Solution Manual For Microeconomics 23e Campbell McConnell, Stanley Brue and Sean Flynn Chapter(1-28)

Solution Manual For Microeconomics 23e Campbell McConnell, Stanley Brue and Sean Flynn Chapter 1-28

Chapter 01 - Limits, Alternatives, and Choices McConnell Brue Flynn 23e DISCUSSION QUESTIONS 1. What is an opportunity cost? How does the idea relate to the definition of economics?

Which of the following decisions would entail the greater opportunity cost: allocating a square block in the heart of New York City for a surface parking lot or allocating a square block at the edge of a typical suburb for such a lot? Explain. LO1.1 Answer: An opportunity cost is what was sacrificed to do or acquire something else. The condition of scarcity creates opportunity cost. If there was no scarcity, there would be no need to sacrifice one thing to acquire another. The opportunity cost would be much higher in New York City as the alternative uses for that square block are much more valuable than for a typical suburban city block.

2. Cite three examples of recent decisions that you made in which you, at least implicitly, weighed marginal cost and marginal benefit. LO1.1 Answer: Answers will vary, but may include the decision to come to class, to skip breakfast to get a few extra minutes of sleep, to attend college, or to make a purchase. Marginal benefits of attending class may include the acquisition of knowledge, participation in discussion, and better preparation for an upcoming examination. Marginal costs may include lost opportunities for sleep, meals, or studying for other classes. In evaluating the discussion of marginal benefits and marginal costs, be careful to watch for sunk costs offered as a rationale for marginal decisions.

3. What is ―utility‖ and how does it relate to purposeful behavior? LO1.1 Answer: ―Utility‖ refers to the pleasure, happiness, or satisfaction gained from engaging in an activity (eating a meal, attending a ball game, etc.). It is an important component of purposeful behavior because people will allocate their scarce time, energy, and money in an attempt to gain the most utility possible.

4. What are the key elements of the scientific method, and how does this method relate to economic principles and laws? LO1.2 Answer: The key elements include the gathering of data (observation), the formulation of possible explanations (hypothesis), testing the hypothesis, 1-1 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

determining the validity of the hypothesis, and repeated testing of the hypothesis that have appeared to be valid in prior tests.

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

5. Make (a) a positive economic statement of your choice, and then (b) a normative economic statement relating to your first statement. LO1.3 Answer: Answers will vary. Example: (a) The unemployment rate is 4.8 percent; (b) the unemployment rate is too high. In general, we treat ―what is‖ statements as positive, ―what should be‖ as normative, but keep an eye out for statements like ―at full employment an increase in the production of pizzas should come at the cost of less robots.‖ Some students may incorrectly identify the statement as normative because of the term ―should.‖ 6. How does the slope of a budget line illustrate opportunity cost and trade-offs? How does a budget line illustrate scarcity and the effect of limited incomes? LO1.4 Answer: Budget lines are always sloped downward. This downward slope shows an inverse relationship between the two goods, meaning that as you increase one, the other must decrease. This decrease is what you are giving up, or the opportunity cost, of the good you are getting more of.

Budget lines illustrate scarcity in that they show you are limited by your income.

Since they slope downward, they show you cannot keep getting more and more of both goods. There is always a trade-off. The area beyond the budget line represents combinations of the goods that are beyond your income.

7. What are economic resources? What categories do economists use to classify them?

Why are resources also called factors of production? Why are they called inputs? L O1.5 Answer: Economic resources are the natural, human, and manufactured inputs used to produce goods and services.

Economic resources fall into four main categories: labor, land (natural resources), real capital (machines, factories, buildings, etc.,) and entrepreneurs.

Economic resources are also called factors of production because they are used to produce goods and services. They are called inputs because they go into a 1-2 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

production process (like ingredients go into a bowl to make a cake), with the resulting goods and services also being referred to as output.

8. Why is money not considered to be a capital resource in economics? Why is entrepreneurial ability considered a category of economic resource, distinct from labor? What roles do entrepreneurs play in the economy? LO1.5 Answer: Money is not considered a capital resource because money is not productive. It provides access to resources but by itself, money does not directly contribute to the production of goods and services. Additionally, the quantity of money in circulation does not determine an economy‘s productive capacity, while the amount of capital and other resources does. Doubling the amount of money in circulation does not change the economy‘s physical capacity to produce goods and services. Money is, however, referred as a financial resource and as financial capital, reflecting its ability to acquire real economic resources.

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

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

9. Explain the typical shapes of marginal-benefit and marginal-cost curves. How are these curves used to determine the optimal allocation of resources to a particular product? If current output is such that marginal cost exceeds marginal benefit, should more or fewer resources be allocated to this product? Explain. LO1.6 Answer: The marginal benefit curve is downward sloping, MB falls as more of a product is consumed because additional units of a good yield less satisfaction than previous units. The marginal cost curve is upward sloping, MC increases as more of a product is produced since additional units require the use of increasingly unsuitable resources. The optimal amount of a particular product occurs where MB equals MC. If MC exceeds MB, fewer resources should be allocated to this use, as the additional cost is more than the additional benefit. The resources are more valuable in some alternative use (as reflected in the higher MC) than in this use (as reflected in the lower MB).

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10. Suppose that, on the basis of a nation‘s production possibilities curve, an economy must sacrifice 10,000 pizzas domestically to get the 1 additional industrial robot it desires but it can get the robot from another country in exchange for 9,000 pizzas.

Relate this information to the following statement: ―Through international specialization and trade, a nation can reduce its opportunity cost of obtaining goods and thus ‗move outside its production possibilities curve.‖ LO1.7 Answer: The message of the production possibilities curve is that an individual nation is limited to the combinations of output indicated by its production possibilities curve. International specialization means directing domestic resources to output which a nation is highly efficient at producing. International trade involves the exchange of these goods for goods produced abroad.

Specialization and trade have the same effect as having more and better resources or discovering improved production techniques. The output gains from greater international specialization and trade are the equivalent of economic growth.

11. LAST WORD Studies indicate that married men on average earn more income than unmarried men of the same age and education level. Why must we be cautious in concluding that marriage is the cause and higher income is the effect?

Answer: Cause and effect are difficult to determine in many instances. Here, it may be possible that the same underlying personality characteristics—such as the ability to get along with people and a commitment to hard work— that lead people to on average earn higher incomes also on average lead them to be more successful in finding mates. Thus, it may not be the case at all that marriage causes higher incomes. Rather, underlying personality characteristics may drive both higher earnings and a greater likelihood of getting married.

REVIEW QUESTIONS 1. Match each term with the correct definition. LO1.1 economics opportunity cost marginal analysis utility a. The next-best thing that must be foregone in order to product one more unit of a given product. b. The pleasure, happiness, or satisfaction obtained from consuming a good or service. c. The social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity. d. Making choices based on comparing marginal benefits with marginal costs.

Answer: a. Opportunity cost; b. Utility; c. Economics; d. Marginal analysis

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2. Indicate whether each of the following statements applies to microeconomics or macroeconomics: LO1.3 a. The unemployment rate in the United States was 5.2 percent in August 2021. b. A U.S. software firm laid off 15 workers last month and transferred the work to India. c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of oranges to rise. d. U.S. output, adjusted for inflation, decreased by 3.5 percent in 2020. e. Last week Wells Fargo Bank lowered its interest rate on business loans by onehalf of 1 percentage point. f. The consumer price index rose by 0.3 percent from July 2021 to August 2021.

Answer: a. Macroeconomics; b. Microeconomics; c. Microeconomics; d.

Macroeconomics; e. Microeconomics; f. Macroeconomics 3. Suppose that you initially have $100 to spend on books or movie tickets. The books start off costing $25 each and the movie tickets start off costing $10 each. For each of the following situations, would the attainable set of combinations that you can afford increase or decrease? LO1.4 a. Your budget increases from $100 to $150 while the prices stay the same. b. Your budget remains $100, and the price of books remains $25, but the price of movie tickets rises to $20. c. Your budget remains $100, and the price of movie tickets remains $10, but the price of a book falls to $15.

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

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

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b. 5 pens. c. zero pens. d. 4 pens.

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

5. As economists use the terms, investment is related to capital in that same way that: L O1.5 a. MB is to MC. b. practice is to acquiring skill. c. color is to sound. d. positive economics is to normative economics.

Answer: The correct answer is b (practice is to acquiring skill) because investment in physical or intangible capital increases a nation's stock of capital in the same way that practice increases a person's level of skill in whatever they choose to practice.

6. For each of the following situations involving marginal cost (MC) and marginal benefit (MB), indicate whether it would be best to produce more, fewer, or the current number of units. LO1.6 a. 3,000 units at which MC = $10 and MB = $13. b. 11 units at which MC = $4 and MB = $3. c. 43,277 units at which MC = $99 and MB = $99. d. 82 units at which MC < MB. e. 5 units at which MB < MC. Answer: a. More, because MB > MC, the benefit of consuming one more unit exceed the opportunity costs (scarce resources used elsewhere) of producing that additional unit. b. Fewer, because MC > MB, the opportunity costs (scarce resources used elsewhere) of producing one more unit exceed the benefit of consuming that additional unit. c. Current number, because MB = MC, there is no net gain in using scarce resources in producing and consuming one more unit. d. More, because MB > MC, see the explanation for part (a) e. Fewer, because MB < MC, see the explanation for part (b) 7. Explain how (if at all) each of the following events affects the location of a country‘s production possibilities curve. LO1.6 1-6 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

a. b. c. d.

The quality of education increases.

The number of unemployed workers increases.

A new technique improves the efficiency of extracting copper from ore.

A devastating earthquake destroys numerous production facilities.

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

8. What are the two major ways in which an economy can grow and push out its production possibilities curve? LO1.7 a. Better weather and nicer cars b. Higher taxes and lower spending c. Increases in resource supplies and advances in technology d. Decreases in scarcity and advances in auditing Answer: The economy produces output from resource inputs like land, labor, and capital. So one major way for an economy to grow and push out its production possibilities curve is for it to obtain more resources. The second major way is to develop new and better technologies so that the economy can produce more from any given amount of resources.

9. To obtain greater output, a nation can: LO1.7 a. invest in more goods for the future (capital) b. increase the quantity and quality of its resources c. engage international specialization and trade d. all of the above Answer: The correct answer is d, all of the above.

There are three primary ways by which a country can increase the amount of output that its economy can produce. Over the longer run, it can do so by devoting more if its current output toward increasing its stock of productive capital by investing (rather than consuming) a larger share of its current output. It can also increase its output by increasing the quantity and quality of its resource inputs, since, all other things equal, higher quantities and qualities of resources increase 1-7 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the amount of output a country can produce. Finally, countries can engage in international specialization and trade to obtain greater output by specializing in the production of items that the country can produce at relatively low opportunity costs compared to other countries and then trading for items for which the country in question has relatively high opportunity costs of production.

PROBLEMS 1. Potatoes cost Janice $1 per pound, and she has $5.00 that she could possibly spend on potatoes or other items. If she feels that the first pound of potatoes is worth $1.50, the second pound is worth $1.14, the third pound is worth $1.05, and all subsequent pounds are worth $0.30 per pound, how many pounds of potatoes will she purchase?

How many pounds will she purchase if she has only $2 to spend? LO1.1 Answer: 3; 2 Feedback: Janice will purchase potatoes until the value of potatoes is less than the cost of potatoes or until her income has been exhausted. For example, assume Janice has $5.00 to spend on potatoes or other items and the cost of a pound of potatoes is $1. Now assume the first pound of potatoes is worth $1.50 to Janice.

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

Now assume Janice only has $2.00 to spend on potatoes. She will purchase the first pound because it is worth $1.50 to her and it only costs a $1. She will purchase the second pound because it is worth $1.14. She has now spent her entire income on potatoes. She would like to purchase the third pound because the value of this pound of potatoes is $1.05, but she does not have the income to make this purchase. Thus, Janice will purchase 2 pounds of potatoes at a total cost of $2.00.

2. Pham can work as many or as few hours as she wants at the college bookstore for $12 per hour. But due to her hectic schedule, she has just 15 hours per week that she can spend working at either the bookstore or at other potential jobs. One potential job, at a café, will pay her $15 per hour for up to 6 hours per week. She has another job offer at a garage that will pay her $13 an hour for up to 5 hours per week. And she has a potential job at a daycare center that will pay her $11.50 per hour for as many hours as she can work. If her goal is to maximize the amount of money she can make each week, how many hours will she work at the bookstore? LO1.1

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Answer: 4.

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

She will choose to work at the café for the full 6 hours because the wage rate at the café is $15 per hour, which is greater than the wage rate at the bookstore of $12. This leaves her with 9 hours of work time remaining. Next, she will choose to work at the garage for the full 5 hours because the wage rate here is $13, which again is greater than the bookstore wage rate $12. After this decision, she only has 4 hours of work time remaining. She will choose to work these last 4 hours at the bookstore because the bookstore wage rate of $12 exceeds the daycare center wage rate of $11.50.

3. Suppose you won $15 on a lotto ticket at the local 7-Eleven and decided to spend all the winnings on candy bars and bags of peanuts. Candy bars cost $0.75 each while bags of peanuts cost $1.50 each. LO1.4 a. Construct a table showing the alternative combinations of the two products that are available. b. Plot the data in your table as a budget line in a graph. What is the slope of the budget line? What is the opportunity cost of one more candy bar? Of one more bag of peanuts? Do these opportunity costs rise, fall, or remain constant as additional units are purchased? c. Does the budget line tell you which of the available combinations of candy bars and bags of peanuts to buy? d. Suppose that you had won $30 on your ticket, not $15. Show the $30 budget line in your diagram. Has the number of available combinations increased or decreased?

Answers: Part a: Alternative Combinations Goods

A

B

C

D

E

F

Candy bars

0

4

8

12

16

20

Bags of peanuts

10

8

6

4

2

0

Part b:

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Bags of Peanuts

Slope 

 .75   .5 1.5

10

20

Candy Bars

Feedback: The slope for the budget line, with candy bars on the horizontal axis, is −0.5 (= −Pcb/Pbp) The opportunity cost of one candy bar is 0.5 bags of peanuts.

Note that the figure could also be drawn with bags of peanuts on the horizontal axis. The slope of that budget line would be −2. The opportunity cost of one more candy bar is ½ of a bag of peanuts. The opportunity cost of one more bag of peanuts is 2 candy bars. These opportunity costs are constant. They can be found by comparing any two of the consumption alternatives for the two goods.

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

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

Part d: Increased.

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B ags of P eanuts Incom e = $ 15

20

Income = $30

10

20

40

Candy Bars

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

4. Suppose that you are on a desert island and possess exactly 20 coconuts. Your neighbor, Friday, is a fisherman, and he is willing to trade 2 fish for every 1 coconut that you are willing to give him. Another neighbor, Kwame, is also a fisherman, and he is willing to trade 3 fish for every 1 coconut. LO1.5 a. On a single figure, draw budget lines for trading with Friday and for trading with Kwame. (Put coconuts on the vertical axis.) b. What is the slope of the budget line from trading with Friday? c. What is the slope of the budget line from trading with Kwame? d. Which budget line features a larger set of attainable combinations of coconuts and fish? e. If you are going to trade coconuts for fish, would you rather trade with Friday or Kwame? Why?

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Answers: Part a:

Part b: −1/2 Feedback: The slope of the budget line from trading with Friday equals −(1/2).

This implies that for every coconut you give up, Friday must give up two fish. Or, for every fish that Friday gives up, you must give up (1/2) a coconut.

Part c: −1/3 Feedback: The slope of the budget line from trading with Kwame equals −(1/3).

This implies that for every coconut you give up, Kwame must give up three fish.

Or, for every fish that Friday gives up, you must give up (1/3) a coconut.

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

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

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5. Refer to the following production possibilities table for consumer goods (automobiles) and capital goods (forklifts): LO1.6

a. Show these data graphically. Upon what specific assumptions is this production possibilities curve based? b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift? Which characteristic of the production possibilities curve reflects the law of increasing opportunity costs: its shape or its length? c. If the economy characterized by this production possibilities table and curve is producing 3 automobiles and 20 forklifts, what could you conclude about its use of its available resources? d. Is production at a point outside the production possibilities curve currently possible? Could a future advance in technology allow production beyond the current production possibilities curve? Could international trade allow a country to consume beyond its current production possibilities curve?

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

automobiles

D (12,6)

C (21,4) 8 B (27,2)

30

forklifts

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

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Feedback: Consider the following example:

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

The cost of producing 2 more automobiles (4 automobiles to 6 automobiles) can be found by moving to point D and calculating the number of forklifts given up for the 2 additional automobiles. At point D, the economy is producing 12 forklifts, which is a loss of 9 forklifts (moving from C to D) for the 2 additional automobiles.

The cost of producing one more forklift can be found in an equivalent fashion.

First, we will move to point B (from point C). Here we must give up 2 automobiles to get 6 forklifts.

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

Part c: Underutilizing.

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

Part d: No; Yes; Yes. Feedback: No, the country cannot produce outside its PPC. Yes, a technological advance would shift the PPC outward allowing the country produce more with a given amount of inputs. Yes, a technological advance would shift the PPC outward, allowing the country to produce more with a given amount of inputs.

Yes, by specializing in goods, we have a comparative advantage producing, so we can trade to gain access to goods beyond our own PPC.

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6. Refer to the following figure. Suppose that the cost of cheese falls, so that the marginal cost of producing pizza decreases. Will the MC curve shift up or down?

Will the optimal amount of pizza increase or decrease? Explain. LO1.6

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

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

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

Answers: See figures.

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Technological advance in producing forklifts and not automobiles.

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

8

30

forklifts

Technological advance in producing automobiles and not forklifts.

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

automobiles

8

30

forklifts

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Technological in advance in producing automobiles and forklifts.

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

automobiles

8

30

forklifts

8. Because investment and capital goods are paid for with savings, higher savings rates reflect a decision to consume fewer goods in the present so as to invest in more goods for the future. On average, households in China save about 35 percent of their annual income each year, whereas U.S. households save only around 7 percent. At the same time, production possibilities are growing at roughly 6 percent per year in China but only about 2 percent per year in the United States. Use graphical analysis of ―present goods‖ versus ―future goods‖ to explain the difference between China‘s growth rate and the U.S. growth rate. LO1.7 Answers: See figures below

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United States

China Future Goods

Future Goods

B

A Present Goods

Present Goods

Feedback: Since the United States is consuming more today rather than saving, their production possibilities curve will shift out slower (less) over time because households are accumulating less capital. China's production possibilities curve will shift out faster (more) over time because households are accumulating more capital. See diagrams above.

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Chapter 02 - The Market System and the Circular Flow McConnell Brue Flynn 23e DISCUSSION QUESTIONS 9. Contrast how a market system and a command economy try to cope with economic scarcity. LO2.1 Answer: A market system allows for the private ownership of resources and coordinates economic activity through market prices. Participants act in their own self-interest and seek to maximize satisfaction or profit through their own decisions regarding consumption or production. Goods and services are produced and resources are supplied by whoever is willing to do so. The result is competition and widely dispersed economic power.

The command economy is characterized by public ownership of nearly all property resources, and economic decisions are made through central planning.

The planning board, appointed by the government determines production goals for each enterprise. The division of output between capital and consumer goods is centrally decided based on the board‘s long-term priorities.

10. How does self-interest help achieve society‘s economic goals? Why is there such a wide variety of desired goods and services in a market system? In what way are entrepreneurs and businesses at the helm of the economy, but commanded by consumers? LO2.2 Answer: The motive of self-interest gives direction and consistency to the economy. The primary driving force of the market system is self-interest.

Entrepreneurs try to maximize their profits; property owners want the highest price for their resources; workers choose the job with the best wages, fringe benefits and working conditions. Consumers apportion their expenditures to maximize their utility, while seeking the lowest possible prices. As individuals express their free choice, the economy is directed to produce the most wanted goods at the lowest possible cost.

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

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

11. Why are private property, and the protection of property rights, so critical to the success of the market system? How do property rights encourage cooperation? LO2.2 Answer: The ownership of private property and the protection of property rights encourage investment, innovation, and, therefore, economic growth. Property rights encourage the maintaining of the property and they facilitate the exchange of the property. However, the most important consequence of property rights is that they encourage people to cooperate by helping to ensure that only mutually agreeable economic transactions take place.

12. What are the advantages of using capital in the production process? What is meant by the term ―division of labor‖? What are the advantages of specialization in the use of human and material resources? Explain why exchange is the necessary consequence of specialization. LO2.2 Answer: Capital goods enable producers to operate more efficiently and to produce more output. ―Division of labor‖ means that workers perform those tasks that are best suited to their individual abilities and skills.

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

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

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13. What problem does barter entail? Indicate the economic significance of money as a medium of exchange. What is meant by the statement ―We want money only to part with it‖? LO2.2 Answer: Barter requires the ―double coincidence of wants.‖ If someone wants something, he/she will have to find someone who wishes to part with that good and at the same time wishes to exchange the good for something that the first party wishes to part with.

With money as a medium of exchange, one knows the purchase price of the item to be purchased and it relative price to other items. Money is a very convenient common denominator, a common measure of value that is also used as a medium of exchange. Money also encourages specialization. Without money, workers and other resources could not be paid except in the output produced. All those who participated in the production of the good would have to collectively exchange it for all the goods and service desired by the resource owners.

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

14. Evaluate and explain the following statements: L O2.2 e. The market system is a profit-and-loss system. f. Competition is the disciplinarian of the market economy.

Answer: e. The quotation is accurate. In a market system, producer decisions are motivated by the attempt to earn profits. Those products that enable a firm to earn at least a normal profit (minimum compensation for the entrepreneur for his/her time and talents) will be produced. If the product cannot be produced for a profit—in other words, if losses are involved in production—the capitalist firm will respond by seeking lower-cost production methods and may halt the production of goods completely. Because profits and/or losses are the motivation behind the fundamental decisions made in a market system, it could be called a ―profit-and-loss economy.‖ f. Competition provides discipline in two ways. First, it forces firms to seek the least-cost production methods or face being driven out of business by their rivals. Second, it prevents successful producers from charging whatever the market will bear. Competition keeps prices at a level where total revenue will just cover the total cost of production including a normal profit, but no more in the long run. If sellers try to charge a price that will earn them economic profits, new firms will enter the industry, increasing supply and lowering 1-21 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

prices until the economic profits are eliminated. Competition is indispensable in this role, because otherwise some other method would have to be found to direct firms to use the least-cost production technique and to charge a price that provides only a normal return. Where competition does not exist, such as in natural monopolies like public utility companies, regulators or publiclyowned companies must assume the role of disciplinarian. Experience has shown that this is a difficult process and does not achieve the same results as easily as a competitive market situation.

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15. Some large hardware stores such as Home Depot, boast of carrying as many as 20,000 different products in each store. What motivated the producers of those individual products to make them and offer them for sale? How did the producers decide on the best combinations of resources to use? Who made those resources available, and why? Who decides whether these particular hardware products should continue to be produced and offered for sale? LO2.3 Answer: The quest for profit led firms to produce these goods. Producers looked for and found the least-cost combination of resources in producing their output.

Resource suppliers, seeking income, made these resources available. Consumers, through their dollar votes, ultimately decide on what will continue to be produced.

The purchasing agents at Home Depot replenish goods based on consumer purchasing and identify those producers that have these goods at the lowest cost.

16. What is meant by the term ―creative destruction‖? How does the emergence of selfdriving cars relate to this idea? LO2.3 Answer: Creative destruction refers to the process by which the creation of new products and production methods destroys the market positions of firms committed to existing products and outdated ways of doing business.

Once developed to the point where the public has full confidence in their safety, self-driving cars will likely cause a large decline in the production of conventional automobiles, just as cars once replaced horse and buggies. In addition, selfdriving cars will likely reduce or eliminate the need for professional drivers such as taxi drivers and delivery drivers.

17. In a sentence, describe the meaning of the phrase ―invisible hand.‖ LO2.4 Answer: Market prices act as an ―invisible hand,‖ coordinating an economy by rationing what is scarce and providing incentives to produce the most desired goods and services.

18. In market economies, firms rarely worry about the availability of inputs to produce their products, whereas in command economies input availability is a constant concern. Why the difference? LO2.4 Answer: In market economies, buyers of inputs know that sellers want to make resources available for sale because that is how they earn their profits. If there aren‘t enough resources available, prices will rise until suppliers come forth with the desired amounts. In command economies the availability of inputs depends on what was specified in the plan, and how well the plan was executed because there is no opportunity (at least not legally) to offer greater payments to increase the amount of resources provided.

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19. Distinguish between the resource market and the product market in the circular flow model. In what way are businesses and households both sellers and buyers in this model? What are the flows in the circular flow model? LO2.5 Answer: The resource markets are where the owners of the resources (the households) sell their resources to the buyers of the resources (businesses). In the product markets, businesses sell the goods and services they have produced to the buyers of the goods and services, the households.

Households (individuals) either own all economic resources directly or indirectly through their ownership of business corporations. These households are willing to sell their resources to businesses because attractive prices draw them into specific resource markets. Businesses buy resources because they are necessary for producing goods and services. The interaction of buyers and sellers establishes the price of each resource.

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

One flow is the flow of real goods and services (produced by businesses), and the other flow is the flow of money known as household consumption expenditure or business revenue (these are the payments for the goods and services produced).

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

This gives them an incentive to manage the business wisely.

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

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

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

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

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

Answer: Command system because there is central government planning of even minor things like how many flow shops can be in operation; g. Market system because while the government is using its power to tax to promote public schools and welfare for the poor, it is mostly leaving markets alone so that they can be the dominant force in deciding what to produce, how to produce it and who will get it.

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h. Laissez-faire system because the government restricts itself to only engaging in activities that protect private property and the operation of the market system.

22. Match each term with the correct definition. LO2.2 private property freedom of enterprise mutually agreeable freedom of choice self-interest competition market An institution that brings buyers and sellers together i. The right of private persons and firms to obtain, control, employ, dispose of, and bequeath land, capital, and other property j. The presence in a market of independent buyers and sellers who compete with one another and who are free to enter and exit the market as they each see fit. k. The freedom of firms to obtain economic resources, decide what products to produce with those resources, and sell those products in markets of their choice l. What each individual or firm believes is best for itself and seeks to obtain m. Economic transactions willingly undertaken by both the buyer and the seller because each feels that the transaction will make him or her better off n. The freedom of resource owners to dispose of their resources as they think best; of workers to enter any line of work for which they are qualified; and of consumers to spend their incomes in whatever way they feel is most appropriate Answer: Market Private Property Competition Freedom of enterprise Self-interest Mutually agreeable Freedom of choice 23. True or False: Money must be issued by a government for people to accept it. LO2.2 Answer: False. Many things have been used as money without having been approved by or produced by governments. Examples included seashells, cattle, and cigarettes. Money is socially defined, and whatever a society accepts as a medium of exchange is money.

24. Assume that a business firm finds that its profit is greatest when it produces $40 worth of product A. Suppose also that each of the three techniques shown in the table below will produce the desired output. LO3 1-26 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Resource units required Resource

Price per unit

Technique #1

Technique #2

Technique #3

Labor

$3

5

2

3

Land

$4

2

4

2

Capital

$2

2

4

5

Entrepreneurial ability

$2

4

2

4

With the resource prices shown, which technique will the firm choose? Why? Will production using that technique result in profit or loss? What will be the amount of that profit or loss? Will the industry expand or contract? When will that expansion or contraction end? o. Assume now that a new technique, technique 4, is developed. It combines 2 units of labor, 2 of land, 6 of capital, and 3 of entrepreneurial ability. With the resources priced as shown in the table, will the firm adopt the new technique?

Explain. p. Suppose that an increase in the labor supply causes the price of labor to fall to $1.50 per unit, all other resource prices remaining unchanged. Which technique will the producer now choose? Explain. q. ―The market system causes the economy to conserve most in the use of resources that are particularly scarce in supply. Resources that are scarcest relative to the demand for them have the highest prices. As a result, producers use these resources as sparingly as is possible.‖ Evaluate this statement. Does your answer to part c, above, bear out this contention? Explain.

Answer: To calculate the cost of each technique, multiply the price per unit of resource by the amount of the resource employed by the technique and add these together.

For example, the cost of technique 1 equals $3 × 5 (labor cost) + $4 × 2 (land cost) + $2 × 2 (capital cost) + $2 × 4 (entrepreneurial cost) = $15 + $8 + $4 + $8 = $35. The same process is applied to techniques 2 and 3. The firm will choose technique 2 because it produces the output at the least cost ($34 compared to $35 for techniques 1 and 3). Economic profit will be $6 (= $40 − $34), causing the industry to expand. Expansion in this industry will continue until prices decline to where total revenue equals total cost of $34 and no additional firms will want to enter the industry because the incentive for economic profits is gone at this point. i. The firm will adopt technique 4 because its cost is now lowest at $32. j. The firm will choose technique 1 because its cost is now lowest at $27.50. k. The statement is logical. Increasing scarcity of a resource causes its price to rise. Firms ignoring higher resource prices will become high-cost 1-28 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

producers. Firms switching to the less expensive inputs become lower-cost producers and earn higher profits than high-cost producers. The market system, therefore, forces producers to conserve on the use of highly scarce resources. Question 7c confirms this: Technique 1 was adopted because labor had become less expensive.

25. Identify each of the following quotes as being associated with either: the concept of the invisible hand or the concept of creative destruction. LO2.4 ―If you compare a list of today‘s most powerful and profitable companies with a similar list from 30 years ago, you will see lots of new entries.‖ r. ―Managers in the old Soviet Union often sacrificed product quality and variety because they were being awarded bonuses for quantitative, not qualitative, targets.‖ s. ―Each day, central planners in the old Soviet Union were tasked with setting 27 million prices–correctly.‖ t. ―It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.‖ Answer: Creative destruction: This quote is a reflection of how fast new technologies and new products destroy the market positions of even very powerful, older firms. l. Incentive problem: This quote is an example of what happens when the invisible hand is not allowed to work. It reflects how the poorly designed financial incentives of the old Soviet Union often led to managers making decisions that were personally beneficial but socially destructive. m. Coordination problem: This quote is an example of what happens when the invisible hand is not allowed to work. It reflects the impossible complexity of centrally coordinating a large economy. n. Invisible hand because this quote (from Adam Smith‘s book The Wealth of Nations) reflects the idea that producers end up doing things that their customers want not out of a sense of charity but rather in an attempt to further their own interests. The butcher, the brewer, and the baker do a good job at their respective tasks because they want their customers‘ money.

26. True or False: Households sell finished products to businesses. LO2.6 Answer: False. Households sell resources to businesses, which use those resources to produce goods and services that are in turn bought and consumed by households.

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27. Aaliyah, Madison, Mia, and Maya have decided to pool their financial resources and business skills to open and run a new coffee shop. They will share any profits or losses that the business generates and will be personally responsible for making good on any debt that their business undertakes. Their business is a: LO2.6 corporation. u. sole proprietorship. v. partnership. w. none of the above.

Answer: Partnership. The coffee shop that these individuals are starting should be classified as a partnership because of the relatively few members involved and because each member is personally liable for any losses that the business generates. Both sole proprietorships and partnerships share that same feature— that those who own and run them are personally responsible for any losses that their businesses generate and for any debts that their businesses owe. By contrast, the owners of a corporation are not personally responsible for their firm‘s losses or debts. That is true because a corporation is its own legal entity, completely separate from its owners. Thus, any money that it owes to creditors is money owed by the corporation itself, and not by those who own the corporation.

28. Ted and Fred are the owners of a gas station. They invested $150,000 each and pay an employee named Lawrence $35,000 per year. This year‘s revenues are $900,000, while costs are $940,000. Who is legally responsible for bearing the $40,000 loss? L O2.6 Lawrence x. Ted y. Fred z. Ted and Fred aa. Lawrence, Ted, and Fred Answer: Ted and Fred. A firm‘s owners bear the firm‘s business risk, including the risk of running a loss (rather than breaking even or generating a profit.) So, in this case, the loss will be borne by Ted and Fred, since they are the owners. Lawrence, by contrast, is an employee and not legally bound to bear any business risk. So he must be paid his salary on time and in full whether or not the firm is running a profit, a loss, or just breaking even.

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

Assume that we specified ―$15 worth of bar soap‖ because soap costs $3 per bar and all three techniques produce 5 bars of soap ($15 = $3 per bar × 5 bars). So you know each technique produces 5 bars of soap. LO2.3 1-30 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

What technique will you want to use if the price of a bar of soap falls to $2.75?

Which technique will you use if the price of a bar of soap rises to $4? To $5?

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bb. How many bars of soap will you want to produce if the price of a bar of soap falls to $2.00? cc. Suppose that the price of soap is again $3 per bar but that the prices of all four resources are now $1 per unit. Which is now the least-profitable technique? dd. If the resource prices return to their original levels (those shown in the table) but a new technique is invented that can produce 3 bars of soap (yes, 3 bars, not 5 bars!) using 1 unit of each of the four resources, will firms prefer the new technique? Why or why not?

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

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

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

Part c: Here we must first calculate the cost incurred by the firm for each technique. Since the price of each input is $1 per unit, the cost for each technique is just the sum of the inputs used. For example, the cost of technique 1 equals $7 [= $4 (labor) + $1 (land) +$1 (capital) + $1 (entrepreneurial ability)] Using the same procedure, the total cost of technique 2 equals $7 (= $2 + $3 + $1 + $1) and the total cost of technique 3 equals $8 (= $1 + $4 + $2 + $1). Thus, the leastprofitable technique is technique 3.

Part d. The total revenue from this new technique equals $3 (price per bar) multiplied by 3 (units sold and produced), or $9. The total cost of this technique equals the sum of the resource prices (in the table above) because this technique employs one unit of each input. Thus, total cost equals $9 ($2 (labor) + $1 (land) + $3 (capital) + $3 (entrepreneurial ability)). Using this new technique economic 1-32 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

profit is zero ($9 (revenue) − $9 (cost)), whereas technique 2 continues to generate $2 of economic profit ($15 (revenue) − $13 (cost)). Since economic profit is greater using technique 2 the firm will continue to employ this technique.

29. Suppose Natasha currently makes $50,000 per year working as a manager at a cable TV company. She then develops two possible entrepreneurial business opportunities.

In one, she will quit her job to start an organic soap company. In the other, she will try to develop an Internet-based competitor to the local cable company. For the soapmaking opportunity, she anticipates annual revenue of $465,000. She estimates the costs for the necessary land, labor, and capital to be $395,000 per year. For the Internet opportunity, she anticipates costs for land, labor, and capital of $3,250,000 per year and revenues of $3,275,000 per year. (a) Should she quit her current job to become an entrepreneur? (b) If she does quit her current job, which opportunity would she pursue? LO2.3 Answers: (a) Yes; (b) She would pursue the soap business.

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

Net revenue from the organic soap company equals $465,000 (revenue) minus $395,000 (cost). This net revenue of $70,000 ($465,000 − $395,000) exceeds Natasha's current wage of $50,000. Thus, she should develop this company instead of working for the cable TV company. This net revenue of $25,000 ($3,275,000 − $3,250,000) is less than Natasha's current wage of $50,000.

Thus, she should not develop this company and continue working for the cable TV company. o. In summary, Natasha should quit her job and start the organic soap company.

30. With current technology, suppose a firm is producing 400 loaves of banana bread daily. Also assume that the least-cost combination of resources for producing those loaves is 5 units of labor, 7 units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at prices of $40, $60, $60, and $20, respectively. If the firm can sell these 400 loaves at $2 per unit, what is its total revenue? Its total cost?

Its profit or loss? Will it continue to produce banana bread? If this firm‘s situation is typical for the other makers of banana bread, will resources flow toward or away from this bakery good? LO2.3 Answers: TR = $800; TC = $760; Profit = $40; Yes, it will continue to produce banana bread; Resources will flow toward this bakery good.

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To calculate total revenue, multiply the selling price by the number of units sold.

Total revenue equals $2 (price) multiplied by 400 (loaves of bread sold). So, total revenue equals $800 (= $2 × 400).

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

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

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

Since the firm is earning positive economic profit, other firms or individuals will want to produce banana bread. Thus, resources will flow toward this bakery good.

If the firm had been suffering from an economic loss, then resources would flow away from this bakery good as firms or individuals would exit the market to avoid the loss.

31. Let‘s put dollar amounts on the flows in the circular flow diagram of Figure 2.2. L O2.5 Suppose that businesses buy a total of $100 billion of the four resources (labor, land, capital, and entrepreneurial ability) from households. If households receive $60 billion in wages, $10 billion in rent, and $20 billion in interest, how much are households paid for providing entrepreneurial ability? ee. If households spend $55 billion on goods and $45 billion on services, how much in revenues do businesses receive in the product market?

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

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

Chapter 03 - Demand, Supply, and Market Equilibrium McConnell Brue Flynn 23e DISCUSSION QUESTIONS 32. Explain the law of demand. Why does a demand curve slope downward? How is a market demand curve derived from individual demand curves? LO3.2 Answer: As prices change, buyers will change the quantity they demand of that item. If the price drops, a larger quantity will be demanded. If the price rises, a lesser quantity will be demanded.

Its downward slope reflects the law of demand—people buy more of a product, service, or resource as its price falls. The relationship between price and quantity 1-35 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

demanded is inverse (or negative). An inverse relationship between two variables will always provide a negative slope.

By adding the quantities demanded by all consumers at each of the various possible prices, we can get from individual demand to market demand.

33. What are the determinants of demand? What happens to the demand curve when any of these determinants change? Distinguish between a change in demand and a movement along a fixed demand curve, noting the cause(s) of each. LO3.2 Answer: There are determinants of demand, which are factors that may shift the demand curve, or cause a ―change in demand.‖ These are the number of buyers, the tastes (or desires) of the buyers, the income of the buyers, the changes in price of related commodities (substitutes and complements), and expectations of the buyers regarding the future price of the commodity under discussion.

The determinants of demand will cause a shift in the demand curve. If it is something that increases the demand, the curve will shift to the right. A decrease in demand will be shown by a shift to the left. This is representative of quantity demanded changing at every price, either increasing or decreasing.

A change in price causes movement along the commodity‘s demand curve. This movement is called a change in quantity demanded. A decrease in price leads to movement down the demand curve, or an increase in quantity demanded.

Increased price leads to movement up the demand curve, or a decrease in quantity demanded.

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34. Suppose that Rhonda has a TikTok account. If all of her TikTok friends switch to SnapChat, in which direction will Rhonda‘s demand for TikTok shift? What will likely happen to Rhonda‘s demand for SnapChat? LO3.2 Answer: Rhonda‘s demand for TikTok will shift to the left because her friends‘ departure means that there will be a much less strong network effect for her. With them gone, the value of interacting on TikTok will be much reduced.

Because all of her TikTok friends moved to SnapChat, SnapChat will have increased network effects for Rhonda, thereby increasing the attractiveness of that social app for Rhonda and thereby increasing her demand for SnapChat.

35. Explain the law of supply. Why does the supply curve slope upward? How is the market supply curve derived from the supply curves of individual producers? LO3.3 Answer: As prices rise because of increased demand for a commodity, producers find it more and more profitable to increase the quantity they offer for sale; that is, the supply curve will slope upward from left to right. Clearly, firms would rather sell at a higher price than at a lower price. Moreover, it is necessary for firms to demand a higher price as they increase production. This comes about because as they produce more and more, they start to run up against capacity constraints and costs rise. At any given time, a plant has a given size. As production increases, the firm will need to add an extra shift and then a third shift, both perhaps at higher wages. It may run out of warehouse space and have to rent at higher cost from another firm. It may have to pay extra to get increasingly urgent raw materials, and so on.

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

36. What are the determinants of supply? What happens to the supply curve when any of these determinants changes? Distinguish between a change in supply and a change in the quantity supplied, noting the cause(s) of each. LO3.3 Answer: The non-price determinants of supply are: resource (input) prices, technology, taxes and subsidies, changes in prices of other related goods, expectations, and the number of sellers. A change in these determinants will cause a shift in the supply curve. Anything causing an increase in supply will shift the supply curve to the right. A decrease in supply will be shown by a shift to the left.

As price increases, the quantity supplied increases. An increase in price causes a movement up a given supply curve. A decrease in price causes a movement down a given supply curve, decreasing quantity supplied.

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37. Between 2018 and 2021, an outbreak of African Swine Fever that spread to dozens of countries led to the slaughter of nearly one-quarter of all of the world‘s domesticated pigs. What impact would you expect that to have had on the supply of pig leather as well as on other pork byproducts such as drumheads, violin strings, and pig-bristle paint brushes? Explain. LO3.5 Answer: The supply of pig leather and other pork byproducts was reduced, raising the prices of pig leather and other pork byproducts such as drumheads, violin strings, and pig-bristle paint brushes. Because pigs were more expensive, it became more costly to produce pork byproducts, reducing the supply and raising the price of related goods.

38. For each stock in the stock market, the number of shares sold daily equals the number of shares purchased. That is, the quantity of each firm‘s shares demanded equals the quantity supplied. Why, then, do the prices of stock shares change? LO3.5 Answer: During any given stock trading session, there will be both prospective buyers and sellers, each willing to buy or sell a certain number of shares depending on the price. If, at the current price (e.g. the day‘s opening price), the quantity of shares demanded exceeds the quantity of shares supplied, buyers must increase their price offers to induce sellers to offer enough shares. This will cause share prices to rise until the quantity demanded equals the quantity supplied.

Suppose that during the trading session there is a report of bad economic news.

Sellers may respond by trying to sell more shares than buyers are wanting at the current price. In order to find enough willing buyers, sellers will have to offer their shares at lower prices. On any given trading day, there will be multiple equilibrium prices, many of them not lasting for more than a few minutes (or even seconds).

39. What do economists mean when they say, ―Price floors and ceilings stifle the rationing function of prices and distort resource allocation‖? LO3.6 Answer: When unrestrained, prices rise and fall to correct imbalances between the quantity supplied and quantity demanded in a market. If sellers find themselves at a given price with more output than consumers are willing to purchase, they will lower the price. Likewise, if the market is not offering enough of a good to satisfy consumer demand, the price will rise. Price floors and ceilings prevent price movements to correct these imbalances. When a price is set above equilibrium (i.e., a price floor), sellers will produce more than the market can support, diverting resources away from more highly valued uses. Price ceilings result in an underallocation of resources toward a particular good, where the excess demand (shortage) reveals that consumers value the good (and therefore the resources used to produce it) more than what the market currently offers.

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40. LAST WORD What caused used car prices to fall near the start of the pandemic and then soar over the next two years? What government policy helped to generate labor shortages in several industries? Expectations about what in particular caused the stock market to crash near the start of the pandemic?

Answer: Used car prices declined at the start of the pandemic as rental car companies were forced to sell their rental car fleets in order to get enough cash to survive the pandemic and in response to the rapid decline in the demand for rental cars. But the price of used cars soared over the following two years as the supply of new cars was constricted by computer chip shortages and consumers desperate for rides turned increasingly toward used cars. Extremely generous government unemployment benefits that paid more than many workers would have made working helped to reduce the supply of labor and thereby generate labor shortages in several industries. The stock market crashed at the start of the pandemic because nervous investors assumed that corporate profits would decline precipitously as a result of the pandemic.

REVIEW QUESTIONS What effect will each of the following have on the demand for small cars such as the Mini-Cooper and Fiat 500? LO3.2 ff. Small cars become more fashionable. gg. The price of large cars rises (with the price of small cars remaining the same). hh. Income declines and small cars are an inferior good. ii. Consumers anticipate that the price of small cars will greatly come down in the near future. jj. The price of gasoline substantially drops.

Answer: a. Demand increases. b. Demand increases. c. Demand increases. d. Demand decreases e. Demand is ambiguous. Since cars and gas are complements, one could argue that the decrease in gas prices would stimulate demand for all cars, including small ones. However, one could also argue that small cars are attractive to consumers because of fuel efficiency, and that a decrease in gas prices effectively reduces the price of the ―gas-guzzling‖ substitutes. That would encourage consumers to switch from smaller to larger cars (S UVs), and demand for small cars would fall. This presents a good illustration of the complexity of many of these changes.

