Solution Manual For Microeconomics, 18th Edition By Christopher T.S. Ragan

INSTRUCTOR’S SOLUTIONS MANUAL for

Microeconomics Eighteenth Canadian Edition

Christopher T. S. Ragan McGill University

Contents Part One Chapter 1 Chapter 2

What Is Economics?

Economic Issues and Concepts ......................................................2 Economic Theories, Data, and Graphs .......................................13

Part Two Chapter 3

An Introduction to Demand and Supply Demand, Supply, and Price ..........................................................25

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Chapter 4 Chapter 5 Part Three Chapter 6 Chapter 7 Chapter 8

CHAPTER 1: ECONOMIC ISSUES AND CONCEPTS

Elasticity ......................................................................................38 Price Controls and Market Efficiency..........................................52 Consumers and Producers Consumer Behaviour ...................................................................62 Producers in the Short Run ..........................................................79 Producers in the Long Run ..........................................................92

Part Four Market Structure and Efficiency Chapter 9 Competitive Markets ..................................................................101 Chapter 10 Monopoly, Cartels, and Price Discrimination............................114 Chapter 11 Imperfect Competition and Strategic Behaviour .......................128 Chapter 12 Economic Efficiency and Public Policy ....................................140 Part Five Chapter 13 Chapter 14 Chapter 15

Factor Markets How Factor Markets Work ........................................................150 Labour Markets and Income Inequality .....................................162 Interest Rates and the Capital Market ........................................174

Part Six Chapter 16 Chapter 17 Chapter 18

Government in the Market Economy Market Failures and Government Intervention ..........................182 The Economics of Environmental Protection ............................195 Taxation and Public Expenditure ...............................................207

Part Seven Canada in the Global Economy Chapter 19 The Gains from International Trade ..........................................217 Chapter 20 Trade Policy ...............................................................................227

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List of Boxes Applying Economic Concepts 1-1 The High Opportunity Cost of Your University Degree 8 1-2 Economics Needs the Other Social Sciences 23 2-1 Where Economists Work 32 2-2 Can Economists Design Controlled Experiments to Test Their Theories? 36 3-1 Demand and Supply Shocks Created by the COVID-19 Pandemic 66 3-2 Why Apples but Not iPhones? 74 4-1 Who Really ―Pays‖ for Payroll Taxes? 95 5-1 Minimum Wages and Unemployment 107 5-2 The Debate over ―Price Gouging‖: Efficiency Versus Public Virtue 120 6-1 Rationality and Framing in Consumer Behaviour 134 7-1 Is It Socially Responsible to Maximize Profits? 162 7-2 Three Examples of Diminishing Returns 171 7-3 The Digital World: When Diminishing Returns Disappear Altogether 177 8-1 Is Canada Falling Behind? 196 8-2 Computers, the Internet, and the Productivity Paradox 198 9-1 Why Small Firms Are Price Takers 212 9-2 The Parable of the Seaside Inn 222 10-1 Network Effects as Entry Barriers 245 13-1 Is Greater Immigration a Solution for ―Labour Shortages‖? 340 14-1 A Century of Legislated Discrimination of Indigenous Peoples 354 15-1 Inflation and Interest Rates 395 15-2 Canada’s Housing Affordability Crisis 400 16-1 The World’s Endangered Fish 416 16-2 Used Cars and the Market for ―Lemons‖ 422 18-1 Using a UBI to Eliminate Poverty 486 19-1 Two Examples of Absolute and Comparative Advantage 506 19-2 Comparative Advantage and Global Supply Chains 514 20-1 Tensions Between Supply Management and Freer Trade 538 Lessons from History 4-1 Economic Development and Income Elasticities 97 8-1 Jacob Viner and the Clever Draftsman 193 9-1 What Do Whaling Ships and Oil Wells Have in Common? 230 10-1 Disruptive Technologies and Creative Destruction 247 12-1 Are Amazon and Facebook the Standard Oil of the Twenty-First Century? 310 13-1 David Ricardo and ―Economic Rent‖ 337 20-1 Tariff Wars and the Stark Lessons from the Great Depression 532 20-2 Canadian Wine: A Free-Trade Success Story 545

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Extensions in Theory 3-1 The Distinction Between Stocks and Flows 55 11-1 The Prisoners’ Dilemma 278 16-1 Arthur Okun’s ―Leaky Bucket‖ 424 18-1 Who Really Pays the Corporate Income Tax? 470 19-1 The Gains from Trade More Generally 504

____________________________________ ____ Part One What Is Economics?

____________________________________ ____ This opening Part of the book is an introduction to economics. The central themes of Chapter 1 are scarcity, choice, opportunity cost, and the selforganizing role of markets. The chapter also examines the gains from specialization and trade, the role of money, the effects of globalization, and ends with a discussion of the various types of economic systems. Chapter 2 examines how economists build their models and test their theories. It also addresses central methodological issues, the most important being the idea that the progress of economics as a discipline (like all scientific disciplines) depends on relating our theories to what we observe in the world around us. Finally, the chapter has an extensive section on graphing. *** Chapter 1 opens with a brief tour of some key economic issues in Canada and other countries—from rising house prices and the dangers of climate change to accelerating technological change and growing income inequality. The purpose is to whet the reader‘s appetite for the kinds of issues economists are thinking about today. This offers a

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natural segue to the discussion of scarcity, without which few of these issues would be very interesting.

The chapter addresses the fundamental concepts of scarcity, choice, and opportunity cost, illustrating these ideas with a production possibilities boundary. It is worth noting that these concepts are relevant to all economies, whether they are organized by central planning or by free markets. We then examine the complexity of modern market economies, examining the decision makers, production, trade, money, and globalization.

Finally, we examine different types of economic systems, including traditional, command, and freemarket systems. We emphasize that all actual economies are mixtures, containing elements of all three pure systems.

Chapter 2 provides a longer introduction to the methodological issues of economics than is usually included in introductory texts. We do this because most students believe that the scientific method is limited to the natural sciences. But to fully appreciate economics, they must understand that its theories are also open to empirical testing and that these theories continually change as a result of what the empirical evidence shows. We Copyright © 2026 Pearson Canada Inc.

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understand that some instructors feel their time is so limited that they cannot spend class time on Chapter 2. We believe that even if it is not covered in class, students’ attention should be called to the issues addressed in the chapter. Our experience is that students benefit from some discussion of the scientific method and from the insight that the social sciences are not all that different from the ―hard‖ sciences, at least in their basic approaches.

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The chapter begins by making thenormative distinctionstatements. between positive and We then work carefully through the various elementsdefinitions, of economic theories, including assumptions, and predictions. Testing theories is as important as developing them, so we emphasize the interaction between theorizing and empirical observation. then present various types of We economic data, and this gets us into a detailed discussion of index numbers, timeseries and cross-section data, and graphs. The final section of the chapter goes through detail. graphing in

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_______________________________________ Chapter 1: Economic Issues and Concepts _______________________________________

This chapter is in three main sections, which begin after a brief introductory mention of some key economic issues of the day, to which we have added the current phenomenon of rapidly rising house prices and also the challenge of Indigenous reconciliation following the age-old discrimination embedded within Canada’s Indian Act. We have also added a new passage about how countries progress through stages of economic development, and how this leads us to use the terms economically advanced and economically developed economies.

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The first substantive section develops the concepts of scarcity, choice, and opportunity cost. To ensure the student really understands what opportunity cost is all about, we have a box that examines the opportunity cost of a university or college degree. This should be a familiar example to which students can easily relate.

The production possibilities boundary is then introduced, and it is shown to embody the three key concepts of scarcity, choice and opportunity cost. Its nature as a frontier between attainable and unattainable is worth stressing, as is the fact that what is attainable is itself subject to change. Four key economic problems are then Copyright © 2026 Pearson Canada Inc.

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discussed, and each one is expressed in terms of the production possibilities boundary. These questions give the student an inkling of the types of questions addressed both in microeconomics and in macroeconomics, including the role of government policy. Our discussion of policy leads us to a new example of scarcity: the growing scarcity of fresh water in many parts of the world. This discussion then points to a new video which examines the policy debates surrounding this crucial issue.

The chapter’s second section examines the complexity of modern economies, asking why the things we want to purchase are almost Copyright © 2026 Pearson Canada Inc.

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always available. What produces this remarkable coordination? We discuss the market as an instrument that brings order to the economy as a whole. Along the way, the student is introduced to Adam Smith’s ―invisible hand‖. The section also discusses who makes the many millions of choices in a market economy, and why incentives matter to the decision-makers. We show the circular flow of income and expenditure as a way of showing the interaction between consumers and producers. We also examine the nature of maximizing decisions (both utility and profit), and the importance of decisions at the margin. Finally, on the production side, we examine the Copyright © 2026 Pearson Canada Inc.

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role of specialization, the division of labour, globalization, and the importance of money in facilitating trade.

The chapter’s third and final section deals with comparative economic systems. Students will read in almost every chapter of this book about a market economy.

Contrasting it with planned and traditional economies is a good way to gain some insight into the concept at the outset. We emphasize that actual economies are rarely, if ever, well represented by the extremes; instead, actual economies are mixed economies, with varying degrees of government ownership and planning. Students are introduced to Karl Marx’s Copyright © 2026 Pearson Canada Inc.

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argument for a centrally planned economy. While Marx had many things right, we argue that central planning has not been successful in proving itself as an efficient way of organizing an economy, allocating resources, or generating prosperity for a large fraction of the population. We have a box at this point explaining why a thorough understanding of economic phenomena and economic policy requires drawing insights from the other social sciences.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1

a) land, labour, capital; factors b) opportunity cost c) production possibilities boundary

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d) scarcity (because points outside the boundary are unattainable); downward (or negative); the opportunity cost associated with any choice e) constant; increasing f) increases (meaning that more units of good B must be given up to get an extra unit of good A) Question 2

a) self; self-interest b) incentives c) firms; households; governments d) increase (maximize); increase (maximize) e) margin; (marginal) cost Question 3

a) division; specialization b) trade c) money d) globalization

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Review Questions Question 4 Any realistic production possibilities boundary displays scarcity, the need for choice, and opportunity cost.

Scarcity: The production possibilities boundary (PPB) separates attainable combinations of goods from those that are unattainable. Thus scarcity is shown by the existence of some unattainable bundles of goods.

Choice: Because of scarcity, societies must somehow choose how resources are to be allocated; thus a particular point on the PPB must be chosen.

Opportunity Cost: The slope of the PPB is negative, revealing the opportunity cost that is unavoidable every time a choice is made. For the economy as a whole, the decision to produce more of one good must involve a decision to produce less of some other good.

Question 5 Consider any country’s PPB, and suppose the two products are X and Y. A technological improvement in industry X shifts the PPB out (along the X axis), increasing the maximum amount of X that can be produced. Note that the maximum amount of Y that can be produced has not changed. But since the PPB has shifted out, there are many combinations of both goods that are now available that were not before, and some of these involve producing more of both goods. Thus, even though the technology for producing Y has not changed, the technological improvement in X allows the country to choose to produce more of both products.

Question 6

The central ideas illustrated by the two-good version of the production possibilities boundary (PPB) are Copyright © 2026 Pearson Canada Inc.

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scarcity, choice, and opportunity cost.

Exactly the same ideas can be illustrated in a more realistic threegood version of the model, which is more complicated to draw, or by the much more realistic N-good version of the model (with N  4), which is impossible to draw. Thus the assumption of only two goods is merely a simplifying one: it allows us to easily grasp and illustrate some central points that would be more difficult to understand in the more general N-good case.

Question 7

a) If all Canadian families had $95,000 of after-tax income (roughly the Canadian median), it would be difficult to say that real poverty existed in Canada. At this level of Copyright © 2026 Pearson Canada Inc.

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income, all families would easily have enough income to provide the essentials of food, shelter, and clothing, and could also have much beyond these essentials. However, there would still be many things that these families could not afford, such as an expensive university education, expensive vacations, a cottage in the country, etc. Defining poverty with any precision is difficult, and we will say more about this in Chapter 18. b) Would scarcity exist in such a setting? Yes, certainly. By scarcity we mean simply an excess of wants over the resources available to satisfy those wants. And scarcity would exist for each of those families because most (if not all) of them would still desire to have more than they actually had.

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c) Scarcity is an excess of wants over the resources available to satisfy those wants. Poverty—at least in its “absolute form”—is concerned with a level of resources below some threshold of sufficiency. One can conceivably eliminate poverty, as in part (a), but that would not eliminate scarcity.

Question 8 Microeconomics is the study of the allocation of resources within and across individual markets, and the determination of relative prices and quantities in those specific markets.

Little or no attention is paid to the behaviour of the aggregate economy. Macroeconomics is the study of the determination of aggregates such as aggregate output, employment, the price level, the unemployment rate, and the exchange rate. When doing macroeconomics, little or no attention is paid to what is going on in the individual markets for specific products.

Question 9 In the answers that follow, note that the statements are made ceteris paribus. In other words, the predicted result of a change in some specific price is made under the assumption that nothing else changes. a) As the price of ski-lift tickets rises, you are likely to substitute toward other leisure activities (whose price has not increased) and thus reduce your purchases of ski-lift tickets. b) As the hourly wage for your weekend job rises, the opportunity cost of not working rises. So, you are more likely than before to decide not to go skiing, and to work instead. c) As the fine for speeding rises, the cost of being caught speeding clearly increases. The benefit of driving over the speed limit is presumably unchanged, however. So, an increase in the value of speeding tickets is likely to cause you to reduce your speed (and to watch more carefully for hidden police cars!).

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d) The higher the weight placed on the assignment, the greater is the incentive for you to work hard on that assignment (and thus hopefully receive a higher grade on the assignment and on the course). This is one obvious reason why professors like to put significant weight on midterm exams—to get students to work hard early in the course rather than leaving all the work to the few days before the final exam! e) As tuition fees for one specific institution increase, you are likely to substitute toward other institutions whose fees have not increased, and thus reduce your desire to attend the first institution. (For small changes in tuition fees, this effect may be very small because of the perceived large differences between some educational institutions.)

Question 10

There are two reasons why the specialization of labour is more efficient than self-sufficiency.

First, since individual abilities differ, specializing allows each person to focus their energies on what they do best, leaving everything else to be done by others. As a result, total output will rise. Second, as people specialize, they often ―learn by doing‖ and become even better at their specific task. Thus, specialization often leads to improvements in ability that would not otherwise occur.

Question 11 The market for doctors’ services depends heavily on the specialization of labour. A person with back pain will not know what is wrong. They go to a general practitioner (GP) who is somewhat familiar with a broad range of symptoms and illnesses. The GP may rule out the simplest possible causes for the pain, and in the process determine that the patient requires the services of a specialist who diagnoses and treats the patient’s back. The patient is referred to this specialist who may diagnose a ruptured disk and perform the delicate surgery necessary to solve the problem. Given this reliance on specialization, the market depends on having relatively more GPs who see a large number of patients and act as ―gatekeepers‖ for patients to the more specific specialists.

Question 12

Traditional systems: Behaviour is based primarily on tradition, custom, and habit.

Command systems: Decisions about production and consumption are determined by a central planning authority.

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Free-market systems: Production and consumption decisions are made privately, by decentralized producers and consumers.

Mixed systems: These economic systems contain elements of tradition, command, and free markets.

Question 13

This quote, if put to a group of students, would stimulate much interesting discussion, not only about views on how alternative economic systems work, but also about the words used to describe them. The term planned economy, for example, describes the conscious use of centralized decision making for key economic decisions, but the results of that process often look anything but planned, with shortages in some sectors, surpluses in others, and often a rather dispirited and unmotivated private sector. On the other hand, the unplanned decentralized market economy––though surely not perfect––creates a much more orderly looking set of outcomes.

Problems Question 14 In general, the opportunity cost (measured in dollars) for any activity includes three things:  the direct (dollar) cost of the activity, plus  the dollar value of whatever you give up in order to do the activity, minus  whatever dollar ―savings‖ the activity generates In this case, the direct cost of transportation, lift tickets and accommodation of $300 is definitely included. The income of $120 that you give up also counts. Finally, we must deal with the restaurant meals of $75. Surely you would have eaten some food even if you hadn’t gone skiing, so the full $75 is not included. But given the relatively high price of restaurant meals compared to buying your own groceries, you will probably include most of the $75. Thus, the opportunity cost of the ski trip is $420 plus some (large) fraction of the $75.

Question 15

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a) The budget line is shown below. If all $240,000 is spent on ATVs, you could purchase 30 of them; if all the money is spent on snowmobiles, you could purchase 20 of them. The downward sloping line divides the attainable from the unattainable combinations of ATVs and snowmobiles.

b) The opportunity cost of one ATV is the number of snowmobiles that must be given up to purchase an additional ATV. Since each ATV costs $8000 and each snowmobile costs $12,000, the opportunity cost of one ATV is 2/3 of a snowmobile. c) The opportunity cost of one snowmobile is the number of ATVs that must be given up to purchase an additional snowmobile. It is equal to 1.5 ATVs. Note that the opportunity cost of an ATV (in terms of forgone snowmobiles) is the inverse of the opportunity cost of a snowmobile (in terms of forgone ATVs). d) In this case, the prices of ATVs and snowmobiles are independent of how many are purchased. This fact is reflected by the budget line being linear (of constant slope). So, both opportunity costs are independent of how many are purchased.

Question 16 In each scenario, one could choose to plot the PPB, where the two numbers provided are the two intercepts along the two axes. The slope of the boundary would show the opportunity cost of each Copyright © 2026 Pearson Canada Inc.

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door (or each window). Alternatively, one can compare the two maximum values, as provided in the question. a) The factory could produce either 1000 windows or 250 doors (or many intermediate combinations). To produce one extra door, it must give up 4 (=1000/250) windows.

In other words, the opportunity cost of one extra door is 4 windows. b) The opportunity cost of one extra door is 1 window (=500/500). c) The opportunity cost of one extra door is 3 windows (=1200/400). d) The opportunity cost of one extra door is 1.35 windows (=942/697). e) The opportunity cost of one extra door is 1.33 windows (=600/450).

Question 17 This question is good for forcing students to think through the computation of opportunity cost and also for showing how the allocation of labour in particular ways can maximize total output. a) You can catch 6 fish or collect 3 bundles of firewood in one day’s work. Thus, your opportunity cost of one additional bundle of firewood is 2 fish (6/3 = 2). For your friend, the opportunity cost of one additional bundle of firewood is 4 fish (8/2 = 4). b) To allocate tasks in the output-maximizing way, each person should do the task for which they have the lower opportunity cost. You have the lower opportunity cost of collecting firewood. Your friend has the lower opportunity cost of catching fish (0.25 of a bundle for your friend as compared to 0.5 of a bundle for you). So, for the two of you to collectively maximize output you should specialize in collecting firewood and your friend should specialize in catching fish. c) What is the total amount of output after two days if you allocate labour as in part (b)?

In two days, you would collect 6 bundles of firewood and your friend would catch 16 fish. The reverse pattern of specialization would yield only 4 bundles of firewood and 12 fish, which is clearly inferior.

Question 18 a) At point a, 2.5 tonnes of clothing and 3 tonnes of food are being produced per year. At point b, annual production is 2.5 tonnes of clothing and 7 Copyright © 2026 Pearson Canada Inc.

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tonnes of food. At point c, annual production is 6.5 tonnes of clothing and 3 tonnes of food. b) At point a, the economy is either using its resources inefficiently or it is not using all of its available resources. Point b and c represent full and efficient use of available resources because they are on the PPB. c) At point b, the opportunity cost of producing one more tonne of food (and increase from 7 to 8) is the 2.5 tonnes of clothing that must be given up. The opportunity cost of producing one more tonne of clothing (from 2.5 to 3.5) appears, from the graph, to be approximately 0.75 tonnes of food that must be given up (from 7.0 to about 6.25). d) Point d is unattainable given the economy‘s current technology and resources. Point d can become attainable with a sufficient improvement in technology or increase in available resources.

Question 19

a) As the table shows, there are only 250 workers in Choiceland, and to construct the PPB we must imagine all the combinations of workers in each sector. Using the two middle columns from the table, we can plot the output levels on a graph to get the following PPB:

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b) If the economy is already producing 45 units of X and 900 units of Y, then 15 extra units of X can only be produced by reducing the production of Y by 300 units. The opportunity cost of 15 units of X is therefore 300 units of Y (or 300/15 = 20 units of Y per unit of X). If the economy is already producing 60 units of X (and 600 units of Y), the opportunity cost of producing an additional 15 units of X is the full 600 units of Y that must be given up.

This implies an opportunity cost of 600/15 = 40 units of Y per extra unit of X. Thus, we see that the opportunity cost of X rises when more of X is already being produced. c) If the economy is producing 40 units of X and 600 units of Y, then either some resources are not being used or they are being used inefficiently; the economy is operating inside the PPB. It would thus be possible to improve the use of resources and increase output of X by 20 units without reducing the output of Y at all. In this sense, the extra output of X has no opportunity cost in terms of forgone units of Y. d) If any given amount of labour can now produce 10 percent more of good Y, then the PPB shifts up in a particular way. Specifically, the Y values increase by 10 percent for any given X value, as shown below.

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Question 20 a) It doesn‘t matter how the two axes are labelled in this case; just label them X and Y. The long civil war destroys much of the country‘s infrastructure and likely reduces the country‘s ability to produce all products. So the PPB shifts inwards, as shown below in part (a) of the figure. b) The axes are now labelled Food and Clothing.

The new technology doubles the maximum amount of food that can be produced, and so shifts the PPB outward in the manner shown in part (b) of the figure. Note that the vertical intercept (maximum amount of clothing) does not change. c) The axes are again labelled Food and Clothing, as in part (c). In this situation, the earthquake destroys many clothing factories and so shifts the PPB inward, reducing the maximum possible amount of clothing (but leaving unaffected the maximum possible amount of food). d) The axes are labelled X and Y, as shown in part (d) of the figure. The immigration increases the labour force and increases the country‘s ability to produce all products. The PPB shifts outward, Copyright © 2026 Pearson Canada Inc.

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increasing the maximum possible amounts of both X and Y. Since the new level of immigration is occurring each year, every year will see such an outward shift in the PPB.

*****

______________________________________________ Chapter 2: Economic Theories, Data, and Graphs ______________________________________________ This chapter is an introduction to the methods economists use in their research. We integrate a detailed discussion of graphing into our discussion of how economists present economic data and how they test economic theories.

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In our experience, students typically do not learn enough about the connection between theory and evidence, and how both are central to understanding economic phenomena. We therefore recommend that considerable emphasis be placed on Figure 2-1, illustrating the process of going from model building to generating hypotheses to confronting data and testing hypotheses, and then returning to model building (or rebuilding). There is no real beginning or end to this process, so it is difficult to call economics an entirely ―theory driven‖ or ―data driven‖ discipline. Without the theory and models, we don‘t know what to look for in the data; but without analyzing the data from the world around us, we can‘t build sensible models of human behaviour and interaction through markets.

The scientific approach in economics, as in the ―hard‖ sciences, involves a close relationship between theory and evidence. *** The chapter is divided into four major sections. In the first section, we make the important distinction between positive and normative statements and advice. Students must understand this distinction, and that the progress of any scientific discipline relies on researchers‘ ability to separate what evidence suggests is true from what they would like to be true. We conclude this section by explaining why economists often seem to disagree even though there is a great deal of agreement among them on many specific issues.

This leads to a box on where economists typically get jobs and the kind of work they do.

The second section explains the elements of economic theories and how they are tested. We emphasize how a theory‘s or model‘s definitions and assumptions lead, through a process of logical deduction, to a set of conditional predictions. We then examine the testing of theories. It is here

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that we focus on the interaction of theory and empirical observation (Figure 2-1). We emphasize the importance of the distinction between correlation and causation, with a simple example.

We have added a box at this point on the growing use of randomized control trials (RCTs) in testing economic hypotheses, and some of the limitations encountered with this empirical approach.

The chapter‘s third section deals with economic data.

We begin by explaining the construction of index numbers, and we use them to compare the volatility of two sample time series.

Index numbers are so pervasive in discussions of economic magnitudes that students must know what these are and how they are constructed. We then make the distinction between cross-sectional and time-series data, and at this point students are introduced to two types of graph.

This brings us to the chapter‘s final section, on graphing. We show how a relation can be expressed in words, in a table, in an equation, or on a graph. We then go into considerable detail on linear functions, slope, non-linear functions, and functions with minima and maxima.

In this discussion, the student is introduced to the concept of the margin, described as the change in Y in response to a one-unit change in X. In all cases, the graphs apply to real-world situations rather than abstract variables.

Pollution abatement, hockey-stick production, firm profits, and fuel consumption are our main examples.

Answers to Study Exercises Fill-in-the-Blank Questions

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Question 1 a) models (or theories) b) endogenous; exogenous c) (conditional) prediction; empirical d) (positively) correlated; causal e) self-interest; utility; profits Question 2 a) index; relative b) absolute value of the price; absolute value of the price c) cross-section d) scatter e) time-series Question 3 a) ΔY/ΔX b) 500; positively; 4 c) 12; negatively; −0.2 d) tangent e) zero; zero Review Questions Question 4

a) normative (―The government should impose…‖ is inherently a value judgment.) b) positive (In principle, we could determine the impact that foreign aid actually has.) c) positive (In principle, we could determine the extent to which fee increases affect access.)

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d) normative (What is or is not unfair is clearly based on a value judgment.) e) normative (Use of the expression ―too much‖ is a value judgment.) f) normative (Use of the word ―should‖ sentence makes it a value judgment.)

in

this

g) positive (We could survey people to determine their preferences regarding these policies.)

Question 5

a) In the Canadian wheat sector, the amount of rainfall on the Canadian prairies is an exogenous variable; the amount of wheat produced is an endogenous variable. b) To the Canadian market for coffee, the world price of coffee is exogenous; the price of a cup of coffee at Tim Horton‘s is endogenous. c) To any individual student, the widespread unavailability of student loans is exogenous; their own attendance at university or college is endogenous. d) To any individual driver, the tax on gasoline is exogenous; his or her own decision regarding which vehicle to purchase is endogenous.

Question 6 The observed correlation cannot lead to a certain inference about causality. It is consistent with the theory that the increase in demand for homes leads to an increase in the price of lumber (which is generally a pretty sensible theory!), but it is also consistent with a different theory—one in which some unobserved factor leads to both the Copyright © 2026 Pearson Canada Inc.

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increase in demand for homes and separately to the increase in the price of lumber. Correlation does not imply causality!

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Problems Question 7 a) Using 2013 as the base year means that we choose $85 as the base price. We thus divide the actual prices in all years by $85 and then multiply by 100. In this way, we will determine, in percentage terms, how prices in other years differ from prices in 2013. The index values are as follows: Year 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Price ($) 85 87 94 104 110 112 120 125 127 127 130

Physics textbook price index (85/85) × 100 = 100 (87/85) × 100 = 102.4 (94/85) × 100 = 110.6 (104/85) × 100 = 122.4 (110/85) × 100 = 129.4 (112/85) × 100 = 131.8 (120/85) × 100 = 141.2 (125/85) × 100 = 147.1 (127/85) × 100 = 149.4 (127/85) × 100 = 149.4 (130/85) × 100 = 152.9

b) The price index in 2018 is 131.8, meaning that the price of the physics textbook is 31.8 percent higher in 2014 than in the base year, 2013. c) From 2020 to 2023, the price index increases from 147.1 to 152.9⎯but this is not an increase of 5.8 percent (152.9 – 147.1).

The percentage increase in the price index from 2020 to 2023 is equal to [(152.9 − 147.1) / 147.1] × 100 = 3.94 percent. d) These are time-series data because the data are for the same product at the same place but at different points in time.

Question 8 a) Using Calgary as the ―base university‖ means that we choose $6.25 as the base price. Thus we Copyright © 2026 Pearson Canada Inc.

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divide all actual prices by $6.25 and then multiply by 100. In this way, we will determine, in percentage terms, how prices at other universities differ from Calgary prices. The index values are as follows:

University Dalhousie Laval McGill Queen’s Waterloo Manitoba Saskatchewan Calgary UBC Victoria

Price per pizza $6.50 5.95 6.00 8.00 7.50 5.50 5.75 6.25 7.25 7.00

Index of pizza prices (6.50/6.25) × 100 = 104 (5.95/6.25) × 100 = 95.2 (6.00/6.25) × 100 = 96 (8.00/6.25) × 100 = 128 (7.50/6.25) × 100 = 120 (5.50/6.25) × 100 = 88 (5.75/6.25) × 100 = 92 (6.25/6.25) × 100 = 100 (7.25/6.25) × 100 = 116 (7.00/6.25) × 100 = 112

b) The university with the most expensive pizza is Queen‘s, at $8.00 per pizza. The index value for Queen‘s is 128, indicating that pizza there is 28 percent more expensive than at Calgary. c) The university with the least expensive pizza is Manitoba, at $5.50 per pizza. The index value for Manitoba is 88, indicating that the price of pizza there is only 88 percent of the price at Calgary.

It is therefore 12 percent cheaper than at Calgary. d) These are cross-sectional data. The variable is the price of pizza, collected at different places at a given point in time (March 1, 2025). If the data had been the prices of pizza at a single university at various points in time, they would be time-series data.

Question 9 a) Using 2018 as the base year for an index number requires that we divide the value of exports (and imports) in each year by the value in 2018, and Copyright © 2026 Pearson Canada Inc.

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then multiply the result by 100. This is done in the table below.

Year 2018 2019 2020 2021 2022

Exports 113.6 117.1 74.3 134.8 211.8

Export Index (113.6/113.6)(100) = 100 (117.1/113.6)(100) = 103.1 (74.3/113.6)(100) = 65.4 (134.8/113.6)(100) = 118.7 (211.8/113.6)(100) = 186.4

Imports 38.7 37.7 23.0 32.1 51.4

Import Index (38.7/38.7)(100) = 100 (37.7/38.7)(100) = 97.4 (23.0/38.7)(100) = 59.4 (32.1/38.7)(100) = 82.9 (51.4/38.7)(100) = 132.8

b) It appears that exports were more volatile over this period than imports. Both variables fell sharply in 2020, although imports fell a little more. But exports grew much faster over the next few years, so overall exports were more volatile than imports. c) The index number for exports increased from 100 to 186.4 between 2018 and 2022, so exports grew by 86.4 percent. Imports grew by 32.8 percent over the same period. d) Both variables dropped sharply in 2020. The obvious explanation is that this was (economically) the worst year of the COVID-19 pandemic. The collapse in Canadian income in that year led to a reduction in imports. The same phenomenon in other countries led to a reduction in their demand for Canadian goods—our exports.

Question 10

This is a good understand the averages rather situations.

question to make sure students importance of using weighted than simple averages in some

a) The simple average of the three regional unemployment rates is equal to (5.5 + 7.2 + 12.5)/3 = 8.4. Is 8.4% the ―right‖ unemployment rate for the country as a whole? The answer is no because Copyright © 2026 Pearson Canada Inc.

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this simple, unweighted (or, more correctly, equally weighted) average does not account for the fact that the Centre is much larger in terms of the labour force than either the West or East, and thus should be given more weight than the other two regions. b) To solve this problem, we construct a weighted average unemployment rate. We do so by constructing a weight for each region equal to that region‘s share in the total labour force. From the data provided, the country‘s total labour force is 17.2 million (5.3 + 8.4 + 3.5). The three weights are therefore: West:

weight = 5.3/17.2 = 0.308

Centre: weight = 8.4/17.2 = 0.488 East:

weight = 3.5/17.2 = 0.203

These weights should sum exactly to 1.0, but due to rounding they do not quite do so. Using these weights, we now construct the average unemployment rate as the weighted sum of the three regional unemployment rates.

Canadian weighted unemployment rate = (.308  5.5) + (.488  7.2) + (.203  12.5) = 7.75 This is a better measure of the Canadian unemployment rate because it correctly weights each region‘s influence in the national total. Keep in mind, however, that for many situations the relevant unemployment rate for an individual or a firm may be the more local one rather than the national average.

Question 11 a) These data are best illustrated with a timeseries graph, with the month shown on the Copyright © 2026 Pearson Canada Inc.

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horizontal axis and the exchange rate shown on the vertical axis.

b) These cross-sectional data are best illustrated with a bar chart.

c) These cross-sectional data are best illustrated in a scatter diagram; the ―line of best fit‖ is clearly upward sloping, indicating a positive Copyright © 2026 Pearson Canada Inc.

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relationship between average investment rates and average growth rates.

Question 12 a) Along Line A, Y falls as X rises; thus the slope of Line A is negative. For Line B, the value of Y rises as X rises; thus the slope of Line B is positive. b) Along Line A, the change in Y is –4 when the change in X is 6. Thus the slope of Line A is ΔY/ΔX = −4/6 = −2/3. The equation for Line A is: Y = 4 – (2/3)X c) Along Line B, the change in Y is 7 when the change in X is 6. Thus the slope of Line B is ΔY/ΔX = 7/6. The equation for Line B is: Y = 0 + (7/6)X

Question 13

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Given the tax-revenue function T = 10 + .25Y, the plotted curve will have a vertical intercept of 10 and a slope of 0.25. The interpretation is that when Y is zero, tax revenue will be $10 billion.

And for every increase in Y of $100 billion, tax revenue will rise by $25 billion. The diagram is as shown below:

Question 14 a) The slope of the straight line connecting two points is equal to the change in Y between the points divided by the change in X between the points. In this case, the change in Y from the first point to the second is 3; the change in X is 9. Thus the slope of the straight line is 3/9 = 1/3. b) From point A to point B, the change in Y is 20 and the change in X is −10. Thus the slope of the straight line is −20/10 = −2. c) The slope of the function is the change in Y brought about by a one-unit change in X, which is given by the coefficient on X, −0.5.

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d) The slope of the function is the change in Y brought about by a one-unit change in X, which is given by the coefficient on X, 6.5. e) The slope of the function is the change in Y brought about by a one-unit change in X, which is given by the coefficient on X, 3.2. f) The Y-intercept of a function is the value of Y when X equals 0. In this case the Y-intercept is 1000. g) The Y-intercept of a function is the value of Y when X equals 0. In this case the Y-intercept is −100. h) The X-intercept of a function (if it exists) is the value of X when Y equals 0. In this case, when Y equals 0 we have the equation 0 = 10 – 0.1X which yields −10 = −0.1X which gives us X = 100.

Question 15 Let A be the firm‘s annual spending on advertising and let R be the firm‘s annual revenues. The equation for advertising (A) as a function of revenues (R) is A = 100,000 + (0.15)R.

Question 16

a) For each relation, plot the values of Y for each value of X. Construct the following table: (i) Y = 50 + 2X X 0 10

Y 50 70

(ii) Y = 50 + 2X + .05X2 X 0 10

Y 50 75

(iii) Y = 50 + 2X − .05X2 X Y 0 50 10 65

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20 30 40 50

90 110 130 150

20 30 40 50

110 155 210 275

20 30 40 50

70 65 50 25

Now plot these values on scale diagrams, as shown below. Notice the different vertical scale on the three different diagrams.

b) For part (i), the slope is positive and constant and equal to 2. For each 10-unit increase in X, there is an increase in Y of 20 units. For part (ii), the slope is always positive since an increase in X always leads to an increase in Y. But the slope is not constant. As the value of X increases, the slope of the line also increases.

For part (iii), the slope is positive at low levels of X. But the function reaches a maximum at X=20, after which the slope becomes negative.

Furthermore, when X is greater than 20, the slope of the line becomes more negative (steeper) as the value of X increases. c) For part (i), the marginal response of Y to a change in X is constant and equal to 2. This is the slope of the line. In part (ii), the marginal response of Y to a change in X is always positive, but the marginal response increases as the value of

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X increases. This is why the line gets steeper as X increases. For part (iii), the marginal response of Y to a change in X is positive at low levels of X. But after X=20, the marginal response becomes negative. Hence the slope of the line switches from positive to negative. Note that for values of X further away from X=20, the marginal response of Y to a change in X is larger in absolute value. That is, the curve flattens out as we approach X=20 and becomes steeper as we move away (in either direction) from X=20.

Question 17

The four scale diagrams are shown below, each with different vertical scales. In each case, the slope of the line is equal to Y/X, which is often referred to as ―the rise over the run‖—the amount by which Y changes when X increases by one unit. (For those students who know calculus, the slope of each curve is also equal to the derivative of Y with respect to X, which for these curves is given by the coefficient on X in each equation.)

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Question 18

The six required diagrams are shown below. Note that we have not provided specific units on the axes. For the first three figures, the tax system provides good examples. In each case, think of earned income as being shown along the horizontal axis and taxes paid shown along the vertical axis.

The first diagram might show a progressive incometax system where the marginal tax rate rises as income rises.

The second diagram shows a proportional system with a constant marginal tax rate. The third diagram shows marginal tax rates falling as income rises, even though total tax paid still rises as income rises.

For the second set of three diagrams, imagine the relationship between the number of rounds of golf played (along the horizontal axis) and the golf score one achieves (along the vertical axis). In all three diagrams the golf score falls (improves) as one golfs more times. In the first diagram, the more one golfs the more one improves on each successive round played. In the second diagram, the rate of improvement is constant. In the third diagram, the rate of improvement diminishes as the number of rounds played increases. The actual relationship probably has bits of all three parts— presumably there is a lower limit to one‘s score so eventually the curve must flatten out.

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Question 19 a) The slope of any curve at any point is equal to the slope of a tangent line to that curve at that point. At point A on the curve shown in the question, the slope of the tangent line is ½ = 0.5, and hence this is the slope of the curve at point A. For point B, the slope of the tangent line is 1 and so this is the slope of the curve at point B. For point C, the slope of the tangent line is 2/.5 = 4 and so this is the slope of the curve at point C. b) The marginal cost of producing good X is shown by the slope of the curve (the change in total cost as output increases by one unit). The slope is clearly rising as the monthly level of production rises, showing that marginal cost increases as output increases. c) The slope of the function is positive and increasing (getting steeper) as the level of monthly production increases. *****

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____________________________________ ___ Part Two An Introduction to Demand and Supply

____________________________________ ___

This Part of the book develops the core of the demand and supply apparatus. Chapter 3 presents the basics, explaining in detail the concepts of demand and supply.

Chapter 4 presents a thorough treatment of elasticity. Chapter 5 offers many examples to help students put this basic economic theory to use, including an initial and intuitive discussion of economic surplus and market efficiency. *** Chapter 3 covers the basic theory of demand, supply, and price. This is the student‘s first really decisive hurdle. When it is cleared, students will Copyright © 2026 Pearson Canada Inc.

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have mastered some economic theory and will be ready to start applying it. A box addresses the kinds of industries where the model of demand and supply can usefully be applied, and also those where it can‘t, and another box provides several examples of demand and supply shocks caused by the COVID-19 pandemic.

Elasticity, examined in detail in Chapter 4, is a more advanced concept. There is some disagreement among teachers about how much should be included in an introductory economics course, but some minimum is required to enable us to discuss the magnitude as well as the direction of changes in prices and quantities. Since the discussion of the various elasticities tends to be rather dry, we explore in detail an important situation in which elasticity is central to the analysis. This is the issue of tax incidence, where we show that the burden of a sales tax depends on the demand and supply elasticities (and we also have a box examining the incidence of payroll taxes).

Chapter 5 is designed to illustrate that even the simple demand and supply apparatus can be usefully applied to important current problems. We think it is valuable early in the course to show that microeconomics does shed insight on such problems. Students like to get a payoff in understanding from their Copyright © 2026 Pearson Canada Inc.

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investment in learning theory, and it is possible to give it to them. The first section discusses the effects of government-controlled prices.

Following a general discussion of the theory, we go on to examine the specific example of rent controls.

We also have a box that presents the basic analysis of legislated minimum wages as an example of a binding price floor. The chapter’s final section provides an intuitive introduction to the ideas of economic surplus and market efficiency, and then uses these concepts to circle back and examine the inefficiency of legislated price controls.

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___________________________________

Chapter 3: Demand, Supply, and Price ___________________________________

This fundamental chapter is divided into three sections: demand, supply, and price determination.

The first two sections of the chapter are treated with a conscious parallelism. We talk in some detail about demand here, but virtually identical comments apply to supply.

A point worth emphasizing to the students is that when we think about a demand curve, we are not asserting that price is the only, or even the most important, determinant of quantity demanded.

Students are introduced to the important distinction between movements along curves and shifts of curves and the related terminology that distinguishes between ―changes in quantity demanded‖ and ―changes in demand‖. Figures 3-3 and 3-4 are designed to clarify this distinction.

The terminology is important and we suggest that you spend some time on it in class. A mathematician would distinguish between the value of the function and the function itself. We label a shift in the demand curve as an increase or a decrease in demand, in contrast to movements from one point to another along a given demand curve, which we label a change in quantity demanded. Despite our renewed efforts at clarity on these points, students should be alerted to possible Copyright © 2026 Pearson Canada Inc.

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confusions, especially early in their use of the concepts of supply and demand. Careful attention to context almost always makes clear what is being discussed.

Our use of the expressions ―a change in quantity demanded‖ and ―a change in demand‖, although quite orthodox, have given some instructors trouble in the past. It is therefore worthwhile to spend some time explaining our approach. Since we do not want to teach students things they will have to unlearn in their subsequent courses, we follow the established practice of defining quantity demanded as the dependent variable in the demand function: Qid =

D(pi, p-i, Y, tastes, ...),

with pi being the product‘s own price, p-i being a vector of all other prices, and Y being money income. With this definition, a ―change in quantity demanded‖ occurs in response to a change in any of the independent variables, not just the product‘s own price. Thus a movement along a demand curve is always a change in the quantity demanded; but a change in quantity demanded is not necessarily a movement along a demand curve, since it can have causes other than just a change in the product‘s own price.

The demand curve––which is simply the relationship between price and quantity demanded, ceteris paribus––refers to the relation Qid

=

d(pi),

where all of the other independent variables are held constant. A ―change in demand‖ refers to a shift in this relation due to a change in any one of the variables that are normally being held constant.

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Confusion sometimes arises because some textbooks define a change in quantity demanded to be only a movement along a demand curve. This begs the question of how to describe a change in Qid when an independent variable other than pi changes. Our usage conforms with common usage in economics in calling any change in Qid a change in quantity demanded. A movement along a given demand curve is only one such change.

As the chapter‘s second section, on supply, comes to a close (in which we also emphasize the distinction between a shift of the curve and a movement along the curve), we have added a box that discusses the COVID-19 pandemic and several of the demand and supply shocks that were created by this dramatic social and economic event. There are many such shocks that were generated by the pandemic, and students will no doubt appreciate a rich in-class discussion of these many shocks, with the objective being to make sure students understand the demandside or supply-side nature of various shocks.

The final section of this chapter is both straightforward and basic. We begin with a brief discussion of the concept of a market. We then bring together a market demand curve and a market supply curve to examine an equilibrium price. The next step is to introduce the standard shifts of the curves to derive the comparative static predictions, often called the laws of supply and demand. We have a worked-out numerical example of a market equilibrium. We then have a brief discussion of relative prices where we explain the importance of relative prices and how, in basic price theory, a ―rise‖ or a ―fall‖ in price means a rise or a fall relative to all other prices. Our own experience is that it is useful to meet this issue head-on rather than sweeping it under the carpet.

The chapter closes with a box that addresses a crucial caveat: as important as the demand and supply model is, it cannot be used to examine all

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markets. The demand and supply model can only be used in markets that satisfy some conditions, in particular large numbers of producers and consumers and more-or-less identical products. *** A Potential Teaching Mistake.

Perhaps the biggest mistake that new instructors to a principles course make in teaching the material of this chapter is to assume that, because it is so basic to them, it can be covered very quickly. Our experience suggests that this is not the case and that a good deal of repetition is important. Figures 3-7 and 3-8 are worth developing on the blackboard or on an overhead, or by using the PowerPoint slides for this text that are available from the publisher. You may also find it valuable to spend the time necessary to work through a few numerical examples of market equilibrium similar to the one in the main text or in the Study Exercises.

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Answers to Study Exercises Fill-in-the-Blank Questions

Question 1 a) desired; actual b) time; time; flow c) price; quantity demanded; increases d) consumers‘ income; prices of other goods; tastes; population; changes in weather e) ceteris paribus; constant Question 2 a) desired; actual b) time; time; flow c) price; quantity supplied; increases d) prices of inputs; technology; taxes or subsidies; prices of other products; number of suppliers; changes in weather

Question 3 a) supply; left; decrease; supply b) demand; right; increase; demand c) demand; right; increase; demand d) supply; left; decrease; supply e) supply; left; decrease; supply f) demand; left; decrease; demand

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Question 4 a) negatively b) positively c) supply; demand d) equals e) rise; equilibrium quantity f) rise; equilibrium quantity Review Questions Question 5 a) Decrease in quantity of fish demanded (movement up along the demand curve after the price rises) b) Demand for fish decreases (demand curve shifts to the left) c) Demand for fish decreases (demand curve shifts to the left) d) Demand for fish decreases (demand curve shifts to the left) e) Demand for fish increases (demand curve shifts to the right) f) Decrease in quantity of fish demanded (movement up along the demand curve due to the reduction in supply and resulting increase in price) Question 6

This is a straightforward repetition of the example given in the text, only now applied to housing. a) An increase in population (or average household income) will shift the demand curve for housing to the right and raise equilibrium house prices. b) As prices rise, individual households will reduce the quantities they demand (perhaps by buying smaller houses or by only buying later in life) thus moving upward along the demand curve.

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The word ―prohibitive‖ may lead some students to make the error in believing prices are so high that no one is buying housing. But, of course, prices stay high only if there are enough purchasers willing to take up all of the available supply at those high prices. The two observations are not inconsistent—they refer to two different phenomena.

Question 7

a) The finding that eating chicken can improve your health will likely lead to an increase in the demand for chicken (and a reduction in the demand for less healthy meats).

This will be shown by a rightward shift in the demand curve for chicken. b) As the price of beef rises, consumers will substitute away from beef and toward other meats, including chicken. This will be shown by a rightward shift in the demand curve for chicken. c) If chicken is a normal good—meaning that consumers want more of it when their real income rises—then the rise in household income leads to an increase in the demand for chicken. This will be shown by a rightward shift in the demand curve for chicken.

Question 8 a) The ideal growing conditions in the Ivory Coast lead to an increase in supply from that country; since it is the world’s largest supplier of cocoa beans, there is likely a noticeable

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increase in the world supply. The world supply curve shifts to the right. b) The large increase in the world price of coffee beans means that farmers currently growing cocoa beans (in many countries) have a more attractive alternative. If they substitute toward growing more coffee beans and fewer cocoa beans, the supply of cocoa beans falls—a leftward shift in the world supply curve. c) The rise in wages increases the costs for cocoa farmers, making this activity less profitable. Other things being equal, this is predicted to reduce current supply of cocoa beans. The result is a reduction in the world supply of cocoa beans—a leftward shift in the supply curve. d) Apparently the profits being earned by cocoa farmers (in many countries) are high enough to attract entry by new farmers. The entry of new farmers results, after a suitable period required for them to set up their operations, in an increase in the overall supply of cocoa beans. The world supply curve shifts to the right.

