution is. Thus, Sweden‘s lower ratio implies that is has less inequality of incomes—which is the same thing as saying that is has more equality of incomes.

2. Some part of income inequality is likely to be the result of discrimination. But other factors responsible for inequality include (select as many as apply): LO18B.2 a. Differences in abilities and talents. b. Differences in education and training. c. Different preferences for work versus leisure.

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d. Different preferences for low-paying but safe jobs relative to high-paying but dangerous jobs.

Answer: a, b, c, and d are all correct.

3. Suppose that a society contains only two members, a lawyer named Monique and a handyman named James. Five years ago, Monique made $100,000 while James made $50,000. This year, Monique will make $300,000 while James will make $100,000.

Which of the following statements about this society‘s income distribution are true?

LO18B.3 Select one or more answers from the choices shown. a. In absolute dollar amounts, the entire distribution of income has been moving upward. b. In absolute dollar amounts, the entire distribution of income has been stagnant. c. The relative distribution of income has become more equal. d. The relative distribution of income has become less equal. e. The relative distribution of income has remained constant. f. The rich are getting richer while the poor are getting poorer. g. The rich are getting richer faster than the poor are getting richer.

Answer: a. In absolute dollar amounts, the entire distribution of income has been moving upward. d. The relative distribution of income has become less equal. g. The rich are getting richer faster than the poor are getting richer.

The following three statements about this society‘s income distribution are true. In absolute dollar amounts, the entire distribution of income has been moving upward.

We know this to be true because each person in this society has seen his or her income rise over the past five years.

The relative distribution of income has become less equal. This is true because Monique‘s share of total income has been rising. Five years ago, Monique‘s $100,000 of income represented 2/3 of the society‘s total income of $150,000 (= Monique‘s $100,000 + James‘ $50,000). But this year, Monique‘s $300,000 of income will represent ¾ of the society‘s total income of $400,000 (= Monique‘s $300,000 + James‘ $100,000). Thus, income inequality has risen because the share of income earned by the richest member of this society has increased.

The rich are getting richer faster than the poor are getting richer. This is true because while James and Monique have both gotten richer, Monique‘s increase in income is larger than James‘ increase in income. In particular, Monique‘s income has tripled from $100,000 to $300,000 while James‘ income has only doubled from $50,000 to $100,000. So the rich are getting richer faster than the poor are getting richer.

4. Suppose that the last dollar that Victoria receives as income brings her a marginal utility of 10 utils while the last dollar that Fredrick receives as income brings him a 1-326 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

marginal utility of 15 utils. If our goal is to maximize the combined total utility of Victoria and Fredrick, we should: LO18B.4 a. Redistribute income from Victoria to Fredrick. b. Redistribute income from Fredrick to Victoria. c. Not engage in any redistribution because the current situation already maximizes total utility. d. None of the above.

Answer: a. Redistribute income from Victoria to Fredrick.

If our goal is to maximize the combined total utility of Victoria and Fredrick, we should redistribute income from Victoria to Fredrick.

This is true because the marginal utility of 15 that Fredrick receives from the last dollar of his income is higher than the marginal utility of 10 that Victoria receives from the last dollar of her income. So, if we took one dollar away from Victoria and redistributed it to Fredrick, the combined total utility of Victoria and Fredrick would rise because while Victoria‘s total utility would fall by 10 utils when we took that dollar away from her, Fredrick‘s total utility would rise by 15 utils when he was given that dollar. Thus, there would be a net increase of 5 utils (= 15 utils gained by Fredrick minus 10 utils lost by Victoria).

In a similar fashion, if our only goal is to maximize their combined total utility, then we should continue to take dollars away from Victoria and give them to Fredrick just as long as Fredrick‘s marginal utility remains greater than Victoria‘s marginal utility.

5. If women are crowded into elementary education and away from fire fighting, wages in fire fighting will tend to be than if women weren‘t crowded into elementary education. LO18B6 a. Higher. b. Lower.

Answer: a. Higher.

Crowding women into elementary education and away from fire fighting will raise wages in fire fighting because the supply of labour flowing to fire fighting will be reduced relative to what it would have been if women were not crowded away from fire fighting and more women were attempting to become fire fighters.

6. In the taste-for-discrimination model, an increase in employer prejudice against visible minorities workers would cause the discrimination coefficient to ________ and the demand curve for visible minorities labour to shift ________. LO18B.6 a. Decrease; right. b. Decrease; left. c. Increase; right. d. Increase; left.

Answer: d. Increase; left.

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In the taste-for-discrimination model, an increase in employer prejudice against Visible minority workers would cause the discrimination coefficient to increase and the demand curve for Visible minority labour to shift left.

The discrimination coefficient increases because it puts a dollar amount on the disutility felt by racist employers when confronted with the possibility of hiring Visible minority workers rather than white workers. Increased employer prejudice translates into higher disutility and therefore a higher discrimination coefficient.

The demand curve for Visible minority labour shifts left when employer prejudice increases because racist employers will be less willing to higher Visible minority workers relative to white workers. With a higher discrimination coefficient, only those Visible minority workers whose productivity is high enough to compensate for the increased disutility felt by racist employers will still be demanded by those racist employers. Those Visible minority workers with lower productivity will no longer be demanded. Thus, the total demand for Visible minority labour will fall.

PROBLEMS 1. In 2019, Forbes magazine listed Jeff Bezos, the founder of Amazon, as the richest person in the United States. His personal wealth was estimated to be $131 billion.

Given that there were about 328 million people living in the United States that year, how much could each person have received if Bezos‘ wealth had been divided equally among the population of the United States? (Hint: A billion is a 1 followed by nine zeros while a million is a 1 followed by six zeros.) LO18B.1 Answer: $399.39 Feedback: Simply divide Jeff Bezos‘ wealth, $131 billion, by the number of people in the United States, 328 million. The answer is $399.39 (= $131,000,000,000/328,000,000).

2. Imagine an economy with only two people. Larry earns $20,000 per year while Roger earns $80,000 per year. As shown in the following figure, the Lorenz curve for this two‐person economy consists of two line segments. The first runs from the origin to point a while the second runs from point a to point b. LO18B.1

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a. Calculate the Gini ratio for this two‐person economy using the geometric formulas for the area of a triangle (= ½ × base × height) and the area of a rectangle (= base × height). Hint: The area under the line segment from point a to point b can be thought of as the sum of the area of a particular triangle and the area of a particular rectangle. b. What would the Gini ratio be if the government taxed $20,000 away from Roger and gave it to Larry? (Hint: The figure will change.) c. Start again with Larry earning $20,000 per year and Roger earning $80,000 per year. What would the Gini ratio be if both their incomes doubled? How much has the Gini ratio changed from before the doubling in incomes to after the doubling in incomes?

Answers: a. The Gini ratio is 0.300. b. The Gini ratio here is 0.100. c. The Gini ratio will remain as it was in part (a) at 0.300; the ratio has not changed.

Feedback: Part a: First, we find the area under the equality line. Using our formula for the area of a right triangle we have an area of 5,000 (= (1/2) × 100 (base or x-axis) × 100 (height or y-axis).

Second, we find the area between the two curves. To do this we start by finding the area UNDER the Lorenz curve (we have easy to use formulas for triangles and rectangles). See the graph below:

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The area of triangle A is 500 (= (1/2) × 50 (base) × 20 (height)).

The base of the triangle is 50 (at 50%) because there are only two people in the economy. The height of the triangle is 20 (at 20%) because the lowest income is $20,000, which is 20% of the total income earned in society (= ($20,000 / $100,000) × 100).

The area of rectangle B is 1,000 (= 50 (base) × 20 (height)).

The area of triangle C is 2,000 (= (1/2) × 50 (base) × 80 (height).

The total area under the Lorenz Curve is 3,500 (= 500(area of triangle A) + 1,000 (area of rectangle B) + 2,000(area of triangle C) . We can now find the area between the two curves, which is 1,500 (= 5,000 (the area under the equality curve) – 3,500 (the area under the Lorenz curve)).

The final step of this procedure is to take the ratio of the area between the two curves and the area under the equality curve, which gives us the Gini ratio. The Gini ratio for this example is 0.3 (=1,500/5,000).

Part b: After the tax and redistribution program Larry's new income is $40,000 and Roger's new income is $60,000. This implies that Larry (50% of the population) now controls 40% of society's income rather than the 20% before the program.

To calculate the new Gini ratio, we use the same procedure as above. However, we use 40% rather than the 20% shown in the diagram.

With this new value we have: The area of triangle A is 1,000 (= (1/2) × 50 (base) × 40 (height)).

The area of rectangle B is 2,000 (= 50 (base) × 40 (height)).

The area of triangle C is 1,500 (= (1/2) × 50 (base) × 60 (height).

The total area under the Lorenz Curve is 4,500. We can now find the area between the two curves, which is 500 (= 5,000 (the area under the equality curve, note this does not change) – 4,500 (the area under the Lorenz curve)).

The Gini ratio for this income distribution is 0.1 (= 500 / 5,000).

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If incomes double, Larry earns $40,000 and Roger earns $160,000. The total income in society is now $200,000. Larry still only controls 20% of the society's income ((=$40,000/$200,000) × 100). Since the doubling of incomes does not change the percentage of income controlled by Larry (or Roger) the Gini ratio will not change.

The answer will be the same as in part a.

3. The desire to maximize profits can work against racial and other types of discrimination. To see why, consider two equally productive accountants named Ted and Jared. Ted is black, and Jared is white. Both can complete 10 audits per month.