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

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

42. Yogi Berra was once asked about a popular New York restaurant. He said, "Nobody ever goes there anymore—it‘s too crowded." All joking aside, was he referring to: LO3.2 a shortage kk. a network effect ll. a surplus mm. a congestion effect Answer: d, a congestion effect.

Yogi Berra, the famous Yankee baseball catcher and manager, said many funny things. In this quote, he is correctly expressing the logic behind the congestion effect, which is that the value of a product (here, going to eat at a particular restaurant) declines for each consumer if too many other consumers are using that same product and thereby causing crowding and congestion that lower the value of the product. The congestion at this New York restaurant will reduce potential customers‘ willingness to pay, thereby reducing demand for the restaurant and shifting the demand curve to the left. When a restaurant is very popular, however, the leftward shift of demand many not be enough to offset the crowding and so the restaurant may still remain crowded despite the congestion effect shifting the demand curve to the left by some amount. As an aside, please also note that not every potential patron will view the crowding at the restaurant as a problem.

Some people love bustling restaurants. For those people, the congestion effect will work in reverse, causing their personal demand curves to shift to the right relative to where those demand curves would have been for if the restaurant were never crowded.

43. What effect will each of the following have on the supply of auto tires? LO3.3 A technological advance in the methods of producing tires. nn. A decline in the number of firms in the tire industry. oo. An increase in the price of rubber used in the production of tires.

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pp. The expectation that the equilibrium price of auto tires will be lower in the future than it is now. qq. A decline in the price of the large tires used for semi-trucks and earth-hauling rigs with no change in the price of auto tires). rr. The levying of a per-unit tax on each auto tire sold. ss. The granting of a 50-cent-per-unit subsidy for each auto tire produced.

Answer: a. Supply will increase because the technological advance allows the tire manufacturers to produce more tires using the same amount of inputs. b. Supply will decrease because there are firms in the industry. c. Supply will decrease because the increase in the price of rubber results in an increase in production costs. Thus, each firm will need to charge a higher price at each level of output (or supply less at each price). d. Supply will increase because the expectation that the equilibrium price of auto tires will be lower in the future causes firms to sell their inventories today while the price is still high. e. Supply will increase because the decline in the price of large tires used for semi-trucks and earth-hauling rigs (with no change in the price of auto tires) will cause firms to reduce production of large tires (now commanding a lower price) and produce more auto tires. These two goods are substitutes in production. f. Supply will decrease because per-unit tax on each auto tire sold increases the cost of production since the tire manufacturers must now pay for input costs plus the per-unit tax. g. Supply will increase because the 50-cent-per-unit subsidy decreases the cost of production. The tire manufacturers receive the subsidy, which they can subtract from their input costs.

44. ―In the corn market, demand often exceeds supply, and supply sometimes exceeds demand.‖ ―The price of corn rises and falls in response to changes in supply and demand.‖ In which of these two statements are the terms ―supply‖ and ―demand‖ used correctly? Explain. LO3.4 Answer: In the first statement, ―supply‖ and ―demand‖ are used incorrectly. Supply and demand are both schedules, or curves, that intersect where quantity supplied and 1-42 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

quantity demanded are equal. One cannot talk of curves that intersect as exceeding or not exceeding each other. Supply and demand cannot exceed each other; however, quantity supplied and quantity demanded can.

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

45. Suppose that in the market for computer memory chips, the equilibrium price is $50 per chip. If the current price is $55 per chip, then there will be a(n) _ of memory chips. LO3.4 shortage tt. surplus uu. equilibrium quantity vv. none of the above Answer: A surplus At the equilibrium price of $50 per chip, the quantity demanded exactly equals the quantity supplied. At higher prices, the quantity supplied increases while the quantity demanded decreases. Thus, at the $55 price, the quantity supplied exceeds the quantity demanded. The result is a surplus of unsold chips because not all of the chips that producers are willing to supply at the $55 price will find buyers at that price. In fact, the equilibrium price of $50 is the only price at which the desires of suppliers with regard to how much they wish to sell are consistent with the desires of buyers with regard to how much they wish to purchase.

46. Critically evaluate: ―In comparing the two equilibrium positions in Figure 3.7b, I note that a smaller amount is actually demanded at a lower price. This observation refutes the law of demand.‖ LO5

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Answer: The key point here is that the second equilibrium occurs after demand has decreased, that is demand has shifted because of a change in determinants, which has caused buyers to want less at every price compared to the original D1 demand curve and schedule. Each equilibrium price refers to a different demand situation.

Therefore, the fact that less is purchased at a lower price when demand decreases does not refute the law of demand. Note that on the second demand curve and schedule, less would still be purchased at a higher price.

47. Label each of the follow scenarios with the set of symbols that best indicates the price change and quantity change that occur in each scenario. In some scenarios, it may not be possible from the information given to determine the direction of a particular price change or a particular quantity change. We will symbolize those cases as, respectively, ―P?‖ and ―Q?‖ The four possible combinations of price and quantity changes are: LO3.5 P↓ Q? P↑ Q? P? Q↓ P? Q↑ On a hot day, both the demand for lemonade and the supply of lemonade increase. ww.

On a cold day, both the demand for ice cream and the supply of ice cream decrease. xx. When Hawaii‘s Mt. Kilauea erupts violently, tourists‘ demand for sightseeing flights increases, but the supply of pilots willing to provide these dangerous flights decreases. yy. In a hot area of Arizona where a lot of their electricity is generated with wind turbines, the demand for electricity falls on windy days as people switch off their air conditioners and enjoy the breeze. But at the same time, the amount of electricity supplied increases as the wind turbines spin faster.

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Answer: a. P: cannot determine with given information, Q: increases The equilibrium quantity will definitely increase as the rightward shifts of both curves guarantee that their intersection point will also shift to the right. However, the change in price will depend on which curve shifts further to the right. If the demand curve shifts horizontally further than the supply curve, the equilibrium price will rise (and vice versa). b. P: cannot determine with given information, Q: decreases With both curves shifting to the left, their intersection will also shift to the left.

Thus, the equilibrium quantity will definitely decline. However, the direction of the price change will depend on which curve shifts further to the left. If the demand curve shifts further than the supply curve, then the intersection point will move down vertically, implying that the equilibrium price will fall. On the other hand, if the supply curve shifts further to the left, then the intersection point will be higher vertically, implying that the equilibrium price will rise. c. P: increases, Q: cannot determine with given information With demand increasing and supply decreasing, the intersection point between the demand curve and the supply curve will have to be higher. Thus, the equilibrium price will definitely rise. However, the change in the equilibrium quantity is uncertain. It will depend on whether the horizontal rightward shift of the demand curve is bigger or smaller than the horizontal leftward shift of the supply curve. If the demand curve moves right more than the supply curve moves left, then the equilibrium quantity will increase. By contrast, if the supply curve moves to the left more than the demand curve moves to the right, the equilibrium quantity will fall. d. P: decreases, Q: cannot determine with given information With demand falling and supply increasing, the intersection point between the demand curve and the supply curve will definitely move down vertically. Thus, the equilibrium price will definitely decline. Whether the equilibrium quantity increases or decreases will depend on which curve shifts further. If the rightward shift of the supply curve exceeds the leftward shift of the demand curve, then the equilibrium quantity will increase. By contrast, if the leftward shift of the demand curve exceeds the rightward shift of the supply curve, the equilibrium quantity will decrease.

48. Suppose the total demand for wheat and the total supply of wheat per month in the Kansas City grain market are as shown in the table below. Suppose that the government establishes a price ceiling of $3.70 for wheat. What might prompt the government to establish this price ceiling? Explain carefully the main effects.

Demonstrate your answer graphically. Next, suppose that the government establishes 1-45 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

a price floor of $4.60 for wheat. What will be the main effects of this price floor?

Demonstrate your answer graphically. LO6

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Answer: a. Price ceilings represent established maximums on a price. This is a means to control prices as it creates the upper limit for a price. b. The equilibrium price is found where quantity supplied equals quantity demanded. This occurs at the price of $4.00 where 75,000 bushels are demanded and 75,000 bushels are supplied (equilibrium quantity). If the government establishes a price ceiling at $3.70 (sellers cannot charge a price above $3.70), there will be an excess demand of 7,000 bushels. Buyers demand 80,000 bushels at the price of $3.70, but sellers only supply 73,000 bushels. c. If the government establishes a price floor at $4.60 (sellers cannot charge a price below $4.60), there will be a surplus of 14,000 bushels. Buyers demand 65,000 bushels at the price of $4.60, but sellers supply 79,000 bushels.

49. A price ceiling will result in a shortage only if the ceiling price is _ the equilibrium price. LO3.6 less than zz. equal to aaa. greater than Answer: Less than. If the ceiling price is set at a value below the equilibrium price, then a shortage will result because quantity demanded will exceed quantity supplied. By contrast, if the ceiling price is set higher than the equilibrium price, it will not affect anything because the equilibrium price will not be in violation of the legal ceiling price and all the market participants can proceed as they normally would. Finally, if the ceiling price happens to be just equal to the market equilibrium price, then the market will behave as normal and reach the market equilibrium price because with the equilibrium price just equal to the ceiling price, nobody is violating the law and nobody has to change his or her behavior.

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PROBLEMS Suppose there are three buyers of candy in a market: Tex, Dex, and Rex. The market demand and the individual demands of Tex, Dex, and Rex for candy are given in the table below. LO3.2 Fill in the missing values. bbb.

Which buyer demands the least at a price of $5? The most at a price of $7? ccc.

Which buyer‘s quantity demanded increases the most when the price decreases from $7 to $6? ddd.

In which direction would the market demand curve shift if Tex withdrew from the market? What would happen to the market demand curve if Dex doubled his purchases at each possible price? eee.

Suppose that at a price of $6, the total quantity demanded increases from 19 to 38. Is this a ―change in the quantity demanded‖ or a ―change in demand‖?

Explain.

Answers: (a) Row 1: 4; Row 2: 2; Row 3: 12; Row 4:4; Row 5: 36. (b) Dex, Tex. (c) Tex. (d) Left, Right. (e) ―A change in demand.‖ Feedback: Consider the following set of values: a. At each price (row), the total quantity demanded will equal the sum of the individual quantities demanded. To find the total quantity demanded at the price of $8, add the quantities demanded by Tex, Dex, and Rex, which equals 4 (= 3 + 1 + 0).

To find Rex‘s quantity demanded at the price of $7, we use the same logic as above. The sum of the individual quantities demanded equals 12 (total quantity demanded). We also know that the sum for Tex and Dex equals 10 (= 8 + 2). This implies Rex‘s quantity demanded at $7 must equal 2 [= 12 (Total) − 8 (Tex) − 2 (Dex)].

The same types of calculations can be applied to the other rows. At $6, the quantity demanded by Tex equals 12 (= 19 − 3 − 4).

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At $5 the quantity demanded by Dex equals 4 (= 27 − 17 − 6).

At the price of $4 the total quantity demanded equals 36 (= 23 + 5 + 8). b. At a price of $5, Dex demands the least amount of goods, which equals 4. Tex demands 17, and Rex demands 6.

At a price of $7, Tex demands the most amount of goods, which equals 8. Dex demands 2, and Rex demands 2. c. When the price is lowered from $7 to $6, Tex‘s quantity demanded increases by 4 (= 12 − 8), Dex‘s quantity demanded increases by 1 (= 3 − 2), and Rex‘s quantity demanded increases by 2 (= 4 − 2). Thus, Tex‘s quantity demanded increases the most when the price is lowered from $7 to $6. d. If Tex withdrew from the market, there would be less demand at every price level. This implies that the demand schedule would shift to the left.

If Dex doubled his purchases at every price level, this would increase demand.

This implies that the demand schedule would shift to the right. e. Since the price is fixed in the statement, this is a change in demand. A change in the quantity demanded results from a change in price.

50. The figure below shows the supply curve for tennis balls, S1, for Drop Volley Tennis, a producer of tennis equipment. Use the figure and the table below to give your answers to the following questions. LO3.3

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

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b. If production costs were to increase, the quantities supplied at each price would be as shown by the third column of the table (―S2 Quantity Supplied‖).

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

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

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

c. The increase in production costs causes supply to decrease at each price level.

Supply falls from 15 to 4 for at the price of $3, thus the change is −11. Supply 1-50 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

falls from 10 to 2 at a price of $2, thus the change is −8. Supply falls from 5 to 0 at a price of $1, thus the change is −5. d. This is a decrease in supply because the schedule shifts left (less quantity supplied at every price).

51. Refer to the expanded table below from review question 9. LO3.4

What is the equilibrium price? At what price is there neither a shortage nor a surplus?

Fill in the surplus-shortage column and use it to confirm your answers. fff. Graph the demand for wheat and the supply of wheat. Be sure to label the axes of your graph correctly. Label equilibrium price P and equilibrium quantity Q. ggg.

How big is the surplus or shortage at $3.40? At $4.90? How big a surplus or shortage results if the price is 60 cents higher than the equilibrium price? 30 cents lower than the equilibrium price?

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

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b.

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

Feedback: a. Pe = $4.00. Equilibrium occurs where there is neither a shortage nor surplus of wheat. At the immediately lower price of $3.70, there is a shortage of 7,000 bushels. At the immediately higher price of $4.30, there is a surplus of 7,000 bushels. Thus, data from top to bottom in the shortage and surplus column is −13; −7; 0; +7; +14; and +21. b. See graph as shown. c. Note: shortages will be negative, and surpluses will be positive. At the price $3.40 there will be a 13,000-bushel shortage (= 72,000 − 85,000 = −13,000).

At the price of $4.90 there will be a 21,000-bushel surplus (= 81,000 − 60,000 = 21,000). At the price of $4.60 (60 cents higher than the equilibrium price) there will be a surplus of 14,000 bushels (= 79,000 − 65,000 = 14,000). At the price of $3.70 (30 cents lower than the equilibrium price) there will be a shortage of 7,000 bushels (= 73,000 − 80,000 = −7,000).

52. How will each of the following changes in demand and/or supply affect equilibrium price and equilibrium quantity in a competitive market? That is, do price and quantity rise, fall, or remain unchanged, or are the answers indeterminate because they depend on the magnitudes of the shifts? LO3.5 Supply decreases and demand is constant. hhh.

Demand decreases and supply is constant. iii. Supply increases and demand is constant. jjj. Demand increases and supply increases.

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kkk.

Demand increases and supply is constant. lll. Supply increases and demand decreases. mmm.

Demand increases and supply decreases. nnn.

Demand decreases and supply decreases.

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

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

Price

S2

S1

P2 P1

D1 Q2

Q1

Quantity

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

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Price

S1

P1 P2

D2 Q2

D1 Quantity

Q1

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

Price

S1 S2

P1 P2

D1 Q1

Q2

Quantity

d. The increase in supply and the increase in demand unambiguously increase the equilibrium quantity. This is because the increase in supply and the increase in demand both increase the equilibrium quantity. However, the change in equilibrium price is indeterminate because the increase in supply puts downward pressure on the equilibrium price and the increase in demand 1-54 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

puts upward pressure on the equilibrium price. The figure below shows these effects when the demand effect dominates.

Price S1 S2

P2 P1

D2 D1 Q1

Quantity

Q2

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

Price

S1

P2 P1

D2 D1 Q1

Q2

Quantity

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

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Price

S1 S2

P1

P2 D2

D1 Quantity

Q1 Q2

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

S2

Price

S1

P2

P1 D2

D1 Q1

Q2

Quantity

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

S2 Price

S1

P2

P1

D2 Q2

Q1

D1 Quantity

53. Use two market diagrams to explain how an increase in state subsidies to public colleges might affect tuition and enrollments in both public and private colleges.

LO3.5 Answer: The supply curve of the public colleges shifts to the right, reducing tuition and increasing enrollments. Enrollment demand curve of private colleges shifts to the left because of substitution away from private colleges.

(See Figure 3.7c for the effect on public colleges, Figure 3.7b for the impact on private colleges.)

Feedback: Consider the case of subsidies to public colleges. The state subsidies to public colleges shift the supply curve of the public colleges to the right, thus reducing tuition and increasing enrollments in these institutions. The decreased cost of public college education leads to some substitution away from the private colleges, where the enrollment demand curve shifts to the left. The final result is a lower cost of tuition in both public and private colleges. (See Figure 3.7c for the effect on public colleges, Figure 3.7b for the impact on private colleges.)

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Public Colleges

Private Colleges

54. ADVANCED ANALYSIS Assume that demand for a commodity is represented by the equation P = 10 − .2Qd and supply by the equation P = 2 + .2Qs, where Qd and Qs are quantity demanded and quantity supplied, respectively, and P is price. Using the equilibrium condition Qs = Qd, solve the equations to determine equilibrium price and determine equilibrium quantity. LO3.5 Answer: equilibrium price is P = 6; equilibrium quantity is Q = 20 Feedback: Consider the following equations: Demand for a commodity is: P = 10 − .2Qd Supply of the commodity is: P = 2 + .2Qs 1-59 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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To solve this system of equations, we use the fact that the equilibrium price in both equations must be the same. Therefore, we can equate the two (eliminate P from the system). This gives us: 10 − .2Qd = 2 + .2Qs We now use the equilibrium condition for quantity: Qs = Qd = Q We substitute Q for Qd and Qs. This gives us: 10 − .2Q = 2 + .2Q Solving for Q: .2Q + .2Q = 8 or .4Q = 8 The equilibrium quantity is: Q = (8/.4) = 20 To find the equilibrium price, we substitute the equilibrium quantity Q = 20 into either the demand function or supply function.

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

55. Suppose that the demand and supply schedules for rental apartments in the city of Gotham are as given in the following table. LO3.6

What is the market equilibrium rental price per month and the market equilibrium number of apartments demanded and supplied? ooo.

If the local government can enforce a rent-control law that sets the maximum monthly rent at $1,500, will there be a surplus or a shortage? Of how many units? How many units will actually be rented each month? ppp.

Suppose that a new government is elected that wants to keep out the poor.

It declares that the minimum rent that landlords can charge is $2,500 per month. If 1-61 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the government can enforce that price floor, will there be a surplus or a shortage?

Of how many units? And how many units will actually be rented each month? qqq.

Suppose that the government wishes to decrease the market equilibrium monthly rent by increasing the supply of housing. Assuming that demand remains unchanged, how many additional units of housing would the government need to supply to get the market equilibrium rental price to fall to $1,500 per month? To $1,000 per month? To $500 per month?

Answers: (a) 12,500 apartments at a rent of $2,000 per month; (b) A shortage of 5,000 apartments per month, 10,000 apartments will actually be rented each month; (c) A surplus of 5,000 apartments per month, 10,000 apartments will actually be rented each month; (d) 5,000 units, 10,000 units; 15,000 units.

Feedback: a. The market equilibrium price is determined by the relationship quantity supplied equals quantity demanded. Thus, to find the equilibrium price we find the price where the quantities are equal, which occurs at the rent (price) of $2,000. The equilibrium quantity at this price is 12,500 apartments. b. If the government imposes a maximum rent of $1,500 the quantity of apartments supplied equals 10,000 and the quantity of apartments demanded equals 15,000. Thus, there is a shortage of 5,000 apartments [= 15,000 (quantity demanded) − 10,000 (quantity supplied)]. The number of apartments actually rented will be determined by supply here. There are only 10,000 available for rent, so only 10,000 will be rented. c. If the government imposes a minimum rent of $2,500, the quantity of apartments supplied equals 15,000 and the quantity of apartments demanded equals 10,000. Thus, there is a surplus of 5,000 apartments [= 15,000 (quantity supplied) − 10,000 (quantity demanded)]. The number of apartments actually rented will be determined by demand here. There are only 10,000 households that want to rent, so only 10,000 will be rented. d. If the government wants to reduce the market equilibrium rent to $1,500 per month, the government would need to increase the supply of apartments by 5,000 units. To see this, start in equilibrium. Here the equilibrium rent is $2,000 and the equilibrium quantity is 12,500 units. If the government adds 5,000 units there will now be 17,500 units for rent in the market at the current rate of $2,000, creating a surplus. The equilibrium price would fall to $1,500, where the quantity supplied is 15,000 − 10,000 units provided privately plus 5,000 units added by the government.

As rents fall, some private units (2,500) would be taken off the market. At the lower rental rate, the quantity demanded increases to 15,000 units. If the government wanted to reduce the equilibrium rent to $1,000, it would need to 1-62 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

add 10,000 units. This would result in an equilibrium quantity of 17,500 units on the market (7,500 provided privately plus the 10,000 new apartments).

If the government wanted to reduce the equilibrium rent to $500, it would need to add 15,000 units. This would result in 20,000 units on the market.

Chapter 03 Appendix McConnell Brue Flynn 23e APPENDIX DISCUSSION QUESTIONS 56. Why are shortages or surpluses more likely with preset prices (such as those on tickets) than with flexible prices (such as those on gasoline)? LO3.7 Answer: Preset prices, rather than responding to demand conditions, attempt to predict the level of demand that will produce an equilibrium quantity. If these predictions are incorrect, there will be an imbalance between the quantity supplied and the quantity demanded. Preset prices often apply to one-time-only events versus something like gasoline that is sold regularly and repeatedly. Sellers can learn from experience how to adjust prices to best meet demand.

57. Most scalping laws make it illegal to sell—but not to buy—tickets at prices above those printed on the tickets. Assuming the existence of such laws, use supply and demand analysis to explain why the equilibrium ticket price in an illegal secondary market tends to be higher than in a legal secondary market. LO3.7 Answer: Ticket prices tend to be higher in illegal secondary markets because sellers face higher costs (thus reducing supply relative to what it would be in a legal secondary market). The additional costs include the higher transactions costs (finding secret locations to transact, monitoring for law enforcement, screening clients, etc.) and compensation for the risk of getting caught (with the associated costs of legal services, fines, incarceration, etc.).

58. Go to the website of the Energy Information Administration, https://www.eia.gov/, and follow the links to find the current retail price of gasoline. How does the current price of regular gasoline compare with the price a year ago? What must have happened to supply, demand, or both to explain the observed price change? LO3.7 Answer: The answer here will depend on the time of the exercise.

59. Suppose the supply of apples sharply increases because of perfect weather conditions throughout the growing season. Assuming no change in demand, explain the effect on 1-63 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the equilibrium price and quantity of apples. Explain why quantity demanded increases even though demand does not change. L O3.7 Answer: The increase in supply will lower the equilibrium price and increase the equilibrium quantity of apples. The increase in supply implies that the supply schedule shifts to the right (more apples are supplied at every price). Quantity demanded increases without a shift in the demand curve because the greater supply causes price to fall. This fall in price causes a movement along the demand schedule.

60. Assume the demand for lumber suddenly rises because of a rapid growth in demand for new housing. Assume no change in supply. Why does the equilibrium price of lumber rise? What would happen if the price did not rise under the demand and supply circumstances described? LO3.7 Answer: Buyers are willing to purchase more new housing, causing price and quantity to increase in that market. In order to satisfy the increased demand for new housing, more lumber (and other building materials) is needed. The greater willingness to pay for housing implies a greater willingness to pay for the materials and labor needed to produce that housing. As the resources become increasingly scarce (because of a given supply and increasing demand), the price rises.

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

61. Assume that both the supply of bottled water and the demand for bottled water rise during the summer but that supply increases more rapidly than demand. What can you conclude about changes in equilibrium price and equilibrium quantity? LO3.7 Answer: The equilibrium price will fall, and the equilibrium quantity will rise.

Whenever supply and demand both increase, equilibrium quantity will rise.

Equilibrium price falls because the increase in supply is greater than the increase in demand (see figure below).

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62. When asked for investment advice, humorist Will Rogers joked that people should ―[b]uy land. They ain‘t making any more of the stuff.‖ Explain his advice in terms of the supply-and-demand model. LO3.7 Answer: By saying they aren‘t making any more land, he is signifying there will eventually be a shortage of land. In the case of a shortage, quantity demanded would be greater than quantity supplied, putting us at a price below equilibrium.

At this point, the market would put upward pressure on the price of land, allowing you to earn money on your investment.

APPENDIX REVIEW QUESTIONS Will the equilibrium price of orange juice increase or decrease in each of the following situations? LO3.7 rrr. A medical study reporting that orange juice reduces cancer is released at the same time that a freak storm destroys half of the orange crop in Florida. sss. The prices of all beverages except orange juice fall in half, while unexpectedly perfect weather in Florida results in an orange crop that is 20 percent larger than normal.

Answer: e. Increase. The medical study reporting that orange juice reduces cancer will cause the demand curve for orange juice to shift to the right. The storm that destroys half the orange crop in Florida will cause the supply curve for orange juice to shift to the left. With these two shifts occurring at the same time, the price of orange juice will increase. f. Decrease. When the prices of other beverages fall in half, demand for orange juice will fall as many people will drink less orange juice. Thus, the demand 1-65 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

curve for orange juice will shift to the left. At the same time, the perfect weather that results in the bumper crop of oranges in Florida will cause the price of oranges to fall. Because oranges are the only ingredient in orange juice, the price of producing orange juice will also fall, thereby increasing the profits of orange juice makers and encouraging them to produce more orange juice. Thus, the supply curve for orange juice will shift to the right. These two shifts occurring at the same time will result in the price decreasing.

63. Consider the market for coffee beans. Suppose that the prices of all other caffeinated beverages go up 30 percent while at the same time a new fertilizer boosts production at coffee plantations dramatically. What is likely to happen to the equilibrium price and quantity of coffee beans? LO3.7 Answer: The equilibrium price may rise or fall, but the equilibrium quantity will rise for certain. Coffee and other caffeinated beverages are substitutes. Thus, when the prices of all other caffeinated beverages rise, people will substitute away from them and consume more coffee. That increase in demand for coffee shifts the coffee demand curve to the right. At the same time, the new fertilizer that boosts coffee production will cause the supply of coffee to increase, thereby shifting the supply curve for coffee to the right. With both the demand and supply curves for coffee shifting to the right, the equilibrium quantity will definitely increase. But it is unclear without knowing more information whether the equilibrium price will increase or decrease. If the demand curve shifts further to the right, the equilibrium price will rise. But if the supply curve shifts further to the right, the equilibrium price will fall.

64. True or False. A price ceiling will result in a shortage only if the ceiling price is greater than the equilibrium price. LO3.7 Answer: False. If the ceiling price is set at a value below the equilibrium price, then a shortage will result because quantity demanded will exceed quantity supplied. By contrast, if the ceiling price is set higher than the equilibrium price, it will not affect anything because the equilibrium price will not be in violation of the legal ceiling price and all the market participants can proceed as they normally would. Finally, if the ceiling price happens to be just equal to the market equilibrium price, then the market will behave as normal and reach the market equilibrium price because with the equilibrium price just equal to the ceiling price, nobody is violating the law and nobody has to change their behavior.

65. Suppose that you are the economic advisor to a local government that has to deal with a politically embarrassing surplus that was caused by a price floor that the government recently imposed. Your first suggestion is to get rid of the price floor, but the politicians don‘t want to do that. Instead, they present you with the following list 1-66 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

of options that they hope will get rid of the surplus while keeping the price floor.

Identify each one as either could work or can’t work. LO3.7 Restricting supply ttt. Decreasing demand uuu.

Purchasing the surplus at the floor price Answer: Could work. There is currently a surplus because, at the floor price, quantity supplied exceeds quantity demanded. If the government can restrict supply, it will be able to reduce the size of the surplus. And if it can restrict supply and shift the supply curve to the left by exactly the amount of the surplus, it will be able to completely eliminate the surplus. Thus, the policy of restricting supply will work if implemented correctly. g. Can’t work. There is a surplus because quantity supplied exceeds quantity demanded. This gap would only be made worse and increased if demand decreases. So, decreasing demand won‘t work. In fact, the government might want to try the opposite, increasing demand. h. Could work. There is a surplus because the quantity that producers wish to supply at the floor price exceeds the quantity that consumers wish to purchase at the floor price. The government can get rid of the unsold surplus by purchasing it at the floor price. In essence, the surplus disappears because the government augments private demand with government demand. Together, the two sources of demand are enough to purchase the total amount supplied at the floor price. Thus, this policy could work if the government is willing to spend the money necessary to purchase the entire surplus at the floor price.

66. Suppose both the demand for olives and the supply of olives decline by equal amounts over some time period. Use graphical analysis to show the effect on equilibrium price and quantity. LO3.7 Answer: The supply and demand curves would shift to the left by an equal amount (supply shifts from S1 to S2 and demand shifts from D1 to D2 in the diagram below), reducing the equilibrium quantity and leaving the equilibrium price unchanged.

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67. Governments can use subsidies to increase demand. For instance, the government can pay farmers to use organic fertilizers rather than traditional fertilizers. That subsidy increases the demand for organic fertilizer. Consider two industries, one in which supply is nearly vertical and the other in which supply is nearly horizontal. Assume that firms in both industries would prefer a higher market equilibrium price, which would mean higher profits. Which industry would probably spend more resources lobbying the government to increase the demand for its output? (Assume that both industries have similarly sloped demand curves.) LO3.7 Both would spend equally. vvv.

The industry with a nearly vertical supply curve would spend more resources. www.

The industry with a nearly flat supply curve would spend more resources.

Answer: b. The industry with a nearly vertical supply curve would spend more resources.

Any demand subsidy will shift the demand curve to the right. That will cause a larger increase in equilibrium price in the industry with the nearly vertical curve.

Thus, the firms in that industry will have larger incentive to lobby the government to subsidize the demand for their output.

APPENDIX PROBLEMS Demand and supply often shift in the retail market for gasoline. Below are two demand curves and two supply curves for gallons of gasoline in the month of May in a small town in Maine. Some of the data are missing. LO3.7 1-68 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Use the following facts to fill in the missing data in the table. If demand is D1 and Supply is S1, the equilibrium quantity is 7,000 gallons per month. When demand is D2 and supply is S1, the equilibrium price is $3.00 per gallon. When demand is D2 and supply is S1, there is an excess demand of 4,000 gallons per month at a price of $1.00 per gallon. If demand is D1 and supply is S2, the equilibrium quantity is 8,000 gallons per month. xxx.

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

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

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

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Answers: (a) See the complete table below for the missing values; (b) equilibrium quantity increases by 1,000 gallons per month, the equilibrium prices falls by $1.00; (c) equilibrium price stays the same (at $2.00), equilibrium price rises (from $2.00 to $3.00), equilibrium price falls (from $2.00 to $1.00); (d) 2,000 gallons per month, 4,000 gallons per month.

Feedback: If demand is D1 and Supply is S1, the equilibrium quantity is 7,000 gallons per month. We can eliminate all rows except the third row in the table above because we actually have values for the first two rows for D1 and S1 and the fourth row has a value of 5,000 for S1. In equilibrium S1 must equal D1, so the only row where this can hold is row 3. So, the entry for row 3-D1 is 7,000 and the entry for row 3-S1 is 7,000 as well.

When demand is D2 and supply is S1, the equilibrium price is $3.00 per gallon. Equilibrium for D2 and S1 occurs at a quantity of 8,000. Therefore, the price in row 2 is $3.00.

When demand is D2 and supply is S1, there is an excess demand of 4,000 gallons per month at a price of $1.00 per gallon. The excess demand of 4,000 occurs in row 4 for D2 and S1. This implies the price in row 4 is $1.00.

If demand is D1 and supply is S2, the equilibrium quantity is 8,000 gallons per month. Since the equilibrium quantity must equal 8,000 for D1 and S2, and the only remaining missing quantity entries are in row 4 for D1 and S2, this implies that the entries for D1 and S2 in row 4 (quantities) are 8,000. i. The initial equilibrium for D1 and S1 is Q = 7,000 and P = $2.00. The second equilibrium for D1 and S2 (an increase in supply) is Q = 8,000 and P = $1.00.

Thus, the change in quantity is an increase of 1,000 (= 8,000 − 7,000) and the change in price is a decrease of $1.00 (= $2.00 − $1.00). j. The initial equilibrium for S2 and D2 is Q = 8,500 and P = $2.00. The second equilibrium for S1 and D1 (both supply and demand fall) is Q = 7,000 and P = $2.00. The equilibrium price remains the same at P = $2.00. The third 1-70 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

equilibrium for D2 and S1 (only supply falls) is Q = 8,000 and P = $3.00.

Compared to the initial equilibrium, price increases from $2.00 to $3.00. The fourth equilibrium for S2 and D1 (only demand falls) is Q = 8,000 and P = $1.00. Compared to the initial equilibrium, price falls from $2.00 to $1.00. k. Since supply is fixed at S1 and demand starts at D1, the initial equilibrium is Q = 7,000 and P = $2.00. For the equilibrium price to increase to $3.00 (from $2.00), demand would need to increase by 2,000. This would result in an equilibrium Q = 8,000 and P = $3.00 (D2 and S1). Note: the original demand at $3.00 is only 6,000, so to support an equilibrium price of $3.00, demand would need to be 2,000 higher. The same logic applies for the equilibrium price of $4.00. If demand is going to support the equilibrium price of $4.00, then demand will need to increase from 5,000 (D1) to 9,000 (D2). Thus, demand will need to increase by 4,000 and the new equilibrium is Q = 9,000 and P = $4.00 (D2 and S1).

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

Suppose that Stromnord has exactly 65 pairs of this style of shoe in inventory at the start of the month of July and will not receive any more pairs of this style until at least August 1. LO3.7 If demand is D1, what is the lowest price that Stromnord can charge so that it will not run out of this model of shoes in the month of July? What if demand is D2? aaaa.

If the price of shoes is set at $75 for both July and August and demand will be D2 in July and D1 in August, how many pairs of shoes should Stromnord order if it wants to end the month of August with exactly zero pairs of shoes in its inventory? How many pairs of shoes should it order if the price is set at $55 for both months?

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

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If demand is D1, the lowest price Stromnord can charge is $70 if it does not want to run out of shoes in the month of July. A price of $65 would result in a demand of 68 pairs of shoes, and Stromnord only has 65 in inventory. (Note: answers must use the values in the table). If demand is D2, the lowest price Stromnord can charge is $55 if it does not want to run out of shoes in the month of July because the demand for shoes is only 27 pairs at this price. This is the lowest value in the table. l. If the price of shoes is set at $75 for both July and August and demand will be D2 in July and D1 in August, then the total demand for these months is 66 pairs of shoes. Since Stromnord has 65 pairs in inventory, it will need to order 1 more pair to meet demand for both months. If the price is set at $55 total demand for both months will be 114. Here Stromnord will need to order 49 pairs (= 114 − 65).

69. Use the table below to answer the questions that follow: LO3.7 If this table reflects the supply of and demand for tickets to a particular World Cup soccer game, what is the stadium capacity? bbbb.

If the preset ticket price is $45, would we expect to see a secondary market for tickets? Why or why not? Would the price of a ticket in the secondary market be higher than, the same as, or lower than the price in the primary (original) market? cccc.

Suppose for some other World Cup game the quantities of tickets demanded is 20,000 lower at each ticket price than shown in the table. If the ticket price remains $45, would the event be a sellout?

Answers: (a) 60,000; (b) Yes, higher; (c) No. Feedback: Stadium Capacity is 60,000. We can infer this from the constant supply independent of price. m. If the preset ticket price is $45, we would expect to see a secondary market because there is a shortage of tickets at this price. The shortage of tickets, which equals 10,000, would allow individuals who have the tickets (or get to 1-72 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

purchase the tickets) to resell them for a higher price. This is because the market would result in a higher equilibrium price of $65, which implies some individuals are willing to pay between $46 and $65 for the tickets. Thus, the price in the secondary market would be higher. n. If demand were 20,000 less at each price, the quantity demanded at $45 would only be 50,000 [= 70,000 (original demand) − 20,000 (decline in demand)].

Since capacity is 60,000 this would not be a sellout.

Chapter 04 - Market Failures: Failures Caused by Externalities and Asymmetric Information McConnell Brue Flynn 23e

DISCUSSION QUESTIONS 70. Use the ideas of consumer surplus and producer surplus to explain why economists say competitive markets are efficient. Why are below- or above-equilibrium levels of output inefficient, according to these two ideas? LO4.1 Answer: When the consumers‘ utility exceeds the price paid, consumer surplus is generated. Likewise, when producers receive a price greater than marginal cost, producer surplus is created. By producing up to the point where MB = MC, the maximum potential consumer surplus and producer surplus are generated.

Producing less than the equilibrium level means that potential surplus is left unrealized. Overproduction subtracts from the surplus because society values the use of the additional resources in other pursuits more than it values them in the consumption of that good.

71. What divergences arise between equilibrium output and efficient output when (a) negative externalities and (b) positive externalities are present? How might government correct these divergences? Cite an example (other than the text examples) of an external cost and an external benefit. LO4.2 Answers: (a) When negative externalities are present, the equilibrium output will be greater than the efficient output. This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision. (b) When positive externalities are present, the equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer‘s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must either aid 1-73 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the producer to encourage more output or engage in its own production of the item with the external benefits.

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

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

72. Why are spillover costs and spillover benefits also called negative and positive externalities? Show graphically how a tax can correct for a negative externality and how a subsidy to producers can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to producers in correcting for a positive externality? LO4.2 Answers: Spillover costs are called negative externalities because they are external to the participants in the transaction and reduce the utility of affected third parties (thus ―negative‖). Spillover benefits are called positive externalities because they are external to the participants in the transaction and increase the utility of affected third parties (thus ―positive‖). To show how taxes and subsidies can correct externalities, see Figures 4.6 and 4.7. Compare (b) and (c) in Figure 4.7.

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

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

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

Using the Coase theorem, we note that it will be to the advantage of individual apple growers and beekeepers to negotiate so that beekeepers (whose hives can be moved) locate their production in or near orchards. This negotiation will occur as long as property ownership is well defined, only a few people are involved, and bargaining costs are low. For example, an apple grower who owns an orchard 1-76 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

could allow a beekeeper to use a portion of his or her land, charging below-market rents so that both parties gain from the agreement.

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

LO4.2 Answers: If the government were to subsidize LoJack purchases, this would reduce the private cost of the anti-theft devices. In turn, this reduction in the private cost would, in-turn, increase the purchase of the LoJack system. The fact that this good was under-utilized in the private sector without the subsidy (because part of the benefit accrued to society, not the individual, in the form of reduced crime is shutting down ―chop shops‖) implies this subsidy is appropriate.

Yes, the government should consider subsidizing LoJack purchases.

75. Explain why zoning laws, which allow certain land uses only in specific locations, might be justified in dealing with negative externalities. Explain why in areas where buildings sit close together tax breaks to property owners for installing extra fire prevention equipment might be justified due to positive externalities. LO4.2 Answers: Zoning could force businesses producing negative externalities to locate in regions where these costs would not spill over onto third parties, or where such costs would at least be reduced. Businesses wanting to locate in regions where external costs would cause the most damage (but where zoning restricts their location) would be forced to eliminate or reduce those external costs. In either case, a more efficient allocation of resources would result.

Tax breaks to property owners who install fire prevention equipment reduces the potential of fire spreading to nearby buildings. Thus, the fire prevention equipment will have positive externalities because of the additional benefit to the community. At the individual level the building owners take into account the benefits for their own business, which implies that fire prevention equipment will be underutilized without the tax break (which reduces direct cost).

76. Because medical records are private, individuals applying for health insurance will know more about their own health conditions than will the insurance companies to which they are applying for coverage. Is this information asymmetry likely to increase or decrease the insurance premium? Why? LO4.4 Answer: This information asymmetry will likely increase the insurance premium because the buyers of the insurance policy have more information about their 1-77 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

health status than the sellers (the insurance companies). Because of this asymmetric information problem, insurance companies will likely suffer losses if they charge an insurance premium based on the average health of the population.

Only the unhealthy will purchase coverage at this ―average‖ price. These potential losses will force insurance companies to charge a higher premium, on average, than they would if they had complete information.

77. Why is it in the interest of people purchasing new homes as well as the builders of new homes to have government building codes and building inspectors? LO4.4 Answer: The reason is related to the lack of information and education on the part of most new homebuyers and builders with regard to every aspect of home construction. To make sure that a new building conforms to adequate safety and construction standards, building codes have been created. The government inspectors provide impartial third-party expertise to assure the buyer that the codes have been met. Such inspections also provide information to builders about the electrical and plumbing installation that is usually done by subcontractors. Without building codes and inspections, the market for new homes might be severely hampered. Thus, builders also benefit from codes and inspectors.

78. Which of the following are moral hazard problems? Which are adverse selection problems? LO4.4 dddd.

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

A person drives carelessly because she has automobile insurance. ffff.

A person who intends to torch his warehouse takes out a large fire insurance policy. gggg.

A professional athlete who has a guaranteed contract fails to stay in shape during the off season. hhhh.

A person who anticipates having a large family takes a job with a firm that offers exceptional child care benefits.

Answers: o. Adverse selection problem: The buyer of the insurance policy has more information about his or her health than the seller when the contract is signed. p. Moral hazard problem: The person changes his or her behavior after the insurance contract is signed. q. Adverse selection problem: The buyer of the insurance policy has more information about the likelihood of an intentional fire than the seller when the contract is signed. r. Moral hazard problem: The person changes his or her behavior after the insurance contract is signed.

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s. Adverse selection problem: The person has more information about her desired family size when the firm hires her.

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

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

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

REVIEW QUESTIONS Draw a supply and demand graph and identify the areas of consumer surplus and producer surplus. Given the demand curve, how will an increase in supply affect the amount of consumer surplus shown in your diagram? Explain. LO4.1 Answer: An increase in supply will lower the price and increase the amount of consumer surplus for a given demand curve. Any individual that was receiving consumer surplus before the change in supply will realize an increase in consumer surplus as the price falls and the difference between their maximum willingness to pay and the market price widens.

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80. Assume that candle wax is traded in a perfectly competitive market in which the demand curve captures buyers‘ full willingness to pay while the supply curve reflects all production costs. For each of the following situations, indicate whether the total output should be increased, decreased, or kept the same in order to achieve allocative and productive efficiency. LO4.1 The maximum willingness to pay exceeds minimum acceptable price. iiii. MC > MB. jjjj. Total surplus is at a maximum. kkkk.

The current quantity produced exceeds the market equilibrium quantity.

Answer: Increased. More candle wax should be produced and sold because doing so would increase allocative efficiency and help to ensure that society‘s limited supply of resources are being used to produce the products that consumers most highly desire. That is true because the minimum acceptable price demanded by producers takes into account the opportunity costs of everything else that they could possibly produce from the resources needed to make more candle wax. Thus, the fact that buyers have a maximum willingness to pay that exceeds the producers‘ minimum acceptable price means that the buyers value turning those resources into additional candle wax more than they would if the resources were turned into any other possible product. Therefore, increasing the production of candle wax would increase allocative efficiency. t. Decreased. Output should be reduced in order to improve allocative efficiency. Because MC > MB at the current level of production, we know that the cost of producing the final unit of candle wax exceeds the benefit felt by consumers from consuming it. This implies that the resources currently being used to produce the final unit of candle wax could be put to better use producing other goods and services. This is true because the MC of the final unit of candle wax includes the opportunity cost of producing other products from the resources currently being used to produce the final unit of candle 1-81 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

wax. Therefore, we can improve allocative efficiency by reducing the production of candle wax so that those resources can be freed up and directed toward the production of products that are more highly valued than the final unit of candle wax. u. Kept the same. Production should be kept at the same level because the level of output that maximizes total surplus is also the level of output that guarantees allocative efficiency. The easiest way to see this is by noting that both reducing production and increasing production will cause allocative inefficiencies. First consider a decrease in candle wax production. If fewer units are produced, total surplus will fall as units for which consumers‘ maximum willingness to pay exceeds producers‘ minimum acceptable price will no longer be produced. That implies a reduction in allocative efficiency because the resources that are freed up by the reduction in candle wax production will end up being used to produce units of other products that are not as highly valued as the foregone units of candle wax. Next consider an increase in candle wax production. If output is increased, total surplus will also fall because the increased production would involve units of candle wax for which consumers‘ maximum willingness to pay is less than producers‘ minimum acceptable price. That implies a reduction in allocative efficiency because the resources used to increase candle wax production could have gone instead into the production of products that would have been more highly valued than the additional candle wax. v. Decreased. The most amazing thing about equilibrium in competitive markets is that when demand curves fully reflect buyers‘ willingness to pay and supply curves fully reflect all production costs, the market equilibrium quantity will be the same as the unique level of output that is both allocatively and productively efficient. Thus, we know that any level of output in excess of the market equilibrium quantity will not be allocatively or productively efficient. We also know that the remedy would be to decrease production back down to the market equilibrium quantity.