Question 9 a) The reduction in the size of the peach harvest due to bad weather is a decrease in the supply of peachesa leftward shift of the supply curve. (For a given demand curve, this leads to an increase in equilibrium price.)

b) An increase in income leads to an increase in the demand for all normal goods. Assuming restaurant meals are a normal good, there will be a rightward shift in the demand curve for restaurant meals. For a given upward-sloping supply curve, this shock leads to an increase in the equilibrium price and quantity of restaurant meals. This is an increase in the quantity supplied of Copyright © 2026 Pearson Canada Inc.

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restaurant meals (caused by the price increase). c) Technological improvements in electronic publishing reduce the cost of producing e-books and therefore cause an increase in supplya rightward shift of the supply curve for e-books. (This causes a fall in the equilibrium price and an increase in equilibrium quantity.) d) Greater awareness of the benefits of a low-carb diet lead to a reduction in demand for bread (and other high-carb food items) and thus, for a given supply curve, to a reduction in the equilibrium price and quantity of bread. As price falls, there is a reduction in the quantity of bread supplied.

Question 10 The diagram below shows the world market for copper, and the initial equilibrium is shown as point E1, with the initial demand curve D1 and supply curve S1. The fast economic growth in China leads to an increase in China‘s demand for copper, and since China is a large economy, this effect is strongly felt in the world copper market; the world demand curve therefore shifts to the right, to D2.

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The explosion in the Chilean port causes a temporary reduction in the world supply of copper because some large fraction of the world‘s copper, even though ready for shipment, cannot get to market. This event leads to a leftward shift of the supply curve, to S2. The new equilibrium is shown at point E2. Each of these events on their own would be predicted to lead to an increase in the equilibrium price of copper; when acting together, the effect on the world price will be even larger.

The overall effect on the equilibrium quantity of copper exchanged is unclear without knowing the relative sizes of the two shifts, although the case we have drawn shows the case where the demand increase outweighs the supply reduction and so overall equilibrium quantity rises.

Question 11 See the two diagrams below, which both show an increase in the demand for kale but little or no increase in the equilibrium price. Part (a) shows an increase in demand but a supply curve that is almost horizontal, indicating that producers can easily increase their output in response to an increase in demand. The effect of the increase in

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demand on price is negligible. Part (b) shows a more conventional market with an upward-sloping supply curve. In this case, the increase in demand for kale occurs together with an increase in the overall supply (possibly unconnected events) and the effect on equilibrium price is negligible.

Question 12

The figures below show the world market for wheat on the right and the Canadian market for wheat on the left. Since wheat is an internationally traded good, its Copyright © 2026 Pearson Canada Inc.

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(single) world price is determined by the intersection of the world demand and world supply curves.

With the world supply curve given

by S0, the equilibrium world price is p0. At this world price, Canada is a net exporter—shown in the left diagram by an excess supply in Canada at price p0.

Ukraine is a major producer of wheat and therefore normally contributes substantially to the world supply of wheat. With Russia’s invasion of Ukraine, much of Ukraine’s (reduced) wheat production could no longer be exported, thus shifting the world supply curve to the left from S0 to S1. This drives the world price up from p0 to p1. Canadian wheat Copyright © 2026 Pearson Canada Inc.

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farmers (as well as those in other countries) benefit because they experience a higher world price at which to sell their product but suffer none of the quantity reductions associated with the Russia-Ukraine war. In fact, they increase their quantity supplied from point A to point B in the lefthand figure. Their income is unambiguously higher than it would be had the war not happened. The increase in income for Canadian wheat farmers is shown by the shaded area. (Note that the higher price leads to more wheat production in Canada but less wheat consumption; the difference represents an increase in

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Canadian wheat exports to other countries.)

Problems Question 13 a) decrease; quantity demanded of b) to the right; increase c) increased; decreased d) quantity demanded of e) The appropriate diagram is shown below.

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Question 14 a) The equilibrium price, where quantity demanded equals quantity supplied, is $480 per tonne. b) At $440, there is excess demand equal to 4.0 million tonnes (per period). c) At $520, there is excess supply equal to 4.0 million tonnes (per period). d) At a price of $440, the excess demand will lead consumers to bid up the price in their efforts to satisfy their (excess) demands.

Price will eventually rise. e) At a price of $520, the excess supply will lead producers to bid down the price in their efforts to sell their (excess) supply of the product. Price will eventually fall.

Question 15

a) At a price of $4.00 per can, quantity demanded is 2 million cans per year and quantity supplied is 8 million cans per year. There is a surplus of 6 million cans per year. b) At a price of $1.50 per can, quantity demanded is 12 million cans per year and quantity supplied is 3 million cans per year. There is a shortage of 9 million cans per year.

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c) Equilibrium, where quantity demanded equals quantity supplied, occurs at a price of $3.00 per can and at a quantity of 6 million cans per year.

Question 16 a) The demand and supply curves for coffee are shown below. Note that the horizontal axis has a break in the scale so that we can focus on the range of quantity beyond Q = 10.

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b) From the table in the question, or by reading off the diagram, we can see the following pattern of excess demands and supplies. Recall that excess demand at any given price is equal to quantity demanded minus quantity supplied.

Price Excess Demand (+) or Supply (−) $2.00 2.40 2.60 3.50 3.90 4.30

+18 +14 + 9 0 − 5 − 9

c) The equilibrium price is the price at which quantity demanded equals quantity supplied. In other words, it is the price at which excess demand is exactly zero. From the table or the diagram we can see that the equilibrium price of coffee is $3.50 per kilogram. d) If a minimum price for coffee were set equal to $3.90 per kg, there would be an excess supply of coffee equal to 5 million kg per year. The only way the government(s) could enforce this minimum price and prevent the price from falling to the freemarket equilibrium level, would be to purchase the excess supply of 5 million kg annually.

Question 17 a) From 2024 to 2025, the price rises and the quantity is unchanged.

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One possibility is a reduction in supply (crop failure?) with a vertical demand curve. Another possibility is an increase in demand with a vertical supply curve. A less extreme and thus more likely possibility is an increase in demand combined with a reduction in supply that leaves Q unchanged. b) From 2024 to 2025, the price falls and quantity increases. The simplest possibility is that there has been an increase in supply (a bumper crop?) and no change in demand—but quantity demanded increases in response to the decline in price. c) From 2024 to 2025, the price and quantity both fall. The simplest possibility is that there has been a Copyright © 2026 Pearson Canada Inc.

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decline in demand (a recession which reduces demand for the crop?). The supply curve is stable, but quantity supplied falls in response to the decline in price. d) From 2024 to 2025, the price is stable, but quantity rises. One possibility is that demand increases and the supply curve is horizontal—reflecting that producers can easily produce more of the crop in response to the increase in demand. Another possibility is that both demand and supply increase, but keep the overall price unchanged.

Question 18 a) The demand curve is: QD = 100 – 3p. This is a straight-line demand curve with a slope of –1/3. The horizontal intercept (p = 0) is QD = 100. The vertical intercept (QD = 0) is p = 33.33. The supply curve is: QS = 10 + 2p. This is a straight-line Copyright © 2026 Pearson Canada Inc.

CHAPTER 6: CONSUMER BEHAVIOUR 67

supply curve with a slope of ½. When p = 0, QS = 10.

Both curves are plotted below.

b) Equilibrium requires QD = QS. defines the equilibrium price, p*.

This

equality

c) Imposing QD = QS, we have 100 − 3p = 10 + 2p.

Solving for p we get 90 = 5p or p = 18. This is what we call p*, the market-clearing price. d) Substituting p* = 18 into the demand function we get Q* = 100 − 3(18) = 46. If we substitute p* instead into the supply function we get Q* = 10 + 2(18) = 46. (Since the demand and supply curves intersect at p* = 18, Q* must be the same whether we use the demand curve or the supply curve.) e) Now there is an increase in demand. The new demand function is QD = 180 − 3p. Equilibrium requires QD = QS which means 180 – 3p = 10 + 2p. The solution for p* is therefore 5p* = 170 or p* = 34.

Substituting p* back into the demand curve we get Q* = 180 − 3(34) or Q* = 78. The law of demand says that an increase in demand leads to a rise in both the equilibrium price and the equilibrium quantity.

Both predictions are correct. f) Now with the new demand curve in place there is an increase in supply. The new supply curve is QS = Copyright © 2026 Pearson Canada Inc.

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90 + 2p. Equilibrium requires 180 – 3p = 90 + 2p.

This gives p* = 18. Substituting p* back into the demand curve leads to Q* = 180 – 3(18) or Q* = 126.

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Question 19 The solution approach is simple and is the same in each of the five cases shown. Equate QD and QS to solve for the equilibrium price, p*.

Then substitute this value of p* back into the demand (or supply) curve to solve for the equilibrium quantity, Q*. a) p* = 1, Q* = 8 b) p* = 9, Q* = 1180 c) p* = 120, Q* = 70 d) p* = 2000, Q* = 5600 e) p* = 50, Q* = 5000 ***** ____________________

Chapter 4: Elasticity ____________________ Elasticity is sometimes relegated to a page or two in introductory textbooks. It is true that the concept and its measurement are sometimes tricky, but we believe it is too important to neglect, and giving only the formal definitions can be worse than neglecting the subject altogether. In this chapter we begin with an intuitive discussion of why elasticity matters, using the example of the 2022 Russian invasion of Ukraine, the decline in the latter‘s exports, and the consequent upward spike in the world price of wheat. We then present the in-depth discussions of own-price demand elasticity and own-price supply elasticity. To help the student see a setting in which these elasticities are crucial to the analysis, we then examine the incidence of excise taxes, emphasizing that the burden of an excise tax depends on the relative elasticities. The final section of the chapter deals with other elasticity concepts, including income Copyright © 2026 Pearson Canada Inc.

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elasticity of demand and cross-price elasticity of demand. We hope the design of this chapter makes the material both readable and relevant for the student. *** The chapter opens with an intuitive discussion of own-price elasticity of demand. Once we start explaining the precise measurement of elasticity, we emphasize the use of average quantities and prices in applying the arc elasticity formula. This will seem inelegant to the mathematically trained student, but it is essential to not confusing the non-mathematical student. This approach to measuring elasticity has the advantage of making the elasticity between any two points on a demand curve the same for increases and for decreases in price.

Also, note that we define own-price elasticity as a positive number, and so we state the ―absolute value‖ of what would otherwise always be a negative number. This decision comes from our experience that students are inevitably confused by speaking of an elasticity of –2 being ―greater than‖ –1, and so on.

We emphasize that the key determinant of demand elasticity is the availability of substitutes. To reinforce this point, we spend some time discussing the difference between long-run and short-run elasticities, where the key difference is the number of substitutes available over the time span in question. This distinction between long-run and short-run demand elasticity is central to understanding such things as the demand response to a supply shock for any commodity that is consumed in conjunction with a durable good.

The chapter‘s second section briefly examines own-price elasticity of supply. The same general points are made as for demand elasticity, but the similarity allows us to be briefer. We show how to compute elasticity between any two points on a positively sloped supply curve and relegate the interesting but special case of a straight-line ray from the origin to a footnote and to an end-ofCopyright © 2026 Pearson Canada Inc.

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chapter Study Exercise. Finally, we discuss the distinction between short-run and long-run supply elasticity and how this affects the responses to a demand shock. (This general issue comes up again in Chapter 5 when we examine the short-run and long-run effects of rent controls.)

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The chapter’s third section is designed to give the students an opportunity to see the importance of elasticity. We discuss the general issue of the incidence of an excise tax. Not only will the students see an interesting and important application of the concept of elasticity, but they will learn the important lesson that who actually pays the tax is quite different from who bears the economic burden of the tax. More than any other single example, the issue of tax incidence should convince the student that elasticity does indeed matter. This discussion leads to a box on the incidence of payroll taxes, which reinforces the main point about elasticity and incidence, but also Copyright © 2026 Pearson Canada Inc.

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has the advantage of applying the demand-and-supply framework to an important labour-market setting.

The final section of the chapter examines other elasticity concepts, specifically income elasticity (normal and inferior, necessities and luxuries) and cross-price elasticity (substitutes and complements). We have a short box that discusses how knowledge of income elasticities can help us to interpret changes in a country’s consumption patterns as it develops economically.

Answers to Study Exercises Fill-in-the-Blank Questions

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Question 1 a) 2; relatively elastic b) 0.4; relatively inelastic c) 1; unit elastic

Question 2 a) price; quantity; average b) negative; absolute value; positive c) inelastic; more d) substitutes; elastic e) increase; reduction Question 3 a) zero b) responsiveness c) quantity supplied; that products‘ price d) elastic e) elastic f) greater; price Question 4 a) excise b) consumer; zero; all c) elastic (relative to supply); seller d) consumers; more

Question 5 a) 0.1; inelastic

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b) 1.5; elastic c) zero; rises or increases d) zero; falls or decreases e) falls or decreases; negative f) rises or increases; positive Review Questions Question 6

a) The record harvests shifted the supply curve to the right and reduced prices. The ―disastrous‖ result for farmers suggests that their incomes have fallen. This would occur if demand for wheat is inelastic. b) We conclude that demand for bus travel is inelastic since total expenditure on bus travel apparently declines as price declines. c) Demand for cell phones is apparently elastic, since total expenditure on cell phones rises as price declines (because quantity demanded increases by a larger proportion than the decline in price).

The students should recognize that the clue of ―revenues soaring‖ means that quantity demanded increased by more than prices declined.

d) The speaker is asserting that he or she has a perfectly inelastic demand for coffee. This is possible over some, but not all, ranges of price––how about at a price of $1000 per cup? Also, one person’s perfectly inelastic demand is not Copyright © 2026 Pearson Canada Inc.

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sufficient to make market demand perfectly inelastic. e) The demand for housing is increasing greatly in Vancouver.

Therefore, the demand curve is shifting to the right. This causes the price to increase (as we move up along an upward-sloping, and likely very inelastic, supply curve). As price rises, we also move (along) any given demand curve. But this tells us nothing about the elasticity of demand.

Question 7 The key to this question is to recognize that own-price elasticity of demand is determined mostly by the availability of substitutes. Notice that the products are listed in order of decreasing generality. That is, item (e) is a subset of (d), which is a subset of (c), which is a subset of (b), which is a subset of (a). This means there are fewer substitutes for ―food‖ (option a) than for ―leafy vegetables sold at your local supermarket on Wednesdays‖ (option e). Thus, we would expect demand for (a) to be the least elastic and demand for (e) to be the most elastic.

Question 8

The demand for the stamps is downward sloping, as shown in the diagram below. The supply is a vertical line at Q = 2. If the stamp dealer sold both stamps, Copyright © 2026 Pearson Canada Inc.

CHAPTER 6: CONSUMER BEHAVIOUR 77

the equilibrium price would be p2 and his total revenue would be the dark shaded area. If, instead, he chooses to burn one stamp, the supply (after the fire) will be a vertical line at Q = 1. If he now sells the single stamp, the equilibrium price will be higher at p1 and his total revenue would be the light shaded area. It should be clear from the diagram that if the demand curve is sufficiently inelastic then p1 will be much higher than p2 and the total revenue from the single stamp when sold at p1 will exceed the total revenue of the two stamps when each is sold at p2. In this case the decision to burn the stamp would be wealth maximizing and perfectly sensible. Remind the students that the question assumes the stamp dealer only cares about wealth maximizing and not about saving a rare stamp from a collector‘s perspective.

Question 9 a) Of the products listed, the ones with the greatest short-run supply elasticity are likely to be those which firms can easily produce when they choose to do so—because the technology is easily available and specific and/or expensive equipment is not necessary.

Probably the supplies of kitchen blenders and doughnuts are most elastic in the short run. b) Less elastic will likely be the supply of fibre-optic cable and rental apartments, both of which probably require specific capital and construction. Least elastic of all would likely be the oil tankers and neurosurgery.

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Question 10

The right diagram for analyzing this question is Figure 4-9 in the textbook. For both alcohol and cigarettes, the elasticity of supply is likely far larger than the elasticity of demand. So the appropriate figure is the left-hand-side of Figure 4-9—a relatively steep demand curve and a relatively flat supply curve.

In the presence of an excise tax on alcohol or cigarettes, the tax leads to a vertical shift of the supply curve equal to the amount of the tax.

With inelastic demand, the consumer price rises by a lot whereas the seller price falls by only a little. The result is that consumers bear most of the economic burden of excise taxes for these products. Discuss with your students why this is and why government would want to tax these goods.

Since they are addictive, especially cigarettes, increasing the price with a tax will not distort the market much and raise a lot of revenue for the government.

Question 11 The right diagram for analyzing this question is Figure 4-7. The sharp increase in demand for flour caused by the increase in ―home baking‖ led to a much higher price for flour in the short run, as inventories were run down and producers scrambled to increase production. But the fact that flour prices returned to ―normal‖ within a few months indicates that the supply of flour is very elastic over a longer period of a few months.

(Indeed, it may even be perfectly elastic.) It is also probably the case that after the first several months of the pandemic, the ―novelty‖ of home baking diminished and the demand for flour fell back to something closer to its normal level, thus reducing the upward pressure on price.

Problems Question 12

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a) The table should be completed as shown below. Note that elasticities are computed ―between the rows‖, reflecting the change in quantity and prices between points on the demand curve. Note also that, as in the textbook, we express elasticity as a positive number, even though price and quantity demanded change in opposite directions as we move along the demand curve.

Price QD

Expenditure %ΔPrice

$11

1

$11

9

3

27

7

5

35

5

7

35

3

9

27

1

11

%ΔQD

Elasticity

20

100

5

25

50

2

33.3

33.3

1

50

25

1/2

100

20

1/5

11

b) The diagram of the demand curve is shown below.

c) At points higher up the demand curve, price is relatively high and quantity demanded is relatively low. Thus, a given Δp (such as the $2 increment shown in the table above) is a small percentage change, whereas a given ΔQ (such as the 2-unit increment shown in the table) is a large percentage change. These same absolute changes will be different in percentage terms as we move to the right along the demand curve (larger for Δp and smaller for ΔQ). Since elasticity is a ratio of the percentage change in quantity demanded to the percentage change in price, it follows that elasticity falls as we move to the right along a linear demand curve.

Question 13 Recall that price elasticity of demand is equal to the percentage change in quantity demanded divided by the percentage change in price. In this case, you know that elasticity equals 0.5 and the question is about the effect of a price increase from $1 to $2,

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an increase of 66.7 percent (using the averaging method discussed in the text). Given the value of elasticity, we expect quantity demanded to fall by 33.3 percent. Since elasticity is less than one, we also expect total expenditure on the product to increase as the price rises.

Question 14 a) Total expenditure along the demand curve is equal to price times quantity demanded.

Thus, the values for total expenditure are:

A B C D E F G H

Total Expenditure $12.0 million $13.3 million $14.0 million $14.4 million $15.0 million $14.3 million $13.8 million $12.4 million

b) As shown in Figure 4-5 in the chapter, we make two diagrams, one for the demand curve and one showing total expenditure. Note in both cases that the scale on the vertical axis does not start at zero. The diagrams are as follows:

c) Own-price elasticity of demand (from one point on the demand curve to another) is the percentage change in quantity demanded divided by the percentage change in price, where we use the average price and quantity over each specific arc of the demand curve (that is, between each pair of price/quantity combinations). The calculations are shown in the table below. (Prices are in $ and quantities are in thousands.)

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Points

Average p and Q

Computation of Elasticity

A to B

p = $32.50, Q = 390

 = (20/390)/(5/32.50) = 0.33

B to C

p = $37.50, Q = 365

 = (30/365)/(5/37.50) = 0.62

C to D

p = $42.50, Q = 335

 = (30/335)/(5/42.50) = 0.76

D to E

p = $47.50, Q = 310

 = (20/310)/(5/47.50) = 0.61

E to F

p = $52.50, Q = 280

 = (40/280)/(5/52.50) = 1.5

F to G

p = $57.50, Q = 245

 = (30/245)/(5/57.50) = 1.41

G to H

p = $62.50, Q = 210

 = (40/210)/(5/62.50) = 2.38

d) ―Elastic‖ demand refers to the range of the demand curve over which the measured elasticity (in absolute value) is greater than one. From the table above, we see that the demand for video games is elastic between points E and H—that is, for prices above $50. e) ―Inelastic‖ demand refers to the range of the demand curve over which the measured elasticity (in absolute value) is less than one. From the table above, we see that the demand for video games is inelastic between points A and E—that is, for prices less than $50.

Question 15 a) The diagram below shows the relevant information and assumes that both demand and supply curves are linear. Point E is the initial equilibrium.

b) An increase in price from $2.00 to $3.00 per can leads to a reduction in quantity demanded from 4200 to 3000 cans per month. Thus, the own-price elasticity of demand is:  = (1200/3600)/(1.00/2.50) = (0.33)/(0.40) = 0.83 This is relatively inelastic demand.

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c) An increase in price from $2.00 per can to $3.00 per can leads to an increase in quantity supplied from 4200 to 4500 cans per month. Thus the own-price elasticity of supply is: S = (300/4350)/(1.00/2.50) = (.0689)/(0.4) = 0.17 This is relatively inelastic supply. d) The availability of substitutes is the key factor affecting elasticity of demand. How willing and able are consumers to substitute to competing products, such as frozen grape juice, apple juice, milk, or soft drinks? e) The ability of producers to substitute toward the production of other goods is the key factor affecting supply elasticity. Can their equipment be used for other purposes? Can their management skills be easily shifted?

Question 16 a) The relevant concept is that of the own-price elasticity of demand, since we are considering changes in the price and quantity of ticket sales. The measure of elasticity in this case is the percentage change in quantity demanded divided by the percentage change in price. The average quantity is 1275 and the average price is $12.50. Thus, we have:  = (150/1275)/(3/12.50) = 0.49 b) The relevant concept is that of the income elasticity of demand because we are relating changes in income to changes in quantity demanded. The measure of income elasticity is the percentage change in quantity demanded divided by the percentage change in income.

The average quantity of BMWs sold is 61,500. Note that we are given the percentage change in income equal to 10 percent or 0.10. Thus, we have: Y = (11,000/61,500)/(0.10) = 1.79 The positive sign reveals that BMWs are a normal good since a rise in income leads to an increase in quantity demanded. c) The relevant concept is that of the cross-price elasticity of demand because we are relating changes in the price of coffee to changes in the quantity demanded of tea. The measure of cross-price elasticity is the percentage change in the quantity demanded of tea divided by the percentage change in the price of coffee. The average coffee price is $3.90 and the average quantity of tea is 7750 kg. Thus, we have: XY = (500/7750)/(1.80/3.90) = 0.14 The positive sign reveals that coffee and tea are substitute goods since a rise in the price of coffee (which presumably reduces the quantity demanded of coffee) leads people to demand more tea. d) The relevant concept is the Canadian own-price elasticity of supply because we are relating changes in the world price of pulp to changes in the quantity of pulp supplied by Canadian firms. The measure of supply elasticity is the percentage change in (Canadian) quantity supplied divided by the percentage change in the world price. The average

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quantity is 9.5 million tonnes. Note that we are given the percentage increase in the price equal to 14 percent, or 0.14. Thus we have: S = (3/9.5)/(0.14) = 2.26 The interpretation of this number is that a 10% increase in the world price of pulp leads to a 22.6% increase in the quantity of pulp supplied by Canadian producers. e) The relevant concept is income elasticity. The percentage change in quantity (relative to the average) is 66.7 percent (40/60) while the percentage change in income (relative to the average) is 14 percent (9,000/64,500). So the income elasticity of Marta’s demand for fruits and vegetables is 66.7/14 = 4.76. These are evidently luxury goods for Marta because the income elasticity is greater than one. f) This is own-price elasticity of demand. The percentage change in price (fees) is 25 percent (5000/20000) and the percentage change in the quantity is (negative) 40 percent (4000/10000). So the elasticity of demand is 40/25 = 1.6.

Question 17 a) The four scale diagrams are shown below. Note that all four diagrams have the same scale on the vertical axes but different scales on the horizontal axes. (This is not essential; it is done simply to make the diagrams fit nicely on the page!)

b) The own-price elasticity of supply is equal to the percentage change in quantity supplied divided by the percentage change in the price. The calculations for cases (i) through (iv) are: i) ii) iii) iv)

average p = $30, average Q = 15 average p = $30, average Q = 7.5 average p = $30, average Q = 6 average p = $30, average Q = 3

S = (10/15)/(20/30) = 1 S = (5/7.5)/(20/30) = 1 S = (4/6)/(20/30) = 1 S = (2/3)/(20/30) = 1

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Note that in each of these cases the supply curve is a straight line from the origin. As we mentioned in footnote #1 in the chapter, the elasticity of all such supply curves, no matter what the slope, is equal to one. (This is not true for all supply curves; just for straight-line supply curves that begin at the origin.) c) As we saw in part (b), the elasticity of supply of each of the four supply curves is equal to one. But the slopes of the four curves are clearly different. The slope of the curve is measured by the change in price per unit change in quantity supplied. The slopes are: (i) 20/10 = 2; (ii) 20/5 = 4; (iii) 20/4 = 5; and 20/2 = 10. The difference between slope and elasticity is that the first is measured in absolute changes whereas the second is measured as percentage changes. This question should make it clear that this difference matters!

Question 18 a) The figure below shows the demand curve (D) and the supply curves before (S0) and after (S1) the imposition of the excise tax of $1.00 per bottle.

b) The local government collects excise tax revenue equal to the after-tax quantity (1400 bottles per day) times the tax ($1 per bottle). So, the tax revenue is $1400 per day, as shown by the shaded area in the figure. c) The after-tax price (or net price) received by the sellers is 80 cents per bottle—which is equal to the price paid by consumers ($1.80) minus the per-bottle excise tax ($1). Sellers therefore receive total daily after-tax revenue of 80 cents times 1400 bottles, which is $1120. d) The consumers’ price increases from $1 to $1.80 as a result of the tax. The sellers’ price declines from $1 to $0.80 because of the tax. So consumers are bearing most of the burden

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of the excise tax (because demand is relatively less elastic than supply, as is clear from the figure).

Question 19 a) The appropriate scale diagram is shown below.

b) The equilibrium price and quantity can be determined algebraically by solving the demand-and-supply system—two equations and two unknown variables. The equilibrium is where the two curves intersect. Algebraically, this occurs where the price on the demand curve is equal to the price on the supply curve. The two curves are given by: Demand:

p = 80 – 5QD

Supply:

p = 24 + 2QS

Thus, we set 80 – 5QD = 24 + 2QS But at the equilibrium, the quantity on the demand curve will also equal the quantity on the supply curve, thus we set QD = QS = Q*. Our equation becomes 56 = 7Q*  Q* = 8 (million litres per month) Substituting this value for Q* back into either the demand curve or supply curve we can solve for the equilibrium price, p*. Using the demand curve, we get p* = 80 – (5  8) = 40 (cents per litre) c) With a tax of 14 cents per litre, there will be a 14-cent wedge between the price the consumer pays (the consumer price) and the price received by the producer (the seller price). Algebraically, we can solve for the new equilibrium by rewriting the demand and supply curves in terms of the consumer price (pC) and the seller price (pS). The demand and supply functions are rewritten as: Demand:

pC = 80 – 5QD

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Supply:

pS = 24 + 2QS

To solve for the equilibrium quantity in the presence of the tax, note that the consumer price minus the 14-cent tax must exactly equal the seller price. Thus, pC – 14 = pS. This gives: 80 – 5Q* – 14 = 24 + 2Q*  42 = 7Q*  Q* = 6 To solve for the consumer and seller prices, simply substitute this value of Q* into the demand and supply curves separately. The consumer and seller prices are pC = 80 – (5  6) = 50 and pS = 24 + (2  6) = 36 d) The gasoline tax raises revenue equal to the number of litres sold (6 million litres per month) times the unit tax (14 cents per litre). Thus, the monthly tax revenue is $840,000.

What share is paid by consumers and what share is paid by producers? The tax has raised the consumer price from 40 cents per litre to 50 cents per litre. Thus, consumers are ―paying‖ 10 cents of each 14 cents of tax, or 71% of the total tax. The seller price fell from 40 cents per litre to 36 cents per litre, so they are ―paying‖ 4 cents of each 14 cents of tax, or 29% of the total tax.

***** _______________________________________________

Chapter 5: Price Controls and Market Efficiency _______________________________________ ________ For those who seek to use economics to understand the world, this is a key chapter. The student is given practice in applying demand and supply to real-world phenomena through comparative-static exercises. Even in courses with an emphasis on pure theory, the exercises in this chapter are important.

Few students really understand the theory until they come to use it to analyze real situations. Doing so gives them a sense of the relevance of the theory they have learned. *** The chapter begins with a general discussion of disequilibrium prices, such as occurs with price ceilings and price floors. Experience shows that Copyright © 2026 Pearson Canada Inc.

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the demonstration that the ―short side‖ of the market dominates in disequilibrium situations is helpful. This is illustrated in Figure 5-1. This is sometimes taken as obvious, but students find it helpful to have it spelled out. In the discussion of price ceilings and price floors, we have distinguished between the assessment of the positive economic effects of interventionist policies and overall normative judgments of such policies.

With the general discussion of disequilibrium prices under their belts, the students can then be introduced to the analysis of minimum wages and legislated rent controls.

The next section examines rent controls, which is an excellent illustration of price ceilings. (Price floors are illustrated in a box examining legislated minimum wages.) Few things are better documented in economics than the long-term effects of binding rent controls in generating a housing shortage and a decline in the quality of rental housing. The stages by which this is shown to occur in the text are only stylized versions of what has actually Copyright © 2026 Pearson Canada Inc.

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happened in many cities throughout the world. We have tried to make very clear the distinction between the short-run and long-run effects of rent controls, where it is the latter that are arguably the most serious. We have also added a discussion of the current housing crisis in Canada, and how it has led to calls for the tightening of rent controls to offer relief to renters, even though this would likely exacerbate the existing problems on the supply side of the housing market.

The chapter’s third and final section offers an intuitive introduction to the ideas of economic surplus and market (allocative) efficiency. It is Copyright © 2026 Pearson Canada Inc.

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important that students see markets as producing economic value by transforming lower-valued resources into products valued more highly by consumers. By placing this material in Chapter 5, students can see early on in their course the benefits of markets and the costs of market interventions, without having to wait for the more complete and technical development of these concepts in later chapters. This discussion leads to a box on ―price gouging,‖ which contrasts the economists’ efficiency arguments with what philosophers often call ―public virtue.‖ This box is intended to make it clear that there is more to life than just economic efficiency, and there is no Copyright © 2026 Pearson Canada Inc.

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absolute ―right‖ answer regarding the social desirability of price gouging.

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Answers to Study Exercises Fill-in-the-Blank Questions

Question 1 a) greater than (above) b) less than (below) c) demand; reduction (decrease) d) adjust (increase) e) supply; reduction (decrease) f) adjust (fall); supply; purchase g) floor h) ceiling

Question 2 a) $5; 600 hats b) price ceiling at $3 c) excess demand; 400 d) price floor at $6 e) excess supply; 200

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Question 3 a) ceiling b) shortage (excess demand) c) inelastic; elastic; larger d)

tenants

(who

secure

low-price

housing);

landlords and tenants who cannot find housing at the legislated rental price

Question 4 a) surplus b) demand; supply c) reduction; surplus; deadweight d) deadweight loss Review Questions

Question 5 a) With a binding price ceiling, the excess demand means that consumers must somehow be rationed by means other than price.

In such a situation, either the seller or the government may impose a Copyright © 2026 Pearson Canada Inc.

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restriction on the number of units any one person can purchase. This situation also encourages rationing by ―sellers’ preferences,‖ where the seller can come up with any (often undesirable) scheme to ration the product, such as by: • religious beliefs or affiliation • race • sexual preferences • occupation b) With a binding price floor, the government could choose to purchase the excess supply, thus transferring resources from taxpayers to producers.

Alternatively, the government could introduce a quota system so that the producers face an upper limit on

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production equal to the quantity demanded at the floor price. c) If the government views the product in question as a necessity, it may introduce a price ceiling in the hope that it will improve consumers’ access to the product.

However, to the extent that the quantity supplied will fall, overall access will be reduced by such a policy. d) If the government views the sellers of the product as deserving of support, a price floor may be seen as a desirable policy. (This is the motivation for a legislated minimum wage.) However, to the extent that quantity demanded for the product will fall, some sellers of Copyright © 2026 Pearson Canada Inc.

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the product may see their markets disappear.

Question 6

The supply of rental accommodation is more elastic in the long run than in the short run because it takes time to build new units or to convert private housing into rental units (or to let existing units physically depreciate).

Therefore, whatever housing shortage exists immediately after the imposition of rent controls only gets worse as time proceeds, as the quantity of rental housing supplied declines as landlords no longer find it profitable to maintain their rental units.

In terms of the diagram below, when rent controls set a maximum price of pC, the housing shortage is Q1Q2 in the short run, but grows to Q3Q2

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as the long-run supply elasticity becomes relevant.

Note that the short-run supply curve is drawn very steep, indicating that the supply of rental housing is highly inelastic in the short run.

Question 7 a) Legislated Rent Controls: Landlords bear the burden because the return on their investment is reduced. Would-be tenants also bear the burden because many of them will not be able to find accommodation when the rent controls reduce the quantity supplied or will have to pay much higher rents if they are able to find a non-rent-controlled apartment. b) Subsidies to Tenants: Taxpayers who are not also tenants do not receive the subsidy and thus bear the burden of this policy. c) Provision of Public Housing: Taxpayers bear the burden because their taxes finance the public housing. Landlords will also bear some burden of the policy if the provision of public housing leads to a decline in overall rents (due to the increase in supply of rental units).

Question 8

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a) With price p* and quantity Q*, the total economic surplus is given by areas 2+3+4+5+6: the area below the demand curve and above the supply curve up to Q*. b) With a price ceiling at p1, the quantity exchanged falls to Q1. Relative to Q*, there is a reduction in output and transactions. On these ―missing‖ transactions, no surplus is earned. The reduction in surplus is given by areas 5+6. This area (measured in dollars) is the per period deadweight loss of the price ceiling. c) With price p* and quantity Q*, the total economic surplus is given by areas 2+3+4+5+6: the area below the demand curve and above the supply curve up to Q*. d) With a price floor at p2, the quantity exchanged falls to Q2. Relative to Q*, there is a reduction in output and transactions.

On these ―missing‖ transactions, no surplus is earned. The reduction in surplus is given by areas 5+6. This area (measured in dollars) is the per period deadweight loss of the price floor. e) For both the price ceiling in part (i) and the price floor in part (ii), the deadweight loss reveals a loss of surplus for society (a combination of buyers and sellers) and thus an inefficient market. Each of these policies creates an overall loss for society, at least as measured by total economic surplus.

Question 9 a) With the market-clearing price of p* and quantity Q*, the total economic surplus is given by areas 2+3+4+5+6. b) If the government imposes an output quota of Q1, then output is restricted to be no greater than this amount. (The price in this case would be driven up to p1.) The reduction in output and transactions

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leads to a reduction in economic surplus, as given by areas 5+6. This is the deadweight loss of the output quota. c) The output quota reduces market efficiency because it reduces the total economic surplus generated by the market. Society as a whole is worse off, at least as measured by the total amount of economic surplus.

Problems

Question 10 a) Price floor at $7: This policy will have no impact on the market equilibrium since the price floor is below the free-market equilibrium price.

It is a non-binding price floor. b) Price floor at $11: This price floor is above the free-market equilibrium price and this is binding. The quantity exchanged is 60 units per day; the surplus (excess supply) is also 60 units per day. c) Price ceiling at $7: This is a binding price ceiling since it is below the free-market equilibrium price. The quantity exchanged is 40 units per day, and there is an excess demand (shortage) of 60 units per day. d) Price ceiling at $11: This policy will have no impact on the market equilibrium since the price ceiling is above the free-market equilibrium price.

It is a non-binding price ceiling.

Question 11

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this occurs at a price of $1600 per month and a quantity of 70,000 units. b) Any ceiling on the price of rental apartments must be below the free-market equilibrium price to have any effect on the market. Thus the highest it can be is just below $1600. c) At a price ceiling of $1000 per month, quantity demanded is 100,000 units whereas quantity supplied is only 60,000 units. There is excess demand (a shortage) of 40,000 units. There has also been a reduction in the equilibrium quantity exchanged (from 70,000 to 60,000 units) because of the reduction in quantity supplied. d) At a quantity of 60,000 units, the maximum price that consumers are willing to pay is $1800 per month for a one-bedroom rental apartment. If all units were supplied on the hidden market, $1800 would be the hidden-market price. e) The previous analysis is for the short run. The long-run supply of rental apartments is more elastic than the short-run supply because landlords and owners can more easily adjust their supply (in either direction) as time progresses. If the price ceiling persists, owners will reduce their supply of rental apartments because of the low rate of return on their investments, thus exacerbating the shortage in the market. So legislated rent controls usually lead to housing shortages, and these shortages typically get worse over time, not better.

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Question 12 a) The graph is provided below.

The free-market equilibrium has a price of $2.50 per burrito and an equilibrium quantity of 250 burritos per month.

b) Total economic surplus is shown by the area below the demand curve and above the supply curve. This is areas A + B. The dollar value of area A is equal to ½ (250  $2.50) = ½ ($625) = $312.50. The dollar value of area B is equal to ½ (250  $2.50) = $312.50. Thus, total economic surplus in the freemarket equilibrium is equal to $625 (per month). c) With a binding price ceiling of $1.50 per burrito, the quantity supplied (and the quantity exchanged) falls to 150 burritos per month. Price clearly falls from $2.50 to $1.50.

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d) Some students are better off while others are worse off. The 150 burritos sold each month at a price of $1.50 are sold to students who ―save‖ $1 relative to the free-market case. These students are made better off by the imposition of the price ceiling. But there are now 100 fewer burritos per month being sold; the students who are willing to pay $2.50 (or more) per burrito but cannot purchase one are made worse off by the price ceiling. e) Overall economic surplus falls as a result of the price ceiling. The ceiling generates a deadweight loss shown by the dark shaded triangle in the second figure. The dollar value of this deadweight loss is ½ (100  $2.00) = $100 per month. This deadweight loss is the economic value that is not generated in the market each month (through no longer selling 100 burritos) because of the binding price ceiling.

Question 13 a) The equilibrium price is $9 and the equilibrium quantity is 80 units per day. The total economic surplus per day is the area below the demand curve

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and above the supply curve. The area below the demand curve and above the price line is (1/2) times $8 times 80 units, which equals $320 per day.

The area above the supply curve and below the price line is (1/2) times $4 times 80 units, which equals $160 per day. Thus, the total economic surplus is $480 per day. b) When a binding price ceiling at $7 per unit is in effect, quantity exchanged falls to 40 units per day. Total surplus is the trapezoid area (which is the sum of two triangles and one rectangle). The total surplus per day is (1/2)($4)(40) + ($6)(40) + (1/2)($2)(40), which is equal to $80 + $240 + $40, which equals $360 per day. c) Under the binding price ceiling, there are 40 fewer units per day being consumed and produced than in the free-market equilibrium. d) The deadweight loss of the binding price ceiling is the difference between the total surplus in (a) and the total surplus in (b). The deadweight loss is $120 per day. e) With a binding price floor of $11 per unit, quantity exchanged is 60 units per day. The total economic surplus in this case is again shown by a trapezoid, with area equal to (1/2)($6)(60) + ($3)(60) + (1/2)($3)(60), which equals $180 + $180 + $90, which is $450 per day. f) The deadweight loss of the binding price floor is the difference between the total surplus in (a) and the total surplus in (e). This is $30 per day.

Question 14

This question requires the student to solve a system of demand and supply curves as shown in the Copyright © 2026 Pearson Canada Inc.

C H A P T E R 6 : C O N S U M E R B E H A V I O U R1 0 3

numerical example near the end of Chapter 3. a) The free-market outcome is determined where quantity demanded equals quantity supplied, QD = QS. Setting p from the demand curve equal to p from the supply curve, we get 225 – 15Q = 25 + 35Q  200 = 50Q

 Q* = 4

Putting Q* = 4 back into the demand curve we get

p* = 225 – (15  4)

 p* = 165

Thus the free-market price of milk is $1.65 per litre and the equilibrium quantity is 4 million litres per month. b) At the guaranteed price quantity demanded is given by

of

$2.00

per

litre,

200 = 225 – (15  QD)  QD = 1.67

(1.67 milli

At the same price, quantity supplied is given by 200 = 25 + 35QS

 QS = 5 (5

million litres) c) Since the government has guaranteed to purchase any amount that the producers cannot sell, the producers will produce the full 5 million litres per month. Thus, at the guaranteed price of $2.00 per litre, there is excess supply of 3.33 million litres per month. This amount (3.33 million litres per month) will be purchased by the government at a price of $2.00 per litre—for a total cost (to taxpayers) of $6.66 million per month. d) The government purchase of milk is financed by taxpayers. Taxpayers are clearly harmed since they Copyright © 2026 Pearson Canada Inc.

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must pay the direct cost for this system of price supports. Consumers are also harmed since they consume less milk and must pay a higher price than would be available in the free market. Milk producers are clearly better off. Not only do they get a higher price per litre, but their surplus production is all purchased by the government.

Question 15 This question relates to the previous question on milk production. The government issues quota for 1.67 million litres per month rather than using a direct price support. a) If milk producers produce the maximum allowed by the quotas, then production will be 1.67 million litres per month. Given the demand curve (p = 225 – 15QD), this implies a price of p = 225 – (15  1.67)  (or $2.00) per litre.

p = 200 cents

b) In the previous question with direct price supports, the price was $2.00 per litre and consumers purchased 1.67 million litres per month.

That is also the case when this quota system is used. Milk producers are clearly worse off under the quota system than under the direct price supports.

With the quota system, they produce 1.67 million litres per month and sell each litre at a price of $2.00. But with the direct price supports they produce 5 million litres per month and sell each litre at the same price. Their collective income is therefore higher by $6.66 million per month under the system of direct price controls. (Note here that consumers do not detect a difference between the direct price supports and the quota system, since price and quantity are the same. Taxpayers surely prefer the quota system since the government is not obliged to purchase the surplus production that would otherwise occur under the system of direct price supports.)

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Question 16 a) The demand and supply market are shown below.

curves in this labour

b) To begin, ignore the minimum wage that is shown.

With a diagram drawn carefully to scale, the freemarket equilibrium wage and level of employment can be seen on the diagram. The equilibrium wage is $9 per hour and equilibrium employment is 3000 hours per month.

Using algebra instead, note that at the equilibrium level of employment, the wage on the demand curve must equal the wage on the supply curve. It follows that 18 – 3LD = 3 + 2LS Solving this equation for the equilibrium L (which we call L*) yields L* = 3. We then substitute this value of L* into either the demand or the supply curve to get w* = 9.

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c) With a binding minimum wage of $10 per hour (shown in the figure), the level of employment will be determined by the demand curve for labour.

Quantity demanded at this higher wage is 8/3 = 2.67 (thousand hours per month). Notice that the quantity of labour supplied has increased and there is an excess supply of labour. d) The shaded triangle shows the deadweight loss created by the imposition of the binding minimum wage and the associated reduction in employment. To compute the dollar value of the deadweight loss, we need to compute the area of this triangle. The ―height‖ of this triangle is the horizontal distance representing the reduction in employment (0.33 thousand hours per month). The ―base‖ of the triangle is the vertical distance between the demand and supply curves at the new level of employment. The height of the demand curve at L = 2.67 is equal to $10. The height of the supply curve at L = 2.67 is equal to 8.33 (ws = 3 + 2(2.67) = 8.33). Thus the ―base‖ of the triangle is equal to 10 − 8.33 = 1.67. It follows that the area of the deadweight loss triangle is equal to (0.5)(1.67 $ per hour)(0.33 thousands of hours per month) = $275.6 per month. *****

____________________________________ ___ Part Three Consumers and Producers

____________________________________ ___ This part of the book explores the building blocks of microeconomics—the theory of consumer demand and Copyright © 2026 Pearson Canada Inc.

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the theory of firms‘ production and cost. We have sought to deal with more than just the theoretical framework, and we have tried to make the book suitable to a wide variety of tastes. In the past, some users have criticized us for being too theoretical, and others have criticized us for being not theoretical enough. We hope our chosen balance is about right. *** Opinions differ greatly among instructors on the amount of demand theory they wish to teach in an introductory class. We have tried to accommodate both those who prefer to teach indifference curve analysis at this level and those who prefer not to.

Chapter 6 develops the theory of consumer demand using the marginal utility approach. Though some instructors dislike using this approach (with some justification), it does have its advantages. In particular, the discussion of marginal utility eases the presentation of consumer surplus as well as the important distinction between total and marginal utility (such as in the diamond–water paradox). For those instructors who prefer to use only the approach of budget lines and indifference curves, the Appendix to Chapter 6 provides a self-contained treatment. Indeed, these instructors can simply replace the first section of the chapter with the Appendix.

Chapter 7 presents the theory of the firm in the short run, when one factor is fixed (usually capital) and the others are variable (labour usually being the most important). We begin with a brief discussion of firms as agents of production. We then discuss the meaning of costs, opportunity costs, and economic profits. We also examine the difference between the various ―runs‖ over which firms make decisions. Profit maximization as a motivation is at the core of this chapter.

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Chapter 8 discusses the choices made by firms in the long run and the very long run. Unlike most other texts, we distinguish the period of time during which all factors are variable but technology is fixed (the long run) from the period of time during which technology is permitted to change (the very long run). We feel that this approach makes it easier for the student to think clearly about firms’ choices in response to factorprice changes (long-run decisions) and firms’ choices in response to changes in technology (very longrun decisions). The Appendix to Chapter 8, analogous to that in Chapter 6, develops the theory of cost and production and long-run Copyright © 2026 Pearson Canada Inc.

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substitution between labour and capital using isoquant analysis. ***

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______________________________ Chapter 6: Consumer Behaviour ______________________________

This chapter is designed to cover the minimum amount of the theory of consumer behaviour needed to read the rest of the book. The chapter is designed to be sufficient for instructors who do not want to teach the intricacies of indifference curves to introductory students. Others may then exercise their preference for indifference analysis by assigning the chapter’s Appendix. *** In the first section of the chapter, we develop the theory of consumer behaviour using the marginal utility approach. After a discussion of total utility and marginal utility, we derive the utility-maximizing condition that the ratio of marginal utility to price be constant across all goods. We then use that condition to derive a downward-sloping demand curve. One common pitfall for students is to think that utility is maximized when the marginal utility for each good is equated, but the key point, of course, is that the Copyright © 2026 Pearson Canada Inc.

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marginal utility per dollar spent on each good needs to be equated. It is worth spending the necessary time in class to make sure that students appreciate this distinction.

The question of realism often comes up at this point: students ask whether people really think this way and make their decisions according to this logic. This important issue is addressed in the text, and it also leads to a box on rationality and the ―framing‖ of prices, and how consumers sometimes respond differently when the situation is framed differently.

The second section contains a detailed but intuitive discussion of income and substitution effects as a way of thinking about the negative slope of demand curves.

Figure 6-3 is especially effective at helping students understand how these different effects operate when a product‘s price changes. Though the formal treatment with indifference curves (in the Appendix) is more precise, this intuitive discussion should be enough to allow students to use the concepts as they continue their study of microeconomics. We also make the point that for most products, the income effect from a change in price is usually quite small, so that the substitution effect is usually the dominant consideration.