LO18B.6 a. Suppose that for any accounting firm that hires either Ted or Jared, all the other costs of performing an audit (besides paying either Ted or Jared) come to $1,000 per audit. If the going rate that must be paid to hire an accountant is $7,000 per month, how much will it cost an accounting firm to produce one audit if it hires either Ted or Jared to do the work? b. If the market price that accounting firms charge their clients for an audit is $1,800, what would the accounting profit per audit be for a firm that hired either Ted or Jared? What is the profit rate as a percentage? c. Suppose that firm A dislikes hiring black accountants while firm B is happy to hire them. So, Ted ends up working at firm B rather than firm A. If Ted works 11 months per year, how many audits will he complete for firm B each year? How much in accounting profits will firm B earn each year from those audits? d. Since firm A passed on hiring Ted because he was black, firm A is forgoing the profits it could have earned if it had hired Ted. If the firm is willing to forgo up to $5,000 per year in profit to avoid hiring blacks, by how many dollars will firm A regret its decision not to hire Ted? Answers: a. The cost of producing one audit will be $1,700. b. The accounting profit per audit would be $100 per audit. The rate of profit per audit is approximately 5.9 percent. c. Ted will complete 110 audits each year. Firm B will earn $11,000 in profit each year from Ted‘s work. d. Firm A will regret its decision not to hire Ted by $6,000.

Feedback: The cost of producing one audit is $1,700. Each audit has a cost of $1,000 and the cost of employing one accountant is $7,000. However, this accountant can complete 10 audits per month, which implies an additional cost per audit of $700. Thus, the total cost of one audit is $1,000 + $700 = $1,700. This cost applies to Ted or Jared.

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Since the cost per audit is $1,700 (from part a) and the price the firm charges per audit is $1,800, the profit per audit is $100 (= $1,800 – $1,700). The profit rate is approximately 5.88% [= $100 (profit per audit) / $1,700 (cost per audit)]. Ted will complete 110 audits working 11 months per year [= 10 (audits per month) × 11 (months)].

Firm B will earn $11,000 a year in accounting profits by hiring Ted [= 110 (audits per year) × $100 (profit per audit, part b)].

Firm A will regret its decision not to hire Ted by $6,000 [= $11,000 (accounting profit) – $5,000 (discrimination amount)].

Chapter 19 - International Trade McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Distinguish among land-, labour-, and capital-intensive goods, citing an example of each without resorting to the textbook examples.? How do distinctive products, unrelated to resource intensity, relate to international trade? LO19.1 Answer: Land-intensive commodities require a relatively large amount of land to produce. Land-intensive commodities include agricultural products such as corn and wheat. Labour-intensive commodities require a relatively large amount of labour to produce. Labour-intensive commodities require much skilled labour in production, such as transistor radios and clothing. Capital-intensive products are produced with a large amount of capital equipment and include manufactured items such as aircraft and automobiles.

These distinctions are important because if a nation has an abundant supply of particular type of resources, it can produce items that are intensive in these resources with a comparative cost advantage. On the other hand, if it has a relative scarcity of certain resources, such as land, then it will be relatively expensive to produce landintensive products such as corn and wheat. The difference in relative resource abundance among nations leads to a difference in comparative costs of production, which is the basis for international trade and specialization.

Distinctive products, those associated with a particular country (perhaps because of a reputation for quality) can provide an export niche for a country. Even though the country may have no cost advantage in producing the good, the ―label‖ on the good is enough to attract buyers willing to pay more than for potentially comparable substitutes.

2. Explain: ―Canada can make certain toys with greater productive efficiency than can China. Yet we import those toys from China.‖ Relate your answer to the ideas of Adam Smith and David Ricardo. LO19.1 Answer: A country is said to have an absolute advantage over other producers of a product if it is the most efficient producer of that product (by which we mean that it can produce more output of that product from any given amount of resource inputs than can any other producer.) A country is said to have a comparative advantage over 1-332 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

other producers of a product if it can produce the product at a lower opportunity cost (by which we mean that it must forego less output of alternative products when allocating productive resources to producing the product in question).

In the case of toys Canada may have an absolute advantage in producing toys relative to China (can produce toys at a lower cost), but will still import the toys from China because China has a comparative advantage in producing toys (lower opportunity cost). In other words, the U.S. can produce toys at a lower cost per unit, but China has to sacrifice less other goods to make the toys. Thus, China should make the toys and Canada should import the toys and produce other goods.

In 1776, Adam Smith used the concept of absolute advantage to argue for international specialization and trade. His point was that nations would be better off if they each specialized in the production of those products in which they had an absolute advantage and were therefore the most efficient producers.

In the early 1800s David Ricardo extended, and modified, Smith‘s idea by demonstrating that it is advantageous for a country to specialize and trade even if it is more productive in all economic activities than some trading partner. A nation does not need Smith‘s absolute advantage—total superiority in producing some good—to benefit from specialization and trade. It needs only a comparative advantage.

In summary, it is the relative cost of producing the good not the absolute cost that drives trade.

3. Suppose Big Country can produce 80 units of X by using all its resources to produce X or 60 units of Y by devoting all its resources to Y. Comparable figures for Small Nation are 60 units of X and 60 units of Y. Assuming constant costs, in which product should each nation specialize? Explain why. What are the limits of the terms of trade between these two countries? How would rising costs (rather than constant costs) impact the extent of specialization and trade between these two countries?

LO19.1 Answer: To answer this question we find the opportunity cost of the two goods.

The opportunity cost of good Y (in terms of good X) in Big Country is 3/4 (=60/80) units of Y for each unit of X. That is, Big Country needs to give up 3/4 units of Y to produce 1 more unit of X. Note, this is the slope to Big Country's Production Possibilities Curve with Y on the vertical axis.

The opportunity cost of good Y (in terms of good X) in Small Nation is 1 (=60/60) unit of Y for each unit of X. That is, Small Nation needs to give up 1 units of Y to produce 1 more unit of X. Note, this is the slope to Small Nation's Production Possibilities Curve with Y on the vertical axis.

Given these opportunity costs Big Country should produce good X (only needs to give up 3/4 units of Y for 1 X) and Small Nation should produce good Y (needs to give up 1 unit of × for 1-unit Y). That is, Big Country has a comparative advantage in producing good X because they have to give up less Y to produce X per unit.

The limits of the terms of trade depend on the opportunity costs. For example, Big Country will never pay more than 4/3 a unit of good X for unit of good Y. Big country, can always produce a unit of Y itself by giving up 4/3 a unit of good X. 1-333 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Small Nation will never accept less 1 unit of good X for a unit of good Y because they can always produce a unit of X for good Y. The terms of trade will be between 1 unit of good X for a unit of good Y and 4/3 a unit of X for a unit of good Y. 4. What is an export demand curve? What is an import supply curve? How do such curves relate to the determination of the equilibrium world price of a tradable good?

LO19.2 Answer: The export demand curve for a particular country is the difference between quantity supplied and quantity demanded in the domestic market for a price above the domestic equilibrium price (the price that would occur in the market if trade were not possible.

The import demand schedule works in the other direction, it is the difference between quantity supplied and quantity demanded in the domestic market for a price below the domestic equilibrium price (the price that would occur in the market if trade were not possible). Here the negative values (quantity supplied minus quantity demanded) are translated into positive values (absolute value) graphically.

The intersection of the world supply and demand schedules determines the equilibrium world price for a tradable good.

5. Why is a quota more detrimental to an economy than a tariff that results in the same level of imports as the quota? What is the net outcome of either tariffs or quota for the world economy? LO19.3 Answer: The reason why a quota is more detrimental to an economy than a tariff that results in the same level of imports (as the quota) is that the government loses revenue. Under the tariff the government collects tax revenue and under a quota this tax revenue is lost. Tariffs and quotas impose costs on domestic consumers but provide gains to domestic producers and, in the case of tariffs, revenue to the Federal government. The consumer costs of trade restrictions are calculated by determining the effect the restrictions have on consumer prices. Protection raises the price of a product in three ways: (1) The price of the imported product goes up; (2) the higher price of imports causes some consumers to shift their purchases to higher-priced domestically produced goods; (3) the prices of domestically produced goods rise because import competition has declined.

Study after study finds that the costs to consumers substantially exceed the gains to producers and government. A sizable net cost or efficiency loss to society arises from trade protection. Conclusion: The gains that trade barriers create for protected industries and their workers come at the expense of much greater losses for the entire economy. The result is economic inefficiency, reduced consumption, and lowers standards of living. Extending this to the world economy is straightforward. If all domestic economies lose because of trade barriers the world loses (efficiency) as well.

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6. ―The potentially valid arguments for tariff protection—military self-sufficiency, infant industry protection, and diversification for stability—are also the most easily abused.‖ Why are these arguments susceptible to abuse? LO19.3 Answer: Each of these valid arguments is often misapplied. Dumping cases by foreign firms in Canada are difficult to prove and rare. Often domestic producers will claim their foreign competitors are dumping when the lower prices simply reflect a comparative advantage in foreign production. If this is true, the use of antidumping duties reduces the benefits of trade.

The protection of new ―infant‖ domestic industries to allow them to develop efficient production techniques is questionable in an advanced economy such as Canada.

There is a tendency for trade barriers to remain in place even after the industry becomes established.

The argument relating to military self-sufficiency is questionable when applied to sectors other than those directly related to defense. Almost all industries can claim to play a role in a wartime economy. As a rule, direct government subsidies are a more equitable means of protecting military security than trade protection, since taxpayers as a whole, rather than just consumers of protected industries will shoulder the burden. Direct subsidies also make the costs of these programs obvious rather than hiding them in the form of higher import prices.

7. Evaluate the effectiveness of artificial trade barriers, such as tariffs and import quotas, as a way to achieve and maintain full employment throughout the Canadian economy.

How might such policies reduce unemployment in one Canadian industry but increase it in another Canadian industry? LO19.3 Answer: Artificial trade barriers may protect jobs in Canada that need to compete with the foreign sector. This would tend to move the Canadian economy towards fullemployment. However, it is likely that foreign countries would impose, or implement, non-tariff barriers on Canadian goods. This response would reduce Canadian exports and cost Canadian jobs in the exporting sector of the economy. This would tend to move the Canadian economy away from full-employment. In effect, the artificial trade barriers will likely reduce unemployment in one industry (import sector) and increase unemployment in another industry (export sector).