81. Efficiency losses _ LO4.1 are not possible if suppliers are willing to produce and sell a product llll. can result only from underproduction mmmm. can result only from overproduction nnnn. none of the answer choices are correct Answer: d; none of the above.

Efficiency losses can result from either overproduction or underproduction. The fact that suppliers are willing to produce and sell a product does not by itself guarantee that the allocatively efficient amount of that product will be produced.

In fact, it is possible for them to either underproduce or overproduce relative to the efficient output level. Either will cause an efficiency loss. Thus, answers a, b, and c are all incorrect.

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82. Match each of the following characteristics or scenarios with either the term negative externality or the term positive externality. LO4.2 Resources are overallocated oooo.

Xochitl installs a very nice front garden, raising the property values of all the other houses on her block pppp.

Market demand curves are too far to the left (too low) qqqq.

Resources are underallocated rrrr.

Water pollution from a factory forces neighbors to buy water purifiers Answer: Negative externality. Resources are overallocated to products that impose negative externalities on third parties. This happens because the firms imposing negative externalities on third parties fail to take into account the costs that would be needed to either prevent the negative externalities or compensate those who suffer from them. Not taking those costs into account renders the firms‘ profits artificially high—which leads them to overproduce. As they do so, resources are overallocated to the production of their products and taken away from the production of other products that would have produced greater net benefits for society. In terms of a supply and demand diagram, the negative externalities lower the polluting firms‘ MC curves and shift the market supply curve to the right. This results in an equilibrium quantity in excess of the optimal output level that would prevail if the firms‘ MC curves correctly accounted for the negative externalities. w. Positive externality. Xochitl‘s garden provides a positive externality for her neighbors because while her main intent was to make herself happy by improving the look of her own property, she has also provided a free benefit to her neighbors. They receive higher property values without having to pay Xochitl anything for them. x. Positive externality. Positive externalities cause market demand curves to be too far to the left (too low) relative to total-benefit demand curves. The problem is that when there are positive externalities, the people receiving the positive externalities do not have to pay for the benefits that they receive. Thus, their willingness to pay for those benefits is not captured by the market demand curve. This causes the market demand curve to end up too far to the left, leading to a market equilibrium quantity that is less than the optimal output. And because output is less than optimal, resources that should have flowed to producing more of the good in question flow instead to the production of other products that are less valued by consumers. y. Positive externality. Resources are underallocated to products that impose positive externalities on third parties. The problem is that when there are positive externalities, the people receiving the positive externalities do not have to pay producers for the benefits that they are receiving. This lowers producer profits and causes them to produce less than the socially optimal output. Because output is below the optimal level, resources that should have 1-83 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

flowed to producing more of the goods in question flow instead to the production of other products that are less valued by consumers. In terms of a supply and demand diagram, the positive externality means that the demand curve is too far to the left (too low) relative to the total-benefit demand curve that includes the willingness to pay of the people receiving the positive externalities. With the demand curve shifted to the left in this way, the market equilibrium output ends up lower than the optimal output. z. Negative externality. The factory‘s water pollution imposes a negative externality on its neighbors because the factory does not take into account the costs that it imposes on them.

83. Use marginal cost-marginal benefit analysis to determine if the following statement is true or false: ―The optimal amount of pollution abatement for some substances, say, dirty water from storm drains, is very low; the optimal amount of abatement for other substances, say, cyanide poison, is close to 100 percent.‖ LO4.3 Answer: Reducing dirty water flow from storm drains has a low marginal benefit, meaning the MB curve would be located far to the left of where it is in the text diagram. It will intersect the MC curve at a low amount of pollution abatement, indicating the optimal amount of pollution abatement (where MB = MC) is low.

Any cyanide in public water sources could be deadly. Therefore, the marginal benefit of reducing cyanide is extremely high and the MB curve in the figure would be located to the extreme right where it would intersect the MC curve at or near 100 percent.

84. People drive faster when they have auto insurance. This example illustrates: LO4.4 adverse selection. ssss. asymmetric information tttt. moral hazard.

Answer: Moral hazard: People driving faster when they have auto insurance is an example of moral hazard. This is true because moral hazard is the tendency of one party to a contract or an agreement to alter his or her behavior after the contract is signed in ways that could be costly to the other party. In this case, drivers who have signed auto insurance contracts alter their driving behavior in a way that is likely to be very costly to the insurance companies, who will have to pay for any increase in the number of accidents that is caused by their customers driving faster.

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

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uuuu.

the asymmetric information problem.

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

86. True or False: A market may collapse and have relatively few transactions between buyers and sellers if buyers have more information than sellers. LO4.4 Answer: True: This statement is true because when buyers have more information than sellers, sellers must worry that buyers will take advantage of them. The standard example of this phenomenon is health insurance because individuals almost always have better information about their own health conditions than insurance companies. This causes a pricing problem for the insurance companies, who would like to keep the cost of insurance low so that it will be widely popular with all sorts of people. But the people that most likely want to buy health insurance are people who know that they are sicker than average and will very likely need a lot of costly treatments in the future. Taking that into consideration, the health insurance companies must raise the price of insurance so as to make sure that they will be collecting enough in premiums to be able to cover those high future costs. But as the price of insurance rises, a lot of healthy people will no longer find it worth their while to buy health insurance. As they drop out of the market, the group of people still buying insurance comes to be dominated by the people who privately know that they are more costly than average. As a result, the market may collapse as many who would have bought insurance at lower prices now choose to go without.

PROBLEMS Refer to Table 4.1. If the six people listed in the table are the only consumers in the market and the equilibrium price is $11 (not the $8 shown), how much consumer surplus will the market generate? LO4.1 Answer: $3 Feedback: Consider the following table as an example:

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

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

Bashir‘s consumer surplus is $2 (= $13 − $11).

Barb‘s consumer surplus is $1 (= $12 − $11).

Bill‘s consumer surplus is $0 (= $11 − $11).

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

87. Refer to Table 4.2. If the six people listed in the table are the only producers in the market and the equilibrium price is $6 (not the $8 shown), how much producer surplus will the market generate? LO4.2 Answer: $6 Feedback: Consider the following table as an example: 1-86 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Using the values above, and assuming an equilibrium price of $6 (not the $8 shown), we first note that an individual will only sell the good if his or her ―minimum acceptable price‖ is less than or equal to the price of the product ($6).

This implies that only Chander, Chaaya, Chuck, and Chazen are willing to sell the good at the price of $6.

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

Chander‘s producer surplus is $3 (= $6 − $3).

Chaaya‘s producer surplus is $2 (= $6 − $4).

Chuck‘s producer surplus is $1 (= $6 − $5).

Chazen‘s Producer surplus is $0 (= $6 − $6).

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

88. Look at Tables 4.1 and 4.2 together. What is the total surplus if Bashir buys a unit from Chander? If Barb buys a unit from Chaaya? If Bashir buys a unit from Chad? If you match up pairs of buyers and sellers so as to maximize the total surplus of all transactions, what is the largest total surplus that can be achieved? LO4.2 Answers: $10 (= $13 − $3); $8 (= $12 − $4); $5 = ($13 − $8); $30.

Feedback: Consider the following table as an example: 1-87 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

If Bashir buys a unit of the good from Chander, then the economic surplus is the difference between Bashir‘s ―maximum price willing to pay‖ and Chander‘s ―minimum acceptable price.‖ The economic surplus is $10 (= $13 − $3).

If Barb buys a unit from Chaaya, then the economic surplus equals $8 (= $12 − $4).

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If Bashir buys a unit from Chad, then the economic surplus is $5 (= $13 − $8).

If we match up buyers and sellers to maximize the total economic surplus, then we need to choose the pairs with the largest gap between ―maximum price willing to pay‖ and the ―minimum acceptable price.‖ This implies the following pairs (Bashir, Chander) with an economic surplus of $10, (Barb, Chaaya) with an economic surplus of $8, (Bill, Chuck) with an economic surplus of $6, (Beeja, Chazen) with an economic surplus of $4, (Brent, Chuma) with an economic surplus of $2, and (Blessing, Chad) with an economic surplus of $0. Adding this up across all pairs gives us a total economic surplus of $30.

89. ADVANCED ANALYSIS Assume the following values for Figures 4.4a and 4.4b.

Q1 = 20 bags. Q2 = 15 bags. Q3 = 27 bags. The market equilibrium price is $45 per bag. The price at a is $85 per bag. The price at c is $5 per bag. The price at f is $59 per bag. The price at g is $31 per bag. Apply the formula for the area of a triangle (Area = ½ × Base × Height) to answer the following questions. LO4.1 What is the dollar value of the total surplus (producer surplus plus consumer surplus) when the allocatively efficient output level is being produced? What is the dollar value of the consumer surplus at that output level? vvvv.

What is the dollar value of the deadweight loss when output level Q2 is produced? What is the total surplus when output level Q2 is produced? wwww. What is the dollar value of the deadweight loss when output level Q3 is produced? What is the dollar value of the total surplus when output level Q3 is produced?

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

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

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

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

We know the form of the demand schedule will be P = C1 + C2Q where C1 and C2 are unknown constants. The intercept, C1, can be found by setting Q equal to zero.

This is point a, so C1 equals 85. To find the slope, C2, we divide the change in quantity by the change in price using our two ordered pairs above (rise-over-run).

This implies C2 equals (20 − 0) / (45 − 85) = −2.

Thus, we have the following demand schedule: P = 85 − 2Q 1-90 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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

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

Thus, we have the following supply schedule: P = 5 + 2Q With these schedules we can now answer the following questions: To calculate total surplus, we use the following formula for the area of a triangle (Area = ½ (Base × Height)).

The area between the demand schedule P = 85 − 2Q and the supply schedule P = 5 + 2Q for the quantity ranging from 0 to 20 is the total economic surplus.

This is a triangle with a base of 80 (the price difference at Q = 0, or points a and c) and a height of 20 (the number of units purchased in equilibrium).

Using these values, we have a total surplus = (1/2) × 80 × 20 = 800.

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

Consider the following additional values for the figures above: Q2 = 15 bags.

Q3 = 27 bags, the price at f is $59 per bag, and the price at g is $31 per bag. aa. The first thing we need to do is calculate the price at Q2 = 15 for the supply and demand schedules. The price on the supply schedule is P = 5 + 2 × 15 = 35. The price on the demand schedule is P = 85 − 2 × 15 = 55. The difference between these two prices is our base, which equals 20. The height is the quantity difference between the equilibrium quantity Q1 = 20 and the underproduction quantity Q2 = 15 (= 5). Thus, the deadweight loss from underproduction is (1/2) × 20 × 5 = 50.

The total surplus can be found by subtracting the deadweight loss from the original total surplus that maximized efficiency. This is 800 (maximum total surplus) −50 (deadweight loss) = 750. bb. Here we follow the same procedure. We are given the price at point f is $59 and the price at point g is $31 (we do not need to calculate these prices using 1-91 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the demand and supply schedule). The quantity Q =27 represents over production (the marginal cost to society exceeds the marginal benefit to society) of 7 units. To calculate the deadweight loss from this overproduction we use the price difference as the base, which is 28 (= 59 − 31), and the amount of overproduction as the height, which is 7 (= 27 − 20). This results in a deadweight loss of 98 (= (1/2) × 28 × 7).

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

90. Refer to Tables 4.1 and 4.2, which show, respectively, the willingness to pay and willingness to accept of buyers and seller of bags of oranges. For the following questions, assume that the equilibrium price and quantity depend on the following changes in supply and demand. Also assume that the only market participants are those listed by name in the two tables. LO4.2 What are the equilibrium price and quantity for the data displayed in the two tables? xxxx.

Instead of bags of oranges, assume that the data in the two tables deal with a good (such as fireworks displays) that can be enjoyed by free riders who do not pay for it. If all the buyers in the two tables free ride, what quantity will private sellers supply? yyyy.

Assume that we are back to talking about bags of oranges (a private good), but that the government has decided that tossed orange peels impose a negative externality on the public that must be rectified by imposing a $2-per-bag tax on sellers. What is the new equilibrium price and quantity? If the new equilibrium quantity is the optimal quantity, by how many bags were oranges overproduced before?

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

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

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To determine the equilibrium price of oranges, we begin by comparing the highest willingness to pay with the lowest minimum acceptable price. Bashir is willing to pay $13 and Chander is willing to accept at minimum $3. This trade is made because Bashir is willing to pay more than Chander requires for the sale. We then move on to the trade between Barb and Chaaya. This trade is 1-93 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

also made because Barb is willing to pay $12 and Chaaya only requires $4 to make the sale. This goes on until the ―maximum willingness to pay‖ equals the ―minimum acceptable price‖. This occurs for the trade between Blessing and Chad. Blessing‘s ―maximum willingness to pay‖ is $8 and Chad‘s ―minimum acceptable price‖ is also $8. Since the six purchasers (each purchases 1 unit) buy the 6 units produced by the six producers (each produces 1 unit), the equilibrium quantity is 6 at the equilibrium price of $8. cc. If instead of bags of oranges, the data in the two tables dealt with a public good like fireworks displays, and all the buyers free ride, then the quantity supplied will be zero. Everyone will try to pay a zero price. dd. If the government decides that tossed orange peels impose a negative externality on the public that must be rectified by imposing a $2-per-bag tax on sellers, then the ―minimum acceptable price‖ will increase by the amount of the tax. The reason is that the producers must now pay an additional $2 on top of their production costs. This implies that the ―minimum acceptable price‖ for Chander is $5(= $3 + $2), Chaaya $6, Chuck $7, Chazen $8, Chuma $9, and Chad $10. Comparing this new ―minimum acceptable price‖ schedule with the original ―maximum willingness to pay‖ schedule we have the following new equilibrium.

Bashir is willing to pay $13 and Chander is willing to accept at minimum $5.

This trade is made because Bashir is willing to pay more than Chander requires for the sale. We then move on to the trade between Barb and Chaaya.

This trade is also made because Barb is willing to pay $12 and Chaaya only requires $6 to make the sale. This goes on until the ―maximum willingness to pay‖ equals the ―minimum acceptable price‖. This occurs for the trade between Brent and Chuma now. Brent‘s ―maximum willingness to pay‖ is $9 and Chuma‘s ―minimum acceptable price‖ is also $9. The potential trade between Blessing and Chad no longer takes place. Blessing is only willing to pay $8 and Chad requires $10 to make the sale. Since only five purchasers (each purchases 1 unit) buy the 5 units produced by the five producers (each produces 1 unit), the new equilibrium quantity is 5 at the equilibrium price of $9.

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

91. Consider a used-car market with asymmetric information. The owners of used cars know what their vehicles are worth but have no way of credibly demonstrating those values to potential buyers. Thus, potential buyers must always worry that the used car they are being offered may be a low-quality ―lemon.‖ LO4.4

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Suppose that there are equal numbers of good and bad used cars in the market and that good used cars are worth $13,000 while bad used cars are worth $5,000.

What is the average value of a used car? zzzz.

By how much does the average value exceed the value of a bad used car?

By how much does the value of a good used car exceed the average value? aaaaa.

Would a potential seller of a good used car be willing to accept the average value as payment for the vehicle? bbbbb.

If a buyer negotiates with a seller to purchase the seller‘s used car for a price equal to the average, is the car more likely to be good or bad? ccccc.

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

Answer: (a) $9,000; (b) By $4,000; $4,000; (c) No; (d) Bad; (e) Yes; $5,000 each Feedback: Since there are an equal number of good and bad used cars in the market the likelihood of each type is 0.50 (or 50% good and 50% bad)). This implies the average value of a used car is $9000 (= 0.5 × $13,000 + 0.5 × $5,000). You can also find the average by adding together the two values ($13,000 + $5,000) and dividing by two = $18,000/2 = $9,000. ee. The average value of a used car exceeds the value of a bad used car by $4,000 (= $9,000 − $5,000).

The value of a good used car exceeds the average value a used car by $4,000 (= $13,000 − $9,000). ff. No, a potential seller of a good used car would NOT be willing to accept the average value since they would not be getting the full value of the car. gg. The car will likely be a bad used car with a value of $5,000. The seller of a good used car is unlikely to accept $9,000 (average value) for a car worth $13,000 (value of a good used car). hh. Yes, this market will come to feature mostly, if not exclusively, lemons. If all the good cars are withdrawn, the remaining bad cars should go for what they are worth, $5,000 each.

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Chapter 05 – Public Goods, Public Choice, and Government Failure McConnell Brue Flynn 23e

DISCUSSION QUESTIONS 92. What are the two characteristics of public goods? Explain the significance of each for public provision as opposed to private provision. What is the free-rider problem as it relates to public goods? Is U.S. border patrol a public good or a private good? Why? What type of good is satellite TV? Explain. LO5.1 Answer: Public goods are nonrival (one person‘s consumption does not prevent consumption by another) and nonexcludable (once the goods are produced, nobody—including free riders—can be excluded from the goods‘ benefits). If goods are nonrival, there is less incentive for private firms to produce them— those purchasing the good could simply allow others the use without compensation. Similarly, if goods are nonexcludable, private firms are unlikely to produce them as the potential for profit is low.

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

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

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

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

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

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

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

In Figure 5.2b, Garcia would incur a net loss of $200 if the measure passes, so it would be in her best interest to spend up to $200 to help defeat the measure. If she paid Johnson $60 to change his vote to ―no,‖ Johnson would receive more economic benefit by voting against the measure. The measure would fail, leading 1-97 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

to a more efficient economic outcome. Note that buying votes in the United States is illegal. Even though it could lead to more efficient economic outcomes in some cases, other complicating factors need to be considered.

94. ―Majority voting ensures that government will produce only those public goods for which benefits exceed costs.‖ Discuss. LO5.2 Answer: The statement is incorrect. A number of government failures and voting paradoxes can lead to situations in which a government overprovides a public good and produces beyond the amount at which MB = MC. Inefficient voting outcomes and the paradox of voting may be to blame.

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95. ―The problem with our democratic institutions is that they don‘t correctly reflect the will of the people! If the people—rather than self-interested politicians or lobbyists— had control, we wouldn‘t have to worry about government taking actions that don‘t maximize allocative and productive efficiency.‖ Critique. LO5.2 Answer: The statement is false. Due to voter failure and the problem that economically inefficient policies are often very popular with the electorate.

96. Does traditional one-person-one-vote (1p1v) majority voting allow voters to directly express differences in strengths of preference? Does quadratic voting do any better?

Discuss the differences and then explain which system you prefer, and why. LO5.2 Answer: Traditional one-person-one-vote (1p1v) majority voting does NOT allow voters to directly express differences in strengths of preference because a single voter‘s vote only counts once regardless of the strength of preference (or how much the voter stands to gain or lose from a public good).

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

Under quadratic voting, the cost of purchasing votes is quadratic, meaning that it increases exponentially with the square of the number of votes purchased. With quadratic voting, each voter will purchase votes up to the point where the marginal benefit from purchasing additional votes equals the marginal cost of purchasing additional votes. Thus, this system would yield more socially efficient outcomes than the one-person-one-vote system, which does not enable voters to express the strength of their preferences.

97. Jean Baptiste Colbert was the Minister of Finance under King Louis XIV of France.

He famously observed, ―The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.‖ How does his comment relate to the special-interest effect? LO5.3 Answer: The logic above applies to special interests and collective action as well.

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

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98. What is rent seeking and how does it differ from the kinds of profit maximization and profit seeking that we discussed in previous chapters? Provide an actual or hypothetical example of rent seeking by firms in an industry, by a union, or by a professional association (for example, physicians, schoolteachers, or lawyers). Why do elected officials often accommodate rent-seeking behavior, particularly by firms, unions, and professional groups located in their home states? LO5.3 Answer: Rent seeking is an appeal to the government for special benefits at taxpayers‘ or someone else‘s expense. The term ‗rent‘ refers to any payment is excess of the minimum amount that is necessary to keep the resource employed in its current use. Rent seeking is different from profit maximization because rentseeking attempts to influence the political process to gain increased profit or income. Standard profit maximization and profit seeking are driven by market forces, such as new products, cost minimization, etc.

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

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

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

LO5.3 Answer: Limited and bundled choice in the political process tends to reduce economic efficiency because blocks of public goods and social programs are provided. That is, instead of evaluating each public good and social program on its respective costs and benefits, the politician chooses all programs together.

Some of these goods and programs may benefit society (positive net benefits), but others may hurt society (negative net benefits).

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

However, we need to look carefully at the logic underlying this argument. Most bureaucratic operations do not provide private goods. They provide public goods 1-100 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

and social services that correct potential market failures through regulation and direct provision. Thus, the market analogy may not apply.

100. Explain: ―Politicians would make more rational economic decisions if they weren‘t running for reelection every few years.‖ L O5.3 Answer: Because political officeholders must seek voter support every few years, they favor programs with immediate and clear-cut benefits and with vague or deferred costs. Conversely, politicians will reject programs with immediate and easily identifiable costs but with long-term, less measurable benefits. Such biases can lead politicians to reject economically justifiable programs and to accept programs that are economically irrational. Politicians may make these and other irrational decisions in order to curry favor with the voters.

101. Critique: ―Thank goodness we have so many government regulatory agencies. They keep Big Business in check.‖ LO5.3 Answer: Government regulatory agencies sometimes fall under the sway of the industries that they are supposed to be regulating. Those instances of ―regulatory capture‖ imply that this statement is overly confident in the ability of government regulatory agencies to keep powerful businesses in check. If regulatory capture occurs, the captured regulator ceases to be a truly independent watchdog looking out for the better interests of the public. Instead, it often imposes regulations that reduce competition and promote high levels of profit in the ―regulated‖ industry.

102. LAST WORD What are the pluses and minuses of corporate location subsidies?

Why do politicians like them so much? Would you be surprised to know that many of the 238 cities bidding for Amazon‘s HQ2 offered much larger location subsidies than did New York City and Alexandria, Virginia? Explain.

Answer: Attracting a large corporation has obvious advantages to a locale. First of all, an increase in jobs will increase local economic activity. The increased spending also helps boost local businesses. Often the increased activity will attract start-up businesses to the area, creating even more jobs and opportunities for local residents. The obvious downside is the cost of the location subsidies to local or state taxpayers. The costs of the subsidies often outweigh the benefits. In addition, a large corporation moving into a locale can have negative indirect effects such as increased traffic and higher costs of housing and other resources for local residents.

Location subsidies are very attractive to politicians because many of them love to be seen at ribbon-cutting ceremonies, looking as though they personally are responsible for bringing new businesses, new jobs, and economic growth to their 1-101 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

area. That‘s an illusion, of course, but one that serves the political goal of getting reelected. Consequently, the subsidies are an example of government failure induced by the principal-agent problem that exists between the voters who must pay for subsidies and the politicians whose main goal is staying in office.

New York and Arlington were the most natural locations for Amazon from the very start due to their proximity to major population centers and airports and other distribution infrastructure that Amazon needs as the western hemisphere‘s largest Internet retailer. This made many people suspect that Amazon would have put HQ2 in New York City and Arlington no matter what. Thus, there would have been no need for either city to give away billions in taxpayer subsidies; they would have gotten HQ2 anyway.

REVIEW QUESTIONS Draw a production possibilities curve with public goods on the vertical axis and private goods on the horizontal axis. Assuming the economy is initially operating on the curve, indicate how the production of public goods might be increased. How might the output of public goods be increased if the economy is initially operating at a point inside the curve? LO5.1 Answer: On the curve, the only way to obtain more public goods is to reduce the production of private goods (from C to B). An economy operating inside the curve can expand the production of public goods without sacrificing private goods (say, from A to B) by making use of unemployed resources.

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103. Use the distinction between the characteristics of private goods and public goods to determine whether the following should be produced through the market system or provided by government: (a) French fries, (b) airport screening, (c) court systems, (d) mail delivery, and (e) medical care. Explain your answers. LO5.1 Answer: ii. French fries: Market system (rival and excludable) jj. Airport screening: Government. The additional safety provided by the mandatory security screenings is non-excludable and non-rival to all passengers on a flight. kk. Court systems: Government. All citizens have access to the legal system in the country, so access to court systems is non-excludable and (to some degree) non-rival. Other arguments also apply, such as the need for impartiality, which could be compromised if users of the court systems were paying the providers directly. ll. Mail delivery: Combined market and government. The law gives the postal service a monopoly, but services such as package delivery have private competition. mm. Medical care: Combined market and government. The mix of private and public production is a controversial topic addressed in the chapter on the economics of health care.

104. We can apply voting paradoxes to the highway construction example of Table 5.2 below. Suppose there are only five people in a society, and each favors one of the five highway construction options listed in Table 5.2. (―No new construction‖ is one of 1-103 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the five options). Explain which of these highway options will be selected using a majority paired-choice vote. Will this option be the optimal size of the project from an economic perspective? LO5.2

Answer: Project B (new 2-lane highway) wins using a paired-choice vote. There is no paradox of voting here, and B is the preference of the median voter. The two voters who favor no new construction and widening, respectively, will prefer new 2-lane highways—project B—to new 4- or 6-lane highways. The two voters preferring new 4- and 6-lane highways will prefer a new 2-lane highway to widening or no new construction. The median voter‘s preference for B will prevail. However, the optimal size of the project from an economic perspective is C, as it would provide a greater net benefit to society than B. 105. True or False: The median-voter model explains why politicians so often stake out fringe positions that appeal only to a small segment of the electorate. L O5.2 Answer: False The median-voter model does NOT explain why politicians so often stake out fringe positions that appeal only to a small segment of the electorate. What it actually does is explain why politicians so often take positions that appeal to the median voter who prefers moderate positions.

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

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

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106. In Figure 5.2b, we saw that traditional one-person-one-vote (1p1v) majority voting results in an inefficient majority Yes vote (two in favor, one opposed). Let‘s see whether the outcome is better under quadratic voting. LO5.2 ddddd.

How much will Garcia be willing to spend on votes? eeeee.

How much each will Johnson and Lee be willing to spend on votes? fffff.

How many votes will Garcia purchase? How many will Johnson and Lee each purchase? ggggg.

What is the total number of votes cast for No? For Yes? hhhhh.

Approval of this project requires a 50-percent-plus-1 majority. Will the project be approved? iiiii.

Does quadratic voting lead to the economically efficient outcome here?

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Answer: The proposed public project has a net value of −$200 to Garcia ($100 value − $300 in additional taxes). Therefore, Garcia would be willing to spend up to $200 on ―no‖ votes to prevent the project from passing to avoid the $200 loss. nn. The proposed public project has a net value of $50 each to Johnson and Lee ($350 value − $300 in additional taxes). Therefore, Johnson and Lee would be willing to spend up to $50 each on ―yes‖ votes to help the project pass because that is the value of the public good to each of them individually. oo. Because the net value of the public project to Garcia is −$200 (as explained in part a), she will buy 14 votes ($142 = $196). She would not buy 15 votes because the cost of 15 votes ($152 = $225) would exceed the value of avoiding the $200 loss. Because the net value of the public project to Johnson and Lee is $50 each (as explained in part b), they will each buy 7 votes ($72 = $49).

They would not buy 8 votes each because the cost of 8 votes ($82 = $64) would exceed the $50 value of the project to each individual. pp. The total number of ―yes‖ votes cast will be 14 and the total number of ―no‖ votes cast will be 14 (as explained in part c). qq. If the project requires a 50-percent-plus-1 majority, the project will NOT be approved because the number of ―yes‖ votes would not exceed the 50-percent threshold. rr. In this case, quadratic voting leads to an economically efficient outcome because the total cost of the project ($900 in additional taxes) exceeds the total value that the individual voters place on the project ($100 + $350 + $350 = $800).

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

Plan A only jjjjj.

Plans C and D only kkkkk.

Plans B and C lllll.

Plans A and B only Answer: We answer this question by comparing the marginal cost of each project to the marginal benefit of each project. If the marginal benefit of a project exceeds the marginal cost, then the project is economically viable. In other words, if the net benefit (marginal benefit minus marginal cost) is positive, then the project is economically viable. In this case, if the total cost of each project doubles, the marginal benefit exceeds marginal cost for Plan A only. Therefore, Plan A is the only economically viable option.

108. Explain the paradox of voting through reference to the accompanying table, which shows the ranking of three public goods by voters Gbowee, Ebadi, and Yousafzai: LO5.3

Answer: The paradox is that majority voting does not always provide a clear and consistent picture of the public‘s preferences. Here the courthouse is preferred to the school (both Gbowee and Edabi ranked the courthouse ahead of the school), and the park is preferred to the courthouse (both Gbowee and Yousafzai ranked the park ahead of the courthouse). Given this, we would surmise that the park is preferred to the school. But paired-choice voting would show that the 1-107 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

school is preferred to the park (both Edabi and Yousafzai ranked the school ahead of the park).

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

Answers: (a) Market demand schedule

Quantity Demanded

Price

1

$8

2

$7

4

$6

7

$5

10

$4

13

$3

16

$2

19

$1

(b) Collective demand schedule

Quantity

Amount Society is Willing to Pay 1-108

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Quantity

Amount Society is Willing to Pay

1

$19

2

$16

3

$13

4

$10

5

$7

6

$4

7

$2

8

$1

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

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

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

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

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

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

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

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

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

Part (b): Derive the collective demand schedule on the assumption that the good is a public good. To accomplish we use the principle of vertical summation. That is, we fix quantity and add up the price (willingness to pay) for the individuals.

The logic here is that the individuals (society) can pool resources to purchase a given quantity because this good will be shared (public good).

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

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

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

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

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

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

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

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

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

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Answer: 4 units Feedback: Collective Demand Schedule:

Quantity

Price Society is Willing to Pay

1

$19

2

$16

3

$13

4

$10

5

$7

6

$4

7

$2

8

$1

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

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

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

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

What are Johnson‘s net benefits for each public good individually and for the two combined? Will he vote yes or no on the proposal to fund both projects simultaneously —or will he be indifferent? ooooo.

Who is the median voter here? Who will the two other voters be attempting to persuade?

Answer: Garcia‘s net benefit for the good in 5.2a is $400 (= $700 of benefit minus $300 of cost). Her net benefit for the public good in 5.2b is −$200 (= $100 of benefit minus $300 of cost). Thus, her combined net benefit for both projects is $200 1-112 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

(= $400 from the first project −$200 from the second project) and she will want to vote yes on funding both projects simultaneously. ss. Lee‘s net benefit for the public good in 5.2a is −$100 (=$200 of benefit minus $300 of cost). Her net benefit for the public good in 5.2b is $50 (= $350 of benefit minus $300 of cost). Thus, her combined net benefit for both projects is −$50 (= $100 from the first project + $50 from the second project) and she will want to vote no on funding both projects simultaneously. tt. Johnson‘s net benefit for the public good in 5.2a is −$50 (= $250 of benefit minus $300 of cost). His net benefit for the public good in 5.2b is $50 (= $350 of benefit minus $300 of cost). Thus, his combined net benefit for both projects is $0 (=−$50 from the first project + $50 from the second project) and he will be indifferent. uu. Johnson is the median voter whose preference is ―in the middle‖ and whose vote will decide the outcome. Thus, Garcia and Lee will put their efforts towards persuading Johnson to vote for their respective positions.

111. Political advertising is often directed at winning over so-called swing voters, whose votes might go either way. Suppose that two political parties—the Freedom Party and the Liberty Party—disagree on whether to build a new road. Polling shows that of 1,000 total voters, 450 are firmly for the new road and 450 are firmly against the new road. Thus, each party will try to win over a majority of the 100 remaining swing voters. LO5.2 Suppose that each party spends $5,000 on untargeted TV, radio, and newspaper ads that are equally likely to reach any and all voters. How much per voter will be spent by both parties combined? ppppp.

Suppose that, instead, each party could direct all of its spending towards just the swing voters by using targeted ads that exploit Internet social media. If all of the two parties‘ combined spending was targeted at just swing voters, how much would be spent per swing voter? qqqqq.

Suppose that only the Freedom Party knows how to target voters using social media. How much per swing voter will it be spending? If at the same time the Liberty Party is still using only untargeted TV, radio, and newspaper ads, what portion of its total spending is likely to be reaching the 100 swing voters? How much per swing voter does that portion amount to? rrrrr.

Looking at your answers to part c, how much more per swing voter will the Freedom Party be spending than the Liberty Party? If spending per swing voter influences elections, which party is more likely to win?

Answer:

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The two parties combined will spend $10,000 (= $5,000 + $5,000). That amounts to $10 per voter (= $10,000 of total combined advertising spending divided by 1,000 total voters). vv. If all advertising could be targeted at just the swing voters, the parties would spend $100 per swing voter (= $10,000 of total combined advertising spending divided by 100 swing voters). ww. Thanks to knowing how to target just swing voters, the Freedom Party will spend $50 per swing voter (= $5,000 of targeted ad spending divided by 100 swing voters). By contrast, because the Liberty Party is using untargeted ads, only about $500 of its $5,000 of advertising spending will flow to swing voters (because swing voters constitute 100 out of 1000, or 10 percent of the total electorate). Thus, the Liberty Party will end up spending about $5 per swing voter (= $500 divided by 100 swing voters) as a result of using untargeted ads.

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

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

To reexamine this situation using quadratic voting, the nearby table presents the maximum willingness to pay of Garcia, Johnson, and Lee for each of the three public goods. Notice that each person‘s numbers for willingness to pay match her or his ordering of preferences (1st choice, 2nd choice, 3rd choice) presented in Table 5.3.

Thus, Garcia is willing to spend more on her 1st choice of national defense ($400) than on her second choice of a road ($100) or her third choice of a weather warning system ($0). LO5.2

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

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sssss.

Across all three voters, how many votes are there in favor of national defense? The road? The weather warning system? ttttt.

If a paired-choice vote is taken of national defense versus the road, which one wins? uuuuu.

If a paired-choice vote is taken of the road versus the weather warning system, which one wins? vvvvv.

If a paired-choice vote is taken of national defense versus the weather warning system, which one wins? wwwww. Review your answers to parts c, d, and e. Has quadratic voting eliminated the paradox of voting that we found when using 1p1v?

Answer: Under a quadratic voting system, each rational voter would be willing to purchase votes up to the point where the marginal benefit from purchasing an additional vote equals the marginal cost of purchasing an additional vote. For example, if Garcia places a $400 value on national defense, it would be rational for her to pay up to $400 to buy votes in favor of national defense. This is the point where MB = MC (for this example, we assume there are no additional costs beyond the cost of purchasing votes). Since the total cost of buying votes is the number of votes squared, we can find the number of votes by taking the square root of the marginal benefit of each public good for each individual voter. If Garcia spends $400 on votes for national defense, she can buy = 20 votes. Since she places a $100 value on the road, she will buy = 10 votes.

Similarly, Johnson will spend up to $50 to buy votes for national defense, so he will buy = 7.07 or 7 votes. (We truncate the decimal places since we assume votes must be purchased in whole numbers.) He will also spend up to $150 to buy 12 votes (= 12.247). We follow the same procedure to calculate that Lee will buy 10 votes for the road and 15 for the weather warning system.

Note that it would also be valid to argue that Johnson might buy 8 votes for national defense and Lee might buy 16 votes for the weather warning system.

In these cases, the marginal costs would slightly exceed the marginal benefits.

However, since the voters have to return any unspent money and they have enough of the $500 remaining to buy the additional vote, one could argue that it could be in their interest to do so since it is not actually their money. yy. We can find the total number of votes for each project simply by adding together the numbers in each row. Doing so, we get the following results: 1-116 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Votes for national defense = 20 + 7 + 12 = 39. Votes for road = 10 + 17 + 10 = 37. Votes for weather warning system = 0 + 12 + 15 = 27. zz. In a paired-choice vote between national defense and the road, national defense would win with a 2-to-1 vote because national defense is a higher preference for both Garcia and Lee. aaa. In a paired-choice vote between the road and the weather warning system, the road would win with a 2-to-1 vote because it is a higher preference than the weather warning system for both Garcia and Johnson. bbb. In a paired-choice vote between national defense and the weather warning system, the weather warning system would win with a 2-to-1 vote because it is a higher preference for both Johnson and Lee. ccc. In this example, quadratic voting has eliminated the paradox of voting found when using a 1p1v voting system. With quadratic voting, national defense received the highest number of votes. It is also the public good with the highest combined willingness to pay among all of the voters.

113. Consider a specific example of the special-interest effect and the collective-action problem. In 2021, it was estimated that the total value of all corn‐production subsidies in the United States totaled about $3 billion. The population of the United States was approximately 300 million people that year. LO5.3 On average, how much did corn subsidies cost per person in the United States in 2021? (Hint: A billion is a 1 followed by nine zeros. A million is a 1 followed by six zeros.) xxxxx.

If each person in the United States is only willing to spend $.50 to support efforts to overturn the corn subsidy, and if antisubsidy advocates can only raise funds from 10 percent of the population, how much money will they be able to raise for their lobbying efforts? yyyyy.

If the recipients of corn subsidies donate just one percent of the total amount that they receive in subsidies, how much could they raise to support lobbying efforts to continue the corn subsidy? zzzzz.

By how many dollars does the amount raised by the recipients of the corn subsidy exceed the amount raised by the opponents of the corn subsidy?

Answers: (a) $10 (b) $15 million (c) $30 million (d) $15 million Feedback: Consider the following example: In 2021, it was estimated that the total value of all corn‐production subsidies in the United States totaled about $3 billion. The population of the United States was approximately 300 million people that year.

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$10.00 (= $3 billion divided by 300 million) ddd. To find the answer to this question, we first calculate the number of individuals willing to fund the antisubsidy advocates. Since only 10 percent of 300 million are willing to provide funding, we have 30 million people providing funding (= 0.10 × 300 million). Each of these individuals is only willing to provide $0.50. This results in a total funding of $15 million (= $0.50 × 30 million). eee. Since the recipients of corn subsidies receive a total of $3 billion from the government, 1 percent of this amount is $30 million (= 0.01 × $3 billion). fff. $15 million (= $30 million − $15 million) 114. Consider a corrupt provincial government in which each housing inspector examines two newly built structures each week. All the builders in the province are unethical and want to increase their profits by using substandard construction materials, but they can‘t do that unless they can bribe a housing inspector into approving a substandard building. LO5.3 If bribes cost $1,000 each, how much will a housing inspector make each year in bribes? (Assume that inspectors works 52 weeks a year and get bribed for every house that they inspect.) aaaaaa.

There is a provincial construction supervisor who gets to hire all of the housing inspectors. He himself is corrupt and expects his housing inspectors to share their bribes with him. Suppose that 20 inspectors work for him and that each passes along half the bribes collected from builders. How much will the construction supervisor collect each year? bbbbbb. Corrupt officials may have an incentive to reduce the provision of government services to help line their own pockets. Suppose that the provincial construction supervisor decides to cut the total number of housing inspectors from 20 to 10 in order to decrease the supply of new housing permits. This decrease in the supply of permits raises the equilibrium bribe from $1,000 to $2,500. How much per year will the construction supervisor now receive if he is still getting half of all the bribes collected by the 10 inspectors? How much more is the construction supervisor getting now than when he had 20 inspectors working in part (b)? Will he personally be happy with the reduction in government services? cccccc.

What would happen if reducing the number of inspectors from 20 to 10 only increased the equilibrium bribe from $1,000 to $1,500? In this case, how much per year would the construction supervisor collect from his 10 inspectors?

How much less is the construction supervisor getting than when he had 20 inspectors working in part (b)? In this case, will the construction supervisor be happy with the reduction in government services? Will he want to go back to using 20 inspectors?

Answer: $104,000 (= 52 weeks times 2 bribes per week times $1,000 per bribe).

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ggg. $1,040,000 (= 20 inspectors times one half times each inspector‘s annual total bribe amount of $104,000). hhh. $1,300,000 (= 10 inspectors times one half times each inspector‘s new annual total bribe amount of $260,000). That annual total bribe amount of $260,000 = $2,500 per bribe times two bribes per week times 52 weeks per year. The construction supervisor is now getting $260,000 more [$1,300,000 − $1,040,000] than when he had 20 inspectors working. The construction supervisor will personally be happy with this reduction in government services because it substantially increases his personal income. iii. $780,000 (= 10 inspectors times one half times each inspector‘s new annual total bribe amount of $156,000.) He will get $260,000 less [$1,040,000 − $780,000] than the construction supervisor was getting than when he had 20 inspectors working in part (b)? The construction supervisor will not be happy with this reduction in government services. He will want to go back to using 20 inspectors because he personally received a higher income from bribes when there were 20 inspectors.

Chapter 06 - Elasticity McConnell Brue Flynn 23e DISCUSSION QUESTIONS 115. Explain why the choice between 1, 2, 3, 4, 5, 6, 7, and 8 ―units,‖ or 1,000, 2,000, 3,000, 4,000, 5,000, 6,000, 7,000 and 8,000 movie tickets, makes no difference in determining elasticity in Table 6.1. LO6.1

Answer: Price elasticity of demand is determined by comparing the percentage change in price and the percentage change in quantity demanded. The percentage change in quantity will remain the same regardless of whether the difference is between 1 unit and 2 units or 1,000 units and 2,000 units.

To see this, note that the percentage change between 1 and 2 equals [(2 − 1)/1 × 100] = 100%. The percentage change between 1,000 and 2,000 equals [(2,000 − 1-119 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

1,000)/1,000] × 100 = 100%. Since these are the same for a given percentage change in price, the elasticities will be the same.

This is also true if you use the midpoints formula. In this case, that the percentage change between 1 and 2 equals [(2 − 1)/(1 + 2)/2)] × 100(1/1.5) × 100 = 67%. The percentage change between 1000 and 2000 equals [(,2000 − 1,000)/((1,000 + 2,000)/2) × 100 = (1,000/1,500) × 100 = 67%.

116. What effect would a rule stating that university students must live in university dormitories have on the price elasticity of demand for dormitory space? How might this rule affect room rates? LO6.1 Answer: The ruling would make the price elasticity of demand more inelastic than if there were no such rule, assuming that there is not another equivalent university nearby to which students could transfer. Although universities are nonprofit organizations, the rule would certainly allow them to raise rates without worrying so much about students moving out to live elsewhere.

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117. You were gifted a box of 50 thermos bottles with a unique logo that you do not need and you plan to sell them on ebay. You were initially thinking of asking for $20 per bottle, but then you found out that demand is elastic at $20. Should you lower your asking price? What if demand were inelastic at $20? LO6.2 Answer: If demand is elastic at $20, you should lower your asking price. That is true because when demand is elastic, a lower price generates higher total revenue (as well as higher total profits since your costs were zero due to the bottles being gifted to you).

If demand is inelastic at $20, you should raise your asking price. That is true because when demand is inelastic, a higher price generates higher total revenue (as well as higher total profits since your costs were zero due to the bottles being gifted to you).

118. The income elasticities of demand for movies, dental services, and clothing have been estimated to be +3.4, +1.0, and +0.5, respectively. Interpret these coefficients.

What does a negative income-elasticity coefficient mean? LO6.5 Answer: All are normal goods—income and quantity demanded move in the same direction. These coefficients reveal that a 1 percent increase in income will increase the quantity of movies demanded by 3.4 percent, of dental services by 1.0 percent, and of clothing by 0.5 percent. A negative coefficient indicates an inferior good; income and quantity demanded move in the opposite direction.