The third and final section develops the idea of consumer surplus and builds on the brief discussion from Chapter 5. We not only develop the main idea (which is key to some of our later discussions of allocative efficiency) but also apply this concept to an explanation of the paradox of value (the diamond–water paradox). This is a short section, but it deserves careful attention because the insights are of great practical importance. We find that students who have attended courses that just take them through the equivalent of the first section of Chapter 6 tend to be critical of demand theory as being ―too theoretical.‖ However, students who have understood the material in

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this final section tend to have more appreciation for the practical value of demand theory.

The Appendix to this chapter offers a self-contained treatment of budget lines and indifference curves. For those instructors who prefer to use only the approach of budget lines and indifference curves in developing basic consumer theory, the Appendix can be used in place of the first section in the chapter. In this way you can avoid entirely the approach to consumer theory based on the idea of diminishing marginal utility. You can then proceed from the Appendix to the second section to emphasize the intuition behind the income and substitution effects, and then to the final section to appreciate some applications of the core consumer theory.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1

a) utility (or satisfaction); diminishes b) marginal utility; equalized c) MUA/pA

= MUB/pB

d) negative e) increases; ski passes; golf games f) 50 g) quantity demanded; negatively sloped Question 2

a) price; constant b) real income; constant c) the same; reduction

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d) opposite; reduction; increase e) substitution; income; income; substitution Question 3 a) below; above; price that is actually paid b) greater c) zero d) $14 e) very low (close to zero); very high f) high; low

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Review Questions Question 4 a) Since salt is a very small element in most people‘s consumption bundle, the income effect is likely to be very small, such that a 10% increase in price should have very little effect on the quantity demanded. Also, note that there are few good substitutes for salt, so demand tends to be relatively inelastic.

b) Blue jeans are relatively expensive purchases, and due to swings in fashion may not be that durable. Therefore, one might expect the income effect to be reasonably large, such that an increase in price is likely to elicit a reasonably large change in consumption. This is compounded by the fact that many people might view a large class of clothing as good substitutes for blue jeans, thus making the demand for jeans relatively elastic.

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c) Even the total of all fruits and vegetables makes up a relatively small portion of the average consumer’s consumption bundle.

This implies a small income effect and, for this reason, demand is likely to be quite inelastic. In addition, there are not many good substitutes to ―all fruits and vegetables,‖ another reason demand is likely to be inelastic. d) While gasoline consumes a significant portion of many people’s income, implying a large income effect, there are few viable substitutes. Consequently, gasoline may exhibit significant response to price increases, but smaller than one might expect from the pure income effect.

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e) Minivans are extremely large purchases and should possess very large income effects. Further, as a consumer durable, minivans may be repaired instead of replaced.

Consequently, quantity demanded for minivans should exhibit very large responses to changes in price.

Working in the same direction, large sedans and sport utility vehicles are, for many consumers, reasonably good substitutes for minivans, making demand even more elastic. f) The income effect from a change in rent for apartments is probably bigger than for most products since rent makes up a large portion of most people‘s monthly budget and recurs every month. g) Luxury cars are expensive and will constitute a significant portion of the consumer‘s income, except for very rich consumers. The income effect is therefore likely to be significant, making demand relatively elastic. However, available substitutes are limited, especially if the luxury car is purchased to confer status and prestige, rather than just being a means of comfortable transportation. In

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the final analysis, it is probably best to segment the groups of consumers between the very rich and the not so rich. Demand among the first group is probably very inelastic; demand among the second group is probably quite elastic. h) Most electronic equipment (TVs, laptops, tablets, smart phones, etc.) are durable goods—they last for a year or two, and sometimes much longer. This durability means that we do not buy them on a regular basis, and the price of the product gets ―spread out‖ over the life of the product. So, the average monthly expenditure on electronic products is relatively small as a fraction of total monthly expenditures, making the income effect from a price change relatively small. i) A one-week, all-inclusive vacation to Cuba might cost anywhere between $700 and $5000 depending on where you live and the quality of the resort that you visit. For most people, this amount represents a significant share of monthly income, and so a 10% price increase is likely to have a significant effect on quantity demanded. On the other hand, these vacations are typically taken only every few years, and so the price of the vacation is a much smaller share of the total income over the larger period. Also, there are lots of substitute places to vacation, so demand will be elastic. j) The fee for a one-day car rental is a relatively small share of most people‘s monthly income. And since most people rent a car only occasionally, a 10% price increase is unlikely to have a large effect on car rentals. So demand will be relatively inelastic. However, for people who rent cars frequently, the income effect from a price increase will be larger.

Question 5 For most products, the substitution effect of a price change is always in the direction of Copyright © 2026 Pearson Canada Inc.

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increasing quantity demanded when the price falls (or reducing quantity demanded when the price rises). (In the extreme case where products are viewed by the consumer as being perfect complements, sometimes called Leontief preferences, the substitution effect is precisely zero.)

The direction of the income effect depends on whether the good is normal or inferior. For a normal good, the income effect of a reduction in price is to increase real purchasing power and to increase quantity demanded; for an inferior good, the income effect of a reduction in price is to increase real purchasing power but to reduce quantity demanded. (The quantity demanded for inferior goods increases when income falls.)

Putting the substitution together, we have:

and

income

effects

Normal goods: Income and work in the same direction

substitution

effects

Inferior goods: Income and substitution work in the opposite direction.

effects

This is why, as shown in Figure 6-2, the demand curve for a product will only be upward sloping in the rare case where that product is ―strongly inferior‖, meaning that the income effect outweighs the substitution effect. This is the case of a Giffen good.

Question 6 a) Consumer surplus at price p0 is given by the triangle defined by points BCD. b) The new equilibrium price is p1 and quantity is Q1. Consumer surplus is now given by the triangle ACE.

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c) On the original Q0 units, the lower price means more consumer surplus, given by the rectangle ABDF. d) The triangle FDE is the new consumer surplus earned on the new (Q1-Q0) units.

Question 7

This is a good question to emphasize the difference between total and marginal value and to clarify how changes in market price are related to changes in either total or marginal value. a) The rightward shift of the demand curve reflects the fact that consumers now place more total value on this item (or, more precisely, more value for any given quantity). Thus, for any given quantity of the product, the area

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under the demand curve has increased. b) In equilibrium, the marginal value of X has not changed, even though the total value has. The reason is that, in this case, the supply curve is perfectly elastic, and so the equilibrium market price is unaffected by the increase in demand. So consumers still consume X until the marginal value is equal to the market price, but the latter is unchanged and thus so is the former. c) The total value that consumers place on a given quantity of Y is unchanged—the demand curve for Y has not moved. d) The increase in supply drives down the price. The reduction in Copyright © 2026 Pearson Canada Inc.

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price leads consumers to consume more of Y until the marginal value is just equal to the price. But since the price has fallen, the marginal value of Y has also fallen, even though there has been no change in preferences (the demand curve hasn’t moved at all).

Question 8 This is a great example of how understanding the concept of marginal value can help us to understand some facts from our everyday experience. For most people, the value of a second morning newspaper, given that they have one already, is very close to zero. There is no value in reading two, and the product cannot usefully be stored until later. Thus, back in the day when newspaper publishers still sold lots of physical newspapers, they used simple vending machines that allowed individuals to take several papers even though they paid for only one because they guessed (correctly, in most cases) that most people would take only one newspaper.

For candy and soft drinks, however, the marginal value of an extra unit is quite highbecause both products are easily storable so that even if you don‘t want a second chocolate bar or soft drink right away, you may well want it in a few hours or a few days. In this case, many individuals might be tempted to take extra units Copyright © 2026 Pearson Canada Inc.

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that they have not paid for; the solution to this problem is that the candy and soft-drink companies use vending machines that allow buyers to only remove one unit at a time.

Question 9 This is a good question to drive home the important difference between marginal and total value, applied to a very important product to Canadians. a) Given a downward-sloping demand for medical and hospital services, the unlimited governmentprovision at a zero price suggests that consumers will use the services until their marginal value is driven to zero. b) Even if the marginal value of medical services is driven to zero, the total value of the consumed services will be quite high. Consumers will simply use these services up to the point where price (zero) equals marginal benefit. If the government then restricts supply (for whatever reason), the total value of services to consumers will fall but the marginal value will rise. This simply reflects the fact that consumers will move up the demand curve. If the government maintains the zero price even when they restrict the supply, there will be excess demand for hospital and medical services.

This leads to long queues, waiting lists, and perhaps even a black market in health-care services. c) If the government maintains the zero price (as actually occurs in most Canadian provinces) but restricts the supply of services below the quantity demanded, there will be a shortage in the market.

This excess demand is likely to take the form of hard-to-get appointments and long waiting times for medical procedures—both of which are actually common features in the Canadian health-care system.

Question 10 Copyright © 2026 Pearson Canada Inc.

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Consider two simple demand-and-supply diagrams, one for the market for cardiac surgeons and one for NHL hockey stars. The demand curves may well be the same for these two types of workers, although each of them would be challenging to compute with any precision. But the real difference is on the supply side. Cardiac surgeons need to go through expensive training for many years in order to earn their credentials and qualify for their positions. This extensive training explains why they are in short supply relative to many other doctors, and also relative to many other occupations. But relative to NHL hockey stars, the cardiac surgeons have a large supply; the very special set of skills possessed by the very best NHL players makes them extremely rare, and the result is that they can command much higher salaries than even the very best specialist surgeons. In terms of the diagrams, the supply curve for the NHL stars is to the left of the supply curve for the cardiac surgeons.

In terms of the ―value‖ question, the higher salary for NHL hockey players suggests that society values them more at the margin than it values surgeons. But the total value placed on the two different sets of workers depends on the position of the demand curves.

Question 11 a) The intuitive reason is that Sophie needs to equate the marginal utility per dollar spent on each product across all products. If this were not equated, then a reallocation of her expenditure would increase her total utility. For example, since F denotes food and X denotes everything else, we have MUF/pF = MUX/pX when her utility is being maximized. If instead, the left-hand side was greater than the right-hand side, then she should spend more on F and less on X until Copyright © 2026 Pearson Canada Inc.

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the equality is achieved. If the left-hand side was less than the right-hand side, then she would increase her utility by spending more on X and less on F. b) We begin with MUF/pF = MUX/pX where Sophie is maximizing her utility. Then the price of food increases, which means that pF rises.

Immediately after the price increase, but before Sophie adjusts her spending, the MUs haven‘t changed, and so we have MUF/pF < MUX/pX Since we no longer have an equality of MU/p across products, Sophie is no longer maximizing her utility. c) In order to increase her utility after the price of food rises, Sophie needs to raise the MU/p for food or decrease the MU/p for everything else, or both. She can do this by spending less on F, which raises MUF, and by spending more on X, which lowers MUX. This adjustment will restore the equality above. d) An increase in the price of food leads Sophie to reduce her spending on food until the ―payoff‖ she gets from the last unit of food (the MU of food) per dollar spent rises to the point where it is equal to the payoff per dollar spent on other things. Since MU rises as less is consumed, this yields a negatively sloped demand curve. e) Markets are made up of many consumers, most (if not all) of whom have diminishing marginal utility for individual products. When the price of the product rises, those consumers all do what Sophie did in the previous question—they reduce their quantity demanded for the product. The magnitude of the effects will differ across different consumers, but the aggregate effect will most often be a reduction in total quantity demanded.

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Problems Question 12 a) The appropriate diagrams for (a) and (c) are shown below. Note that the horizontal scales for both diagrams are the same but the vertical scales are different. Note also that marginal utility is plotted between the integer values for the number of avocados consumed because marginal utility measures the change in utility from consuming one more avocado.

b) The marginal utility is the change in utility divided by the change in the number of units consumed. The marginal utilities are given in the following table: Change in Consumption

0th to 1st 1st to 2nd 2nd to 3rd 3rd to 4th 4th to 5th 5th to 6th

Margi nal Utili ty 100 85 60 40 30 20

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6th to 7th 10 7th to 8th 5 c) The graph of marginal utility is shown above. d) Brett likes avocados, and each extra avocado increases his total utility. But after some point (and perhaps right away, as in this case), each successive avocado adds less to his total utility (or satisfaction) than the previous one assuming they are being consumed in the same time period.

That is, the utility that Brett gains from each extra avocado falls. Most of us experience this phenomenon regularly, whether it be with cold beverages on a sunny day, pieces of pizza, or meals at a nice restaurant.

Question 13 The key point here is to recognize that utility maximization requires that the marginal utility per dollar spent on each good should be equated across both goods. If this equality does not hold, then the pattern of expenditure can be changed in such a way as to increase total utility. Recall also that, in the presence of declining Copyright © 2026 Pearson Canada Inc.

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marginal utility, an increase in the marginal utility from consuming some product requires a reduction in the number of units of that product consumed. The table below shows the computation of MU/p for each good and states whether consumption of X or Y should be changed.

Ca se A B C D

E

MUX/pX MUY/pY Change pattern of consumption?

Need to raise MUX/pX 2/10 3/5 relative to MUY/pY. Need Consume to less raise of X andMUmore X/pX 4/12 2/4 relative to MUY/pY. of Y. MU /p equals Consume less MU ofY/p X Y.and more X X 1/3 2/6 Do not change pattern of of Y. MU consumption.

X/pX equals MUY/pY. 2/4 2/4 Do not change pattern of Need to reduce MUX/pX consumption.

4/3 3/4 relative to MUY/pY. Consume more of X and less of Y.

Question 14 In each case Luc is assumed to be maximizing his utility, so MU/P is equated across restaurant meals and ―all other goods‖. a) The MU of consuming restaurant meals is 100, so MU/P is 5. Since the price of all other goods is $10, the MU from consuming those goods must be 50. b) The MU from consuming all other goods is 40, so MU/P is 4. Since the price of restaurant meals is $20, the MU from consuming restaurant meals must be 80.

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c) The MU of consuming restaurant meals is 56, so MU/P is 56/20 = 2.8. Since the price of all other goods is $10, the MU from consuming those goods must be 28. d) The MU from consuming all other goods is 122, so MU/P is 12.2. Since the price of restaurant meals is $20, the MU from consuming restaurant meals must be 244.

Question 15 a) From the figure, it is clear that total utility when consumption is 500 units is 75. At 600 units it is approximately 77.5. At 700 units it also appears to be 77.5. b) Determining the value of marginal utility at any given level of consumption requires knowledge of the slope of the function for total utility. In order to know precisely the slope of the function at any given point, we would have to compute the slope of a tangent line at that point. But even without doing this we can tell that the function is steeper when consumption is 100 units than when consumption is 200 units or 500 units. So we can know for certain that marginal utility is higher when consumption is 100 than it is when consumption is 200, which is higher than when consumption is 500 units. The function clearly displays diminishing marginal utility. c) Diminishing marginal utility is shown by the fact that the slope of the function declines as the level of consumption increases. d) From the figure, it appears that total utility reaches a maximum when consumption reaches 600 units per period. So every extra unit of consumption beyond this point apparently does not increase utility at all—this is the situation of marginal utility being equal to zero. This situation is often referred to as satiation and is thought to be quite rare in reality.

Question 16

a) In order to maximize utility, the ratio of MU to p must be equal across all products. For each shopping trip shown, the MU/p ratios are 0.5 for both products. So Sally is maximizing her utility on each trip. b) As the price of shoes declines, Sally is purchasing more shoes and this is what reduces her MU of her consumption of shoes. (The extra utility obtained from a pair of shoes declines as the number of pairs increases.) c) Since the price of everything else is being held constant across the five shopping trips, it is clear that the only variable changing is the price Copyright © 2026 Pearson Canada Inc.

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of shoes. Thus, we can detect the shape of Sally‘s demand curve for shoes from the information given in the table (drawn under the ceteris paribus assumption). As the price of shoes falls from $250 to $50 (with other prices being held constant), Sally‘s shoe purchases rise. Thus, we know that Sally‘s demand curve for shoes is downward sloping.

Question 17

a) See the two diagrams below. For Good X, both effects work in the same direction. For Good Y, the two effects work in opposite directions.

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b) Good X has a downward-sloping demand curve. The substitution effect of the price increase reduces consumption, as does the income effect (which means that consumption declines and real income falls). So Good X is a normal good. c) Good Y has a downward-sloping demand curve. The substitution effect of the price increase reduces consumption. But the income effect is to increase consumption as real income falls (due to the price increase). So Good Y is an inferior good. d) For Good X, the income effect and substitution effects are working in the same direction (consumption falls as price rises). For Good Y, the two effects are working in the opposite direction: the price rise leads to a reduction in consumption with the substitution effect, but an increase in consumption for the income effect. e) In order to be a Giffen good, the demand curve must be upward-sloping. This requires that the income effect be opposite to and larger than the substitution effect. So, if Q1 were to the right of Q0, Good Y would be a Giffen good.

Question 18

a) The sum of Rupert’s willingness to pay for the first five pizzas is 18 + 16 + 13 + 9 + 4 = $60. Thus, Rupert would be willing to pay $60 per week for these five pizzas—this is the total value that Rupert places on five weekly pizzas. b) Rupert will purchase pizzas until his willingness to pay for the next pizza is less than the market price. At a price of $10 per pizza, Rupert will buy three pizzas per week. c) The total value that Rupert places on the three pizzas is 18 + 16 + 13 = $47. The amount Rupert must spend to buy them is $10 per pizza times three pizzas, or $30. Thus, Rupert‘s consumer surplus is $17. (Alternatively, we could add the consumer surplus generated from each of the three pieces consumed: $8 + $6 + $3 = $17.)

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Question 19 a) The demand and supply curves are plotted in the diagram below.

To compute the equilibrium price and quantity algebraically, we must solve the system of equations.

Equate the prices in the demand and supply functions to get 30 – 4Q* = 6 + 2 Q*  24 = 6 Q*  Q* = 4 Substitute this value of Q* back into either the demand or supply curve to solve for p*. Using the demand curve to do so, we get p* = 30 – (4  4) = 14

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b) The total value that consumers place on Q* units of the good is shown by the area under the demand curve up to Q = 4 units.

This is shown by areas A + B + C. c) The value that consumers place on an additional unit of the good— the marginal value—is shown by the equilibrium market price, p* = 14. Given the market price, consumers consume the good until the last unit delivers utility equal in value to the market price.

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d) The new supply curve is p = 2 + 2QS. The new equilibrium quantity, Q** is found by 30 – 4Q** = 2 + 2Q**  28 = 6Q**  Q** = 4.67 and p** = 30 – (4  4.67) = 11.33 As the supply curve shifts, price falls and consumers increase their quantity demanded of the product.

Consumers’ marginal value of the good has now fallen and is equal to the new equilibrium market price. e) Consumers have not changed the total value they place on any given amount of the good, but their marginal value has fallen. As the equilibrium price falls, consumers consume more of the product, thus Copyright © 2026 Pearson Canada Inc.

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diminishing the marginal value of the product. *****

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________________________________________ Appendix to Chapter 6: Indifference Curves _________________________________________

Answers to Appendix Study Exercises

Question 1 a) The appropriate scale diagram is shown below. b) Bundles c and i are on the same indifference curve, marked I1 in the figure. Bundles d, g, and h are also on the same indifference curve (marked I2), but each is preferred to either c or i. Thus I2 lies above and to the right of I1. Bundle e is Katie‘s favourite bundle of those shown, and so the indifference curve through this bundle (I3) must lie above and to the right of I2. c) Katie clearly prefers bundle e to bundle g. How about comparing bundle f to bundle g? We know that Katie is indifferent between bundles d and g. Also, we can be sure that she prefers d to f, for the simple reason that d and f have the same amount of magazines but d has more ice cream cones. But this immediately means that she also prefers g to f.

Thus, Katie‘s ranking is: e is preferred to g, and g is preferred to f.

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Question 2 a) The cost of each bundle is shown in the following table. Since Katie has $36 per month, she can afford only bundles a, c, f, g, and i. She cannot afford bundles b, d, e, and h.

a

b c d e f g h i

Cost ($) 36 40 36 38 40 34 36 44 36

b) If Katie spends her entire $36 on ice cream cones, she can afford to buy 9 cones. This is the vertical intercept of the budget line shown below.

If she spends her entire $36 on magazines, she can afford to buy 6 magazines. This is the horizontal intercept of the budget line. The (absolute value of the) slope of the budget line is equal to the ―rise over the run,‖ which in this case is equal to 9/6, which is 1.5. This slope is equal to the relative price of magazines to ice cream cones (= 6/4 = 1.5). c) Recall that Katie can only afford bundles a, c, f, g, and i. Which one will she choose? Recall from Question 1 that Katie prefers bundle g to bundle f, and she also prefers g to both c and i. So Katie definitely won‘t choose c, f, or i. This leaves only bundle a. But from the figure of the indifference curves above, it is also clear that bundle g is on a higher indifference curve than bundle a, so she won‘t choose bundle a. Thus Katie‘s utilitymaximizing choice is bundle g.

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Question 3 a) For the budget line given by Line 1, point A shows the tangency between the budget line and the indifference curve—this shows the highest level of utility that Debra can achieve. b) If the price of Coronas declined, then the maximum available amount of Coronas (with a given money income) would increase. This amount of Coronas is the horizontal intercept of the budget line. c) Point B shows the hypothetical consumption bundle that Debra would choose if the price of Coronas declined and her money income was reduced so that she could just achieve her original level of utility. The movement from A to B is the substitution effect of the reduction in the price of Coronas. It shows that the substitution effect of a decline in the price of a product is unambiguously to increase the consumption of that product and decrease the consumption of the other product. d) Point C is the new consumption bundle that Debra chooses after the actual reduction in the price of Coronas. If Coronas are a normal good, then an increase in real income must lead Debra to increase her consumption of Coronas. This implies that point C must lie to the right of point B (the movement from B to C being the pure income effect of the price change). The diagram as drawn does indeed satisfy this restriction. e) If Coronas were an inferior good for Debra, her map of indifference curves would be different from those shown in the figure in the text. In this case, the increase in real income shown by the shift of the budget line from the dashed line to line 2 would lead Debra to reduce her consumption of Coronasthat is, her new consumption point would lie to the left of point B.

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Question 4

This is a good question for emphasizing which factors lie behind the shape of an indifference curve (in the common situation where both items are ―goods‖). The key point is that the more substitutable are the two items in terms of providing utility, the flatter (less curved) is the indifference curve. Thus, with items that are close substitutes, even small changes in relative prices will lead to large changes in the utilitymaximizing bundle—that is, there are large substitution effects.

Coke and chips are complements, and so we would expect the indifference curves to be quite curved—in the extreme case of perfect complements, they would be L-shaped. For Coke and Pepsi, however, we expect the indifference curves to be rather flat since (for most people) Coke and Pepsi are close substitutes. ***** _____________________________________

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Chapter 7: Producers in the Short Run _____________________________________ Students are often puzzled by the question: ―Just how many factors of production can firms vary when they are producing?‖ It is important for them to realize that the answer depends on the context. To understand the principle of substitution, it is necessary to have at least two variable factors of production, but it may be distracting to deal with more than two. Classical economists seeking to illustrate this point used ―land‖ and ―labour.‖ As soon as they wished to distinguish human-made factors from natural ones, they added ―capital.‖ For other types of applications, it is necessary to distinguish many kinds of labour skills. We also distinguish between the basic factors of production (land, labour, and capital) and those intermediate products that are produced by some firms and used as inputs by others.

We have placed the discussion of economic and technical efficiency in Chapter 8 where it naturally arises in the discussion of the firm‘s long-run choices. Some instructors feel that efficiency is too important to postpone. However, treating it earlier raises problems since students should first be exposed to a precise discussion of production functions, firms‘ opportunity costs, and their short-run choices. *** Chapter 7 begins with a discussion of firms as agents of production. We discuss the various types of firms, how they are organized, and also how they are financed. Our discussion of the goal of profit maximization leads to a box on corporate social responsibility and whether it is consistent with maximizing profits—a topic that today‘s students find fascinating (and controversial).

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The second section examines profits and costs.

Central to this discussion is the difference between the accounting concepts of costs and profits and the corresponding economic concepts. We also explain why understanding profit maximization requires us to understand both the cost side and the revenue side of the firm‘s problem. This sets us up for the rest of the chapter dealing with short-run costs. Finally, we briefly mention the variety of firms‘ decisions and their summary classification as ―short run,‖ ―long run,‖ and ―very long run.‖ It is worth emphasizing to students that these are types of decisions, not real time periods that are the same for all kinds of firms.

The chapter‘s third section begins the formal analysis of firm behaviour. We introduce and illustrate the relationship between total product, average product, and marginal product. Students often seem baffled by the mathematical relationship between marginal and average, so we spend some time on this. This leads to a box on some everyday examples of the concept of diminishing returns, including examples of gym workouts, pollution control, and portfolio diversification. Discussion of the box makes for lively class time and it is sometimes interesting to challenge students to find examples of diminishing returns in news stories over the next week. When we do this, we usually find that discussion of why some of the offered illustrations are not cases of diminishing returns provides more insight than the discussion of correct illustrations.

The fourth and final section examines the whole family of short-run cost curves, which we develop from a simple production function with fixed capital and fixed factor prices. The short-run cost curves are developed in the conventional fashion. We plot the short-run cost curves using the specific example of a production function developed earlier in the chapter. Students can review this example closely

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and plot the curves for themselves to make sure they are comfortable with the various relationships. Our detailed discussion of U-shaped cost curves leads to a box discussing the digital world in which many products have large, and fixed development costs but constant and near-zero marginal costs. Cost curves can still be drawn in these situations, of course, but diminishing marginal returns no longer apply. This section closes by examining how changes in factor prices and changes in the firm‘s capital stock affect the family of short-run cost curves.

This provides a nice motivation and link to the next chapter on firms‘ long-run decisions. ***

A Caveat. This is one of the shorter chapters in the book, but its length is not indicative of its importance. Students will likely view the production and cost relationships as rather dull stuff.

Since learning this material represents an investment for use later in the course, we suggest to our students that this is an example of capitalistic production at work— we must invest in some vocabulary and some analytic tools before Copyright © 2026 Pearson Canada Inc.

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discussing the much more interesting matters of pricing and market structure that occur in later chapters.

Answers to Study Exercises

Fill-in-the-Blank Questions Question 1 a) production function b) implicit costs c) capital; time d) economic profits e) short run; long run Question 2 a) diminishing returns (to the variable factor) b) marginal product c) above; below d) maximum e) fall; negative Question 3 a) minimum b) increase c) increasing

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d) increasing e) capacity f) marginal cost; average variable cost; average total cost Review Questions Question 4 a) Hourly wages are an explicit cost. These are subtracted from revenues for computing both accounting and economic profits. b) Depreciation of physical capital is an explicit cost. It is subtracted from revenues for computing both accounting and economic profits. c) The risk-free 2 percent return is part of the alternative return that investors could have earned if they did not invest in this firm. This is an implicit (opportunity) cost and is subtracted from revenues to compute economic profit. It is ignored in the computation of accounting profit. d) Rental payments for a production facility are an explicit cost. It is subtracted from revenues for computing both accounting and economic profits. e) The additional wages the owner could have received in alternative employment is an implicit (opportunity) cost. It is subtracted from revenues to compute economic profit but ignored in the computation of accounting profit. f) The risk premium of 3 percent is part of what owners could have earned if they invested elsewhere rather than in this firm. It is an implicit (opportunity) cost and is subtracted from revenues to get economic profit but ignored in the computation of accounting profit.

Question 5

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a) Note that the opportunity cost of remaining in business is not only the $70,000 in explicit expenses the carpenter incurs, but also the income from the furniture factory that the carpenter cannot receive because they have made the decision to operate their own shop. If this forgone salary is any larger than $30,000, then the carpenter should go back to the factory. Another way to say this is that their (accounting) profits are $30,000 per year when they run their own business. So if their salary at their first job is higher than $30,000, they should go back to the factory. b) The answer in part (a) implicitly assumes that the current outcome is expected to continue into the future. But if the cabinetmaking business is expected to perform more poorly in the future than in the past two years, the carpenter will likely be prepared to go back to their old job at a lower wage. If instead the business is expected to do much better in the near future, then a premium on the old wage might be required to convince them to return to their old job.

Question 6 There is no reason provided for why the ―usual‖ diminishing returns does not apply in this situation. We are told that the minimum ATC occurs with at least 8 workers, so ATC is declining as output rises from zero to the level consistent with 8 workers (given the capital stock). It follows that the AP curve is rising and reaches a maximum at 8 workers.

With diminishing returns, the AP curve then begins to fall as the number of workers rises from 8 to 16 (and so the ATC curve rises). The MP curve must be above the AP curve when the latter is rising, and it is also likely rising. When AP begins to fall, however, MP must be below it. The MP curve will begin falling (diminishing returns) at a lower number of workers than 8, and it will intersect the AP curve at its maximum.

Question 7 LeBron James’ average score is 25 points per game (computed over the total number of games he has played this season). His points from the last game of the season are 12; this is his marginal score. When his average is re-calculated after the last game, it will be lower than 25 points (although we don’t know how much lower unless we know how many games he played this season). His average score falls because his marginal score is below his average—the usual marginal–average relationship.

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Question 8 a) At this level of output, note that MC is above ATC, which means that ATC must be rising as output increases. This further implies that we are at a level of output beyond which ATC and AVC reach their minimum points. So we are on the upward-sloping portion of the MC curve and thus are already encountering diminishing marginal returns and also on the upward-sloping portion of the AVC curve and so are encountering diminishing average returns. b) Since the firm is on the upward-sloping portion of the ATC curve, it is operating beyond its level of capacity. c) At this level of output, note that MC is below ATC, which means that ATC must be falling as output increases. This further implies that we are at a level of output below which ATC and AVC reach their minimum points. So we are on the downward-sloping portion of the marginal and average curves. The firm has not yet encountered diminishing marginal or average returns. d) Since ATC is falling, the firm is producing below its capacity.

Question 9 For a firm producing physical products such as steel or lumber or appliances or furniture, the law of diminishing returns almost certainly applies and so the firm‘s cost curves would be like those discussed in the chapter. In particular, the firm‘s MC curve will be U-shaped—although whether it is ―sharply‖ so or ―gradually‖ so depends crucially on the nature of the firm‘s technology.

But for a firm making digital products such as apps or movies or online courses or ebooks, the nature of costs is quite different. In these situations, the firm will typically have large fixed costs associated with the initial development of the product. But once the product is developed, additional units of the product can be produced and distributed at very low costs, and this cost will typically not increase as the level of output increases. In other words, the firm‘s MC curve will be flat (horizontal) at a very low level; diminishing returns is absent. See the box in this chapter for further discussion.

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Problems Question 10 a) As shown in Table 7-1 in the chapter, accounting profits are equal to revenues minus explicit costs, and do not include the opportunity cost of the owner’s financial capital.

The total revenues shown are $657,000. The total explicit costs equal $542,000. Thus the accounting profit is the difference between the two, $115,000. b) The 16 percent rate of return on capital is an annual rate. If equally risky ventures in other industries can generate a 16 percent annual return, then the opportunity cost on Mr. Buford’s capital for one year is 0.16  ($400,000) = $64,000. c) Economic profits are equal to accounting profits minus the opportunity cost of the owner’s financial capital. Thus economic profits for Spruce Décor in 2025 are $115,000 – $64,000 = $51,000. d) If Spruce Décor is a typical firm in the industry, then the typical firm is making positive economic profits. Thus profits in this industry are higher than what is available in equally risky ventures in other industries. Such positive economic profits will lead other firms to enter this industry.

Question 11 a) The explicit costs are wages and salaries, bank interest, cost of supplies, and depreciation. The total is $920,000. b) The implicit costs are the risk-free return on the owner‘s capital, the risk premium on that same capital, and the additional wages that could have been earned in the next best alternative. Since alternative wages in this example are zero, the opportunity costs are only the return on the owner‘s capital. The total is $70,000. c) Accounting profits are revenues minus explicit costs. The accounting profits are $30,000. d) Economic profits are revenues minus (explicit + implicit) costs. The economic profits are negative $40,000. So, there are economic losses being earned—meaning that the returns are less than would be available in the next best alternative venture.

Question 12 Copyright © 2026 Pearson Canada Inc.

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a) The table is completed below. Note that for marginal product (MP), the computation is done for the change in output and labour input between rows.

Thus, the first value in the table for MP reflects the change in output from 0 to 2 and the change in labour from 0 to 1; the marginal product is therefore equal to ∆TP/∆L = 2/1 = 2.

Units of Labour AP (per week) 0 1 2 3 4 5 6 7 8

Number of Snowboards MP (per week) 2 5 9 14 18 21 23 24

2 2.5 3 3.5 3.6 3.5 3.3 3

2 3 4 5 4 3 2 1

b) The MP and AP curves are shown in the figure below. The point of diminishing marginal productivity occurs between 3 and 4 units of labour.

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Question 13 a) The average product of labour is equal to total output divided by the number of units of labour input. The values are shown in the table below and the AP curve is plotted in the figure below. b) The marginal product of labour is equal to the change in total output divided by the change in labour input that brought it about. In the table above, we compute the marginal product according to the change in values from one row to the next, so the first row is left empty. The MP curve is plotted in the figure above. Note that the values are plotted at the midpoints of the units of labour.

Average Product

AP = 200/100 = 2.0 AP = 260/120 = 2.17 AP = 350/140 = 2.5 AP = 580/160 = 3.63 AP = 720/180 = 4.0 AP = 780/200 = 3.9 AP = 800/220 = 3.64 AP = 810/240 = 3.38

Marginal Product MP = 60/20 3.0 MP = 90/20 4.5 MP = 230/20 11.5 MP = 140/20 7.0 MP = 60/20 3.0 MP = 20/20 1.0 MP = 10/20 0.5

= = = = = = =

c) The law of diminishing marginal returns is satisfied for labour because (eventually) the marginal product of labour falls as more and more labour is used.

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d) As we explained in the text, the average product of labour can only rise if the marginal product exceeds the average product. This relationship is seen clearly in the figure for levels of labour input below 180. Similarly, the average product of labour only falls when the marginal product is less than the average product, as seen in the figure for values of labour above 180. It follows that the MP curve must intersect the AP curve at its maximum, as shown in the figure.

Question 14 a) By substituting the values of K and L into the production function provided (Q = KL – 0.1L2), the values for Q are found. The answers are: K 10 10 10 10 10 10 10 10

L 5 10 15 20 25 30 40 50

Q = KL – .1L2 50 – .1(25) = 47.5 100 – .1(100) = 90 150 – .1(225) = 127.5 200 – .1(400) = 160 250 – .1(625) = 187.5 300 – .1(900) = 210 400 – .1(1600) = 240 500 – .1(2500) = 250

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to 10. Note that the curve goes through the origin because when L equals 0, Q also equals 0 (independent of the value of K).

c) If K increases to K = 20, then the values of Q will also increase (for any given value of L). The recomputed values for Q are in the table below. The new curve is shown in the diagram above, indicated by K = 20.

K 20 20

L 5 10

Q = KL – .1L2 100 – .1(25) = 97.5 200 – .1(100) = 190

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20 20 20 20 20 20

15 20 25 30 40 50

300 – .1(225) = 277.5 400 – .1(400) = 360 500 – .1(625) = 437.5 600 – .1(900) = 510 800 – .1(1600) = 640 1000 – .1(2500) = 750

d) A larger capital stock means that any given amount of labour now has more capital to work with, and thus can produce more output. This increase in the average product of labour is reflected simply by the upward shift in the curve shown above. Note also, however, that in this case (and in many others), the increase in K also increases the marginal product of labour for any given level of labour input. This is shown by the increase in the slope of the curve for any level of L. For example, for L = 25, the slope of the K = 20 curve is greater than the slope of the K = 10 curve. This shows that the increase in K has made labour more productive at the margin.

Question 15 a) The relationships between output and the units of variable input can be described as follows:

i)

Output increases proportionally with the variable input. That is, an x percent increase in L leads to an x percent increase in total output. ii) Output is positive even when there is no L. And for each unit change in L there is a constant unit change in output. iii) Up to some critical level of L, output increases proportionally with increases in L. But beyond this critical level of L, further increases in L lead to no change in total output. iv) Output increases with every increase in L, but each successive unit increase in L leads to smaller increases in total output.

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b) The average product curves for the four cases are shown in the figure below. In the first case, the AP is constant. In the second case, due to the positive vertical intercept of the TP curve, the AP curve falls as L increases. In the third case, up to the critical level of L, L*, the AP is constant. But beyond that point, since output does not increase but L does, the AP curve falls. In the fourth case, the AP curve is steadily declining.

c) The marginal product curves are also shown in the diagram above. In the first case, the slope of the TP curve is constant and so the MP curve is a horizontal line. In the second case, the MP is also constant, even though AP declines steadily. In the third case, the MP is positive and constant up to L*, after which point MP is zero. In the fourth case, MP steadily falls and is below AP. d) Note that in all four cases, AP is only falling if MP is below AP.

Question 16

The graph showing the relationship between agricultural output and fertilizer use is as follows.

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The average products, calculated as an average over the fifteen-unit intervals, are shown below. We have calculated the marginal products over the same intervals, but note that the MP applies for the change from one row to the next.

Fert Ave Ma ilize rag rgin r e al Dos Pro Pro e duc duc t t 0 — — Copyright © 2026 Pearson Canada Inc.

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15 30 45 60 75 90 105 120 135 150

6.9 0.28 5 0 3.6 0.41 8 3 2.6 0.50 2 7 2.0 0.48 9 7 1.7 0.32 4 7 1.4 0.08 6 0 1.2 0.03 6 3 1.1 0.02 0 7 0.9 0.01 8 3 0.8 0.02 9

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Average product falls throughout, so diminishing average productivity sets in at a very low, perhaps even zero, dose. Marginal product rises for the first few intervals and then declines roughly steadily, so diminishing marginal productivity sets in somewhere between 30 and 60 doses.

Question 17 a) The firm’s average total cost is given by the sum of average variable cost ($100 per unit) and average fixed cost ($50 per unit), which is $150 per unit. The level of daily output is thus equal to total costs divided by average total cost, which is $30, 000/$150, which is 200 units per day. b) The firm’s total variable costs are given by the level of output times average variable costs, or 200 units times $100 per unit, which is $20,000 per day. c) The firm’s total fixed costs are given by the level of output times average fixed costs, or 200 units times $50 per unit, which is $10,000 per day.

Question 18

a) Average fixed cost (AFC) is equal to total fixed cost (TFC) divided by the level of output. The values for AFC are shown in the table below. b) Average variable cost (AVC) is equal to total variable cost (TVC) divided by the level of output.

The values for AVC are shown in the table below. c) Average total cost (ATC) is equal to total cost (TVC + TFC) divided by the level of output.

Alternatively, ATC is equal to the sum of AFC and AVC. The values for ATC are shown in the table below. The firm‘s ―capacity‖ is the level of output at which ATC is minimized, which in this case is 8 (thousand) bicycles per year.

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Ou AFC tp Avera ut ge (00 Fixed 0s Cost pe ($) r ye ar) 1 200/1 = 200 2 200/2 = 100 3 200/3 = 66.7 4 200/4 = 50 5 200/5 = 40 6 200/6

AVC ATC Avera Avera ge ge Varia Total ble Cost Cost ($) ($) 40/1 = 240 40 70/2 = 135 35 105/3 101.7 = 35 120/4 80 = 30 135/5 67 = 27 155/6 59.2

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= 33.3 = 25.8 7 200/7 185/7 = 28.6 = 26.4 8 200/8 230/8 = 25 = 28.8 9 200/9 290/9 = 22.2 = 32.2 10 200/10 350/10 = 20 = 35 11 200/11 425/11 = 18.2 = 38.6

55.0 53.8 54.4 55 56.8

d) The scale diagram is shown below. Note that the uppermost section of the AFC curve is not shown.

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Question 19 a) Average fixed cost is total fixed cost divided by output. Total fixed cost is here given by total cost ($1,000,000) minus total variable cost ($600,000), which is $400,000. Since output is 20,000 units, average fixed costs must be $400,000/20,000, which equals $20 per unit. b) Total variable cost is total cost ($100,000) minus total fixed cost ($20,000), which is equal to $80,000. Since output is 20,000 units, average variable cost must be $80,000/20,000, which equals $4 per unit. c) The firm’s average total cost is the sum of average variable cost ($10) and average fixed cost ($5), which is $15 per unit. The firm’s total cost is then given by the level of output (750 units) times the average total cost of $15 per unit. So total cost is $11,250. d) Average variable cost is given by average total cost ($12) minus average fixed cost ($4), which is equal to $8 per unit. Total variable cost is then equal to the level of output (400 units) times the average cost of $8 per unit. Total variable cost is therefore $3200. e) Total fixed costs are given by total costs ($20 million) minus total variable costs ($18 million), which equals $2 million. Average fixed costs are this $2 million divided by the level of output (1,250,000 units). Average fixed costs are therefore $1.60 per unit.

Question 20 a) The table is filled out below.

Units of Labour per day 10 20 30

Total Output per day 100 300 900

TFC

TVC

TC

1000 1000 1000

1000 2000 3000

2000 3000 4000

MC

AFC

AVC

ATC

5 1.67

10.00 3.33 1.11

10.00 6.67 3.33

20.00 10.00 4.44

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40 50 60 70

1320 1500 1620 1680

1000 1000 1000 1000

4000 5000 6000 7000

5000 6000 7000 8000

2.38 5.56 8.33 16.67

0.76 0.67 0.62 0.60

3.03 3.33 3.70 4.17

3.79 4.00 4.32 4.76

b) The firm’s capacity level of output is that level which minimizes ATC. This occurs when output is 1320 units per day. c) One can easily compute the marginal product of labour (in increments of 10 units of labour). The MP of labour between L = 20 and L = 30 is equal to 60. The MP of labour between L = 30 and L = 40 is 42. So diminishing returns is first encountered somewhere between L = 25 and L = 35. Note that this is also where MC reaches its minimum and then begins to rise.

***** f

___________________________________ Chapter 8: Producers in the Long Run ____________________________________

The analysis of firms’ choices of factor combinations and the economics of how these choices are made in response to changes in factor prices and technology is important material to cover in any course in microeconomics. Without studying this element of firms’ longrun behaviour, it would be difficult (if not impossible) to explain Copyright © 2026 Pearson Canada Inc.

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phenomena such as firms’ incentive to substitute away from oilintensive production methods following significant and sustained oil-price increases (or toward oilintensive production methods when the price declines), or firms’ widespread substitution toward information and communications technology (ICT) equipment following large declines in the price of computers (as has been happening over the past three decades, at least), or some firms’ decisions to substitute away from high-cost domestic labour by locating their production facilities in countries with lower wages. It dismays us to see some introductory textbooks completely bypassing the Copyright © 2026 Pearson Canada Inc.

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general topic of ―factor substitution,‖ presumably for the sake of brevity. *** The chapter‘s opening section introduces the ideas of technical and economic efficiency. We emphasize that in the long run, when the firm must choose how to produce any given level of output, the firm must choose among many different production methods. But not all methods will minimize costs. We stress that profit maximization requires cost minimization and that technical efficiency is necessary, but not sufficient, for cost minimization. The remainder of the section is concerned with the significance of substituting cheaper for more expensive factors in achieving cost reductions.

The principle of substitution is another of economists‘ great insights, and we stress it. For instructors who prefer a more formal treatment of the firm‘s costminimization problem, using isoquants and isocost lines, the chapter‘s Appendix offers a complete treatment. We also have a box on the famous mistake

by Jacob Viner involving short-run and long-run cost curves. Our experience is that teaching Viner‘s mistake helps students to understand what the LRAC curve is really all about––they also appreciate seeing some of the historical elements of microeconomics.

The second and final section, which discusses the very long run, emphasizes the importance of productivity growth, firms‘ responses to technological change, and the endogenous nature of much technological change. We stress this material for three reasons.

First, since technological change has a greater long-run effect on living standards than variations Copyright © 2026 Pearson Canada Inc.

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in economic efficiency, we feel that students should get some exposure to these issues. We have a box that addresses the importance of productivity growth in driving long-run living standards, mentions that Canada‘s annual rate of productivity growth has declined since the late 1970s, and also highlights the fact that the level of productivity is now considerably lower in Canada than in other advanced economies. This poses an important challenge for Canadian policymakers.

Second, growth economics itself has become more micro-oriented, and leaving growth to be covered solely in macro courses may result in much of the fundamental microeconomics being missed.

Third, there is increasing evidence that growth and technological change are endogenous to the economic system, responding to the same microeconomic incentives as do short-run and longrun adjustments. In our discussion we include a new box addressing what is often called the ―productivity paradox‖—that, despite the widespread use of computers and the Internet, there is little evidence that these technologies have had a significant effect on overall productivity.

In spite of the above considerations, our treatment of technological change is quite brief. We do this in the hope that instructors will cover this short version whereas they might skip a fuller discussion because of the pressure of time.

Answers to Study Exercises Fill-in-the-Blank Questions

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Question 1 a) minimizing b) variable; fixed c) equalized d) principle of substitution Question 2 a) decreasing costs; economies of scale; falling b)

minimum

efficient

scale;

constant

costs

(or

constant returns to scale) c) increasing costs; diseconomies of scale; rising d) lowest possible unit cost e) tangent; variable; fixed

Question 3 a) downward b) productivity; input (often labour) c) growth; technological d) endogenous Review Questions Question 4 Cost minimization is necessary but not sufficient for profit maximization. To see this, note that profits (Π) equal revenues (R) minus costs (C), or Π = R(Q) – C(Q)

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where note that both R and C depend on (are functions of) output, Q. For any given level of output, profit maximization therefore requires that the difference between R and C be maximized. If the firm is not minimizing its costs for any given level of output, then profits can be increased for any given R(Q). Thus, cost minimization is necessary for profit maximization.

To see why cost minimization is not sufficient for profit maximization, imagine a situation in which the firm has minimized C(Q) for any given level of Q. But if the firm has not maximized R(Q) for that same level of Q, then profits will not be maximized.

Question 5 a) Both price changes are having the effect of increasing the price of labour relative to IT equipment.

Firms are predicted to substitute away from labour and toward IT equipment, as has been occurring in many industries over the past few decades. b) Since land is relatively more expensive than building (construction) costs in large cities than in small cities, the prediction is that developers will ―economize‖ on land more in large cities than in small ones. Buildings in large cities are therefore predicted to be taller, and to get taller over time (if land gets relatively even more Copyright © 2026 Pearson Canada Inc.

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expensive).

This tendency toward highrise construction in big cities has in fact occurred. c) The principle of substitution also applies when firms consider hiring different ―types‖ of labour, whether the workers differ by regions or by skills (or something else). In this example, the higher relative wages in Canada suggests that firms will gradually substitute away from expensive Canadian labour and toward cheaper southern U.S. labour. So new plants will be built in the southern U.S. states and Canadian plants will be phased out. d) The rise in Chinese wages reflects the rising labour productivity as millions of people move annually from the countryside to the cities. But as these wages rise, and IT equipment continues to get ever cheaper, there is an incentive to substitute away from labour and toward capital. Over the past 15 years, the capital intensity of Chinese manufacturing has increased.