8. In 2020, manufacturing workers in Canada earned an average wage that was about six times more than that earned by manufacturing workers in Mexico. (a) How can Canadian manufacturers possibly compete? (b) Why isn‘t all manufacturing done in Mexico and other low-wage countries? LO19.3 Answer: Canada can compete if the workers are more productive. That is, if the productivity level for workers in Canada is higher. If this is the case, then some manufacturing will take place in Canada (with productivity adjusted wages equalized). The other reason that all manufacturing doesn‘t take place in the low wage countries may be due to trade barriers.

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9. How might protective tariffs reduce both the imports and the exports of the nation that levies tariffs? In what way do foreign firms that ―dump‖ their products onto the Canadian market in effect provide bargains to Canadian consumers? How might the import competition lead to quality improvements and cost reductions by Canadian firms? LO19.3 Answer: If a country imposes import tariffs other countries may follow with their own import tariffs. These foreign import tariffs will reduce the exports of the nation that originally imposed the import tariffs.

If foreign firms dump their products on the Canadian market they are in effect selling them for below cost. This provided the consumers in Canada a bargain because they can purchase the goods at below cost price. The fact that foreign firms will be losing 'money' by dumping makes it difficult to sustain this practice for long periods of time.

If domestic firms need to compete with imports this may lead to quality improvements in domestic goods to differentiate themselves from the imports and may result in cost reductions in Canada as firms, try to compete on the cost side of the ledger (allows the firm to lower price).

The LAST WORD What was the central point that Bastiat was trying to make in his imaginary petition of the candle makers?

Answer: Bastiat‘s objective was to discredit the arguments in favor of protectionism by carrying the arguments to logical but absurd conclusions. Bastiat was demonstrating that there are numerous forces that create competitive challenges for firms and industries, but that doesn‘t necessarily justify the imposition of protectionist measures.

REVIEW QUESTIONS 1. In Country A, a worker can make 5 bicycles per hour. In Country B, a worker can make 7 bicycles per hour. Which country has an absolute advantage in making bicycles? LO19.1 a. Country A. b. Country B. Answer: b. Country B. Feedback: Country B has an absolute advantage in making bicycles because Country B is more efficient in the sense of being able to convert the same amount of input into a larger amount of output.

Please note that the definition of absolute advantage focuses on the efficiency with which countries can turn input into output. It says nothing at all about the opportunity costs of producing a particular type of output or how much of other products must to 1-336 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

be foregone in order to produce a unit of that particular type of output. The concept of comparative advantage deals with those opportunity-cost issues.

2. In Country A, the production of 1 bicycle requires using resources that could otherwise be used to produce 11 lamps. In Country B, the production of 1 bicycle requires using resources that could otherwise be used to produce 15 lamps. Which country has a comparative advantage in making bicycles? LO19.1 a. Country A. b. Country B. Answer: a. Country A. Feedback: Country A has a comparative advantage in making bicycles because Country A has a lower opportunity cost of producing bicycles when we measure opportunity cost in terms of the amount of alternative products that must be foregone in order to produce 1 bicycle.

To produce 1 bicycle, Country A only has to give up the production of 11 lamps. By contrast, Country B has to give up the production of 15 lamps. Thus, if we had to decide which country should be producing bicycles, we would go with Country A because it can produce bicycles at a lower opportunity cost in terms of lamps foregone.

3. True or False: If Country B has an absolute advantage over Country A in producing bicycles, it will also have a comparative advantage over Country A in producing bicycles. LO19.1 Answer: False.

Feedback: This statement is false because the possession of an absolute advantage does not necessarily imply that a country will also have a comparative advantage.

A country can have an absolute advantage but not a comparative advantage because the definitions of absolute advantage and comparative advantage focus on different things. Absolute advantage focuses on costs as measured by the amount of inputs required to make a single unit of given product. Thus, the country that can produce a single bicycle using the least amount of labor input is the country that has the absolute advantage in producing bicycles.

By contrast, comparative advantage focuses on costs as measured by the amounts of other products that a country has to forego in order to free up the resources necessary to make single unit of a given product. Thus, even if a country is really efficient at making bicycles in the sense of being able to make a single bicycle using only a very small amount of labor, it may still be really inefficient at making bicycles in the sense of having to give up a lot of other goods and services in order to free up the labor needed to make a single bicycle. That is, it may have an absolute advantage but not a comparative advantage.

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4. Suppose that the opportunity-cost ratio for pears and apples is 4P:1A in British Columbia but 1P:2A in Ontario. Which province has the comparative advantage in producing apples? LO19.1 a. British Columbia. b. Ontario. c. Neither.

Answer: b. Ontario.

Feedback: Ontario has the comparative advantage in producing almonds.

This is true because Ontario has to give up less pears in order to produce a ton of almonds. The easiest way to see this is to begin by dividing both sides of Ontario‘s opportunity-cost ratio by 2. That will give you ½P:1A. That version of Ontario‘s opportunity-cost ratio makes it clear that for every ton of apples that Ontario produces, it must forego ½ ton of pears. By contrast, British Columbia‘s opportunitycost ratio of 4P:1A indicates that for every ton of apples that British Columbia produces, it must forego 4 tons of pears. As a result, Ontario has a comparative advantage in producing apples because it can produce them at a lower opportunity cost as measured by the amount of pears that must be foregone in order to free up enough resources to produce one ton of apples.

5. Suppose that the opportunity-cost ratio for fish and lumber is 1F:1L in Canada but 2F:1L in Iceland. Then should specialize in producing fish while should specialize in producing lumber. LO19.1 a. Canada; Iceland. b. Iceland; Canada.

Answer: b. Iceland; Canada.

Feedback: The correct answer is that Iceland should specialize in producing fish while Canada should specialize in producing lumber.

This is true because Iceland has a comparative advantage in producing fish while Canada has a comparative advantage in producing lumber. Those comparative advantages imply that if each country specializes in the production of the product for which it has a comparative advantage, total output between the two countries can rise. It is for that reason—increasing the total amount of output that can be produced—that the two countries should specialize and trade.

To see that Iceland has a comparative advantage in producing fish, divide both sides of its opportunity-cost ratio by 2. Doing so yields, 1F:½L. That version of Iceland‘s opportunity cost ratio demonstrates that in order to produce one ton of fish, Iceland has to give up only ½ ton of lumber. By contrast, Canada‘s opportunity cost ratio of 1F:1L indicates that in order to produce one ton of fish, Canada must give up one ton of lumber. Thus, Iceland has the comparative advantage in producing fish because it can produce fish at a lower opportunity cost in terms of lumber foregone.

A similar analysis demonstrates that Canada has the comparative advantage in producing lumber because it has the lower opportunity cost in terms of fish foregone.

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You can see this by comparing Canada‘s opportunity-cost ratio of 1F:1L with Iceland‘s opportunity cost ratio of 2F:1L. Canada only has to give up one ton of fish to produce a ton of lumber whereas Iceland has to give up 2 tons of fish to produce a ton of lumber.

6. Suppose that the opportunity-cost ratio for watches and cheese is 1C ≡1W in Switzerland but 1C ≡4W in Japan. At which of the following international exchange ratios (terms of trade) will Switzerland and Japan be willing to specialize and engage in trade with each other. LO19.1 Select one or more answers from the choices shown. a. 1C = 3W. b. 1C = 1/2 W. c. 1C = 5W. d. ½ C = 1W. e. 2C = 1W. Answers: a. 1C:3W and d. ½C:1W Feedback: These are the only two correct answers because they are the only two international exchange ratios (terms of trade) that will be advantageous to both countries.

One way to see this is to note that only international exchange ratios that lie between the domestic opportunity-cost ratios of the two countries will be acceptable to both. That is, only international exchange ratios between Switzerland‘s opportunity cost ratio of 1C:1W and Japan‘s opportunity cost ratio of 1C:4W will be beneficial to both countries and therefore acceptable as international exchange ratios at which both countries would be willing to trade.

For a deeper understanding of why that is true, recall that specialization and trade will only happen if each country feels that the international exchange ratio is better than what the country could do if it shut its borders and did not engage in international trade.

To see how this works, consider the first possible answer, in which the international exchange ratio is 1C:3W. Switzerland will find that ratio attractive because it will allow greater consumption than its domestic opportunity-cost ratio. To see why, note that its domestic opportunity-cost ratio of 1C:1W implies that for every watch that Switzerland wants, it will have to give up a unit of cheese if it limits itself to domestic production and does not engage in international trade. But if Switzerland instead opts for international trade, it will be able to get three watches for each unit of cheese that it produces and then trades for watches at the international exchange ratio of 1C:3W. Because getting three watches for each unit of cheese is better than getting only one watch for each unit of cheese, Switzerland will want to trade at the international exchange ratio of 1C:3W. For similar reasons, Japan will also find this international trade ratio attractive. To see why, note that if Japan did not trade, its domestic opportunity-cost ratio of 1C:4W implies that it would have to give up four watches for each unit of cheese that it wants.

By contrast, if it took advantage of the international exchange ratio of 1C:3W, it would be able to get one unit of cheese through trade by producing and then trading away only three watches. Clearly it is better to have to give up only three watches to get a unit of cheese than to have to give up four watches to get a unit of cheese. And so Japan will 1-339 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

also want to trade at the international exchange ratio of 1C:3W rather than ban trade and produce domestically.

Finally, note that international trade will not take place if the international exchange ratio lies outside of the range that lies between each country‘s own domestic opportunity cost ratio. International trade will not take place in such cases because any such international exchange ratios will be acceptable to only one—but not both—of the countries. As a result, one of them won‘t be willing to trade.