119. Research has found that an increase in the price of beer would reduce the amount of marijuana consumed. Is cross elasticity of demand between the two products positive or negative? Are these products substitutes or complements? What might be the logic behind this relationship? LO6.5 Answer: If the cross elasticity is negative, this implies that an increase in the price of one good results in a decrease in the quantity purchased of another good.

This implies that the goods are complements; as the price of one good increases, one reduces the consumption of the other good (purchases less). Cross elasticity of the two products above is negative. Thus, the products appear to be complementary. As one drinks beer, one also smokes marijuana.

120. LAST WORD What is the purpose of charging different prices to different groups of customers? Supplement the two broad examples in the Last Word with two additional examples of your own. (Hint: Think of price discounts based on group characteristics or time of purchase.)

Answer: The primary purpose for charging different prices is to increase revenue and, in turn, profits. Other examples include student and senior citizen discounts (group characteristics based on age or activity), and movies and golf courses 1-121 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

(discounts for consumption during ―off-peak‖ times in order to spread out consumption and increase revenue).

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REVIEW QUESTIONS Suppose that the total revenue received by a company selling basketballs is $600 when the price is set at $30 per basketball and $600 when the price is set at $20 per basketball. Without using the midpoint formula, can you tell whether demand is elastic, inelastic, or unit-elastic over this price range. LO6.2 Answer: Demand is unit elastic. The company is initially selling 20 basketballs at a price of $30, which results in a total revenue of $600. The company then decreases its price to $20 a ball and still has a total revenue of $600. This implies that the company is now selling 30 basketballs. The decrease in price of $10 on the previous balls sold resulted in a decrease in revenue of $200 (= $10 × 20).

However, the company sells 10 more balls at the lower price, resulting in a $200 increase in revenue (= $20 × 10). Thus, we know that demand is unit-elastic over this range because there is no change in total revenue.

121. How would the following changes in price affect total revenue? That is, would total revenue increase, decrease, or remain unchanged? LO6.2 dddddd. Price falls, and demand is inelastic eeeeee.

Price rises, and demand is elastic ffffff.

Price rises, and supply is elastic gggggg. Price rises, and supply is inelastic hhhhhh. Price rises, and demand is inelastic iiiiii.

Price falls, and demand is elastic jjjjjj.

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

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

Using these rules, we have the following answers. jjj. Decrease: As the price falls, individuals purchase more of the good. However, the decrease in price on the previous units sold outweighs the gains from selling more units. kkk. Decrease: As the price increases, individuals purchase less of the good, reducing total revenue. However, the increase in price on the previous units 1-123 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

sold increases total revenue. Here the loss in quantity sold outweighs the increase in the price effect.

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lll. The total revenue test is not relevant to elasticity of supply. However, with supply, since price and quantity move in the same direction, an increase in price will result in an increase in total revenue (a higher price and selling more) regardless of whether supply is elastic or inelastic. mmm. The total revenue test is not relevant to elasticity of supply. However, with supply, since price and quantity move in the same direction, an increase in price will result in an increase in total revenue (a higher price and selling more) regardless of whether supply is elastic or inelastic. nnn. Increase. When demand is inelastic and the price increases, the increase in price will increase total revenue. ooo. Increase. When demand is elastic and the price decreases, individuals purchase relatively more of the good, increasing total revenue. ppp. No change: Here the decrease in total revenue that results from the decrease in price is offset by the increase in total revenue from selling more units.

122. What are the major determinants of price elasticity of demand? Use those determinants and your own reasoning in judging whether demand for each of the following products is probably elastic or inelastic: (a) bottled water; (b) toothpaste; (c) Crest toothpaste; (d) ketchup; (e) diamond bracelets; (f) Microsoft‘s Windows operating system. LO6.3 Answer: The key determinants of price elasticity are substitutability, proportion of income, luxury versus necessity, and time. The larger the number of substitutes available, the more elastic the demand. The higher the price of a good is relative to a consumer‘s income, the more elastic the demand. Generally, goods seen as luxury items have a more elastic demand. The longer time duration, the more elastic the demand. (a) Bottled water: This good is likely elastic because there are a number of substitutes (water fountains, cans of soda, etc.) (b) Toothpaste: This good is likely inelastic because there aren‘t many substitutes and it is a necessity (in economic terms). (c) Crest toothpaste: This specific brand of the good is likely elastic. There are a number of substitutes for this specific brand of the good. (d) Ketchup: This good is likely inelastic. There aren‘t many substitutes for ketchup (for people who like ketchup) and it makes up a small percentage of income. (e) Diamond bracelets: This good is likely elastic because it is a luxury good and may make up a large fraction of income (more than ketchup).

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(f) Microsoft‘s Windows operating system: This good is likely inelastic because there aren‘t many substitutes for this good and it has become a necessity in a number of workplaces.

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123. In 2017, Leonardo da Vinci‘s painting Salvador Mundi sold for $450 million.

Portray this sale in a demand and supply diagram and comment on the elasticity of supply. Comedian George Carlin once mused, ―If a painting can be forged well enough to fool some experts, why is the original so valuable?‖ Provide an answer. L O6.4 Answer: The supply is perfectly inelastic—vertical—at a quantity of 1 unit. The $450 million price is determined where the downward-sloping demand curve intersects this supply curve.

Since the supply curve intersects the demand curve above its midpoint, the elasticity of demand must be elastic at the existing price of $450 million. There can be many forged copies of a painting but only one original, even if buyers can be fooled by a forgery.

124. Suppose the cross elasticity of demand for products A and B is +3.6 and for products C and D is −5.4. What can you conclude about how products A and B are related? Products C and D? LO6.5 Answer: The cross elasticity relates the percentage change in quantity demanded to the percentage change in price of a different good. If the cross elasticity is positive, this implies that an increase in the price of one good results in an increase in the quantity purchased of another good. This implies the goods are substitutes, as the price of one good increases, consumers substitute more of the other good (purchase more).

The given cross elasticity values implies that goods A and B are substitutes and that goods C and D are complements.

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

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

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

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

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

E

(40  10)/((40  10)/2) (30/25) 1.2 Yields    1.79  1.8 in absolute value (1  2/((1  2)/2) (1/1.5) 0.67

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

E

(20  10)/((20  10)/2) (10/15) 0.67 yields    0.56   0.56 in absolute value (1  4/((1  4)/2) (3/2.5) 1.2

Given the two points in Figure 6.2c (10,3) and (30,1), we can calculate the elasticity. (Note this is an approximation of the nonlinear schedule.)

E

(30  10)/((30  10)/2) (20/20) 1 Yields    1  1 in absolute value (1  3/((1  3)/2) (2/2) 1

125. Investigate how demand elasticities are affected by increases in demand. Shift each of the demand curves in Figures 6.2a, 6.2b, and 6.2c to the right by 10 units. For example, point a in Figure 6.2a would shift rightward from location (10 units, $2) to (20 units, $2) while point b would shift rightward from location (40 units, $1) to (50 units, $1). After making these shifts, apply the midpoint formula to calculate the demand elasticities for the shifted points. Are they larger or smaller than the elasticities you calculated in Problem 1 for the original points? In terms of the midpoint formula, what explains the change in elasticities? LO6.1

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Answers: 1.29; 1/3 = .3333; 2/3 = .6667; smaller; everything in the midpoint formula stays the same except the reference point for quantity, which increases—that increase reduces the elasticity.

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

Given the two points in Figure 6.2a (10,2) and (40,1), note that the ordered pair is (Q,P). With the 10 unit increase in quantity we now have the two points (20,2) and (50,1). We can calculate the elasticity..

E

(50  20)/((50  20)/2) (30/35) 0.86 Yields    1.29  1.29 in absolute value (1  2/((1  2)/2) (1/1.5) 0.67

Given the two points in Figure 6.2b (10,4) and (20,1), with the 10 unit increase in quantity, we now have (20,4) and (30,1). We can calculate the elasticity.

E

(30  20)/((30  20)/2) (10/25) 0.4 yields    0.33   0.33 in absolute value (1  4/((1  4)/2) (3/2.5) 1.2

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

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E

(40  20)/((40  20)/2) (20/30) 0.67 Yields    0.67   0.67 in absolute value (1  3/((1  3)/2) (2/2) 1

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

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

What can you conclude about the relationship between the slope of a curve and its elasticity? Explain why demand is elastic in the northwest segment of the demand curve and inelastic in the southeast segment. LO6.1

Feedback: To calculate the elasticity, we use the midpoint formula. First, we calculate the percentage change in quantity demanded. Second, we calculate the percentage change in price.

Then we divide the percentage change in quantity demanded by the percentage change in price.

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To report the values as positive numbers, we then take the absolute value of the answer. For example, we have the following elasticities as we move down the demand schedule (demand elasticities are reported as positive values).

Moving from $5 to $4: elasticity = 3 in absolute value Moving from $4 to $3: elasticity = 1.4 in absolute value As we move from $3 to $2, the elasticity is 0.714, and as we move from $2 to $1, the elasticity is 0.333.

This demand curve has a constant slope of −1 (=−1/1), but elasticity declines as we move down the curve.

When the initial price is high and the initial quantity demanded is low, a unit change in price is a low percentage change while a unit change in quantity demanded is a high percentage change. The percentage change in quantity demanded exceeds the percentage change in price, making demand elastic. When the initial price is low and the initial quantity demanded is high, a unit change in price is a high percentage change while a unit change in quantity demanded is a low percentage change. The percentage change in quantity demanded is less than the percentage change in price, making demand inelastic.

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

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

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

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

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

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

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Total revenue at the price $1.50 and the quantity of 100 equals $150 (= $1.50 × 100). Danny then decreases his price to $1.00 and sells 300 brownies now. Total revenue at this new price equals $300 (= $1.00 × 300). Since total revenue increased after Danny decreased his price, we know from the rule above that demand is elastic over this range.

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

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

129. What is the formula for measuring the price elasticity of supply? Suppose the price of apples goes up from $20 to $22 a box. In direct response, Goldsboro Farms supplies 1,200 boxes of apples instead of 1,000 boxes. Compute the coefficient of price elasticity (midpoint approach) for Goldsboro‘s supply. Is its supply elastic or inelastic? Explain.

LO6.4 Answers: elasticity of supply 

percentage change in quantity supplied percentage change in price

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

Consider the following values: Suppose the price of apples goes up from $20 to $22 a box. In direct response, Goldsboro Farms supplies 1,200 boxes of apples instead of 1,000 boxes. Here we have two ordered pairs (1,000, 20) and (1,200, 22), note the form is (Q,P).

Es 

(1.200  1.000)/((1.200  1.000)/2) (200/1.100) 0.1818    1.91 (22  20)/((22  20)/2) (2/21) 0.095

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The same interpretation for the price elasticity of demand also applies to the price elasticity of supply. Supply is elastic if greater than 1, inelastic if less than 1, and unitelastic if the elasticity equals 1. Thus, in this case, supply is elastic.

130. ADVANCED ANALYSIS Currently, at a price of $1 each, 100 popsicles are sold per day in the perpetually hot town of Rostin. Consider the elasticity of supply.

In the short run, a price increase from $1 to $2 is unit-elastic (Es =1.0). How many popsicles will be sold each day in the short run if the price rises to $2 each? In the long run, a price increase from $1 to $2 has an elasticity of supply of 1.50. How many popsicles will be sold per day in the long run if the price rises to $2 each? (Hint: Apply the midpoint approach to the elasticity of supply.) LO6.4 Answers: 200 per day in the short run; 300 per day in the long run.

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

Es 

 Q2  Q1  /   Q2  Q1  /2   P2  P1  /   P2  P1  /2 

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

Consider the following values: At a price of $1 each, 100 popsicles are sold per day in Rostin. In the short run, a price increase from $1 to $2 is unit elastic (Es = 1.0). So how many popsicles will be sold each day in the short run if the price rises to $2 each? In the long run, a price increase from $1 to $2 has an elasticity of 1.50. So how many popsicles will be sold per day in the long run if the price rises to $2 each?

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

Es  1 

 Q2  100 /   Q2  100  /2   Q2  100  /   Q2  100  /2   (1/1.5)  2  1 /   2  1 /2 

This implies:

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 Q2  100    1   Q  100   2   Q2  50       Q2  100  /2   1.5  2  3  2  Solving for Q2 we have the following:

Q2  100 

Q2 100  2  400  3  400      Q2   Q2      200 3 3 3 3  2  3 

We can do the same exercise for the long run. Here we have the following information.: Es = 1.5 with the ordered pairs of (100,1) and (Q2,2). Here we need to solve for Q2.

Es  1.5 

 Q2  100 /   Q2  100  /2   Q2  100  /  Q2  100  /2   1/1.5  2  1 /   2  1 / 2 

This implies:

 Q2  100   1  Q  100   Q2  50   Q2  150  Q  300 2 2   2   Q2  100  /2   2  Thus, 200 popsicles will be sold in the short run and 300 in the long run when price increases from $1 to $2. (Note, this implies an increase in demand (shift to the right)).

131. Inbee likes to play golf. The number of times per year that she plays depends on the price of playing a round of golf, her income, and the price of other types of entertainment—in particular, the price of going to a movie instead of playing golf.

The three demand schedules in the following table show how many rounds of golf per year Inbee will demand at each price per round under three different scenarios. In scenario D1, Inbee‘s income is $50,000 per year and movies cost $9 each. In scenario D2, Inbee‘s income is also $50,000 per year, but the price of seeing a movie rises to $11. And in scenario D3, Inbee‘s income goes up to $70,000 per year, while movies cost $11. LO6.5

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Using the data under D1 and D2, calculate the cross elasticity of Inbee‘s demand for golf at all three prices. (To do so, apply the midpoint approach to the cross elasticity of demand.) Is the cross elasticity the same at all three prices? Are movies and golf substitute goods, complementary goods, or independent goods?

Explain. kkkkkk. Using the data under D2 and D3, calculate the income elasticity of Inbee‘s demand for golf at all three prices. (To do so, apply the midpoint approach to the income elasticity of demand.) Is the income elasticity the same at all three prices?

Is golf an inferior good? Explain.

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

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

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

Here we use the same formula:

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10  15  10  15 /2    5/12.5  0.4  2 Ec  0.2 11  9   2/10   11  9  /2  We do the same exercise for $35 for a game of golf. Here we have the ordered pairs (25, 9) and (15, 11).

15  25  15  25 /2    10/20   0.5  2.50 Ec  0.2 11  9   2/10   11  9  /2  Finally, we have the ordered pair of (40, 9) and (20, 11) at the price of $20 for a game of golf.

 20  40    20  40 /2   20/30   0.6667  3.33 Ec  0.2 11  9   2/10   11  9  /2  The cross elasticities are not the same at all three golf game prices. The percentage change in quantity demanded is larger when the price of a game of golf decreases.

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

Thus, our answer is golf and movies are complements.

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

Finally, two goods are independent if the cross elasticity is zero. A price change in one good does not change the quantity of the other good. qqq. To calculate the income elasticity, we use a similar approach. Here we divide the percentage change in quantity demanded by the percentage change in income. We do this at every price for the good.

For our golf example, we have the following income elasticities: At the price of $50 for a golf game (hold constant for this calculation because we are looking at how golf games respond to a change in income), we have the following ordered pairs (10, 50,000) and (15, 70,000). Note that the ordered pair is (golf games, income).

E1 

15  10   15  10  /2 



 5/12.5

 70, 000  50, 000   20, 000/60, 000    70, 000  50, 000  /2 



0.4  1.20 0.33

We do the same exercise for $35. Here we have the ordered pairs (15, 50,000) and (30, 70,000).

E1 

 30  15   30  15 /2 



15/22.5

 70, 000  50, 000   20, 000/60, 000    70, 000  50, 000  /2 



0.67  2.00 0.33

Finally, we have the ordered pair of (20, 50,000) and (50, 70,000) at the price of $20 for a game of golf.

E1 

 50  25   50  20  /2 



 30/35

 70, 000  50, 000   20, 000/60, 000    70, 000  50, 000  /2 



0.86  2.57 0.34

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

To determine if golf is a normal good or inferior good, we have the following rule: If the income elasticity is positive, then the good is a normal good. The higher an individual‘s income, the more of the good they consume. Thus, golf is a normal good.

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

Chapter 07 - Utility Maximization McConnell Brue Flynn 23e DISCUSSION QUESTIONS 132.

Complete the following table and answer the questions below: LO1

llllll.

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

Answer: Missing total utility data, top – bottom: 18; 33. The missing total utility for the second unity can be found by adding the marginal utility (change in utility) to the total utility for the first unit. By consuming the second unit, 8 more units of utils are added; thus, total utility is 18 (= 10 + 8). Missing marginal utility data, top – bottom: 7; 5; 1. The missing marginal utility values are found by subtracting the total utility for the previous unit consumed from the total utility of the unit with the missing value (the change in utility). The marginal utility for the third 1-143 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

unit is 7, which equals 25 (total utility for the third unit) minus 18 (total utility for the second unit). rrr.

A decreasing rate; because marginal utility is declining.

sss. Disagree. The marginal utility of a unit beyond the first may be sufficiently great (relative to product price) to make it a worthwhile purchase. Consumers are interested in maximizing total utility, not marginal utility. ttt. Agree. This product‘s price could be so high relative to the first unit‘s marginal utility that the consumer would buy none of it.

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133. Mrs. Simpson buys loaves of bread and quarts of milk each week at prices of $2.00 and $1.60, respectively. At present, she is buying these products in amounts such that the marginal utilities from the last units purchased of the two products are 160 and 140 utils, respectively. Is she buying the utility-maximizing combination of bread and milk? If not, how should she reallocate her expenditures between the two goods?

LO2 Answer: Mrs. Simpson is not buying the utility-maximizing combination of bread and milk because the marginal utility per cent spent on each good is not equal.

The marginal utility per cent of bread is 0.8 (= 160 utils/200 cents); the utility per cent of milk is 0.875 (= 140 utils/160 cents). Mrs. Simpson should buy more milk and less bread.

134. How can time be incorporated into the theory of consumer behavior? Explain the following comment: ―Want to make millions of dollars? Invent a product that saves Americans lots of time.‖ LO2 Answer: Time is money. This expression is a time-saving way of making the point that for a person who can make so much per hour, every hour spent not working is so much money not made. A person can be said to ―consume‖ a ball game or an evening at the theater. If the ball game costs $10 and the theater $20, at first sight one could say the ball game is a better deal. But if the person makes $20 an hour and is forgoing this in taking the time off, then we must take into account the time spent at the ball game or at the theater. If the ball game goes into extra innings and takes 4 hours, then its total cost is $90 (= $10 + $80). If the theater takes 3 hours, its total cost is $80 (= $20 + $60). Assuming the marginal utility of the ball game and attending the theater are the same, the theory of consumer behavior (with time taken into account) would therefore have this consumer going to the theater.

135. Explain: LO2 Before economic growth, there were too few goods; after growth, there is too little time. oooooo. It is irrational for an individual to take the time to be completely rational in economic decision making. pppppp. Telling your spouse the name of the restaurant where you would like to eat for your birthday makes sense in terms of utility maximization.

Answer: Before economic growth, most people lived at the subsistence level. By practically anyone‘s definition, this implies ―too few goods.‖ After economic growth, goods are in relative abundance. To make (or consume) more takes time, but the relative abundance of goods means that there are already many goods to enjoy. So, now there is a clash between the use of time to make more 1-145 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

goods and the use of time to relax and enjoy the goods one already has. There just isn‘t enough time. uuu. To be completely rational in economic decision making, provided one does not take time into consideration, one has to take account of every factor.

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

136. In the last decade or so there has been a dramatic expansion of small retail convenience stores (such as 7 Eleven, Kwik Trip, and Circle K), although their prices are generally much higher than prices in large supermarkets. What explains the success of the convenience stores? LO2 Answer: These stores are selling convenience as well as the goods that are purchased there. Because of their small size and convenient locations, they save busy consumers‘ time. In an era when most consumers are working at least 40 hours per week, their time is valuable, and when only a few items are needed, the time saved must be worth the additional cost one pays for shopping at these convenience stores. (You seldom, if ever, see anyone buying a week‘s worth of groceries at such shops.)

137. Many apartment-complex owners are installing water meters for each apartment and billing the occupants according to the amount of water they use. This system contrasts with the former procedure of having a central meter for the entire complex and dividing up the collective water expense as part of the rent. Where individual meters have been installed, water usage has declined 10 to 40 percent. Explain that drop in terms of price and marginal utility. LO3

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Answer: The way we pay for a good or service can significantly alter the amount purchased. An individual living in an apartment complex who paid a share of the water expense measured by a central meter would have little incentive to conserve. Individual restraint would not have much impact on the total amount of water used.

Suppose there were 10 apartments in the complex; each apartment would be billed for one-tenth of the cost of the water. A single gallon of water would carry a price equal to one-tenth the amount charged by the water district. The very low price per gallon would encourage the use of water until the marginal utility of an additional gallon was correspondingly low. If the tenants paid separately for their own water, the full market price of water would be considered when making their consumption choices.

138. Using the utility-maximization rule as your point of reference, explain the income and substitution effects of an increase in the price of product B, with no change in the price of product A. LO4 Answer: The utility-maximization rule compares the marginal utilities per dollar of the goods under consideration (in this case A and B). An increase in the price of product B would reduce the marginal utility per dollar of B. This would discourage consumption of B, and with a pure income effect, would not alter consumption of A. If the increased price of B caused the marginal utility per dollar of the last unit of B to fall below the M U/$ of the next unit of A, we would expect the consumer to substitute A for B in consumption (substitution effect).

Also, an increase in the price of B reduces available consumer income, which would discourage consumption of A and B (income effect).

139. ADVANCED ANAYLSIS A ―mathematically fair bet‖ is one in which the amount won will on average equal the amount bet—for example, when a gambler bets $100 for a 10 percent chance to win $1,000 ($100 = 0.10 × $1,000). Assuming diminishing marginal utility of dollars, explain why this is not a fair bet in terms of utility. Why is it a more unfair fair bet when the ―house‖ takes a cut of each dollar bet? Is gambling irrational? LO4 Answer: Because the marginal utility of money diminishes the more you have, the utility of the $100 used to make the bet is greater than the $900 that you might gain ($1,000 − $100) if you win the bet. It is even less of a ―fair bet‖ when the ―house‖ takes its cut, because the $100 bet has the possibility of yielding less than $900 in winnings.

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

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140. Rank each of the following three gift possibilities in terms of how much utility they are likely to generate, and explain your reasoning: a store-specific gift card worth $15, a $15 item from that specific store, and $15 cash that can be spent anywhere.

LO5 Answer: From the highest to lowest likely utility, we would rank the options as follows: Cash, gift card, specific item. Even though the price of each option is the same, we don‘t know how the recipient will value them as such. The $15 specific item may not be something the recipient likes, meaning he may value it less than $15. The gift card may be for a store that the recipient won‘t like, but it gives him the flexibility to select the item. The cash gives him the ability to select how the money is spent, and he can therefore purchase the item he values the most. The more say that the recipient has on how the money is spent, the more likely the option will have a higher utility.

141. LAST WORD Why are houses in Amsterdam narrow rather than closetless? What unfortunate negative side effect resulted from the British Window Tax? How would current American homeowners likely react to a tax on south-facing rooftop solar panels?

Answer: Houses in Amsterdam are narrow rather than closetless because houses in Amsterdam were taxed based on the length of the side of the house facing the local canal rather than on the number of rooms in the building (as was the case in the Desert Southwest of the United States during the Spanish Colonial period.) In Amsterdam, the same tax amount would be levied on a 20-foot wide house that was one story tall and not very deep as would be levied on a 20-foot wide house that was five stories tall and very deep. Thus, to get as much house as possible without paying any more in taxes, Amsterdam homebuilders created narrow houses that were tall and deep.

Because the British window tax caused buildings in Britain to have fewer windows, ventilation was poor, with the unfortunate unintended negative side effect of promoting the spread of airborne diseases like tuberculosis.

If faced with a tax on south-facing rooftop solar panels, many current American homeowners would either avoid rooftop solar altogether or, alternatively, move any rooftop solar panels around so that they no longer faced south, thereby avoiding the tax.

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REVIEW QUESTIONS True or False: The law of diminishing marginal utility predicts the consumption behavior of addicts quite well. LO1

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Answer: False.

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

142. Frank spends $75 on 10 magazines and 25 newspapers. The magazines cost $5 each and the newspapers cost $2.50 each. Suppose that his M U from the final magazine is 10 utils while his MU from the final newspaper is also 10 utils.

According to the utility-maximizing rule, Frank should: LO2 reallocate spending from magazines to newspapers. qqqqqq. reallocate spending from newspapers to magazines. rrrrrr. be satisfied because he is already maximizing his total utility. ssssss. none of the choices are correct.

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

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

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

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Thus, by reallocating his spending from the product with the lower MU per dollar to the product with the higher MU per dollar, Frank will be able to increase the total utility that he receives from his budget.

143. Demand curves slope downward because, other things held equal, LO3 an increase in a product‘s price lowers MU. tttttt. a decrease in a product‘s price lowers MU. uuuuuu. a decrease in a product‘s price raises MU per dollar and makes consumers wish to purchase more units. vvvvvv. an increase in a product‘s price raises MU per dollar and makes consumers wish to purchase more units.

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

Rational consumers decide how to spend their limited budgets by comparing the marginal utilities per dollar that they can get from various products. If the prices of all other products stay the same while the price of product X falls, then the MU per dollar of money spent on product X will increase. That will mean that any money spent purchasing units of product X will get the consumer more MU than previously. Thus, consumers interested in getting as much utility as possible when spending their limited budges will want to spend more of their limited budgets on product X. This behavior explains the downward slope of demand curves because a decrease in the price of product X leads to an increase in the quantity demanded of product X. 144.

Jermaine spends his money on cucumbers and lettuce. If the price of cucumbers falls, the MU per dollar of cucumbers will _ and Jermaine will _ cucumbers for lettuce. L O4 fall; substitute wwwwww. rise; substitute xxxxxx. fall; supply yyyyyy. rise; demand Answer: b, rise; substitute When the price of cucumbers falls, the MU per dollar of cucumbers will rise. As a result, each dollar spent on cucumbers will now bring more marginal utility than it did previously. Cucumbers thus become relatively more attractive than they were previously, and so Jermaine will switch, or substitute, some of his spending away from lettuce and towards cucumbers in order to maximize his utility given the new, lower price of cucumbers.

145.

Aaliyah spends her money on lemonade and iced tea. If the price of lemonade falls, it is as though her income _ . LO4 increases 1-152 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

zzzzzz. aaaaaaa.

decreases stays the same

Answer: a, increases.

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

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

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

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

Write down her marginal utility for each repetition. Once Mylie‘s total utility begins to decrease, does each additional singing of the song hurt more than the previous song or less than the previous song? LO1 Answers: 50, 40, −20, −50, −70, −150; More than the previous one.

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

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

146. John likes Coca-Cola. After consuming one Coke, John has a total utility of 10 utils. After two Cokes, he has a total utility of 25 utils. After three Cokes, he has a total utility of 50 utils. Does John show diminishing marginal utility for Coke, or does he show increasing marginal utility for Coke? Suppose that John has $3 in his pocket.

If Cokes cost $1 each and John is willing to spend one of his dollars on purchasing a first can of Coke, would he spend his second dollar on a Coke, too? What about the third dollar? If John‘s marginal utility for Coke keeps on increasing no matter how many Cokes he drinks, would it be fair to say that he is addicted to Coke? LO1 Answers: Increasing; Yes; Yes. Feedback: Consider the following values: After consuming one Coke, John has a total utility of 10 utils. After two Cokes, he has a total utility of 25 utils. After three Cokes, he has a total utility of 50 utils. Also, assume John has $3 in his pocket and Cokes cost $1 each.

John‘s marginal utility equals the change in total utility as he consumes an additional unit. Thus, his marginal utility from the first Coke is 10 (= 10 − 0), the marginal utility from his second Coke is 15 (= 25 − 10), and the marginal utility from his third Coke is 25 (= 50 − 25). Since his marginal utility is increasing at an increasing rate, he shows increasing marginal utility for Coke.

If John consumes the first can of Coke, we know that his marginal utility per dollar was sufficient to induce the purchase. Since his marginal utility increases as he consumes more Coke, his marginal utility per dollar will also increase (price does not change). This implies that he will purchase the second Coke because it provides even more marginal utility per dollar than the first Coke did. The same is true for the third can of Coke. He will spend his entire income on Coke; thus, it is fair to say he is addicted to Coke.

147. Suppose that Omar‘s marginal utility for cups of coffee is constant at 1.5 utils per cup no matter how many cups he drinks. In contrast, his marginal utility per doughnut is 10 for the first doughnut he eats, 9 for the second, 8 for the third, and so on (that is, declining by 1 util per additional doughnut). In addition, suppose that coffee costs $1 per cup, doughnuts cost $1 each, and Omar has a budget that he can spend only on doughnuts, coffee, or both. How big would that budget have to be before he will spend a dollar buying a first cup of coffee? LO2 1-154 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: $10.

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Feedback: To answer this question, we first need to calculate the marginal utility per dollar for doughnuts. Recall that the marginal utility per dollar for a good is the marginal utility divided by the price of the good (= MU/P). For the first doughnut we have 10 (=10/$1), the second doughnut 9 (= 9/$1), third 8, fourth 7, fifth 6, sixth 5, seventh 4, eighth 3, ninth 2, and tenth 1. The marginal utility per dollar for every cup of coffee is 1.5 (= 1.5/$1).

To determine how big the budget would have to be before Omar would spend a dollar buying his first cup of coffee, we compare the marginal utility per dollar values. Omar will purchase the first doughnut before he buys a cup of coffee because the marginal utility per dollar for the doughnut is greater than the marginal utility per dollar for the cup of coffee (10 > 1.5). The same is true for the second.. This process is repeated until the marginal utility per dollar of coffee becomes greater than that of the doughnut. This implies Omar will buy 9 doughnuts at the price of $1 before he buys his first cup of coffee. Therefore, his budget will need to $10 before he buys his first cup of coffee, $9 on the doughnuts and $1 for the cup of coffee.

148. Columns 1 through 4 in the table below show the marginal utility, measured in utils, that Ricardo would get by purchasing various amounts of products A, B, C, and D. Column 5 shows the marginal utility Ricardo gets from saving. Assume that the prices of A, B, C, and D are, respectively, $18, $6, $4, and $24 and that Ricardo has an income of $106. LO2

What quantities of A, B, C, and D will Ricardo purchase in maximizing his utility? bbbbbbb. How many dollars will Ricardo choose to save? ccccccc. Check your answers by substituting them into the algebraic statement of the utility-maximizing rule.

Answer: (a) 4 units of good A, 3 units of good B, 3 units of good C, zero units of good D; (b) $4; (c) $106 [= ($18 × 4) + ($6 × 3) + ($4 × 3) + ($24 × 0) + $4] 1-156 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Feedback: Consider the following information and use the table above: the prices of A, B, C, and D are, respectively, $18, $6, $4, and $24 and Ricardo has an income of $106.

The first step is to convert the marginal utility values into marginal utility per dollar values. Recall this is MU/P.

Marginal Utility per Dollar Unit 1

Marginal Utility per Dollar Unit 2

Marginal Utility per Dollar Unit 3

Marginal Utility per Dollar Unit 4

Marginal Utility per Dollar Unit 5

Marginal Utility per Dollar Unit 6

Marginal Utility per Dollar Unit 7

Marginal Utility per Dollar Unit 8 Un

Column 1, Good A 4.00

3.00

2.50

2.00

1.50

1.00

0.83

0.67

4

4.00

2.50

2.00

1.50

1.17

0.83

0.33

0.17

3

Column 3, Good C 3.75

3.00

2.00

1.75

1.25

1.00

0.88

0.75

3

Column 4, Good D 1.50

1.25

1.00

0.75

0.54

0.29

0.17

0.08

0

5.00

4.00

3.00

2.00

1.00

0.50

0.25

0.13

4

Column 2, Good B

Column 5, Saving

The table above reads across rows (for example, the first row labeled ‗Column 1, Good A‘ is Marginal Utility per Dollar for Good A). The columns represent the marginal utility per dollar for the different goods for each unit consumed and saving (for example, column 1 ‗Marginal Utility per Dollar Unit 1‘ tells us the marginal utility per dollar for the first unit of every good and saving).

This will make the comparison a little easier. www. To determine the optimal amount of goods that Ricardo will purchase, we choose the goods with the highest marginal utility per dollar as we move from left to right. We continue to do this until income is exhausted. We see that the first unit of saving ($1) provides $5.00 worth of utility per dollar, so Ricardo makes this choice. Next, he purchases one unit of good A and good B with a marginal utility per dollar of 4. He will also save the second dollar (an additional $1) because the marginal utility per dollar is 4. The next decision leads Ricardo to purchase the first unit of good C with a marginal utility per dollar of 3.75. Then he moves on to purchase the second unit of good A, the second unit of good B, and he saves an additional dollar because the marginal utility per dollar is 3 for these goods. After these purchases, he has an income left of $53. Since he has income left, he continues to buy more goods using the approach above. xxx. In conclusion, Ricardo will consume 4 units of good A, 3 units of good B, 3 units of good C, zero units of good D, and save $4. This will exhaust his income $106 [= ($18 × 4) + ($6 × 3) + ($4 × 3) + ($24 × 0) + $4].

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149. You are choosing between two goods, X and Y, and your marginal utility from each is shown in the table below. If your income is $9 and the prices of X and Y are $2 and $1, respectively, what quantities of each will you purchase to maximize utility? What total utility will you realize? Assume that, other things remaining unchanged, the price of X falls to $1. What quantities of X and Y will you now purchase? Using the two prices and quantities for X, derive a demand schedule (prices and quantities demanded table) for X. LO3

Answer: X = 2 units, Y = 5 units; total utility = 48; X = 4, Y = 5; Demand schedule =

Price Demanded

Quantity Demanded

2

2

1

4

Feedback: Your income is $9 and the prices of X and Y are $2 and $1, respectively.

The first step is to convert the marginal utility values into marginal utility per dollar values. Recall this is MU/P. See the table below.

Marginal Utility per Dollar Unit 1

Marginal Utility per Dollar Unit 2

Marginal Utility per Dollar Unit 3

Marginal Utility per Dollar Unit 4

Marginal Utility per Dollar Unit 5

Marginal Utility per Dollar Unit 6 Units

Good Y (1st price)

8.00

7.00

6.00

5.00

4.00

3.00

5

Good X (1st price)

5.00

4.00

3.00

2.00

1.50

1.00

2

Good Y (2nd price)

8.00

7.00

6.00

5.00

4.00

3.00

5

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Good X (2nd price)

10.00

8.00

6.00

4.00

3.00

2.00

4

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The first two rows define the marginal utility per dollar for goods X and Y when the price of good X is $2 and the price of good Y is $1. Each column is the marginal utility for the unit consumed (Marginal utility per dollar for unit 1 is for the first unit consumed, Marginal utility per dollar for unit 2 is for the second unit consumed, etc.).

To determine the optimal number of goods to purchase. we choose the goods with the highest marginal utility per dollar as we move from left to right. We continue to do this until income is exhausted.

First, we only consider the first two rows for goods X and Y for the first price of good X (price of X is $2). We purchase the first unit of good Y with a marginal utility per dollar of 8. Next, we purchase the second unit of good Y with a marginal utility per dollar of 7, followed by the third unit of good Y with a marginal utility per dollar of 6. Continuing on, we purchase the fourth and fifth unit of Good Y and the first and second unit of good X ($5 and $4 marginal utility per dollar). Thus, we purchase 5 units of good Y and 2 units of good X. The total cost is $9 [= ($1 × 5) + ($2 × 2)], which exhausts income.

The total utility is then found by adding up the marginal utility values for the goods consumed using the values in the original table. The total utility from good Y is 30 (= 8 + 7 + 6 + 5 + 4) and the total utility from good X is 18 (= 10 + 8).

The sum of these two values is the total utility, which equals 48 (= 30 + 18).

Now we consider the case where the price of good X falls to $1. Here, we only consider the last two rows for goods X and Y for the second price of good X. Here our first purchase is the first unit of good X with a marginal utility per dollar of 10. Next, we purchase the second unit of good X and the first unit of good Y with a marginal utility per dollar of 8.00. We continue this process until income is exhausted. The optimal consumption level for good X is 4 and for good Y is 5.

This gives us the ordered pairs for good X: (P = 2, Q = 2) and (P = 1, Q = 4). We can use these ordered pairs to graph the demand schedule (not required).

150. ADVANCED ANAYLSIS Let MUA = z = 10 − x and MUB = z = 21 − 2y, where z is marginal utility per dollar measured in utils, x is the amount spent on product A, and y is the amount spent on product B. Assume that the consumer has $10 to spend on A and B—that is, x + y = 10. How is the $10 best allocated between A and B? How much utility will the marginal dollar yield? LO3 Answer: $7 on good B; $3 on good A; MUA = 7, MUB = 7.

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Feedback: To solve this system of equations, we set MUA = MUB. This is required if we are maximizing utility. This leaves with only x and y to solve for using the individual‘s budget constraint.

Consider the following equations: Let MUA = z = 10 − x and MUB = z = 21 − 2y, where z is marginal utility per dollar measured in utils, x is the amount spent on product A, and y is the amount spent on product B. Also, assume that the consumer has $10 to spend on A and B—that is, x + y = 10.

We know from our optimization rule that MUA = MUB, which implies 10 − x = 21 − 2 y. Or, after some rearranging, 2 y y − x = 11. Combining this equation with our budget constraint, x + y =10, we have two equations and two unknowns (x and y).

Use the budget constraint to solve x, or x = 10 − y. Substitute x from this equation into our optimality rule (2 y − x x = 11), which gives us 2 y − (10 − y) = 11.

Again, after some rearranging, we have 2 y − 10 + y = 11, or 3 y = 21. Thus, we spend $7 on good B. Using our budget constraint (9 x + y = 10), this implies we spend $3 on good A. To check our answer, substitute these values into the marginal utility equations: MUA= 10 − x, or MUA = 10 − 3 = 7 and MUB = 21 − 2 y = 21 − (2 × 7) = 7.

Thus, MUA = MUB., and the marginal dollar will yield 7 utils.

151. Suppose that with a budget of $100, Fatima spends $60 on sushi and $40 on bagels when sushi costs $2 per piece and bagels cost $2 per bagel. Then, after the price of bagels falls to $1 per bagel, she spends $50 on sushi and $50 on bagels. How many pieces of sushi and how many bagels did Fatima consume before the price change? At the new prices, how much money would it have cost Fatima to buy those same quantities (that is, the quantities that she consumed before the price change)?

Given that it used to take Fatima‘s entire $100 to buy those quantities, how big is the income effect caused by the lower price of bagels? LO4 Answers: 30 pieces of sushi and 20 bagels; $80 [= (30 × $2) + (20 × $1)]; $20.

Feedback: This implies that Fatima bought 30 pieces of Sushi (= $60/$2) and she bought 20 bagels (= $40/2) before the price change.

If Fatima purchased the same quantities of sushi and bagels with the new prices it would only cost her $80. She still spends $60 on sushi because the price hasn‘t changed (still $2) and she was consuming 30 pieces. However, the cost of the 20 1-162 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

bagels has fallen to $20 because the price of the bagel is only $1 now. This implies Fatima has an additional $20 to spend as a result of the lower price of bagels [= $100 (original cost) − $80 (new cost)].

Chapter 07 Appendix McConnell Brue Flynn 23e APPENDIX DISCUSSION QUESTIONS 152. What information is embodied in a budget line? What shifts occur in the budget line when income (a) increases and (b) decreases? What shifts occur in the budget line when the price of the product shown on the vertical axis (c) increases and (d) decreases? LO7.6 Answer: A budget line shows all the combinations of any two products that a consumer can purchase, given the prices of the products and the consumer‘s income. As income increases, (a) the budget line shifts to the right (outward); when income decreases, (b) the budget line shifts to the left (inward). As the price of the product on the vertical axis increases, (c) the budget line, while remaining anchored at its original position on the horizontal axis, will fan to the left (inward); as the price decreases, (d) the budget line, while remaining anchored at its original position on the horizontal axis, will fan to the right (outward).

153. What information is contained in an indifference curve? Why are such curves (a) downward sloping and (b) convex to the origin? Why does total utility increase as the consumer moves to indifference curves farther from the origin? Why can‘t indifference curves intersect? LO7.6 Answer: Every point on an indifference curve shows some combination of two products that will give equal utility to a consumer; that is, each combination of the two products has the same level of total utility.

Indifference curves are (a) downward sloping because both products yield utility to the consumer. Going down the curve means more of one commodity is being consumed, thus increasing the consumer‘s total utility. To keep total utility constant, some amount of the other commodity must be given up to precisely offset the gain in total utility. Thus, the quantities of the two commodities are inversely related. Any curve showing an inverse relationship is downward sloping and (b) convex to the origin because the consumer‘s willingness to give up more of one commodity to get more of another diminishes as more and more of one commodity is substituted for the other. When the consumer has much of one commodity but little of the other, the consumer will resist more and more, giving up what little still remains of the first commodity. This resistance is shown by the consumer demanding a great deal of the abundant commodity in exchange for a 1-163 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

small amount of the scarce commodity. Technically expressed, the marginal rate of substitution declines as one moves southeast along an indifference curve.

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Total utility increases as the consumer moves to indifference curves farther from the origin because each successive curve embodies larger amounts of both commodities.

Indifference curves cannot intersect because each curve shows a different level of total utility over its entire length, but a point of intersection of two curves would necessarily mean that at that point the two curves had the same total utility.

154. Using Figure 4, explain why the point of tangency of the budget line with an indifference curve is the consumer‘s equilibrium position. Explain why any point where the budget line intersects an indifference curve is not equilibrium. Explain: ―The consumer is in equilibrium where MRS = PB/PA.‖ LO7.6

Answer: The tangency point places the consumer on the highest attainable indifference curve; it identifies the combination of goods yielding the highest total utility.

All intersection points place the consumer on a lower indifference curve.

MRS is the slope of the indifference curve; PB/PA is the slope of the budget line. Only at the tangency point are these two slopes equal. If MRS > PB/PA or MRS < PB/PA, adjustments in the combination of products can be made to increase total utility (get to a higher indifference curve).

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APPENDIX REVIEW QUESTIONS Consider two bundles of coffee and chocolate and how Ted feels about them. The first bundle consists of two cups of coffee and two chocolate bars. The second bundle consists of one cup of coffee and three chocolate bars. If the first bundle gives Ted a total utility of 18 utils while the second bundle gives Ted a total utility of 19 bundles, could the two bundles be on the same indifference curve? Why or why not? LO7.6 Answer: No: An indifference curve is a set of bundles all providing the same total utility. Since these two bundles provide different total utility, they must be on separate indifference curves. The curve with the higher total utility will be farther from the origin.

155. Xenia spends her money on flowers and cookies so as to maximize her total utility. The price of flowers and cookies is $2 each. At that price, Xenia buys three flowers and two cookies. When the price of flowers decreases to $1, Xenia buys eight flowers and one cookie. Which of the following statements about Xenia‘s reaction to the price change is not true? LO7.6 ddddddd. Xenia‘s budget line shifted outward when the price of flowers fell. eeeeeee. Xenia moved to a higher indifference curve after the price of flowers fell. fffffff.

Xenia‘s demand curve for flowers shifted to the right. ggggggg. Xenia‘s attainable set was smaller before the price of flowers fell.

Answer: a. and c. Xenia‘s budget line does not shift outward. When the price of flowers falls, the budget line will stay anchored at the intercept along the cookie axis and fan outward along the flower axis. Given that the budget line fans outward along the flower axis, the tangency point will be at a higher indifference curve. The change in the price of flowers would change the quantity demanded of flowers. Nonprice determinants are what shift the demand curve. The attainable set is the combinations represented by the area under the budget line. Given that the budget line fans outward after the price of flowers falls, the area under the budget line is larger after the price change.