Question 6 a) With Plant #1 and output Q1, average costs are equal to c1. b) ―Decreasing‖ or ―increasing‖ costs is a long-run property of the firm‘s costs. At Q1, the firm is experiencing decreasing costs because at this output level the LRAC curve is downward sloping. c) The decreasing costs in part (b) are due to economies of scale, which is a long-run phenomenon (with all factors of production changing when the firm‘s ―scale‖ is changing). Average costs are falling because output rises more than in proportion to the rise in costs as the firm‘s production expands. d) Now consider output Q2 with Plant #2: i)

average costs are c2

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ii) the LRAC curve is horizontal, and so there are constant costs iii) no further economies of scale And for output Q3 and Plant #3:

i) average costs are c3 ii) the LRAC curve is upward sloping and so there are increasing costs iii) diseconomies of scale Question 7 a) ―Diseconomies of scale‖ describes what happens to unit costs as all factors of production are increasing as the firm expands its scale of production. For example, if the firm increases its capital stock and its labour force by 10 percent, what happens to unit costs? Since all factors are variable in this exercise, it is clearly a long-run concept. The most often cited Copyright © 2026 Pearson Canada Inc.

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explanation for diseconomies of scale (unit costs increasing as scale rises) is that after some point the costs associated with planning, managing, and monitoring the operations of a large firm start to rise. It simply becomes difficult to keep everything running smoothly, and unit costs rise as a result of organizational and management mistakes. ―Diminishing marginal product‖ refers to the relationship between changes in output and changes in one variable factor when other factors of production are being held constant. Since one or more factors are fixed in this exercise, this is clearly a short-run concept.

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b) See the diagram above that shows an LRAC curve as well as an SRATC curve. At output equal to Q*, longrun average costs are rising, indicating diseconomies of scale. Also, at Q* short-run average total costs are rising. Recall that SRATC rises if MC is above SRATC, and MC rises when there is diminishing marginal product of the variable factor.

Thus, we draw MC rising at Q* so there is diminishing marginal returns.

Question 8

a) ―Economies of scale‖ describes what happens to unit costs as all factors of production are increased as the firm expands its scale of production. For example, if the firm increases its capital stock and its labour force by 10 percent, what Copyright © 2026 Pearson Canada Inc.

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happens to unit costs? Since all factors are variable in this exercise, it is clearly a long-run concept. The most often cited explanation for economies of scale (unit costs decreasing as scale rises) is that as the scale of operation increases, the firm is better able to take advantage of the benefits of specialization and the division of labour. These productivity gains imply a reduction in unit costs. ―The spreading of overhead‖ refers to the behaviour of average fixed costs as the level of output rises. For a given amount of fixed costs (capital costs, product development costs, etc.), average fixed costs clearly decline as the level of output rises. Since this concept clearly Copyright © 2026 Pearson Canada Inc.

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relies on the existence of fixed costs (which means there are some fixed factors of production), it is clearly a short-run concept. This is an important reason for declining average total costs in the short run.

Even if average variable costs have started to rise due to diminishing marginal product, a large enough decline in AFC can still make ATC decline.

b) See the diagram above that shows an LRAC curve as well as an SRATC curve. At output equal to Q*, longrun average costs are falling, indicating economies of scale. Also, at Q* short-run average total costs are falling. Note that even though MC is shown to be Copyright © 2026 Pearson Canada Inc.

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rising at Q*, and thus diminishing returns to the variable factor has already set in, SRATC is still falling. This must be due to the continued spreading of overhead, as reflected by an AFC curve that is falling as Q rises (not shown).

Question 9 a) See the left-hand diagram below.

Economies of scale (long run) mean that we are on the downward-sloping portion of the LRAC curve.

Diminishing marginal product (short run) means that we are on the upwardsloping portion of the SRATC curve.

The diagram has the output level Q* which satisfies both conditions. b) See the right-hand diagram below.

Diseconomies of scale (long run) mean that we are on the upwardsloping portion of the LRAC curve.

But falling short-run total costs means that the effect from spreading one’s Copyright © 2026 Pearson Canada Inc.

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overhead is offsetting the falling marginal product of the variable factor. The diagram has the output level Q* which satisfies both conditions.

Problems Question 10 a) The ratios of marginal products to factor prices in this case are: K: MPK/PK = 80/2 = 40 L: MPL/PL = 20/10 = 2 This firm is not minimizing its costs; to do so it should use more K and less L.

b) The ratios in this case are: K:

MPK/PK = 80/20 = 4

L:

MPL/PL = 20/5 = 4

This firm is minimizing substitution is required.

its

costs.

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No

further

C H A P T E R 9 : C O M P E T I T I V E M A R K E T S1 2 8

c) The ratios in this case are: K:

MPK/PK = 80/40 = 2

L:

MPL/PL = 20/5 = 4

This firm is not minimizing its costs; to do so it should use less K and more L.

Question 11 a) Due to the property of diminishing marginal returns, we know that as the use of the factor increases, ceteris paribus, the marginal product of the factor declines. Thus, in the table, as we move from method A to method G, the production method is using more capital and less labour. Thus, production is becoming more capital intensive. b) Cost minimization requires the firm to adjust capital and labour use until the ratio of marginal products equals the ratio of factor prices. In this case, PK/PL = 8/4 = 2. So the cost-minimizing production method is method B, which has MPK = 12 and MPL = 6. c) For method A, MPK/MPL = 14/3 which exceeds 2.

Thus, the firm should use more K and less L. For methods C through G, MPK/MPL is less than 2. In all these cases the firm should use less K and more L. d) At the new factor prices, PK/PL = 4/6 = 0.67. The new cost-minimizing production method is D which uses more K and less L than method B. It makes sense that as the price of capital falls relative to the price of labour, the cost-minimizing firm substitutes toward capital and away from labour.

This is the principle of substitution.

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Question 12 a) The level of output for which this plant size is optimal in the short run is the level of output that minimizes short-run average unit costs. This output is Q1 and is the capacity of the plant. Average costs at Q1 are equal to c1. b) In the long run, it is optimal to be on the longrun average cost curve. Thus, this plant size is optimal in the long run only for the level of output Q0, because at this point the SRATC curve is tangent to the LRAC curve. Unit costs at this level of output are c0. c) Unit costs are minimized in the short run at c1 at an output level of Q1. At that level of output, the lowest possible costs (in the long run) are c4.

Why is c1 greater than c4? The answer is that the capital stock that is required to achieve c4 in the long run is larger than the capital stock that would deliver c1 in the short run. That is, the plant size corresponding to the SRATC curve is optimal only for a lower level of output (Q0). To produce the higher level Q1, costs would be minimized by expanding the capital stock and building a larger plant. But if you maintain the current small plant, costs are higher. d) To increase output to Q2 in the short run, the firm need only hire more units of the variable factors of production. The firm will therefore move along its SRATC curve and unit costs will be c3. e) To increase output to Q2 in the long run, the firm would increase its plant size. For this larger plant size there would be an associated SRATC curve that would be tangent to the LRAC curve at Q2 units of output. Unit costs in the long run would be c2.

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Question 13

a) Total cost is simply the cost of capital plus the cost of labour. The completed table is shown below.

Total Cost A 110$3 + 20$6 = $330 + $120 = $450 B 90$3 + 25$6 = $270 + $150 = $420 C 70$3 + 33$6 = $210 + $198 = $408 D 50$3 + 43$6 = $150 + $258 = $408 E 30$3 + 55$6 = $90 + $330 = $420 Copyright © 2026 Pearson Canada Inc.

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F 10$3 + 70$6 = $30 + $420 = $450 b) Clearly, methods C and D are lower-cost production methods than any of the others. c) An isoquant is a curve that shows the various combinations of K and L that can be used to produce a given level of output—500 tires per day in this case. The diagram below shows this particular isoquant. d) See the diagram below. The (absolute value of the) slope of the isocost line is the ratio of factor prices, pL/pK = 3/6 = 0.5. The costminimizing production method at these factor prices is either method C or D (since they are the same).

Thus, the isocost line passes through both points C and D in the diagram above, but lies below points A, B, E, and F. The interpretation is that production methods A, B, E, and F cannot be achieved at the same low cost as methods C and D. The horizontal and vertical intercepts of the isocost line are K = 408/6 = 68; and L = 408/3 = 136.

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e) If the price of labour rises from $3 to $5 per unit, a cost-minimizing firm will substitute away from labour and toward capital. In the diagram above, this will be a movement up and to the left along the isoquant (we are told it still wants to produce 500 tires per day). With the new factor prices, it is easy to recompute the total costs in the table above. The isocost line becomes steeper— its new slope will be 5/6 = 0.833. The costminimizing method of production is now method F, with a total cost of $470. (Remember that the rise in the price of labour makes all production methods more expensive, but the least expensive is now the most capital-intensive method.) *****

___________________________________ ____ Part Four Market Structure and Efficiency

___________________________________ ____ The four chapters in this Part of the book cover the core theory of markets, to which we have always given a balanced treatment of theory, applications, and policy. Chapters 9 and 10 on perfect competition and monopoly include some brief discussions of efficiency that anticipate the more detailed discussion in Chapter 12. In addition to covering the basic theory of monopoly, Chapter 10 addresses the economics of cartels and price discrimination by any firm with market power. Chapter 11 examines the intermediate forms of imperfect competition— monopolistic competition and oligopoly. The first Copyright © 2026 Pearson Canada Inc.

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part of Chapter 12 continues to give the standard welfare case in favour of perfect competition (and against monopoly). We also discuss the relationship between productive efficiency, allocative efficiency, and the production possibilities boundary. The second part of Chapter 12, on economic regulation and competition policy, updates the policy discussion and addresses the trade-off that mergers often create between reduced competition and reduced costs. *** The four chapters are arranged so that the instructor who must leave out some of the material can do so with relative ease. Chapters 9 and 10 are the basic theories of perfect competition and monopoly, respectively. Instructors usually assign these two chapters in their entirety. Chapter 11 covers both monopolistic competition and oligopoly, and most instructors will want to cover at least the core sections; there are many side issues that might successfully be left to students to read on their own. Some simple but useful game theory is introduced in this chapter, and it is shown how this way of thinking can help us examine the nature of firm interaction.

The first half of Chapter 12 introduces the important distinction between productive and allocative efficiency and then examines the relationship between market structure and allocative efficiency. It relates allocative efficiency to the concepts of consumer surplus and producer surplus.

It also discusses how the allocatively efficient point on the production possibilities boundary is determined, using a diagram that links the production possibilities boundary to two supply-anddemand diagrams representing the underlying competitive markets. Having discussed allocative efficiency in some detail, the concept of a market failure is then briefly introduced. This provides the student with some motivation for the study of

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policy that follows and provides a hint of what is to come in Part 6 of the textbook. The remainder of Chapter 12 examines regulation and competition policy. ***

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______________________________ Chapter 9: Competitive Markets ______________________________ The first section of this chapter deals with the often-confusing distinction between competitive market structure and competitive firm behaviour. We hope our discussion resolves the apparent paradox that there can be a great deal of competitive behaviour in market structures that are oligopolistic, while there is no competitive behaviour whatsoever in market structures that economists call perfectly competitive.

In the second section, we develop the theory of perfect competition around four key structural assumptions:  a homogeneous product;  well-informed customers;  each firm is small relative to the overall size of the industry; and  the industry has freedom of entry and exit.

Though these structural assumptions are sufficient, but not necessary, for price-taking behaviour, our experience shows that students find it easier to come to terms with the abstract model of Copyright © 2026 Pearson Canada Inc.

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perfect competition if it is erected on the structural assumptions that help to make price taking seem reasonable. Students who wish to argue that these are unrealistic assumptions can be directed to look at the great commodity exchanges where well-informed buyers purchase grains, meats, minerals, and energy products under conditions that closely resemble perfect competition.

We treat the competitive firm‘s infinitely (perfectly) elastic demand curve as an empirical approximation rather than as an extreme assumption.

We hope this helps to make the model more relevant to students. The detailed calculation of an individual wheat farmer‘s demand elasticity given the wheat industry‘s demand elasticity is examined in a box. The data used in this box are real. Note that they yield a virtually horizontal demand curve for a firm producing a commodity whose market demand is nonetheless quite inelastic.

The third section examines the behaviour of perfectly competitive firms and derives their supply curves from first principles. Here is where the rules for profit maximization appear. The possibility that firms may earn negative profits

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and remain in business (price less than ATC but greater than AVC) leads to a box on the parable of the seaside inn. We have a discussion and table to illustrate the firm‘s shut-down decision.

Having dealt with the short-run determination of price under perfect competition, the chapter then turns to a full discussion of long-run industry equilibrium. We examine entry-attracting prices as well as exit-inducing prices, and how such changes in the number of firms lead to shifts in the industry supply curve. We use two-part diagrams for these analyses that allow students to see what is happening for individual firms as well as for the industry as a whole.

The examples of declining industries and changes in technology provide students with excellent applications of the basic Copyright © 2026 Pearson Canada Inc.

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theory. These examples should give students some feeling for the importance and relevance of longrun market analysis. This discussion leads to a box explaining how the whaling industry in the mid-1800s (which eventually virtually disappeared) looked very similar to the modern-day oil industry, due to changes in technology as well as changes in demand.

Answers to Study Exercises

Fill-in-the-Blank Questions Question 1 a) homogeneous Copyright © 2026 Pearson Canada Inc.

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b) price c) small d) entry; exit Question 2 a) perfectly elastic (horizontal) b) marginal revenue; average revenue c) price; quantity; total revenue; quantity; the change in total revenue; the change in output d) total fixed cost Question 3 a) average variable costs Copyright © 2026 Pearson Canada Inc.

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b) produce no output (―shut down‖) c) reduce or decrease d) increase e) equal; maximized f) greater; increase Question 4 a) AVC b) ATC; AVC c) ATC; enter

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Question 5 a) enter; right; fall (decrease) b) exit; left; rise (increase) c) zero; minimum; ATC; minimum; average cost Review Questions Question 6 a) Let the equilibrium market price be p* (which equals $3 in Figure 91). Any firm that tried to charge a higher price would make no sales whatsoever, since consumers would simply make their purchases from other (lower-price) sellers. b) Each (small) firm is able to sell as much as it wants to supply to the market at the price p*. Thus, selling Copyright © 2026 Pearson Canada Inc.

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at a lower price would not increase sales but would reduce profits. So, no firm has the incentive to charge any price below p*. c) Each individual firm is very small relative to the market (check Figure 9-1 again and compare the units on the quantity axes in the two parts of the figure). Thus, for any change in output that is realistic for the firm, there would be no significant or noticeable effect on the industry level of output and thus no significant effect on the market price. Thus, each firm sees that it can sell any reasonable amount at the given market price. (Read Applying Economic Concepts 9-1 to see an application—we show that even though the market demand for Copyright © 2026 Pearson Canada Inc.

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wheat is quite inelastic, the demand for any individual farmer’s wheat is almost perfectly elastic.)

Question 7

This is a good question to help students understand which real-world observations about markets are consistent with perfect competition. It also helps to reinforce the important distinction between a competitive market and competitive behaviour.

Fact (a) is consistent with perfect competition, since different methods will always be found when embodied changes in technological knowledge are occurring.

Fact (b) is also consistent since it is the industry association‘s attempt to shift the market demand curve rather than an individual firm‘s attempt to shift its own demand curve.

Fact (c) is plainly inconsistent, since price takers would not advertise their own brand because they do not have a brand—their product is identical to that of other firms.

Fact (d) is not necessarily inconsistent since it is quite possible that 24 firms selling a homogeneous product could each act as if they were price takers.

Fact (e) is probably inconsistent since the two largest firms will have significant market power.

However, if the products really are identical and MES is large, then this industry could still be competitive.

Fact (f) is consistent with perfect competition since large profits may merely mean that an increase in demand has left existing firms earning

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profits in an industry that is not yet in long-run equilibrium (when entry will eventually eliminate the profits).

Question 8 a) In order to be able to earn positive economic profits, there must be some level of output for which the price exceeds average total cost. This is impossible for both Firm 1 and Firm 4 since in both cases the ATC curve is always above the price line. Firm 2 could, at best, break even (and earn zero profit). Positive economic profits are only possible for Firm 3. b) Firm 4 is the only firm that will produce positive output while earning negative profits (losses). To see this, note that the combined rules from the chapter imply that price-taking firms should produce at the level of output where price equals marginal cost, so long as price is no less than average variable cost. The firms that will optimally choose to produce positive levels of output (at p = MC) are Firm 2, Firm 3 and Firm 4 (Firm 1 will shut down since price is less than the minimum of AVC). Firm 2 will break even and will continue producing. Firm 3 will earn a positive profit and will continue producing. Firm 4 will earn negative profits (losses) but is just covering its variable costs; it will remain producing as long as price falls no further. c) Firm 1 will not produce at the current price because it cannot even cover the variable costs of production. All other firms will produce at the current price.

Question 9

a) Entry is probably restricted although it is possible (if unlikely) that demand has continued to rise at a rate that has been unanticipated over the last two decades. It could also mean that because of exceptional risk in the industry, accounting profits are high although economic profits are zero. b) This tells us nothing about ease of entry or exit. The absence of entry for 20 years is consistent with a perfectly competitive industry in which technological change is increasing the capacity of existing firms at the same rate that demand is growing (which includes the special case of zero change). Students might find it instructive to draw the case in which cost changes offset a demand shift so that the number of firms in the industry in long-run equilibrium does not change.

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c) The young average age of firms suggests that there has been quite a bit of new entry in recent years. d) If existing plants are using equipment of very different vintages, it suggests heavy capital, long useful life, and possibly low variable costs. It also suggests that firms are able to expand their operations (new equipment) and in this sense there is relatively easy entry. e) This plainly suggests slow exit, possibly for the same reasons as in (d), but it says nothing about ease of entry.

Question 10 a) The diagrams are shown below. The left-hand diagram shows the initial industry equilibrium at price p0 and quantity Q0.

b) The right-hand diagram below shows a typical firm when the industry is in long-run equilibrium. The typical firm is producing q0 units of output. It is not only earning zero economic profits in the short run (p = SRATC), but it also has no unexploited economies of scale—that is, it is at the minimum of its LRAC curve. c) The increase in demand for barley shifts the demand curve to D and raises the shortrun equilibrium price to p1. The increase in market price causes each firm to increase its own output along its MC curve, to output q1 for the typical firm shown. Short-run profits for each firm at this new high price are shown by the shaded area.

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d) The positive profit in part (c) leads other firms to enter this industry. As new barley farmers enter the industry, the industry supply curve shifts to the right and reduces the equilibrium market price. Entry continues until existing firms are not making any economic profits. As long as technology has not changed, firms’ cost curves do not shift and so supply shifts eventually to S, where the market price has returned to p0. At this point, the typical firms are again making zero economic profits. Note that in the new long-run equilibrium, industry output has increased (because of the entry of new firms) but each of the ―old‖ firms is producing the same amount as it did in the initial long-run equilibrium.

Question 11 a) At the price p1, the typical firm in the industry is making zero economic profits, since price equals average total cost. There is no incentive for outside firms to enter this industry, and nor is there any incentive for existing firms inside this industry to leave.

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b) As the market demand curve shifts to the left, the equilibrium market price declines. As the price falls below p1, firms are now making losses, but they will remain producing in this industry as long as they continue to cover their variable costs. The price can fall all the way to p2 and typical firms will remain actively producing in this industry (although their level of output will decline as they move along their MC curves). c) If demand continues to fall and moves further to the left than D2, firms inside this industry will no longer be able to cover their variable costs. They will begin shutting down their production. As they do so, the industry supply Copyright © 2026 Pearson Canada Inc.

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curve will shift to the left and the price will rise. Note that this process of industry exit and price increase may take a considerable period, especially if firms have a lot of industry-specific capital equipment, which acts as an ―exit barrier.‖ d) The government can attempt to prevent the decline of this industry, but it is difficult if the underlying demand for cigarettes is declining.

Would government step in as a demander of the product? If so, what would they do with all of the cigarettes? The government could provide financial assistance to the cigarette-producing firms, in which case it is merely delaying what appears to be the inevitable decline Copyright © 2026 Pearson Canada Inc.

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of the industry, and it is costing taxpayer resources during the process. A likely more effective policy is for the government to provide transitional assistance to the workers displaced from the cigarette firms that are shutting down. Training programs and relocation assistance can be very effective in helping workers move away from one declining industry and become prepared to work in some other industry.

Problems Question 12 a) The completed table is shown below. Recall that total revenue is equal to price times quantity.

Pric Qua Tota Aver Mar Copyright © 2026 Pearson Canada Inc.

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e ($) ntity

2

150

2

175

2

200

2

225

2

250

l age ginal Reve Reve Reve nue nue nue ($) ($) ($) 300 300/ 150 =2 350 350/ 50/2 175 5 = 2 =2 400 400/ 50/2 200 5 = 2 =2 450 450/ 50/2 225 5 = 2 =2 500 500/ 50/2 250 5 = 2 =2

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b) See the table above. Average revenue is equal to total revenue divided by quantity. Marginal revenue is equal to the change in total revenue divided by the change in quantity; it is computed using the change from one row to the next. c) A perfectly competitive firm is a price taker. It can sell any amount at the given market price, which in this case is $2. Since every unit it sells is sold at the price of $2, it follows that its average revenue is $2 but also its marginal revenue is $2. d) See the figure below. Note that the vertical scales on the two diagrams are different, though both are measured in dollars. The slope of the TR curve is the change in Copyright © 2026 Pearson Canada Inc.

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total revenue divided by the change in quantity, TR/Q. This is marginal revenue and is equal to 2.

Question 13 a) The completed table is shown below. The firm’s supply curve is given by the section of its MC curve above the minimum of the AVC curve. Profits are determined by the difference between price and average total cost, ATC. For the first row in the table, price ($3) is Copyright © 2026 Pearson Canada Inc.

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below ATC and AVC for any possible output level, as can be seen in the diagram, and so the firm chooses not to produce at all (and so there are no profits).

Pri Firm’ Is Is Price Profits ce s price > AVC? positiv ($) Outpu > e? t ATC? 3 Do No No No not profits produ ce 4 130 No No Negati units (Price ve = AVC) profits 5 145 No Yes Negati units ve profits Copyright © 2026 Pearson Canada Inc.

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6

155 units

No

Yes

7

165 units

Yes

Yes

8

175 units

Yes

Yes

9

185 units

Yes

Yes

10

195 units

Yes

Yes

Negati ve profits Positiv e profits Positiv e profits Positiv e profits Positiv e profits

b) The firm shuts down when the market price falls below the minimum of the AVC curve. In this case, when the price falls below $4, Copyright © 2026 Pearson Canada Inc.

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the firm will shut down. The reason is that when price < AVC, the firm cannot cover even its variable costs, and so the firm is better off to close down rather than continue to produce and increase its losses. c) The firm’s supply curve is its MC curve above the minimum point of AVC. There will be no production when price < AVC, for the reason given in part (b). For prices above AVC, profit maximization requires the firm to produce until marginal revenue (which equals market price) is equal to marginal cost.

Thus, the MC curve above the AVC curve is the firm’s supply curve.

Question 14

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a) Total industry supply at each price is simply equal to the sum of the quantities supplied by all of the individual firms. The completed table is shown below.

Mar Industry ket Quantity pric Supplied e ($) 2.50 100 + 0 + 0 = 100 3.00 125 + 0 + 0 = 125 3.50 150 + 100 + 0 = 250 4.00 175 + 150 + 0 = 325 4.50 200 + 200 + 100 = 500 Copyright © 2026 Pearson Canada Inc.

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5.00 225 + 250 + 175 = 650 5.50 250 + 300 + 250 = 800 6.00 275 + 350 + 325 = 950 b) The scale diagrams are shown below. Note that the vertical scales are the same in all four figures, but the horizontal axis for the Industry figure is different from the other three figures.

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c) Firm B produces no output at prices of $3.00 or below because those prices do not cover Firm B’s average variable costs. Similarly, for Firm C and prices at or below $4.00.

Question 15

a) The table below shows the correct cost data.

Output is in units and all costs are in dollars.

Output 0 100 200 300 400 500 600 700 800 900

TVC 0 40 70 120 180 250 330 420 520 630

TFC 100 100 100 100 100 100 100 100 100 100

TC 100 140 170 220 280 350 430 520 620 730

MC

ATC

AVC

0.40 0.30 0.50 0.60 0.70 0.80 0.90 1.00 1.10

1.4 0.85 0.73 0.70 0.70 0.72 0.74 0.78 0.81

0.40 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70

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b) The figure below shows the AVC, MC and ATC curves.

c) The firm should optimally choose to produce zero units of output when the price falls below the minimum of the AVC curve—in this case, a price of $0.35. d) At a price of $0.80 per napkin, the profit-maximizing level of output is given by the MC curve at that price. In this case, the answer is approximately 550 napkins (in the middle of the range 500–600 napkins). At a price of $0.60 per napkin, the optimal output is in the range 300–400 napkins. At a price of $1.00 per napkin, the optimal output is in the range 700-800 napkins.

e) Consider the above diagram to answer this question. At a market price of $0.70 per napkin, the profit-maximizing level of output is (approximately) 450 napkins per day. In this situation, the firm‘s total revenue is $315 per day. Average total cost is $0.70 per napkin. So total (economic) profit for the firm is zero, and profit per unit is zero. The firm is just covering its economic cost.

Question 16 For this question, compare market price to AVC to see if the firm should produce at all. Then compare the firm‘s marginal cost at its current level of output to the market price. If p > MC, the firm should produce more; if p < MC, the firm should produce less.

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a) Price is $64 and AVC is $48, so producing is OK. Since marginal cost is $67, the firm should reduce its output. b) Price is $64 and AVC is $66, so firm should not produce at all. c) Price is $64 and AVC is $58, so producing is OK. Since MC is $60, less than price, the firm should increase output. d) Price is $64 and AVC is $62, so producing is OK. Since MC equals price, the firm should not change its output level. e) Price is $10 and AVC is $11 (= $66,000/6,000 units), so firm should not produce at all. f) Price is $4 and AVC is $3 (=$30,000/10,000 units), so producing is OK. Since MC equals price, the firm should not change its output.

Question 17 a) From the demand-and-supply diagram, we can see that when price equals $60 per crate, the equilibrium industry output is 12,000 crates per month. At this price, each firm maximizes its profits by producing 120 crates per month. 100 firms × 120 crates per firm = 12,000 crates in total (per month). b) When a firm‘s output is 120 crates per month, its ATC is equal to $45 per crate. With the market price of $60, each firm is earning economic profits of $15 per crate (p – ATC). With output of 120 crates per month, each firm‘s profit is therefore $1800 per month. The existence of positive economic profits in this industry will lead to the entry of new firms since they can expect to earn more profits in this industry than in their next best alternative. c) The entry of new firms leads to an expansion of productive capacity in this industry, which appears as a rightward shift of the industry supply curve.

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As the market supply curve shifts to the right, the equilibrium price declines, and each firm in the industry reduces its level of output as it moves down its MC curve. The new long-run equilibrium occurs at a price of $40 per crate, determined by the minimum point on firms‘ ATC0 curves. Each firm will then be producing 100 crates per month, earning zero economic profits, and total industry output will be 16,000 crates per month. There will be 160 firms operating in this industry, but each one producing less than in the initial long-run equilibrium. In the initial long-run equilibrium we had 100 firms each producing 120 crates per month with a positive economic profit. Now there are 160 firms producing 100 crates per month with zero economic profit. d) As technology improves and average costs decline, the initial effect is that firms already in the industry begin earning positive economic profits. This leads to the entry of new firms, which shifts the market supply curve to the right and lowers the equilibrium market price. In the new long-run equilibrium, the price is equal to the minimum of ATC1, which is $30 per crate, and each firm in the industry is producing 80 crates per month and earning zero profits. Total industry output is 18,000 crates per month and so there are 225 firms (18,000/80) operating in the industry.

Once again, the entry of new firms to the industry leads to an expansion of industry output but a reduction in output per firm—firms are getting smaller.

The ultimate beneficiaries of the technological improvement are the product‘s consumers who benefit through more consumption and lower prices. The firms benefit for some time through earning profits, but only as long as it takes for the new firms to enter and drive profits to zero. Ultimately, all firm profit disappears.

Question 18

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a) A long-run equilibrium in the industry requires that firms are earning zero profits so that there is no reason for entry to or exit from the industry. At the equilibrium market price of 80 cents per box, industry output is 100,000 boxes per month. At this price each firm will maximize its profit at an output level of 1,000 boxes per month.

With total output of 100,000 boxes per month, there must be 100 firms operating in this industry. b) As demand declines and price falls to 60 cents per box, each firm in the industry reduces its output and moves down along its own MC curve. In this new short-run equilibrium, each firm remains in production as long as the market price is greater than or equal to AVC. At the new price of 60 cents per box, no firm has left the industry, each firm produces 600 boxes per month, and each is earning losses of 30 cents per box (ATC = 90 cents). Total loss per firm equals $180 per month. c) Firms are still producing because they are (just) covering their variable costs. If they instead decided to produce zero output, they would earn no revenues but would still have to pay their fixed costs. It is therefore profit-maximizing for firms to continue producing as long as they can cover their variable costs. If market price were to decline further (below 60 cents per box), firms would stop producing. But this situation of producing while earning economic losses means that firms have no incentive to replace their capital.

Over time, as their capital wears out, firms will choose to leave this industry. This process will generally be slow and gradual, but eventually it will occur and the market supply curve will shift to the left. d) As firms gradually leave this industry, the market supply curve shifts to the left, leading to an increase in the equilibrium market price. As price rises, the remaining firms increase their output as they move upward along their (unchanged)

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MC curves. The new long-run equilibrium occurs at a market price of 80 cents per box, which is determined by the minimum of the unchanged ATC of the firms. Total industry output will have declined to 40,000 boxes per month and each remaining firm will be producing 1,000 boxes per month. There will be only 40 firms still operating in this industry. e) If firms‘ costs are unchanged and there is a decline in market demand, the adjustment involves a short-run reduction in price, industry output, and firm-level output, as well as firm profits. But this is only a short-run equilibrium. Since profits are negative, this situation leads to the exit of firms, which then leads to an increase in market price.

If firms‘ cost structures have been unchanged, then the market price will rise back to its initial level. The result will be that industry output falls but that price returns to its initial level. This is a ―declining industry‖ not because prices are falling in the long run (because they aren‘t) but because total output is declining.

***** ___________________________________________________ Chapter 10: Monopoly, Cartels, and Price Discrimination ____________________________________________________ The first section of the chapter examines the total, marginal, and average revenue for a single-price monopolist.

Although straightforward, students usually appreciate time spent on this material that prepares the ground for what is to come. With the basics in place, the text then moves on to examine short-run and long-run outcomes in a monopolized industry. When discussing the long-run equilibrium for the industry, we emphasize the role of entry barriers, in the absence of which no monopoly could persist. Both natural and created barriers are

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discussed, including the current importance of ―network effects‖ in many digital industries. We then go on to discuss the Schumpeterian concept of creative destruction that circumvents entry barriers in the very long run. We also have a box that presents some old and new everyday examples of creative destruction, or what is often now called ―disruptive technologies.‖ The next section examines cartels as monopolies. The analysis shows the potential for monopolizing any competitive industry. It also studies the forces that push toward the break-up of a cartel when each firm seeks to maximize its own profits at the cartel-created price. This section concentrates on the theory of a cartel that creates a complete monopoly. We mention both OPEC and DeBeers as once-effective cartels, as well as the less familiar but Canadian case of Canpotex for potash and the more recent attempt by Ivory Coast and Ghana to create a cartel in cocoa beans.

The final section of the chapter covers a topic that students usually find fascinating—price discrimination. Of course, price discrimination is not limited to monopoly firms and can be practised by many firms with market power, but most reviewers have agreed that discussing price discrimination in this chapter is effective. We utilize the concept of consumer surplus to explain discrimination among units sold to a single buyer, and then move on to the case of discrimination between various market segments, which is illustrated with a detailed numerical example.

We emphasize that price discrimination between segmented markets requires the profit-maximizing prices to be higher in the market segments with less-elastic demand. We then proceed to a detailed discussion of ―hurdle pricing‖ which includes many familiar examples of price discrimination.

Some readers have wondered why we devote this amount of space to a topic that is often reserved

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for intermediate courses. Our answer is that price discrimination is an important phenomenon in any modern economy. A large fraction of the markets in which market power is present exhibits price discrimination, as suggested by the ease of finding examples such as the pricing of airline seats, movie tickets, monthly bus passes, and grocery-store coupon specials. Moreover, such important foreigntrade issues as the alleged ―dumping‖ of foreign steel into the Canadian and U.S. markets involve the concept of price discrimination.

We think it is important to emphasize the point that there is no clear relationship between price discrimination and consumer welfare, despite the common belief to the contrary. Many students initially see price discrimination as nothing but an attempt by profit-hungry firms to ―steal‖ surplus away from consumers. While price discrimination often does involve a transfer of surplus from consumers to firms, it also often leads to an increase in total output, with the result that some consumers benefit from a lower price than they would face if the firm was unable to charge different prices. So, there is often a difficult trade-off involved: some consumers are faced with a higher price, and thus are worse off, while other consumers are made better off by consuming more at a lower price. A careful discussion in class about these competing effects of price discrimination is recommended.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) horizontal; downward sloping Copyright © 2026 Pearson Canada Inc.

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b) marginal revenue; marginal cost; equals; is greater than c) greater than d) less than or below e) entry barriers f) natural; minimum efficient scale Question 2 a) profits; cartel b) total output; price c) cheat; more d) entry e) monopolies Question 3 a) price discrimination b) power; willingness; arbitrage c) segments; less d) increase; increases; (allocatively) efficient

Review Questions

Question 4 a) The diagram is shown below. The demand curve and its associated marginal revenue curve are conventional. The monopolist‘s MC curve is the horizontal axis, since we are told that the firm has no variable costs whatsoever.

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b) The profit-maximizing output is where MR = MC. But in this case it is where MR equals zero since MC is always equal to zero in this example. In the diagram the profit-maximizing output is Q* and the price is p*. c) The marginal value of the water to society is given by the current market price, p*. The marginal cost to society is zero. Thus, allocative efficiency is not achieved with this outcome, as is usual in the case of a monopolist. The problem is that producing more than Q* would benefit society by more than it would cost society, and so society as a whole would be better off if the price were lower and quantity were higher. The monopolist (only part of society) is better off to restrict output and raise price. d) The monopoly outcome (p* and Q* in the above diagram) is not efficient for society because the marginal value to society of an extra unit (p*) is greater than the marginal cost to society (zero).

Relative to what is optimal for society, the monopoly outcome has too little output being produced. The efficient outcome would be to produce this good until the market price was equal to MC, which means zero (in the diagram above, this outcome occurs where the demand curve intersects the horizontal axis).

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Question 5 a) Patented blood-pressure medication. The entry barrier is the legal patent. Once the patent expires, entry is simple for competing firms. Until then, they must develop some alternative medication that has the same effect but uses a different chemical composition (one that does not violate the patent). b) Legal services. The entry barrier is the restricted entry into law schools, determined mostly by the provincial governments (in Canada), and the examinations required before individuals are ―called to the bar‖ and thus qualified to practice law. In recent years, technological change (especially the Internet) allows many routine legal tasks to be done by computer programs and lower-wage lawyers in other countries. c) Electricity transmission. The transmission of electricity is largely a natural monopoly because of the need for only a single set of transmission lines, which require a large, fixed cost to build. There is no obvious circumvention of this entry barrier, although it is gradually becoming economical to build small electricity generating units closer to consumers, thus reducing the need for all generation to be connected to the grid. d) Municipal sewage services. This is also a natural monopoly because of the need for only a single sewage system. No obvious innovative way to circumvent this entry barrier (although we are starting to see small, experimental ways that even individual households can treat their waste with natural ponds and vegetation in their own back yards). e) A popular social-media platform. The important entry barrier here is the ―network effects‖ that apply, rather than any special technology. It is very easy to create a new social-media platform, but few people will choose to use it unless many others are already using it. For such platforms, the benefit to any one user of the platform depend crucially (and positively) on the total number of users of the same platform, as is true for X or Instagram, for example. Once a specific platform becomes popular, it is very difficult for newly innovated platforms to displace it—difficult, but not impossible. A new platform with just the right features could attract enough users that it becomes the new ―must use‖ platform. f) Delivery of first-class mail in Canada. Canada Post has a legal monopoly over the delivery of first-class mail. But it has no such privileged position with respect to the delivery of parcels, or the transmission of information by email, fax, or couriers. Not surprisingly, we have seen Canada Post’s market power being gradually eroded, year by year, to the point where it is having a difficult time covering its costs. g) Taxicabs. The entry barrier is the system that most cities have in restricting the number of taxi licences issued. This tends to keep taxi fares above the level that would likely exist if there were free entry into the industry. The recent development of Uber, the app-based system that connects drivers to customers, is challenging the market power of established taxi companies in many cities. h) Hotels. There is free entry to this industry, although considerable capital is required to build hotels, especially a chain of standardized ones across the country. Airbnb, like Uber, is challenging the established hotels by offering an easy, online way to connect those

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seeking a room with those who have a room to let.

Question 6 a) Presumably one would most want to monopolize the industry with the largest potential monopoly profits, which depend on both volume of sales and profit per unit. These depend on level of demand and closeness of substitutes. Chocolate bars may be a poor candidate on both grounds. Historically, coal has had an enormous dollar volume of sales, but profits per unit have been falling due to competition from other fuels, especially natural gas in recent years (whose low price has led to substitution away from coal on a large scale in the United States). Outboard motors have no close substitute, but the size of the market is relatively smaller than that of coal or copper wire. Few local newspapers are highly profitable these days, especially with the rise of Internet-based news sites. Copper wire, despite the competition of aluminum, is probably the second-best choice after coal. b) As is clear from the previous answer, there are several factors. But the key general point is that one would presumably aim to monopolize the industry with the highest profits—but there are several factors that determine an industry‘s profitability. c) Which industry a consumer wishes to not be monopolized depends crucially on that consumer‘s buying habits. A typical university student would probably dislike monopolization of the chocolate bar and newspaper industries and may not even notice if the other industries were monopolized. An owner of a construction firm would dislike the monopolization of the copper wire industry, while an electric utility would probably be strongly opposed to the monopolization of the coal industry.

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d) The industry that is most profitable to monopolize may or may not line up with the consumption pattern of any particular consumer.

Question 7 a) The two diagrams are shown below. Note that the horizontal scale is different on the two diagrams. The left-hand diagram shows industry output, measured

by Q; the right-hand diagram shows the firm’s level of output, measured by q. In the left-hand diagram, the S curve is the competitive supply curve, which is also the horizontal summation of all the firms’ MC curves.

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b) If the farmers could successfully collude to restrict output, they would collectively act like a monopolist, choosing output such that MR equals MC. They would collectively produce output equal to QM and charge price pM. c) In the right-hand diagram, we see that the cartel‘s restriction of output requires the typical farmer to produce output equal to only qM. (Since QM is roughly one-half of Q0, it must be the case that for the typical firm qM is roughly half of q0, as shown in the right-hand diagram.) The high price of pM means that the typical farmer earns profits given by the light shaded area. d) Yes, it is definitely profitable for each individual farmer to increase its output rather than to leave output at qM. Given that all other farmers are restricting their output, the industry price of pM becomes each individual farmer‘s MR curve. But MC is much lower than pM, so each individual farmer would like to cheat on the agreement and produce more. e) Given the cartel price of pM, each individual farmer has the incentive to increase output all the way to q*, where the cartel price is equal to MC. In this case, profits for the individual cheating farmer would be the sum of the two shaded areas.

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f) If all firms cheated in this way, the industry output would rise significantly and the market price would fall below the cartel price pM. This is exactly why cartels tend to be unstable; all individual cartel members have the incentive to cheat on the agreement, and this cheating essentially eliminates the output-restricting behaviour of the cartel.

Question 8 Remember that price differences are said to be discriminatory only if they are not justified by cost differences. a) It seems clear that airline pricing is discriminatory, discriminating ―against‖ business travellers who travel mostly during the week and have inelastic demands. b) The price differences between business class and economy class are partly discriminatory but are also partly based on cost differences. For example, the use of Copyright © 2026 Pearson Canada Inc.

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150 percent more space would appear to justify prices 150 percent higher. But space occupied is not the only cost. It would be surprising, however, if there were not a good bit of price discrimination included in business-class fares, reflecting the greater willingness to pay on the part of those having expense accounts, or those for whom being in business class is a desirable image (a form of ―snob appeal‖). c) These price differences are clearly discriminatory. The sales personnel are trying to extract as much consumer surplus as possible from each consumer. For those customers that like to bargain and show that they are prepared to walk out the door and purchase from other firms, a lower price is surely available. But for those who dislike bargaining and want to make a quick purchase, their inelastic demand will result in a higher price being paid. In this case of ―hurdle pricing,‖ the hurdle that must be cleared in order to get the low price is to actively (and effectively) bargain with the sales personnel.

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d) If MBA students are required to pay their own tuition fees, they will probably be more ―price sensitive‖ than their employers would be in those situations where employers agree to fund the tuition costs of their employees who leave their job temporarily to get an MBA. One important reason is that the tuition fees paid by the employer are almost certainly a tax-deductible cost of doing business while the same fees, if paid by the student, would be unlikely to be tax-deductible.

Question 9 a) Arbitrage is prevented because the product (movie viewing) is a service rather than a good; an ―adult‖ can not purchase a ―senior‖ ticket and then see the movie because the ticket will easily be checked at the theatre entrance.

Without price discrimination, seniors would be worse off and adults would be better off because the single price would probably be between the two discriminatory prices.

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b) This is ―hurdle pricing,‖ where the hurdle that must be cleared to get the low price is to wait 6–12 months before buying the book.

Impatient people (inelastic demand) will buy the hardcover book at a high price; patient people (elastic demand) will wait and buy the paperback book at a low price. Note that in this case the products are also slightly different, and thus the price differential partly reflects differences in cost (hardcover books are more expensive to produce than paperbacks). It is difficult to determine who would be better off and worse off without price discrimination in this case because there is a difference in the products.

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only one type of book (at a single price), then the single price would likely be between the hardcover and paperback prices. c) This is ―hurdle pricing‖ where the hurdle is to reveal that you are prepared to haggle. The firm usually just posts a price, and most customers simply pay that price or do their business elsewhere. But many firms will reduce their price if you ask them and tell them that you are thinking of changing your phone package and going elsewhere. You might wonder what prices would be like if firms were absolutely committed to posting a single price and then sticking to it.

That single posted price would probably be less than what would Copyright © 2026 Pearson Canada Inc.

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otherwise be the ―starting‖ price, but greater than what the final (after haggling) price would be.

Thus successful hagglers would be worse off with the single posted price, and poor hagglers would be better off. d) Typical business travellers do not want to stay over the Saturday night whereas typical non-business travellers do. The former have lesselastic demands, and so this pricing scheme is aimed at segmenting the two groups of customers. Without price discrimination, the single price would probably be less than the discriminatory business price and greater than the discriminatory non-business price. Thus business travellers would be better off and Copyright © 2026 Pearson Canada Inc.

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non-business travellers would be worse off without the price discrimination. e) Loyalty programs for hotels are similar to other loyalty programs: the more you spend at one specific hotel, the more ―rewards‖ you receive—in the form of room upgrades, discounts on future bookings, etc. So it is the ―frequent users‖ of a hotel who benefit from better service or lower prices, with higher prices being charged for all ―normal‖ customers (that is, the ones not registered in the loyalty program). If the hotel was not able to offer such a loyalty program, its price would likely rise—making the ―loyal‖ customers worse off but

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probably the ―normal‖ customers better off. f) University entrance scholarships clearly benefit the recipients because, for a given tuition fee, they imply that the student pays a lower overall cost. It is a clear case of price discrimination in favour of those students who receive the scholarship, where their selection is based on merit (at least as perceived by those on the admissions committee) or perhaps on financial need. But since the funds for such scholarships often come from the university’s overall tuition revenues, it is likely that the existence of these scholarships leads to an increase in the ―regular‖ tuition fee. In other words, the Copyright © 2026 Pearson Canada Inc.

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―regular‖ students are effectively cross-subsidizing those students who receive the scholarships. In this case, if universities were unable to price discriminate through the offering of such scholarships, there is good reason to expect overall tuition fees to fall.

Problems

Question 10 a) Total revenue (as we move along the demand curve) is equal to price times quantity demanded. Average revenue is equal to total revenue divided by quantity = (pQ) / Q = p. So average revenue is simply equal to price. The completed table is shown below.

Pri ce ($)

Quant Total Revenue ($) ity

20

100

18

125

16

150

Average Revenue ($)

20  100 = 2000/100 = 20 2000 18  125 = 2250/125 = 18 2250 16  150 = 2400/150 = 16

Marginal Revenue ($)

250/25 10 150/25 6

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14

175

12

200

10

225

8

250

6

275

4

300

2400 14  175 = 2450 12  200 = 2400 10  225 = 2250 8  250 = 2000 6  275 = 1650 4  300 = 1200

2450/175 = 14 2400/200 = 12 2250/225 = 10 2000/250 = 8 1650/275 = 6 1200/300 = 4

50/25 = 2 –50/25 –2 –150/25 –6 –250/25 –10 –350/25 –14 –450/25 –18

= = = = =

b) Marginal revenue is equal to the change in total revenue divided by the change in quantity. In the table above it is shown for a change from one row to the next. For any given quantity, marginal revenue is less than price. This is because in order to sell more output, we must move down the demand curve and so price on all units must fall. Thus, the price on the new units is not equal to marginal revenue — we must subtract from this new price the amount that we lose on the previous units by having to reduce their price.

(Look back to Figure 10-1 for the illustration of this point.)

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c) The scale diagram is shown above. Note that the MR curve is plotted at the midpoint of the intervals of quantity demanded. d) When TR reaches its maximum in the bottom diagram, an increase in quantity (and a reduction in price) leads to no change in total revenue.

Thus, marginal revenue (in the top diagram) at this point is exactly zero. At larger quantities than this, marginal revenue is negative.

Question 11

See the figure below.

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a) The total revenue (TR = price × quantity) is shown in the table below.

Point A B C D E F G

Price 160 140 120 100 80 60 40

Quantity 20 30 40 50 60 70 80

H

20

90

TR 3200 4200 4800 5000 4800 4200 3200

MR

100 60 20 -20 -60 100 1800 140

b) The firm is moving from point A on the demand curve to point B. It loses $20 per unit on its initial 20 units, for a loss of $400. It gains $140 on the new 10 units, for a gain of $1400. So the total change in revenue is $1000 from A to B. The firm‘s marginal revenue as it moves from A to B is this $1000 divided by the extra 10 units, or $100 per unit. c) Using the same approach, we compute the MR for each interval in the table. The MR curve is plotted on the diagram above.

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d) For a perfectly competitive firm, extra units of output can be sold without affecting the market price (because the firm is very small relative to the market), so MR is equal to market price. But for a monopolist, any extra output can only be sold by driving down the market price. Thus MR is less than price for a monopolist.

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Question 12

a) The profit-maximizing quantity is where MR = MC, at 400 games per week. The profit-maximizing price is $60 per game. b) The ATC at Q = 400 is $30 per game. c) At the profit-maximizing price and quantity, the profit is given by the rectangle defined by points acef. The total profit is ($30 per game) × (400 games per week) = $12 ,000 per week.