7. Which of the following are benefits of international trade? LO19.1 Choose one or more answers from the choices shown. a. A more efficient allocation of resources. b. A higher level of material well-being. c. Gains from specialization. d. Promoting competition. e. Deterring monopoly. f. Reducing the threat of war.

Answer: All of the choices are correct.

Feedback: All of the answers are correct because each one is indeed a benefit of international trade.

8. We see quite a bit of international trade in the real world. And trade is driven by specialization. So why don‘t we see full specialization—for instance, all cars in the world being made in South Korea, or all the mobile phones in the world being made in China? Choose the best answer from among the following choices. LO19.1 a. High tariffs. b. Extensive import quotas. c. Increasing opportunity costs. d. Increasing returns.

Answer: c. Increasing opportunity costs.

Feedback: The correct answer is that we don‘t see full specialization because of increasing opportunity costs.

International trade is indeed driven by specialization, but the benefits of specialization can dissipate as a country specializes more and more in the production of one good.

What happens is that diminishing returns set in so that the country will face increasingly high opportunity costs for producing the good in question. As costs rise, so will the price that it has to charge to foreigners for additional units of the good.

At some point, the price will rise so high that foreigners will no longer want to buy any more because it will be cheaper for them to produce additional units domestically or purchase them yet another country whose production has not yet been affected by diminishing returns and increasing costs. As a result, what we see in the real world is incomplete specialization, with several countries often dominating an industry but no single country achieving full specialization and 100% control of global production.

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As an example, consider cars, which are exported to other countries from South Korea, the United States, Japan, Germany, France, Sweden, and so on. Each of these countries has specialized some of its industrial capacity into the production of cars, but diminishing returns implies that none of them has been able to capture 100% of the world car market.

9. True or False: If a country is open to international trade, the domestic price for a homogeneous good can differ from the international price for the same good. LO19.2 Answer: False.

Feedback: If a country is open to international trade, the domestic price for a homogeneous good will always be equal to the international price. That is because anyone in the country who wants to buy or sell will be participating in the international market and paying the international price that equates the quantities demanded and supplied globally. By contrast, if a country is closed to international trade, the domestic price can differ substantially from the international price because the domestic price will be affected only by domestic demand and domestic supply.

10. Suppose that the current international price of wheat is $6 per bushel and that the Canada is currently exporting 30 million bushels per year. If Canada suddenly became a closed economy with respect to wheat, would the domestic price of wheat in Canada end up higher or lower than $6? LO19.2 a. Higher. b. Lower. c. The same.

Answer: b. Lower.

Feedback: If Canada suddenly became a closed economy, the domestic price of wheat would end up being lower than the current international price of wheat.

That is because from the perspective of Canadian farmers, closing the Canadian economy to international trade in wheat would mean drastically lowering the overall demand for their product. That is, the total demand for Canadian wheat would fall sharply because Canadian wheat farmers would now be cut off from all of the foreigner consumers who had previously been consuming all of the wheat that the Canada had been exporting. That reduction of the total demand for Canadian wheat would result in a lower equilibrium domestic price of wheat if Canada were to become a closed economy with respect to wheat.

11. Suppose that if Iceland and Japan were both closed economies, the domestic price of fish would be $100 per ton in Iceland and $90 per ton in Japan. If the two countries decided to open up to international trade with each other, which of the following could be the equilibrium international price of fish once they begin trading? LO19.2 1-341 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

a. $75. b. $85. c. $95. d. $105.

Answer: c. $95.

Feedback: The correct answer is that $95 could be the equilibrium international price of fish if Iceland and Japan began trading fish with each other.

That is true because an equilibrium in international trade can only exist if the international price can adjust so that one country becomes the exporter, the other country becomes the importer, and the quantity exported and supplied by the exporting country exactly equals the quantity imported and demanded by the other country. The $95 price is the only price that could possibly make that happen because it's the only price at which one of the countries will want to export and the other will want to import.

In particular, Iceland will want to import at the $95 price because that price for fish is less than its domestic price of $100. At the same time, Japan will want to export at the $95 price because that price is more than the $90 domestic price at which fish can be sold. Thus, it is possible that $95 could be the equilibrium international price because one country will want to export while the other will want to import.

By contrast, none of the other prices could possibly work because for each of them, you wouldn‘t end up with one country wanting to import and one country wanting to export.

12. Draw a domestic supply-and-demand diagram for a product in which Canada does not have a comparative advantage. What impact do foreign imports have on domestic price and quantity? On your diagram show a protective tariff that eliminates approximately one-half of the assumed imports. What are the price-quantity effects of this tariff on (a) domestic consumers, (b) domestic producers, and (c) foreign exporters? How would the effects of a quota that creates the same amount of imports differ? LO19.3 Answer:

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Canada does not have a comparative advantage in this product so the world price Pworld is below the Canadian domestic price of Pdomestic. Imports will reduce the domestic price, increasing consumption from nontrade, and decreasing domestic production. See the graph. A tariff (a) harms domestic consumers by increasing price and decreasing consumption; (b) aids domestic producers through the increase in price and the expansion of domestic production; (c) harms foreign exporters by decreasing exports. (Assuming that the country imposing the tariff is a small part of the world market. If not, price could also be affected.)

13. Canadian apparel makers complain to Parliament about competition from China.

Parliament decides to impose either a tariff or a quota on apparel imports from China.

Which policy would Chinese apparel manufacturers prefer? LO19.3 a. Tariff. b. Quota.

Answer: b. Quota.

Feedback: Chinese apparel manufacturers would prefer a quota because it would generate higher per-unit prices for the goods they sell in the United States.

With either a tariff or a quota, China will see its total volume of sales to the United States decline. But the question then becomes: Which policy would offer China the greater amount of benefits to help compensate for the decline in sales?

A tariff won‘t help the Chinese at all because the money from the tariff will be collected by the Canadian government. But a quota can actually increase China‘s per-unit selling price because the reduction in supply caused by the quota will raise the equilibrium price of apparel in Canada. As a result, while the quota will mean that China will be selling fewer units of clothing in Canada, it will also mean that each of the units of clothing that it does continue to sell will be sold at a higher perunit price.

Thus, China will prefer a quota over a tariff because it will at least be getting more per unit despite selling fewer units. (Whether or not the increase in per-unit price can make up for the decline in the number of units sold will depend on the elasticities of the demand and supply curves.)

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1. Assume that the comparative-cost ratios of two products—baby formula and tuna fish—are as follows in the nations of Canswicki and Tunata: Canswicki: 1 can baby formula = 2 cans tuna fish Tunata: 1 can baby formula = 4 cans tuna fish In what product should each nation specialize? Which of the following terms of trade would be acceptable to both nations: (a) 1 can baby formula = 2 1/2 cans tuna fish; (b) 1 can baby formula = 1 can tuna fish; (c) 1 can baby formula = 5 cans tuna fish?

LO19.1 Answer: Canswicki should produce baby food, and Tunata should produce tuna; (a) acceptable; (b) not acceptable; (c) not acceptable.

Feedback: In what product should each nation specialize?

The opportunity cost of producing 1 can of baby formula in Canswicki is 2 cans of tuna fish.

The opportunity cost of producing 1 can of baby formula in Tunata is 4 cans of tuna fish.

Since the opportunity cost of producing baby formula is lower in Canswicki, this implies Canswicki should produce baby formula. This also implies that Tunata should specialize in producing Tuna.

We can also look at the opportunity cost of producing cans of tuna fish (in terms of foregone cans of baby formula).

The opportunity cost of producing 1 can of tuna fish in Canswicki is 1/2 a can of baby formula.

The opportunity cost of producing 1 can of tuna fish in Tunata is 1/4 a can of baby formula.

Since the opportunity cost of producing tuna fish is lower in Tunata, this implies Tunata should produce tuna fish. This also implies that Canswicki should specialize in producing baby formula.

Which of the following terms of trade would be acceptable to both nations:? (a) 1 can baby formula = 2 1/2 cans tuna fish?

These terms of trade are acceptable. The best Canswicki can do without trade is produce 2 cans of tuna fish for each can of baby formula. If they trade 1 can of baby formula for 2.5 cans of tuna fish, they will be better off. Tunata will also trade because they only need to give up 2.5 cans of tuna fish for each can of baby formula.

If Tunata produced baby formula themselves, they would need to give up 4 cans of tuna fish for each can of baby formula. (b) 1 can baby formula = 1 can tuna fish?

These terms of trade would not be acceptable. Canswicki would not be willing to trade 1 can of baby formula for 1 can of tuna fish. They can do better themselves by producing 2 cans of tuna fish for each can of baby formula. (c) 1 can baby formula = 5 cans tuna fish?

These terms of trade would not be acceptable. Tunata would not be willing to trade (give up) 5 cans of tuna fish for 1 can of baby formula. They could do better themselves by producing a can of baby food and giving up 4 cans of tuna fish.

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2. The following are hypothetical production possibilities tables for New Zealand and Spain. Plot the production possibilities data for each of the two countries separately.

Referring to your graphs, answer the following: LO19.1

a. What is each country‘s cost ratio of producing plums and apples? b. Which nation should specialize in which product? c. Show the trading possibilities lines for each nation if the actual terms of trade are 1 plum for 2 apples. (Plot these lines on your graph.) d. Suppose the optimum product mixes before specialization and trade were alternative B in New Zealand and alternative S in Spain. What would be the gains from specialization and trade?

Answers: a. New Zealand: cost of producing 1 apple is 0.25 plums; cost of producing 1 plum is 4 apples; Spain: cost of producing 1 apple is 1 plum; cost of producing 1 plum is 1 apple. b. New Zealand should produce apples and Spain should produce plums. c. See graphs:

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d. Total Gain Apples = 20 (= 60 - 40); Total Gain Plums = 10 (= 60 -50) Feedback: a. What is each country‘s cost ratio of producing plums and apples?