APPENDIX PROBLEMS Assume that the data in the following table give an indifference curve for Mr. Chen.

Graph this curve, putting A on the vertical axis and B on the horizontal axis.

Assuming that the prices of A and B are $1.50 and $1, respectively, and that Mr. Chen has $24 to spend, add his budget line to your graph. What combination of A and B will Mr. Chen purchase? Does your answer meet the MRS = PB/PA rule for equilibrium? LO7.6

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Answers:

A= 8 units, B = 12 units. Yes, the answer must meet the MRS = PB/PA rule for equilibrium.

Feedback: The budget constraint for Mr. Chen is as follows: $1.50A + $1.00B = $24. The most A units Mr. Chen can consume is 16 (= $24/$1.50; set B units to zero and solve for A). This is the vertical intercept. The most B units Mr. Chen can consume is 24 (= $24/$1.00; set A units to zero and solve for B). This is the horizontal intercept. To determine the bundle Mr. Chen will (can) consume, we check the combinations in the table above to see which bundle is affordable (satisfies the budget constraint).

Combination of 16 units of A and 6 units of B: Substituting these values into the budget constraint: ($1.50 × 16) + ($1.00 × 6) = $30 > $24 (not affordable). It 1-168 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

cannot be the optimal bundle. Combination of 12 units of A and 8 units of B: Substituting these values into the budget constraint: ($1.50 × 12) + ($1.00 × 8) = $26 > $24 (not affordable). It cannot be the optimal bundle. Combination of 8 units of A and 12 units of B: Substituting these values into the budget constraint: ($1.50 × 8) + ($1.00 × 12) = $24 = $24 (affordable). This could be the optimal bundle. Combination of 4 units of A and 24 units of B: Substituting these values into the budget constraint: ($1.50 × 4) + ($1.00 × 24) = $30 > $24 (not affordable). This cannot be the optimal bundle. Since the only bundle that is affordable out of the given choices is the combination of 8 units of A and 12 units of B, this must be the optimal bundle. Note, this is where the budget line intersects Mr. Chen‘s highest indifference curve that isn‘t beyond his budget.

Graphically (see graph above), we know that equilibrium will satisfy the condition MRS = PB/PA. This implies that the indifference curve must be tangent to the budget constraint at the combination of 8 units of A and 12 units of B (the optimal bundle). Here the MRS = $1.00/$1.50 = 2/3.

156. Explain graphically how indifference analysis can be used to derive a demand curve. LO7.6 Answers:

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Feedback: The solid maroon budget line corresponds to the highest price, $8. At this price, the consumer chooses 4 units of good X. At a lower price of $4 (shown by the dashed maroon line), the consumer chooses 8 units of good X (and a smaller quantity of good Y). At an even lower price of $2 (the dotted maroon line), the consumer chooses 12 units of good X (with no change in the quantity of good Y). In the diagram on the right, these three price-quantity combinations ((P1 = $8, Q1 = 4), (P2 = $4, Q2 = 8), and (P3 = $2, Q3 = 12)) represent the demand for good X. 157. ADVANCED ANALYSIS First, graphically illustrate a doubling of income without price changes in the indifference curve model. Next, on the same graph, show a situation in which the person whose indifference curves you are drawing buys considerably more of good B than good A after the income increase. What can you conclude about the relative coefficients of the income elasticity of demand for goods A and B? LO7.6 Answers:

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Given this change in income, the consumer will buy relatively less of good A and more of good B. Good B is more income-elastic than good A. Feedback: First, the new budget line will have the same slope as the original, and both intercepts will be doubled.

The income elasticity for good B is greater than that of good A. This must be true since income doubled and good B consumption increased by more than good A. In fact, since good B consumption increased more than good A, this implies that spending on good B more than doubled and is income-elastic. The opposite must be true for good A.

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Chapter 08 - Behavioral Economics McConnell Brue Flynn 23e DISCUSSION QUESTIONS 158. Suppose that Joe enjoys and repeatedly does stupid things like getting heavily into debt and insulting police officers. Do these actions constitute systematic errors? If he gets what he wants each time, would economists consider his stupid actions to be errors? Explain. LO8.1 Answer: Joe‘s stupid behaviors does not constitute systematic errors because of the way the word ―error‖ is used by economists; an error only occurs if a person behaves in a way that reduces the likelihood of getting what he or she wants.

Because Joe actually wants to do these stupid things, the fact that he is achieving them implies that he is not making any errors.

159. Why do behavioral economists consider it helpful to base a theory of economic behavior on the actual mental processes that people use to make decisions? Why do neoclassical economists not care about whether a theory incorporates those actual mental processes? LO8.1 Answer: Behavioral economists do consider it helpful to base a theory of economic behavior on the actual mental processes that people use to make decisions. They have that preference because those sorts of theories tend to offer better practical advice for improving outcomes. This is true because any systematic errors that are being made are very likely to be the result of the actual mental processes that are being used to make decisions. In those sorts of situations, any possible improvement in outcomes will be the result of either adjusting or circumventing those error-prone mental processes.

Neoclassical economists do not care about whether a theory incorporates the actual mental processes used to make decisions because they only care about whether a theory makes accurate predictions about observed behavior. Put slightly differently, neoclassical economists are not interested in improving outcomes.

This is because the neoclassical tradition assumes that people never make systematic errors. That belief rests on the contention that people are rational and can figure out for themselves what the best behaviors are to achieve any particular goal. Under that assumption, there is no reason to worry about improving people‘s behavior because people are already behaving optimally. Thus, the only thing a theory needs to do is correctly predict the current behavior that is assumed by neoclassical economists to be optimal.

160. Economist Gerd Gigerenzer characterizes heuristics as ―fast and frugal‖ ways of reaching decisions. Are there any costs to heuristics being ―fast and frugal‖? Explain 1-172 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

and give an example of how a fast and frugal method for doing something in everyday life comes at some costs in terms of other attributes forgone. LO8.2 Answer: While heuristics are fast and frugal, they are not perfect. In particular, they achieve high speed and low energy use at the cost of precision and accuracy.

The brain could employ other methods for reaching decisions that would on average reach better results, but those methods would run more slowly and use more energy.

As an example of how a fast and frugal method for doing something comes at some cost in terms of other attributes forgone, consider a bartender checking IDs. A short glance at a driver‘s license and the person offering it will allow him to quickly and easily detect obvious fakers. But if he wants to raise his accuracy rate and be able to detect and reject more sophisticated fakers, he will have to carefully examine the ID and ask the person offering it several questions to see if they seem legit. Doing so will take up both more time and more energy. It is slower and more costly than just giving IDs a quick glance.

161. ―There‘s no such thing as bad publicity.‖ Evaluate this statement in terms of the recognition heuristic. LO8.2 Answer: When people apply the recognition heuristic, they assume that if an option is more easily recognized, it is probably more important or more highly ranked. Therefore, to the extent that even bad publicity increases recognition, it will make the people who see the bad publicity more likely to assume that the person or product receiving the bad publicity is of high value. Be cautious, though. The recognition heuristic is not the only process that people utilize when ranking people or products. Thus, to the extent that bad publicity might cause negative emotions, bad publicity could indeed be bad for whoever or whatever receives that bad publicity.

162. For each of the following cognitive biases, come up with at least one example from your own life. LO8.2 hhhhhhh. Confirmation bias iiiiiii.

Self-serving bias jjjjjjj.

The overconfidence effect kkkkkkk. Hindsight bias lllllll.

The availability heuristic mmmmmmm.

The planning fallacy nnnnnnn. Framing effects Answer: yyy. Answers will vary. Confirmation bias refers to the human tendency to pay attention only to information that agrees with one‘s preconceptions.

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Information that contradicts those preconceptions is either ignored completely or rationalized away. Confirmation bias allows bad decisions to continue long after an impartial weighing of the evidence would have put a stop to them. zzz. Answers will vary. Self-serving bias refers to people‘s tendency to attribute their successes to personal effort or personal character traits while attributing any failures to factors beyond their control. Self-serving bias makes it difficult for people to learn from their mistakes because they incorrectly assume that anything that went wrong was beyond their control. aaaa. Answers will vary. The overconfidence effect refers to people‘s tendency to be overly confident about how likely their judgments and opinions are to be correct. bbbb. Answers will vary. People engage in hindsight bias when they retroactively believe that they were able to predict past events. cccc. Answers will vary. The availability heuristic causes people to base their estimates about the likelihood of an event not on objective facts but on whether or not similar events come to mind quickly and are readily available in their memories. Because vivid, emotionally charged images come to mind more easily, people tend to think that dramatic events such as homicides, shark attacks, and lightning strikes are much more common than they really are. At the same time, they underestimate the likelihood of unmemorable events. dddd. Answers will vary. Last-minute test cramming is a good example. The planning fallacy is the tendency to massively underestimate the time needed to complete a task. eeee. Answers will vary. Framing effects occur when a change in context (frame) causes people to react differently to a particular piece of information or to an otherwise identical situation.

163. Suppose that Amir is loss averse. In the morning, Amir‘s stockbroker calls to tell him that he has gained $1,000 on his stock portfolio. In the evening, his accountant calls to tell him that he owes an extra $1,000 in taxes. At the end of the day, does Amir feel emotionally neutral because the dollar value of the gain in his stock portfolio exactly offsets the amount of extra taxes he has to pay? Explain. LO8.3 Answer: If Amir is loss averse, he will feel losses more intensely than gains. This implies that the increase in taxes of $1,000 will cause a greater level of disutility than the gain in utility Amir derives from the $1,000 increase in his stock portfolio. In effect, because Amir is loss averse, he worse off in terms of utility. If 1-174 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

we use the intensity figure from the textbook, the $1,000 loss is felt 2.5 more intensely than the $1,000 gain.

164. You just accepted a campus job helping to raise money for your school‘s athletic program. You are told to draft a fund-raising letter. The bottom of the letter asks recipients to write down a donation amount. If you want to raise as much money as possible, which would be preferable: mentioning that your school is ranked third in the nation in sports or that your school is better than 99 percent of other schools at sports? Explain. LO8.3 Answer: The framing effect suggests that you might raise more revenue by stating that the school is better in sports than 99 percent of other schools. This is because the value 99 serves as an ―anchor‖ number and may increase the size of the donation. That is, if people are exposed to a larger number prior to making the donation they will likely use that number as a reference point. If, on the other hand, you stated the school was ranked third in sports, the donations might be lower because people will use 3 as their reference number or ―anchor.‖

165. In the early 1990s, New Jersey and Pennsylvania reformed their automobile insurance systems so that citizens could opt for either a less-expensive policy that does not allow people to sue if they get into accidents or a more-expensive policy that does allow people to sue if they get into accidents. In New Jersey, the default option was the less-expensive policy that did not allow suing. In Pennsylvania, the default option was the more-expensive policy that did allow suing. Given those options, which policy do you think most people in New Jersey ended up with? What about in Pennsylvania? Explain. LO8.3 Answer: Status quo bias caused the majority of people in both New Jersey and Pennsylvania to stay with the default option that was presented to them. As a result, most people in New Jersey ended up with the less-expensive policy that did not allow suing while most people in Pennsylvania ended up with the moreexpensive policy that did allow suing.

166. Give an example from your own life of a situation where you or someone you know uses a precommitment to overcome a self-control problem. Describe why the precommitment is useful and what it compensates for. Do not cite any precommitment strategy that was mentioned in this chapter. LO8.4 Answer: Answers will vary, but should not include automatic payroll deductions, salary smoothing, or early withdrawal penalties. Precommitments are actions taken ahead of time that make it difficult for the future self to avoid doing what the present self desires.

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167. What would a behavioral economist say about each of the following statements?

LO8.5 a. ―Nobody is truly charitable-people donate give money just to show off.‖ b. ―America has a ruthless capitalist system. Considerations of fairness are totally ignored.‖ c. ―Selfish people always get ahead. It‘s like nobody even notices!‖ Answer: Answers will vary.

Behavioral economics would say that people often act in their own self-interests; however, not exclusively. Economic transactions are heavily influenced by moral and ethical factors. ffff. Behavioral economics has studied moral and ethical factors that affect economic behavior and fairness is among the most important. There is both field and experimental evidence that fairness has a strong effect on people's behavior. Examples: giving to charity, obeying the law, and the outcomes of experimental games. gggg. Experiments have shown that people are not exclusively selfish, and when people are treated unfairly, they react very strongly.

168. Do people playing the dictator game show only self-interested behavior? How much divergence do we see in the splits that dictators give to the other player? LO8.5 Answer: Most people playing the dictator game show a concern for others. In particular, most dictators give at least some of the money to the other player even though the game is fully anonymous and the other player has no way of retaliating. There is a wide range of generosity seen among dictators. About 5 percent give everything to the other player. On the other hand, about one-third of all dictators keep everything for themselves while 17 percent of dictators split the money perfectly evenly between themselves and the other player.

169. Evaluate the following statement. ―We shouldn‘t generalize from what people do in the ultimatum game because $10 is a trivial amount of money. When larger amounts of money are on the line, people will act differently.‖ LO8.5 Answer: This statement is inconsistent with experimental evidence. When hundreds or even thousands of dollars are on the line, the strong preference that responders have for being treated fairly still remains. As a result, the responders reject unfair offers at the same rates whether large or small amounts of money are at stake.

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170. LAST WORD Why are modern human brains so focused on the short run as opposed to the long run? How generous are Social Security benefits for seniors? And how does Save More Tomorrow avoid loss aversion?

Answer: Modern human brains are so focused on the short run because our ancestors lived short, tough lives. It made no sense for them to be focused on the distant future. Their attention had to be focused on present problems in order to survive. Our brains are descendent from those of ancestors who were presentfocused. And thus, we have inherited a tendency to think very little about future issues like saving for retirement. Social Security benefits are not very generous since Social Security was only designed to keep seniors out of dire poverty. The average Social Security recipient's monthly check is only a few hundred dollars per month more than the poverty level for a single person. Save More Tomorrow avoids loss aversion by having people commit to saving a percentage of future raises. That way, they never have to feel a sense of loss (as they would if they had to cut back on current expenses in order to save more out of current income.)

REVIEW QUESTIONS Which of the following are systematic errors? LO8.1 A colorblind person who repeatedly runs red lights. ooooooo. An accountant makes occasional math errors that are sometimes on the high side and sometimes on the low side. ppppppp. Many people see faces in clouds. qqqqqqq. Miranda pays good money for a nice-looking apple that turns out to be rotten inside. rrrrrrr.

Elvis always wants to save more but then spends his whole paycheck, month after month.

Answers: Yes, being colorblind causes the driver to systematically (routinely, repeatedly, and predictably) make the error of running red lights. hhhh. Because these errors are randomly high and low, there is no systematic (routine, repeated, and predictable) tendency to them. They are all errors, but they do not constitute a systematic error. iiii. The tendency to see faces in clouds is a systematic (routine, repeated, and predictable) error because there obviously are no faces in clouds. The tendency to see faces in clouds arises from the fact that the brain has many error-prone heuristics for attempting to judge emotion and feelings from other people‘s faces. Those heuristics are so overly eager to quickly discern emotions and facial expressions from visual information that they ―see‖ faces even where there are none.

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jjjj. Because Miranda has only made this error one time, it is not a systematic error. In addition, there is no way to avoid this type of bad outcome by looking at the external features of an apple. Thus, Miranda made no avoidable error in judgment when she selected the apple that turned out to be bad. Put slightly differently, Miranda suffered from bad luck. What happened to her was not the result of engaging in an action that would predictably lower her chances of getting what she wants. kkkk. Each month, Elvis‘s spending of his entire paycheck causes him to fail to achieve his goal of saving more. Thus, his spending behavior is a systematic error in that it routinely, repeatedly, and predictably prevents him from achieving his goal.

171. Identify each statement as being associated with neoclassical economics or behavioral economics. L O8.1 People are eager and accurate calculators.

People are often selfless and generous. sssssss.

People have no trouble resisting temptation. ttttttt.

People place insufficient weight on future events and outcomes. uuuuuuu. People only treat others well if doing so will get them something they want.

Answer: See table 8.1 in the text.

Neoclassical economics llll. Behavioral economics mmmm.

Neoclassical economics nnnn. Behavioral economics oooo. Neoclassical economics TABLE 8.1 Major Differences between Behavioral Economics and Conventional Neoclassical Economics Topic

Neoclassical Economics

Behavioral Economics

Rationality

People are fundamentally rational and will adjust their choices and behaviors to best achieve their goals. Consequently, they will not make systematic errors.

People are irrational and make many errors that reduce their chances of achieving their goals. Some errors are regularly repeated systematic errors.

Stability of preferences

People‘s preferences are completely stable and unaffected by context.

People's preferences are unstable and often inconsistent because they depend on context (framing effects).

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Topic

Neoclassical Economics

Behavioral Economics

Capability for making mental calculations

People are eager and accurate calculators.

People are bad at math and avoid difficult computations if possible.

Ability to assess future options and possibilities

People are just as good at assessing future options as current options.

People place insufficient weight on future events and outcomes.

Strength of willpower

People have no trouble resisting temptation.

People lack sufficient willpower and often fall prey to temptation.

Degree of selfishness

People are almost entirely selfinterested and self-centered.

People are often selfless and generous.

Fairness

People do not care about fairness and only treat others well if doing so will get them something they want.

Many people care deeply about fairness and will often give to others even when doing so will yield no personal benefits.

172. Label each of the following behaviors with the correct bias or heuristic. LO8.2 Your uncle says that he knew all along that the stock market was going to crash in 2020. vvvvvvv. When Fred does well at work, he credits his intelligence. When anything goes wrong, he blames his secretary. wwwwwww.

Ellen thinks that being struck dead by lightning is much more likely than dying from an accidental fall at home. xxxxxxx. The sales of a TV that is priced at $999 rise after another very similar TV priced at $1,300 is placed next to it at the store. yyyyyyy. The sales of a brand of toothpaste rise after new TV commercials announce that the brand ―is preferred by 4 out of 5 dentists.‖ Answer: Hindsight bias. People engage in hindsight bias when they retroactively believe that they were able to predict past events. pppp. Self-serving bias. This refers to people‘s tendency to attribute their success to personal effort or character traits while attributing failures to factors outside their control. qqqq. Availability heuristic. This causes people to base their estimates about the likelihood of an event on how quickly they come to mind, not on objective facts. rrrr. Framing effect. This occurs when a change in context causes people to react differently.

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ssss. Status quo bias. The tendency that people have to favor any option that is presented to them as the default option.

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173. Erik wants to save more, but whenever a paycheck arrives, he ends up spending everything. One way to help him overcome this tendency would be to: LO8.4 teach him about time inconsistency. zzzzzzz. tell him that self-control problems are common. aaaaaaaa. have him engage in precommitments that will make it difficult for his future self to overspend.

Answer: c; Have him engage in precommitments that will make it difficult for his future self to overspend.

Precommitments are effective in helping people to overcome the self-control problems associated with myopia and time inconsistency. By contrast, simply informing people that they are time inconsistent or that they are prone to selfcontrol problems does little good because those tendencies are deeply wired into the brain.

174. Many proposers in the ultimatum game offer half to the responder with whom they are paired. This behavior could be motivated by (select all that might apply): L O8.5 a. fear that a fair-minded responder might reject an unequal split. b. a desire to induce the responder to reject the offer. c. a strong sense of fairness in the proposers. d. unrestrained greed in the proposers.

Answer: a and c.

Proposers who offer half to their responders are likely motivated by either of two desires. The first is that they are genuinely fair-minded and wish to share equally.

The second is that they are not fair-minded but still offer half in order to avoid offending the sense of fairness of the responders with whom they are paired. The nice thing about the dictator game is that it removes the possibility of rejection.

Thus, if we see dictators offering half, we know that they must be truly fairminded because they do not have to worry about the possibility of rejection.

PROBLEMS One type of systematic error arises because people tend to think of benefits in percentage terms rather than in absolute dollar amounts. For example, Samir is willing to drive 20 minutes out of his way to save $4 on a grocery item that costs $10 at a local market. But he is unwilling to drive 20 minutes out of his way to save $10 on a laptop that costs $400 at a local store. In percentage terms, how big are the savings on the grocery item? On the laptop? In absolute terms, how big are the savings on the grocery item? On the laptop? If Samir is willing to sacrifice 20 minutes of his time to save $4 in one case, shouldn‘t he also be willing to sacrifice 20 minutes of his time to save $10 in the other situation? Explain. LO8.2 1-181 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: The percentage savings on the grocery item is 40 percent [= ($4/$10) × 100]. The percentage savings on the laptop is 2.5 percent [= ($10/$400) × 100]. In absolute terms, the savings on the grocery item is $4 and the savings on the laptop is $10.

Yes, if Samir is willing to sacrifice 20 minutes of his time to save $4 in one case, he should be more than happy to get $10 for sacrificing 20 minutes in the other case. In terms of economic terminology, his behavior in the first case indicates that saving $4 exceeds the opportunity cost of whatever else he could be doing with 20 minutes‘ worth of time. If that is so, then $10 will also exceed that same opportunity cost.

Samir‘s decision, however, is not based on rationally comparing the absolute amount that can be saved with the opportunity cost of 20 minutes‘ worth of time.

Rather, he bases his decision on whether a given amount saved seems big in percentage terms. If it does, he is willing to sacrifice 20 minutes. If not, he will shop locally and pay more.

175. Anne is a bargain-minded shopper. Normally, her favorite toothpaste costs the same at both of her local supermarkets, but the stores are having competing sales this week. At one store, there is a bonus offer: Buy 2, get 1 free. At the other store, toothpaste is being sold at 40 percent off. Anne instantly opts for the first offer. Was that really the less-expensive choice? (Hint: Is ―buy 2, get 1 free‖ the same as 50 percent off?)

LO8.2 Answer: Anne made the wrong choice because she—like most consumers— erroneously believes that ―buy 2, get 1 free‖ is equivalent to a 50 percent discount. To see what‘s going on, assume a price of $1 per tube of toothpaste. In that case, ―buy 2, get 1 free‖ implies that Anne would pay $2 for three tubes. That comes out to 67 cents per tube (= $2 divided by three tubes), which implies that ―buy 2, get 1 free‖ is the same as a 33 percent discount (because 67 cents per tube is 33 percent less than $1 per tube). By contrast, the other store‘s offer of ―40 percent off‖ would mean that the tubes that normally sell for $1 each are now only 60 cents each. So, it would definitely be better to for ―40 percent off‖ rather than ―buy 2, get 1 free‖.

176. The coffee shop near the local college normally sells 10 ounces of roasted coffee beans for $10. But the shop sometimes puts the beans on sale. During some sales, it offers ―33 percent more for free‖. Other weeks, it takes ―33 percent off‖ the normal price. After reviewing the shop‘s sales data, the shop‘s manager finds that ―33 percent more for free‖ sells a lot more coffee than ―33 percent off.‖ Are the store‘s customers making a systematic error? Which is actually the better deal? Explain. LO8.2 1-182 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: The store‘s customers are indeed making a systematic error because ―33 percent off‖ is actually a much better deal that ―33 percent more for free.‖ To see why, start with ―33 percent off.‖ Since the price of 10 ounces is normally $10, 33 percent off would mean that 10 ounces would cost just $6.70. That implies that the coffee will cost just 67 cents per ounce (= $6.70 per 10 ounces divided by 10 ounces). By contrast, getting 33 percent more for free would mean that $10 would purchase 13.30 ounces (= the 10 original ounces plus an extra 3.30 ounces). The cost per ounce is $10/13.3 = $0.75, which is higher than $0.67 with ―33 percent off. So ―33 percent off‖ actually implies a substantially lower cost per ounce than does ―33 percent more for free.‖ Behavioral economists believe that people prefer the ―33 percent more for free‖ option to the ―33 percent off‖ option because they have a shopping heuristic based on the word free. According to this hypothesis, people‘s brains are enthusiastically biased towards any offer that contains the word free because people assume that obtaining anything for free will definitely improve their utility. That assumption would be true here in this example if the whole package of coffee were free. But because customers have to pay for the first 10 ounces, the entire package is not free and indeed has a higher cost per ounce than when the store is offering ―33 percent off‖. But that reality is overlooked because the ―free heuristic‖ biases people.

177. Angela owes $500 on a credit card and $2,000 on a student loan. The credit card has a 15 percent annual interest rate and the student loan has a 7 percent annual interest rate. Her sense of loss aversion makes her more anxious about the larger loan.

As a result, she plans to pay it off first—despite the fact that professional financial advisors always tell people to pay off their highest-interest-rate loans first. Suppose Angela has only $500 at the present time to help pay down her loans and that this $500 will be the only money she will have for making debt payments for at least the next year. If she uses the $500 to pay off the credit card, how much interest will accrue on the other loans over the coming year? On the other hand, if she uses the $500 to pay off part of the student loans, how much in combined interest will she owe over the next year on the remaining balances on the two loans? By how many dollars will she be better off if she uses the $500 to completely pay off the credit card that than partly paying down the student loan? (Hint: If you owe X dollars at an annual interest rate of r percent, your annual interest payment will be X × r, where the interest rate, r, is expressed as a decimal.) LO8.3 Answer: Angela would be better off following the expert advice and paying down the higher-interest-rate loan first.

If she uses the $500 to pay off her credit card debt, she will only have to pay interest on her student loan. That interest will come to $140 (= $2,000 × 0.07). By contrast, if she uses the $500 to pay down part of her student loan, she will still 1-183 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

have two debts outstanding, the $500 she owes on her credit card plus the $1,500 (= $2,000 minus her $500 payment) she will still owe on her student loan. Over the next year, the $500 balance on the credit card will accrue $75 (= $500 × 0.15) of interest while the remaining $1,500 balance on the credit card will accrue $105 (= $1,500 × 0.07) in interest. Thus, if Angela uses the $500 to pay off part of her student loan rather than all of her credit card debt, she will end up accruing a total of $180 (= $75 + $105) in interest over the next year.

That $180 in interest is $40 more than the $140 in interest she would accrue if she ignored her loss-aversion instincts and used the $500 to pay off the higher-interest credit card debt first.

178. ADVANCED ANALYSIS In the algebraic version of prospect theory, the variable x represents gains and losses. A positive value for x is a gain, a negative value for x is a loss, and a zero value for x represents remaining at the status quo. The so-called value function, v(x), has separate equations for translating gains and losses into, respectively, positive values (utility) and negative values (disutility). The gain or loss is typically measured in dollars, and the resulting value (utility or disutility) is measured in utils. A typical person values gains (x > 0) using the function v(x) = x0.88 and losses (x < 0) using the function v(x) = −2.5(−x)0.88. In addition, if the person stays at the status quo (where x = 0), then v(x) = 0. First use a scientific calculator (or a spreadsheet program) and the typical person‘s value functions for gains and losses to fill out the missing spaces in the following table. Then answer the questions that follow. LO8.3

What is the total value of gaining $1? Of gaining $2? bbbbbbbb. What is the marginal value of going from gaining $0 to gaining $1? Of going from gaining $1 to gaining $2? Does the typical person experience diminishing marginal utility from gains? cccccccc. What is the marginal value of going from losing $0 to losing $1? Of going from losing $1 to losing $2? Does the typical person experience diminishing marginal disutility from losses? dddddddd. Suppose that a person simultaneously gains $1 from one source and loses $1 from another source. What is the person‘s total utility after summing the values 1-184 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

from these two events? Can a combination of events that leaves a person with the same wealth as they started with be perceived negatively? Does this shed light on status quo bias?

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eeeeeeee. Suppose that an investor has one investment that gains $2 while another investment simultaneously loses $1. What is the person‘s total utility after summing the values from these two events? Will an investor need to have gains that are bigger than her losses just to feel as good as she would if she did not invest at all and simply remained at the status quo?

Answer: The completed table should look like this:

Gain or Loss Total Value of Gain or Loss

Marginal Value of Gain or Loss

−3

−6.57

−1.97

−2

−4.60

−2.10

−1

−2.50

−2.50

0

0.00

-

1

1.00

1.00

2

1.84

0.84

3

2.63

0.79

The total value of gaining $1 is 1.00 util. The total value of gaining $2 is 1.84 utils. ffffffff.

The marginal value of going from gaining $0 to gaining $1 is 1.00 util (= 1.00 − 0.00 utils). The marginal value of going from gaining $1 to gaining $2 is 0.84 utils (= 1.84 utils − 1.00 utils). Thus, the typical person does experience diminishing marginal utility for gains. gggggggg. The marginal value of going from losing $0 to losing $1 is −2.50 utils (=2.50 utils − 0.00 utils). The marginal value of going from losing $1 to losing $2 is −2.10 utils (=−4.60 utils − (−2.50 utils)). Thus, the typical person does experience diminishing marginal disutility for losses. hhhhhhhh. The person‘s combined total utility from the two events will be −1.50 utils (= 1.00 util from the gain of $1 − 2.50 utils from the loss of $1). Thus, a combination of events that leaves a person with the same amount of wealth as she held initially can leave the person feeling worse off. This is one explanation for the origin of status quo bias. People don‘t want to make changes because losses feel so much worse than gains—that even ending up back where they started can feel worse than if they had simply stayed at the status quo. iiiiiiii.

This investor‘s total utility will be −0.66 utils (= 1.84 utils from gaining $2 − 2.50 utils from losing $1). So, yes, an investor will have to have gains that exceed her losses by a substantial amount if she wants to end up feeling better than if she had done nothing and remained at the status quo.

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179. Ted has always had difficulty saving money, so on June 1, Ted enrolls in a Christmas savings program at his local bank and deposits $750. That money is totally locked away until December 1 so that Ted can be certain that he will still have it once the holiday shopping season begins. Suppose that the annual rate of interest is 10 percent on ordinary savings accounts (which allow depositors to withdraw their money at any time). How much interest is Ted giving up by pre-committing his money into the Christmas savings account for six months instead of depositing it into an ordinary savings account? (Hint: If you invest X dollars at an annual interest rate of r percent, you will receive interest equal to X × r, where the interest rate r is expressed as a decimal.) LO8.4 Answer: Ted is giving up $37.50 in interest over the six-month period. To see why, note that because he put his $750 into an ordinary savings account for a year, he would receive interest totaling $75 (= 10 percent per year times $750).

Since $75 is the amount of interest he would receive for one year, he would receive half of that amount, or $37.50 for six months (= half a year).

Chapter 09 - Businesses and the Costs of Production McConnell Brue Flynn 23e DISCUSSION QUESTIONS 180. Distinguish between explicit and implicit costs, giving examples of each. What are

some explicit and implicit costs of attending college? LO9.1 Answer: Explicit costs are payments the firm must make for inputs to non-owners of the firm to attract them away from other employment, for example, wages and salaries to its employees. Implicit costs are non-expenditure costs that occur through the use of self-owned, self-employed resources, for example, the salary the owner of a firm forgoes by operating his or her own firm and not working for someone else.

The explicit costs of going to college are the tuition costs, the cost of books, and the extra costs of living away from home (if applicable). The implicit costs are the income forgone and the hard grind of studying (if applicable).

181. Distinguish among accounting profit, economic profit, and normal profit. Which type

of profit determines how entrepreneurs allocate resources among different business ventures? Explain. LO9.1 ANSWER: ACCOUNTING PROFIT EQUALS SALES REVENUE MINUS EXPLICIT COSTS, SUCH AS MATERIAL, THE WAGES OF EMPLOYEES, ETC.

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Economic profit equals the accounting profit minus the additional implicit costs of the business. This includes entrepreneurial ability, forgone interest, forgone labor income, etc. Economic profit determines how entrepreneurs allocate resources between different business ventures. If economic profit is greater zero, this implies the business venture is earning above-average normal profits (more than other alternative business ventures on average). Thus, more resources will flow towards this activity. The opposite is true when economic profit is negative.

NORMAL PROFIT EQUALS THE ACCOUNTING PROFIT YOU COULD HAVE POTENTIALLY EARNED IN A DIFFERENT (OR ALTERNATIVE) BUSINESS VENTURE. THIS GIVES US A TRUE MEASURE OF THE OPPORTUNITY COST OF THE CURRENT BUSINESS VENTURE.

Economists classify normal profits as costs, since in the long run the owner of a firm would close it down if a normal profit were not being earned. Since a normal profit is required to keep the entrepreneur operating the firm, a normal profit is a cost.

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182. Complete the table directly below by calculating marginal product and average product.

Plot the total, marginal, and average products and explain in detail the relationship between each pair of curves. Explain why marginal product first rises, then declines, and ultimately becomes negative. What bearing does the law of diminishing returns have on short-run costs? Be specific. ―When marginal product is rising, marginal cost is falling. And when marginal product is diminishing, marginal cost is rising.‖ Illustrate and explain graphically. LO9.2 ANSWER:

Inputs labor 0 1 2 3 4 5 6 7 8

of Total product 0 15 34 51 65 74 80 83 82

Marginal product NA 15 19 17 14 9 6 3 −1

Average product NA 15 17 17 16.25 14.8 13.33 11.86 10.25

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Plots, or graphs, for this problem will need to be done by students and instructors.

Marginal product is the slope—the rate of change—of the total product curve.

When TP is rising at an increasing rate, MP is positive and rising. When TP is rising at a diminishing rate, MP is positive but falling. When TP is falling, MP is negative and falling. When the marginal product is above the average, the margin ―pulls‖ the average up. When the marginal product is below the average, the margin ―pulls‖ the average down.

MP first rises because the fixed capital gets used more productively as added workers are employed. Each added worker contributes more to output than the previous worker because the firm is better able to use its fixed plant and equipment. As still more labor is added, the law of diminishing returns takes hold.

Labor becomes so abundant relative to the fixed capital that congestion occurs and marginal product falls. At the extreme, the addition of labor so overcrowds the plant that the marginal product of still more labor is negative—total output falls.

Because labor is the only variable input and its price (its wage rate) is constant, MC is found by dividing the wage rate by MP. When MP is rising, MC is falling; when MP reaches its maximum, MC is at its minimum; when MP is falling, MC is rising.

183. Why can the distinction between fixed costs and variable costs be made in the short

run? Classify the following as fixed or variable costs: advertising expenditures, fuel, interest on company-issued bonds, shipping charges, payments for raw materials, real estate taxes, executive salaries, insurance premiums, wage payments, sales taxes, and rental payments on leased office machinery. ―There are no fixed costs in the long run; all costs are variable.‖ Explain. LO9.3 Answer: The distinction can be made because there are some costs that do not vary with total output. These are the fixed costs that, fundamentally, are related to the scale or size of the plant. In the short run, by definition, the scale of the plant cannot change: The firm cannot bring in more machinery or move to a larger building. All costs that are related to the scale of the plant—costs that continue to be incurred even though the firm‘s output may be zero—are fixed costs. On the other hand, the firm can increase its output by using its plant—its fixed capital— more intensively, that is, by hiring more labor, or by using more materials. But by doing so, it will increase its operating costs, its variable costs.

Advertising expenditures: variable costs (although it may be reasonable to argue a fixed component). Fuel: variable costs. Interest on company-issued bonds: fixed costs. Shipping charges: variable costs. Payments for raw materials: variable costs. Real estate taxes: fixed costs. Executive salaries: fixed costs. Insurance premiums: fixed costs. Wage payments: variable costs. Sales taxes: variable costs.

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Rental payments on leased office machinery: fixed costs (although it is possible that short-term lease arrangements on some types of office equipment may rise or fall with output).

In the long run, the firm can, by definition, get out of paying all of its short-run fixed costs; its lease is up, it can fire its executives without penalty, the insurance has run out, and so on. All of its costs at this moment, then, are variable. It can decide to continue producing at the same scale and thus reassume all its previous fixed costs for the next short-run period; or it can decide to increase its scale and thus increase its fixed costs; or it can decide to go out of business and thus have no costs at all.

184. List several fixed and variable costs associated with owning and operating an

automobile. Suppose you are considering whether to drive your car or fly 1,000 miles to Florida for spring break. Which costs—fixed, variable, or both—would you take into account in making your decision? Would any implicit costs be relevant? Explain.

LO9.3 Answer: Fixed costs associated with owning and operating an automobile include the price of the car (probably monthly payments); insurance; driver‘s license; car license; and depreciation. Variable costs associated with owning and operating an automobile include gasoline, oil, lubricants; repairs; car wash; and depreciation, which is also in part a variable cost since the more the car is driven, the more it depreciates.

The costs of driving to Florida are the same variable costs (including depreciation) listed above. Going by plane, the variable cost is the cost of the ticket. It would probably be cheaper to drive but this would leave out the relevant implicit cost—your time and the wear and tear on yourself of driving there and back. The plane would be faster. How much is it worth to you to arrive sooner and stay longer and be fresher on arrival? On the other hand, maybe you would find the car useful in Florida, and having your own car saves the variable cost of renting one if you fly.

185. Use the concepts of economies and diseconomies of scale to explain the shape of a

firm‘s long-run ATC curve. What does ―minimum efficient scale‖ mean? What bearing can the shape of the long-run ATC curve have on the structure of an industry?

LO9.4

Answer: The long-run ATC curve is U-shaped. At first, long-run ATC falls as the firm expands and realizes economies of scale from labor and managerial specialization and the use of more efficient capital. The long-run ATC curve later turns upward when the enlarged firm experiences diseconomies of scale, usually resulting from managerial inefficiencies.

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The MES (minimum efficient scale) is the smallest level of output needed to attain all economies of scale and minimum long-run ATC.

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If long-run ATC drops quickly to its minimum cost which then extends over a long range of output, the industry will likely be composed of both large and small firms. If long-run ATC descends slowly to its minimum cost over a long range of output, the industry will likely be composed of a few large firms. If long-run ATC drops quickly to its minimum point and then rises abruptly, the industry will likely be composed of many small firms.

186. LAST WORD What sorts of business risks does the availability of cloud computing help to mitigate or eliminate? Do firms that ―rent‖ cloud computing services benefit from the long-run economies of scale available to the firms that offer cloud computing services?

Answer: The availability of cloud computing services helps businesses, especially smaller businesses, mitigate or eliminate the risks associated with purchasing new computers for themselves. In particular, these firms no longer have to worry about purchasing computers that will be under- or unused in the future (which can happen if the demand for the firms‘ output in the future ends up being less than anticipated or if firms‘ demand is highly seasonal). By renting computing services instead of buying their own computers, these firms do not have to take on the risk of buying computing power that might not get used in the future.

Yes, the firms that ―rent‖ cloud computing services do in fact benefit from the long-run economies of scale available to the companies that offer cloud computing services. This is the case because there is intense competition between the companies that provide cloud computing services, such that these highly competitive companies end up having to lower their prices as they compete with each other for business. Thus, as the overall scale of cloud-computer providers grows and thereby causes their respective ATCs to decline, competition then forces them to lower the prices that they charge to firms that want to ―rent‖ cloud computing services. In this fashion, the long-run economies of scale available to the companies that offer cloud computing services get passed on to the firms that ―rent‖ those services.

REVIEW QUESTIONS Linda sells 100 bottles of homemade ketchup for $10 each. The cost of the ingredients and the bottles and the labels was $700. In addition, it took her 20 hours to make the ketchup and to do so she took time off from a job that paid her $20 per hour. Linda‘s accounting profit is _ while her economic profit is _ . LO9.1 a. $700; $400 b. $300; $100 c. $300; negative $100 1-193 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

d. $1,000; negative $1,100 Answer: c; $300; negative $100.

Linda‘s revenue is $1,000 (=100 bottles of ketchup sold at $10 each). Linda‘s explicit costs for ingredients, bottles, and labels are $700. Thus, her accounting profit (which subtracts explicit costs from revenue) is $300 (= $1,000 of revenue minus $700 of explicit costs).

Linda‘s implicit cost is the opportunity cost of the 20 hours of labor that she put into making the ketchup. Because she gave up making $20 per hour for each of those 20 hours of labor, the implicit cost of her labor is $400 (= $20 per hour times 20 hours). Thus, her economic profit (which subtracts both explicit costs and implicit costs from revenue) is negative $100 (= $1,000 in revenue minus $700 in explicit costs minus $400 in implicit costs).

187. Which of the following are short-run adjustments, and which are long-run adjustments? LO9.1 jjjjjjjj.

Wendy‘s builds a new restaurant. kkkkkkkk. SpaceX hires 200 more production workers. llllllll.

A farmer increases the amount of fertilizer used on his corn crop. mmmmmmmm. An Amazon distribution center adds a third shift of workers.

ANSWER:

tttt. Long-Run. This is a capital investment, which takes time to become productive. uuuu. Short-Run. The new laborers can work immediately. vvvv. Short-Run. Although this takes time via the growing process, this is still a short-run adjustment. It influences the growth of current crops immediately. wwww.

Short-Run. The new laborers can work immediately.

188. A firm has fixed costs of $60 and variable costs as indicated in the table. Complete

the table and check your calculations by referring to problem 4 at the end of Chapter 10. LO9.3

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Graph total fixed cost, total variable cost, and total cost. Explain how the law of diminishing returns influences the shapes of the variable-cost and total-cost curves. nnnnnnnn. Graph AFC, AVC, ATC, and MC. Explain the derivation and shape of each of these four curves and their relationships to one another. Specifically, explain in nontechnical terms why the MC curve intersects both the AVC and the ATC curves at their minimum points. oooooooo. Explain how the location of each curve graphed in question 3b would be altered if (1) total fixed cost is $100 rather than $60 and (2) total variable cost is $10 less at each level of output.

Answer:

Total product

Total fixed cost

Total variable cost

Total cost

Average fixed cost

Average variable cost

Average total cost

0

$60

$0

$60

1

60

45

105

$60

$45

$105

40

2

60

85

145

30

42.5

72.5

35

3

60

120

180

20

40

60

30

4

60

150

210

15

37.5

52.5

35

5

60

185

245

12

37

49

40

6

60

225

285

10

37.5

47.5

45

7

60

270

330

8.57

38.57

47.14

55

8

60

325

385

7.5

40.63

48.13

65

9

60

390

450

6.67

43.33

50

75

10

60

465

525

6

46.5

52.5

Marginal cost $45

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See the graph below. Over the 0 to 4 range of output, the TVC and TC curves slope upward at a decreasing rate because of increasing marginal returns. The slopes of the curves then increase at an increasing rate as diminishing marginal returns occur.

xxxx. See the graph below. AFC (= TFC/Q) falls continuously since a fixed amount of capital cost is spread over more units of output. The MC (= change in TC/change in Q), AVC (= TVC/Q), and ATC (= TC/Q) curves are Ushaped, reflecting the influence of first increasing and then diminishing returns. The ATC curve sums AFC and AVC vertically. The ATC curve falls when the MC curve is below it; the ATC curve rises when the MC curve is above it. This means the MC curve must intersect the ATC curve at its lowest point. The same logic holds for the minimum point of the AVC curve.

yyyy. (1) If TFC has been $100 instead of $60, the AFC and ATC curves would be higher—by an amount equal to $40 divided by the specific output.

Example: at 4 units, AVC = $25.00 [= ($60 + $40)/4]; and ATC = $62.50 [= ($210 + $40)/4]. The AVC and MC curves are not affected by changes in fixed costs.

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(2) If TVC has been $10 less at each output, MC would be $10 lower for the first unit of output but remain the same for the remaining output. The AVC and ATC curves would also be lower—by an amount equal to $10 divided by the specific output. Example: at 4 units of output, AVC = $35.00 [= $150 − $10)/4], ATC = $50 [= ($210 − $10)/4]. The AFC curve would not be affected by the change in variable costs.

189. When seven workers are employed at the same time at a local McDonald‘s, the restaurant‘s average product is 10 Big Macs per worker per hour. If adding an additional worker causes the average product to fall to 9.5 Big Macs per worker per hour, then we know that the eighth worker‘s marginal product must be: LO9.2 less than 10 Big Macs per hour. pppppppp. equal to 10 Big Macs per hour. qqqqqqqq. more than 10 Big Macs per hour. rrrrrrrr. a negative number.