Question 13

a) For any firm, profits are maximized at that level of output where marginal revenue equals marginal cost. In the diagram, MR equals MC at output of Q0. At this level of output, the monopolist charges the price p4. b) Profits per unit are equal to price minus average total cost. Thus the profits are the rectangle defined by the points p2p4BC. Since price exceeds average total cost, the monopolist‘s profits are positive. c) Recall that the deadweight loss from monopoly is the reduction in total surplus caused by the monopolist‘s output restriction (relative to what would be observed if the market were perfectly competitive). The deadweight loss of monopoly is the ―triangle‖ defined by three pointsB, E, and the point of intersection of the MR and MC curves (point D). d) If the industry were instead a perfectly competitive one, equilibrium price and quantity would be determined by the intersection of demand and supply, where the industry supply curve would be given by the summation of the firms‘ MC curves.

Thus point E would be the competitive equilibrium, with price p3 and quantity Q2.

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Question 14

For this question, profits are (p – ATC) × Q in each case. To determine whether the firm should increase or decrease output, compare MR with MC. a) Total profit is (15 – 5) × 600 = $6000. Profit per unit is $10. Since MR = MC, the firm should not change its output. b) Total profit is (18 – 5.5) × 300 = $3750. Profit per unit is $12.50. Since MR > MC, the firm should increase its output. c) Total profit is (11 – 6) × 680 = $3400. Profit per unit is $5. Since MR < MC, the firm should reduce its output. d) Total profit is (15 – 17) × 600 = –$1200. Profit (loss) per unit is –$2. Since MR = MC, the firm should not adjust its output. e) Total profit is (13 – 12.50) × 700 = $350.

Profit per unit is $0.50. Since MR < MC, the firm should reduce its output.

Question 15 a) The competitive equilibrium is at the intersection of the market demand curve and the market supply (MC) curve. The equilibrium price is $200 per unit and the equilibrium quantity is 100,000 units per month. At this market price, each of the 50 firms will be producing 2000 units per month, and it will be maximizing profits by doing so. The typical firm in this case has average total cost of $200 per unit and revenue per unit (price) of $200. Each firm is just covering its total costs and so has zero economic profit. b) If the 50 firms now create a cartel which replicates the monopoly outcome, total industry output falls to 60,000 units per month and price rises to $300 per unit. Since the cartel agreement divides this output equally among the firms, each firm‘s output is 1200 units per month (=60,000 / 50). Each firm now earns a total revenue of $360,000

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per month (= $300 × 1200 units). As the diagram clearly shows, each firm‘s average total cost at this level of output is well below $300 (and closer to $225). So, each firm is earning positive economic profits. c) For each individual firm within the cartel, the marginal revenue associated with producing one more unit is the current market price, $300, since one more unit produced would have a negligible effect on total industry quantity and thus on market price.

Each firm would experience a marginal cost which is much lower than price; in the diagram, it appears that each firm‘s marginal cost of producing one more unit (when its output level is 1200 units) is about $150. Since the marginal revenue is far greater than the marginal cost, each firm within the cartel has a clear incentive to cheat on the agreement and instead to produce more output. In fact, each would like to increase its own output until its own MC was equal to $300, which occurs in the diagram at an output level of 3000 units per month. d) If all, or even many, firms act on the incentives described above, then the cartel will break down because total output will rise above 60,000 units per month and market price will fall below $300. e) Cartels are inherently unstable because of the tension between the collective best interest of the firms and their individual best interests. Acting collectively, their best outcome occurs when they restrict output and elevate the price. But each individual firm has the incentive to increase output when the other firms are restricting theirs. If there were a way to enforce the cartel agreement, this problem would be solved. But in the absence of enforceable agreements (which are generally illegal), the instability of cartels cannot be avoided.

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Question 16 a) With such ―perfect‖ price discrimination, the monopolist would choose output where the demand curve intersects the MC curve, and so would sell 600 games per week. The price on the last game would be $40. b) Without price discrimination, the single-price monopoly output yields consumer surplus given by the triangle cde. c) With ―perfect‖ price discrimination, the consumer surplus is zero because each unit is sold at the highest price consumers are willing to pay for that unit (the height of the demand curve). d) It is difficult to practise perfect price discrimination because the monopolist would need to know consumers‘ willingness to pay for every unit and would also have to be able to prevent arbitrage.

More likely forms of price discrimination might include: • different prices for different customer ―groups‖ such as business vs. leisure • different price on different days of the week • different prices for different times of the day • ―bulk purchase‖ discounts in which customers buy several games in advance for a lower price per game than is available when customers buy a single game

Question 17

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diagrams. The different demand curves in the two regions reflect different tastes, different willingness to pay by consumers, different availability of substitutes, and much else.

b) The MR curves are also shown in the diagrams above. Notice that the horizontal intercept of the MR curve is exactly half of that for the demand curve, and that the vertical intercept is the same as that for the demand curve. The equations for these two MR curves are: Europe: MR = 150 – 2QD United States: MR = 62.5 – 0.5QD c) The MC curve is horizontal at $15 in both diagrams. The horizontal MC curve reflects the assumption that the scale of production does not affect Levi‘s cost for producing an additional unit (though any fixed costs would imply that average costs decline as output rises).

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d) To solve for the profit-maximizing level of output in each market segment, we must set MR = MC in each segment separately. Since the markets are completely segmented, this problem is just like having two independent monopoly problems, the solution to each being to have MR = MC. For each of the two segments, we thus have: Europe: MC = MR ⇒ 15 = 150 – 2QD States: MC = MR ⇒ 15 = 62.5 – 0.5QD

United

For Europe, this gives QD = 75 – 7.5 = 67.5. At this quantity, the price in Europe is given by the demand curve (QD = 150 – p) which gives p* = 82.5.

For the United States, this gives QD = 125 – 30 = 95. At this quantity, the price in the United States is given by the demand curve (QD = 250 – 4p) which gives p* = 38.75.

e) Own-price elasticity of demand at the profitmaximizing point is given (in absolute value terms) by:

 = (Q / p)  (p / Q) In Europe, the measure of elasticity is E = (1)  (82.5 / 67.5) = 1.22. In the United States, the measure of elasticity is A = (4)  (38.75 / 95) = 1.63. Thus U.S. demand is more elastic than European demand and, as we explained in the text, the price in the United States is

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therefore lower than the price in Europe. *****

____________________________________________________ _ Chapter 11: Imperfect Competition and Strategic Behaviour ____________________________________________________ __

This chapter is long but contains a lot of valuable material. Most firms are neither perfect competitors nor pure monopolists, and thus an understanding of real-world firm behaviour requires an understanding of both monopolistic competition and oligopoly. Not surprisingly, the insights gained in this chapter apply mostly to the idea of strategic behaviour between firms, something that simply does not exist in perfect competition and monopoly.

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*** The chapter begins by discussing the structure of the Canadian economy. We divide Canadian industries into two broad groups, those with many small firms and those with a few large firms. We no longer show data on concentration ratios because problems with these ratios led Statistics Canada to stop computing them. But we have expanded our discussion of concentration, and now discuss four different measures, which have moved broadly together (averaged across industries) over the past four decades. We make the point that competition from foreign firms, which is increasingly important in any economy today, is not included in conventional measures of industrial concentration, and that this fact implies that domestic measures may not be clear indicators of the amount of overall competition in the relevant market.

This opening section also offers a general discussion of the entire range of imperfectly competitive market structures. It is pointed out that most manufacturing industries produce differentiated products, and each firm must create its own versions of the product and must also determine the price at which it is willing to sell.

With highly differentiated products, firms often have unexploited economies of scale in subproduct lines (different versions of the same general product). Other characteristics that are pointed out include several forms of non-price competition, none of which would occur in either perfect competition or monopoly.

The chapter‘s second section deals with the theory of monopolistic competition. We examine both the short-run equilibrium, in which profits may be either positive or negative, and the long-run equilibrium, in which free entry ensures zero profits. The discussion covers the excess-capacity theorem as well as the argument that excess capacity

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does not necessarily imply inefficiency as long as customers sufficiently value product diversity.

Finally, the issue of the empirical relevance of monopolistic competition is raised; we argue that many local services (such as dry cleaning, landscaping, hair salons, and restaurants) exist in industries that are well described by the theory of monopolistic competition.

The chapter then turns to the analysis of oligopoly, a crucial market structure in modern developed economies. We begin by describing two basic types of oligopoly: those with identical products and those with differentiated products. We then explain in general terms why strategic behaviour is central to oligopoly and why this makes the analysis complicated. With these basic ideas covered, we then establish the central dilemma for oligopoly (to cooperate or compete). This sets us up for an introduction of some simple game theory, which we use to illustrate the strategic choices involved. The significance of the Nash equilibrium is stressed. The tension between the advantages of achieving the cooperative outcome, and the temptation to compete toward a non-cooperative outcome, becomes the analytical device on which the entire discussion is hung. A box discusses the Prisoners‘ Dilemma model in economics, with some applications to other disciplines.

We then turn to a discussion of the importance of entry barriers, and how incumbent firms can potentially act to enhance these barriers, including by purchasing a small competitor before it can Copyright © 2026 Pearson Canada Inc.

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become large enough to become a real competitive threat. Our experience is that students find it intriguing to be presented with even a partial explanation of the brand proliferation and heavy advertising against each firm’s own brands that goes on in the soap, beer, breakfast cereal, and cigarette industries.

Finally, we address the question of how to evaluate oligopoly. Although efficiency is not explained in detail until the next chapter, students can see intuitively the value to consumers of holding prices as close as possible to full costs.

Answers to Study Exercises Fill-in-the-Blank Questions

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195

Question 1 a) concentrated; concentration ratio b) large; small; small; large c) differentiated d) downward-sloping e) demand

Question 2 a) marginal cost; marginal revenue b) larger; higher c) zero (economic) d) long-run average cost (LRAC); excess capacity

Question 3 a) strategic; their rivals (other firms in the industry) b) marginal cost; marginal revenue c) restrict; profits; increase; profits d) entry barriers e) brand proliferation; advertising; predatory pricing; or purchasing rival firms f) innovation; innovate

Review Questions Question 4 a) monopolistic competition, oligopoly, monopoly b) monopolistic competition, oligopoly, monopoly c) perfect competition d) monopoly and oligopoly if there are sufficient entry barriers e) perfect competition, some oligopoly (those producing commodities such as cement or steel) f) monopolistic competition, oligopoly g) all profit-maximizing firms h) perfect competition

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i) perfect competition, monopolistic competition j) monopolistic competition, often oligopoly

Question 5

a) Textbooks of a particular type, such as firstyear university economics texts, are a differentiated product. There is freedom of entry and unexploited economies of scale––the large fixed costs of writing, editing, and graphic design can be spread over more and more books with only a relatively small variable cost (mostly associated with printing). One would expect, therefore, that the return (royalties plus any reputation effects) would just repay the opportunity cost of each academic‘s time in writing his or her book, and that entry would continue until the available market was so divided among competing texts that benefits just equal costs. Of course, the occasional superb writers would gain economic rents on their scarce talents. So as a first approximation for beginning students, the industry looks close to monopolistically competitive (or perhaps oligopolistic). b) Again, a model of monopolistic competition will get quite far with this one.

Colleges and universities, however, have larger fixed costs than textbooks. c) Given the evidence that the MES in cigarettes is small, the industry might have become monopolistically competitive. However, most brands are produced by a few firms, each of whom work hard to discourage or prevent entry. The cigarette industry is an oligopoly producing a differentiated commodity––as are most consumer goods industries. In many cases, however, scale effects make the industry naturally oligopolistic. Where the MES is small, as with cigarettes, however, the puzzle is why the industry evolved as an oligopoly rather than as a case of (large group) monopolistic competition.

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d) Free entry, high fixed costs, and differentiated products characterize the restaurant market. The high fixed costs and the spatial location may mean that there are significant pure profits because of the lumpiness of entry in any particular niche of the market. e) The production of automobiles is probably best described as an oligopoly, with a small number of firms and much product differentiation.

The retailing of the automobiles, on the other hand, has smaller MES, freer entry, and location of the dealership may play an important role. It is therefore likely that the model of monopolistic competition is useful, although once again the symmetry assumption is troubling since there are many ―levels‖ of automobiles. The entry of a new BMW to compete with a Mercedes or Lexus model, for example, is likely to have little effect on the market for the Toyota Corolla. f) and g) Landscaping firms and home-renovation firms exist in industries that are probably well described by the theory of monopolistic competition. There are no significant economies of scale, entry is relatively easy, and location is important. The products are significantly differentiated, not so much by the nature of the product being sold but by the reputations and quality of workmanship and punctuality that individual firms or contractors offer to their customers. In these markets, many firms succeed and get new customers through word-of-mouth recommendations from previous customers.

Question 6 The two diagrams are shown below. In both the short run and the long run, the firm is profit maximizing by choosing output where marginal revenue equals marginal cost. In the short run, the firm is shown to have positive profits (since at Q* price exceeds ATC).

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These profits attract new firms to enter the industry. As new firms enter, the demand curve shifts to the left and becomes flatter, because total industry output must now be divided among a larger number of firms. Entry occurs until firms have zero profit in the long-run equilibrium, which shows a tangency between ATC and the demand curve.

Question 7 a) The only difference between perfectly competitive and monopolistically competitive markets is that in the latter each firm produces a differentiated product, whereas in the former all firms produce an identical product. The product differentiation gives each firm some market power (a downward-sloping demand curve), but the availability of many close substitutes ensures that demand is quite elastic. b) As is true for any firm, profits are maximized at that level of output where MR = MC. In the figure, this occurs at point c. c) Given the output defined in part (b), the price is given by point a on the demand curve.

Thus the firm charges price equal to p0. Since this price is greater than average total costs (given by point b), the firm is earning positive economic profits. Profits are shown by the rectangle defined by p1p0ab. d) There is free entry and exit in monopolistically competitive industries. The positive profits earned in part (c) will attract new entry. As new firms enter the industry, existing firms will find demand for their own product declining, reducing their profits.

Question 8 a) Free entry and exit implies that firms will enter if existing firms are making positive profits, and this entry will dissipate those profits. Conversely, firms will exit if they are making negative profits (losses), and the exit will increase the profits (reduce the losses) of the remaining firms. Thus, firms in the long-run equilibrium of a monopolistically competitive industry will have zero profits. At point A, price is equal to average total costs, and so profits are zero. b) Point B is the long-run equilibrium market price that would exist if the industry were

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perfectly competitive, since it is at the minimum of the average cost curve. c) This firm’s long-run equilibrium price, pA, is greater than the price that minimizes its average costs, and in this sense there is an inefficiency compared to perfect competition.

But as we argued in the text, the higher unit cost is the price we pay for greater product diversity, and it may well be the case that consumers benefit more from the diversity than they lose from the higher prices, in which case we could not say that monopolistic competition is unambiguously worse than perfect competition.

Question 9 a) Car repair. There are many small car repair centres, each of which offers slightly differentiated service, guarantees, etc. There is unlikely to be much strategic behaviour, except perhaps among those located very closely together. Entry and exit is easy.

Monopolistic competition rather than oligopoly. b) Haircuts. Lots of product differentiation here, especially in terms of the individual barber or stylist that provides the service. Like car repair, location is probably a very important factor to the consumer. Entry and exit is easy. Monopolistic competition rather than oligopoly. c) Dry cleaning. There is less product differentiation here than in the first two examples, but location is still very important. Entry and exit are easy. Because non-price competition may be less important, there may be some strategic behaviour between dry cleaners that are located close to one another. But otherwise monopolistic competition is probably a better description. d) Soft drinks. There are a very small number of firms that produce the vast majority of soft drinks. There is brand proliferation and massive advertising that makes large entry barriers. There is lots of room for strategic behaviour in pricing, special deals, and promotions. This is a classic case of oligopoly. e) Breakfast cereals. This industry has been a clear oligopoly, with extensive brand proliferation and much advertising. In recent years, however, there has been some entry to the market of new products and ―independent‖ producers, but this entry has been relatively small in terms of the entire industry. f) Restaurant (not fast food) meals. There is lots of product differentiation, and relatively easy entry and exit. But location is also very important, and so there may be strategic behaviour within localized markets. But the large number of restaurants within most localities suggests limited strategic behaviour, and so monopolistic competition is a good description. (For fast food, the better description is oligopoly, with enormous advertising costs and numerous franchise outlets presenting considerable entry barriers.) g) Automobiles. There is a small number of producers and lots of product differentiation.

Advertising is very important. Lots of strategic behaviour in terms of new model features and pricing. Definitely oligopoly.

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Question 10

a) The barriers to entry are: brewing: capital costs to establish national distribution, brand proliferation, advertising airlines: large capital costs, ownership of scarce routes and landing rights railways: large capital costs, ownership of right of way (on scarce land) banking: large range of products, large capital costs to establish system of branches, lots of advertising, reputation, and brand loyalty social media platforms: network effects—once many people start using a specific platform, and benefiting from each other‘s use, it becomes harder for other platforms to get started, unless they offer something quite different and attractive for the customers internet service providers: large capital costs are required to establish national networks, and entry to the industry is regulated by the Canadian government grocery stores: heavy brand advertising and large national distribution networks provide barriers to entry for firms that want to compete nationally, but there are fewer barriers to firms that want to compete only in local markets b) Technology is changing in the following ways that will tend to circumvent these entry barriers: brewing: development of regional microbreweries to satisfy niche markets airlines: development of small regional jets allows regional airlines to develop railways: development of standardized containers may allow more competition from trucks in short-haul markets, but this does Copyright © 2026 Pearson Canada Inc.

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201

nothing to circumvent the barriers to entry for long-haul markets banking: development of internet and telephone banking allows banks to establish a market presence without extensive network of branches social media platforms: network effects are inevitable with social media, because their entire purpose is to build and use large networks of people. Technological change will be unlikely to ―circumvent‖ the entry barriers that come with network effects. Only the offering of new and attractive services or features will lead to the entrance of new platforms. internet service providers: entry barriers will persist so long as regulation by the Canadian government persists (which has nonetheless been gradually relaxed in recent years) grocery stores: barriers to entry are slowly being circumvented not so much through technological change but by gradual entry first into local markets, followed by gradual expansion and entry into other local markets

Question 11 The starting point for this industry, as described in the question, is an oligopoly with several firms selling differentiated products. Each firm sells its own version of the product at its own price, and in each case this price is only slightly above the firm‘s marginal cost. This outcome suggests that these firms, even if there is only a small number of them, are competing pretty actively against each other; if there were active collusion we would expect prices to be higher above marginal costs.

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a) As the one firm starts acquiring the others, the industry is naturally becoming more concentrated.

The central concern is that the rise in concentration may lead to less active competition, and maybe even some collusion. The feared result is higher prices for consumers, lower overall output, and an overall decline in welfare for society. b) The largest firm now embarks on an expensive advertising campaign. To the extent that this advertising is informative to consumers, explaining how this firm‘s product is different from and perhaps superior to other firms‘ products, there is clear value in it. The danger, however, is that this advertising may create an effective entry barrier, deterring the entry of new firms into the industry, or perhaps the expansion of existing ones. In practice, both effects are probably at play—the advertising is informative but also helps to deter entry. c) If the largest firm were instead to embark on an expensive program of research and development to improve its product or develop new ones, most people would view this as beneficial. The firm wants to do this to stay ahead of its rivals, and it may actually work to deter entry. But the new or better products also benefit the consumers. This greater emphasis on research would be viewed as a natural and desirable aspect of competition among oligopolistic rivals. d) If oligopolistic firms are earning positive economic profits, does this indicate some problem for society? Not necessarily. Positive profits for an oligopoly firm may indicate that this firm is highly innovative and successful in producing and delivering a product to consumers that they value very highly. For example, it is difficult not to view Apple in this way, as they have been enormously innovative and able to charge high prices for products that consumers around the world value very highly.

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However, high profits may also be earned by oligopoly firms who are less innovative but earn their profits by deterring entry and eliminating their competitors through acquisitions. Facebook, for example, benefits from the network effects that are intrinsic to digital platforms, as this produces a powerful entry barrier. At the same time, Facebook has enormous market power in the market for online advertising and has actively acquired many small firms that could have expanded to become active and substantial competitors.

The bottom line here is that there is no clear relationship between profits and behaviour when it comes to analyzing oligopoly. Attention must be paid to the details of what the various firms in the industry are doing, how they are competing (or not), and the source of their profits. It is certainly not true that the mere existence of large firm profits is evidence of a social problem!

Problems Question 12 a) The (domestic) four-firm concentration ratio is equal to the sales of the four largest firms expressed as a fraction of the total industry sales. The concentration ratios are: Forestry products: Chemicals: Women’s clothing: Pharmaceuticals:

(185 + 167 + 98 + 47) / 550 = 497 / 550 = 90.3% (27 + 24 + 9 + 4) / 172 = 64 / 172 = 37.2% (6 + 5 + 4 + 2) / 94 = 17 / 94 = 18.1% (44 + 37 + 22 + 19) / 297 = 122 / 297 = 41.1%

b) The most concentrated industry is Forestry products, and then Pharmaceuticals, followed by Chemicals and then Women’s clothing. c) If Canada trades with the world in these industries, then the relevant market must be taken to be the world market. In this case, even if the four Canadian firms were the largest in the world (which would be unlikely), the concentration ratios would be lower than in part (a)—and thus the Canadian firms would have much less market power than what is suggested by the domestic concentration ratios. The modified concentration ratios, using the Canadian sales of the four firms divided by total world sales, would then be: Forestry products: Chemicals:

497 / 1368 = 36.3% 64 / 2452 = 2.6%

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Women’s clothing: Pharmaceuticals:

17 / 3688 = 0.5% 122 / 2135 = 5.7%

Question 13 a) The missing columns are completed below.

Quantity 1000 1100 1200 1300 1400 1500 1600 1700 1800

Total Marginal Average Marginal Profit Revenue Revenue Total Cost Cost 30 000 25 5000 31 900 19 23.6 10 5900 33 600 17 22.7 12 6400 35 100 15 21.9 13 6600 36 400 13 21.4 15 6400 37 500 11 21.5 22 5300 38 400 9 21.9 28 3400 39 100 7 22.6 35 600 39 600 5 23.9 45 –3400

b) The curves are plotted in the diagram below.

c) The profit-maximizing number of car washes is 1300 per month. This is where the MR and MC curves intersect. d) The profit-maximizing price is $27 per car wash. e) Profits are given by total revenues minus total costs, or $6600 per month. f) Product differentiation might occur in any number of ways, including: • the use of a special soap or car wax • offering free coffee and newspapers for customers while they wait • offering nice lounges with free wi-fi for customers while they wait • locating near stores that customers like to shop in while they wait

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Question 14 a) Each hair salon produces a similar but differentiated product. Hair cuts differ across salons in a number of ways—quality, style, location, hours of operation, personnel, etc.

This differentiation means that each hair salon can charge a different price, one tailored to its own customers and product, and so it faces a downward-sloping demand curve. But the fact that all hair salons are selling a similar product means that there are considerable substitution possibilities between them, and this is what makes each demand curve relatively flat (elastic). b) For the hair salon shown, its profit-maximizing quantity is determined where marginal revenue equals marginal cost, which occurs at a quantity of 100 cuts per day. Its optimal price, shown at this quantity along the demand curve, is $40 per cut. c) At the quantity of 100 cuts per day, the firm’s average total cost is $30. So its profit per unit is $10, and so the firm’s total daily profit is $1000. d) Not all outcomes will be exactly the same. Each salon faces a slightly different demand curve and produces a different version of the product. So, there will be many different price/quantity outcomes across the many hair salons in this market. Some salons may be earning positive profits, some may be earning negative profits, some may be earning zero profits. e) If many or most hair salons in this market are earning positive profits, these profits will tend to attract the entry of new firms, who enter the market in the belief that they can establish their businesses and capture some of these profits for themselves. As new salons enter the market and attract some of the existing customers, the demand curves facing the existing salons will shift gradually to the left. As the demand (and marginal revenue) curves shift to the left, hair salons will maximize their profits by reducing their prices (assuming that nothing changes the MC curves). Some salons may find that they are now unable to earn a positive profit and may exit the industry. f) In the long-run equilibrium, there is no incentive for firms to either enter or exit the industry. This means that existing hair salons are just covering their full costs, earning no economic profit. In terms of the diagram, all firms’ demand curves have shifted to the left to the point where their profit-maximizing output and price occurs where the demand curve is just tangent to the ATC curve (as in Figure 11-1 part (ii) in the text).

Question 15 a) and b) There are actually two Nash equilibria in this game. One is that both firms bid $10,000. The other is that both firms bid $5000. In both cases, neither firm would want to change its behaviour given the behaviour of the other firm. c) If the two firms could cooperate, they would clearly both prefer the high-bid equilibrium to the low-bid equilibrium, for the simple reason that they both get a higher payoff in the high-bid case. We predict cooperation (collusion) to lead to the outcome that both firms bid $10,000 and end up sharing the contract.

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Question 16 a) If both Honda and Toyota build a large plant and produce many cars, the industry quantity will be high and the price will be low. Thus, profits for both firms are low ($14 million each). If both build only a small plant, industry output will be low and price will be high; in this case both firms earn high profits ($20 million each). The third possibility is that one firm builds a small plant and the other builds a large plant. In this case, industry output is ―medium‖ and price is also ―medium.‖ But the firm that builds the large plant gets the most profit because it dominates the market and benefits from the other firm’s restriction of output that keeps market price higher than otherwise. b) The cooperative outcome is that the two firms agree to build small plants, thus keeping total output low and prices high. The problem is that once such an agreement is made, each firm has an incentive to ―cheat‖ by building a large plant instead. A binding contract might help—except that it would almost certainly be against the law! c) Honda’s best action is to build a large plant—independent of what Toyota does. Thus, building a large plant is a dominant strategy for Honda. d) Toyota’s best action is to build a large plant—independent of what Honda does. Thus, building a large plant is a dominant strategy for Toyota. e) The non-cooperative outcome is that both firms build a large plant. This is the only Nash Equilibrium in this game.

***** _____________________________________________ Chapter 12: Economic Efficiency and Public Policy _____________________________________________

This chapter does two things. First, it lays out the basic welfare economics of monopoly and competition, establishing the standard result that monopoly leads to allocative inefficiency. The result is presented first without the use of Copyright © 2026 Pearson Canada Inc.

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consumer and producer surplus, emphasizing instead the difference between marginal benefits and marginal costs of extra output. An optional (and strongly recommended) subsection that uses the concept of surplus follows.

Either way, the material motivates the idea that monopoly leads to efficiency problems. The chapter then deals with the regulation of natural monopolies and the economics of competition policy. *** In the first section of the chapter we develop two kinds of productive efficiency—at the level of the firm and at the level of the industry. The first requires that firms minimize their cost of producing any level of output. An industry is productively efficient when marginal cost for all firms is equated. We have a diagram to make this point. We then develop in detail the concept of allocative efficiency (which we introduced in Chapter 5 and mentioned only briefly in other chapters). We do this slowly as students often have a difficult time with this concept. We show the relationship between the two types of efficiency and the production Copyright © 2026 Pearson Canada Inc.

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possibilities boundary⎯productive efficiency implies being anywhere on the boundary, but allocative efficiency is achieved only at a specific point on the boundary. We have a large diagram showing in detail how the allocatively efficient point on the boundary is determined, and how it relates to the level of output in each of the underlying product markets.

We then compare competition and monopoly in terms of productive and allocative efficiency.

Finally, we recall producer surplus (first seen in Chapter 5) which, when used together with consumer surplus, provides another way of thinking about allocative efficiency. We also have a brief discussion of market failure that will hopefully whet the students‘ appetites for the material to come in Part 6.

The chapter’s second section deals with the theory of economic regulation. We first examine the case of natural monopolies, including the use of average-cost and marginal-cost pricing. We explain how average-cost pricing distorts long-run investment decisions, and also how technological change can make today’s natural monopoly Copyright © 2026 Pearson Canada Inc.

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tomorrow’s competitive (or rivalrous and oligopolistic) industry. We then discuss the regulation of oligopolies and emphasize the reasons for being skeptical about the value of direct control. This leads to a brief discussion of deregulation and privatization. We also discuss the current concern regarding rising corporate concentration, which applies to the technology sector but is also a more general phenomenon.

This discussion leads to box on whether Amazon and Facebook might become the Standard Oil of the 21st century—a box that reviews the history of the ―Robber Barons‖ from the late 19th and early 20th centuries.

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The chapter‘s final section examines Canadian competition policy. It has been substantially rewritten for this 18th edition of the textbook, to reflect the current concerns about Canada‘s competition policy and the need to reform it in the direction of preventing mergers that significantly lessen competition. We begin with a short historical outline, emphasizing the developments in the 1986 Competition Act and the fact that, until 2022, it only prohibited price-fixing agreements in the product market but not in the labour or other input markets. We then discuss three considerations within the Competition Act that influence the Competition Bureau‘s analysis regarding the likely effects of mergers: the threshold for reporting; the efficiencies defence; and the onus to show harm. In each case, we explain the basic logic at play, but also why there might be some concerns about this aspect of the current Competition Act. Our final discussion is about the case for reforming the Competition Act, especially with regard to making anti-competitive mergers more difficult. This policy debate has been heating up in the past few years in Canada, and we think it is valuable to ensure that students are made aware of the basic issues involved.

Answers to Study Exercises

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Fill-in-the-Blank Questions Question 1 a) productively; allocatively b) more; less c) perfect competition d) price exceeds marginal cost e) maximized f) less; consumers; the producer; the deadweight loss of monopoly

Question 2 a) minimum efficient scale (MES) b) zero; exceeds; allocatively efficient c) not; little d) losses (negative profits)

Question 3 a) prevent; lessen b) criminal; less c) price-fixing; mergers; trade d) cost; increases; efficiencies defence

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Review Questions

Question 4 a) All points on the production possibilities boundary reflect productive efficiency both for firms and industries. Thus, if lime producers are not minimizing costs (productive inefficiency), then only point A could represent this situation. b) All points on the production possibilities boundary reflect productive efficiency both for firms and industries. Thus points B, C, and D are possible. c) At point B there is a monopolized lime industry but a competitive coconut industry. Since point B is on the production possibilities boundary, we know that it is productively efficient. But the monopoly in the lime industry means it is not allocatively efficient. At point B there are too few limes being produced (and thus too many coconuts being produced). d) At point D there is a monopolized coconut industry but a competitive lime industry. Since point D is on the production possibilities boundary, we know that it is productively efficient. But the monopoly in the coconut industry means it is not allocatively efficient. At point D there are too few coconuts being produced (and thus too many limes being produced).

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e) If point C is allocatively efficient, we know that price equals marginal cost in all industries simultaneously. In each industry, we are at the intersection of the competitive demand and supply curves, and total surplus is maximized.

Question 5 a) See the diagram below. At the free-market equilibrium, consumer surplus is the light shaded area (which would continue upward if the demand curve continues all the way to the vertical axis).

Producer surplus is the dark shaded area. b) With the quota system in place, industry output falls to QQ and market price rises to pQ. At this high price consumers are still prepared to buy all of the reduced quantity of eggs.

c) The rise in price leads to a fall in consumer surplus. Consumer surplus falls by the trapezoid defined by p*pQAC. Producer surplus rises by the rectangle p*pQAD but falls by the triangle BDC. Thus, the rectangle p*pQAD is simply a redistribution from consumers to producers. However, the triangle ABC is no longer ―earned‖ as consumer and Copyright © 2026 Pearson Canada Inc.

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producer surplus because these eggs are no longer produced under the quota system. This is the deadweight loss of the quota system and reflects the extent of the allocative inefficiency of the quota system.

Question 6 a) See the diagram below. At the free-market equilibrium in the competitive labour market, consumer surplus (earned by the firms who hire workers) is the light Copyright © 2026 Pearson Canada Inc.

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shaded area. Producer surplus (earned by the workers who sell their labour services to firms) is the dark shaded area.

b) In the labour market, consumer surplus accrues to firms who hire labour services. Consumer surplus is the difference between the dollar amount they are prepared to pay (as a wage) and the amount they actually pay in the equilibrium.

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labour services. Producer surplus is the difference between the dollar amount workers are prepared to accept and the amount they are actually paid. c) The establishment of a minimum wage at wM raises the wage that firms must pay and thus reduces the quantity of labour demanded by firms to LM. So LM is the new level of employment. (At the new wage, there is unemployment equal to M L L.) d) Recall that a market is said to be allocatively efficient when the amount of total surplus in that market is maximized. So a loss of surplus means a reduction in efficiency. With the minimum wage in place, consumer surplus falls by the trapezoid w*wMAC. Producer surplus rises by the rectangle w*wMAD but falls by the triangle BDC. The rectangle w*wMAD is simply a redistribution from firms to those workers who are lucky enough to remain employed after the policy comes into effect. The triangle ABC is the net loss in consumer and producer surplus as a result of the policy and reflects the extent of the allocative inefficiency of the minimum-wage policy.

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Question 7 a) See the diagram below. A single-price monopolist produces where marginal revenue equals marginal cost and so chooses output QM and price pM. Consumer surplus is the light shaded area and producer surplus is the dark shaded area.

b) If the industry were perfectly competitive, output would be Q* and price would be p*. In this case, consumer surplus would be the triangle p*AB and producer surplus would be the area Ep*B. c) A monopolist restricts output (and elevates price) and, in doing so, reduces the total amount of surplus. The loss in surplus is the area CDB─the deadweight loss of monopoly. d) With a perfectly price-discriminating monopolist, the demand curve becomes the marginal revenue curve because each unit is sold at a different price (given by the height of the demand curve at that quantity). So the profit-maximizing level of output in this case is Q*. There is no consumer surplus whatsoever because each unit of the good is sold at the consumer‘s maximum willingness to pay. Producer surplus is given by the area EAB.

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e) It is not monopoly per se that leads to allocative inefficiency─it is a monopoly that is unable to ―perfectly‖ price discriminate. As the analysis in (d) shows, a perfectly pricediscriminating monopolist is just as efficient as perfect competition. Of course, considerations of equity may enter a discussion of the desirability of price discrimination, as it involves (in this case) a transfer of all consumer surplus toward the producer.

Question 8 This quote is correct (and it would be worthwhile spending some time in class discussing this point).

Allocative efficiency is only about ―getting the quantities right‖––specifically, getting the quantities such that the marginal cost (to society) of each good equals the marginal benefit (to society) of each good. Once the quantities are correct, prices are purely a method of distributing available surplus between buyers and sellers.

In a free-market system, however, it is the prices that help to bring about the efficient allocation of resources. If prices are free to clear (competitive) markets, then prices will adjust until quantity demanded equals quantity supplied. At this point the marginal cost of each good will equal that good‘s price (which equals the marginal benefit of the good).

This question is designed to alert the student to the potential dangers of adopting the view that allocative efficiency simply requires ―price equals marginal cost in all industries‖. This view is correct only if the prices are free-market prices.

One can easily imagine a situation in which governments set prices in some industries at levels below their free-market equilibrium values. If the government can prevent the formation of black

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markets, then price may equal marginal cost even though there is clearly not allocative efficiency.

Question 9 a) See the diagram below. If existing regulation forced average-cost pricing, then the price would be p1 and quantity would be Q1. b) Since at Q1, price exactly equals average cost, the natural monopoly firm would be earning zero economic profits. c) Since with price p1 and quantity Q1 the price would exceed marginal cost (equal to c1), society would benefit by having more units of this good.

The outcome is allocatively inefficient. d) For regulation that forced marginal-cost pricing, price would be p2 and quantity would be Q2. e) In this case, price would be less than average total cost (equal to c2) and the firm would make losses (negative economic profits) shown by the shaded area.

f) Since price equals marginal cost in this case, the outcome would be allocatively efficient since society values the last unit exactly the same as it costs to produce it. But the losses (if they persist) ensure that the firm will eventually shut Copyright © 2026 Pearson Canada Inc.

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down, so this outcome is unsustainable without some form of financial support to the firm. This shows the basic problem of achieving efficiency in cases of natural monopoly.

Question 10 This is a good question for forcing students to think about what we mean by “the market,” especially for thinking about competition policy.

Geography is important in conjunction with the attributes of the product, especially transport costs. a) In the case of baked goods, transportation costs (relative to the value of the good itself) are quite high. In addition, perishability is important. Both of these factors suggest that the relevant geographic market will be relatively small, perhaps a large metropolitan area or even a small province. b) In the case of cement, the weight and bulk of the product suggest high transportation costs (relative to price of the product).

But perishability is not a problem, as it is with baked goods. This suggests a larger geographic market than with baked goods but still somewhat localized.

There would not be just one cement firm for a large province or more than one province. c) In the case of gold jewellery, the transportation costs (relative to the value of the product) are very low. Perishability is not at all an issue. This suggests a large geographic market.

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d) Computer hardware also has low transportation costs relative to the value of the product. It also has no real perishability. Thus, the geographic market is large.

Problems Question 11 a) If each firm is producing 1000 bundles per day, the marginal costs for Firms A, B, and C are $15, $10, and $30, respectively. Since MC is not equated across the three firms, the industry is not productively efficient. b) To keep total output at 3000 bundles per day, output should shift away from firm C and toward firms A and B. In fact, if the outputs are 1400 for each of firms A and B and 200 for firm C, the industry would be productively efficient and MC would be equated at 20. c) At a market price of $20 per bundle, each pricetaking firm would maximize its profits by choosing its own output so that MC = $20. This would be the allocation from part (b) (1400, 1400, 200) and would be productively efficient. d) We are told that this is a perfectly competitive industry, in which case the market price (at the intersection of market demand and supply curves) is equal to marginal cost. Since price equals MC, the outcome from part (c) is allocatively efficient.

Question 12 a) Since average cost is defined to equal total cost divided by output, we can find total cost by simply multiplying output by average cost. Marginal cost is the change in total cost divided by the change in output. The completed table is shown

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below. Note that marginal cost is computed as a change from one row to the next.

Summer Tees

Fancy Tees

Quant ity 5 10

ATC ($) 8 7

TC ($) 40 70

15

6

90

20

6

120

25

7

175

30

9

270

35

11

385

MC ($) Quant ity 5 30/5 = 10 6 20/5 = 15 4 30/5 = 20 6 55/5 = 25 11 95/5 = 30 19 115/5 35 = 23

ATC ($) 9 7

TC ($) 45 70

MC ($)

6

90

20/5 = 4

5

100

10/5 = 2

5.50

137. 37.5/5 = 5 7.5 195 57.5/5 = 11.5 280 85/5 = 17

6.50 8

25/5 = 5

b) The ATC and MC curves for each firm are shown below. Note that the data for the MC curves are plotted in the midpoint of the output intervals.

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c) If Summer is producing 30 shirts, its total cost is $270. If Fancy is producing 15 shirts, its total cost is $90. The total cost for both firms is therefore $360. d) If Summer produces 10 fewer shirts, its total costs fall to $120, for a reduction of $150. e) If Fancy produces 10 more shirts, its total costs rise to $137.50, for an increase of $47.50. f) For the two firms together to minimize the total cost of producing 45 shirts, marginal cost must be equated across the two firms. In this case, however, we are restricted to having each firm produce increments of 5 shirts. So the possible allocations that have marginal cost ―close‖ across the two firms are: Summer has Q = 15, TC = $90; Fancy has Q = 30, TC = $195; Grand TC = $285

Summer has Q = 20, TC = $120; Fancy has Q = 25, TC = $137.5; Grand TC = $257.5 Summer has Q = 25, TC = $175; Fancy has Q = 20, TC = 100; Grand TC = 275

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Summer has Q = 30, TC = $270; Fancy has Q = 15, TC = $90; Grand TC = $360 From these possibilities, it is clear that the cost-minimizing allocation is for Summer Tees to produce 20 shirts and Fancy Tees to produce 25 shirts, for a total production cost of $257.50. In this case, Summer‘s MC is (something greater than) $6 whereas Fancy‘s MC is (something greater than) $7.50, which is as close as we can get the marginal costs (to each other) given the restriction that each firm must produce in increments of five shirts. g) Productive efficiency for an industry requires that any given level of industry output be produced at minimum cost, and this requires that MC be equated across all firms in the industry. The allocation of production shown in part (f) gets us as close to productive efficiency as possible, given the restriction that firms produce in increments of five shirts.

Question 13 a) Total revenue is $30 × 60 units per day = $1800 per day. Consumer surplus is the area of the triangle below the demand curve, above the price line = $900 per day. Producer surplus is the area of the triangle above the supply curve, below the price line = $900 per day. Total economic surplus is $1800 per day. (Note that it is not usually the case that total economic surplus is equal to total revenue.) b) In this case, the producers form a cartel and jointly produce the monopoly output. Total revenue is $1350 per day. Consumer surplus is $225 per day; producer surplus is $1125 per day. Total surplus is $1350 per day, less than in part (a). c) Comparing the two situations in (a) and (b), consumer surplus falls by $675 per day when the

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firms collude; but producer surplus rises by $225 per day. Total surplus falls by $450 per day. d) The deadweight loss is the surplus that would be earned in a competitive market but that is not earned when output is restricted. It is shown by the area between the demand and supply curves for the units not produced. The deadweight loss in this case is $450 per day.

Question 14 a) This firm is a natural monopoly because its LRAC curve is declining over the entire range of the demand curve—so there is only room for one firm in this industry to achieve its minimum efficient scale. b) An unregulated monopoly will presumably try to maximize profits, thus choosing its output where MR = MC, an output level of 6 million units per month.

Price will be $0.32 and profit will be $0.10 × 6 million units, or $600,000 per month. c) With marginal-cost pricing, the firm will be required to set a price of $0.08. Output will be 15 million units per month and profit will be a loss of $0.06 × 15 million, or $900 000 per month. d) With average-cost pricing, the firm will be required to set a price of $0.16. Output will be 12 million units per month and profit will be zero. e) Marginal-cost pricing is efficient (since price = MC) but the firm makes economic losses and so the outcome cannot be sustained without some assistance being provided to the firm. f) Average-cost pricing allows the firm to cover its full economic costs, but since price exceeds MC, the outcome is inefficient. Society would benefit from having more output. *****

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____________________________________ ____ Part Five Factor Markets

____________________________________ ____ An understanding of factor markets is required in order to fully appreciate many issues, including the existence of factor-price differentials, the importance of factor mobility, the potential effects of minimum-wage legislation, the consequences of labour-market discrimination, the meaning of rising income inequality, the meaning of economic rent, the importance of financial capital, the relationship between interest rates and firms‘ investment demand, and the functioning of capital markets.

We understand that many instructors, facing serious time constraints, feel forced to omit this Part of the book entirely. For these instructors, however, we recommend that at least Chapter 13 be assigned as required material. The general principles covered in this chapter are simply too important to omit, and with these general principles firmly in place it is then possible to have the students read Chapters 14 and 15 on their own.

Many economists, and through them their students, acquire the view that there is something special and difficult about the theory of factor markets. We strive in our treatment to remove the mystery. We stress at the outset that the theory of factor-price determination is just another application of price theory where we have to examine behaviour in both competitive and non-competitive markets.

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The central point worth emphasizing to students before even beginning the detailed discussion of these three chapters is that factor markets are linked to product markets—they are not a ―side show.‖ There is a demand for factors only because there is an underlying demand for the products those factors produce. This is the notion that factor demands are derived demands. The connection also works in the opposite direction—the demand for products arises because of the income earned by factors in the factor markets. It may help to remind your students about the circular flow of income (Chapter 1), which emphasizes this linkage between factor markets and product markets. *** We have organized our discussion of factor markets into three chapters. In Chapter 13 we examine the theory of factor pricing, factor-price differentials, and the importance of factor mobility. The discussion relates to all types of factors—labour, land, and capital. We also develop the important concept of economic rent and argue that factor mobility is the key determinant of whether any factor‘s earnings are economic rent or merely the amount necessary to secure that factor‘s usetransfer earnings.

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In Chapter 14 we discuss labour markets. We begin with a discussion of wage differentials, including a section on the effects of discrimination, which leads to a new box on the legislated discrimination against Indigenous Peoples in Canada under the Indian Act. We then address legislated minimum wages and labour unions.

The chapter closes with a thorough discussion of the distribution of income and the recent increases in income inequality, including possible causes, why it matters, and possible government responses.

Chapter 15 examines the functioning of capital markets, beginning with an introductory section describing firms’ demand Copyright © 2026 Pearson Canada Inc.

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for (physical and financial) capital, households’ supply of capital, and the intermediating role of financial institutions. We have an extensive discussion of present value that feeds into the material on firms’ demand for investment. We discuss households’ decision to save and what variables influence the flow of desired saving. Our discussion of capital-market equilibrium includes the analysis of the effects of technological progress and policies directed at increasing the incentives to either invest or save. _______________________________________

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_______________________________________ Chapter 13: How Factor Markets Work _______________________________________ This chapter offers a general discussion of how factor markets work. Students must understand the link between product markets and factor markets, and that factor demands are derived demands. It is also crucial for students to understand the central concepts of factor mobility and economic rent. With the principles from this chapter in place, students can read Chapters 14 and 15 on their own, and learn much about both labour and capital markets.

This chapter is divided into three sections; the demand for factors; the supply of factors; and the operation of factor markets, including factorprice differentials, the role of factor mobility, and the meaning of economic rent. A theme that runs throughout the chapter is how factor mobility affects factor prices and also how it affects the way in which given factor earnings are divided between rent and transfer earnings. *** The chapter‘s opening section, on the derived demand for factors, makes a clear distinction between the ―physical‖ and the ―revenue‖ parts of marginal revenue product (MRP). Many students find this concept difficult, and so it deserves a thorough treatment. We emphasize that the general case is that of marginal revenue product, but that MRP takes a different form in competitive versus non-competitive situations.

The second section deals with factor supplies. Factor mobility enters the analysis here by being Copyright © 2026 Pearson Canada Inc.

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the primary explanation for why the elasticity of supply of a particular type of labour (or any other factor service) to a particular firm is much greater than the elasticity to an entire industry which, in turn, is greater than the elasticity to the entire economy. As with our earlier discussions of elasticity in Chapter 4, time plays a key role in factor mobility, and therefore it also plays a central role in these various elasticities. In the discussion of population and labour supply, we have added material on recent increases in Canada’s annual inflow of immigration.

The final section deals with the operation of factor markets. There is an extensive discussion of temporary versus equilibrium factor-price differentials, stressing the role of factor mobility and intrinsic differences in factors and in job attributes. We then examine why government policies designed to eliminate equilibrium factor-price Copyright © 2026 Pearson Canada Inc.

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differentials tend to get thwarted by factor mobility. We next discuss the concept of economic rent, with examples to make sure that students really understand the concept. This leads to a box that explains David Ricardo‘s original use of the term. The chapter ends with an application of an important policy issue: whether greater immigration can be used to address perceived ―labour shortages‖.

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Answers to Study Exercises

Fill-in-the-Blank Questions Question 1 a) demand curve b) inelastic c) inelastic d) shift to the right e) marginal product (MP); shift up (or to the right); shift up (or to the right)

Question 2 a) marginal revenue; marginal product b) hiring one additional unit of a variable factor of production c) marginal revenue product (MRP); factor price d) marginal revenue product (MRP); factor price

Question 3 a) $12.50 (= $50 × 0.25);

– $9.50 (= $12.50 –

$22); fewer hours of labour b) $300 (= $100 × 3); $100 ( = $300 – $200); more day-rentals c) $6000 (= $12000 × 0.5); $0 ($6000 – $6000); the same months of labour

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Question 4 a) mobile b) mobile c) low d) firms; industries e) horizontal (elastic) f) market

Question 5 a) differentials b) equilibrium c) equilibrium; natural d) equilibrium; acquired e) opportunity; moving f) economic rent

Review Questions Question 6 a) and b). For each example, we list the reason why the COVID-19 pandemic caused the industry to expand and also the resulting increase in derived demands.