The opportunity cost of producing 1 apple in New Zealand is 0.25 plums. That is, for each apple produced in New Zealand the country must give up 0.25 plums.

The opportunity cost of producing 1 apple in Spain is 1 plum. That is, for each apple produced in Spain the country must give up 1 plum.

We can also look at the opportunity cost of producing plums.

The opportunity cost of producing 1 plum in New Zealand is 4 Apples. That is, for each plum produced in New Zealand the country must give up 4 Apples.

The opportunity cost of producing 1 plum in Spain is 1 apple. That is, for each plum produced in Spain the country must give up 1 Apple. b.

Which nation should specialize in which product?

The opportunity cost of producing apples in New Zealand is lower than Spain's opportunity cost of producing apples. Therefore, New Zealand should produce apples and Spain should produce plums.

c. Show the trading possibilities lines for each nation if the actual terms of trade are 1 plum for 2 apples. (Plot these lines on your graph.)

The graphs below show each country's production possibilities schedules with and without trade. Apples are on the vertical axis and plums are on the horizontal axis.

New Zealand has a vertical intercept of 60 apples (produce only apples) and a horizontal intercept of 15 plums (produce only plums). The slope of production possibilities schedule equals -4 (negative 4). This slope is the opportunity cost of producing plums. That is, for each plum produced by New Zealand they must give up 4 apples.

However, after trade, New Zealand's horizontal intercept will be 30 apples. Since the terms of trade are 1 plum for 2 apples, New Zealand could specialize in apple production and trade 2 apples for each plum (produce 60 apples and receive 30 plums). The slope of the after-trade production possibilities schedule is -2 1-346 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

(negative 2). New Zealand must now only give up 2 apples for each additional plum consumed (trade 2 apples for additional plum).

The same logic applies to Spain. Before trade the vertical intercept is 60 apples and the horizontal intercept 60 plums. The slope of the production possibilities schedule is -1, which is the opportunity cost of 1 more plum in terms of apples.

After trade Spain's vertical intercept is now 120 apples and the horizontal intercept remains at 60 plums. Spain will produce only plums and can trade now 1 plum for 2 apples (terms of trade). If they trade all 60 plums for apples they will receive 120 apples. The new slope of the production possibilities schedule is -2, which is the opportunity cost of consuming (not trading) 1 more plum.

(NOTE: The intercepts above reflect possibilities not actual equilibrium consumption bundles. For example, if Spain produced only plums and traded these for apples, they should be able to consume 120 apples (vertical intercept after trade). The problem is that New Zealand is only producing 60 apples (the most it possibly can). This is not a flaw in the logic of the problem because we are only considering the construction of the production possibilities schedules. The next step would be to allow terms of trade to adjust in response to shortages and surpluses of goods based on country preferences. We do not do this step here.) d. Suppose the optimum product mixes before specialization and trade were alternative B in New Zealand and alternative S in Spain. What would be the gains from specialization and trade?

The first step is to determine total production before any trade takes place.

New Zealand's optimal product mix before trade is alternative B (given above): Apples = 20 Plums = 10 Spain's optimal product mix before trade is alternative S (given above): Apples = 20 Plums = 40 Combined, the optimal mix before trade is: Before Trade Total Apples = 40 (20 New Zealand plus 20 Spain) Before Trade Total Plums = 50 (10 New Zealand plus 40 Spain) The next step is to determine total production after specialization. Recall New Zealand will specialize in apple production (produce only apples) and Spain will specialize in plum production (produce only plums).

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After Trade Total Apples = 60 (New Zealand alternative D) After Trade Total Plums = 60 (Spain alternative R) The final step is to determine the total gain for each good, which is the difference between total production before trade and total production after trade.

Total Gain Apples = 20 (= 60 - 40) Total Gain Plums = 10 (= 60 -50) 3. The following hypothetical production possibilities tables are for China and Canada.

Assume that before specialization and trade the optimal product mix for China is alternative B and for Canada is alternative U. LO 19.1 a. Are comparative-cost conditions such that the two areas should specialize? If so, what product should each produce? b. What is the total gain in apparel and chemical output that would result from such specialization? c. What are the limits of the terms of trade? Suppose that the actual terms of trade are 1 unit of apparel for 1½ units of chemicals and that 4 units of apparel are exchanged for 6 units of chemicals. What are the gains from specialization and trade for each nation?

Answers: a. Yes; China should produce apparel and Canada should produce chemicals. b. Total Gain apparel = 6000; Total Gain chemicals = 2. c. Limits of the terms of trade = 1000 units of apparel for 1 ton of chemicals and 1000 units of apparel for 2 tons of chemicals; gain of 2000 units of apparel and 2 tons of chemicals.

Feedback: a. Are comparative-cost conditions such that the two areas should specialize? If so, what product should each produce?

Yes, the two areas should specialize.

The opportunity cost of producing 1000 units of apparel is 1 ton of chemicals in China. The opportunity cost of producing 1000 units of apparel is 2 tons of chemicals.

Thus, the opportunity cost for apparel is lower in China. This implies China should produce apparel and Canada should produce Chemicals. b. What is the total gain in apparel and chemical output that would result from such specialization?

The first step is to determine total production before any trade takes place.

China's optimal product mix before trade is alternative B (given above): Apparel = 24,000 Chemicals = 6 1-348 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Canada' optimal product mix before trade is alternative U (given above): Apparel = 4,000 Chemicals = 12 Combined, the optimal mix before trade is: Before Trade Total Apparel = 28,000 (24,000 China plus 4,000 US) Before Trade Total Chemicals = 18 (6 China plus 12 US) The next step is to determine total production after specialization. Recall China will specialize in apparel production (produce only apparel) and Canada will specialize in Chemical production (produce only chemicals).

After Trade Total Apparel = 30,000 (China alternative A) After Trade Total Chemicals = 20 (US alternative W) The final step is to determine the total gain for each good, which is the difference between total production before trade and total production after trade.

Total Gain Apparel = 2000 (=30,000-28,000) Total Gain Chemicals = 2 (=20-18) c. What are the limits of the terms of trade? Suppose that the actual terms of trade are 1 unit of apparel for 1½ units of chemicals and that 4 units of apparel are exchanged for 6 units of chemicals. What are the gains from specialization and trade for each nation?

To determine the limits of the terms of trade we look at opportunity cost. The opportunity cost of producing 1000 units of apparel is 1 ton of chemicals in China.

The opportunity cost of producing 1000 units of apparel is 2 tons of chemicals.

The most China will trade (give up) is 1000 units of apparel for 1 ton of chemicals. If Canada required more China could do better producing the chemicals themselves.

The most Canada is willing to trade (give up) is 2 tons of chemical for 1000 units of apparel. If China required more, Canada could do better producing the apparel This implies the range, or limits, of the terms of trade.

1000 units of apparel for 1 ton of chemicals 1000 units of apparel for 2 tons of chemicals Now assuming the actual terms are 1000 units of apparel for 1.5 tons of chemicals and that the ACTUAL amount traded (exchange) is 4000 units of apparel for 6 tons of chemicals we can find the new consumption levels for each country.

Canada produces all 20 tons‘ of chemicals. They trade 6 tons of chemical for 4000 units of apparel. So, after trade Canada consumes 14 tons of chemical and 4000 units of apparel.

China produces all 30,000 units of apparel. They trade 4000 units of apparel for 6 tons of chemicals. So, after trade China consumes 6 tons of chemical and 26,000 units of apparel.

The gain to China comes in apparel. Before trade they consumed 24,000 units of apparel and after trade they consume 26,000. This is a gain of 2000 units of apparel.

The gain to Canada comes in chemicals. Before trade they consumed 12 tons of chemicals and after trade they consume 14 tons of chemicals. This is a gain of 2 tons of chemicals.

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4. Refer to Figure 3.6. Assume that the graph depicts the Canadian domestic market for corn. How many bushels of corn, if any, will Canada export or import at a world price of $1, $2, $3, $4, and $5? Use this information to construct the Canadian export supply curve and import demand curve for corn. Suppose that the only other cornproducing nation is France, where the domestic price is $4. Which country will export corn? which county will import it? LO 19.2

Answer: At a price of $1: -15,000; Price $2: -7,000; Price $3: 0; Price $4: 6,000; Price $5: 10,000.

Feedback: Consider the following example. Refer to Figure 3.6 (Chapter 3 – beginning of section 3.4). Assume that the graph depicts Canadian domestic market for corn. How many bushels of corn, if any, will Canada export or import at a world price of $1, $2, $3, $4, and $5? Use this information to construct the Canadian export supply curve and import demand curve for corn. Suppose that the only other cornproducing nation is France, where the domestic price is $4. Which country will export corn; which county will import it?

To calculate the amount of imports or exports subtract quantity supplied from the quantity demanded at each price: Price $1: quantity supplied - quantity demanded = 1,000 - 16,000 = -15,000 (on the import supply schedule below this value will be positive) Price $2: 4,000 - 11,000 = -7,000 Price $3: 7,000 - 7,000 = 0 Price $4: 10,000 - 4,000 =6,000 Price $5: 12,000 - 2,000 = 10,000

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At a price of $4 Canada will export corn and France will import corn.

Chapter 19B - Natural Resource and Energy Economics McConnell Brue Flynn Barbiero 16ce DISCUSSION QUESTIONS 1. Describe Thomas Malthus‘ theory of human reproduction. Does it make sense for some species—say, bacteria or rabbits? What do you think makes humans different?

LO19B.1 Answer: Thomas Malthus‘ theory of human reproduction is that as living standards (specifically the food supply from Malthus‘ perspective) rise above subsistence, people will tend to have more children (they can afford them) and population will grow. Eventually, however, the population growth will overwhelm food supply growth, and living standards will be pushed back to subsistence.

Malthus‘ theory works well for non-human life forms – bacteria and rabbit populations will continue to expand so long as there is a food supply to support them.