Answer: ‗a‘ is the correct answer because the addition of the eighth worker would only cause the average product to fall if the marginal product of the eighth worker was less than the average product of the first seven workers. Averages always fall when the next number included in the average is less than the existing average.

190. Indicate how each of the following would shift the (1) MC curve, (2) AVC curve, (3) AFC curve, and (4) ATC curve of a manufacturing firm. In each case specify the direction of the shift. LO9.3 A reduction in business property taxes ssssssss. An increase in the nominal wages of production workers tttttttt.

A decrease in the price of electricity uuuuuuuu. An increase in insurance rates on plant and equipment vvvvvvvv. An increase in transportation costs Answer: This is a change in the fixed cost. This implies there will be no change in MC or AVC. Since this is a decrease in fixed cost, AFC shifts down and ATC shifts down (sum of AVC and AFC). zzzz. This is a change in variable cost. Since wages are now higher, MC shifts up, AVC shifts up, and ATC shifts up. There is no change in AFC. aaaaa. This is a change in variable cost. The lower price of electricity implies MC shifts down, AVC shifts down, and ATC shifts down. There is no change in AFC. bbbbb.

This is a change in the fixed cost. This implies there will be no change in MC or AVC. Since this is an increase in fixed cost, AFC shifts up and ATC shifts up.

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ccccc. This is a change in variable cost. Since transportation costs are now higher, MC shifts up, AVC shifts up, and ATC shifts up. There is no change in AFC. 191. True or false. The U shape of the long-run ATC curve is the result of diminishing returns. LO9.4

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Answer: False The long-run ATC curve‘s U shape cannot be explained by diminishing returns.

That is because the definitions of short run and long run that are used in microeconomics imply that diminishing returns can only take place in the short run.

To see why, recall that the short run is a period of time that is too brief for a firm to alter its plant capacity while the long run is a period long enough for a firm to adjust the quantities of all the resources that it employs, including plant capacity.

The difference between those definitions matters because diminishing returns applies only when one productive resources or input is held constant. Thus, it cannot happen in the long run when, by definition, firms have had enough time to adjust all their inputs, including plant capacity.

So, what does cause the U shape of the long-run ATC curve? The answer is economies and diseconomies of scale related to factors such as labor specialization and capital efficiency.

192. Suppose a firm has only three possible plant-size options, represented by the ATC

curves shown in the figure. What plant size will the firm choose in producing (a) 50, (b) 130, (c) 160, and (d) 250 units of output? Draw the firm‘s long-run average-cost curve on the diagram and describe this curve. LO9.4

Answer: (a) To produce 50 units, the firm will choose plant size #1, since its ATC is lower for this size firm in producing less than 80 units. (b) To produce 130 units, the firm will choose plant size #2, since its ATC is lower for size #2 in producing between 80 and 240 units. (c) To produce 160 units, the firm will choose plant size #2, since its ATC is lowest for producing between 80 and 240 units.

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(d) To produce 250 units, the firm will choose plant size #3, since its ATC is lowest for production of more than 240 units.

The firm‘s long-run average-total-cost curve will be the lower sections of the different plant size ATC schedules. Specifically, to the left of 80 units ATC1 will be the first section of the long-run ATC curve. Between 80 and 240 ATC2 will make up the second section of the long-run ATC curve. Finally, to the right of 240 ATC3 will make up the rest of the firm‘s long-run ATC curve.

PROBLEMS Gomez runs a small pottery firm. She hires one helper at $12,000 per year, pays annual rent of $5,000 for her shop, and spends $20,000 per year on materials. She has $40,000 of her own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn her $4,000 per year if alternatively invested. She has been offered $15,000 per year to work as a potter for a competitor. She estimates her entrepreneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72,000. Calculate the accounting profit and the economic profit for Gomez‘s pottery firm. LO9.1 Answer: Accounting profit = $35,000; Economic profit = $13,000.

Explicit costs are the direct costs incurred from production: $37,000 (= $12,000 for the helper + $5,000 of rent + $20,000 of materials).

Implicit costs are the costs that are indirectly incurred by the activity: $22,000 (= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship).

Accounting profit = $35,000 (= $72,000 of revenue − $37,000 of explicit costs) Economic profit = $13,000 (= $72,000 − $37,000 of explicit costs − $22,000 of implicit costs) 193. Imagine you have some workers and some handheld computers that you can use to take inventory at a warehouse. There are diminishing returns to taking inventory. If one worker uses one computer, he can inventory 100 items per hour. Two workers sharing a computer can together inventory 150 items per hour. Three workers sharing a computer can together inventory 160 items per hour. And four or more workers sharing a computer can together inventory fewer than 160 items per hour. Computers cost $100 each and you must pay each worker $25 per hour. If you assign one worker per computer, what is the cost of inventorying a single item? What is the cost if you assign two workers per computer? Three? How many workers per computer should you assign if you wish to minimize the cost of inventorying a single item? LO9.2 1-200 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: 1.25; 1.00; 1.09; 2 If you assign one worker per computer, the cost of inventorying a single item is $1.25. You incur the cost of the computer, $100, and the cost of employing one worker, $25, which is divided by the number of units inventoried, 100 [= ($100 + $25) / 100)].

If you assign two workers per computer, the cost of inventorying a single item is $1.00. You incur the cost of the computer, $100, and the cost of employing two workers, $50 ($25 each), which is divided by the number of units inventoried by the two workers, 150 [= ($100 + $50) / 150)].

If you assign three workers per computer, the cost of inventorying a single item is $1.09. You incur the cost of the computer, $100, and the cost of employing three workers, $75 ($25 each), which is divided by the number of units inventoried by the three workers, 160 [= ($100 + $75) / 160)].

To minimize the cost of inventorying a single item, you should assign two workers to each computer. This is the lowest cost per unit inventoried given the information above.

194. Let‘s explore how rising costs helped to kill off most printed newspapers after the Internet became available in the mid-1990s. Imagine that you are a newspaper publisher in the year 2004. You are in the middle of a one-year factory rental contract for your factory that requires you to pay $500,000 per month, and you have contractual salary obligations of $1 million per month that you can‘t get out of. You also have a marginal printing cost of $0.25 per paper as well as a marginal delivery cost of $0.10 per paper. If sales fall by 20 percent from 1 million papers per month to 800,000 papers per month, what happens to the AFC per paper, the MC per paper, and the minimum amount that you must charge to break even? LO9.3 Answers: AFC per paper rises from $1.50 per paper to $1.88 per paper; MC does not change; and the minimum amount that the paper must charge to break even rises from $1.85 per paper (= $1.5 million in fixed costs divided by 1 million papers plus $0.35 per paper in marginal costs) to $2.23 per paper (= $1.5 million in fixed costs divided by 800,000 papers plus $0.35 per paper in marginal costs).

Here Marginal Cost (MC) is constant, which implies that Average Variable Cost (AVC) is constant and equals MC. This does not imply Average Total Cost (ATC) is constant or has to equal MC. Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)

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Divide through by the quantity Q, which implies TC/Q = FC/Q + VC/Q. This gives us ATC = AFC + AVC.

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Now, since MC is constant (each unit of output costs MC to produce), thus we have MC × Q = Variable Cost (VC). Note this is variable cost (VC) because we do not have to produce.

Divide this by Q, which implies that MC = VC/Q = AVC Substituting this result into the ATC equation, we have ATC = AFC + MC (or AVC).

Thus, MC and AVC are the same in this set-up.

The original average fixed cost (AFC) was $1.50, which equals the total fixed cost $1.5 million divided by the number of papers sold (1 million, the original amount). Note here that labor is treated as a fixed cost because of the contractual obligation (you must pay even if production stops, assuming the company does not file for bankruptcy) (= $1,500,000/1,000,000).

Now assuming sales fall by 20% to 800,000 papers sold, the new average fixed cost (AFC) is $1.88. This equals the total fixed cost $1.5 million divided by the new number of papers sold, 800,000 (= $1,500,000/800,000). Thus, the AFC increases from $1.50 to $1.88 after the decrease in sales.

The marginal printing and marginal delivery costs are still the same; therefore, marginal costs do not change.

To breakeven before the decline in sales, the company needed to charge enough to cover the AFC, $1.50, and the average variable cost (AVC) of $0.35 (This is the sum of the printing cost and delivery cost per paper). Thus, the company needed to charge $1.85 per paper.

To breakeven after the decline in sales, the company needs to charge enough to cover the AFC, $1.88, and the average variable cost (AVC) of $0.35 (This is the sum of the printing cost and delivery cost per paper, note this does not change because the cost is per paper). Thus, the company needed to charge $2.23 per paper.

195. There are economies of scale in ranching, especially with regard to fencing land.

Suppose that barbed-wire fencing costs $10,000 per mile to set up. How much would it cost to fence a single property whose area is one square mile if that property also happens to be perfectly square, with sides that are each one mile long? How much would it cost to fence exactly four such properties, which together would contain four square miles of area? Now consider how much it would cost to fence in four square 1-203 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

miles of ranch land if, instead, it comes as a single large square that is two miles long on each side. Which is more costly—fencing in the four, one-square-mile properties or the single four-square-mile property? LO9.4

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Answers: $40,000 for the single one-square-mile property; $160,000 for four of the one-square-mile properties; $80,000 for the single four-square-mile property that is two-miles on each side; it is cheaper to fence in a single foursquare-mile property than four, one-square mile properties.

Feedback: Fencing a single property whose area is one square mile with sides that are each one mile long: The answer is 4 times $10,000 for each side of the fence, or $40,000.

Fencing exactly four such properties, which together would contain four square miles of area: The four squares below represent our 4 properties. Each of these cost $40,000 to fence. Thus, the cost of fencing these four properties equals $160,000 (= 4 × $40,000).

Now, consider how much it would cost to fence in four square miles of ranch land if, instead, it comes as a single large square that is two-miles long on each side.

Here, we only need to fence the outside perimeter in the diagram below. First, recognize that each side of the square below is twice as long as the problem above (separate properties), which implies it is going to cost $20,000 to fence each side (2 miles long). There are four sides, so the total cost of fencing this area is $80,000 (= 4 × $20,000).

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This implies that it is cheaper to fence a property of four-square miles than four properties of one square mile. The cost savings comes from the fact that we do not need to fence off the inner sides of the square miles (dashed lines).

Chapter 10 - Pure Competition McConnell Brue Flynn 23e DISCUSSION QUESTIONS 196. Briefly state the basic characteristics of pure competition, pure monopoly, monopolistic competition, and oligopoly. Into which of these market classifications does each of the following most accurately fit? (a) a supermarket in your hometown; (b) the steel industry; (c) a Kansas wheat farm; (d) the commercial bank in which you have an account; (e) your cell phone service provider. In each case, justify your classification. LO10.1 Answer: Pure competition: very large number of firms; standardized products; no control over price: price takers; no obstacles to entry; no nonprice competition.

Pure monopoly: one firm; unique product: with no close substitutes; much control over price: price maker; entry is blocked; mostly public relations advertising.

Monopolistic competition: many firms; differentiated products; some control over price in a narrow range; relatively easy entry; much nonprice competition: advertising, trademarks, brand names.

Oligopoly: few firms; standardized or differentiated products; control over price circumscribed by mutual interdependence: much collusion; many obstacles to entry; much nonprice competition, particularly product differentiation. (e) Hometown supermarket: oligopoly. Supermarkets are few in number in any one area; their size makes new entry very difficult; there is much nonprice 1-206 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

competition. However, there is much price competition as they compete for market share, and there seems to be no collusion. In this regard, the supermarket acts more like a monopolistic competitor. Note that this answer may vary by area. Some areas could be characterized by monopolistic competition while isolated small towns may have a monopoly situation. (f) Steel industry: oligopoly within the domestic production market. Firms are few in number; their products are standardized to some extent; their size makes new entry very difficult; there is much nonprice competition; there is little, if any, price competition; while there may be no collusion, there does seem to be much price leadership. (g) Kansas wheat farm: pure competition. There are a great number of similar farms; the product is standardized; there is no control over price; there is no nonprice competition. However, entry is difficult because of the cost of acquiring land from a present proprietor. Of course, government programs to assist agriculture complicate the purity of this example.

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(h) Commercial bank: monopolistic competition. There are many similar banks; the services are differentiated as much as the bank can make them appear to be; there is control over price (mostly interest charged or offered) within a narrow range; entry is relatively easy (maybe too easy!); there is much advertising. Once again, not every bank may fit this model—smaller towns may have an oligopoly or monopoly situation. (i) Your cell phone service provider: oligopoly. There are the providers: Verizon, Sprint, T-Mobile, A T&T which account for 70–80% of the market. So, they are few in number; their products are differentiated; their size makes new entry very difficult; there is much nonprice competition; there is little true price competition; while there does not appear to be any collusion, there has been much price leadership.

197. Strictly speaking, pure competition is relatively rare. Then why do we study it? L O10.2 Answer: It can be shown that pure competition results in low-cost production (productive efficiency)—through long-run equilibrium occurring where P equals minimum ATC—and allocative efficiency—through long-run equilibrium occurring where P equals MC. Given this, it is then possible to analyze real-world examples to see to what extent they conform to the ideal of plants producing at their points of minimum ATC and thus producing the most desired commodities with the greatest economy in the use of resources.

198. Explain how the market demand curve for a perfectly competitive industry can be downsloping while the demand curves for each of the firms in that perfectly competitive industry are horizontal. LO10.3 Answer: Market demand graphs as a downward sloping curve. An entire industry (all firms producing a particular product) can affect price by changing industry output. For example, all firms, acting independently but simultaneously can increase price by reducing output. But the individual competitive firm cannot do that because its output is such a small fraction of its industry‘s total output. For the individual competitive firm, the market price is therefore a fixed value at which it can sell as many or as few units as it cares to. Graphically, then, the individual competitive firm‘s demand curve plots as a horizontal line.

199. ―Even if a firm is losing money, it may be better to stay in business in the short run.‖ Is this statement ever true? If so, under what condition(s)? LO10.5 Answer: Yes, a firm may want to stay in business even if it is losing money. For example, assume the firm has a fixed cost of $1,000 which it must pay even if it stops production. Now assume that average variable cost is $10 per unit and price of the product is $15 per unit. Finally, assume that output equals 100 units using 1-208 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the MR = MC rule. This implies total revenue equals $1,500, variable cost equals $1,000, and total cost equals $2,000 (the sum of variable and fixed cost). The firm is losing money because profit equals −$500 (= $1500 − $2000). However, this loss is less than the fixed cost it would incur in the short run if it shut down, which equals $1,000. Thus, it is better to stay in business and lose $500 rather than close down and lose $1,000 in the short run.

In conclusion, as long as price exceeds the average variable cost, the firm should produce in the short run given fixed cost are present by definition.

200. Consider a firm that has no fixed costs and that is currently losing money. Are there any situations in which it would want to stay open for business in the short run?

If a firm has no fixed costs, is it sensible to speak of the firm‘s distinguishing between the short run and the long run? LO10.5 Answer: No, the firm will want to shut down. This follows because the firm is losing money, but there are no fixed costs. Since there are no fixed costs, only variable cost, revenue must be less than total variable cost or price is less than average variable cost (the shut-down rule). In other words, the firm can shut down and lose nothing because there are no fixed costs or it can keep producing and earn a negative profit.

In a more general sense, a firm with no fixed cost is really in the long run. By definition, the short run implies there are fixed cost present that the firm cannot get out of paying either implicitly or explicitly. The long run implies all factors and costs can adjust to the economy.

201. Why is the equality of marginal revenue and marginal cost essential for profit maximization in all market structures? Explain why price can be substituted for marginal revenue in the MR = MC rule when an industry is purely competitive. L O10.5 Answer: If the last unit produced adds more to costs than to revenue, its production must necessarily reduce profits (or increase losses). On the other hand, profits must increase (or losses decrease) so long as the last unit produced—the marginal unit—is adding more to revenue than to costs. Thus, so long as MR is greater than MC, the production of one more marginal unit must be adding to profits or reducing losses (provided price is not less than minimum AVC). When MC has risen to precise equality with MR, the production of this last (marginal) unit will neither add nor reduce profits.

In pure competition, the demand curve is perfectly elastic; price is constant regardless of the quantity demanded. Thus, MR is equal to price. This being so, P 1-209 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

can be substituted for MR in the MR = MC rule. (Note, however, that it is not good practice to use MR and P interchangeably, because in imperfectly competitive models, price is not the same as marginal revenue.)

202. ―The segment of a competitive firm‘s marginal-cost curve that lies above its AVC curve constitutes the firm‘s short-run supply curve.‖ Explain using a graph and words. LO10.6 Answer: The firm will not produce if P < AVC. When P > AVC, the firm will produce in the short run at the quantity where P (= MR) is equal to its increasing MC. Therefore, the MC curve above the AVC curve is the firm‘s short-run supply curve, it shows the quantity of output the firm will supply at each price level. See Figure 10.6 for a graphical illustration.

203.

Explain how the long run differs from the short run in pure competition. LO10.1 Answer: The entry and exit of firms in our market models can only take place in the long run. In the short run, the industry is composed of a specific number of firms, each with a plant size that is fixed and unalterable. Firms may shut down in the sense that they can produce zero units of output in the short run, but they do not have sufficient time to liquidate their assets and go out of business.

In the long run, by contrast, the firms already in an industry have sufficient time to either expand or contract their capacities. More important, the number of firms in the industry may either increase or decrease as new firms enter or existing firms leave.

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204. Use the concept of opportunity costs to explain why profits encourage entry into purely competitive industries and how losses encourage exit from purely competitive industries. LO10.2 Answer: Remember that normal profit is our measure of opportunity cost. Entry or exit will continue until the market price generates a normal profit for firms in the industry. With firms earning a normal profit, there will be no incentive to either enter or exit the industry. This situation constitutes long-run equilibrium in a purely competitive industry.

205. How do the entry and exit of firms in a purely competitive industry affect resource flows and long-run profits and losses? LO10.2 Answer: Entry and exit help to improve resource allocation. Firms that exit an industry due to low profits release their resources to be used more profitably in other industries. Firms that enter an industry chasing higher profits bring with them resources that were less profitably used in other industries. Both processes increase allocative efficiency.

In the long run, the market price of a product will equal the minimum average total cost of production. Thus, long run economic profits are zero.

206. In long-run equilibrium, P = minimum ATC = MC. Of what significance for economic efficiency is the equality of P and minimum ATC? The equality of P and MC? Distinguish between productive efficiency and allocative efficiency in your answer. LO10.4 Answer: The equality of P and minimum ATC means the firm is achieving productive efficiency; it is using the most efficient technology and employing the least costly combination of resources. The equality of P and MC means the firmis achieving allocative efficiency; the industry is producing the right product in the right amount based on society‘s valuation of that product and other products.

207. According to the basic model of pure competition, in the long run all firms in a purely competitive industry will earn normal profits. If all firms earn only a normal profit in the long run, why would any firms bother to develop new products or lower-cost production methods? Explain. LO10.5 Answer: Competition involves the never-ending attempts by entrepreneurs and managers to earn above-normal profits by either creating new products or developing lower-cost production methods for existing products. These efforts cause creative destruction, the financial undoing of the market positions of firms committed to existing products and old ways of doing business by new firms with 1-212 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

new products and innovative ways of doing business. That is, if firms can innovate, they can earn economic profit in the short run.

208. ―Ninety percent of new products fail within two years—so you shouldn‘t be so eager to innovate.‖ Do you agree? Why or why not. LO10.5 Answer: If your firm happens to be one of the 10% that succeeds, you can capture short-run economic profits. You may even qualify for a patent on your product which allows you to act as a monopolist for a given amount of time. So, if you can capture enough expected economic profit in the short run to cover your initial investment, then it is worthwhile to innovate. (This argument ignores risk.

If you add risk to the investment story, then you will need to receive additional expected economic profit to undertake the investment to innovate.)

209. LAST WORD How did hotels attempt to weather the decline in revenue caused by the COVID-19 pandemic? What option did rental car companies have that restaurants and hotels lacked in terms of raising funds to survive the downturn?

Answer: Hotels tried to survive the decline in revenue by cutting back on variable costs, especially the labor needed to service hotel rooms daily and to provide perks like free breakfasts. Unlike restaurants and hotels, rental car companies had an asset—the cars in their rental car fleets—that could be easily sold during the economic downturn to raise money. By contrast, neither hotels nor restaurants had any such assets that they could sell off to survive the downturn. The key point is that when the demand for rental cars declines, rental car companies don‘t need all their cars. Thus they are free to sell off their excess cars to raise emergency cash.

By contrast, hotels and restaurants do not have any similar assets that can be sold off in small units as demand declines.

REVIEW QUESTIONS Suppose that the paper clip industry is perfectly competitive. Also assume that the market price for paper clips is 2 cents per paper clip. The demand curve faced by each firm in the industry is: LO10.3 e. a horizontal line at 2 cents per paper clip. f. a vertical line at 2 cents per paper clip. g. the same as the market demand curve for paper clips. h. always higher than the firm‘s MC curve.

Answer: a. A horizontal line at 2 cents per paper clip.

In any perfectly competitive industry, the demand curve faced by an individual firm is a horizontal line at the market equilibrium price. This is because in a perfectly competitive industry each firm‘s output is too small to affect the overall market equilibrium price. Thus, each firm can sell as many or as few units of output as it pleases without affecting the market equilibrium price.

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In the case of the paper clip industry used in this question, each firm can sell as many or as few paper clips as it wishes at the market equilibrium price of 2 cents per paper clip. That is equivalent to each firm perceiving demand to be a horizontal line at a price of 2 cents per paper clip because whether the firm produces one paper clip or many, it will always be able to sell the amount it produces for 2 cents per paper clip. Thus, from the perspective of each individual firm, there is no trade-off between the amount it wishes to sell and the price at which it can sell. The demand curve perceived by each individual firm will be horizontal.

By contrast, the overall market demand curve will still be downward sloping, so that there will still be an inverse relationship between the total amount that the industry produces and the price of paper clips. For the overall market demand curve, the more firms produce, the lower the price per paper clip. That is, the overall market demand curve will be downward sloping.

210. Use the following demand schedule to determine total revenue and marginal revenue for each possible level of sales: LO10.3

wwwwwwww. What can you conclude about the structure of the industry in which this firm is operating? Explain. xxxxxxxx. Graph this firm‘s demand, TR, and MR curves for this firm. yyyyyyyy. Why do the demand and MR curves coincide? zzzzzzzz. ―Marginal revenue is the change in total revenue associated with additional units of output.‖ Explain verbally and graphically, using the data in the table.

Answer:

Product Price ($) 2

Quantity Demanded

Total Revenue ($) Marginal Revenue ($)

0

0

NA

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Product Price ($)

Quantity Demanded

Total Revenue ($) Marginal Revenue ($)

2

1

2

2

2

2

4

2

2

3

6

2

2

4

8

2

2

5

10

2

ddddd.

The industry is purely competitive—this firm is a ―price taker.‖ The firm is so small relative to the size of the market that it can change its level of output without affecting the market price. eeeee. See graph. fffff. The firm‘s demand curve is perfectly elastic; MR is constant and equal to P.

ggggg. True. When output (quantity demanded) increases by 1 unit, total revenue increases by $2. This $2 increase is the marginal revenue. Figure: The change in TR is measured by the slope of the TR line, 2 (= $2/1 unit).

211. A purely competitive firm whose goal is to maximize profit will choose to produce the amount of output at which: LO10.4 TR and TC are equal. aaaaaaaaa. TR exceeds TC by as much as possible. bbbbbbbbb.

TC exceeds TR by as much as possible. ccccccccc. none of the above.

Answer: b. TR exceeds TC by as much as possible.

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A purely competitive firm that wishes to maximize profit will choose to produce the amount of output at which TR exceeds TC by as much as possible. That is because profit is the difference between TR and TC. Stated algebraically, Profit = TR − TC. Consequently, a competitive firm‘s profit will be maximized when TR exceeds TC by as much as possible. Note, however, that it is possible that a firm facing difficult circumstances could find itself in the very unfortunate position of never being able to make a profit. That can happen if TR < TC at every possible output level. In such situations, the firm will always lose money. But it will attempt to lose as little money as possible. That will be done by choosing the output level at which the loss is as small as possible. As explained in this section, it will either shut down production and produce zero units of output (if the price is less than minimum AVC) or produce the amount of output at which MR = MC (if price exceeds minimum AVC). It will undertake whichever of those two options produces the smaller loss.

212. If it is possible for a perfectly competitive firm to do better financially by producing rather than shutting down, then it should produce the amount of output at which: LO10.5 MR < MC. ddddddddd.

MR = MC. eeeeeeeee. MR > MC. fffffffff. none of the above.

Answer: b. MR = MC. It may be possible for a firm facing better circumstances to either make a positive profit or generate a loss that is smaller than the fixed-cost loss that it would incur if it shut down production. In such situations, the firm will do as well as it possibly can if it chooses to produce the amount of output at which MR = MC. That amount of output will either maximize the firm‘s profit (if it is possible for the firm to make a profit) or minimize the firm‘s loss (if the firm must make a loss).

Keep in mind that depending upon its circumstances, it may be better for a firm to shut down production and produce zero units of output than for it to produce a positive amount of output. This will be true in cases where the firm is facing losses AND those losses would be smaller if it shut down production than if it produced a positive amount of output. That is why, in such situations, the firm will prefer to shut down and produce nothing and thereby only lose the value of its fixed costs rather than producing a positive amount of output and losing even more money.

213.

A perfectly competitive firm that makes car batteries has total fixed costs of $10,000 per month. The market price at which it can sell its output is $100 per battery. The firm‘s minimum AVC is $105 per battery. The firm is currently 1-216 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

producing 500 batteries a month (the output level at which MR = MC). This firm is making a _ and should _ production. LO10.5 profit; increase ggggggggg. profit; shut down hhhhhhhhh. loss; increase iiiiiiiii. loss; shut down

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Answer: d. loss; shut down.

This firm is making a loss and should shut down production. We know that it is making a loss because the market price at which it can sell its batteries is less than the minimum AVC. That implies that its revenue per battery is not even high enough to cover the variable cost of producing its output. But the situation is even worse because each month the firm has $10,000 in fixed costs. So, if the firm produces output, not only will it be failing to cover the variable cost of producing output, it will also be failing to cover its fixed cost of producing output.

The firm should shut down immediately and produce nothing because producing nothing will minimize the size of its loss. That is because if it produces nothing, it will only lose $10,000 per month, the value of its fixed cost.

By contrast, if it continues to produce output, it will lose not only its fixed cost but also an additional amount because its revenues are not even high enough to cover the variable cost of producing output. Thus, it would lose less money if it shut down production than if it continued producing output. Better to lose just the fixed-cost amount of $10,000 per month rather than an even larger amount!

214. Consider a profit-maximizing firm in a competitive industry. For each of the following situations, indicate whether the firm should shut down production or produce where MR = MC. LO10.5 P < minimum AVC. jjjjjjjjj.

P > minimum ATC. kkkkkkkkk.

Minimum AVC < P < minimum ATC. Answers: The firm should shut down production because in this price range (P < minimum AVC) the firm would always lose less money by shutting down than by producing output. This is true because shutting down would result in a loss equal to the firm‘s fixed cost while producing any positive amount of output would lose the firm even more money. hhhhh.

The firm should produce where MR = MC because in this price range (P > minimum ATC) the firm will maximize profits by choosing to produce the amount of output at which MR = MC. Note that with the price higher than minimum ATC, the firm is guaranteed to make a profit. The only question is how much output to produce in order to maximize that profit. The answer is given by the MR = MC rule, which tells us that in any situation in which producing is preferable to shutting down, a competitive firm will do as well as it possibly can if it produces where MR = MC.

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iiiii. The firm should produce where MR = MC because in this price range (minimum AVC < P < minimum ATC) the firm will minimize its loss by producing where MR = MC. To see why this is the case, first note that because the price is less than minimum ATC, the firm will be forced to make a loss. But we know that because price exceeds minimum AVC, the firm will not want to shut down.

The question then is how much to produce. The answer is given by the MR = MC rule, which tells us that in any situation in which producing is preferable to shutting down, a competitive firm will do as well as it possibly can if it produces where MR = MC. In this case where the firm will be forced to take a loss, the size of that loss will be minimized by producing the amount of output at which MR = MC. 215. When discussing pure competition, the term long run refers to a period of time long enough to allow: L O10.1 firms already in an industry to either expand or contract their capacities. lllllllll. new firms to enter or existing firms to leave. mmmmmmmmm. both a and b. nnnnnnnnn. neither a or b.

Answer: c. Both a and b.

When discussing pure competition, the term long run refers to a period of time long enough for existing firms to expand or contract their capacities AND for the overall number of firms to increase or decrease as new firms enter or existing firms exit.

For intuition, note that the long run is the amount of time necessary for both existing and potential firms to react to profit incentives. High profits will tend to cause existing firms to expand capacity while also attracting new firms to enter the industry. Low profits or losses will tend to cause existing firms to reduce capacity or exit the industry. They will also discourage any new firms from entering the industry.

216. Suppose that the pen-making industry is perfectly competitive. Also suppose that all current firms and any potential firms that might enter the industry all have identical cost curves, with minimum ATC = $1.25 per pen. If the market equilibrium price of pens is currently $1.50, what would you expect the equilibrium price to be in the long run? LO10.2 $0.25. ooooooooo. $1.00. ppppppppp. $1.25. qqqqqqqqq. $1.50.

Answer: c, $1.25.

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We would expect the long-run market equilibrium price of pens to be equal to the minimum ATC of $1.25 per pen.

To understand why, note that the current market equilibrium price of $1.50 is higher than minimum ATC. This implies that each firm in the industry will be making a positive economic profit because the $1.50 price at which a firm can sell a pen exceeds the average total cost of producing that pen.

These positive economic profits will attract new firms to enter the industry. As each new firm enters, it will increase the total supply of pens. That increase in supply decreases the market equilibrium price of pens and, consequently, the profits earned by each firm in the industry.

Firms will continue to enter the industry as long as profits are positive. Thus, they will continue to enter as long as the market price is greater than the minimum ATC of $1.25 per pen. Entry will only stop once the number of firms has increased industry supply so much that the market equilibrium price drops down to the minimum ATC of $1.25 per pen. Thus, in the long run, we would expect the market price of pens to be $1.25.

217. Suppose that as the output of mobile phones increases, the cost of touch screens and other component parts decreases. If the mobile phone industry is purely competitive, we would expect the long-run supply curve for mobile phones to be: L O10.3 upward sloping. rrrrrrrrr. downward sloping. sssssssss. horizontal. ttttttttt.

U-shaped.

Answer: b. Downward sloping.

This is a decreasing-cost industry because the cost of mobile-phone components declines as output increases. These decreases in input costs will lower the ATC curves of every firm in the industry. The result will be that as output increases, the equilibrium price of mobile phones will decrease. This implies that the industry‘s long-run supply curve will be downward sloping as increases in output lead to decreases in price.

218. Using diagrams for both the industry and a representative firm, illustrate competitive long-run equilibrium. Assuming constant costs, use these diagrams to show how (a) an increase and (b) a decrease in market demand will upset that long-run equilibrium.

Trace graphically and describe verbally the adjustment processes by which long-run equilibrium is restored. Now rework your analysis for increasing- and decreasing-cost industries and compare the three long-run supply curves. LO10.3 1-220 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer:

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An increase in demand in the market (industry) will lead to a shortage and thus an increase in market price. The representative firm, being a price taker, will react to this higher price (which also represents demand for the firm‘s product and the firm‘s marginal-revenue curve) by producing more. This output decision is based on P = MR = MC. jjjjj. At this higher price, the firm is earning economic profits. This will act as a signal for other firms to enter this industry—there are no barriers to entry. As new firms enter, industry supply also shifts outward, placing downward pressure on market price. This process will continue until the market price is equal to the minimum average total cost of the representative firm. This represents the long-run equilibrium for the industry and the firm such that neither economic profits nor losses are being realized.

219. Suppose that purely competitive firms producing cashews discover that P exceeds MC. Is their combined output of cashews too little, too much, or just right to achieve allocative efficiency? In the long run, what will happen to the supply of cashews and the price of cashews? Use a supply-and-demand diagram to show how that response will change the combined amount of consumer surplus and producer surplus in the market for cashews. LO10.4 Answer: The combined output is too little to achieve allocative efficiency. The marginal benefit of producing more cashews (as measured by P) exceeds the cost of the resources necessary to produce them.

In the long run, the supply will increase as firms enter (or expand) to capture the economic profits being earned. The increase in supply will reduce the price of cashews.

The increase in supply will unambiguously increase the combined area under the demand curve and above the supply curve (consumer surplus and producer surplus, respectively). See figure 11.6b for reference.

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PROBLEMS A purely competitive firm finds that the market price for its product is $20. It has a fixed cost of $100 and a variable cost of $10 per unit for the first 50 units and then $25 per unit for all successive units. Does price exceed average variable cost for the first 50 units? For the first 100 units? What is the marginal cost per unit for the first 50 units? about the marginal cost for units 51 and higher? For each of the first 50 units, does MR exceed MC? Is MR > MC for units 51 and higher? What output level will yield the largest possible profit for this purely competitive firm? (Hint: Draw a graph similar to Figure 10.2 using data for this firm.) L O10.5 Answer: Yes; Yes; the MC per unit is $10 per unit for the first 50 units; the MC per unit is $25 per unit for subsequent units; Yes, MR > MC; For units 51 and up, MR < MC; Producing 50 units will maximize profit.

Feedback: Does price exceed average variable cost for the first 50 units? Yes, price ($20) exceeds average variable cost for the first 50 units since AVC for the first 50 units is $10 per unit [= ($10 per unit × 50 units)/50 units].

What about for the first 100 units? Yes, price ($20) exceeds average variable cost for the first 100 units since AVC for the first 100 units is $17.50 per unit [= ($10 per unit × 50 units + $25 per unit × 50 units)/100].

What is the marginal cost per unit for the first 50 units? What about for units 51 and higher? For each of the first 50 units, does MR exceed MC? What about for units 51 and higher? The MC is $10 per unit for the first 50 units and the MC is $25 per unit for subsequent units.

For each of the first 50 units, MR > MC since $20 > $10 and for units 51 and up, MR < MC since $20 < $25.

What output level will yield the largest possible profit for this purely competitive firm? The firm will produce 50 units to maximize profit because the MC of the 51st unit exceeds marginal revenue.

220. A purely competitive wheat farmer can sell any wheat he grows for $10 per bushel. His five acres of land show diminishing returns because some are better suited for wheat production than others. The first acre can produce 1,000 bushels of wheat, the second acre 900, the third 800, and so on. Draw a table with multiple columns to help you answer the following questions. How many bushels will each of the farmer‘s five acres produce? How much revenue will each acre generate? What are the TR and MR for each acre? If the marginal cost of planting and harvesting an acre is $7,000 1-224 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

per acre for each of the five acres, how many acres should the farmer plant and harvest? LO10.5 Answers: The student should end up constructing a table similar to the following.

The farmer should plant and harvest four acres.

Feedback: The first step is to calculate the revenue generated by each acre (column 3). Each entry, the acre‘s revenue, is found by multiplying the price per bushel by the acre‘s yield. The revenue generated by the first acre is $10,000 (=$10 × 1,000), the second acre $9,000 (=$10 × 900), the third acre $8,000 (=$10 × 800), etc...

The next step is to calculate total revenue (column 4). Total revenue equals the sum of revenue generated by each successive acre being cultivated. Total revenue for the first acre is $10,000, total revenue for first and second acre is $19,000 (=$10,000 + $9,000), total revenue for the first, second, and third acre is $27,000 (= $10,000 +$ 9,000 + $8,000), etc...

The final step is to calculate marginal revenue (column 5). Marginal revenue equals the change in total revenue as each successive acre is cultivated. Marginal revenue for the first unit is $10,000 because as we move from cultivating zero acres to one acre our total revenue changes by $10,000. The marginal revenue for the second acre equals $9,000, which is the total revenue of the second acre minus the revenue generated by the first acre (=$19,000 − $10,000). etc...

Using our MC=MR rule, the farmer should plant and harvest 4 acres. Marginal revenue for the fourth acre equals $7,000 and the marginal cost equals $7,000.

221. Latoya runs a print shop that makes posters for large companies. It is a very competitive business. The market price is currently $1 per poster. She has fixed costs of $250. Her variable costs are $1,000 for the first thousand posters, $800 for the second thousand, and then $750 for each additional thousand posters. What is her AFC per poster (not per thousand!) if she prints 1,000 posters? 2,000? 10,000? What 1-225 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

is her ATC per poster if she prints 1,000? 2,000? 10,000? If the market price fell to 70 cents per poster, would there be any output level at which Latoya would not shut down production immediately? LO10.5 Answers: AFC per poster is $0.25 for 1,000; $0.125 for 2,000; $0.025 for 10,000. ATC per poster is $1.25 for 1,000 posters; $1.025 for 2,000 posters; and $0.805 for 10,000. Shutdown is determined by AVC. The AVC per poster for more than 2,000 posters is $0.75 per poster, so Latoya will shut down if the price falls to 70 cents per poster.

Feedback: Consider the following example. The market price is currently $1 per poster. She has fixed costs of $250. Her variable costs are $1,000 for the first thousand posters, $800 for the second thousand, and then $750 for each additional thousand posters.

What is her AFC per poster (not per thousand!) if she prints 1,000 posters? 2,000?

10,000?

To calculate average fixed cost (AFC) divide total fixed cost by the number of posters being produced (=Total Fixed Cost / # of posters).

Therefore, her AFC for 1,000 posters is $0.25 (= $250/1,000), for 2,000 posters $0.125 (= $250/2,000), and for 10,000 posters $0.025 (= $250/10,000).

What is her ATC per poster if she prints 1,000? 2,000? 10,000?

Before we calculate the average total cost (ATC) per poster we need to find the average variable cost (AVC) per poster using the information above. The AVC is found by dividing the total variable cost by the number of posters produced.

AVC for 1,000 posters is $1.00. This is the total variable cost of $1,000 divided by the number of posters, 1,000 (= $1,000/1,000).

AVC for 2,000 posters is $0.90. This is the total variable cost $1,800; $1,000 for the first 1,000 and $800 for the second 1,000, divided by the total number of posters 2,000 (= $1,800/2,000).

AVC for 10,000 posters is $0.78. This is the total variable cost of 7,800; $1000 for the first 1,000; $800 for the second 1,000; and $6,000 for the next 8,000 ($750 per 1,000 or 8 × $750), divided by 10,000 posters (= $7,800/10,000).

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Now we can find her ATC, which equals the sum of her average fixed cost and her average variable cost (=AFC + AVC).

ATC for 1,000 posters is $1.25 (= $0.25 + $1.00). ATC for 2,000 posters is $1.025 (= $0.125 + $0.90). ATC for 10,000 is $0.805 (= $0.025 + $0.78).

Since the price is 70 cents per poster Latoya will shut down because average variable cost never falls below or is equal to 70 cents per poster.

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222. Assume the following cost data in the following table are for a purely competitive producer: LO10.5

At a product price of $56, will this firm produce in the short run? If it is preferable to produce, what will be the profit-maximizing or loss-minimizing output? What economic profit or loss will the firm realize per unit of output?

Answer the questions in part a assuming product price is $41. i. Answer the questions in part a assuming product price is $32. j. In the table below, complete the short-run supply schedule for the firm (columns 1 and 2) and indicate the profit or loss incurred at each output (column 3).

k. Now assume that there are 1,500 identical firms in this competitive industry That. is, there are 1,500 firms, each of which has the cost data shown in the table.

Complete the industry supply schedule (column 4). l. Suppose the market demand data for the product are as follows:

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What is the equilibrium price? What is the equilibrium output for the industry?

For each firm? What will profit or loss be per unit? Per firm? Will this industry expand or contract in the long run?

Answer: (a) Yes; 8 units; the total economic profit equals $62.96. (b) Yes; 6 units; the total economic profit (loss) equals −$39.00. (c) The firm will not produce; the firm shuts down and incurs the loss of $60.00 (fixed cost). (d) and (e)

(2) Quantity supplied, single firm

(1) Price

Profit or loss (−)

(4) Quantity (+) supplied, 1500 firms

(3)

$26

0

$−60

0

32

0

−60

0

38

5

−55.00

7500

41

6

−39.00

9000

46

7

−7.98

10500

56

8

62.96

12000

66

9

144.00

13500

(f) $46; 10,500; 7 units; per-unit loss is −$1.14; the loss per firm is −$7.98; industry will contract.

Feedback: The rule is to produce at the level of output where Marginal Revenue equals (or is greater than if we are using integers) Marginal Cost as long as revenue is sufficient to cover fixed cost (Price is greater than Average Fixed Cost).

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In the case above the market is competitive so Marginal Revenue equals the price of $56. From the table above we see that the marginal cost for the 8th unit is $55 and the marginal cost of 9th unit is $65. The firm will want to produce 8 units where the marginal revenue of $56 is greater than the marginal cost of $55. For the 9th unit of output this is not the case.

We also need to verify that price exceeds average variable cost at this level of production. The answer is yes, average variable cost is $40.63 which is less than the price of $56.

At this level of production, the firm will earn a positive economic profit per unit of $7.87 (= $56 (price of product) − $48.13 (average total cost for the 8th unit). The total economic profit equals $62.96 (=8 (number of units sold) × $7.87 (profit per unit)). kkkkk.

The same process is applied here. The price of $41, which is marginal revenue, is greater than the marginal cost of the 6th unit in the table above. Beyond this level of production marginal cost exceeds marginal revenue. Thus, the firm will produce 6 units as long as price covers average variable cost.

The average variable cost for 6 units is $37.50, which is less than the price.

The firm will produce the 6 units of output.

At this level of production, the firm will earn a negative economic profit per unit or loss per unit of −$6.50 [= $41 (price of product) −$47.50 (average total cost for the 6th unit)]. The total economic profit (loss) equals −$39.00 [= 6 (number of units sold) × (−$6.50) (loss per unit)]. lllll. We could go through the same exercise here. However, by recognizing that the price of $32 is below average variable cost at all levels of production the firm will not produce. Thus, the firm shuts down and incurs the loss of $60.00 (fixed cost). d and e.

(1) Price $26

(2) Quantity supplied, single firm 0

(4) Quantity Profit (+) or supplied, loss (−) 1500 firms (3)

$−60

0

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32

0

−60

0

38

5

−55.00

7500

41

6

−39.00

9000

46

7

−7.98

10500

56

8

62.96

12000

66

9

144.00

13500

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f. To determine the equilibrium price, we look at the total quantity demanded schedule and the total quantity supplied schedule (for the 1,500 firms above) to find the price where quantity demanded equals quantity supplied.

This occurs at the price of $46 where quantity demanded = 10,500 and quantity supplied = 10,500. The quantity 10,500 is the equilibrium output for the industry. Note that at prices below $46 quantity demanded exceeds quantity supplied and at prices above $46 quantity supplied exceeds quantity demanded.

The equilibrium output for each firm is 7 units [= 10,500 (industry output)/ 1,500 (number of firms)].

Since the equilibrium price of $46 is below the average total cost for 7 units of output at the firm level there will be a loss. The per-unit loss for the firm is −$1.14 [= $46 (price) − $47.14 (average total cost for 7 units)].

The loss per firm is −$7.98 [= 7 units produced) × (−$1.14) (loss per unit)].

This industry will contract due to the negative economic profit (or economic loss).

223. The normal (accounting) profit in the economy is 5 percent. A firm in a purely competitive industry is earning $5.50 on every $50 invested by its founders. What is its percentage rate of return? Is the firm earning an economic profit? If so, how large?