Cleaning products: The pandemic led to heightened concerns about hygiene, increasing the demand for

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hand sanitizer, disinfecting wipes, and other cleaning products.

Derived demands: The labour and supplies and vehicles required to produce these cleaning products and to distribute them to stores. For example, there was an increase in demand for the alcohol used to make sanitizing products.

Fitness equipment: Many parts of the economy were shut down as people were encouraged or required to remain at home. Gyms were required to close in most jurisdictions. This led many individuals to purchase their own fitness equipment so they could work-out at home.

Derived demands: The labour and supplies needed to produce the equipment, and to distribute them to stores. In many cases, these products were purchased online and thus home delivery was needed, which means a demand for those deliveryrelated resources.

Gaming: With most people remaining at home and going out very little, leisure time was significantly altered. Online gaming increased in popularity as it could easily be done from home.

There was also an increase in demand for board games as more families were spending more time at home.

Derived demands: The labour required to develop and improve and maintain the online programs as use of them increased sharply. The people and supplies needed to produce more board games.

Grocery Retailing: Restaurants were required to close in most jurisdictions, or were open only for take-out meals and home delivery. With the decline in restaurant visits, many people increased their home-cooking activities, and this led to an increase in demand for basic groceries. (Notice,

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however, that there might not have been an increase in overall demand for food, as the demand for food from restaurants presumably fell. Food that would ordinarily have been supplied by wholesalers to restaurants was then being supplied to grocery stores instead.)

Derived demands: The labour required to work in grocery stores and keep the shelves stocked.

For example, in the first few months of the pandemic, there was an increase in demand for flour and yeast required for home baking (baking sourdough bread was a real ―thing‖ for a few months in 2020!). A second derived demand was the increase in demand for the paper packaging for the flour.

Video Communications: As millions of people continued working from home during the pandemic, there was an increase in demand for using software (such as Zoom and MS Teams) to allow people to hold their meetings online. These technologies were also used to allow friends and family to meet online when they could not meet in person.

Derived demands: The labour required to develop and improve and maintain these online programs as use of them increased sharply.

Food Delivery: Even though most grocery stores remained open, many people preferred to have their groceries delivered to their homes, and many grocery stores quickly adapted to offer this service. The same was true for restaurant meals.

The result was an increase in demand for home delivery of food.

Derived demands: The labour and vehicles needed for an increase in home delivery.

Pet Care: With millions of people staying at home during the pandemic, there was a realization that this was a good time to get a pet, and as a result there was an increase in demand for the pets and

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for the products and services required to take care of those pets.

Derived demands: The labour and supplies required to raise or import more pets, produce more pet food and accessories, etc.

Renovation Materials: Millions of people staying home during the pandemic was also a natural time for many people to spend time fixing and renovating things at home, and so there was a large increase in demand for renovation materials—lumber, drywall, tools, doors and windows, and a whole range of hardware.

Derived demands: The labour and supplies required to produce, distribute, stock, and sell these products would all experience an increase in demand.

Question 7

a) The upward-sloping supply curve of workers to the fast-food industry reflects workers’ willingness to leave other industries (or leisure) to seek employment in the fast-food industry when fastfood wages rise. b) See the diagram below. The demand for fast-food workers is derived from the demand for fast food.

The decline in the demand for fast food leads to a decline in the demand for workers in the fast-food industry. The demand curve therefore shifts to D and results in a decline in the wage to w1 and Copyright © 2026 Pearson Canada Inc.

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employment to L1, and thus a decline in workers‘ earnings. The equilibrium moves from E0 to E1. The reduction in fast-food workers‘ earnings is shown by the shaded area. (Note that the reduction in fastfood employment will be offset to some extent by the increase in employment in other industries that occurs as workers leave the fast-food industry and seek employment elsewhere, thus increasing the supply of workers to other industries.)

c) We take as the starting point the initial equilibrium before the decrease in demand (that is, point E0). We then have an increase in the supply of workers to S. The result is that wages fall and employment rises. The new equilibrium is E2.

d) Relative to the initial equilibrium, we don’t know what happens to workers’ earnings in the fast-food industry. Employment has Copyright © 2026 Pearson Canada Inc.

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increased but wages have fallen.

Depending on the elasticity of labour demand, workers’ total earnings could go either way. If labour demand is relatively elastic, the percentage increase in employment will exceed the percentage decline in the wage, and total earnings will rise. If labour demand is relatively inelastic, total earnings will fall.

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Question 8 a) Ocean liners take several years to build. It also takes quite a while to refit an existing ship into a luxury liner. Thus the elasticity of supply to the world is very inelastic. Diagram 2 shows this. b) Canada is a relatively small share of the world market for ocean liners. A rise in the price paid in Canada would cause some ocean liners to redirect their supply away from other countries toward Canada. Diagram 3 shows this. c) An individual Canadian firm is tiny relative to the overall market and so that firm faces a given price of ocean liners. It can purchase all the ocean liners it can afford at that world price. This perfectly elastic supply is shown in Diagram 1. d) The more mobile is a factor toward a particular use, the more elastic is the supply of that factor for that particular use.

Question 9 a) See the diagrams below. Note that in the initial equilibrium the wage in both industries is equal to $20 per hour.

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b) The increase in demand for steel pipe leads also to an increase in demand for steel-pipe workers. This is the derived demand for steel-pipe workers. The increase in demand shifts the demand curve in the right-hand diagram to D, with the result that wages and employment in that industry rise.

c) Employment did increase in the steel-pipe industry because the supply curve of workers to that industry is upward sloping. This positive slope means that workers are prepared to leave other industries (or leisure) and seek employment in the steel-pipe industry when the wages there increase. Thus, the extra workers in the steel-pipe industry have come Copyright © 2026 Pearson Canada Inc.

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from other industries (and also from leisure). d) Some of the newly employed workers in the steelpipe industry came from the sheet-iron industry. (We are told that workers can switch relatively easily between the two sectors.) As workers leave the sheet-iron industry, the supply curve for workers to that industry shifts to the left, driving up the wage and reducing employment. This is shown by the shift of S to S in the left-hand figure. e) To the extent that workers are able to switch between industries, the wage differential will eventually return to the differential in place before the shock occurred. In this example, we assumed there was no initial differential, implicitly assuming that workers viewed the jobs as very close substitutes in terms of their nonmonetary attributes. Following this shock, wages will rise in the sheet-iron industry until wages in the two industries are equal at the higher level.

Question 10 a) Probably most of the rental payment received by a landlord is not an economic rent. He probably needs most of this to induce him to keep the building in repair and to replace it when it wears out. b) Probably most of the salary of the Prime Minister is an economic rent. This supposes that politicians who have sought to be Prime Minister would be willing to serve even if the salary were much lower. c) For this question the perspective is important.

Imagine that we are interested in knowing how much of a professional athlete‘s or recording artist‘s fee for one particular event is economic rent. In this case, the individual has many alternatives (different days, different cities, different events) and so perhaps very little of his or her fee is Copyright © 2026 Pearson Canada Inc.

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economic rent. However, if we take a broader perspective and ask how much of their total income as an athlete or musician is economic rent, then we have to know what that person‘s next best alternative profession is. If Lady Gaga‘s best alternative was to be, for example, a lawyer, then even if she was an outstanding lawyer she would make far less than she earns as a musician, and thus most of her annual earnings would be economic rent.

Similarly for Roger Federer. d) Evidently the window cleaner thinks that, considering monetary and non-monetary benefits, he is better off in his present occupation than in the alternative that he sees. Perhaps, therefore, some of his earnings are rent, but it is probable that much of his pay should be regarded as necessary to keep him in his present occupation. The general point, of course, is that what constitutes a transfer earning for a particular factor owner depends on the alternative uses of the factor that he or she is selling and on the non-monetary benefits as well as the monetary ones.

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e) The Google engineer who loves his or her job is no different than any other worker who loves going to work: they may be being paid more than they need to remain in the position, and thus they may be earning economic rent. This is true in the broadest perspective. However, from the perspective of the individual employer (such as Google), the employee‘s earnings may be just enough to keep them in that particular job rather than taking a similar job with a different employer. In this case, from the perspective of Google, the payments to the employee contain no rent.

Question 11 The talents required to play major league baseball are very scarce, and the marginal revenue product is high, so those talents earn large economic rents.

The other workers listed clearly do things of value, but many people can be trained to do those jobs.

Since the talents required are less scarce, there is a lower equilibrium wage. The ―paradox of value,‖ comparing diamonds to water, is relevant to this issue.

Question 12 As we will see in a box in Chapter 18, a tax applying to economic profits (at a lower rate than 100%) will raise revenue for the government without altering firms’ supply decisions.

The reason is straightforward: as long as economic profits are positive, the firm has an incentive to continue producing because it can earn more through this activity than through its next best alternative, its transfer earnings (because the firm’s opportunity costs are included as part of its economic costs). So if economic profits are positive before taxes, they will still be positive (but lower) after the tax. It follows that the firm would still be earning more than its transfer earnings.

Economic profit is not always the same thing as economic rent (see the three examples of rent in the text), although it often is. If the government could tax oil companies’ economic profits, it could both raise revenue and leave unchanged their supply decisions because the firm would still be earning in excess of its transfer earnings. In general, however, this is not the approach used by Canadian provincial governments when they collect royalties from oil-producing firms. The royalties usually apply to the firms’ revenues, or sometimes to their accounting profits. In either case, the imposition of royalties at high rates could alter

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the firm’s production decisions. However, in recent years when the price of oil has been very high, the royalties (typically at low rates) would still leave the firms’ economic profits significantly positive, thus leaving their supply decisions unaltered.

Problems Question 13 a) The completed table is below. Note that the MP is computed as the change from one level of L (and Q) to the next. For example, the MP of labour is 8 for the change of L from 4 to 5.

L 4 5 6 7 8 9 10 11 12

Q 40 48 55 61 66 70 73 75 76

w 10 10 10 10 10 10 10 10 10

p 4 4 4 4 4 4 4 4 4

MP — 8 7 6 5 4 3 2 1

MRP — 32 28 24 20 16 12 8 4

b) See the table above. For marginal product and marginal revenue product, the calculations are made for the change in output (or revenue) from one row to the next. So, for example, an MP of 8 applies for the change in output from 40 units to 48 units (4 workers to 5 workers). c) The firm should hire the next unit of labour as long as the marginal revenue product exceeds the marginal cost of the worker (which is the wage).

Following this rule, the firm will only hire an extra worker if profits rise as a result. d) Given the wage of $10, the firm should hire up to the point where the MRP of the last worker just equals $10. The 10th worker has an MRP of $12; the 11th worker‘s MRP is $8. Therefore, the firm should hire 10 workers, but not the 11th.

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Question 14 a) See the diagram below. (Note that the MRP is shown at the mid-points of the number of workers to show that it is associated with the change in the factor input.)

b) At a wage of $10 per hour, the firm should hire up to the 10th worker but should stop at that point. c) At a wage of $5 per hour, the firm should hire up to the 11th worker, but stop at that point. d) At a wage of $20 per hour, the firm should hire up to the 8th worker (who has an MRP of exactly $20). e) Since the firm‘s profit-maximizing rule is to hire labour up to the point where MRP equals the wage, the MRP curve shows the firm‘s optimal level of employment at any given level of the wage. Thus, the MRP curve is the firm‘s labour-demand curve.

Question 15 a) In a competitive labour market, the demand curve for labour is the same as firms‘ MRP curve for

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labour. So the MRP for the 10,000th hour of labour is $15 (at point D). b) At a market wage of $16 per hour, the quantity of labour supplied will be 12,000 hours per month whereas the quantity demanded will be only 8000 hours per month. The excess supply of labour will tend to push the wage down until the market clears. c) Assume the market is clearing (at point D) with a wage of $15 per hour and employment of 10,000 hours per month.

— total factor earnings = $150,000 per month (= $15 per hour × 10,000 hours) — transfer earnings of the 10,000th hour = $15 (at any lower wage that hour would not be supplied) — economic rent for the 10,000th hour of labour = $0 — transfer earnings of the 6000th hour of labour = $13 — economic rent for the 6000th hour of labour = $2 (= $15 wage − $13 transfer earnings) d) The demand curve for landscaping workers would shift to the right if either the workers‘ marginal product increased (perhaps because of firms‘ use of better equipment, which raises the MP of workers) or because of an increase in the price of landscaping services (which increases the landscaping firms‘ marginal revenue). ***** ________________________________________________ Chapter 14: Labour Markets and Income Inequality ________________________________________________ This chapter within labour

discusses many markets. It is

interesting issues divided into three

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sections: wage differentials, including a formal model of labour-market discrimination and a detailed examination of some recent research on the effects of minimum wages; labour unions, including some things that economists don’t know about the effects of unionization; and measures of income distribution and the causes of rising income inequality, including the potential policy responses. *** The first section examines the nature of wage differentials. We state clearly at the outset exactly what conditions would be required to have a single wage in the labour market. We begin by discussing wage differentials in competitive labour markets. We emphasize the substantial returns to formal education as well as to on-the-job training.

We then provide a simple model of labour-market discrimination to address another source of wage differential. This discussion leads to a new box on how the Indian Act has been an important source of legislated discrimination against Canada‘s Indigenous Peoples for over a century and how it has contributed to much weaker socio-economic outcomes among Indigenous Canadians. We then move on to discuss differentials in non-competitive markets.

This includes a brief discussion of unions, monopsony, and then bilateral monopoly. Finally, we discuss the economic effects of minimum wages, in both competitive and non-competitive markets, and review some of the mixed empirical evidence.

The second section of the chapter deals with labour unions. Even though unions do not play as large a role in the Canadian private sector as they do in other countries, especially many countries in Western Europe, they are still relevant in many individual industries, and students often see union issues discussed in the news. We begin with a brief discussion of the extent of unionization in Canada, both in the aggregate and across various industries.

We then move on to discuss the trade-off that unions

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face between wages and employment existence of a union wage premium.

and

also

the

The chapter‘s final section discusses the distribution of income and the phenomenon of rising income inequality. We introduce basic concepts from distribution theory. We then present Canadian and international data showing the trend over the past few decades toward rising income inequality. But we also make the point (and show the data) that, at least in Canada, increases in pre-tax income inequality over the past 50 years have not translated into equivalent increases in after-tax income inequality because of the success of Canada tax-and-transfer system.

Several possible explanations of rising income equality are examined, including skill-biased technical change, globalization, growing corporate concentration, the decline of labour unions, ―superstar‖ theory, the recent argument developed by Thomas Piketty, and more. Finally, we briefly discuss the challenges of designing policies to reduce income inequality.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1

a) identical (or equal) b) working conditions; inherited skills; human capital; discrimination c) human capital d) right; fall

Question 2 a) higher; lower

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b) lower; lower c) reduction; increase; fall d) increase e) average; above; one; all

Question 3

a) fallen; public administration (government) b) wages; number c) 10 (ten); union wage Question 4

a) land, labour, capital b) families (or sometimes individuals) c) same (or equal) d) unequal e) Gini coefficient; 0; 1

Review Questions

Question 5 The general point is that knowledge about proportions is relevant, but it does not suffice, as the examples suggest. (The answers below are not exhaustive.) a) Students should see at once that there may be differences in talents, in social and family pressures, and in other occupational opportunities as well as in artificial barriers. The shortage of great Jewish baseball players (Hank Greenberg and Sandy Koufax were notable exceptions) has often been noted by the owners of New York baseball teams. They recognized the potential drawing ability of Jewish superstars if they could be found. To the best of Copyright © 2026 Pearson Canada Inc.

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our knowledge religious prejudice has not been charged against professional sports in North America. b) ―Too few‖ male members of a relatively low-paid occupation may indicate discrimination, but it is unlikely to be discrimination against males. A more likely explanation is that there is discrimination against females in some higher-paid occupations, and this increases the supply of women to the lower-paid jobs. This is exactly the outcome predicted from the model discussed in the chapter. c) To determine the ―appropriate‖ number of females among the set of judges, we should probably take note of the representation of women among the total number of lawyers. Indeed, because the legal profession has only been open to women in large numbers since about 1970, an adjustment should probably be made for the fact that the age distribution of women lawyers is younger than that of either all lawyers or of judges. Having said that, one might profitably inquire as to whether discrimination accounts for the fact that, until recently, almost all lawyers were men. If it does, the notion of indirect discrimination is supported by the population comparisons. d) There may be discrimination among employers but there may also be discrimination among prisoners!

The latter would lead prisoners to react differently to male and female guards and lead employers to prefer the former for reasons unrelated to sex prejudice. e) There may be discrimination by school boards in favour of female teachers (and against male teachers) or there may be clear preferences by many males not to be school teachers.

f) It is unlikely that engineering departments discriminate against Copyright © 2026 Pearson Canada Inc.

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women when admitting graduate students; they are typically looking for the most qualified candidates, independent of race, religion, language, gender, and so on. But discrimination in the market for professional engineers (if it existed) would reduce the job prospects for female engineering graduates and thus reduce female applications to graduate programs. Even this explanation, however, seems unlikely, especially in recent years.

A more likely explanation would be that, for some reason due to preferences, women are less attracted to studying engineering than to studying other disciplines. g) It is very difficult to argue that black people are under-represented Copyright © 2026 Pearson Canada Inc.

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among business leaders because of a reduced preference for such a career. So, the underrepresentation of black people among business leaders is probably indicative of some kind of discrimination, either current or past. There may be current racial discrimination, for example, making it more difficult for aspiring black entrepreneurs to qualify for and receive bank loans to or receive a business licence. But even if there is no current discrimination, the result of past discrimination against black people may result in a smaller population of black people with the educational or financial assets required to launch a business career.

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Question 6 a) Pilots: the difference could be due to differences in working conditions, in which case the difference may be an equilibrium wage differential. Or the difference may be due to temporary differences in the two airlines‘ financial conditions, in which case the differentials may not persist. b) Construction workers: workers are generally mobile across regions and across sectors, and construction workers have shown themselves in recent years to be quite mobile. This mobility suggests that workers in other regions and sectors will flow toward Alberta‘s oil sands, thus reducing the wage there. However, if the high wages in the Alberta oil sands reflect bad working and/or living conditions, as is likely to be the case, than some wage differential will exist in equilibrium. So the current differentials are probably a combination of temporary and permanent effects. c) Dental surgeons and hygienists: dental surgeons have much more (and very costly) training than hygienists, and this probably accounts for most if not all of the wage differential. This is an equilibrium differential. d) Pilots and flight attendants: pilots require far more (and costly) training than do flight attendants, and this accounts for the wage differential. It is an equilibrium differential. e) Economists: the skills are similar and so is the training. But the nature of the jobs is quite different, and these differences account for the large wage differentials. Academic economists have tremendous flexibility and independence to write and say more-or-less what they wish, whereas bank economists are employees who speak on behalf of their employer and have little or no independence.

This is mostly a compensating, and thus equilibrium, wage differential.

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Question 7 a) The diagrams are shown below. The key difference between the two industries is the position of the supply curves. The demand curves can be the same or different, reflecting the marginal product of labour in each industry. We have assumed that all workers have the same inherent skills and the same preferences, but that non-monetary aspects of the two jobs are different. These differences tend to increase the supply of workers to the Pleasant industry and reduce the supply of workers to the Grimy industry. b) Wages are higher in the Grimy industry. Since workers all have the same skills, this wage differential does not reflect differences in skills. Instead, it reflects the undesirable working conditions in the Grimy industry. In equilibrium, workers must be indifferent between working in the two industries (otherwise they will move, and the equilibrium will change). So, wages must be higher in the Grimy industry to offset the negative nonmonetary aspects of the job in that industry. As we discussed in Chapters 13 and 14, this wage differential is called a compensating differential.

c) At the initial high wage, the improved working conditions in the Grimy industry will make the Grimy jobs more attractive than those in the Pleasant industry. Workers will then shift away from the Pleasant industry and move toward the Grimy industry. This movement will shift the supply curves to S in both diagrams, reducing the wage in the Grimy industry and increasing the wage in the Pleasant industry. This adjustment will continue until wages are once again equated across the two industries at wage w*.

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Question 8 This is a good question to apply the simple model of labour-market discrimination. a) This is a wage differential caused by skill differences. The MRP is higher for the highskilled chefs than for the lower-skilled servers, but also the supply of high-skilled chefs is less than that of low-skilled servers. The result is that the equilibrium wage for chefs exceeds that for servers. This is an equilibrium wage differential. b) Note that since men and women are equally skilled (on average), there will be equal fractions of male and female chefs (50 percent each), and equal fractions of male and female servers (50 percent each). Thus, on average, men and women earn the same wage.

There is no gender-based discrimination (and no market outcome suggestive of discrimination). c) Now suppose that employers discriminate in favour of men when they hire chefs. In this case, the supply of high-skilled female chefs declines, and so the supply curve in part (i) shifts to the left. At the same time, those high-skilled women who are excluded from working as chefs now seek jobs as low-skilled servers, and so the supply of labour in part (ii) shifts to the right. The result is that wages rise for male chefs and wages fall for all servers. d) In part (c), the wage differential between chefs and servers widens as a result of the discrimination. Before the discrimination, there was no male-female wage differential.

But after the discrimination, we see that only men earn the high wages earned by chefs.

Since some men earn the high wage, but all women earn the lower wage, it is clear that the discrimination has created a male-female wage differential—on average, men earn more than women even though on average they are equally skilled. e) Employers might come to recognize that the high-skilled female chefs are just as good (on average) as the high-skilled male chefs and begin to hire them. If they do so, the discrimination will slowly be reversed and the market outcome would return to its initial equilibrium, where the only wage differential is based on skills. Another possibility is that consumers begin to notice the discrimination and shun the restaurants that discriminate against female chefs. Once this happens, employers will have a clear financial incentive to make sure they hire qualified female chefs (and advertise that fact very well).

Question 9 This is an excellent example of the ―sample selection‖ problem in econometrics. If unionized workers and non-unionized workers were identical in every respect (age, education, years of experience, etc.), then a simple comparison of the average wage in unionized jobs and non-unionized jobs would indeed show the ―wage premium‖—that is, the wage premium due to unionization. But these two groups of

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workers are not identical. Moreover, even after controlling for many of those attributes of the workers (by using a multivariate regression, for example), there is still a sample-selection problem, because whether or not a worker is unionized is, to some extent at least, a matter of choice. And this element of choice must be correctly controlled for to get an accurate estimate of the pure union wage premium.

Question 10 a) Unemployment almost certainly increases the inequality of the size distribution of income.

Unemployment is not equally distributed among households of different incomes—it occurs disproportionately at middle and lower-income households. b) The answer really depends on the reasons for the population growth. If the city is enjoying new prosperity and new employment, average income will certainly be rising.

There is no necessary presumption, however, about the direction of the change in the size distribution of income caused by an increase in the local rate of growth. If some citizens get left behind, while others gain rising incomes, the size distribution may become more unequal. (Certainly landowners will gain an increase in relative wealth and incomes.) c) This will increase inequality in real (although not necessarily in money) incomes, since food is proportionately a larger share of the budgets of low-income families. d) An effective employment-insurance program is likely to decrease income inequality, at least between middle- and low-income groups. e) Most people that contribute to RRSPs and TFSAs are middle- and upper-income earners, and thus they are getting most of the benefits from such programs.

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awarded to income earned within an RRSP or TFSA (or to the initial contributions made to an RRSP) would hurt middle- and upper-income people the most, and have less of an effect on lower-income earners. The size distribution of income would probably become less unequal. f) The COVID-19 pandemic almost certainly increased the inequality of income, as the majority of people who lost their jobs were those in lower-wage, service-sector positions—such as restaurant servers, retail clerks, hotel workers, airline attendants, etc. Working in the other direction, however, is the collection of government programs designed to provide income relief to these people. (And there is some evidence that many people in Canada actually received more in relief payments than they lost through unemployment.)

Question 11 a) This appears to be a concern about the availability of suitable daycare services (probably especially for lower-income families) and thus appears to be more a concern about poverty than income inequality. Presumably the mere existence of some very rich families is not a fundamental cause of the lack of availability of daycare to lowerincome families. b) Suppose the government maintained the current income-tax rates. At the same time, if the government provided low-cost daycare services directly, or subsidized the private provision of such services, this would have little or no effect on the after-tax distribution of income. Such daycare policies would have no direct effect on market incomes, income-tax rates, or financial transfers to households, thus leaving the after-tax income distribution unaltered. c) Despite the answer to (b), this policy would have a potentially large impact on the spending

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259

patterns and overall cost of living, especially important for lower-income Canadians. Faced with accessible and affordable daycare services, many Canadian families would now find that they can spend less on daycare (than before the policy change) and thus spend more on other things. So even though the policy would not affect the aftertax distribution of income, it would surely help many Canadian families.

Problems

Question 12 a) See the diagram below. The competitive equilibrium in this labour market would have employment L* and wage w*.

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b) With a binding minimum wage in a competitive labour market, the wage rises to wmin and this increase in the cost of labour leads firms to reduce their level of employment to Lmin. c) In the absence of the minimum wage, a monopsony in the labour market would reduce employment and also reduce the wage relative to the levels in the competitive labour market.

The monopsonist maximizes profits by choosing a level of employment where the marginal cost of labour is equal to the MRP of labour (which is given by the demand curve).

The monopsony outcome is a wage wp and employment Lp. d) Beginning with the monopsony outcome (wp, Lp), if the government introduces a minimum wage below w* but higher than wp, then both wages and employment will rise—the labour-market outcome will move from point A to some point like B (the precise location of point B depends on the minimum wage, but it will be on the supply curve above point A). e) Binding minimum wages do not always reduce employment. If minimum wages are introduced into a competitive labour market, then wages will rise and employment will fall. But if they are introduced into a market in which a single buyer of labour is using its market power to keep both wages and employment below their competitive levels, then the effect may be to increase both wages and employment. Of course, a very high minimum wage introduced into a monopsonized labour market may still reduce employment—this is the case where the minimum wage is so high that it occurs above the intersection of the MRP and MC curves.

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Question 13 We start in a situation in which each of the 600 workers is paid $5000 as their monthly wage. So $5000 is the average cost of labour (the average monthly wage). If this monthly wage must increase to $5100 for all workers in order to attract one additional worker, the marginal cost is the $5100 for the 601st worker plus the extra $100 for the first 600 workers. So the marginal cost of labour is ($100)(600) + $5100 = $65 ,100.

Question 14 a) The supply curve for labour shows the number of workers that are prepared to work at various hourly wages. This is shown by the first two columns in the table. The demand curve for labour is the firms’ MRP of labour, shown in the last column. The scale diagrams are shown below.

b) The MRP curve is the firms‘ demand for labour.

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between $17 and $18 and at a level of employment of about 230 workers. c) The marginal cost of labour (as seen by a single buyer of labour—a monopsonist) is the change in total labour cost divided by the change in the number of workers hired. We compute this marginal cost as a change from one row in the table to the next. For each interval of employment (L), the values are shown below.

L = 50 to L=100: 700 / 50 = 14 L = 100 to L=150: MC 900 / 50 = 18 L = 150 to L=200: MC 1100 / 50 = 22 L = 200 to L=250: MC 1300 / 50 = 26 L = 250 to L=300: MC 1500 / 50 = 30 L = 300 to L=350: MC 1700 / 50 = 34

MC = (1200 – 500) / 50 = = (2100 – 1200) / 50 = = (3200 – 2100) / 50 = = (4500 – 3200) / 50 = = (6000 – 4500) / 50 = = (7700 – 6000) / 50 =

d) The monopsonist maximizes profits when employment is set such that the marginal cost of labour equals the marginal revenue product of labour. In the diagram this occurs where the MC curve intersects the MRP curve. In this case, the monopsonist maximizes profits by employing only 175 workers and offering a wage (along the S curve) of only $15. So the single buyer of labour uses its market power to reduce employment and reduce the wage it pays to its workers (relative to what would occur in a competitive labour market).

Question 15 a) The equilibrium wage is where the quantity of labour demanded equals the quantity of labour supplied. The equilibrium wage is $425 per week.

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The equilibrium level of employment is 4875 units of labour. b) After unionization, the wage rises to $500 per week. Assuming that firms are free to choose the level of employment (the firms‘ ―right to manage‖), then employment will be determined by the labour demand curve. Employment will be 4500 units. c) At the higher wage of $500 per work, the quantity of labour supplied is 5625 units of labour. So unless the union can restrict the supply of labour, there will be 1125 units of labour unemployed.

Question 16 a) Since 6‗2‖ is much taller than average, the height requirement will very likely restrict the supply of couriers, thus shifting the supply curve to the left and driving up the wage rate for bike couriers. b) See the figure below. If the couriers form a union and impose a minimum acceptable wage of $15 per delivery, then the new supply curve is horizontal at $15 and extends from point A to B, and then proceeds up the S0 curve. The higher wage will reduce the quantity of couriers demanded, to QU in the figure.

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c) If the local government imposes a legal minimum wage of $13 per delivery, the new supply curve is given by CDS0, as shown in the figure below.

Employment would be determined by the demand curve and equal to QMW, less than Q0.

Question 17 a) The completed table is shown below.

Household Income Rank

Percenta ge of Aggregat e Income

Cumulati ve Percenta ge

Lowest fifth

6.8 14.1

6.8 20.9

21.5

42.4

26.2

68.6

31.4

100.0

Second fifth Third fifth Fourth fifth Highest fifth

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b) The scale diagram is shown below. The Lorenz curve is the plot of the third column (cumulative percentage) in the table above.

c) The extent of income inequality in Fantasyland is shown by the deviation of the Lorenz curve from the diagonal. With perfect equality, the Lorenz curve would lie along the 45-degree line. The more unequal the distribution of income, the further away from the diagonal is the Lorenz curve. d) The system of income redistribution will, if effective, reduce the extent of income inequality and thus shift the Lorenz curve closer toward the diagonal. Note that we now have two Lorenz curves— Copyright © 2026 Pearson Canada Inc.

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one for pre-tax (and transfers) and the other for post-tax (and transfers). ***** ______________________________________________ Chapter 15: Interest Rates and the Capital Market _______________________________________________ This chapter examines the market for financial capital and the determination of the equilibrium interest rate. We carefully explain the connection between physical capital and financial capital, and how financial intermediaries bring together the investment plans of firms with the saving plans of households. The chapter includes an extensive discussion of present value as it relates to firms‘ investment decisions. *** The chapter begins with a brief overview of capital markets in which capital is supplied mostly by households wishing to save and demanded by firms wishing to increase their capital stock through investment.

We discuss briefly the role of financial intermediaries, even though we emphasize that the rest of the chapter focuses only on the behaviour of households and firms.

The first substantive section presents the concept of present value in considerable detail. We analyze the valuation of single future payments as well as a stream of payments into the future. By using examples and carefully altering the size of the payments, the interest rate, and the length of the payment stream, students see the individual determinants of present value.

The chapter then discusses firms‘ investment demand, in which present value plays a central role. We emphasize the relationship between the

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interest rate and aggregate investment demand. We also show how technological progress that increases the marginal product of capital leads to an increase in the quantity of investment demanded (at any given interest rate).

The next section briefly examines households‘ supply of saving.

We emphasize three main determinants of household saving: current income, expected future income, and the interest rate.

The final section puts demand and supply together to examine capital-market equilibriumin particular, the determination of the equilibrium real interest rate.

The comparative statics analysis considers the effects of technological progress, population and income growth, and policies directed at encouraging either saving or investment.

A boxed discussion explains the difference between real and nominal interest rates in the presence of inflation. This section should help students understand what is really going on in the capital market when shocks of various types occur.

The chapter concludes by considering Canadian data and using the model to explain the observed upward trend in the capital stock with no clear trend in the real interest rate. This discussion then leads to a new box on one of the most important types of investment—residential construction—and the ongoing housing crisis in Canada. The box lays out several demand-side and supply-side factors at play, as well as some possible policy approaches to restoring housing affordability.

Answers to Study Exercises

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Fill-in-the-Blank Questions Question 1 a) physical capital b) increase c) increase; increase d) reduce; reduce; reduction e) rightward shift; movement up and to the left along Question 2 a) reduce; increase; increase b) increase; rightward shift c) increase; reduction; reduction; leftward shift (or decrease) Question 3 a) the quantity of capital demanded equals the quantity of capital supplied; exceeds; reduction b) exceeds; increase c) reduction; increase; increase d) increase; increase; increase e) increase; upward trending; no clear trend Review Questions

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Question 4 a) This pattern is explained by the principle of diminishing marginal product of the variable factor. As the stock of capital rises (holding the amounts of other factors constant), each successive unit of capital contributes less to output (and revenue) than the previous unit. b) A profit-maximizing firm should purchase a unit of capital as long as the PV of the future MRPs of the capital exceeds its purchase price. If a unit of capital costs $5000, the profit-maximizing firm will purchase 105 units of capital. It would decrease profits to purchase the 106th unit because it would add more to costs ($5000) than to revenues ($4000). c) At a lower interest rate, the discounted present value of the given stream of future MRPs increases (because the interest rate is in the denominator of the PV computation). Thus, if the price of capital were to remain at $5000 per unit, the firm would adjust its profit-maximizing level of capital—it would purchase more units of capital. Graphically, this is a movement down along the firm‘s demand curve for capital.

Question 5

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a) The purchase price of a new snowplow is $50,000. At a 4% interest rate, the PV of the snowplow is also $50,000. The firm should be indifferent about purchasing the snowplow in this situation. b) If the interest rate is instead 6%, the PV of the same stream of future MRPs will be lower. With the same purchase price of $50,000, the firm should not purchase the snowplow. c) If the interest rate is instead 2%, the PV of the stream of future MRPs will exceed $50,000. The firm should definitely purchase the snowplow if the price is still $50,000. d) Back to the 4% interest rate. If the price of home snowblowers is now expected to fall, then it is likely that the demand for snow-clearing services will decline, thus reducing the future stream of MRPs. If the purchase price for a snowplow is still $50,000, the firm should not purchase it. e) A booming economy in Wintertown is likely to increase residential developments and the demand for snow-clearing services, thus increasing the future stream of MRPs. The firm should now purchase the snowplow at the $50,000 price.

Question 6 a) The firm will compute the stream of expected MRPs from each unit of Copyright © 2026 Pearson Canada Inc.

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capital, and then purchase all units of capital for which the purchase price is less than or equal to that unit’s present value of the stream of MRPs. The present value of the stream of future MRPs depends negatively on the interest rate—that is, a fall in the interest rate raises the present value of any given stream of MRPs. Thus, for a given purchase price of capital, a decline in the interest rate raises the PV of capital and leads the firm to purchase more units. This means a larger flow of desired investment.

Thus, the firm’s investment demand curve is downward sloping. b) An ―especially good market‖ for its product in the future means that the future MRP from any unit of capital increases (because the firm‘s product price increases). This increase in MRPs leads the firm to desire more units of capital, meaning a larger flow of desired investment. Hence there is a

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rightward shift in the firm‘s investment demand curve. c) The technical problem reduces the stream of future MRPs (because the future marginal product of capital declines) and thus leads to a leftward shift in the firm‘s investment demand curve. At any given interest rate, the firm purchases fewer units of new capital (i.e., a smaller flow of desired investment).

Question 7 a) Evaluate the company‘s expected stream of profits at the expected world prices of oil over the lifetime of the reserves. Add to the market rate of interest a risk premium for the uncertainty of the world price and discount to find the present value of the flow of profits. b) Estimate its price path over time and discount at the market interest rate plus any risk premium for uncertainty about the demand (and thus the market price) for the resource. c) Add a risk premium (to reflect the possibility of the government defaulting on the debt) to the market interest rate and discount to find present value. d) The original purchase price of the ticket is irrelevant––although some students will not think so. The expected value of a single ticket, if the drawing were to take place now, would be $2 (the $2 million prize divided by the 1 million tickets). To find the present value of the drawing in one year‘s time, discount the $2 by the market rate of interest (no further risk premium is needed). Clearly, the $10 purchase price is excessive.

Question 8

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a) A rise in the interest rate implies that current consumption is more expensive in terms of foregone future consumption. Thus, the substitution effect of a rise in the real interest rate is to reduce current consumption and increase current saving. b) The income effect of a rise in the interest rate depends on whether the household is a borrower (net debtor) or a lender (net creditor). For lenders, a rise in the interest rate increases their purchasing power and probably leads to more current consumption and less saving. For borrowers, a rise in the interest rate reduces their purchasing power and probably leads to reduced current consumption and more saving. c) When we aggregate over all households in the economy, the income effects for borrowers tend to offset the income effects for lenders. We are then left with the aggregate of the substitution effects, all of which operate in the same direction, tending to increase households‘ desired saving when the interest rate rises. d) Because the aggregate of the substitution effects almost certainly outweighs the aggregate of the income effects (of a rise in the interest rate), the aggregate supply of saving curve is upward sloping. In other words, a rise in the interest rate increases the aggregate quantity of saving supplied because substitution effects dominate income effects (in the aggregate).

Question 9 The first statement is correct and is simply the statement that firms‘ profit-maximizing investment demand curves are downward sloping, as we discussed in detail in the chapter. The second statement, however, is incorrect. We should only ever expect to see a negative correlation between actual investment and the interest rate if we know that the aggregate Copyright © 2026 Pearson Canada Inc.

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investment demand curve is stablein this case, changes in the interest rate caused by changes on the supply side of the capital market will lead to movements along a stable investment demand curve.

However, it is entirely possible that changes in firms‘ expectations of future business prospects or changes in technology are the fundamental shocks, leading to changes in the equilibrium interest rate.

In such cases, with the supply side of the capital market stable, the changes in investment demand will lead to a positive correlation between actual investment and interest rates.

More realistically still, there will be shocks on both the demand side and the supply side of the capital market at the same time. Thus, there is no reason to expect any particular correlation between actual investment and real interest rates.

Problems Question 10 a) The PV in this situation = ($1000) / (1.035) = $966.18. b) The PV in this situation = ($1000) / (1.035)3 = $901.94. c) The PV in this situation = ($1000) / (1.035) + ($1000) / (1.035)2 + ($1000) / (1.035)3 = = $966.18 + $933.51 + $901.94

=

$2801.63. d) We are not given the interest rate so cannot compute the PV. But if r is the annual (compounded) interest rate, the PV = ($1 million) + ($1 million) / (1 + r) + ($1 million) / (1 + r)2. e) Call the necessary deposit D. In order to withdraw $5000 one year from now, we must have D(1.04) = $5000. So, D = $4807.69. f) To answer this question, we compute the implied interest rate of your friend‘s loan. Call this r*.

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We determine r* with the following relationship: ($12,000) × (1 + r*)2 = $13 ,500. So we have (1 + r*)2 = 1.125, which yields r* = 6.07 percent. If you can borrow instead from a commercial bank at 4 percent, you would be better off to do so.

Question 11 a) The present value of each asset is equal to the discounted stream of payments (discounted back to the present period). We assume for this question that the first payment takes place one year from now, the second payment two years from now, and the third payment three years from now. In this case, the PV of the four assets are: A: PV = $1000 / (1.08) + 0 + 0 = $925.93 B: PV = 0 + 0 + $5000 / (1.07)3 = $5000 / 1.225 = $4081.49 C: PV = $200 / (1.09) + 0 + $200 / (1.09)3 = $183.49 + $154.44 = $337.93 D: PV = $50 / (1.10) + $40 / (1.10)2 + $60 / (1.10)3 = $45.45 + $33.06 + $45.08 = $123.59 b) In each case, the most the firm would be willing to pay to purchase the asset is the asset‘s present value. At any higher price, the firm is better off lending its money at the interest rate.

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c) If the asset‘s listed selling price is less than its present value, all firms would want to purchase it. There will be an excess demand for the asset that will cause its price to rise. From the argument in part (b), at any price above PV there will be an excess supply that will cause the asset‘s price to fall. Thus the competitive equilibrium asset price is the asset‘s present value.

Question 12 We assume for this question that the revenues occur at the end of each year so that the first year gets discounted back to the present. a) PV = $9000 / (1.02) + $9000 / (1.02)2 + $9000 / (1.02)3 = $8823.53 + $8650.52 + $8480.90 = $25 954.95 b) PV = $9000 / (1.03) + $9000 / (1.03)2 + $9000 / (1.03)3 = $25 457.70 c) PV = $9000 / (1.06) + $9000 / (1.06)2 + $9000 / (1.06)3 = $24 057.11 d) PV = $9000 / (1.10) + $9000 / (1.10)2 + $9000 / (1.10)3 = $22 381.66

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Question 13 In each case, the opportunity cost of spending $1000 this year is the amount that could instead be purchased next year if the $1000 is saved now and it accumulates at the interest rate. a) $1000 × (1.05) = $1050.00 b) $1000 × (1.07) = $1070.00 c) $1000 × (1.09) = $1090.00 d) To answer this question we need to think about the separate income and substitution effects associated with an increase in the interest rate.

Students might want to review these concepts from Chapter 6.

A rise in the interest rate implies that current consumption is more expensive in terms of foregone future consumption—because the higher interest rate means that any amount saved today would become a larger amount in the future. So we can say that the relative price of current consumption, in terms of foregone future consumption, rises when the interest rate increases. The substitution effect of a rise in the real interest rate is to reduce current consumption and increase current saving.

The income effect of a rise in the interest rate is the increase in the lifetime purchasing power caused by the increase in the interest rate. This depends crucially on whether the household is currently a borrower or a lender. A borrower‘s lifetime income falls when the interest rate rises Copyright © 2026 Pearson Canada Inc.

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because they have to pay this interest rate. A lender‘s lifetime income rises when the interest rate rises because they receive this interest rate.

However, when we aggregate over all households, the income effects for borrowers tend to offset the income effects for lenders. We are left with the aggregate of the substitution effects, suggesting that households increase their desired saving when the interest rate rises. This explains the positive slope of the supply curve for capital.

Question 14

a) See the diagram below. The tax credit makes investment more profitable and shifts the investment demand curve to the right, from I1 to I2. For an unchanged supply of saving curve, the result is a higher real interest rate and larger flows of both investment and saving (the flow of investment increases from I* to I**). b) There is no contradiction. The increase in investment demand led to the increase in the equilibrium interest rate. The flow of investment was able to increase only because the higher interest rate induced households to increase their desired saving, thus ―financing‖ the greater desired investment by firms. The I curve is still downward sloping, showing a negative relationship Copyright © 2026 Pearson Canada Inc.

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between interest rates and the flow of desired investment (for any given pattern of future MRPs).

c) The tax credit makes saving more attractive and shifts the S curve to the right, from S1 to S2. If we begin with the initial investment demand curve, I1, the real interest rate falls and the flows of both investment and saving rise. The way the diagram is drawn, the equilibrium flow of investment increases in this case from I* to I**. d) Again, there is no contradiction. The interest rate fell because of the increase in the supply of saving. The flow of saving was able to rise only because the lower interest rate induced firms to absorb this greater flow of financial capital by increasing their desired investment. The S curve is still upward sloping, slowing a positive relationship between real interest rates and the flow of desired saving (along any given S curve). *****

____________________________________ __ Part Six

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Government in the Market Economy

____________________________________ __ This Part of the book is designed to ensure that students understand the role of government policy in modifying the outcomes in a free-market economy. If instructors feel pressed for time (as they often do), we recommend covering Chapter 16 in detail and then leaving Chapters 17 and 18 for students to read on their own. For those instructors and students who have specific interests in environmental issues, Chapter 17 includes a detailed treatment of pollution as an externality and examines several methods, including both direct regulations and market-based schemes, for dealing with pollution problems. It also presents a primer on the problem of global climate change, ideal for the many students who will have little systematic knowledge of the topic beyond what they get from the media.

Chapter 18 can also be left to students to read on their own, but the chapter deals with many Canadian tax and social policies that interested students may wish to discuss in class. *** Chapter 16 deals with market failures and the nature of government intervention. We begin by presenting the basic functions of government, which include the establishment and enforcement of laws that protect individuals from the arbitrary use of power. We then briefly review the case for free markets. We develop what we call the ―informal defence‖ of free markets, which emphasizes the flexibility of markets, the incentives for innovation, and the decentralization of economic power. This contrasts with the ―formal defence‖ of free markets based on the concept of allocative efficiency. The discussion then turns to various types of market failures, where we define a market failure narrowly as a situation in which the

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market fails to generate allocative efficiency.

These market failures include the presence of market power, externalities, public goods and commonproperty resources, and problems due to asymmetric information. We then address other motives for government intervention (such as altering the distribution of income and promoting social responsibility) that are not based on the pursuit of allocative efficiency.

The chapter then examines the basic tools of government intervention and includes a discussion of the direct and indirect costs of government intervention. Our belief is that introductory classes in economics too often discuss market failures and the role for government intervention without at the same time recognizing that government intervention is itself costly and imperfect. We therefore provide some balance to the discussion by addressing the important concept of ―government failure,‖ which is based on modern public-choice theory. The chapter contains several interesting boxes that help to illustrate the central theoretical concepts.

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Chapter 17 deals with environmental policy.

Given the current high profile of environmental issues and the increasing need for environmental protection, students are sure to find this interesting material. We have often found that students are intrigued with the idea of an optimal level of pollution greater than zero. We have an extensive discussion of the various methods of controlling pollution. We then turn to a detailed primer on the problem of global climate change, including a discussion of the nature of the ongoing international negotiations, the various policy approaches that might be effective, and a broad description of current Canadian climate policy.

Chapter 18 begins by discussing the basic elements of the Canadian tax system, and then proceeds to examine how to evaluate tax systems in terms of equity and efficiency. We then explore the nature of public expenditure, at which point we discuss Canada‘s system of fiscal federalism. The discussion of Canadian social policy includes the recent challenges of reforming the Canada Pension Plan and Old Age Security as well as the ongoing pressures for reforming the healthcare system. In the discussion of income-support programs, we have a box on how the negative income tax (with a guaranteed annual income) might be used as a means of avoiding poverty traps in which low-income households face very high marginal income-tax rates. *** Our view is that Chapter 16 contains crucial information for introductory students and should not be skipped by instructors. (In contrast, students who have carefully reviewed Chapter 16 could work on their own through Chapters 17 and 18.) Students cannot even begin to think clearly about government‘s appropriate role in the economy without understanding three fundamental points:

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 the concept of market failure, and why allocative efficiency is a desirable goal;  that governments usually have reasonable motives for intervention that go beyond the pursuit of allocative efficiency; and  that tools of government intervention are blunt and imperfect and thus all government intervention imposes some costs on society.

Students need to know that government intervention is only warranted in economic terms if the benefits of the intervention are greater than the costs. They also need to know why it is difficult to precisely determine these costs and benefits. In short, students need a balanced view—they need to know why the question regarding the ―best‖ level of government in the market economy is a question requiring a complex and qualified answer. There is little here that is black or white.

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____________________________________________________ _ Chapter 16: Market Failures and Government Intervention _______________________________________________ ______ This chapter does several things. First, it discusses the very basic functions of government, including the establishment and enforcement of laws.

Second, it presents what we call the ―informal defence‖ of free markets—a defence not based on the idea of allocative efficiency but based instead on the advantages in terms of flexibility and incentives for innovation. Third, it introduces the concept of a market failure, defined as a situation in which the free market fails to generate allocative efficiency. It also examines several sources of market failure, including market power, externalities, public goods, common-property resources, and asymmetric information. Fourth, the chapter discusses the various reasons governments may choose to intervene that are unrelated to allocative inefficiency.