They have a biological drive to procreate and lack any ability to reason that unchecked population growth might eventually have adverse effects.

Humans also have a biological drive to procreate (or at least to engage in the activities that lead to procreation), but also have the technology (birth control) and self-control to limit the number of children born. In less developed economies (including pre-industrial times in Canada, Europe, etc.), a large number of births was a way to hedge against high rates of infant / childhood mortality. As living standards rise and the risk of premature death falls significantly, families tend to focus more on quality (providing less children more opportunities) than quantity (maximizing family size).

2. Demographers have been very surprised that total fertility rates have fallen below 2.0, especially because most people in most countries tell pollsters that they would like to have at least two children. Can you think of any possible economic factors that might 1-351 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

be causing women in so many countries to average fewer than two children per lifetime? What social or political changes might play a role? LO19B.1 Answer: There are a number of factors that could lead to the decline, including greater participation by women in the paid labour force, the transformation of children from an economic asset (e.g. on the farm) to a liability, higher divorce rates, and changed attitudes and access to birth control.

3. Resource consumption per person in Canada is either flat or falling, depending on the resource. Yet living standards are rising due to improvements in technology that allow more output to be produced for every unit of input used in production. What does this say about the likelihood of our running out of resources? Could we possibly maintain or improve our living standards even if the population were expected to rise in the future rather than fall? Explain. LO19B.1 Answer: The fact that we are able to raise living standards without using as many resources reduces the likelihood that we will run out of resources. Even if we run out of a specific resource, substitutes exist and technological advance increases the quantity and viability of substitutes.

Even if population continues to rise indefinitely, technological advances that reduce inputs per unit of output make it possible to maintain or improve living standards.

4. A community has a night-time energy demand of 50 megawatts, but a peak daytime demand of 75 megawatts. It has the chance to build a 90-megawatt coal‐fired plant that could easily supply all of its energy uses even at peak daytime demand. Should it proceed? Could there be lower‐cost options? Explain. LO19B.2 Answer: A large coal fired plant likely has high fixed costs. It may have lower operating costs than other energy sources, but if those lower costs (economies of scale) are only achieved when the plant is at or near capacity, actual operating costs may not be lower than the alternatives. Natural gas or hydroelectric plants, for example, might have lower fixed costs and be able to operate efficiently on a smaller scale than a coal fired plant. A community should look at the net benefits of each energy option, including using a combination of energy sources. Only by comparing the net benefits can a community find the method(s) of power generation that is most economically efficient.

5. Suppose you hear two people arguing about energy. The first person says that we are running out of energy. The other counters that we are running out of cheap energy.

State which person is correct, and why. LO19B.2 Answer: The second person may be correct; the first is not. There will always be sources of energy available (flowing water, the wind, and the sun, if nothing else), but 1-352 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

some aren‘t cheap to use. In recent decades, oil has been one of the cheapest sources, but as growing demand begins to outstrip our ability to increase production, prices rise and it becomes less cheap. As oil prices rise, other sources of energy (solar, wind, biodiesel) become economically viable. They are not necessarily cheap energy sources as oil was, but they are energy sources. Technological advances may also discover new cheap sources of energy, in which case neither of our two people will be correct.

6. Recall the model of non-renewable resource extraction presented in Figure 19B.2.

Suppose a technological breakthrough means that extraction costs will fall in the future (but not in the present). What will this do to future profits and, therefore, to current user cost? Will current extraction increase or decrease? Compare this to a situation where future extraction costs remain unchanged but current extraction costs fall. In this situation, does current extraction increase or decrease? Does the firm‘s behavior make sense in both situations? That is, does its response to the changes in production costs in each case maximize the firm‘s stream of profits over time?

LO19B.4

Answer: A reduction in future extraction costs will increase future profits, increasing the user cost for present extraction. This will cause current extraction to decrease as firms wait to take advantage of the new technology. In contrast, if only current extraction costs fall, it is more profitable to extract in the present, and current extraction will increase.

The firm‘s behaviour in both situations makes economic sense. The firm is trying to maximize the firm‘s stream of profits over time; changes that make current extraction more profitable will cause greater extraction now; changes increasing the profitability of future extraction will lead firms to extract less in the present.

7. If the current market price rises, does current extraction increase or decrease? What if the future market price rises? Do these changes in current extraction help to ensure the resource is extracted and used when it is most valuable? LO19B.4 1-353 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Answer: An increase in the current market price, all else equal, would increase the profitability of current extraction. This would lead firms to extract more in the present. Conversely, an increase in future prices increase the user cost of present extraction and will discourage current extraction. As long as the firms have good information about current and future profitability (including current and future resource prices and extraction costs), these changes in current extraction assure that resources will be extracted when their economic value is greatest. (Note that this also assumes the absence of externalities that, if considered, would alter extraction patterns.)

8. ADVANCED ANALYSIS Suppose a government wants to reduce its economy‘s dependence on coal and decides as a result to tax coal-mining companies $1 per tonne for every tonne of coal they mine. Assuming that coal-mining companies treat this tax as an increase in extraction costs this year, what effect will the tax have on current extraction in the model used in Figure 19B.2? Now, think one step ahead. Suppose that the tax will be in place forever, so that it will also affect extraction costs in the future. Will the tax increase or decrease user cost? Does this effect increase or decrease the change in current extraction caused by the shift of the EC curve? Given your finding, should environmental taxes be temporary? LO19B.4 Answer: If the tax only increases current extraction costs (i.e. will not be extended into the next period), current extraction will be less profitable and less will occur. If, however, the tax is permanent, it will also increase future extraction costs, lower future profits, and reduce the user cost considered for current extraction decisions.

Referring to the model represented by Figure 19B.2, while the EC curve will shift up the total cost curve (TC), the decrease in user cost (UC) will shift it back down, but not by the full amount (the present value of a $1 tax in the future is less than $1). The result will be some reduction in current extraction, but not as much as if the tax were temporary. If the government wants to better discourage current extraction, environmental taxes should be temporary. Although that leaves the question of what to do next year; if the government keeps imposing ―temporary‖ taxes, eventually there will be an expectation of permanency, regardless of the official status of the tax.

9. ADVANCED ANALYSIS User cost is equal to the present value of future profits in the model presented in Figure 19B.2. Will the optimal quantity to mine in the present year increase or decrease if the market rate of interest rises? Does your result make any intuitive sense? (Hint: If interest rates are up, would you want to have more or less money right now to invest at the market rate of interest?) LO19B.4 Answer: An increase in market interest rates will reduce the present value of a future payment (including future profits from extraction), so an increase in interest rates will reduce the user cost and increase the optimal quantity of current extraction.

Intuitively, higher interest rates mean that it is even more valuable to have a dollar to 1-354 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

invest now than in the future, so altering production to generate more current profits yields a greater long-run stream of profits than delaying extraction (and profits) to a later period.

10. Various cultures have come up with their own methods to limit catch size and prevent fishery collapse. In old Hawaii, certain fishing grounds near shore could be used only by certain individuals. And among lobster fishers in Maine, strict territorial rights are handed out so that only certain people can harvest lobsters in certain waters. Discuss specifically how these systems provide incentives for conservation. Then think about the enforcement of these property rights. Do you think similar systems could be successfully enforced for deep sea fishing, far off shore? LO19B.5 Answer: Those given rights to a certain fishery have an incentive to harvest at a sustainable rate so that they can generate a long-run stream of profits. If the area to be fished is carefully defined and reasonably small, enforcing the property rights over a given fishery should be relatively easy. The further the fishing moves from shore, the more difficult and costly it would be to enforce these rights. Illegal fishers could go undetected more easily, and the added time and fuel costs to patrol further from shore would greater limit the ability to enforce.

11. Aquaculture is the growing of fish, shrimp, and other marine species in enclosed cages or ponds. The cages and ponds not only keep the creatures from swimming away but also provide aquaculturalists with strong property rights over their animals.

Does this provide a good incentive for low‐cost production as compared with fishing in the open seas where there are few if any property rights? LO19B.5 Answer: By having property rights over the fish, aquaculturalists have strong incentives to care for the fish, including finding ways to raise the seafood using lowcost techniques. Aquaculturalists have little incentive to invest in fish in open waters, as the likelihood of someone else benefiting from their efforts is high.

The LAST WORD The figure in ―The Last Word‖ section shows that a tenfold increase in a country‘s GDP per person is associated with about a 20-point increase in EPI. Do you think that this pattern can be extrapolated into the future? That is, could Canada (which currently has an EPI of 72.18) gain another 20 points if it increased its GDP per person by a factor of 10 from its current level?

Answer: The data suggests that there is a strong positive relationship between the wealth of a country and environmental quality. The figure in The Last Word shows that a 10-fold rise in living standards is associated with a 20-point increase in the EPI (Environmental Performance Index). However, getting richer does not guarantee doing well environmentally. There are many other factors that may influence environmental quality, such as, individual preferences, the geographical size and resources of the country, and urban design. However, the evidence does suggest that economic growth may not lead to environmental degradation. Canada' EPI is higher than many poor countries.

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REVIEW QUESTIONS 1. The long-run downward trend in commodity prices is consistent with the idea that: LO19B.1 a. We are quickly running out of resources. b. Resource demands have been increasing faster than resource supplies. c. Birthrates will soon increase due to the falling cost of living. d. Resource supplies have increased faster than resource demands.

Answer: d. Resource supplies have increased faster than resource demands.

For the last 200 years, the demand for resources has been growing steadily, driven by an increasing world population and by increasing per-capita consumption. The only way that commodity prices could have shown the long-run downward trend that they have is if the supply of commodities increased faster than the demand for commodities (so that equilibrium prices would have fallen as a result of supply increasing faster than demand).

Thus, the correct answer to this question is that the long-run downward trend in commodity prices is consistent with the idea that resources supplies have increased faster than resource demands.