Will this industry see entry or exit? What will be the rate of return earned by firms in this industry once the industry reaches long-run equilibrium? LO10.5 Answers: Percentage rate of return is 11 percent (= $5.50/$50); Yes, it is earning an economic profit; It’s economic profit is 6 percent (= 11 percent − 5 percent); This industry will see entry; Once the industry reaches equilibrium, firms in the industry will earn the economy’s normal rate of profit, 5 percent.

Feedback: Since the firm is earning $5.50 on every $50 invested, the percentage rate of return is 11% [= ($5.50 / $50) × 100].

Yes, the firm is earning an economic profit of 6%, which equals the difference between the actual percentage rate of return and the normal rate of profit in the economy (= 11% − 5%).

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This industry will see entry because the rate of return is greater than the normal rate of profit (economic profit is positive) resources could earn on average in other industries.

In the long run firms in this industry will earn the normal rate of profit. This is when entry of new firms stops.

224. A firm in a purely competitive industry is currently producing 1,000 units per day at a total cost of $450. If the firm produced 800 units per day, its total cost would be $300, and if it produced 500 units per day, its total cost would be $275. What are the firm‘s ATC per unit at these three levels of production? If every firm in this industry has the same cost structure, is the industry in long-run competitive equilibrium? From what you know about these firms‘ cost structures, what is the highest possible price per unit in long-run equilibrium? If that price ends up being the market price and if the normal rate of profit is 10 percent, then what will each firm‘s accounting profit per unit be? LO10.4 Answers: The firms’ ATC per unit at 1,000 units per day is $0.45 (= $450/1,000); at 800 units per day it is $0.38 (= $300/800); and at 500 units per day it is $0.55 = ($275/500). This industry is not in long-run equilibrium because the firms in the industry are not producing at the minimum point on their ATC curves—they are producing at an output level higher than minimum ATC. From what we know of these three output levels, the highest that the long-run equilibrium price could be is $0.38 since that is the lowest of the three ATC per unit that we know and in long-run equilibrium firms must be producing at the lowest possible ATC per unit. If $0.38 ends up being the market equilibrium price in the long run and if the normal profit rate that must hold in long-run equilibrium is 10%, then the firm must be earning a normal profit of 3.8 cents per unit (= 10% × $0.38).

Feedback: The average total cost (ATC) is found by dividing total cost by the number of units being produced. ATC for 1,000 units is $0.45 (=$450 / 1,000).

ATC for 800 units is $0.375 (= $300 / 800). ATC for 500 units is $0.55 (= $250 / 550).

No, because the firm is producing 1,000 (as stated in the question) this industry cannot be in long-run equilibrium because it is not producing at the lowest ATC (ATC at 1,000 units is greater than ATC at 800 units).

The highest possible price that could be supported in the long run is the lowest ATC in the industry. Given the information above, this is $0.375 or $0.38 after rounding.

In the long run, competitive firms will earn zero economic profit, so their accounting profit will equal the normal profit. Since the normal rate of profit is 10 1-233 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

percent and the firm will charge $0.38 for each unit in the long run, the accounting profit will be $0.038 (3.8 cents per unit). This is 10 percent of the price (=.10 × $0.38).

225. There are 300 purely competitive farms in the local dairy market. Of the 300 dairy farms, 298 have a cost structure that generates profits of $24 for every $300 invested.

What is their percentage rate of return? The other two dairies have a cost structure that generates profits of $22 for every $200 invested. What is their percentage rate of return? Assuming that the normal rate of profit in the economy is 10 percent, will there be entry or exit? Will the change in the number of firms affect the two that earn $22 for every $200 invested? If so, how? What will be the rate of return earned by most firms in the industry in long-run equilibrium? If firms can copy each other‘s technology, what will be the rate of return eventually earned by all firms? LO10.4 Answers: The 298 dairies earn an 8 percent (= $24/$300) rate of return while the two other dairies earn an 11 percent (= $22/$200) rate of return. Because the normal rate of return of 10% is higher than the 8 percent earned by the 298 dairies, there will be exit. The exit will affect the two dairies that are earning 11 percent returns because they can claim a larger market share from the exit of the other firms. In long-run equilibrium, most firms (the ones that remain from the original 298) will earn the normal 10% rate of return. If firms can copy the technology used by the two more efficient firms, then all firms will end up earning the normal 10% rate of return after all firms have copied the better technology and expanded output until the increase in market supply brings down the market price low enough that all firms in the industry are earning the normal profit.

Feedback: The percentage rate of return for the firms is found by dividing profits by the amount invested. This is multiplied by 100 to convert into percentage form.

The percentage rate of return for the 298 firms is 8 percent [= ($24 / $300) × 100].

The percentage rate of return for the 2 firms is 11 percent [= ($22 / $200) × 100].

There will be exit in this industry because the normal rate of profit is 10 percent and the 298 firms are only earning a return of 8 percent. That is, firms will exit this industry and invest their resources in other industries which, on average, are earning 10 percent This will not affect the 2 firms that are earning an 11 percent rate of return on their investment.

To stop the exit of firms from this industry, the firms will need to earn a 10 percent rate of return. This allows the two firms earning a rate of return of 11 percent on their investment to increase their market share.

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If firms can copy the technology used by the two more efficient firms, then all firms will end up earning the normal 10 percent rate of return after all firms have copied the better technology and expanded output until the increase in market supply brings down the market price low enough that all firms in the industry are earning the normal profit.

Chapter 11 - Pure Monopoly McConnell Brue Flynn 23e DISCUSSION QUESTIONS 226. ―No firm is completely sheltered from rivals; all firms compete for consumer dollars. Therefore, pure monopoly does not exist.‖ Do you agree? Explain. How might you use the concept of cross elasticity of demand to judge whether monopoly exists?

LO11.1 Answer: Though it is true that ―all firms compete for the dollars of consumers,‖ it is playing on words to hold that pure monopoly does not exist. If you want electric lights, you have to deal with a single company. It is a pure monopoly in that regard, even though you can switch to oil or natural gas for heating. Of course, you can use oil, natural gas, or kerosene for lighting too—but these are hardly convenient options.

The concept of cross elasticity of demand can be used to measure the presence of close substitutes for the product of a monopoly firm. If the cross elasticity of demand is greater than one, then the demand that the monopoly faces is elastic with respect to substitute products, and the firm has less control over its product price than if the cross elasticity of demand were inelastic. In other words, the monopoly faces competition from producers of substitute products.

227. Discuss the major barriers to entry into an industry. Explain how each barrier can foster monopoly. Which barriers, if any, do you feel give rise to monopoly that is socially justifiable? LO11.2 Answer: Economies of scale are a barrier to entry because of the need for new firms to start big to achieve the low production costs of those already in the industry. However, not all industries need techniques of production that require large scale. In many industries, the minimum efficient scale is only a small percentage of domestic consumption. Economies of scale can help protect an oligopoly. The already-established firms in the market are very efficient at production, with low costs. A new firm entering the market would have high start1-235 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

up costs. Most consumers will choose to buy from the efficient firm because they can offer lower prices than the new firm.

Natural monopolies give rise to monopoly that is socially justifiable. The economies of scale are sometimes such that having two or more firms serving the market would increase costs unreasonably. Two telephone companies, or gas companies, or water companies, or electricity companies in the same city would be highly inconvenient and costly as long as transmission requires wires and pipes. In such instances, it makes sense for government to grant exclusive franchises and then regulate the resulting monopoly to ensure the public interest is protected.

Network effects are present when the value of a product increases as more people use it. The greater the number of people using a network, the greater your own demand for it will be, all other things equal. Industries that are subject to network effects will generally tend toward monopoly as customers pile into whichever networks already have the most users, thereby leaving smaller networks to wither and die. Network effects serve as powerful barriers to entry because startups with only a few users will have extreme difficulty competing with established firms with many people already on a network. An additional implication of network effects is that they offer a first-mover advantage, because the first firms to enter an industry with network effects are likely to end up with substantial monopoly power. Being able to pick up a few customers early on, network effects will cause more and more people to follow, thereby guaranteeing the first firm, or firms, massive market share.

Patents and licenses are legal barriers to entry that also, to some extent, are justifiable. If inventions were not protected at all from immediate copying by those who bore none of the costs, the urge to invent and innovate would be lessened and the costly secrecy that is enforced already would have to be much greater and more costly. However, this does not mean that abuses do not exist in the present system and a case can be made for reducing the present 17 years for which patents are granted.

Ownership of essential raw materials is another barrier to entry. It has little social justification except to the extent that the hope of gaining a monopoly in the supply of an essential raw material leads to more prospecting.

Unfair competition is the last of the barriers and has no social justification at all, which is why price-cutting to bankrupt a rival is illegal. The problem here, though, is to prove that cutthroat competition truly is what it appears to be. We see this mostly in oligopolies.

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228. How does the demand curve faced by a purely monopolistic seller differ from that confronting a purely competitive firm? Why does it differ? Of what significance is the difference? Why is the pure monopolist‘s demand curve not perfectly inelastic?

LO11.3 Answer: The demand curve facing a pure monopolist is downward sloping; that facing the purely competitive firm is horizontal, perfectly elastic. This is so for the pure competitor because the firm faces a multitude of competitors, all producing perfect substitutes. In these circumstances, the purely competitive firm may sell all that it wishes at the equilibrium price, but it can sell nothing for even so little as one cent higher. The individual firm‘s supply is so small a part of the total industry supply that it cannot affect the price.

The monopolist, on the other hand, is the industry and therefore is faced by a normal downward-sloping industry demand curve. Being the entire industry, the monopolist‘s supply is big enough to affect prices. By decreasing output, the monopolist can force the price up. Increasing output will drive it down.

Part of the demand curve facing a pure monopolist could be perfectly inelastic; if the monopolist puts only a very few items on the market, it is possible the firm could sell them all at, say, $1, or $2, or $3. But it is the very fact that the monopolist could sell the same amount at higher and higher prices that would ensure that the profit-maximizing monopolist would not, in fact, sell in this perfectly inelastic range of the demand curve. Indeed, the monopolist would not sell in even the still slightly inelastic range of the demand curve. The reason is that so long as the demand curve is inelastic, MR must be negative, but since the MC of any item can hardly be negative also, the monopolist‘s profit must decrease if it produces here. To equate a positive MR with MC, the monopolist must produce in the elastic range of its demand curve.

229. Assume that a pure monopolist and a purely competitive firm have the same unit costs. Contrast the two with respect to (a) price, (b) output, (c) profits, (d) allocation of resources, and (e) impact on income transfers. Because both monopolists and competitive firms follow the MC = MR rule in maximizing profits, how do you account for the different results? Why might the costs of a purely competitive firm and those of a monopolist be different? What are the implications of such a cost difference? LO11.5 Answer: With the same costs, the pure monopolist will charge a higher price, have a smaller output, and have higher economic profits in both the short run and the long run than the pure competitor. As a matter of fact, the pure competitor will have no economic profits in the long run even though it might have some in the short run. Because the monopolist does not produce at the point of minimum ATC and does not equate price and MC, its allocation of resources is inferior to that of the pure competitor. Specifically, resources are underallocated to monopolistic 1-237 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

industries. Since a pure monopolist is more likely than the pure competitor to make economic profits in the short run and is, moreover, the only one of the two able to make economic profits in the long run, the distribution of income is more unequal with monopoly than with pure competition.

In pure competition, MR = P because the firm‘s supply is so insignificant a part of industry supply that its output has no effect on price. It can sell all that it wishes at the price established by demand and the total industry supply. The firm cannot force the price up by holding back part or all of its supply.

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The monopolist, on the other hand, is the industry. When it increases the quantity it produces, price drops. When it decreases the quantity it produces, price rises. In these circumstances, MR is always less than price for the monopolist; to sell more it must lower the price on all units, including those it could have sold at the higher price had it not put more on the market. When the monopolist equates MR and MC, it is not selling at that price: The monopolist‘s selling price is on the demand curve, vertically above the point of intersection of MR and MC. Thus, the monopolist‘s price will be higher than the pure competitor‘s.

Economies of scale may be such as to ensure that one large firm can produce at lower cost than a multitude of small firms. This is certainly the case with most public utilities. And in such industries as basic steel-making and car manufacturing, pure competition would involve a very high cost. On the other hand, monopolies may suffer from X-inefficiency, the inefficiency that a lack of competition allows. Monopolies may also incur nonproductive costs through ―rent-seeking‖ expenditures. For example, they may try to influence legislation that protects their monopoly powers.

230. Critically evaluate and explain each statement: LO11.5 uuuuuuuuu.

Because they can control product price, monopolists can guarantee profitable production by simply charging the highest price consumers will pay. vvvvvvvvv.

The pure monopolist seeks the output that will yield the greatest per-unit profit. wwwwwwwww. An excess of price over marginal cost is the market‘s way of signaling the need for more production of a good. xxxxxxxxx.

The more profitable a firm, the greater its monopoly power. yyyyyyyyy.

The monopolist has a pricing policy; the competitive producer does not. zzzzzzzzz. With respect to resource allocation, the interests of the seller and of society coincide in a purely competitive market but conflict in a monopolized market.

Answer: mmmmm.

The statement is false. If the monopolist charged the highest price consumers would pay, it would sell precisely one unit! (Conceivably, it might sell a little more than one if more than one consumer made matching bids for the first unit offered.) It is highly unlikely that the sale of one unit (or a very few) would cover the very high AFC of one or a very few units. And even a monopolist that does produce sensibly where MR = MC may still suffer a loss: P can be below ATC at all levels. nnnnn.

The statement is false. The monopolist seeks the output that will yield the greatest profit. The profit equation is Q(P − ATC). It is not (P − ATC). If the monopolist sells one unit for $100 when ATC is $60, then its profit per unit and total profit is $40 (= $100 − $60). Nice, but if the same 1-239 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

monopolist can sell 1,000 units for $40 when ATC is $39, then, though its per unit profit is a mere $1 (= $40 − $39), its total profit is $1,000 [= 1,000($40 − $39)]. This is much better than $40. ooooo. The statement is true. Price is the value society sets on the last item produced. Marginal cost is the value to society of the alternative production forgone when the last item is produced. When P > MC, society is willing to pay more than the opportunity cost of the last item‘s production. ppppp.

This statement can be true and probably is in many cases. Large profits allow expansion to gain economies of scale and thus prevent the late entry of smaller rivals. Large profits also enable the firm to price below cost, to engage (illegally) in a price war. Moreover, large profits in the short run are often associated with monopoly power. In the long run, only a firm with monopoly power can gain economic profits; in pure competition such profits would invariably be competed away by new entry. qqqqq.

The statement is true. The monopolist must equate MR and MC. Having determined at what quantity this equality occurs, the monopolist simultaneously sets price. This price differs at each output because the demand curve is downsloping. The pure competitor accepts the price given by total industry supply and demand. Knowing this externally given price, the competitor then equates it with the firm‘s MC and produces the amount determined by this equality. rrrrr. The statement is true. In pure competition, P = MC. This means that the value society sets on the last item produced (its price) is equal to the cost of the alternative commodities that are not produced. This is because producing the last item of the commodity in question is its MC. In monopoly, P > MC. This means that society values the last item produced more than its cost.

231. Assume a monopolistic publisher has agreed to pay an author 10 percent of the total revenue from the sales of a book. Will the author and the publisher want to charge the same price for the book? Explain. LO11.5 Answer: The publisher is a monopolist seeking to maximize profits. This will occur at the quantity of output where MC = MR. (See Figure 12.4)

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The author who will receive 10 percent of the total revenue will maximize his payment if the book is priced where MR = 0. This will occur where the price elasticity of demand is equal to 1 and total revenue is maximum. (See Figure 12.3)

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The author would prefer a lower price than the publisher. Consult Key Graph 12.3 and compare the price charged where MC = MR and the price that would be necessary to maximize total revenue when MR = 0. This is a highly unlikely outcome since the publisher, whether economically literate or not, is certain to recognize the revenue maximizing price as disadvantageous.

232. U.S. pharmaceutical companies charge different prices for prescription drugs to buyers in different nations, depending on elasticity of demand and governmentimposed price ceilings. Explain why these companies, for profit reasons, oppose laws allowing re-importation of drugs to the United States. LO11.6 Answer: U.S. pharmaceutical companies are price discriminating based in part on the different elasticities of demand in different nations. Reimportation allows reselling of the goods, making it more difficult to price discriminate. To the extent they could still charge different prices, the difference in prices would have to be 1-242 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

small enough so that reimportation was not profitable. Prohibition of reimportation would allow pharmaceutical companies to charge the profitmaximizing price in each nation, without fear of being undercut back in the U.S. by those in nations where the drugs are cheaper.

233. Explain verbally and graphically how price (rate) regulation may improve the performance of monopolies. In your answer, distinguish between (a) socially optimal (marginal-cost) pricing and (b) fair-return (average-total-cost) pricing. What is the ―dilemma of regulation‖? LO11.7 Answer: Monopolies that are natural monopolies are normally subject to regulation. Because of extensive economies of scale, marginal cost is less than average total cost throughout the range of output. An unregulated monopolist would produce at Qm when MC = MR and enjoy an economic profit. Society would be better off with a larger quantity. Output level Qr would be socially optimal because MC = Price and allocative efficiency would be achieved.

However, the firm would lose money producing at Qr since ATC exceeds the price. In order for the firm to survive, public subsidies out of tax revenue would be necessary, which is the ―dilemma of regulation.‖ Another option for regulators is to allow a fair-return price that would allow the firm to break even economically (cover all costs including a normal profit).

Setting price equal to ATC would deliver Qf output and only partially solve the underallocation of resources. Despite this dilemma, regulation can improve on the results of monopoly from the social point of view. Price regulation (even at the fair-return price) can simultaneously reduce price, increase output, and reduce the economic profits of monopolies.

234. It has been proposed that natural monopolists should be allowed to determine their profit-maximizing outputs and prices, and then government should tax their profits away and distribute them to consumers in proportion to their purchases from 1-243 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the monopoly. Is this proposal as socially desirable as requiring monopolists to equate price with marginal cost or average total cost? Explain. LO11.7 Answer: No, the proposal does not consider that the output of the natural monopolist would still be at the suboptimal level where P > MC. Too little would be produced and there would be an underallocation of resources. Theoretically, it would be more desirable to force the natural monopolist to charge a price equal to marginal cost and subsidize any losses. Even setting price equal to ATC would be an improvement over this proposal. This fair-return pricing would allow for a normal profit and ensure greater production than the proposal would.

235.

LAST WORD What are the benefits and risks associated with just-in-time delivery of inputs to factories? Why do computer chip factories run continuously rather than maintaining some spare capacity? What is the underlying economic concept that explains why 80 percent of the world‘s most advanced computer chips are produced by a single firm, Taiwan Semiconductor, rather than by many small firms?

Answer: The major benefit of just-in-time delivery of inputs to factories is that it eliminates the costs associated with maintaining inventories of inputs–especially the fact that inventories are costly to purchase but do not, by definition, generate any revenue. The major risk associated with just-in-time delivery of inputs to factories is that if even a single type of input is not delivered on time, the entire factory production line will have to be shut down. When you have no inventories of inputs, even a slight delivery delay will shut production.

Computer chip factories run continuously in order to spread their massive fixed costs over as many units of output as possible and thereby achieve economies of scale.

The 80 percent market share enjoyed by Taiwan Semiconductor is best explained by the presence of large economies of scale in computer chip manufacturing.

Those economies of scale, in turn, are driven by the extremely high fixed costs of setting up a chip-making factory. Any firm that can build such a plant and then run it at full capacity will be able to produce at a lower cost per unit than would multiple competitors each producing a fraction of its volume. Thus, the tendency of the computer chip manufacturing industry is towards natural monopoly, which is why Taiwan Semiconductor holds such a massive market share in the production of cutting-edge computer chips.

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REVIEW QUESTIONS Which of the following could explain why a firm is a monopoly? Select one or more answers from the choices shown. LO11.2 Patents aaaaaaaaaa.

Economies of scale.

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bbbbbbbbbb. cccccccccc. dddddddddd. eeeeeeeeee.

Inelastic demand.

Government licenses.

Downward-sloping market demand.

The absence of network effects

Answer: Patents, Economics of scale, and Government licenses.

A firm is a pure monopoly when it is the only firm in its industry. A firm may be the only firm in its industry for a variety of reasons. These include holding patents that legally prevent any other firm from duplicating its products; having economics of scale that allow the firm to produce at a lower cost than potential rivals; and enjoying government licenses that make it the sole legal producer of a product in a given area.

236. The MR curve of perfectly competitive firm is horizontal. The MR curve of monopoly firm is: LO11.3 horizontal, too. ffffffffff. upward sloping. gggggggggg. downward sloping. hhhhhhhhhh. it depends.

Answer: Downward sloping.

The MR curve of a monopoly firm is downward sloping because the only way for a monopoly firm to increase the amount of output that it sells is by lowering the price it charges in order to move down along its downward-sloping demand curve. But the monopolist must lower the price not just on additional units but also on earlier units, too. As a result, the MR that the firm collects declines with each successive unit that it wishes to sell. Graphically, this implies that the MR curve is downward sloping, as MR declines with output.

237. Use the demand schedule below to calculate total revenue and marginal revenue at each quantity. Plot the demand, TR, and MR curves, and explain the relationships between them. Explain why the marginal revenue of the fourth unit of output is $3.50, even though its price is $5. Use Chapter 6‘s total-revenue test for price elasticity to designate the elastic and inelastic segments of your graphed demand curve. What generalization can you make about the relationship between marginal revenue and elasticity of demand? Suppose the marginal cost of successive units of output is zero.

What output would the profit-seeking firm produce? Finally, use your analysis to explain why a monopolist will never produce in the inelastic region of demand.

LO11.3

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Answer: To calculate Total Revenue multiply price (P) by Quantity Demanded (Q): TR = P × Q. To calculate Marginal Revenue find the change in total revenue for each unit demanded: MR = Δ TR = TR (i + 1) − TR(i).

See table below.

Price (P)

Quantity Demanded (Q)

Total Revenue (TR)

Marginal Revenue (MR)

$7.00

0

$0

NA

6.50

1

6.50

$6.50

6.00

2

12.00

5.50

5.50

3

16.50

4.50

5.00

4

20.00

3.50

4.50

5

22.50

2.50

4.00

6

24.00

1.50

3.50

7

24.50

0.50

3.00

8

24.00

−0.50

2.50

9

22.50

−1.50

Because TR is increasing at a diminishing rate, MR is declining. When TR turns downward (starts decreasing), MR becomes negative. Marginal revenue is below D because to sell an extra unit, the monopolist must lower the price on the marginal unit as well as on each of the preceding units sold. Four units sell for $5.00 each, but three of these four could have been sold for $5.50 had the monopolist been satisfied to sell only three. Having decided to sell four, the monopolist had to lower the price of the first three from $5.50 to $5.00, sacrificing $.50 on each for a total of $1.50. This ―loss‖ of $1.50 explains the difference between the $5.00 price obtained on the fourth unit of output and its marginal revenue of $3.50.

Demand is elastic from P = $6.50 to P = $3.50, a range where TR is rising. The curve is of unitary elasticity at P = $3.50, where TR is at its maximum. The curve is inelastic from then on as the price continues to decrease and TR is falling.

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When MR is positive, demand is elastic. When MR is zero, demand is of unitary elasticity. When MR is negative, demand is inelastic.

If MC is zero, the monopolist should produce 7 units where MR is also zero. It would never produce where demand is inelastic because MR is negative there while MC is positive.

The graph below summarizes the analysis discussed above.

238. How often do perfectly competitive firms engage in price discrimination? LO11.6 Never. iiiiiiiiii. Rarely. jjjjjjjjjj. Often. kkkkkkkkkk.

Always.

Answer: Never.

Note that this question asks about perfectly competitive firms, not monopolies!

Perfectly competitive firms never engage in price discrimination because they have no way of charging different prices to different consumers.

This is true because perfectly competitive firms are price takers who have no influence over the market price. Each and every unit that they produce must be sold in the market at the market price. As a result, they have no ability to charge different prices to different consumers—as must be done when engaging in price discrimination.

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239. Suppose that a monopolist can segregate his buyers into two different groups to which he can charge two different prices. To maximize profit, the monopolist should charge a higher price to the group that has: LO11.6 the higher elasticity of demand. llllllllll. the lower elasticity of demand. mmmmmmmmmm. richer members.

Answer: the lower elasticity of demand.

In order to maximize profit, the monopolist should charge a higher price to the group that has the lower elasticity of demand. This is true because a lower elasticity implies that a given increase in price will lead to a smaller decline in quantity demanded. Thus, it will be more profitable to assign the higher price to the group with the lower elasticity because the quantity that they demand will fall off less if the higher price were assigned to the group with the higher elasticity of demand.

240. The socially optimal price (P = MC) is socially optimal because: LO11.7 it reduces the monopolist‘s profit. nnnnnnnnnn. it yields a normal profit. oooooooooo. it minimizes ATC. pppppppppp. it achieves allocative efficiency.

Answer: It achieves allocative efficiency The socially optimal price is socially optimal because it achieves allocative efficiency. This is true because the socially optimal price is determined by where the downward-sloping demand curve intersects the upward-sloping MC curve, thereby causing the regulated monopoly to produce every unit for which benefits exceed costs.

241. The main problem with imposing the socially optimal price (P = MC) on a monopoly is that the socially optimal price: LO11.7 may be so low that the regulated monopoly can‘t break even. qqqqqqqqqq. may cause the regulated monopoly to engage in price discrimination. rrrrrrrrrr. may be higher than the monopoly price.

Answer: May be so low that the regulated monopoly can’t break even.

The main problem with imposing the socially optimal price (P = MC) on a monopoly is that the socially optimal price may be so low that the regulated monopoly can‘t break even. In such situations, alternatives must be found in order to prevent the monopoly from going bankrupt and thereby denying society the chance to purchase the good or service made by the monopoly. These alternatives include providing a public subsidy to make up for the firm‘s losses or switching to fair-return pricing, which would guarantee that the regulated monopoly could make a normal profit and thereby remain in business.

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PROBLEMS Connections are valuable and Metcalf‘s Law tells us that the value, V, of a network is approximately equal to the square of the number, n, of people or objects connected to the network. That is, V = n2. Apply Metcalf‘s law to the following situation: Santiago is choosing between two local dating apps, one which has 5 users and the other which has 50 users. What is the value of the smaller network? Of the larger network? How many times bigger is the value of the larger network than the value of the smaller network? Which app will Santiago probably choose? Aside from anything else that might distinguish the two apps, does the larger network size of the more popular dating app constitute a barrier to entry? LO11.1

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Answer: The value of the smaller network is 25 (= 52). The value of the larger network is 2,500 (= 502). The app with 50 users is 100 times more valuable than the app with 5 users. That is because the value of the app with 50 users is 2,500 (= 502) while the value of the app with 5 users is 25 (= 52). (Please note that the larger network is 100 times more valuable despite having only 10 times more users. So, a relatively small difference in the number of users causes a massively larger difference in the values of the wo networks.) Santiago will probably select the app with the larger network because it is the one that will offer him the most potential connections. Aside from any other considerations, the larger network size of the app with more users does constitute a barrier to entry just by itself because its larger network size means more potential connections and thus more value to potential users relative to the smaller network.

242. Suppose a pure monopolist faces the following demand schedule and the same cost data as the competitive producer discussed in problem 4 at the end of Chapter 10.

Calculate the missing TR and MR amounts and determine the profit-maximizing price and profit-maximizing output for this monopolist. What is the monopolist‘s profit? Verify your answer graphically and by comparing total revenue and total cost.

LO11.4

Answer:

Price (P)

Quantity Demanded (Q)

Total Revenue (TR)

Marginal Revenue (MR)

$115

0

$0

NA

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Price (P)

Quantity Demanded (Q)

Total Revenue (TR)

Marginal Revenue (MR)

100

1

100

100

83

2

166

66

71

3

213

47

63

4

252

39

55

5

275

23

48

6

288

13

42

7

294

6

37

8

296

2

33

9

297

1

29

10

290

−7

Profit-maximizing price = $63; profit-maximizing quantity = 4 units; monopolist‘s profit = $42.

The graph should have the general shape of Figure 12.4.

Feedback: To calculate Total Revenue, multiply price (P) by Quantity Demanded (Q): TR = P×Q To calculate Marginal Revenue, find the change in total revenue for each unit demanded: MR = Δ TR = TR (i + 1) − TR (i).

See table below.

Price (P)

Quantity Demanded (Q)

Total Revenue (TR)

Marginal Revenue (MR)

$115

0

$0

NA

100

1

100

100

83

2

166

66

71

3

213

47

63

4

252

39

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55

5

275

23

48

6

288

13

42

7

294

6

37

8

296

2

33

9

297

1

29

10

290

−7

To determine profit-maximizing price and profit-maximizing output for this monopolist use the cost data in the table below.

To find the profit-maximizing quantity compare marginal revenue from the first table above with the marginal cost from second table.

Price (P)

Quantity Demanded (Q)

Marginal Revenue (MR)

Marginal Cost (MC)

$115

0

NA

NA

100

1

$100

$45

83

2

66

40

71

3

47

35

63

4

39

30

55

5

23

35

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48

6

13

40

42

7

6

45

37

8

2

55

33

9

1

65

29

10

−7

75

Starting with the first unit MR = $100 > MC = $45, produce this unit. The same logic applies to units 2, 3, and 4. However, for the fifth unit MR = $23 < MC = $35. Thus, the firm does NOT produce this unit. (NOTE: We have modified the MR = MC rule to MR > MC, which is more general. Produce all units where MR > MC.) The profit maximizing quantity produced is 4 units.

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The profit maximizing price is the price associated with the profit maximizing quantity, 4 units. Thus, the profit maximizing price is $63.

The monopolist‘s profit equals total revenue minus total cost. Total revenue equals $252 at 4 units of output. We still need total cost. From the ‗cost data‘ table we see that average total cost (ATC) equals $52.50. Since ATC equals total cost divided by quantity we can determine total cost from the ATC cost data.

ATC = Total Cost / Quantity or Total Cost = Quantity × ATC = 4 × $52.50 = $210 Profit = $252 − $210 = $42 Another approach is to use the following relationship.

Profit = TR − TC Divide through by Q Profit/Q = TR/Q − TC/Q Since TR/Q = Average Revenue = P and TC/Q = ATC, we have: Profit/Q = P − ATC Rearranging, Profit = Q (P − ATC) = 4($63 − $52.50) = 4 × $10.5 = $42 Either approach above will work.

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243. Suppose that a price-discriminating monopolist has segregated its market into two groups of buyers. The first group described by the demand and revenue data that you developed for problem 1. The demand and revenue data for the second group of buyers is shown in the following table. Assume that MC is $13 in both markets and MC = ATC at all output levels. What price will the firm charge in each market?

Based solely on these two prices, which market has the higher price elasticity of demand? What will be this monopolist‘s total economic profit? LO11.6

Answer: Price in market 1 = $48; price in market 2 = $33; the second market has the higher price elasticity of demand; total economic profit = $330.

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Feedback: Let‘s start with the second market. Marginal cost is $13 for all output levels. The marginal revenue from producing the 6th unit is $13 (= $198 − $185), so this is the last unit produced by the firm for this market.

Thus, the marginal revenue equals marginal cost rule results in 6 units being produced in this market (MR = MC = $13 at 6 units in this market).

The price the firm charges in this market is $33, which is the price associated with the 6th unit.

The firm‘s profit in this market can be found using the following relationship (see problem 1 in this chapter for derivation).

Profit Market 2 = Q (P − ATC) = 6($33 − $13) = 6 × $20 = $120 The first market is found in problem 1 (Table reproduced below):

Price (P)

Quantity Demanded (Q)

Total Revenue (TR)

Marginal Revenue (MR)

$115

0

$0

NA

100

1

100

100

83

2

166

66

71

3

213

47

63

4

252

39

55

5

275

23

48

6

288

13

42

7

294

6

37

8

296

2

33

9

297

1

29

10

290

−7

Again, marginal cost is $13 for all output levels.

The marginal revenue equals marginal cost rule results in 6 units being produced in this market as well (MR = MC = $13 at 6 units in this market).

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The price the firm charges in this market is $48, which is the price associated with the 6th unit.

The firm‘s profit in this market can be found using the following relationship (see problem 1 in this chapter for derivation).

Profit Market 1 = Q (P − ATC) = 6($48 − $13) = 6 × $35 = $210

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The combined profit from both markets gives us total profit.

Total Profit = Profit Market 1 + Profit Market 2 = $120 + $210 = $330 Since the firm charges a higher price in the second market (a price of $48), this market has the higher price elasticity of demand.

244. Assume that the most efficient production technology available for making vitamin pills has the cost structure given in the following table. Note that output is measured as the number of bottles of vitamins produced per day and that costs include a normal profit. LO11.6

What is ATC per unit for each level of output listed in the table? ssssssssss. Are there economies of scale in production? (Answer yes or no.) tttttttttt. Suppose that the market price for a bottle of vitamins is $2.50. At that price the total market quantity demanded is 75,000,000 bottles. How many firms will be in this industry? uuuuuuuuuu.

Suppose that, instead, the market quantity demanded at a price of $2.50 is only 75,000. How many firms will be in this industry? vvvvvvvvvv.

Review your answers to parts b, c, and d. Does the level of demand determine this industry‘s market structure?

Answers: m. ATC per bottle is $4 per bottle at 25,000 bottles, $3 per bottle at 50,000 bottles, $2.50 per bottle at 75,000 units, and $2.76 per bottle at 100,000 units. n. No. o. There will be 1000 firms in this industry. p. There will be one firm in this industry. q. Yes. Feedback: To find Average Total Cost (ATC) divide Total Cost by Output (Quantity).

ATC = Total Cost / Output Output

TC

MC

ATC

25,000

$100,000

$0.50

$4.00

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Output

TC

MC

ATC

50,000

150,000

1.00

$3.00

75,000

187,500

2.50

$2.50

100,000

275,500

3.00

$2.76

sssss. Yes, the ATC does decline for output levels up to 75,000. Beyond this, the ATC increases. ttttt. Since $2.50 is minimum ATC, firms will produce at this level of output.

Any firm that deviated from this level would incur a higher ATC and would be unprofitable at the market price of $2.50.

The total number of firms can be found by dividing the market quantity demanded by output produced by a firm at the ATC of $2.50, which is 75,000.

Number of firms = market quantity demanded / output minimum ATC = 75,000,000/75,000 = 1,000. uuuuu.

The total number of firms under this assumption is: Number of firms = market quantity demanded / output minimum ATC = 75,000/75,000 = 1. vvvvv. Yes, high demand will result in a competitive industry while very low demand can result in a monopoly industry.

245. A new production technology for making vitamins is invented by a college professor who decides not to patent it. Thus, it is available for anybody to copy and use. The TC per bottle for production up to 100,000 bottles per day is given in the following table. LO11.6

What is ATC for each level of output listed in the table? wwwwwwwwww. Suppose that for each 25,000-bottle per day increase in production above 100,000 bottles per day, TC increases by $5,000 (so that, for instance, 125,000 bottles per day would generate total costs of $85,000 and 150,000 bottles 1-261 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

per day would generate total costs of $90,000). Are there economies of scale at all output levels? xxxxxxxxxx.

Suppose that the price of a bottle of vitamins is $1.33. At that price, the total quantity demanded by consumers is 75,000,000 bottles. How many firms will there be in this industry? yyyyyyyyyy.

Suppose that, instead, the market quantity demanded at a price of $1.33 is only 75,000. How many firms will there be in this industry? zzzzzzzzzz.

Review your answers to parts b, c, and d. Does the level of demand determine this industry‘s market structure? aaaaaaaaaaa.

Compare your answer to part d of this question with your answer to part d of problem 4. Do both production technologies show constant returns to scale?

Answers: ATC per bottle is $2.00 per bottle for 25,000 bottles, $1.40 per bottle for 50,000 bottles, $1 per bottle for 75,000 bottles, and $0.80 per bottle for 100,000 bottles. wwwww.

Yes, the ATC decreases for all output levels so there economies of scale at all output levels. xxxxx. Only one firm since this is a natural monopoly situation. yyyyy. Only one firm since this is a natural monopoly situation. zzzzz. No, the level of demand does not determine this market’s structure. aaaaaa.

No, the new technology of this problem shows economies of scale and this industry is therefore a decreasing-cost industry.

Feedback: To find Average Total Cost (ATC) divide Total Cost by Output (Quantity).

ATC = Total Cost / Output Output

TC

ATC

25,000

$50,000

$2.00

50,000

70,000

$1.40

75,000

75,000

$1.00

100,000

80,000

$.0.80

bbbbbb.

The last two rows provide the additional cost and output information (you could continue to add rows for additional output).

Output

TC

ATC

25,000

$50,000

$2.00

50,000

70,000

$1.40

75,000

75,000

$1.00 1-262

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100,000

80,000

$.0.80

125,000

$85,000

$0.68

150,000

$90,000

$0.60

From this additional information we can conclude this is a decreasing cost industry because ATC falls as output increases at all levels. cccccc. Because there are economies of scale at all levels of output, we have a natural monopoly situation, and there will only be one firm.

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dddddd.

Again, because there are economies of scale at all levels of output, we have a natural monopoly situation, and there will only be one firm. eeeeee. No, because there are economies of scale at all levels of output, there will only be one firm regardless of demand. ffffff. No, the second technology (this problem) has increasing returns to scale.

246. Suppose you have been tasked with regulating a single monopoly firm that sells 50-pound bags of concrete. The firm has fixed costs of $10 million per year and a variable cost of $1 per bag no matter how many bags are produced. LO11.7 If this firm kept on increasing its output level, would ATC per bag ever increase? Are there economies of scale at all output levels? bbbbbbbbbbb.

If you wished to regulate this monopoly by charging the socially optimal price, what price would you charge? At that price, what would be the size of the firm‘s profit or loss? Would the firm want to exit the industry? ccccccccccc.

You find out that if you set the price at $2 per bag, consumers will demand 10 million bags. How big will the firm‘s profit or loss be at that price? ddddddddddd.

If consumers instead demanded 20 million bags at a price of $2 per bag, how big would the firm‘s profit or loss be? eeeeeeeeeee.

Suppose that demand is perfectly inelastic at 20 million bags, so that consumers demand 20 million bags no matter what the price is. What price should you charge if you want the firm to earn only fair rate of return? Assume as always that TC includes a normal profit.

Answers: ATC will never increase. There are economies of scale at all output levels. gggggg.

Charge $1 per bag. At that price, the firm would lose its $10 million fixed costs. This firm would be losing money and will want to exit the industry. hhhhhh.

The firm will break even (no profit or loss). iiiiii. The firm will make an economic profit of $10 million. jjjjjj. You should charge $1.50 per bag if you want this firm to earn a fair rate of return.

Feedback: ATC will never increase. There are economies of scale at all output levels. The intuition is that FC get distributed over more and more units so that ATC will fall asymptotically towards the $1 per bag marginal cost. kkkkkk.

Charge $1 per bag since the MC of all bags is $1 per bag. At that price, the firm would lose its $10 million fixed costs (since the price is just enough to cover variable costs). This firm would be losing money and will want to exit the industry.

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llllll. The firm‘s revenue equals $20,000,000 [= $2 (price) × 10,000,000 (quantity)].

The firm‘s Fixed Cost equals $10,000,000 (given above).

The firm‘s Total Variable Cost equals $10,000,000 [= $1 (variable cost of producing each bag) × 10,000,000 (quantity)].

The firm‘s Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $20,000,000 [=$10,000,000 (Total Fixed Cost) + $10,000,000 (Total Variable Cost)].

The firm‘s profit equals $0 [= $20,000,000 (revenue) − $20,000,000 (total cost)]. The firm breaks even. mmmmmm. The firm‘s revenue equals $40,000,000 [= $2 (price) × 20,000,000 (quantity)].

The firm‘s Fixed Cost equals $10,000,000 (given above).

The firm‘s Total Variable Cost equals $20,000,000 [= $1 (variable cost of producing each bag) × 20,000,000 (quantity)].

The firm‘s Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $30,000,000 [=$10,000,000 (Total Fixed Cost) + $20,000,000 (Total Variable Cost)).

The firm‘s profit equals $10,000,000 (= $40,000,000 (revenue) − $30,000,000 (total cost)]. nnnnnn.

The fair rate of return is where economic profit is zero (Total Cost above includes normal profit).

The first step is to find Total Cost.

The firm‘s Fixed Cost equals $10,000,000 (given above).

The firm‘s Total Variable Cost equals $20,000,000 [= $1 (variable cost of producing each bag) × 20,000,000 (quantity)].

The firm‘s Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $30,000,000 [= $10,000,000 (Total Fixed Cost) + $20,000,000 (Total Variable Cost)].

The second step is to find revenue (here the price is not known).

Revenue = Price (unknown) × 20,000,000.

The final step is to use the definition of profit to solve for the unknown price.

Profit = Revenue − Total Cost = Price × 20,000,000 − $30,000,000 We can also set profit to zero (fair rate of return requirement): Price × 20,000,000 − $30,000,000 = 0 or Price × 20,000,000 = $30,000,000 which gives us, Price = $30,000,000 / 20,000,000 = $1.50.

Thus, the firm should charge $1.50 per bag to earn a fair rate of return.

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Chapter 12 - Monopolistic Competition McConnell Brue Flynn 23e DISCUSSION QUESTIONS 247. How does monopolistic competition differ from pure competition? From pure monopoly? Explain fully what product differentiation may involve. Explain how the entry of firms into its industry affects the demand curve facing a monopolistic competitor and its economic profit. LO12.1 Answer: In monopolistic competition, there are many firms but not the very large numbers of pure competition. The products are differentiated, not standardized.

There is some control over price in a narrow range, whereas the purely competitive firm has none. There is relatively easy entry; in pure competition, entry is completely without barriers. In monopolistic competition, there is much nonprice competition, such as advertising, trademarks, and brand names. In pure competition, there is no nonprice competition.

In pure monopoly, there is only one firm. Its product is unique and there are no close substitutes. The firm has much control over price, being a price maker.

Entry to its industry is blocked. Its advertising is mostly for public relations.

Product differentiation may well only be in the eye of the beholder, but that is all the monopolistic competitor needs to gain an advantage in the market—provided, of course, the consumer looks upon the assumed difference favorably. The real differences can be in quality, in services, in location, or even in promotion and packaging, which brings us back to where we started: possibly nonexistent differences. To the extent that product differentiation exists in fact or in the mind of the consumer, monopolistic competitors have some limited control over price, for they have built up some loyalty to their brand.

When economic profits are present, additional rivals will be attracted to the industry because entry is relatively easy. As new firms enter, the demand curve faced by the typical firm will shift to the left (fall). Because of this, each firm has a smaller share of total demand and now faces a larger number of close-substitute products. This decline in a firm‘s demand reduces its economic profit.

248. Suppose that a monopolistically competitive firm pays for an ad campaign that backfires, causing many consumers to dislike the firm‘s product. In which direction does demand shift, right or left? What happens to the slope and to the elasticity of demand? What happens to the firm‘s pricing power? LO12.1

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Answer: The ad campaign that backfired will cause the demand for the monopolistically competitive firm‘s product to shift to the left as consumers switch to similar products made by competing firms. We can also expect that the demand curve will get flatter, indicating greater elasticity of demand at any possible price. That increase in elasticity of demand implies that the firm will have less pricing power as any possible percentage increase in product price will result in a larger percentage decrease in quantity demanded than was the case before the failed advertising campaign. The damage done to consumer‘s love for the product means that any given price increase implies more customers switching to competing products, thereby causing a larger decrease in the quantity demanded of this firm‘s product.