Finally, the chapter introduces some basic ideas about government intervention. We note that markets may work but that markets may also fail; the parallel proposition is that government intervention may work and government intervention may also fail. This chapter attempts to pull together much of what can be said at an introductory level on these matters. *** The chapter‘s first section briefly discusses the most basic functions of government, especially the establishment and enforcement of laws and the protection of property rights. We then present the ―informal defence‖ of free markets. The formal defence is based on the concept of allocative (Pareto) efficiency, and was discussed extensively in Chapter 12 (and also Chapter 5). But we have

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found that students are often more interested in, and willing to accept, the informal defence of free markets––the arguments that free markets are extremely flexible, provide a stimulus to innovation, and reduce the concentration of political and economic power.

The chapter then turns to a detailed discussion of market failures. We use the term market failure to refer only to situations in which the free market fails to achieve efficient resource allocation. It is too much to expect the market to produce the ―right‖ distribution of income, especially since there is no agreement on what that right distribution is, and so we do not use the term market failure to describe the more normative motivations for government intervention.

Our discussion of market failure is detailed. We discuss market power, externalities, public goods, commonproperty resources, and problems of asymmetric information. There is a box on the world‘s endangered fish, another on the ―lemons problem‖ of adverse selection, and a brief discussion of how the policy response to the 2008 financial crisis generated concerns of moral hazard in the banking sector. Our discussion of public goods leads to a policy debate podcast addressing the issue of whether rich countries should pay Brazil to stop the cutting of the Amazon rainforest, since its aircleansing properties are a global public good.

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The chapter‘s fourth section examines other motivations—aside from allocative inefficiency—for government intervention. Here we emphasize why the free market may generate outcomes that do not accord with certain social goals.

The main motivations are to redistribute income, to have some specific goods provided publicly rather than privately, to protect individuals from others (and sometimes from themselves), and to promote social responsibility.

We provide justifications for government intervention even when the market may already be allocatively efficient. It is useful as a reminder that much of the debate about the proper role of government represents a continuing evaluation of the conflicts among various objectives, each of which may be regarded as desirable (e.g., both equity and efficiency).

The final section of the chapter presents a fairly high-level discussion of the tools and costs of government intervention. We also discuss the reality of government failure. Anyone who has been involved in policy decisions knows that government intervention can produce failures on a par with free-market failures. We try to produce a balanced discussion by pointing out the many ways that government intervention can fail just as free markets can fail. We characterize the field of public-choice theory as the application of economic analysis to political and governmental issues.

Beyond its intrinsic interest, it provides an illustration of how to analyze the costs and benefits of government intervention when there is government, as well as market, failure. We stress that decision makers‘ objectives may not coincide with the public interest, an application of the principal-agent problem. In short, we strive to present a balanced and realistic view of government intervention, both its strengths and weaknesses. ***

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We think the material covered in this chapter is extremely important.

If you have been following the book’s order of topics in your classroom lectures, then your students have learned much about markets—including product markets, factor markets, competitive markets, and imperfectly competitive markets.

They have learned about allocative efficiency. However, except for the discussion in Chapter 12 dealing with regulation of natural monopolies and competition policy, your students do not yet have a sense of the many types of situations in which markets fail to produce a socially desirable outcome. It is crucial that they be Copyright © 2026 Pearson Canada Inc.

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exposed to these possibilities. It is equally crucial, however, that your students recognize that the free market’s failure to achieve allocative efficiency is not immediately a justification for government intervention. In many cases, government intervention might not be able to correct the market failure; in others, the cost of government intervention may exceed the welfare losses of the initial inefficiency. This chapter, if presented carefully and in detail, can leave your students with a much better overall sense of what markets can and cannot do, and of what government policy can and cannot do. We hope you share our view of this chapter’s importance Copyright © 2026 Pearson Canada Inc.

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and devote the necessary time to explaining these issues.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) marginal cost; allocatively efficient

b) free markets:  provide automatic coordination of the actions of decentralized decision-makers  provide incentives for innovation  permit the decentralization of economic power c) a market failure d) market failures include:  monopoly (or market) power  externalities  non-rivalrous and non-excludable goods (public goods); rivalrous and non-excludable goods (common -property resources)  asymmetric information Question 2 a) private marginal cost; social marginal cost; externalities

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b) private marginal benefit; social marginal benefit; positive externality c) equal d) negative; greater than; many e) positive; greater than; few

Question 3 a) private; free market b) common-property resource; overused c) zero; zero d) public goods; free-rider e) moral hazard f) moral hazard (and maybe also adverse selection, depending on the insurance)

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Question 4 a) social goals b) income distribution c) paternalism d) preference e) reduces; does not

Review Questions Question 5 Each of these examples can be treated at length as a policy question, or in more limited fashion. We think it is worth pushing discussion in every case to the point where students come to realize the real choices involved in balancing benefits against costs. They should also realize that some of their views of the proper action may depend on who actually bears the costs (or receives the benefits) and who they think should bear the costs (or receive the benefits).

a) Smoking is interesting because it raises the question of whether damage that people may do to themselves and to others constitutes a neglected social cost. There is room for debate here. The danger that the smoker (or his or her family) will become a drain on the Copyright © 2026 Pearson Canada Inc.

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public purse (healthcare costs) is sometimes seen as a flimsy argument on which to base a policy of interfering with free choice, but the argument has certainly been used. The notion that the old man with lung cancer is a different person than the young man that he was twenty years earlier may provide an appealing basis for calling this an externality. Evidence that second-hand smoke is a health danger to non-smokers clearly strengthens the externality argument (social costs greater than private costs) and thus strengthens the case for intervention. b) If weather forecasting is actually accurate (often debatable!), then it is valuable information to all who Copyright © 2026 Pearson Canada Inc.

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receive it. So the social benefits are far greater than the benefits that accrue only to the private individual or institution that does the forecasting. There is a clear argument here for government to play a role in financially supporting the forecasting or doing it outright.

(As we see in this chapter, information is often a public good, and thus there is often a strong justification for its provision by the government.) c) and d) In the cases of gun ownership and drilling for offshore oil the negative externalities are obvious—possible harm to others and possible harm to the environment—so that the social costs of the action exceed the Copyright © 2026 Pearson Canada Inc.

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private costs. A general issue lies in how to distinguish between an activity that we wish to permit (e.g., drilling for oil) and one that we wish to prohibit (e.g., drilling for oil carelessly in a way which creates costly oil spills). What determines the distinction? Partly it is the balance of private gain against public danger in the activity, partly it rests on the ability to devise alternatives if the activity is prohibited. The prohibition of the use of offshore oil would raise costs of domestic oil. Gun control is a matter on which people feel strongly, with important regional differences. e) The positive externalities from public health research are similar Copyright © 2026 Pearson Canada Inc.

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to those for weather forecasts: the benefits to the general public that come from having good information (regarding new diseases, new treatments, etc.). So the social benefits of the information exceed the private benefits to those who produce the information. There is thus a strong justification for government to financially support such research, or to conduct the research in government labs. f) Vaccinations for COVID-19 (or any other contagious disease) involve important positive externalities. By receiving an effective vaccination, any individual’s chances of contracting the disease is reduced; this is the private benefit. The social benefit is Copyright © 2026 Pearson Canada Inc.

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that one individual being vaccinated reduces the probability that the disease spreads to others.

This is a case where the social benefits of one vaccination exceed the private benefits.

Question 6 The key to this question is to clearly identify the ―action‖ in question, and then to determine whether this action imposes costs or confers benefits on third parties.

Activity

Blow smoke in others’ faces.

Cut your lawn early on Sunday morning.

A firm conducts R&D and generates basic knowledge that is freely available.

A firm produces aluminum and toxic waste as a byproduct.

Positive or Negative Externality?

Smoking generates a negative externality (as most others do not like the smoke in their faces).

Cutting your lawn generates a negative externality (as most others want to sleep on Sunday mornings).

Investing in R&D generates a positive externality (if the knowledge created is of value).

Producing aluminum generates a negative externality (since the toxic waste is harmful to some water, air, etc.).

MCS greater MBS greater than or less than or less than MCP? than MBP? There is a cost to others, so MCS > MCP. There is a cost to others, so MCS > MCP.

There is a benefit to others, so MBS > MBP.

There is a cost to others, so MCS > MCP.

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Question 7 a) In the absence of government intervention in this market, the equilibrium price and quantity would be determined by demand and supply, where the supply curve is the MCP curve. The equilibrium price and quantity are p* and Q*, as shown in the figure below.

b) There are positive externalities associated with the vaccination of individuals. The benefits accrue to third parties because those individuals who use the vaccinations are less likely to pass the disease on to others. These external benefits mean that the social marginal benefits of each vaccination are greater than the private marginal benefits. c) The positive externality results in the MBS curve lying above the MBP curve. The vertical distance between the two curves is the magnitude of the marginal external benefit. In the diagram above, the socially optimal quantity of vaccinations is Q**, determined by the intersection of the MCP curve and the MBS curve. d) The positive externality in this market suggests that the free-market outcome will be inefficient, with too few vaccinations being consumed and Copyright © 2026 Pearson Canada Inc.

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produced.

If the government subsidized the production or consumption of vaccinations, it could bring about an increase in the quantity of vaccinations and thus improve the efficiency of the outcome. So there is a clear efficiency motivation for government intervention in this market. But the government could also choose to do this on equity grounds. The argument would be that low-income people should not be less able to access vaccinations than high-income people (which is the basic equity argument for the public provision of healthcare services), and government intervention of this kind could improve accessibility.

Since vaccinations can impose private marginal costs in the form of reaction to the vaccination, the government may have to require them to prevent people from free riding off of other people having the vaccination. If everyone but my child is vaccinated, my child will still get the benefits without bearing the costs. But if too many people follow this logic, there won‘t be enough people with the vaccination to prevent outbreaks.

Question 8 The private returns to higher education are high enough so that without public support people would still generally find it profitable to acquire education. The question is whether they would acquire, on average, ―too little.‖ Arguably, there is a positive externality arising from having a population that is generally well educated. This would justify some subsidy. Also, much research is undertaken in universities, and there is a publicgood component to research. Finally, the social norm of equal opportunity is supported by subsidy to lowincome students.

In principle, one would want to compare the world without subsidy with the current state of affairs. More practically, one could evaluate particular subsidies against the benefits discussed above. Do public universities make sense? Would

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needs-based tuition grants and expanded public support for research do just as well? What would be the important differences among such schemes? The point here is to get students thinking about public policy issues from an economic perspective, and the issue is a good one because, as university students, they will all be somewhat familiar with it.

Question 9

A good is rivalrous if one person’s consumption of the good diminishes the amount available for other people. A good is excludable if there is some way to prevent an individual from using it.

Laptop computer: This is a private good. It is both excludable and rivalrous.

Clothing: This is a private good. It is both excludable and rivalrous.

Library: It is excludable because entrance fees could be charged (even though they almost never are). As long as it is not filled to Copyright © 2026 Pearson Canada Inc.

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capacity, it is non-rivalrous.

However, any individual book within the library is rivalrous (at any given time).

Lighthouse: It is non-excludable because once it is operating there is no way to prevent someone from benefiting from the light. It is also non-rivalrous since my use of the light does not reduce the amount available for others.

Medical services: It is excludable because user fees could be charged (even though they generally are not charged in Canada). It is also rivalrous since one person’s use of a doctor’s time (or the hospital’s equipment) means that it cannot simultaneously be used for others.

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Published product safety information: In principle, this is excludable because individuals could be charged for the information. But it is difficult to see how individuals could be prevented from posting this information on the Internet, thus making it nonexcludable. It is non-rivalrous because all people (who have the information) can use it simultaneously and not diminish the amount available for others.

Pacific salmon: In principle, this is excludable because the owner (the government) can require fishermen to purchase licences (though enforcement is difficult). It is certainly rivalrous because one fish caught by one person cannot then Copyright © 2026 Pearson Canada Inc.

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be caught by another (unless sport fishermen are using a catch-andrelease strategy which does not hurt the fish). a) Which are public goods? This requires both non-excludability and non-rivalry. Lighthouses are probably a pure public good in this sense. Product-standards information is a public good if excludability is not feasible. b) Common-property resources display non-excludability and rivalry. Pacific salmon are clearly a common-property resource. A medical system with zero fees (at the margin) will also look like a common-property resource, though positive user fees make it appear like a private good.

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Question 10 a) Not all of these products are public goods: Heart surgery: This is both rivalrous and excludable, and so it is not a public good.

Primary schooling: This is both rivalrous and excludable, and so it is not a public good.

City bus transportation: This is both rivalrous and excludable, and so it is not a public good.

Public swimming pool: This is excludable and potentially rivalrous (if it is crowded). So this is a ―club good‖ when uncongested, but a private good when crowded.

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b) Governments often provide (or heavily subsidize) these products for various reasons: Heart surgery: Healthcare, especially for crucial things such as heart surgery, is often provided by governments ―for free‖ on the grounds of equity. It is believed by many people that healthcare is so important to quality of life that access should not be determined by one’s ability to pay, which is what would occur if health care was delivered only through private markets.

Primary schooling: Primary schooling is also viewed as so fundamentally important for an individual’s lifetime economic and social prospects (including being Copyright © 2026 Pearson Canada Inc.

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able to participate responsibly in our democratic system) that access should not be limited to those who can afford to pay. For this reason, most governments provide primary (and secondary) education for free to users, financed out of general tax revenues.

City bus transportation: Municipal governments usually provide some amount of subsidies to their public transit systems, although they usually require users to pay a price for each trip (or to purchase monthly passes). In other words, the revenues raised through ticket sales do not cover the full costs of the operation of the system.

Governments do this both to encourage ridership (to reduce Copyright © 2026 Pearson Canada Inc.

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traffic and road pollution) and also to provide a vital service to lowincome residents.

Public swimming pool: This is much like the case for city buses.

Municipal governments usually charge some amount for swimming, but typically not enough to cover all of the costs involved. Access to sporting facilities by low-income residents is one of the objectives, on equity grounds.

Question 11 a) For allocative efficiency, all goods should be produced (and consumed) until the marginal cost to society equals the marginal benefit to society. Uncrowded museums or highways have a Copyright © 2026 Pearson Canada Inc.

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marginal cost of zero because an extra person using the good does not increase costs for society. Thus, the price should equal zero so that consumers will use the good until their MB equals zero. b) Private firms will always charge a positive price because they need to make at least zero economic profits if they are to remain in the industry. And since providing these goods is costly (at least on average, even if not at the margin), positive prices are required to break even.

But the positive price immediately implies that consumers will move up their demand curves and thus consume less than what is socially optimal (MB will be greater than MC, which equals zero). Thus, if Copyright © 2026 Pearson Canada Inc.

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private firms provide these goods, allocative efficiency will not be achieved. c) Crowded museums and highways mean that marginal cost is positive because one additional person using the good imposes congestion costs on the other users. In these cases, allocative efficiency requires a positive price so consumers will reduce their consumption to the point where MB equals MC, which is positive because of the congestion.

Question 12 a) If residents have access to the grazing land at zero price, then the private MC of using the land is zero – the MCP curve is therefore Copyright © 2026 Pearson Canada Inc.

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coincident with the horizontal axis.

See the figure below.

b) With unrestricted access to the land (a price of zero), Q* grazing will occur because at this point the marginal benefits of grazing have been driven to the private marginal cost (zero). c) The outcome from part (b) is not efficient—there is too much grazing of this land. The problem is that at Q* the private (and social) marginal Copyright © 2026 Pearson Canada Inc.

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benefit of grazing is zero whereas the social marginal cost is much higher. This is the problem with over-crowded grazing land—too many animals are on the land. d) The efficient level of grazing is Q**, where the social marginal costs equal the social marginal benefits. But this will never occur as a market outcome if there is a zero price attached to the use of the land. e) If residents were charged a positive price for use of the land, the price would result in an upward shift of the private MC curve. If the price were chosen carefully, it would be set equal to p**. In this case, the private MC curve would become a horizontal line at p**, and Copyright © 2026 Pearson Canada Inc.

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the market outcome would then be efficient. f) If the common land were sold off in small parcels to the town’s residents, then (at least in principle) each land-owning resident could restrict access to his or her own piece of land. With restricted access, the problem of the ―tragedy of the commons‖ would be solved.

Each owner could use the land to the point where his or her own MB of land use was equal to his or her own MC of land use.

Question 13 a) From the discussion in Chapter 13, economic rent is a payment to a factor of production over and above what is necessary to keep that Copyright © 2026 Pearson Canada Inc.

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factor in its current use. When the pig farmers lobby the government for financial assistance, there is unquestionably a perceived need for assistance to the pig farmers— when the world price of pork declines, profits for pig farmers decline and some may be making economic losses. But some of the payments that might get paid to the pig farmers are probably economic rent in the sense that some of the pig farmers would continue to be pig farmers even in the absence of financial support. This type of lobbying is therefore called rent seeking. b) Lobbying for financial assistance may be privately productive but it is not socially productive.

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Successful lobbying may have a private payoff in terms of generating a payment from the government to the pig farmers, and it is this expected payoff that leads farmers to lobby. But the financial assistance is a redistribution of income from taxpayers to farmers, and so the private gains to farmers are matched by financial losses to other parties (taxpayers). If the farmers spend $500,000 and get nothing from the government, the cost to society (which includes the farmers) of the lobbying is the $500,000 of resources that is wasted. c) If the $500,000 is spent and changes government policy, then the overall cost of the lobbying is Copyright © 2026 Pearson Canada Inc.

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the $500,000 in direct lobbying costs plus any costs (or minus any benefits) created by the policy change. In the case where the policy is a pure lump-sum redistribution of money from taxpayers to farmers, the overall cost of the lobbying is the $500 000 direct cost of the lobbying (since the redistribution generates no net gains or losses for society). But if the change in policy assists pig farmers in a distortionary manner (as is likely), then the cost of the lobbying is the direct cost of $500,000 plus the costs of the distortions created by the change in policy.

Problems

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Question 14 a) If the production of each kilowatt hour (kwh) of electricity generates external costs of 25 cents, then the social marginal cost (for any given level of output) is given by the private marginal costs plus 25 cents. So the social marginal cost curve, MCS, is above the private marginal cost curve, MCP, curve by 25 cents, as shown in the figure below. b) In the absence of government intervention, and assuming that the market is competitive, the price and quantity will be determined by the intersection of the demand curve and the supply curve, which is given by the MCP curve. So the equilibrium price will be 10 cents per kilowatt hour and the equilibrium quantity will be 12 million kwh of electricity per month. c) The socially optimal allocation of resources is such that electricity is produced to the point where the MC to society is equal to the MB to society. The demand curve shows the MB to society of consuming units of electricity, and the MCS curve shows the marginal cost to society of producing electricity. So the socially optimal quantity of electricity is 8 million kwh per month and this would be the quantity demanded if the price were 30 cents per kilowatt hour.

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d) In the absence of government intervention, the free market will produce and consume too much electricity. If the government imposed a tax of 25 cents per kilowatt hour of electricity produced and required electricity-generating firms to pay this tax, then the firms‘ private MC curves would shift up vertically by 25 cents. At this point, the private MC curve (inclusive of the tax) would coincide with the social MC curve, and the externality would be fully ―internalized‖. The competitive market outcome in this case (with the tax) would be allocatively efficient.

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Question 15 a) The total value placed on the park by the 100 residents is $32,000. If the cost to build the park is $35,000, then the town should not do it because even if all residents used the park it would not generate total benefits to cover the total costs. b) If the park costs only $20,000 to build, then the town should do it because the total value to the residents is $32,000. Thus, there would be $12,000 of net benefits if the park were built. The city could pay for the construction of the park by levying general taxes (on income, property, or sales, for example) and then financing the park out of general tax revenues.

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c) If the town builds the park and then charges residents $50 for an annual pass, only those residents that value the park at or above $50 will purchase the pass (and use the park). From an accounting perspective, the park will make a loss since it costs $20,000 to build but the revenue from the annual passes will be only $50  90 = $4500.

Moreover, allocative efficiency is not achieved since the marginal benefit (the benefit of the marginal resident) equals $50 which exceeds the marginal cost to society, which is zero. (Note that the construction cost is not part of the marginal cost associated with the extra use of an already existing park.) This is a case of inefficient exclusion.

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Question 16 a) The profit-maximizing price for the monopolist is where MR equals MC. Since MC is $10, and MR = 100 – Q/25, we can solve for the quantity where MC = MR: 100 – Q / 25 = 10  Q* = 2250 (daily visitors) To solve for the profit-maximizing price (p*), substitute this Q* into the demand curve: p* = 100 – Q* / 50  p* = 55 (dollars) b) At the monopolist’s price of $55, the marginal benefit to consumers is $55 whereas the marginal cost is $10. This is not allocatively efficient; society would be better off

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if more people attended the water slides. c) If the government now purchases the water park and operates it with the objective of being allocatively efficient, it will set the price equal to marginal cost, at $10 for a daily pass. By reducing the price, it will attract consumers to the point where their marginal benefit (along the demand curve) is equal to the price, which now equals MC. This is allocatively efficient. Substituting this price into the demand curve, we can solve for the number of daily visitors: 10 = 100 – Q / 50  Q** = 4500 (daily visitors)

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d) With 4500 daily visitors, it is soon recognized that the line-ups are long and the park is crowded and less pleasant. The government determines that the ―true‖ MC curve (which includes the costs of congestion) is $10 up to a quantity of 3000, and then given by MC2 (as shown in the diagram in the question).

Allocative efficiency (as always) requires that the price be equal to the marginal cost. In this case, a price of $30 for the daily pass would result in a quantity demanded such that marginal cost also equals $30— an efficient outcome. Using the demand curve at a price of $30, we can determine the number of daily visitors: Copyright © 2026 Pearson Canada Inc.

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30 = 100 – Q / 50  Q*** = 3500 (daily visitors) e) Free and unlimited access to parks and museums and art galleries would likely lead to such a large quantity demanded that congestion costs would become a real problem. In such a situation, the true marginal cost of an extra person could be well above the zero price, with the result being that the park or museum is overused from an efficiency perspective. *****

___________________________________________________ Chapter 17: The Economics of Environmental Protection ___________________________________________________ Regulations are pervasive in our society, and they are used to correct all the types of market failures identified in Chapter 16. This chapter considers environmental policy in detail. The chapter is meant to provide detailed examples of how simple microeconomic theory can illuminate important and difficult issues of public policy. It also provides students with a primer on the problem of global

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climate change. In our view it is necessary that students have access to a systematic discussion of some of the key economic issues related to climate change. *** The first section examines the economics of pollution control. The analysis of externalities is central to this discussion. We review the logic of why pollution is a negative externality, increasing the marginal social cost of production (of whatever product is causing the pollution) above the marginal private cost. We also emphasize the importance for policy of internalizing externalities. A vital point is that the optimal level of pollution is typically not zero. Few mistaken ideas that many students hold are harder to unseat than the one that pollution ought to be prohibited at any cost. When students begin to recognize that the principle of marginal benefit equalling marginal cost applies here, too, they have finally begun to understand the basic message of microeconomics.

We then consider various methods used to control or reduce pollution. We begin with direct ―command and control‖ regulations—which often appear to the student to be the natural type of policy to use—and show why they often are inefficient because they do not minimize the cost of any given Copyright © 2026 Pearson Canada Inc.

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amount of pollution abatement.

However, there are situations where direct regulations are likely to be an efficient policy, and we discuss some examples. This leads to our discussion of emissions taxes and tradable pollution permits, now usually referred to as ―cap-andtrade‖ systems. We emphasize that tradable pollution permits and emissions taxes are very similar in the sense that they both force polluters to bear some costs and they both can achieve efficient (least-cost) pollution abatement.

The chapter’s final section offers a detailed guide to the economics of global climate change. We begin with a basic description of the problem, including the important Copyright © 2026 Pearson Canada Inc.

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distinction between the flow of annual greenhouse-gas emissions and the accumulated stock of greenhouse gases in the atmosphere. The distinction leads not only to a recognition that much of the damage done to date will not be reversible (for many decades) but also that any policy designed to significantly reduce annual emissions will have substantial effects on the economy. We explain the connection between greenhousegas emissions, energy use, and GDP, and explain why the key challenge can be seen as reducing the emissions per unit of energy used, which means fundamentally changing the way we produce and use energy. Finally, we discuss the Copyright © 2026 Pearson Canada Inc.

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ongoing international negotiations, the outlines of what effective policy might look like, and the current state of federal and provincial policies in Canada.

Answers to Study Exercises

Fill-in-the-Blank Questions Question 1 a) marginal cost b) marginal benefit c) marginal cost of abatement; marginal benefit of abatement d) greater Question 2 a) social; private b) tax; internalized c) marginal external cost; allocatively efficient Question 3 a) lowest b) not; not c) marginal; equalized

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327

d) marginal; equalized Question 4 a) direct regulatory controls b) emissions tax (If the burning of fuel leads to emissions, then a tax per unit of fuel used is equivalent to a tax per unit of emissions.) c) tradable emissions permits (or a cap-and-trade system); market Question 5 a)

negative;

externality

(the

external

costs

associated with their emission of greenhouse gases) b) negative; global c) 54 billion tonnes; 5 billion tonnes d)

price;

internalize;

carbon

tax;

cap-and-trade

system

Review Questions Question 6 a) The marginal cost curve for pollution abatement is upward sloping for the same reason that most MC curves are upward Copyright © 2026 Pearson Canada Inc.

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sloping. As we produce more and more of this good (pollution abatement), the costs associated with extra production increase. Put another way, the initial units of pollution abatement can be produced relatively cheaply by adopting all the quick and easy and obvious methods of abatement. But eventually it gets more difficult to increase the amount of pollution reduction, and at this point MC rises. b) The marginal benefit of pollution abatement is downward sloping for the same reason that most demand curves are downward sloping. In a very dirty environment, the initial units of pollution reduction are very desirable and thus highly valued.

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But as the amount of pollution abatement increases, and thus the environment gets cleaner and cleaner, the value of additional abatement falls. c) All greenhouse-gas emissions are not eliminated at Q*—there would only ever be no emissions at a very high level of Q, well to the right of Q* in the figure. At this level of abatement (100%), the MC of abatement would be extremely high. d) Q* is the economically optimal amount of pollution abatement and thus leads to the optimal amount of greenhouse-gas emissions. At Q* the marginal cost of abatement equals the marginal benefit of abatement. It would not be optimal to abate more than Q* because the costs to society of doing so would exceed the benefits. The important point to learn here is that all production creates pollution of some kind—even the regular activities of ―just living‖ creates waste and carbon dioxide emissions. The economic problem is to assess the costs of pollution abatement (the resources used) and the benefits of pollution abatement (the avoidance of the pollution costs), and to balance them at the margin. This will invariably result in a positive amount of pollution at the optimal outcome.

Question 7 a) See the diagram below. The demand curve for pollution permits reflects the benefits that the owner of the permit receives by not having to abate pollution. In other words, the marginal benefit of owning a pollution permit is the firm‘s marginal cost of pollution abatement. The demand curve for Copyright © 2026 Pearson Canada Inc.

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permits is downward sloping for the same reason that the MC of abatement is upward sloping. A firm that owns many pollution permits needs only to abate a little pollution, and the marginal cost of doing so is low, and thus the benefit from having an additional permit is correspondingly low.

In contrast, a firm that owns very few pollution permits must abate a lot of pollution, and the marginal cost of doing so is high, and thus the benefit from having an additional permit is correspondingly high.

b) The supply curve for pollution permits is vertical at Q*, the number of permits issued by the government. The equilibrium price of each permit will be p*, and from the discussion in (a) we know this will equal firms‘ marginal abatement cost. c) If a technological improvement lowers the marginal cost of pollution abatement, then it also reduces the marginal benefit from owning a pollution permit (because the cost of not having a permit has fallen). Thus, the demand curve for pollution permits shifts down with the result that the equilibrium price of permits falls. d) If Greenpeace, or any other group for that matter, purchases pollution permits and then retires them (meaning that they do not use the permits to

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produce pollution), the equilibrium price of permits will rise and the legally permitted amount of pollution will fall. The supply curve effectively shifts to the left, as would happen if the government decided to reduce the outstanding number of permits by buying them back from current owners.

This is shown by the shift of the supply curve to S in the figure. This question reveals one of the advantages of tradable pollution permits—it allows the public to express its preferences for less pollution by ―putting its money where its mouth is‖ and purchasing existing pollution permits.

Naturally, the increase in the scarcity of pollution permits, with no change in the underlying demand, leads to a rise in their price.

Question 8 a) The chapter argues that direct controls are usually more costly than indirect (market-based) policies, but there are some exceptions. For automobiles, some direct controls make a great deal of sense. For example, the regulations that require catalytic converters to be installed in all cars requires the government to monitor only a small number of auto manufacturers. With a market-based policy (such as a tax on certain kinds of emissions), the government would somehow

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need to monitor the emissions from millions of cars. b) When the policy objective is to reduce certain emissions rather than to eliminate them altogether, indirect (market-based) policies work well, even for automobiles. The emission of greenhouse gases is an excellent example. With a tax on gasoline (which already exists), consumers will presumably reduce their use of gasoline (over time, especially) and thus reduce their emissions. In this case, as long as the government can verify that the tax is imposed on the sale of gasoline, the government need not monitor the actual drivers or their cars. c) The politics of an emissions tax is difficult because if the government imposes such a tax it can be accused by its political opponents of engineering a ―tax grab‖ that can be used to finance all sorts of government expenditures. Any political party that prefers lower taxes (and smaller government) may like to avoid such a Copyright © 2026 Pearson Canada Inc.

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policy. So one advantage of direct regulatory controls is that they do not appear directly in the government‘s budget statement of revenues (taxes) and expenses (subsidies), even though they may impose an even larger cost on firms and workers. In Canada over the past few years, this aspect of carbon pricing (either a tax or a capand-trade system) played a significant role in generating political opposition to these policies, both at the provincial and federal levels.

Question 9 a) GHG / Energy is the amount of greenhouse-gas emissions created per unit of energy used. A decrease in the share of energy that comes from burning fossil fuels, ceteris paribus, will decrease this ratio. b) Energy / GDP is the amount of energy used per unit of GDP produced. Improvements in energy efficiency, both by households and firms, will lead to reductions in this ratio. c) Increases in world population will tend to increase world GDP, partly because more labour leads to an increase in the world's productive potential and partly because with more people there is greater demand for output. In addition, even with a constant population, most people strive to increase their individual incomes, thus leading to an increase in Copyright © 2026 Pearson Canada Inc.

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per capita GDP. For both reasons, world GDP is likely to continue growing. Current trends suggest world GDP growth of 3–5 percent annually for the next few decades. d) Ongoing and gradual increases in energy efficiency reduce the second term, but for many years the decrease is only by about 1 percent annually, which is far less than the expected annual growth of global real GDP. e) From parts (c) and (d), it follows that the second and third terms, taken together, are likely to continue rising by about 2–4 percent for the foreseeable future. Thus, in order to reduce the annual flow of global GHG emissions, there will need to be dramatic reductions in the GHG / Energy term.

This will involve significant changes in the world‘s energy use, away from fossil fuels and toward nonemitting sources. Or, if we continue to be intensive users of fossil fuels, the GHG emissions will need to be captured and stored.

Question 10 a) As firms reduce their output of goods and services (as they typically do during a recession), they also naturally reduce their emission of greenhouse gases because it is largely the act of production (and use of energy) that leads to emissions.

Permits allow the firms to emit greenhouse gases without paying any kind of penalty. So if the firms have less production of goods and services, they will have a reduced demand for emissions permits. b) Yes. The reduction in demand for emissions permits is expected to lead to a reduction in the market equilibrium permit price, as would happen with a leftward shift in the demand curve in Figure 17-6. c) There are two reasons that the permit prices are likely to rise over time. First, as the economies Copyright © 2026 Pearson Canada Inc.

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grow, as they did between 2010 and 2023 (with the exception of the time of the COVID pandemic), the increase in economic activity naturally increases the demand for permits because firms in many industries are attempting to increase their output.

This increase in demand for permits (shown by a rightward shift of the demand curve in Figure 17-6) will push prices up. Second, as the cap on total emissions in the EU tightens gradually each year, the supply curve in a figure such as Figure 17-6 shifts to the left, increasing the equilibrium price of permits. d) A properly functioning cap-and-trade system will generally not display a constant price for permits.

As long as there are business cycle fluctuations and also changes in firms‘ abatement technologies, we expect the overall demand for permits to be changing. For a given overall supply of permits, these changes lead to changes in the equilibrium price. e) That these price fluctuations are expected, however, does not necessarily mean that they do not generate some problems. One important problem with such price fluctuations (in general) is that firms are less able to make long-run investment plans because they cannot accurately predict the future permit price. This is one disadvantage with a capand-trade system as compared to an emissions tax.

Problems Question 11 a) As the cleanliness of water increases, it is typically more difficult to increase the cleanliness further. Initial efforts to clean water that is quite dirty are relatively easy and involve low costs. But as the water gets cleaner and cleaner, it is costlier to remove the ever-morescarce impurities. Thus, the MC curve for water-

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pollution abatement is upward sloping. See the diagram below. Note that the horizontal axis measures the cleanliness of water (increasing from left to right) or, equivalently, the amount of pollution abatement already achieved (increasing to the right, in unspecified units).

b) See the diagram above. The MB curve is downward sloping because the cleaner is the existing water, the less value there is to further cleaning it.

Clean water is a scarce good; the scarcer is clean water, the more we value it at the margin. c) The optimal amount of water cleanliness is at the level where the MC of further cleaning equals the MB of further cleaning. In this case, the optimal cleanliness of water is 60%. The cost of further cleaning the water exceeds the benefits to society of doing so. d) When the water is only 60% clean, there is still some pollution. But the cost of reducing the pollution further (cleaning the water more) exceeds the benefits to society of reducing the pollution.

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Thus, the optimal (efficient) level of pollution is positive.

Question 12 a) See the diagram below. If each unit of lumber produced also generates $10 of damage to the environment, the social marginal cost of production is $10 greater than the private marginal cost (at each level of output). We draw the social marginal cost curve and label it MCS. The competitive equilibrium (in the absence of any pollution regulation) is price pC and quantity QC. b) The allocatively efficient level of lumber output is that level where the marginal cost to society of an extra unit of lumber equals the marginal benefit to society of an extra unit. Since we have not assumed an externality associated with the consumption of lumber, social marginal benefit and private marginal benefit are the same and are given by the demand curve. The efficient level of output is Q*. As with all negative externalities, the free market ends up producing too much of the product in question, Q* < QC.

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c) If lumber producers are required to pay a $10 tax per unit of lumber produced, then their private marginal costs rise by exactly $10, making MCP the same as MCS. In this case, the pollution externality has been fully internalized because firms are required to pay the full social cost of their production. The competitive equilibrium with such pollution taxes will be price p* and quantity Q*.

This is allocatively efficient. d) The vertical distance between the two MC curves is exactly $10. But p* is less than $10 greater than pC. This is because there is some slope to the demand curve, and so some of the reduction in supply (due to the tax) ends up as higher prices but some ends up as reduced equilibrium quantity. The less elastic is the demand curve, the more the price would increase from its pre-tax level. Only in the case of perfectly inelastic demand (a vertical demand curve), would p* be exactly $10 greater than pC.

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Question 13 a) See the figure below showing the MC and MB of reducing (abating) tonnes of solid waste. b) The socially optimal amount of abatement is where MB of abatement equals MC of abatement, which in this case occurs when 4 tonnes of waste is being abated. c) The net benefit of abating 4 tonnes of solid waste is shown by the difference between MB and MC for each unit abated. The net benefit is equal to $3000 on the first tonne, $2300 on the second, $1500 on the third, and $0 on the fourth. The total net benefit is thus equal to $6800.

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d) If the hospital chooses to abate 6 tonnes of waste, the net societal benefit from the 6th tonne is -$6800. Note that the cost to society of this tonne of abatement is very high ($7000) and the benefit to society is very small ($200). So society would actually be better off not to abate this 6th tonne of waste. (Note that the same is true for the 5th tonne of waste.)

Question 14 a) In a competitive free market, the outcome will be determined by supply (private MC) and demand (private MB). Given the equations provided, the equilibrium Q* satisfies: 20 + 0.5Q* = 50 – 0.25Q* which implies that 0.75Q* = 30 Q* = 40.

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and so

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b) The allocatively efficient level of output, Q**, is where marginal social cost is equal to private marginal benefit. With the equations provided, we have: 30 + 0.75Q** = 50 – 0.25Q** which implies that Q** = 20.

The allocatively efficient level of output is less than the competitive equilibrium level because there is a negative externality—the free market produces ―too much‖ of the fertilizer. c) The marginal external cost (MEC) at Q* is given by the difference between the marginal social cost and the marginal private cost. Using the equations for MCP and MCS we see that MCP(Q*) = 40 and that MCS(Q*) = 60. It follows that the MEC at Q* is equal to 20. d) Now do the same, except use the Q** level of output. MCP(Q**) = 30 and MCS(Q**) = 45. It follows that the MEC at Q** is 15. e) The emissions tax appropriate to result in Q** is equal to the MEC at Q**, which is equal to 15.

To see this, rewrite the private marginal cost (in the presence of the tax) as: MCP = 20 + 15 [the tax] + 0.5Q With MB given by 50 – 0.25Q, the competitive equilibrium would now be given by the Q that solves the following: 50 – 0.25Q = 35 + 0.5Q which implies 0.75Q = 15 and so is the efficient level of output.

Q = 20, which

Question 15 a) For abating Q3 units of pollution, the marginal cost for Softies Inc. is $30; the marginal cost for Cuddlies Inc. is $50.

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b) Yes. Since MC of abatement is currently not equated across the two firms, the given amount of pollution abatement could be achieved at a lower total cost. For example, Softies could abate one additional unit and Cuddlies could abate one fewer unit and the total cost would fall.

This redistribution could continue until marginal cost is equated across the two firms. (Note that if units of abatement are indivisible, we may not be able to exactly equate MC across the two firms, but we definitely could if units are perfectly divisible.) c) A tax of $40 per unit of emissions is each firm‘s ―marginal benefit‖ of abatement because for each unit of pollution abated the firm avoids having to pay $40. d) With a per-unit emissions tax of $40, each firm will abate until the marginal cost of abatement equals $40. For Softies Inc., the diagram shows that the amount of abatement will be approximately halfway between Q4 and Q5. For Cuddlies Inc. the amount of abatement is approximately three-quarters of the way between Q1 and Q2. Thus, we see that if both firms face the same per-unit emissions tax, the firm that can abate at lower cost will end up abating more, and the high-cost-abatement firm ends up abating less. e) No. Since the marginal cost of abatement is equated across the two firms, there is no way to reduce the total cost of the given amount of pollution abatement.

Question 16 a) With the regulatory control dictating that each firm abates 100 tonnes of GHGs, the MC of abatement is $80 for HiCost and $40 for LoCost.

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b) The total cost of abating 100 tonnes for LoCost is (100)($40)(1/2) = $2000. The total cost of abating 100 tonnes for HiCost is (100)($40) + (100)($40)(1/2) = $6000. So the total combined cost of abating 200 tonnes is $8000. c) Since the equilibrium permit price is $60 per tonne of emissions, this value is also the marginal benefit of abatement to firms—since by abating one extra tonne of emissions, any firm can avoid having to purchase a permit at this price. d) At a permit price of $60, HiCost decides to abate only emissions where the marginal abatement cost is less than $60; so it abates 50 tonnes.

LoCost makes the same type of decision and chooses to abate 150 tonnes. HiCost abates less, and thus purchases permits to allow its higher emissions. LoCost abates more, and thus sells the permits it doesn‘t need (with its lower emissions). So LoCost ends up selling permits to

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HiCost. Each firm ends up with a MC of abatement equal to $60, the permit price. e) The total cost for HiCost of abating 50 tonnes is (50)($40) + (50)($20)(1/2) = $2500. The total cost for LoCost of abating 150 tonnes is (150)($60)(1/2) = $4500. So the total combined cost of abating all 200 tonnes is $7000. f) If the objective is to reduce any given amount of pollution at the lowest possible cost, the cap-and-trade system is preferable to the direct regulatory controls since the total abatement cost is lower ($7000 as compared with $8000). Of course, the government may choose objectives other than cost-minimization, in which case it might be led to choose the regulatory approach.

Question 17 a) With the regulatory control dictating that each firm abates 100 tonnes of GHGs, the MC of abatement is $80 for HiCost and $40 for LoCost.

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345

b) The total cost of abating 100 tonnes for LoCost is (100)($40)(1/2) = $2000. The total cost of abating 100 tonnes for HiCost is (100)($40) + (100)($40)(1/2) = $6000. So the total combined cost of abating 200 tonnes is $8000. c) With an emissions tax of $60 per tonne, this value is also the marginal benefit of abatement to firms—since by abating one extra tonne of emissions, any firm can avoid having to pay this tax. d) With an emissions tax of $60 per tonne, HiCost decides to abate only emissions where the marginal abatement cost is less than $60; so it abates 50 tonnes. LoCost makes the same type of decision and chooses to abate 150 tonnes. Each firm ends up with a MC of abatement equal to $60, the emissions tax. e) The total cost for HiCost of abating 50 tonnes is (50)($40) + (50)($20)(1/2) = $2500. The total cost for LoCost of abating 150 tonnes is

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(150)($60)(1/2) = $4500. So the total combined cost of abating all 200 tonnes is $7000. f) If the objective is to reduce any given amount of pollution at the lowest possible cost, the emissions tax is preferable to the direct regulatory controls since the total abatement cost is lower ($7000 as compared with $8000). Of course, the government may choose objectives other than cost-minimization, in which case it might be led to choose the regulatory approach.

Question 18 a) Across any two time periods, the percentage change in GHGs will be very well approximated by the sum of the percentage changes of the three elements on the right-hand side of the equation— call them GHG intensity of energy, energy intensity of GDP, and GDP itself. We are told that in 2025 the first element falls by 3%, the second falls by 2%, and the third rises by 4%.

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The result must be a fall in GHGs of (approximately) 1%. b) In 2026 we are told that the first element falls by 5%, the second element falls by 5%, and the third rises by 3%. The result is that GHGs must fall by (approximately) 7%. c) In 2027 we are told that the first two elements are unchanged but the third increases by 4%. The result must be that GHGs rise by (approximately) 4%. *****

_________________________________________ Chapter 18: Taxation and Public Expenditure _________________________________________

This chapter presents some simple analytical concepts for discussing government taxation and expenditure as well as an outline of Canadian government spending, Copyright © 2026 Pearson Canada Inc.

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with an emphasis on social programs. Many instructors have told us they rarely have time to discuss this material. Given the importance of knowing the basics of government spending and taxation, we have tried to keep the discussion as brief as possible, while still presenting the essential ideas. Our own experience is that many students want and benefit from some discussion of how and why Canadian governments tax and spend the way they do. *** The chapter is divided into four sections. In the first section, we discuss the basic elements of the Canadian tax system, including data that show tax revenues for Copyright © 2026 Pearson Canada Inc.

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combined Canadian governments.

We have a brief discussion of various taxes (at all levels of government). There is also a box on ―Who really pays the corporate income tax?‖ which makes the distinction between taxing accounting profits (which happens) and taxing economic profits (which generally doesn’t happen, but which is usually more efficient).

The second section examines how we might evaluate a tax system, both in terms of equity and efficiency. In the discussion of efficiency, we have a detailed discussion of excess and direct burdens and use a figure to illustrate the concepts in the case of an excise tax. This is worth spending some time on in class as we have found that many students do not immediately understand the importance of this distinction. We then emphasize these concepts by analyzing the deadweight loss of an income tax.

Finally, we address the disincentive effects of taxation by introducing a simple Laffer curve.

The third section examines the nature of public expenditure in Canada. We briefly mention the Copyright © 2026 Pearson Canada Inc.

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massive spending during the COVID-19 pandemic, but we focus our discussion on what occurs during ―normal‖ years. Any discussion of public spending in Canada naturally involves a discussion of our system of fiscal federalism, without which any student would have a difficult time making sense of spending patterns.

We then discuss Canadian social programs, including education, health care, income-support programs, employment insurance, and retirement and elderly benefits.

We review the ongoing pressures for reforming various parts of Canada’s social safety net. The discussion of income-support

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programs leads to a box on the idea of a universal basic income (UBI).

The final section of the chapter offers a general but brief discussion evaluating the role of government in the economy.

Answers to Study Exercises Fill-in-the-Blank Questions Question 1 a) 3600 / 22,500 = 0.16 = 16% b) average tax rate c) (0.2)(25,000) + (0.3)(17,000) = 5000 + 5100 = $10 ,100

d) regressive e) property; wealth (more specifically, the part of wealth from residential real estate) Question 2 a) equity; efficiency b) (social) benefit; (social) cost c) direct; excess d) excess burden (or deadweight loss) e) reduce

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a) fiscal federalism; public services; tax rates b) Canada Health Transfer; Canada Social Transfer; Equalization Payments c) The five pillars are:  Education  Health Care  Income-Support Programs  Employment Insurance  Retirement

and

Elderly

Benefits d) provincial; federal; transfers

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e) federal government; revenue neutral f) Registered Retirement Saving Plans (RRSPs); Tax-Free Saving Accounts (TFSAs) Review Questions Question 4 a) The direct burden of the tax is given by the revenue the tax raises.

In both diagrams this is the light shaded rectangle. See the figure below.

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b) The excess burden of the tax is the loss of consumer or producer surplus that results from the reduction in quantity exchanged caused by the imposition of the tax.

In Midas, where demand is perfectly inelastic, there is no change in the equilibrium quantity as a result of the tax, and so there is no excess burden. In Neptune, however, there is an excess burden, as shown by the dark shaded triangle, which comprises the loss of both consumer and producer surplus.

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c) The excess burden of the tax is the measure of the extent of allocative inefficiency of the tax. In Midas the tax imposes a cost on consumers of gasoline, but the tax revenue is simply transferred to taxpayers (the government) and so there is no cost to society overall. In Neptune, however, the imposition of the tax leads to less gasoline consumption and production and thus a loss of consumer and producer surplus. In Neptune the gasoline tax creates allocative inefficiency.

Question 5 a) The holders of capital assets are the obvious beneficiaries, and typically these people are located in Copyright © 2026 Pearson Canada Inc.

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the upper half of the income distribution. Thus, the favourable tax treatment of capital gains is likely to be a regressive policy. b) This tax treatment of capital gains is likely to increase income inequality since it represents a tax reduction (relative to the full taxation of capital gains) that applies mostly to people in the upper part of the income distribution. It also likely encourages ―capital deepening‖ (an increase in the capital–labour ratio). It also diverts resources into the legal and financial sectors as individuals find that it pays to organize their affairs so that the maximum possible amount of their

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income is taken in the form of capital gains.

Question 6 a) The two effects are inconsistent in the sense that the more the taxes discourage the behaviour (drinking or smoking), the less revenue they raise.

As long as demand is neither perfectly inelastic nor perfectly elastic (i.e., as long as demand is downward sloping), there will be both some reduction in usage and some revenue raised. Thus, there is really a trade-off here. b) If demand is completely inelastic, then drinking and smoking will not fall at all when a tax is imposed (or increased). In this case, the incidence of the tax will fall completely on the consumers and tax revenue will be maximized. The greater the elasticity of demand, the more the incidence of the tax falls on producers and the more consumers‘ use of the product is discouraged by the tax.