2. It would cost the town of Irondale $50 million to build a gas-powered generator that could produce a maximum of 5 megawatts of electricity at 15 cents per hour. Another alternative would be for Irondale to build a $100 million coal-fired generator that could produce a maximum of 15 megawatts of electricity at 5 cents per hour. Irondale should: LO19B.2 a. Build the coal-fired generator because its hourly operating costs are so much lower. b. Build the gas-powered generator since it is less expensive to build. c. Build the coal-fired generator because, while it would cost twice as much to build, it would produce three times as much electricity. d. Obtain more information before deciding what to do.

Answer: d. Obtain more information before deciding what to do.

The correct answer is that Irondale should obtain more information before deciding what to do. This is true because it is not possible to determine which of these two plant sizes would be the best way to supply Irondale‘s electricity needs without knowing what those needs are.

For example, suppose that Irondale‘s maximum electricity demand over the course of a day is never greater than 5 megawatts of electricity. Then it would likely be very wasteful to build a plant with a 15-megawatt capacity, as two-thirds of the plant‘s capacity would never be used.

Alternatively, suppose that Irondale‘s demand for electricity is 20 megawatts. Then the best option would likely be to build one coal-fired plant and one gas-fired plant.

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But, again, it is not possible to know what the best thing to do is without getting more information about Irondale‘s demand situation.

3. After mining 9273 tonnes of coal, Blue Sky Mining‘s managers note that the marginal cost of mining the next tonne of coal would be $40 per tonne. They also calculate that the user cost of mining that next tonne of coal would be $35. If the market price of coal is $72, should Blue Sky mine an additional tonne of coal? LO19B.4 a. Yes. b. No. c. More information is needed.

Answer: no.

Blue Sky should not mine another tonne of coal because the total cost of doing so would exceed the price at which that tonne could be sold.

To see this, note that the total cost of mining the next tonne of coal is the sum of its extraction cost of $40 per tonne and its user cost of $35 per tonne. So the total cost would be $75 per tonne. That value exceeds coal‘s selling price of $72 per tonne. So Blue Sky should not mine the next tonne of coal as doing so would result in a loss of $3.

4. Good methods for helping to protect natural resources include: LO19B.5 a. Establishing property rights and giving them to local users. b. Encouraging first-come-first-served property rights. c. Teaching people to consider user cost. d. Having the government set up and enforce ITQs. Answer: a, b, and d are correct.

Assigning property rights to local users creates incentives for them to conserve.

The basic idea is that property rights allow local users to benefit from not using a resource up as quickly as possible. That is because people who possess property rights know that anything that they do not use this year will be available for them to use and benefit from in the future. That gives them an incentive to harvest their resource at a sustainable rate.

By contrast, in a first-come-first-served system of property rights, each person fears that somebody else will harvest the resource first. That gives each person an incentive to harvest as much of the resource as possible, as quickly as possible, before anyone else can. The unfortunate result is that the resource is quickly depleted.

That tendency can also be slowed by teaching people to consider user cost so that they can see an incentive to reduce current consumption and by having the government set up and enforce individual transferrable quotas (ITQs) so that the total amount harvested will be set at a sustainable level and the harvesting will be done by the lowest-cost fishers or harvesters.

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5. Ingvar and Olaf are the only two fishermen in their area. Each has been assigned an ITQ that allows him to catch 20 tonnes of salmon. Ingvar‘s MC of catching salmon is $6 per tonne while Olaf‘s MC of catching salmon is $7 per tonne. If the price of salmon is $10 per tonne, then to maximize efficiency, the two guys should trade ITQs until Ingvar is in charge of catching _________ tonnes while Olaf catches __________ tonnes. LO19B.5 a. 20; 20. b. 30; 10. c. 40; 0. d. 0; 40.

Answer: c. 40; 0.

To maximize efficiency, the two guys should trade ITQs until Ingvar is in charge of catching 40 tonnes while Olaf catches 0 tons.

This is true because Ingvar is the more efficient fisher, the one with the lower MC of catching salmon. In particular, efficiency would be greater if he were the one catching all the fish because his lower MC implies that he can get the job done while using up less resources.

PROBLEMS 1. Suppose that the current (first) generation consists of 1 million people, half of whom are women. If the total fertility rate is 1.3 and the only way people die is of old age, how big will the fourth generation (the great‐grandchildren) be? How much smaller (in percentage terms) is each generation than the previous generation? How much smaller (in percentage terms) is the fourth generation than the first generation? Are you surprised by how quickly the population declines? LO19B.1 Answer: fourth generation = 274,625; each successive generation will be 35% smaller than the previous one; the fourth generation will be 72.53% smaller; no.

Feedback: Consider the following example. The current (first) generation consists of 1 million people, half of whom are women. Also assume that the total fertility rate is 1.3.

How big with the fourth generation be? To answer this question, we first note that the total fertility rate is the average number of children a woman is expected to have during her lifetime. This implies that the total fertility rate of 1.3 translates into a population growth rate of (1.3/2) - 1 = -0.35 (approximate decline of 35%). The reason is that each woman must have 2 children on average to replace one male and one female (ignoring mortality).

Using the rate of population growth above, we can calculate the size of each sequential generation.

Second Generation (our children): 1,000,000 × (1 + (-0.35)) = 1,000,000 × (1 - 0.35) = 1,000,000 × .65 = 650,000.

Third Generation (our grand-children): 650,000 × (1-0.35)) = 650,000 × .65 = 422,500.

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Fourth Generation (our great grand-children): 422,500 × (1-0.35)) = 422,500 × .65 = 274,625.

Note you could use the formula: Future Population = (First) Initial Population × (1+Rate of Growth)T , where T is the number periods into the future.

Our example is: Future Population = 1,000,000 × (1 - 0.35)3 = 1,000,000 × 0.274625 = 274,625 From the rate of decline found above, each successive generation will be 35% smaller.

The fourth generation will be 72.53% smaller (= (274,625-1,000,000)/1,000,000)).

This shouldn't be a surprise given the student‘s understanding of compounding over time.

2. A coal‐fired power plant can produce electricity at a variable cost of 4 cents per kilowatt hour when running at its full capacity of 30 megawatts per hour, 16 cents per kilowatt hour when running at 20 megawatts per hour, and 24 cents per kilowatt hour when running at 10 megawatts per hour. A gas‐fired power plant can produce electricity at a variable cost of 12 cents per kilowatt‐hour at any capacity from 1 megawatt per hour to its full capacity of 5 megawatts per hour. The cost of constructing a coal‐fired plant is $50 million but it only costs $10 million to build a gas‐fired plant. LO19B.2 a. Consider a city that has a peak afternoon demand of 80 megawatts of electricity.

If it wants all plants to operate at full capacity, what combination of coal‐fired plants and gas‐fired plants would minimize construction costs? b. How much will the city spend on building that combination of plants? c. What will the average cost per kilowatt‐hour be if you average over all 80 megawatts that are produced by that combination of plants? (Hint: A kilowatt is one thousand watts, while a megawatt is one million watts). d. What would the average cost per kilowatt‐hour be if the city had instead built three coal‐fired plants?

Answers: a. b. c. d.

Two coal-fired plants plus 4 gas-fired plants The city will spend $140 million building the plants 6 cents per kilowatt-hour 7 cents per kilowatt-hour

Feedback: Consider the following example. A coal‐fired power plant can produce electricity at a variable cost of 4 cents per kilowatt hour when running at its full capacity of 30 megawatts per hour, 16 cents per kilowatt hour when running at 20 1-359 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

megawatts per hour, and 24 cents per kilowatt hour when running at 10 megawatts per hour. A gas‐fired power plant can produce electricity at a variable cost of 12 cents per kilowatt‐hour at any capacity from 1 megawatt per hour to its full capacity of 5 megawatts per hour. The cost of constructing a coal‐fired plant is $50 million but it only costs $10 million to build a gas‐fired plant.

Parts a and b: A city has a peak afternoon demand of 80 megawatts of electricity. If it wants all plants to operate at full capacity, what combination of coal‐fired plants and gas‐fired plants would minimize construction costs?

To operate at full capacity, we have three choices. Choice 1: 2 coal-fired plants and 4 gas-fired plants; Choice 2: 1coal-fired plant and 10 gas-fired plants; Choice 3: 16 gasfired plants (max capacity needs to add up to 80 megawatts per hour).

Choice 1 will cost $140 million (=$100 million (coal) + $40 million (gas)).

Choice 2 will cost $150 million (=$50 million (coal) + $100 million (gas)).

Choice 3 will cost $160 million (=$160 million (gas)).

The city should build 2 coal-fired plants and 4 gas-fired plants to minimize production costs. The total cost of construction is $140 million.

You could also recognize that it takes 6 gas-fired plants to replace 1 coal-fired plant to produce a 30 megawatt capacity. Since the cost of building 6 gas-fired plants ($60 million) is greater than the $50 million for the coal-fired plant build coal-fired plants until the remainder of necessary capacity is less than 30. Then fill this remainder with gas-fired plants.

Part c: What will the average cost per kilowatt‐hour be if you average over all 80 megawatts that are produced by that combination of plants? (Hint: A kilowatt is one thousand watts while a megawatt is one million watts).

To calculate the average cost per kilowatt hour we first recognize that 75% of our energy will be produced by the 2 coal fired plants (30 megawatt capacity) and 25% of our energy will be produced by 4 gas-fired plants (5 megawatt capacity). The cost per kilowatt hour for the coal-fired plants is 4 cents and the cost per kilowatt hour for the gas-fired plants is 12 cents per hour.

Taking a weighted average of the two costs per kilowatt hour using the percentages of energy production as weights we have: Average cost per kilowatt hour = 0.75 × $0.04+0.25 × 0.12 = $0.03 + $0.03 = $0.06 (or 6 cents).

Part d: What would the average cost per kilowatt‐hour be if the city had instead built three coal‐fired plants?

If the city built three coal-fired plants, then two would operate at full capacity (30 megawatts) at a cost of 4 cents per kilowatt hour and the second would operate at 2/3 capacity (20 megawatts) at a cost of 16 cents per hour.

They average cost per kilowatt hour is $0.07 or 7 cents (= 0.75 × $0.04 + 0.25 × $0.16).

3. Suppose that Sea Shell Oil Company (SS) is pumping oil at a field off the coast of Nigeria. At this site, it has an extraction cost of $30 per barrel for the first 10 million 1-360 Copyright © 2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

barrels it pumps each year and then $60 per barrel for all subsequent barrels that it pumps each year, up to the site‘s maximum capacity of 90 million barrels per year.

LO19B.4 a. Suppose the user cost is $50 per barrel for all barrels and that the current market price for oil is $90 per barrel. How many barrels will SS pump this year? What is the total accounting profit on the total amount of oil it pumps? What is the total economic profit on those barrels of oil? b. What if the current market price for oil rises to $120 per barrel while the user cost remains at $50 per barrel? How many barrels will SS pump and what will be its accounting profit and its economic profit? c. If the current market price remains at $120 per barrel but the user cost rises to $95 per barrel, how many barrels will SS pump this year and what will be its accounting profit and its economic profit?

Answers: a. SS will pump only 10 million barrels. The accounting profit would be $600 million, while the economic profit would be $100 million. b. At $120 per barrel, the firm would now produce its maximum capacity of 90 million barrels per year. Accounting profits will be $5.7 billion, and economic profits will be $1.2 billion. c. SS will pump zero barrels of oil. For instance, the total cost of pumping any of the first 10 million barrels is no $125 per barrel (= $30 of extraction cost + $95 of user cost), which exceeds the market price of $120 per barrel.

Feedback: Part a: Suppose the user cost is $50 per barrel for all barrels and that the current market price for oil is $90 per barrel. How many barrels will SS pump this year? What is the total accounting profit on the total amount of oil it pumps? What is the total economic profit on those barrels of oil?

SS will pump only 10 million barrels. It will pump those 10 million because it is economically profitable to do so, as each of those barrels brings in $90 in revenue but has only $80 in total costs, including opportunity costs (= $50 explicit cost plus $30 user cost). The accounting profit would be $600 million (= $60 per barrel of accounting profit on 10 million barrels) while the economic profit would be $100 million (= $10 per barrel on 10 million barrels). The firm would not pump any additional barrels because for subsequent barrels the total cost per barrel including the user cost would be $110, which would exceed the revenue per barrel of $90.

Part b: What if the current market price for oil rises to $120 per barrel while the user cost remains at $50 per barrel? How many barrels will SS pump and what will be its accounting profit and its economic profit?

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At $120 per barrel, the firm would now produce its maximum capacity of 90 million barrels per year since revenue exceeds total costs for all barrels. Accounting profits will be $5.7 billion (= $90 per barrel times 10 million barrels + $60 per barrel times 80 million barrels) and economic profits will be $1.2 billion (= $40 per barrel times 10 million barrels + $10 per barrel times 80 million barrels).

Part c: If the current market price remains at $120 per barrel but the user cost rises to $95 per barrel, how many barrels will SS pump this year and what will be its accounting profit and its economic profit?

SS will pump zero barrels of oil this year as the total economic cost of pumping barrels exceeds the revenue per barrel. For instance, the total cost of pumping any of the first 10 million barrels is no $125 per barrel (= $30 of extraction cost + $95 of user cost), which exceeds the market price of $120 per barrel.

4. Deepali and Kyle are fishers with different equipment and, as a result, different costs for catching fish. Deepali‘s costs for catching fish are $1000 per tonne for the first 5 tonnes and then $2500 per tonne for any additional tonnes. Kyle can harvest fish at a cost of $3000 for the first 15 tonnes and then $1400 for any additional tonnes.

LO19B.5 a. If society wants 30 tonnes of fish and for some reason will only allow one of the two fishers to do all the fishing, which fisher should society choose if it wants to minimize the cost of catching those 30 tonnes of fish? What will be the total cost of catching the fish? What will be the average cost per tonne for the 30 tonnes? b. If society wants 30 tonnes of fish and wants them for the least cost regardless of who is catching them, how much should Deepali and Kyle each catch? What will be the total cost of catching 30 tonnes? What will the average cost‐per‐tonne be for the 30 tonnes? c. Suppose that Deepali and Kyle can both sell whatever amount of fish they catch for $3000 per tonne. Also suppose that Deepali is initially given ITQs for 30 tonnes of fish while Kyle is given ITQs for zero tonnes of fish. Suppose that Kyle is willing to pay Deepali $550 per tonne for as many tonnes of ITQs as Deepali is willing to sell to Kyle. How much profit would Deepali make if he used all the ITQs himself? What if Deepali sold 25 tonnes of his ITQs to Kyle while using the other 5 tonnes of ITQs to fish for himself? d. What price per tonne can Kyle offer to pay Deepali for 25 tonnes of ITQs such that Deepali would make exactly as much money from that deal (in which he sells 25 tonnes‘ worth of his ITQs to Kyle while using the rest to fish for himself) as he would by using 30 tonnes of ITQs for himself?

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a. Kyle should catch all the fish; total cost will be $66,000. The average cost per tonne will be $2200. b. Deepali should catch 5 tonnes and Kyle should catch 25 tonnes. The total cost will be $64,000. The average cost per tonne will be $2,133.33. c. If Deepali used the ITQs himself his profit would be $22,500. By contrast, if he fished with 5 tonnes‘ worth of permits and sold the rest for $550 each, he would make $23,750. d. $500 per tonne of ITQs Feedback: Consider the following example. Deepali‘s costs for catching fish are $1000 per tonne for the first 5 tonnes and then $2500 per tonne for any additional tonnes. Kyle can harvest fish at a cost of $3000 for the first 15 tonnes and then $1400 for any additional tonnes.

Part a: If society wants 30 tonnes of fish and for some reason will only allow one of the fishers to do all the fishing, which fisher should society choose if it wants to minimize the cost of catching those 30 tonnes of fish? What will be the total cost of catching the fish? What will the average cost per tonne be for the 30 tonnes?

The first step is to calculate the total cost of catching 30 tonnes of fish for both Deepali and Kyle.

The total cost for Deepali is $67,500 (= $1000 × 5 (first 5 tonnes) + $2500 × 25 (next 25 tonnes)).

The total cost for Kyle is $66,000 (= $3000 × 15 (first 15 tonnes) + $1400 × 15 (next 15 tonnes)).

Kyle should harvest the fish. The average cost per tonne equals $2200 (=$66,000/30).

Part b: If society wants 30 tonnes of fish and wants them for the least cost regardless of who is catching them, how much should Deepali and Kyle each catch? What will be the total cost of catching 30 tonnes? What will be the average cost per tonne for the 30 tonnes?

The first step is to recognize that Deepali can catch the first 5 tonnes of fish at the lowest cost. Thus, Deepali will catch the first 5 tonnes of fish.

The second step is to determine the lowest cost for the next 25 tonnes of fish.

The total cost for Deepali is $62,500 (= $2500 × 25 (next 25 tonnes)).

The total cost for Kyle is $59,000 (= $3000 × 15 (first 15 tonnes) + $1400 × 10 (next 10 tonnes)).

Thus, Kyle should harvest the next 25 tonnes.

The answer is that Deepali should harvest 5 tonnes and Kyle should harvest 25 tonnes.

Note: We could also compare the average cost per tonne for the next 25 tonnes. Here the average cost per tonne for Deepali is $2500 (=$62,500/25) and the average cost per tonne for Kyle is $2360 (=$59,000/25).

The total cost for the 30 tonnes of fish is $64,000 (=$5000 (Deepali's 5 tonnes) + $59,000 (Kyle's 25 tonnes)).

The average cost per tonne is $2133.33 (=$64,000/30).

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Part c: Suppose that Deepali and Kyle can both sell whatever amount of fish they catch for $3000 per tonne. Also suppose that Deepali is initially given ITQs for 30 tonnes of fish while Kyle is given ITQs for zero tonnes of fish. Suppose that Kyle is willing to pay Deepali $550 per tonne for as many tonnes of ITQs as Deepali is willing to sell to Kyle. How much profit would Deepali make if he used all the ITQs himself? What if Deepali sold 25 tonnes of his ITQs to Kyle while using the other 5 tonnes of ITQs to fish for himself?

If Deepali harvested the 30 tonnes himself his revenue would be $90,000 (=$3000 × 30). The total cost of harvesting 30 tonnes is $67,500 (see part a).

Thus, Deepali's profit is $22,500 (= $90,000 - $67,500).

If Deepali Harvests 5 tonnes of fish his revenue will be 15,000 (=$3000 × 5). His cost from harvesting 5 tonnes will be $5000 (see part a). His profit from harvesting the 5 tonnes of fish is $10,000 (=$15,000 - $5000). Now Deepali also sells Kyle 25 ITQs for a price of $550. This brings in the additional revenue of $13,750 (=$550 × 25) at zero cost.

Thus, Deepali's profit is $23,750 (= $10,000 (Harvesting) + $13,750 (sale of ITQs)).

Deepali should harvest 5 tonnes and sell 25 tonnes worth of ITQs Part d: What price per tonne can Kyle offer to pay Deepali for 25 tonnes of ITQs such that Deepali would make exactly as much money from that deal (in which he sells 25 tonnes‘ worth of his ITQs to Kyle while using the rest to fish for himself) as he would by using all the ITQs for himself?

The profit per-tonne Deepali can make on his next 25 tonnes is $500 (= $3000 (sale price per tonne) - $2500 (cost per tonne, next 25 tonnes)). Thus, $500 per tonne is the lowest price that Kyle could pay Deepali. At that price, Deepali makes exactly as much money using the permits himself as he would be selling them to Kyle.

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