Question 7 The key to understanding this question is in recognizing that the excess burden of a tax is determined by the consumer and producer surplus that is lost when the tax is imposed. This loss of Copyright © 2026 Pearson Canada Inc.

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surplus, in turn, is determined by the relative elasticities of demand and supply for the good. As the previous question showed, if demand is perfectly inelastic, there is no excess burden, even though there is a direct burden (the tax generates tax revenue). In contrast, when the demand for the good is perfectly elastic, the tax will generate a large loss of surplus and thus a large excess burden.

In the four cases shown, the key difference is the elasticity of demand for the goods. As we move from item (a) to item (d), the good in question has fewer and fewer substitutes and thus demand is becoming less and less elastic. For simplicity, think of supply as being Copyright © 2026 Pearson Canada Inc.

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the same in each case. Thus, the ratio of excess burden to direct burden will be highest for case (a) and lowest for case (d).

An excise tax for one brand of breakfast cereal will push up the supply curve but lead to little increase in price, because consumers will easily substitute toward other brands. Of course, this means a large reduction in the quantity consumed of this breakfast cereal. Thus, the loss of consumer surplus from the consumption of this good will be large. In contrast, the direct burden will not be that large precisely because of the large reduction in equilibrium quantity consumed. The ratio of excess

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burden to direct burden will therefore be high.

Now consider an excise tax on all goods (which is basically what Canada’s GST is, with some exceptions). Demand for everything is not very elastic—people cannot easily substitute away from this tax.

Put differently, a tax applied to all goods and services does not introduce substitution effects and thus causes very little substitution among goods. There will be a direct burden of the tax, as people remit taxes to the government, but the excess burden will be very small.

The ratio of excess burden to direct burden will be very small.

It should be clear that an excise tax on all goods and services is Copyright © 2026 Pearson Canada Inc.

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essentially a tax on earned income, since people eventually spend their earned income on goods and services. Thus, the excess burden of such a tax can be thought about in terms of the labour market. The tax reduces the after-tax wage and reduces employment. The loss of consumer and producer surplus in the labour market is therefore the measure of the excess burden of the GST (or tax on earned income).

How big is the excess burden? If labour supply is very inelastic, as many studies show it to be, then the excess burden of such a tax is very small. This is part of the basic efficiency argument in favour of consumption taxes such as the GST.

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Question 8 a) Wages to Canadian soldiers overseas (or anywhere) are purchases of goods and services.

Since one could argue that everyone benefits (approximately) equally from peacekeeping, these payments are unlikely to have much effect on the income distribution. b) Employment-insurance benefits are transfers. These transfers increase the equality of the income distribution because in their absence the unemployed would have less income (at least until they found a new job). c) Federal payments to the provinces are transfers. But when those funds get spent on highway construction, the provincial Copyright © 2026 Pearson Canada Inc.

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governments are purchasing goods and services. Since more-or-less everybody uses highways, this will have little or no effect on the income distribution. d) Pension payments are transfers, since no goods or services are being exchanged for the payments. In the absence of those pension payments, the retired Justices would have less income, but the effect on the income distribution depends on what their pre-pension income is. If it is already high, then the pension payments would reduce the equality of the income distribution. (Of course, one should also note that if such pension payments did not exist, then the salaries to Justices would almost certainly be higher.

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In this view, the pension payments themselves are really just delayed payments for goods and services received.) e) Salaries paid to government workers are purchases of goods and services. The effect on the income distribution depends partly on what those government workers are doing. For example, payments to workers who operate the welfare system are necessary expenditures to a program that increases the equality of the income distribution.

Question 9 a) The overall tax freedom day is determined by the overall average tax rate, where we compute the average tax rate as the share of Copyright © 2026 Pearson Canada Inc.

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GDP taken by all taxes (income, property, GST, sales taxes, etc.).

But individuals will have different tax freedom days for the simple reason that individuals have different tax rates. Thus, an individual with very low income may pay very low (or zero) taxes, have an average tax rate of 5 percent, and thus have a tax freedom day sometime in the first half of January. In contrast, a highincome individual may have an average tax rate of 45 percent and thus face a tax freedom day in the latter half of June. b) This points to the obvious problem of using the average tax rate as a sensible measure of the ―cost‖ of government. The problem is that some of the tax revenues collected by governments are used to deliver goods and services that people would purchase anyway, such as primary education, health care, the use of roads, etc. Thus, we must recognize that at least some of the taxes that we pay obviously bring benefits to individuals.

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Problems Question 10 a) In order to raise $10 billion to finance new public goods, the government will likely impose new taxes or raise existing ones. As we discussed in this chapter, almost all realworld taxes impose both a direct and an excess burden, the latter being the deadweight loss created when the tax changes relative prices and changes behaviour. As long as there is some excess burden from this tax increase, then the total cost to society will be greater than $10 billion, which is the direct burden of the new taxes. (Though we do not say this in the chapter, current estimates of the excess burden of taxation in Canada are approximately $0.30 for every dollar raised, suggesting that the total cost of raising $10 billion would be about $13 billion.) b) The benefits from spending $10 billion on new national parks (or any other public good) depend crucially on how the citizens value these new parks. As we discussed in Chapter 16, in order to determine the total value to society of a new public good, we need to know each person’s marginal value of that good. Since everyone can (in principle) benefit from public goods at the same time, we then add up these marginal values across all individuals. Depending on the details of the public good, the aggregate value of benefits could be pretty much anything; some public goods may deliver large aggregate benefits while others could deliver very small benefits. c) Suppose that estimated total costs from (a) exceed estimated total benefits from (b), which is certainly possible. If the objective of the policymakers is only to maximize net benefits to society as a whole, the decision in this case would presumably be to not raise taxes by $10 billion and not build the new national parks for $10 billion. But the government’s objective may not be purely to maximize net benefits to society but instead to use this policy as part of an overall policy package to improve the distribution of income, shifting resources away from higher-income families and toward lower-income families. For example, if the new public goods are especially used and valued by lowerincome families, but the new taxes are levied mostly on families with higher incomes, there may be a sensible argument for providing these new parks even though the overall costs to society exceed the overall benefits.

Question 11

Parts (a) and (b) are answered in the following table. The average income-tax rate is equal to the total tax paid divided by total income.

The marginal income-tax rate is Copyright © 2026 Pearson Canada Inc.

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equal to the rate paid on the individual’s next dollar of income.

Income

Taxes Paid

Average Rate Marginal Rate

$0 0 $10,000 0 $20,000 0 $30,000 $1,500 $40,000 $3,000 $50,000 $6,000 $60,000 $9,000 $70,000 $12,000 $80,000 $15,000 $90,000 $18 ,500 $100,000 $22,000 $110,000 $25 ,500 $120,000 $29,000

0 0 0 5% 7.5% 12.0% 15.0% 17.1% 18.8% 20.6% 22.0% 23.2% 24.1%

0 0 0 15% 15% 30% 30% 30% 30% 35% 35% 35% 35%

c) See the diagram below. The curve for the marginal tax rate is a step function, showing the four distinct tax brackets. For incomes of $20,000 and below, the marginal tax rate and the average tax rate are both equal to zero.

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d) By ―progressive,‖ we mean that the average tax rate rises with income. From the figure above, it is clear that this system is progressive.

What makes it so is the system of tax brackets with higher marginal tax rates in higher-income tax brackets. (As always, the average is rising because the marginal is above the average.)

Question 12 The table below shows the computed values: Michael Lindsay Annual pre-tax $35 000 $400 taxable income 000 Percentage of 10% 40% after-tax income saved Copyright © 2026 Pearson Canada Inc.

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Income tax paid

$2250

$127 000 After-tax income $32 750 $273 000 Sales tax paid $1928.30 $10 715.9 Percentage of 6.4% 31.8% pre-tax income paid in income tax Percentage of 5.5% 2.7% pre-tax income paid in sales tax Overall average 11.9% 34.5% tax rate a) To calculate the sales tax paid, note that if X is the value spent on goods and services including the sales tax then the pre-sales-tax expenditure is Z, where Z(1.07) = Copyright © 2026 Pearson Canada Inc.

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X. It follows that the total sales tax paid is equal to (0.07)X / (1.07). b) An income tax is progressive if the average income-tax rate rises as income rises and it is regressive if the average income-tax rate falls as income rises. In this case, the income tax is clearly progressive since Lindsay, with much higher income than Michael, also pays a much higher average income-tax rate. c) The progressivity of the sales tax depends crucially on the consumption–saving behaviour of individuals and how this behaviour changes as their income rises. In general, if individuals save a higher fraction of their income when their income is higher (which tends to be Copyright © 2026 Pearson Canada Inc.

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true), then the sales tax ends up being regressive. In our example, Lindsay’s average sales-tax rate is 2.7% (of her pre-tax income) whereas Michael’s is 5.5% and so the sales tax is regressive. d) In this example, the income tax is progressive while the sales tax is regressive. Taking the two taxes together, however, we still have a progressive tax system, since the overall average tax rate rises as income rises—Lindsay’s average rate of 34.5% is much higher than Michael’s average rate of 11.9%.

Question 13 a) Producers’ net revenue before the tax is simply price times quantity, which is $120 million per Copyright © 2026 Pearson Canada Inc.

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month in Flatland and $120 million per month in Steephills. After the tax is imposed, producers’ net revenue is equal to the producer price times quantity, which is $73.5 million per month in Flatland and $103.5 million per month in Steephills. b) The direct burden of an excise tax is the revenue collected, which is equal to the tax times the quantity exchanged. In Flatland the direct burden is $14 million per month while in Steephills it is $18 million per month. c) The excess burden of an excise tax is the loss of economic surplus caused by the tax (the deadweight loss). It is given by the areas of the triangles where, in these cases, the Copyright © 2026 Pearson Canada Inc.

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bases of the triangles are equal to $0.20 and the heights are the reduction in quantity exchanged as a result of the tax. For Flatland the deadweight loss is equal to $3 million per month and for Steephills it is $1 million per month. d) The allocative efficiency of an excise tax is measured by the deadweight loss it creates, which is the excess burden. So in this case the more efficient excise tax is the one on Steephills. The tax is more efficient because it changes behaviour by less than the tax on Flatland, and this occurs because demand is less elastic on Steephills than it is on Flatland.

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Question 14

a) After-tax income = $8000 + (0.65)  (Earned Income). Note that ―earned income‖ does not include the $8000 guaranteed annual income because it is not ―earned‖ income. Thus, the line showing after-tax income (YAT) has a vertical intercept of $8000 and a slope of 0.65. See the figure below (although note that the vertical and horizontal scales are different).

b) The 45-degree line shows all points where aftertax income equals earned income. With the UBI system, this equality only occurs at one level of Copyright © 2026 Pearson Canada Inc.

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earned income—the ―breakeven‖ level of earned income. This is where the taxes paid on earned income exactly equal the guaranteed annual income of $8000. If we call Y* this breakeven level of earned income, then (0.35)  Y* = $8000 or Y* = $22,857.

c) Total net taxes paid is given by: Net Taxes Paid = (0.35)  (Earned Income) – $8000 So the average tax rate is given by: Average Tax Rate = (0.35) – $8000 / (Earned Income) d) See the figure below. The average tax rate is denoted ATR. The marginal tax rate (MTR) is constant and equal to 0.35. Note that ATR is zero at the breakeven level of earned income. As earned income approaches zero, the ATR falls and approaches negative infinity. As earned income rises above Y*, the average tax rate rises but never quite reaches the MTR of Copyright © 2026 Pearson Canada Inc.

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0.35. Because the ATR rises as earned income rises, the UBI is a progressive income-tax system.

____________________________________ ___ Part Seven Canada in the Global Economy

____________________________________ ___

International themes are woven throughout the book, and we Copyright © 2026 Pearson Canada Inc.

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address trade when necessary and mention the importance of globalization in the functioning of modern economies. But until now we have not addressed the international issues in detail. A systematic treatment of international trade and trade policy is the purpose of the next two chapters.

Chapter 19 deals with the gains that arise from international trade, emphasizing the role of comparative advantage. We have data figures showing the importance of trade, both for the world and for Canada. We also have a simple demand-and-supply discussion of exports and imports that shows that actual trade patterns in competitive markets are predicted to follow the pattern of comparative advantage. We also discuss the terms of trade and why they matter.

Chapter 20 deals with the theory and practice of trade policy, which has become more discussed and controversial in recent years. We examine the valid cases for protection as well as several faulty arguments. We examine the effects of tariff and quotas in some detail. The chapter also includes a discussion of the World Trade Organization and the North American Free Trade Agreement, including the recent re-negotiations of NAFTA (now replaced with the USMCA).

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***

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___________________________________________ Chapter 19: The Gains from International Trade ___________________________________________

In this chapter, we develop the standard theory of the gains from trade that result from the exploitation of comparative advantages. We give a patient tabular exposition of comparative advantage and the gains from trade, including two examples discussed in a box. In a different box, we present a graphical representation of the gains from trade when the country’s production possibilities boundary displays the ―usual‖ increasing opportunity costs. We have a discussion of exports and imports in a supply-and-demand framework that shows actual trade patterns Copyright © 2026 Pearson Canada Inc.

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following the pattern of comparative advantage. Finally, we have a thorough discussion of the terms of trade. ***

In the introduction to the chapter, we have data showing the importance of international trade, both for the world and for Canada.

We then explore in some detail the sources of the gains from trade. We present the gains due to specialization in a simple Ricardian setting, and we have a diagram showing these gains. We have a box examining two numerical examples.

We also have a box showing the gains from trade due to specialization in the more realistic setting in which countries have a Copyright © 2026 Pearson Canada Inc.

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concave production possibilities boundary. We then go beyond most introductory texts by discussing the gains from trade due to economies of scale and learning-by-doing.

Though the Ricardian setting of a single factor and constant returns generates invaluable insights about the gains from trade, students must learn that a great deal of trade is undertaken in imperfectly competitive industries, and they should know the nature of the gains from this trade. We conclude the section by examining the sources of comparative advantage. The sources that we identify include different national factor endowments (Heckscher-Ohlin) and different climates. These are the Copyright © 2026 Pearson Canada Inc.

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traditional ―natural‖ reasons and they set the stage for the discussion of acquired comparative advantage that follows.

In the chapter‘s second section we discuss the determination of trade patterns. It is one thing to show students that specialization and trade according to comparative advantage would be beneficial; it is quite another to show that this is actually what happens. We use a simple demandand-supply framework, combined with the international law of one price, to show which goods Canada will export and which goods Canada will import. The central message is that Canada will export goods for which it is a low-cost producer (relative to the world), and it will import goods for which it is a high-cost producer (relative to the world). We take care to explain the connection between prices, costs of production, and comparative advantage. We think this section is a valuable part of the chapter and should help students think clearly about comparative advantage and actual trade flows.

We then ask whether comparative advantage is obsolete, a claim often heard in popular debate. We argue that comparative advantage is not obsolete–– but what is obsolete is the idea that government policy cannot affect a country‘s pattern of comparative advantage. This is obviously not an argument that government necessarily should try to change the pattern of comparative advantage; it only recognizes the implications of acquired comparative advantage. We have added a new discussion of the emerging concerns about national security and about whether countries may now be prepared to sacrifice some economic benefits from trade in return for some political and security benefits which may accrue Copyright © 2026 Pearson Canada Inc.

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from conducting less trade with oppressive regimes.

We have an optional box that discusses global supply chains and how they relate to the idea of comparative advantage, and how recent global events are leading firms to re-think these supply chains.

Our discussion sets the stage for the coverage of trade policy in the next chapter.

The chapter concludes by discussing the terms of trade, and how changes in world markets can lead to either improvements or deteriorations in a country‘s terms of trade. We show how changes in the terms of trade affect a country‘s consumption possibilities, and we also present some data showing Canada‘s terms of trade over the past few decades.

Answers to Study Exercises

Fill-in-the-Blank Questions Question 1 a) global output (and therefore consumption) b) absolute advantage; absolute advantage c) opportunity costs d) absolute advantage e) increase f) comparative advantage; gains from trade Question 2 a) one price; a single b) supply; export; less

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c) demand; world; domestic d) exports; imports; improvement e) imports; exports

Review Questions Question 3

a) and b) The slopes of the PPBs show the opportunity costs in each country. The steeper PPB in France than in Canada shows that France must give up more wine per unit of lumber produced than is necessary in Canada. Equivalently, Canada must give up more lumber per unit of wine produced than is necessary in France. Thus, Canada has the comparative advantage in lumber and France has the comparative advantage in wine. c) With the relative prices shown by the slope of the dashed line, Canadian producers will specialize in the production of lumber, thereby maximizing Canada‘s income. Production in Canada will take place where the dashed line touches Canada‘s PPB. Similarly, French producers will specialize in the

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production of wine, thereby maximizing France‘s income. French production will take place where the dashed line touches France‘s PPB. Both of the dashed lines touch at the axis of the product in which the country has a comparative advantage, showing that each country will completely specialize. d) With specialization as in part (c), but consumers in both countries wanting to consume both goods, there is only one possible pattern of trade. Canada will export lumber and import wine, and France will do the reverse.

Question 4 a) In both markets, the absence of international trade implies that the equilibrium price will be the one that clears the domestic market. In the figure below, these prices are denoted p .

C

b) Now suppose that Canada is open to world trade, and the world price of each product is denoted p .

In the newsprint market, the world price exceeds the domestic Canadian price. But the law of one price applies and so only the single world price applies (since Canada is a small player in the much larger world economy). At the high world price, Canadian producers increase their quantity supplied to Q1 and Canadian consumers reduce their quantity demanded to W

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Q2. The world.

balance is

exported to

the rest of

the

c) In the machinery market, the world price is less than the domestic Canadian price. But the law of one price applies and so only the single world price applies. At the low world price, Canadian producers reduce their quantity supplied to Q2 and Canadian consumers increase their quantity demanded to Q1.

The balance is imported from the rest of the world.

Question 5

a) The damage of Brazil’s coffee crop will lead to an increase in the world price of coffee (since Brazil is such a large producer of coffee).

Coffee is an imported good for Canada, and thus this shock leads to a terms-of-trade deterioration for Canada. b) A large OPEC output restriction will lead to an increase in the world price of oil. Canada produces and exports oil, but it also imports oil. However, Canada is a net exporter of oil and so the rise in the price of oil should have a larger effect on Canada‘s export price index than on its import price index. Thus, Canada‘s terms of trade should improve. c) The development of copper mines in Chile will reduce the world price of copper. Canada is a net exporter of copper and so this will lead to a deterioration of Canada‘s terms of trade.

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d) The Asian recession leads to a reduction in pork demand and thus to a reduction in the world price of pork. Pork is an important Canadian export, so the decline in its price is a terms-of-trade deterioration for Canada. e) The large reduction in the Russian wheat crop would reduce the world supply and raise the world price. Since Canada is a net exporter of wheat, this price increase represents a terms-of-trade improvement for Canada. f) Canada is a large exporter of potash (an important ingredient for fertilizers). Any significant restriction of potash output will increase the world price and thus represent a terms-of-trade Copyright © 2026 Pearson Canada Inc.

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improvement for Canada. (As it happens, three Canadian potashproducing firms have created just such a cartel and attempt to influence the world price in such a manner.)

Question 6 A rise in the price of one‘s exports is an improvement in the terms of trade; a rise in the price of one‘s imports is a deterioration in the terms of trade. The probable effects on relative prices are: a) Favourable change in the terms of trade for coffee exporters, unfavourable change for coffee importers. b) Fall in the price of Korean steel relative to Canadian steel. This improves the terms of trade for Canada and worsens the terms of trade for Korea. c) No effect predicted since a general inflation should not change relative prices in any systematic way. d) There will be a fall in the world price of oil.

The terms of trade worsen for oil exporters and improve for oil importers.

Question 7 The quote reflects the often-heard view that one country can only benefit from trade at the expense of its trading partner––that is, that international

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trade is a ―zero-sum‖ proposition. This chapter formalizes the proposition that international trade gives rise to benefits to both trading countries— that is, international trade is a ―positive-sum‖ activity. Indeed, the theory in this chapter suggests that the only situation in which one country will not gain at all from trade is the situation where free trade leads to no change in that country‘s terms of trade (and thus to no change in its pattern of production).

Question 8 The answer here is similar to the answer to Question 7. If trade agreements between two or more countries permit domestic consumers to get access to foreign products at lower prices and also permit domestic firms to get access to foreign markets, it is very difficult to see how benefits to the trading partner come at the expense of the domestic country—as President Trump often argues. The basic theory of the gains of trade is all about why international trade is not a zero-sum activity.

Of course, free-trade agreements usually result in the reallocation of resources within the partner countries, and these reallocations typically involve temporary unemployment and other disruptions. These are genuine costs of free trade, but they are generally short-lived and smaller in total than the aggregate gains to the country. The policy challenge is to make sure that the injured parties are assisted, partly so that political support for free trade can be solid and widespread.

Question 9 a) The connection between a nation‘s wealth and its ability to freely engage in trade is the essence of what we have called in this chapter ―the gains from trade.‖ A nation that refuses to engage in foreign trade forgoes the full amount of any possible gains Copyright © 2026 Pearson Canada Inc.

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from such trade. Especially for a small country such as Canada, the advantages of specialization and international trade are large. b) The theory of comparative advantage that we have developed in this chapter shows that the gains from trade between two countries depend on the differences between the two countries‘ autarkic opportunity costs (the slopes of their PPBs).

Specifically, the larger are the differences in the countries‘ pre-trade opportunity costs, the larger will be the gains from specialization and trade. The logic is simple. If another country can produce some product at a much lower opportunity cost than is possible in my country, then we stand to gain a lot by not producing that good here but instead importing it from that country. c) There will be no benefits from specialization and trade if two countries have the same opportunity costs (the slopes of their PPBs are the same). As long as there are some differences, there will be some gains from trade. (The allocation of those gains between the two countries depends on the freetrade relative prices relative to the pre-trade opportunity costs.) d) The diagram is simple and is like Figure 19-3. If two countries have PPBs of exactly the same slope, and thus exactly the same pattern of opportunity costs, then the free-trade relative prices will also be that same slope. In this case, there will be no difference between each country‘s PPB and each country‘s free-trade consumption possibilities.

Neither country will benefit at all from trade. But if there are at least some differences in the pretrade opportunity costs (as in Figure 19-3), then the free-trade terms of trade will result in an expansion of both countries‘ consumption possibilities and so both countries will gain from trade.

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Problems Question 10 a) Note that because the production possibilities boundary is a straight line, we know that the opportunity cost of either good is constant, no matter how much of it is being produced. The opportunity cost of producing more ice is the fish that are not produced. By moving from point B to point A, we produce 100 more tonnes of ice, and we must forgo producing 15 tonnes of fish. b) Similarly, the opportunity cost of producing more fish is the ice that is not produced. From the diagram, it is clear that as we move from point A to point B, we produce 15 more tonnes of fish by giving up 100 tonnes of ice. Since the boundary is linear, it follows that to produce only 10 more tonnes of fish, we would have to give up (2/3) × 100 = 66.7 tonnes of ice.

Question 11 a) Brazil has the absolute advantage in both goods because the same amount of resources (1 million acres of land) can produce more of both goods than is possible in Mexico. b) The country with the comparative advantage in wheat is the country that produces wheat with the lowest opportunity cost—that is, the country that gives up the least corn for each bushel of wheat produced. Brazil must give up 1/3 of a bushel of corn to produce each bushel of wheat. Mexico must give up 1/2 a bushel of corn to produce each bushel of wheat. Since 1/2 exceeds 1/3, it is clear that Brazil has a comparative advantage in wheat production.

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c) Using the same logic as in (b), we see that Mexico has a comparative advantage in corn production. d) It is certainly possible for a country to have an absolute advantage in both goods—this only requires that the country be more efficient than the other country in the production of both goods.

Here, by ―more efficient‖ we mean less input per unit of output. In this case, Brazil is more efficient in both wheat and corn and so it has the absolute advantage in both goods. But comparative advantage is based on the idea of opportunity cost— what must be given up in the production of one good to get more of the other good. The opportunity cost is revealed by the slope of the production possibilities boundary. And if a country has a lower opportunity cost for one good, then it must have a higher opportunity cost for the other good.

Graphically, this simply says that if the PPB is steeper in one country than in another with respect to one axis, then it must be flatter in the first country than in the second with respect to the other axis. e) See the figure below. Note that each country has 1 million acres of land. So the most wheat that Brazil could produce is 90 million bushels; and the most corn it could produce is 30 million bushels.

Similarly, Mexico could never produce more than 50 million bushels of wheat or 25 million bushels of corn.

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f) The slope of a country’s production possibilities boundary shows the opportunity cost in that country for each good. For example, the slope of Brazil’s PPB in the figure is (negative) 1/3 (note the different scales on the two axes).

This is the opportunity cost of one bushel of wheat in Brazil, meaning that Brazil must forgo 1/3 of a bushel of corn in order to produce an extra bushel of wheat. The inverse of the slope is (negative) 3, Copyright © 2026 Pearson Canada Inc.

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which is the opportunity cost of one bushel of corn in Brazil.

Question 12 a) The values in the table show what can be produced with one unit of equivalent resources in each country. So the two countries are equally efficient at producing dairy products, but New Zealand is less efficient at producing beef than Australia. So Australia has the absolute advantage in the production of beef and neither country has an absolute advantage in the production of dairy products. b) To produce an extra 12 tonnes of dairy products in New Zealand, 4 tonnes of beef must be given up. So the opportunity cost of 1 tonne of dairy products in NZ is 4/12, which is 1/3 of a tonne of beef. In Australia, the opportunity cost of an extra tonne of dairy products is 16/12 = 1.33 tonnes of beef.

For the opportunity cost of beef in each country, the numbers are simply the inverses. In NZ, the opportunity cost of 1 tonne of beef is 3 tonnes of dairy products. In Australia, the opportunity cost of one tonne of beef is ¾ of a tonne of dairy products. c) Comparative advantages are given by the lowest opportunity costs. So in this example, New Zealand has the comparative advantage in producing dairy products and Australia has the comparative advantage in producing beef. d) See the figure below.

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e) The slope of each country‘s production possibilities boundary shows the opportunity costs of production in each country—how much of one good must be given up in order to produce one more unit of the other good. The steeper slope for Australia (note that the scales of the two diagrams are the same) indicates that dairy production can only be increased by giving up more beef production than is the case in NZ. In other words, the steep slope of the PPB in Australia shows that Australia is the higher-opportunity-cost producer of dairy (and thus the lower-opportunity-cost producer of beef).

Question 13 a) The terms of trade is equal to Terms of Trade = (Index of Export Prices / Index of Import Prices) × 100

See the table below.

Yea r

Index of Impor t Price s

Index of Expor t Price s

Terms of Trade

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201 8 201 9 202 0 202 1 202 2 202 3 202 4

90

110

95

87

98

83

100

100

102

105

100

112

103

118

(110/90)  100 = 122.2 (87/95)  100 = 91.6 (83/98)  100 = 84.7 (100/100)  100 = 100.0 (105/102)  100 = 102.9 (112/100)  100 = 112.0 (118/103)  100 = 114.6

b) An improvement in the terms of trade is indicated by an increase in the value in the fourth column—it means that export prices are rising relative to import prices. Put another way, this means that the country needs to sell fewer units of its exports in order to get one unit of imports. A terms-of-trade improvement occurs every year in this case beginning in 2020—the terms of trade continually increase from 2020 to 2024. c) The terms of trade deteriorate (fall) from 2018 through 2021. d) A terms-of-trade ―improvement‖ is an increase in the price of exports relative to the price of imports. This is good for the country as a whole because it means that one unit of exports can purchase more units of imports, indicating that the country as a whole can get access to more overall consumption by giving up fewer of its own produced goods. *****

_______________________

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Chapter 20: Trade Policy _______________________ Most introductory textbooks have a single chapter on international trade, which includes both the simple theory of the gains from trade as well as some elementary aspects of trade policy. Given the importance of trade and trade policy to Canada, however, we feel it is valuable to offer a more thorough treatment. This separate chapter examines both the theory and practice of trade policy. We restate the case in favour of free trade. We then offer some reasonable arguments in favour of protection as well as some invalid ones. We review policies that raise import prices as well as policies that directly restrict quantities; we also discuss how the levying of tariffs can sometimes lead to ―tariff wars,‖ as happened in the 1930s and may be happening again today.

We discuss international trade agreements, such as the WTO and NAFTA (and its renegotiation into the USMCA).

Finally, we address the emerging concern related to whether there are costs associated with trading with geopolitical rivals when the benefits of that trade are used to finance their nefarious activities. We hope instructors will take the time to cover some of the central themes in this chapter. *** The chapter is divided into three sections. The first section deals with the theory of trade policy.

Here we review the case for free trade (which was made in detail in Chapter 19) and then examine in detail the case for protectionism. We offer three general situations in which protection might sensibly be pursued, even if it involves a sacrifice of some income: diversifying the economy and avoiding volatile swings in national income; protecting certain groups of workers; and enhancing national security. We also offer three arguments in

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favour of protection as a means of increasing national income: to improve a country‘s terms of trade; to encourage infant industries or promote learning by doing; and to help the country earn pure profits with ―strategic‖ exports. We then discuss four commonly heard, but fallacious, arguments for protectionism. A box examines the connection between recessions and protectionism, motivated by the global recession of 2008–2009 and how it led political leaders to commit to avoiding implementing the kinds of protectionist measures that had been used during the Great Depression.

The design of this section reflects our belief that it is very important for students to get a balanced treatment of the cases for and against free trade. Too many textbooks present the arguments (on either side) as if there is no sensible opposing view. We emphasize that there are some conditions under which free trade may not be optimal, but they tend to be rather special conditions; students should understand how special these conditions are.

The second section discusses methods of protection. We discuss policies that directly raise prices, such as tariffs; we also discuss policies that directly reduce quantities, such as import quotas. In the case of quotas, the newly created rents are received by the foreign producers and their distributors, rather than by the domestic governments or producers. The long-lasting dispute between Canada and the United States over softwood lumber offers an excellent example of the choice between tariffs and quotas. We then examine traderemedy laws and non-tariff barriers, including dumping and countervailing duties. We end this section with a new discussion of the confrontation of trade policy with climate policy—a brief description of the emerging issue of ―border carbon adjustments,‖ which have been implemented recently in the European Union. This leads to a box addressing another policy area that confronts trade policy—the supply-managed agricultural industries Copyright © 2026 Pearson Canada Inc.

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399

that are becoming an obstacle to international trade negotiations.

The chapter‘s final section discusses current trade policy. We examine the WTO, the various types of regional trade agreements, and we also explain the effects of trade creation and trade diversion.

The final discussion in the section centres around NAFTA and its successor agreement, USMCA. We review the core elements of the agreement and briefly discuss the trade performance following the agreement. Our overall discussion of Canadian free trade leads to a box on Canadian wine—a surprising free-trade success story.

Answers to Study Exercises

Fill-in-the-Blank Questions Question 1 a) comparative; specialize; comparative advantage b) worse c) lower d) infant industry e) invalid; exported f) trade; employment

Question 2 a) increase; decrease; increase; fall b)

domestic

producers;

the

government;

consumers; foreign producers c) reduction; deadweight Copyright © 2026 Pearson Canada Inc.

domestic

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d) increase; fall; increase e) domestic producers; foreign producers; domestic consumers f) reduction; deadweight

Question 3 a) trade creation b) trade diversion; countries outside the group c) national treatment; domestic; foreign

Review Questions Question 4 This question is good because it poses the arguments in “real” language instead of textbook language and thus forces students to really think about what is being said, and whether it is sensible. These would be good exam questions for this reason. a) This is the oft-heard argument about the need to diversify an economy so that it does not rely so much on one type of exports—agricultural in this case. This is potentially a valid argument, but it needs to be considered carefully.

Because of volatile international prices, the income earned from agricultural exports is also volatile. The country‘s average income may be high, but volatile. It is reasonable to consider giving up some average income in return for more stable income—this is the essence of insurance. The real Copyright © 2026 Pearson Canada Inc.

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policy question is whether government policies— tariffs or subsidies for the manufacturing sector, for example—can successfully lead to the build-up of that sector, and at what cost. There is a tradeoff between the benefits of more stable national income and the costs of the policies required to get this stability. b) This statement is pretty much the classic argument in favour of using protectionist policies to increase overall employment, and there is little or no merit to this invalid argument.

Using tariffs to protect against the imports of goods ―we can produce at home‖ will almost certainly increase employment and wages in those protected sectors, but it will do so by raising prices on those products for all consumers, including the domestic firms that may purchase those products as intermediate goods. It will also lead to lower incomes in the countries we are importing from, and this will lead them to purchase fewer of our exports. There is a tradeoff between the gains to the protected sector and the losses to the other parts of the economy. The problem in this policy debate is that the increase in jobs in the protected sector will be easy to identify whereas the larger costs to the economy, including likely the reduction in overall employment, are much less direct and harder to identify. c) This is a commonly heard argument by (extreme) supporters of free trade, and it is almost certainly wrong—an invalid argument.

Free trade is indeed based on voluntary transactions between firms and consumers in one country and firms and consumers in other countries.

And the parties directly engaged in those transactions will no doubt be better off as a result of those transactions. But there is more going on than this—there is also the changes in the allocation of resources that occur as domestic

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firms and workers move away from some sectors (formerly protected ones) and move toward other sectors (with growing exports). Such movements of resources do not happen instantly or smoothly.

There will be bankruptcies as firms close down.

Unemployment will rise and last until workers find new jobs. So, while the country as a whole may be better off from freer trade—measured by per capita GDP—it is very likely that some individual firms and workers will be made worse off, at least during the period of transition. This is the key tradeoff for any country moving toward freer trade. d) This statement mixes two important objectives— raising overall living standards and raising profits and wages in a specific sector. It is unlikely that tariffs are a good way to accomplish both objectives, and so this is (usually) an invalid argument.

Tariffs and other protectionist policies may be successful in raising wages or employment for some workers in specific sectors, but unless the country is large in the international markets for those products or the sector generates economic profits in foreign markets, these tariffs will likely lead to a reduction in the country‘s overall level of living standards. The tariffs will raise prices for all domestic consumers (some of whom are firms using the product as intermediate goods, which will now have higher costs) and will lead foreign consumers (whose income has fallen due to our tariffs) to purchase less of our exports. Once again there is a tradeoff between the benefits to the protected firms and workers and the costs to the rest of the economy. e) This statement is often heard in times of conflict and makes sense on the surface. The danger is that it is often used to advocate protection for products and sectors that are not genuinely related

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to national security, and so it is often an invalid argument.

One can easily imagine several products whose supplies to the military need to be secure, so that in times of conflict or war the military‘s access to these supplies is not hampered in any way. Using tariffs or subsidies to encourage the domestic production of such goods may be justified on these grounds. But there will be a cost from using these policies, as presumably the supplies can be imported more cheaply from abroad (otherwise we would be producing them domestically already).

The tradeoff here is between the extra costs we incur to encourage domestic production and the benefits we receive by having a more secure source of supply. The danger is that this argument is used for a range of products that are not genuinely connected to our national security. In this case we would suffer the increase in costs and get no benefit from greater security of supply. But the protected firms and workers would be better off; it is no surprise that protectionist arguments of this type often come from those sectors that would benefit directly from the protection.

Question 5

a) See the figure below. The demand and supply curves are for Canadian consumers and Canadian producers, respectively. The world price, pw, is shown below the price that would exist in Canada if Canada were a closed economy, pc.

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Canada produces Q1 units of steel and consumes Q2 units of steel, importing the difference from abroad.

b) We assume here that we are talking about one particular grade of steel, so that the foreign steel is identical to the domestic steel. With a tariff of t dollars per unit on imported steel, the price in Canada of imported steel will now be pw+t.

But the law of one price says that identical products will sell for the Copyright © 2026 Pearson Canada Inc.

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same price, so the price of domestic steel will also rise by t dollars per unit (the price in the rest of the world will not be affected by the Canadian tariff since Canada is a small country). The Canadian price rises to pw + t. The quantity supplied domestically rises to Q3 while the quantity demanded domestically falls to Q4. Imports therefore fall from Q1Q2 to Q3Q4. c) Domestic consumers clearly lose since they consume less steel and pay a higher price per unit. The loss of consumer surplus is shown by areas 1 plus 2 plus 3 plus 4.

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producer surplus is shown by area 1. The taxpayers (in the form of the government) benefit by the amount shown in area 3, since this is the revenue raised by the tariff. Thus, area 1 is simply a redistribution away from consumers toward producers, and area 3 is a redistribution away from consumers toward taxpayers. We are left with areas 2 and 4 as a net loss to society—this is the deadweight loss of the tariff.

Question 6 a) Before the tariff is imposed, the price of shoes is pw and Q1 units are produced in Canada. But Q2 units are consumed in Canada, so the difference, Q1Q2, is imported. After Copyright © 2026 Pearson Canada Inc.

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the tariff is imposed, the price is pw + t, and imports fall to Q3Q4. b) Canadian shoe production rises from Q1 to Q3 as a result of the tariff being imposed. The producer surplus of Canadian shoe producers increases by area A. c) The tariff raises the domestic price and reduces consumer surplus in Canada by areas A + B + C + D. d) The tariff revenue is equal to the per-unit tariff times the quantity of imports. The quantity of imports is Q3Q4. So the tariff revenue is shown by area C. e) The overall effect of the tariff is to create a net loss of surplus for the economy, represented by the areas B + D. This area is the deadweight loss of the tariff.

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Question 7 a) At the world price of pw, Canadian consumers demand Q2 units of shoes, Q1Q2 of which must come from imports. If the government restricts the quantity of imports to Q3Q4, there will be an excess demand for shoes in Canada at the price pw. This excess demand forces up the Canadian price. The equilibrium is reached when at the new price the demand for imported shoes just equals Q3Q4 units. (Note that as the Canadian price rises, two things reduce the quantity of imports demanded—an increase in domestic production and a reduction in domestic consumption.) From the diagram it Copyright © 2026 Pearson Canada Inc.

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is clear that this new price must be exactly equal to pw + t.

Note also that the law of one price is not violated here, although it may appear to be. The high price in Canada is caused by the import quota.

There is no way that arbitrageurs could buy shoes at the low world price and then sell them at the high Canadian price because such arbitrage would violate the import quota and thus be illegal. So it is the obstacle to arbitrage that permits the price differential to exist.

b) With a tariff, area C would be the tariff revenue. But with an import quota equal to Q3Q4 units, there is no tariff revenue. It is the foreign producers who now earn area C—they earn a higher price on their Q3Q4 exports to Canada than they earn on their other units.

Having the right to sell in the import-restricted market is valuable! c) The effect on consumers is the same with a tariff or a quota— Copyright © 2026 Pearson Canada Inc.

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consumers face a higher price and their consumption falls in both cases. It is also the same for Canadian producers—they produce and sell more and also benefit from a higher price. The only difference is area C. With a tariff, this area is the tariff revenue for Canadian taxpayers (their government). With a quota, this area is revenue for foreign producers. For Canada overall, therefore, the tariff is preferable to the import quota.

Question 8 a) These policies were referred to as ―Voluntary Export Restrictions (VERs).‖ VERs are voluntary because they raise profits for the foreign producers. Similar to the Copyright © 2026 Pearson Canada Inc.

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case of the import quota in the previous question, the VERs had the effect of restricting the volume of imports of Japanese cars into North America. By creating an ―artificial‖ scarcity of cars, the VER drove up the price of all cars in North America. The result is that the Japanese producers were able to earn higher profits (as shown by area 3 in Figure 20-2 in the textbook). The VER effectively gives the Japanese producers some monopoly power that they might not have otherwise had. b) See the analysis in Question 6(b).

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would be collected by their own government in the form of tariff revenue. c) North American consumers are paying for the benefits to the Japanese producers (and to the domestic producers and their workers).

Question 9 This is a good question to make students think through the various types of trade polices that are available. It is important for students to see who gains and who loses from the alternative policies.

a) The consumers in Houseland are made worse off, since the price of lumber will rise. These consumers will generally include firms that use lumber as an input. The lumber producers (and workers) in Houseland are better off, since they are protected and can sell their Copyright © 2026 Pearson Canada Inc.

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product at a higher price than before. The lumber producers and workers in Forestland are worse off since the tariff reduces the demand for their product. b) The export tax imposed by Forestland reduces the supply of lumber to Houseland and thus drives up the price of lumber in Houseland. The consumers in Houseland are worse off, just as in case (a). The lumber producers and workers in Houseland are better off, just as in case (a), since the price of their product is driven up. The lumber producers and workers in Forestland are also worse off, just as in case (a)—their product sells for a higher price in Houseland, but this benefit gets taxed away by their home government, leaving them with only the costs associated with reduced output levels. The one important difference from case (a), however, is that with the export tax the government of Forestland collects the tax revenue, whereas with the import tariff the government of Houseland collects the tariff (tax) revenue. c) The agreement to restrict exports from Forestland drives up the price of lumber in Houseland. Consumers in Houseland are worse off.

Lumber producers and workers in Houseland are better off. Lumber producers and workers in Forestland are now better off, since they are effectively imposing some monopoly power—by restricting output they are driving the price up.

The extent of the price rise, of course, will depend on the elasticity of demand for lumber in Houseland. d) Which policy will get the most political support?

In Houseland, all three policies are bad for

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consumers and good for the lumber producers and workers. So there will naturally be disagreement between these two groups over any of the policies.

In Forestland, the lumber producers would probably favour the voluntary export restriction, but the government may feel it necessary to use an export tax in order to enforce such a restriction.

Question 10

a) American consumers would benefit from the dumping of Canadian steel into the U.S. market because they would be able to buy steel at a lower price than they otherwise could. American steel producers (and their workers) would be harmed since they would lose sales to the Canadian steel companies. b) With antidumping duties imposed on the imported Canadian steel, the U.S. steel producers would be protected—they would be better off. But American consumers would now be forced to pay a higher price than what would otherwise be the case—they would be worse off. c) The simple view of dumping is that the foreign (Canadian) producers are offering (for whatever reason) low-priced products to domestic (American) consumers, and the standard theory of the gains from Copyright © 2026 Pearson Canada Inc.

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trade suggests that the United States would be better off overall to trade freely, and thus to welcome the dumped steel with open arms. U.S. steel producers could then reallocate their resources toward the production of goods for which the United States has a comparative advantage.

A contrary view emphasizes that such dumping is rarely permanent. If the Canadian firms are dumping the steel as a means of driving the American producers out of business, then the long-run effect will be less competition and higher prices in the United States.

Question 11 These successive points are designed to show the student that the fear of cheap Chinese goods flooding into Canada and causing a major loss of Canadian jobs is probably highly unwarranted. a) Chinese comparative advantage depends on relevant unit labour costs, which is a combination of wage rates and labour productivity.

The statement suggests that Chinese workers were cheap (per hour), but quite unproductive, and so expensive (per unit of output produced). b) The theory, and the experience of world trade and tariff reductions since 1947, shows that rich countries do not have to fear trading with poor countries. The gains from trade are generally shared (not necessarily equally) among the trading partners.

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c) As time passes, more and more production passes into this category where wage costs are a very low proportion of total costs. For such products, location will be mainly determined by factors other than relative wage rates.

Problems Question 12 a) With no international trade in hockey sticks (autarky), the Canadian equilibrium price would be $100 and the quantity transacted would be 1.0 million sticks per year. b) With international trade and a world price of $120, Canadian firms would produce 1.2 million sticks and Canadian consumers would purchase 800,000. Canada would therefore export 400,000 hockey sticks per year. c) If the world price were instead $60, Canadian firms would produce only 600,000 sticks per year while Canadian consumers would purchase 1.4 million.

The balance of 800,000 sticks per year would come from imports. d) If the world price were $60 but the Canadian government imposed a tariff of 50 percent, the tariff-ridden world price (in Canada) would increase to $90. Even though the tariff applies only to imported sticks, the fact that all sticks are identical means that all sticks in Canada will sell at this higher tariff-ridden price. In this situation, Canadian production rises to 900,000 sticks per year, Canadian consumption falls to 1.1 million, and the level of imports falls to 200,000 sticks per year. e) The beneficiaries of the tariff are the Canadian firms, who can now sell more sticks at a higher price, and their workers, who will be more in demand and may as a result receive higher wages and more secure employment. Those hurt by the Canadian tariff

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are Canadian consumers, who prices for the same product.

now

must

pay

higher

f) With the 50 percent tariff in place, the total tariff revenue to the Canadian government is the volume of imports (200,000 sticks per year) times the tariff ($30 per stick). This is $6 million per year, which can be used to finance government priorities.

Question 13 a) With a 20 percent tariff on all imported towels, the lowest-price towels are those made in Canada.

Canada will produce its own towels—none will be imported. b) With no tariffs at all, the cheapest towels are the Bangladeshi ones. So Bangladeshi towels get imported into Canada. This is ―trade creation.‖ c) With free trade between Canada and the United States, but a 20 percent tariff on goods from other countries, the U.S. towels now Copyright © 2026 Pearson Canada Inc.

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become the cheapest towels in the Canadian market. Canada imports U.S. towels and stops importing towels from Bangladesh. This is ―trade diversion.‖ d) Part (b) is trade creation. It is beneficial because Canada is buying from the cheapest producer rather than producing towels domestically at a higher price. Part (c) is trade diversion. It is not beneficial because trade is diverted from the genuinely low-cost producer (Bangladesh) toward a higher-cost producer (the United States) because of the tariff that applies only to Bangladesh.

Question 14

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a) A tariff of 33% on imported siding will increase the price within Canada from $6 to $8 per square foot (while leaving the world price of $6 unaltered). Canadian producers will move up the supply curve, increasing production from 200,000 to 350,000 bundles per month. As the price rises, Canadian consumers will reduce their quantity demanded, from 800,000 to 650,000 bundles per month. b) As a result of the tariff (and the reduced consumption and increased production), Canadian imports of siding will fall from 600,000 to 300,000 bundles per month. Each imported bundle has 100 square feet of siding, and the tariff is $2 per square foot. So the Canadian Copyright © 2026 Pearson Canada Inc.

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government will collect tariff revenues equal to $2 × 100 × 300 000 = $60,000,000 per month. c) If instead the Canadian government imposes a maximum level of imported siding of 300,000 bundles per month, the result will be that the Canadian price rises to the point where domestic demand equals domestic production + imports of 300,000 bundles. This implies a price of $8 per square foot, exactly the same as under the 33% tariff in part (a). Domestic production rises to 350,000 bundles per month and Canadian consumption falls to 650,000 bundles per month.

Imports fall to 300,000 bundles per month. The effects on the domestic Copyright © 2026 Pearson Canada Inc.

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market under the tariff and the (equivalent) quota are exactly the same, except… d) …there is no tariff revenue for the Canadian government under the quota system. The higher price paid by Canadian consumers (on imported siding) goes to the foreign firms who are producing those imported goods. e) The $2 tariff and the 300,000 bundle import quota have exactly the same effects on domestic consumers and domestic producers.

But they differ in terms of the tariff revenue which accrues to Canadian taxpayers (or their government).

The tariff is a clearly preferred policy for Canada, since Canada

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gains by receiving the tariff revenue. *****

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