249. Compare the elasticity of a monopolistic competitor‘s demand with that of a pure competitor and a pure monopolist. Assuming identical long-run costs, compare graphically the prices and outputs in the long run under pure competition and under monopolistic competition. Contrast the two market structures in terms of productive and allocative efficiency. Explain: ―Monopolistically competitive industries are populated by too many firms, each of which produces too little.‖ LO12.2 Answer: The monopolistic competitor‘s demand curve is less elastic than a pure competitor and more elastic than a pure monopolist. Your graphs should look like Figure 11.6 (pure competition) and Figure 13.1 (monopolistic competition). Price is higher and output lower for the monopolistic competitor than for a pure competitor. Pure competition: P = MC (allocative efficiency); P = minimum ATC (productive efficiency). Monopolistic competition: P > MC (allocative inefficiency) and P > minimum ATC (productive inefficiency). Monopolistic competitors have excess capacity; meaning that fewer firms operating at capacity (where P = minimum ATC) could supply the industry output. Therefore, there are too many firms, each of which produces too little output.

250. ―Monopolistic competition is monopolistic up to the point at which consumers become willing to buy close-substitute products and competitive beyond that point.‖ Explain. LO12.2 Answer: As long as consumers prefer one product over another regardless of relative prices, the seller of the product is a monopolist. But in monopolistic competition, this happy state is limited because there are many other firms producing similar products. When one firm‘s prices get ―too high‖ (as viewed by consumers), people will switch brands. At this point, our firm has entered the competitive zone unwillingly, which is why monopolistically competitive firms are forever trying to find ways to differentiate their products more thoroughly and thus to gain more monopoly price-setting power.

251. ―Competition in quality and service may be just as effective as price competition in giving buyers more for their money.‖ Do you agree? Why or why not? Explain 1-268 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

why monopolistically competitive firms frequently prefer nonprice competition to price competition. LO12.2

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Answer: This can certainly be true. It depends on how much consumers value quality and service and how much they are willing to pay for it through higher product prices. In a monopolistically competitive market, the consumer can buy a substitute brand for a lower price if the consumer prefers a lower price to better quality and service.

The monopolistically competitive firm frequently prefers nonprice competition to price competition because the latter can lead to the firm producing where P = ATC and thus making no economic profit or, worse, producing in the short run where P < ATC and thus suffering an economic loss, with the possibility of eventually going out of business. Nonprice competition, on the other hand, if successful, results in more monopoly power: the firm‘s product has become more differentiated from now less-similar competitors in the industry. This increase in monopoly power allows the firm to raise its price with less fear of losing customers. Of course, the firm must still follow the MR = MC rule, but its success in nonprice competition has shifted both the demand and MR curves upward to the right. This results in simultaneously a larger output, a higher price, and more economic profits.

252. Critically evaluate and explain: LO12.3 fffffffffff. In monopolistically competitive industries, economic profits are competed away in the long run. Hence, there is no valid reason to criticize these industries‘ performance and efficiency. ggggggggggg.

In the long run, monopolistic competition leads to a monopolistic price but not to monopolistic profits.

Answer: oooooo.

The first part of the statement may well be true, but it does not lead logically to the second part. The criticism of monopolistic competition is not related to the profit level but to the fact that the firms do not produce at the point of minimum ATC and do not equate price and MC. This is the inevitable consequence of imperfect competition and its downward-sloping demand curves. With P > minimum ATC, productive efficiency is not attained. The firm is producing too little at too high a cost; it is wasting some of its productive capacity. With P > MC, the firm is not allocating resources in accordance with society‘s desires; the value society sets on the product (P) is greater than the cost of producing the last item (MC). pppppp.

The statement is often true, since competition of close substitutes tends to compete price of the average firm down to equality with ATC. Thus, there is no economic profit. However, the firm is producing where its (moderately) monopolistically downward-sloping demand curve is tangent to the ATC curve, short of the point of minimum ATC and thus at a higher than purely competitive price. In other words, it is at a ―monopolistic‖ price.

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253. LAST WORD What would you expect to happen to the proportion of big chain restaurants relative to mom-and-pop restaurants in a town that lowers its minimum wage? Will the proportion change due to exits or due to entrances? Which type of restaurant will see more in the way of exits or entrances? Why? Answer: In a restaurant market that contains both large chain restaurants and ―mom and pop‖ restaurants, both types will be making zero economic profit. Due to the chain restaurant being fairly highly capitalized, a lower minimum wage won‘t impact its cost curves very much. However, ―mom-and-pop‖ restaurants will have their cost curves impacted by much more due to them being more labor intensive. This could in turn cause more ―mom-and-pop‖ restaurants to enter the market, causing the proportion of big chain restaurants to fall. Due to the lowering of labor costs, the ―mom-and-pop‖ restaurant is the type we would expect to see entrances. Due to the capital-intensive structure of the big chain restaurant, we wouldn‘t expect to see much in the way of exits or entrances.

REVIEW QUESTIONS 1. A monopolistically competitive firm gets a massive amount of free advertising when a government agency gives it an award and millions of people mention the award to each other on social media. Which of the following is most likely to happen? LO12.1 r. Demand becomes less elastic and pricing power decreases. s. Demand becomes more elastic and pricing power decreases. t. Demand becomes more elastic and pricing power increases. u. Demand becomes less elastic and pricing power increases.

Answer: Demand becomes less elastic and pricing power increases.

When advertising is successful, a firm‘s demand curve will shift to the right and become steeper, implying that demand will become less elastic at every possible price. That reduced elasticity will give the firm greater pricing power because less elastic demand implies that any price increase initiated by the monopolistically competitive firm will cause a smaller decrease in sales, all other things equal.

2. There are 10 firms in an industry, and each firm has a market share of 10 percent.

What is the industry‘s Herfindahl index? LO12.1 Answer: 1,000.

This industry‘s Herfindahl index is 1,000. To understand why, begin by recalling that the Herfindahl index is used by economists to measure the degree to which an industry‘s output is concentrated and that the index is the sum of the squared percentage market shares of all firms in the industry.

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In this question, there are 10 firms in the industry and each firm has a market share of 10 percent. Thus, the squared market share of each firm in the industry will be 100 (= 102). And the sum of the squared market shares will be 1,000 (= 100 + 100 + 100 + 100 + 100 + 100 + 100 + 100 + 100 + 100). As a result, the industry‘s Herfindahl index is 1,000.

3. In the small town of Geneva, there are 5 firms that make watches. The firms‘ respective output levels are 30 watches per year, 20 watches per year, 20 watches per year, 20 watches per year, and 10 watches per year. What is the four-firm concentration ratio for the town‘s watch-making industry? LO12.1 Answer: 90.

The four firm concentration ratio for the town‘s watch-making industry is 90. To see why, recall that the four firm concentration ratio is the percentage expression of the ratio of the output of the four largest firms in an industry relative to total industry output. Here, the total industry output is 100 watches per year (= 30 + 20 + 20 + 20 + 10) and the output of the four largest firms is 90 watches per year (= 30 + 20 + 20 + 20). So the four firm concentration ratio is 90, because the ratio (= 90/100) is 90 when expressed as a percentage.

4. Which of the following best describes the efficiency of monopolistically competitive firms? LO12.3 Allocatively efficient by productively inefficient hhhhhhhhhhh. Allocatively inefficient but productively efficient iiiiiiiiiii.

Both allocatively efficient and productively efficient jjjjjjjjjjj.

Neither allocatively efficient nor productively efficient Answer: D. Neither allocatively efficient nor productively efficient.

Monopolistically competitive firms are neither allocatively efficient nor productively efficient. Both types of inefficiency have the same cause: product differentiation. That is true because it is product differentiation that gives each firm in a monopolistically competitive industry its small share of monopoly power. With that monopoly power comes a downward-sloping MR curve that when intersected with the firm‘s upward-sloping MC curve results in a profitmaximizing output level that is inefficiently low. Productive efficiency is when the firm produces where price = minimum ATC. Due to product differentiation, these firms produce at a lower quantity. Allocative efficiency is when the firm produces where P = MC. Due to the downward-sloping MR curve, price will be higher than MC.

PROBLEMS Suppose that a small town has seven burger shops whose respective shares of the local hamburger market are (as percentages of all hamburgers sold): 23 percent, 22 percent, 18 percent, 12 percent, 11 percent, 8 percent, and 6 percent. What is the four‐firm 1-273 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

concentration ratio of the hamburger industry in this town? What is the Herfindahl index for the hamburger industry in this town? If the top three sellers combined to form a single firm, what would happen to the four‐firm concentration ratio and to the Herfindahl index? LO12.1 Answers: The four-firm concentration ratio is 75 percent; the Herfindahl Index is 1,702 (= 529 + 484 + 324 +144 + 121 + 64 + 36); The new four-firm concentration ratio would be 94 percent; the new Herfindahl Index would be 4,334 = (3,969 + 144 +121 + 64 + 36).

Feedback: The four-firm concentration ratio is found by adding together the percentage of sales of the top four firms in the industry. For the values above, the four-firm concentration ratio equals 75 percent (= 23 percent + 22 percent + 18 percent + 12 percent).

The Herfindahl index is found by squaring the percentages for all of the firms in the industry (not the decimal form) and then adding these values together. For the values above, the Herfindahl index equals 1,702 (= 232 + 222 +182 +122 + 112 + 82 + 62 = 529 + 484 + 324 + 144 + 121 + 64 + 36).

If the top three sellers combine to form a single firm, this combined firm will control 63 percent of the market (= 23 percent + 22 percent + 18 percent). Thus, we now have five firms in the industry whose respective shares of the local hamburger market are 63 percent, 12 percent, 11 percent, 8 percent, and 6 percent.

The new four-firm concentration ratio is 94 percent (= 63 percent + 12 percent + 11 percent + 8 percent). The new Herfindahl index is 4,334 (= 632 + 122 + 112 + 82 + 62 = 3,969 + 144 + 121 + 64 + 36).

254. Suppose that the most popular car dealer in your area sells 10 percent of all vehicles. If all other car dealers sell either the same number of vehicles or fewer, what is the largest value that the Herfindahl index could possibly take for car dealers in your area? In that same situation, what would the four‐firm concentration ratio be? L O12.1 Answers: To maximize the Herfindahl Index means to have an industry with as much concentration as possible. That calls for firms that are as big as possible. With the largest firm controlling only 10 percent, the way to have the rest of the industry be as concentrated as possible would be for there to be 9 other firms, each also controlled 10 percent of the market (for a total of 10 firms each controlling 10 percent). In that situation, the Herfindahl index would be 1,000 (= 10 × (102)) and the four-firm concentration ratio would be 40 percent (= 4 × 10 percent).

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Feedback: Given that the maximum number of firms in the market equals 10, at a maximum concentration share of 10 percent for all firms, the largest Herfindahl index possible is 1,000 [=10 (number of firms) × 102 (percentage squared for each firm)].

This logic also implies that the four-firm concentration ratio (largest possible) is 40 percent [= 4 (largest four firms, which could be any of the ten) × 10 percent (share of the market)].

255. Suppose that a monopolistically competitive restaurant is currently serving 230 meals per day (the output where MR = MC). At that output level, ATC per meal is $10 and consumers are willing to pay $12 per meal. What is the firm‘s profit or loss?

Will there be entry or exit? Will this restaurant‘s demand curve shift left or right? In long‐run equilibrium, suppose that this restaurant charges $11 per meal for 180 meals and that the marginal cost of the 180th meal is $8. What is the firm‘s profit? Suppose that the allocatively efficient output level in long-run equilibrium is 200 meals. Is the deadweight loss greater than or less than $60? Explain. LO12.3 Answers: The firm will earn a profit of $460 [= ($12 − $10)*230]; there will be entry, shifting the firm’s individual demand curve to the left; In long-run equilibrium, this firm will be earning zero profit so the information about what the firm is charging and what the MC is for the 180th meal are irrelevant pieces of information for this particular question; The deadweight loss will be less than $60—students can see this by noting that $60 must be an upper bound because even if the $3 per unit difference between marginal benefit as given by the demand curve ($11) and marginal cost as given by the MC curve ($8) continued for all units between the 180th and the 200th, the deadweight loss would only amount to $60 (= $3 per unit times 20 units). But with MC rising for all of these units and the demand curve falling, the deadweight loss would have to be smaller.

Feedback: Since the restaurant‘s ATC per meal is $10 and the restaurant receives $12 per meal, the restaurant‘s profit per meal is $2 (= $12 − $10). Given that the restaurant sells 230 meals at this price, its profit is $460 (= $2 × 230).

Given that this restaurant is making an economic profit, there will be entry into this industry since other firms will try to capture some of this economic profit.

The entry of other firms will reduce demand for the restaurant, causing its demand schedule to shift to the left.

Now assume that in long‐run equilibrium this restaurant charges $11 per meal for 180 meals and that the marginal cost of the 180th meal is $8. Also assume that the allocatively efficient output level in long-run equilibrium is 200 meals. The economic profit in the long run is always zero in this type of market (monopolistic competition).

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The deadweight loss will be less than $60—students can see this by noting that $60 must be an upper bound because even if the $3 per-unit difference between marginal benefit as given by the demand curve ($11) and marginal cost as given by the MC curve ($8) continued for all units between the 180th and the 200th, the deadweight loss would only amount to $60 (= $3 per unit × 20 units). But with MC rising for all of these units and the marginal benefit (shown by the demand curve) is falling, the deadweight loss would have to be smaller.

Chapter 13 – Oligopoly and Strategic Behavior McConnell Brue Flynn 23e DISCUSSION QUESTIONS 256. Why do oligopolies exist? List five or six oligopolists whose products you own or regularly purchase. What distinguishes oligopoly from monopolistic competition?

LO13.1 Answer: Oligopolies exist for several reasons, the most common probably being economies of scale. If economies of scale are substantial, as they are in the automobile industry, for example, only very large firms can produce at minimum average cost. This makes it virtually impossible for new firms to enter the industry. A small firm could not produce at minimum cost and would soon be competed out of the business; yet to start at the required very large scale would take far more money than an unestablished firm is likely to be able to raise before proving it will be profitable. Other barriers to entry include ownership of patents by the oligopolists and, possibly, massive advertising that gives would-be newcomers no chance to establish a presence in the public‘s mind. Finally, there is the urge to merge. Mergers have the clear advantage of reducing competition— of giving the emerging oligopolists more monopoly power. Also, mergers may result in more economies of scale and thereby increase that barrier to new entry.

Oligopolies with which we deal include manufacturers of automobiles, ovens, refrigerators, personal computers, gasoline, and courier services.

Oligopoly is distinguished from monopolistic competition by being composed of few firms (not many); by being mutually interdependent with regard to price (instead of control within narrow limits); by having differentiated or homogeneous products (not all differentiated); and by having significant obstacles to entry (not easy entry). Both engage in much nonprice competition.

257. What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent?

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Answer: A four-firm concentration ratio of 60 percent means the largest four firms in the industry account for 60 percent of sales; a four-firm concentration ratio of 90 percent means the largest four firms account for 90 percent of sales.

258. Explain the general meaning of the following profit payoff matrix for oligopolists X and Y. All profit figures are in thousands. LO13.2

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kkkkkkkkkkk.

Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic industries. lllllllllll. Assuming no collusion between X and Y, what is the likely pricing outcome? mmmmmmmmmmm.

In view of your answer to part b, explain why price collusion is mutually profitable. Why might there be a temptation to cheat on the collusive agreement?

Answer: qqqqqq.

X and Y are interdependent because their profits depend not just on their own price, but also on the other firm‘s price. Note that Y‘s profits are in the lower corner and X‘s profits are in the upper corner. rrrrrr. Likely outcome: Both firms will set price at $35. If either charged $40, it would be concerned the other would undercut the price and its profit by charging $35. For example, if firm X chooses a price of $40 and firm Y chooses a price of $40, then firm X‘s profits are $57,000 and firm Y‘s profits are $60,000. However, if firm Y chooses to charge $35, it can increase its profit to $69,000. In effect, firm Y has an incentive to deviate from the price of $40. The same logic applies to firm X. If firm X deviates from the price of $40, it can increase profits to $59,000. The catch is that both firms recognize this incentive structure and realize that if they continue to charge $40 and the other firm deviates from this price, their profits will fall (If firm X continues to charge $40 and firm Y charges $35, rather than $40, to capture higher profits, then firm X‘s profits will fall to $50,000. If firm X also charged $35, its profits would be $55,000, which is better than $50,000). Thus, both firms charge a price $35: X‘s profit is $55,000; Y‘s, $58,000.

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ssssss. Through price collusion—agreeing to charge $40—each firm would achieve higher profits (X = $57,000; Y = $60,000).

But once both firms agree on $40, each sees it can increase its profit even more by secretly charging $35 while its rival charges $40, which was discussed above.

259. What assumptions about a rival‘s response to price changes underlie the kinkeddemand curve for oligopolists? Why is there a gap in the oligopolist‘s marginalrevenue curve? How does the kinked-demand curve explain price rigidity in oligopoly? LO13.3 Answer: Assumptions: (1) Rivals will match price cuts.: (2) Rivals will ignore price increases. The gap in the MR curve results from the abrupt change in the slope of the demand curve at the going price. Firms will not change their price because they fear that if they do their total revenue and profits will fall.

260. Why might price collusion occur in oligopolistic industries? Assess the economic desirability of collusive pricing. What are the main obstacles to collusion? Speculate as to why price leadership is legal in the United States, whereas price-fixing is not.

LO13.3 Answer: Price wars are a form of competition that can benefit the consumer but can be highly detrimental to producers. As a result, oligopolists are naturally drawn to the idea of price-fixing among themselves, i.e., colluding with regard to price. It is nice to know whether one‘s rivals will cut prices or quantity, so that a mutually satisfactory solution can be reached. It is also convenient to be able to agree on what price to set to bankrupt any would-be interloper in the industry.

From the viewpoint of society, collusive pricing is not economically desirable, due to its being higher than the price in a competitive market. From the oligopoly‘s viewpoint, it is highly desirable since, when entirely successful, it allows the oligopoly to set price and quantity as would a profit-maximizing monopolist.

The main obstacles to collusion are demand and cost differences (which result in different points of equality of MR and MC); the number of firms (the more firms, the lower the possibility of getting together and reaching sustainable agreements); cheating (it pays to cheat by selling more below the agreed-on price—provided the other colluders do not find out); recession (when demand slumps, the urge to shave prices—to cheat—becomes much greater); potential entry (the aboveequilibrium price that is the reason for collusion may entice new firms into this profitable industry—and it may be hard to get new entrants into the combine, quite apart from the unfortunate increase in supply they will cause); legal obstacles (for a century, antitrust laws have made collusion illegal).

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Price leadership is legal because although the firms may follow the dominant firm‘s price, they are not compelled to. Also, the tacit agreement on price does not include an agreement to control quantity and to divide up the market. Price-fixing is illegal in the United States because it destroys competition. This is what our antitrust laws protect against.

261. Why is there so much advertising in monopolistic competition and oligopoly?

How does such advertising help consumers and promote efficiency? How does advertising promote inefficiency? LO13.4 Answer: Two ways for monopolistically competitive firms to maintain economic profits are through product development and advertising. Also, advertising will increase the demand for the firm‘s product. The oligopolist would rather not compete on a basis of price. Oligopolists can increase their market share through advertising financed with economic profits from past advertising campaigns.

Advertising can operate as a barrier to entry.

Advertising provides information about new products and product improvements to the consumer. Advertising may result in an increase in competition by promoting new products and product improvements. It may also result in increased output for a firm, pushing it down its ATC curve and closer to productive efficiency (P = minimum ATC).

Advertising may result in manipulation and persuasion rather than information.

An increase in brand loyalty through advertising will increase the producer‘s monopoly power. Excessive advertising may create barriers to entry into the industry. When advertising either leads to increased monopoly power or is selfcanceling, economic inefficiency results.

262. ADVANCED ANALYSIS Construct a strategic form payoff matrix involving two firms and their decisions on high versus low advertising budgets and the effects of each on profits. Show a circumstance in which both firms select high advertising budgets even though both would be more profitable with low advertising budgets.

Why won‘t they unilaterally cut their advertising budgets? LO13.4 Answer: Consider the following example, where Firm B‘s profits are in the lower corner and Firm A‘s profits are in the upper corner:

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Profits from each advertising strategy appear in the cells above.

In the payoff matrix above, each firm can choose between a low and high advertising budget. If, for example, Firm A chooses a high budget and Firm B a low budget, Firm A‘s profit will be $120, and Firm B‘s only $60.

The payoff matrix suggests that both firms should have high advertising budgets, but if both choose to do so, they will both be worse off relative to if they both had low budgets. Neither firm will reduce its budget because if it does and its rival doesn‘t, the firm reducing will lose profits to the other firm. Unless they collude, the firms will both end up with large advertising budgets and reduced profits.

Also note that any values with the ordering above can serve as an answer to this question:

The restrictions are $X > $Q > $Z > $Y. 1-281 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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263. Is the game shown by Figure 13.1 a zero-sum game or is it a positive-sum game?

How can you tell? Are there dominant strategies in this game? If so, what are they?

Which cell represents a Nash equilibrium and why? Explain why it is so difficult for Uptown and RareAir to achieve and maintain a more favorable cell than the Nash equilibrium in this single-period pricing game. LO13.6

Answer: This is a positive-sum game since the sum of the payoffs for each firm is positive. Yes, the dominant strategy is for both firms to use a low-price strategy.

This strategy will provide the highest payoff regardless of what the other firm does. The Nash equilibrium is for both firms to play the low-price strategy (lowlow, cell D) since neither firm has an incentive to deviate from this strategy given the strategy of the competing firm.

The more favorable outcome would be for both firms to collude and use the highprice strategy. Both firms would earn a profit of $12 rather than $8 in this case.

The problem is that both firms have an incentive to deviate from this strategy given that the other firm is playing the high-price strategy. By pricing low, given the other firm is pricing high, profits increase to $15 (rather than $12 through cooperation).

264. Refer to the payoff matrix in discussion question 3. First, assume this is a onetime game. Explain how the $60/$57 outcome might be achieved through a credible threat. Next, assume this is a repeated game (rather than a one-time game) and that the interaction between the two firms occurs indefinitely. Why might collusion with a credible threat not be necessary to achieve the $60/$57 outcome? LO13.6

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Answer: Either firm could threaten to flood the market to induce the other firm to choose the $40 pricing strategy. This threat is likely to be credible since both firms benefit from also choosing the $35 pricing strategy once the other firm has already deviated from the agreed $40/$40 pricing strategy. In a repeated game setting, this threat may not be necessary since the present value of cooperation may exceed the one-time gains from deviating from the $40/$40 pricing strategy.

Thus, each firm may have incentive not to deviate from the $40/$40 strategy out of fear of lower profits in the future.

265. Refer to the payoff matrix below. LO13.6

Assuming this is a sequential game with no collusion, what is the outcome if Firm A moves first to build a new type of commercial aircraft? Explain why first-mover strategies in the real-world are only as good as the profit projections on which they 1-284 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

are based. How could a supposed ―win‖ from moving first turn out to be a big loss, while the ―loss‖ of being preempted turns out to be a blessing in disguise?

Answer: The dominant strategy for Firm B is to build. The payoff from this build strategy is greater than the alternative not to build, regardless of what Firm A does. Since Firm A will recognize this strategy, it will choose not to build, thus minimizing its losses. Thus, even as a first mover, Firm A will choose not to build.

A ‖win‖ for Firm B may not materialize if the projections about profits are incorrect. For example, if there is a global downturn that reduces the demand for aircraft and Firm B has already built the aircraft, then this may result in a loss for Firm B. 266. How do network effects give Internet firms a boost with respect to first mover advantages? When network effects are at play for an Internet firm, how does an increase in the number of people using its product shift its demand curve, all other things equal? LO13.6 Answer: An Internet firm whose product is subject to network effects will have a first-mover advantage over rival firms if it can attract a large number of users to its own product before rivals can attract substantial numbers of users to their alternatives. That is true because, with network effects, whichever firm‘s network becomes the largest will become the most valuable to potential customers and will therefore attract even more users. Thus, a head start in the number of users can snowball into market dominance and any firm that gets to start first will have an advantage over rivals, all other things equal. When network effects are at play, an increase in the number of people using a given product will shift the demand curve to the right (think of individual demand curves summing up horizontally) and also make the demand curve more inelastic (steeper) as the increasing size of the network makes the product more valuable to both current and potential users.

267. LAST WORD What is it about the credit card industry that allows its firms to not have to compete on price (the interest rate)? Who ultimately pays for credit card rewards? How do rewards payments affect industry profits?

Answer: The firms in the credit-card industry do not have to compete on price (interest rate) because the industry is a highly concentrated oligopoly industry with only a few major firms (rather than a purely competitive industry with many small firms, each of which is too small to have any control over price.) The cardholders who do not pay off their balances each month are the ones who ultimately pay for the rewards offered by credit card issuers. That is true because it is the 1-285 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

interest paid on credit card loans by people who do not pay off their balances each month that fund the reward programs offered by card-issuing banks. Rewards payments are, to card issuers, a cost of doing business. So, the more they spend on rewards, the lower their profits (since profits = revenues less costs).

REVIEW QUESTIONS Which of the following apply to oligopoly industries? Select one or more answers from the choices shown. LO13.1 A few large producers nnnnnnnnnnn.

Many small producers ooooooooooo.

Strategic behavior ppppppppppp.

Price taking Answer: A few large producers, Strategic behavior.

Oligopoly industries feature markets dominated by a few large producers that engage in strategic behavior. These firms may sell homogeneous or differentiated products. But because of their fewness, the producers in an oligopolistic industry are not price takers. Rather, each firm controls a large enough fraction of industry that it can influence its own price by how much it decides to produce.

That, though, implies that the firms in an oligopoly industry are involved in a strategic situation in which there is mutual interdependence. As an example, note that the decision by one firm to increase its own output would lower its own price and draw customers away from rival firms. But those rival firms are large enough to retaliate by increasing their own outputs and driving down their own prices in a bid to steal customers back. This interdependence implies that each firm must consider the possible reactions of its rivals to its own pricing, output, and advertising decisions.

268. Facepalm, Instarant, and Snaphat are rival firms in an oligopoly industry. If kinked-demand theory applies to these three firms, Facepalm‘s demand curve will be: LO3 more elastic above the current price than below it. less elastic above the current price than below it. of equal elasticity both above and below the current price. none of the above.

Answer: A. More elastic above the current price than below it.

If kinked demand theory applies to these three firms, Facepalm‘s demand curve will be more elastic above the current price than below it. This is true because of how the theory predicts firms to behave if Facepalm raises or lowers its prices. If it raises its prices, then they will not raise their prices. That will leave Facepalm charging a higher price than its rivals, which will lead many of its customers to switch to the rivals. Stated slightly differently, a price increase will lead to a large 1-286 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

change in quantity demanded as customers defect, which is the same thing as saying that a price increase will be met with elastic demand.

On the other hand, if Facepalm lowers its prices, its rivals will match that price decrease with decreases of their own. They will make those matching decreases because they do not want Facepalm to steal their customers by offering a lower price. Thus, a decrease in price will not lead to much of a change in Facepalm‘s quantity demanded – which is the same thing as saying that a price decrease will be met with inelastic demand.

Taking these two scenarios into account, we see that Facepalm‘s demand curve will be more elastic above the current price than below it. Geometrically, this implies a kinked-demand curve, with the flatter section above the current price and the steeper section below the current price.

269. Consider an oligopoly industry whose firms have identical demand and cost conditions. If the firms decide to collude, then they will want to collectively produce the amount of output that would be produced by: LO13.3 a monopolistic competitor. a pure competitor. a pure monopolist. none of the above.

Answer: C. A pure monopolist.

Each of these colluding oligopoly firms with identical demand and cost conditions will want to produce the same amount of output as if it were a pure monopolist.

That is because the monopoly output level would maximize each firm‘s profit.

What is more, the fact that the firms all face identical demand and cost conditions implies that they will all end up charging the same price and thereby not competing with each other. This is true because their identical demand and cost conditions imply that they will each be facing identical situations. Thus, they will each choose the same monopoly output and set the same monopoly price.

This is important to understand because it shows how much collusion depends upon firms having identical or highly similar demand and cost conditions. If, by contrast, firms had very different demand or cost conditions, then each firm‘s preferred monopoly output and price would vary depending on the specific demand and cost conditions that it itself is facing. As a result, firms will find it very hard to collude as it will no longer be the case that all firms want to set the exact same price. Instead, significant price competition is likely to break out after each firm attempts to set its own price.

270. In an oligopoly, each firm‘s share of the total market is typically determined by: LO13.4 scarcity and competition.

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qqqqqqqqqqq. kinked-demand curves and payoff matrices. rrrrrrrrrrr. homogeneous products and import competition. sssssssssss. product development and advertising.

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Answer: D. Product development and advertising.

In an oligopoly, each firm‘s share of the total market is typically determined by product and development and advertising. This is true because there is relatively little price competition in oligopoly industries. That leaves two major methods by which oligopoly firms can increase their share of the total market. The first is to develop new products that are more appealing than existing alternatives. The second is to use advertising to steal market share away from rival firms.

Oligopolistic firms often use both methods quite aggressively.

271. Some analysts consider oligopolies to be potentially less efficient than monopoly firms because at least monopoly firms tend to be regulated. Arguments in favor of a more benign view of oligopolies include: LO13.5 oligopolies are self-regulating. oligopolies can be kept in line by foreign competition. oligopolistic industries may promote technological progress. oligopolies may engage in limit pricing to keep out potential entrants.

Answer: Oligopolies are self-regulating.

Oligopolies are not self-regulating. They often attempt collusion in order to collectively earn the monopoly profit. On the other hand, to the extent that a domestic oligopoly industry faces substantial foreign competition, it will have to lower prices, increase output, and behave more efficiently from society‘s standpoint. Oligopolistic industries may also promote society‘s interests if they promote technological progress by funneling some of their economic profits back into R&D. And to the extent that oligopolies are worried about new entrants, they may engage in limit pricing, a policy that would reduce their prices and increase their output levels up toward socially efficient levels. Limit pricing, however, is illegal in many countries. This pricing strategy is used to eliminate competition within a market or prevent it from entering at all.

272. Collusive agreements can be established and maintained by: LO13.6 credible threats. ttttttttttt. one-time games. uuuuuuuuuuu. empty threats. vvvvvvvvvvv. first-mover advantage.

Answer: Credible threats.

Collusive agreements can be established and maintained by credible threats. This is true because credible threats that are made by a strong enforcer can help to prevent cheating and thereby maintain the group discipline required for collusion to succeed in driving up prices and reducing output.

273. True or false. Potential rivals may be more likely to collude if they view themselves as playing a repeated game rather than a one-time game. LO13.6 1-289 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: True.

Potential rivals may indeed be more likely to collude if they view themselves as playing a repeated game rather than a one-time game. This is true because repeated games allow firms to engage in reciprocity. In particular, the firms can take turns in doing nothing to interfere as the other firm pursues a highly profitable business venture such as launching a new product. Then, the next period, the firms switch roles, with the other firm now pursuing a highly profitable business venture while its rival does nothing to interfere. This sort of mutually beneficial alternation is only possible if the firms view themselves as playing a repeated game. Repeated games also allow for a firm to punish the other firm if they try to cheat in the game. This gives them more confidence that they will both follow through with the plan. If they think of themselves as playing a one-time game, then they will be less likely to collude as it is not possible to take turns and engage in reciprocity or to punish the other firm.

274. Property developers who build shopping malls like to have them ―anchored‖ with outlets of one or more famous national retail chains, like Target or Nordstrom.

Having such ―anchors‖ is obviously good for the mall developers because anchor stores bring a lot of foot traffic that can help generate sales for smaller stores that lack well-known national brands. But what‘s in it for the national retail chains? Why should they become ―anchors‖? Choose the best answer from the following list.

LO13.6 The anchor stores want to make a credible threat against the developer. wwwwwwwwwww.

The anchor stores may feel there is a first-mover advantage to becoming one of only a few anchor stores at a new mall. xxxxxxxxxxx.

The property developers are making empty threats to smaller stores. yyyyyyyyyyy.

The smaller stores face a negative-sum game.

Answer: The anchor stores may feel there is a first-mover advantage to becoming one of only a few anchor stores at a new mall.

The famous national retail chains know that there are only a limited number of good spots in new malls. So, to displace their rivals, they compete to get outlets placed into new malls that look to be successful.

PROBLEMS Consider a ―punishment‖ variation of the two-firm oligopoly situation shown in Figure 14.1. Suppose that if one firm sets a low price while the other sets a high price, then the firm setting the high price can fine the firm setting the low price. Suppose that whenever a fine is imposed, X dollars are taken from the low-price firm and given to the high-price firm. What is the smallest amount that the fine X can be such that both firms will want to always set the high price? LO13.6 1-290 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: $3 million and one cent (also accept $3 million as an answer here).

Feedback: Let‘s look at the following example. Consider a ―punishment‖ variation of the two-firm oligopoly situation shown in Figure 14.1 in the chapter (not in this appendix). Suppose that if one firm sets a low price while the other sets a high price, then the firm setting the high price can fine the firm setting the low price. Suppose that whenever a fine is imposed, X dollars is taken from the low-price firm and given to the high-price firm. What is the smallest amount that the fine X can be such that both firms will want to always set the high price?

From the above figure we can see if one firm deviates from the high price while the other maintains the high price the firm that deviates will earn an extra $3 million in profits (If the firm continued with the high price, it would earn $12 million and if the firm deviates, it will earn $15 million).

Given this potential for additional profit, the fine will need to be equal to or greater than this value. If the fine is set at $3 billion (plus one cent), it is in the firm‘s interest to maintain the high price because the fine (penalty) is greater than the gain.

275. Consider whether the promises and threats made toward each other by duopolists and oligopolists are always credible (believable). Look back at Figure 13.1. Imagine that the two firms will play this game twice in sequence and that each firm publicly claims the following policy: Each says that if both it and the other firm choose the high price in the first game, then it will also choose the high price in the second game (as a reward to the other firm for cooperating in the first game). LO13.6

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As a first step toward thinking about whether this policy is credible, consider the situation facing both firms in the second game. If each firm bases its decision on what to do in the second game entirely on the payouts facing the firms in the second game, which strategy will each firm choose in the second game? zzzzzzzzzzz.

Now move backward in time one step. Imagine that it is the start of the first game and each firm must decide what to do during the first game. Given your answer to part a, is the publicly stated policy credible? (Hint: No matter what happens in the first game, what will both firms do in the second game?) aaaaaaaaaaaa.

Given your answers to a and b, what strategy will each firm choose in the first game?

Answer: Each firm will choose the low-price strategy in the second game. tttttt. No. uuuuuu.

Each firm will choose the low-price strategy in the first game.

Feedback: Each firm will choose the low-price strategy in the second game. The reason is that there can be no penalty after this stage of the game because the game ends. Here the low-price strategy strictly dominates the high-price strategy for both firms. If Uptown Air plays low, it is better off than if it played high regardless of the choice made by RareAir. If RareAir plays high, then Uptown Air receives $15 million (which is greater than $12 million). If RareAir plays low, then Uptown Air receives $8 million (which is greater than $6 million).

The same logic applies to the choice made by RareAir. Thus, the choice is low-low at this stage of the game. vvvvvv.

The policy is not credible because firms will not follow through on promises to play the high-price strategy in the second game. Because both firms will base their decisions in the second game on the payouts in the 1-292 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

second game, they will always choose the low-price strategy in the second game. wwwwww. Each firm will choose the low-price strategy in the first game. This is because they know that nothing they do in the first game will affect the decisions that each of them will make to play the low-price strategy in the second game. Thus, they base their decision about the first game solely on the payouts from the first game. Doing so leads both firms to choose the low-price strategy in the first game.

276. ADVANCED ANALYSIS Suppose you are playing a game in which you and one other person each pick a number between 1 and 100, with the person closest to some randomly selected number between 1 and 100 winning the jackpot. (Ask your instructor to fund the jackpot.) Your opponent picks first. What number do you expect her to choose? Why? What number would you then pick? Why are the two numbers so close? How might this example relate to why Home Depot and Lowes, Walgreens and Rite Aid, McDonald‘s and Burger King, and other major pairs of rivals locate so close to each other in many well-defined geographical markets that are large enough for both firms to be profitable? LO13.6 Answer: As the first player it is optimal to choose 50. The reasoning is that your opponent could choose a number that significantly reduces your chances of winning if you didn‘t choose 50. For example, if you choose 1, the next player could choose 2. Thus, the only way you win is if the number 1 is drawn. How about picking 25? Your opponent would pick 26. Thus, you only have a 25 percent chance of winning. How about 49? The same logic applies.

The logic applies to companies that market similar (identical products). All of these companies choose a central location to maximize their share of costumers, assuming consumers base their behavior on distance alone. But even if this isn‘t a valid assumption, the theory still applies for a homogeneous population.

Assuming your opponent selected their location to optimize their exposure to consumers, by locating close by, you are putting yourself in the best position to gain their consumers.

Chapter 14 - Internet Oligopoly: Networks and Platforms McConnell Brue Flynn 23e DISCUSSION QUESTIONS 277. Why do the cost structures of many Internet businesses cause them to have continuously declining average total cost curves? LO14.1 Answer: Many Internet businesses have continuously declining average total cost curves because they have massive fixed costs that have to be paid no matter how 1-293 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

many subsequent customers they obtain. As more and more customers use their service, those fixed costs get distributed over more and more people, thereby reducing average total cost per user. Consequently, the average total cost curve of these sorts of firms is continuously declining as their massive upfront fixed costs are distributed over more and more users.

278. ―Because Internet companies have ATCs that fall toward zero as the number of users increases, the only thing they have to do to make a profit is attract a lot of users.‖ Respond to this assertion and explain your reasoning. LO14.1 Answer: This assertion is false because attracting more customers is not the same thing as getting more customers to pay for the product. It is relatively easy to attract a lot of customers if you do not charge for your product. However, if you decide to charge for your product, many of your customers may stop using it.

Therefore, while Internet companies that have an ATC that falls toward zero as the number of users increases will see ATC decline if they get a lot of users, those firms might still not be profitable because the only way to get so many users may be to charge them nothing. And if they are charging their users nothing, then they will have no revenues to offset (1) the massive fixed costs that they had to invest to get the business started and (2) the variable costs that need to be paid to keep it running.

279. How does selling advertising to raise revenue solve the challenge that Internet firms have with highly elastic demand curves for their main products? LO14.1 Answer: Selling advertising to raise revenue solves the challenge that Internet firms have with highly elastic demand curves for their main products because it allows them to generate revenue without having to charge for their main products.

These firms‘ ability to continue giving away their main products for free thanks to advertising revenue means that they do not have to worry about losing many or most of their customers, as they would if they had to charge a price higher than zero for their main products.

280. Compare making cars to making video game software. Does making each additional car require a substantial amount of marginal and variable costs? What costs are involved in making each additional copy of a piece of software that has already been on the market for several months? In which case are fixed costs going to be a larger part of total costs? In which case will ATC have a greater tendency to decline as output increases? LO14.1 Answer: Making an additional car requires substantial marginal and variable costs, whereas making an additional copy of a piece of software that has already been completed requires virtually no marginal or variable costs, because copying any type of software or information is practically free these days. Thus, fixed costs will be a larger portion of total costs in developing software than in producing automobiles. The fact that fixed costs are virtually all of total costs in 1-294 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

software development implies that ATC will have a greater tendency to decline as output increases in the case of software as opposed to automobiles.

281. Define the term network effect and give at least one example not found in the textbook of a network effect that exists on the Internet or that affects an Internet business. Also give at least one non-textbook example of a network effect that occurs offline, in real life. In both cases, explain how the network effects of your examples vary with the number of users. LO14.2 Answer: A network effect is observed when the value of a network increases or decreases with the number of people who use the network. For instance, the value of a telephone network increases as more people use the network. In contrast, the value of a road network may decline as more people drive their cars on it, depending on how congested it already is. Your own examples of network effects should show these sorts of tendencies toward positive or negative network effects.

282. What is a positive network effect, and how can positive network effects generate monopoly power? LO14.2 Answer: A positive network effect exists when the value of a network increases as more people use the network. Examples include social media apps like Instagram and communication apps like WhatsApp. The greater the total number of users on any such network, the more valuable it is to people using the network, all other things equal, because each person on the network will have more people to interact with. Positive network effects can generate monopoly power because people will naturally gravitate to the largest network; by virtue of its being the largest network, it will have the most users and thus the largest positive network effect to be enjoyed by both current and potential users. That competitive advantage for large networks will harm smaller competitors, and, all other things equal, will tend to make the industry a monopoly because potential customers will gravitate toward the largest network so as to enjoy the largest positive network effect.

283. A social network grows rapidly at first, causing positive network effects that, other things equal, shift demand to the right. But then negative network effects rapidly increase, pushing demand to the left, other things equal. Could the two effects cancel each other out? Could the network, as a result, reach an equilibrium number of users, all other things equal? Explain your reasoning. LO14.2 Answer: Yes, the two effects could cancel each other out if the network reaches a size where any further growth causes equal amounts of positive network effects (due to increasing the number of people you could potentially connect with) and negative network effects (due to the congestion caused by so many people being on the network). At that point, the network would reach an equilibrium number of users, all other things equal, because at that size there would be no particular reason for additional users to join or for existing users to leave. At that scale, the 1-295 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

size of the network will provide neither a net inducement for further increases in size nor a net inducement for reductions in size.

284. What is network pollution and how does it relate to the fact that certain dating sites and restaurant review sites try to use information about users‘ current location to show them only dating profiles and restaurant reviews of, respectively, people and restaurants that are located nearby? (Hint: What would happen to the value of such a recommendation network if its users were instead shown profiles or reviews from any distance away?) LO14.2 Answer: Network pollution is a negative network effect that occurs on social networks when the presence of too many connected users degrades the average quality of the information that users obtain from the network. If someone is looking for a place to eat lunch nearby, then local restaurants will be of interest, not restaurants located far away. Similarly, when looking for dates, many people only want to see profiles of people who live relatively close by. Thus, the realworld proximity of other network members is important in these situations.

Members who are located farther away are less valuable. As a result, being shown a lot of profiles of distant network members will feel like network pollution to users who want nearby options. To avoid that network pollution, many dating sites and restaurant review sites use users‘ current location to show them only dating profiles and restaurant reviews that are located nearby ―IRL‖ (in real life).

285. What are network switching costs and how do they relate to the possibility of technological lock-in? LO14.2 Answer: Network switching costs are the costs that users face if they want to switch from one network to another. Consider fax machines. From our current perspective, they are a primitive technology for sending documents electronically. But millions of businesses still use them because so many other businesses still use them. Suppose that you work in an industry where everyone is used to passing documents around by using fax machines. Imagine that you decide to get rid of your fax machine. By doing that, you put yourself at a huge disadvantage compared to your competitors who are still able to send documents via fax. One of the network switching costs in this situation would be the lost revenues and profits for any company that tries to be the first to stop using fax machines. Fear of these negative consequences has helped to lock in fax-machine technology. If every company in the world were starting from scratch today and deciding what technology to use to send documents around, nobody would say, ―Hey! Let's use fax machines!‖ But because fax machines are already in wide use, they have a huge positive network effect attached to them that makes it difficult for people to switch away from using them.

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286. What is a digital platform, and why might giving away its main product for free help a digital platform to maximize its overall profit? LO14.3 Answer: A digital platform is an Internet website or app that facilitates interactions between two or more distinct but interdependent sets of users. A digital platform may give its main product away for free in order to attract a large number of users, whose presence on the platform in large numbers will allow it to earn substantial revenues by charging advertisers to place ads on the platform and thereby gain access to the platform‘s many users.

287. Microsoft and Sony compete in the market for video game consoles (Xbox versus PlayStation). Why do these firms subsidize the prices of their respective video game consoles to the point of selling each console at a loss? Why do they give developers (for free) the programming tools necessary to make video games on their respective platforms? LO14.3 Answer: Microsoft and Sony subsidize the price of video game consoles in an effort to get as many gamers as possible to use their platform. This desire to gain as many users as possible makes Microsoft and Sony willing to sell their respective gaming consoles at a loss. Their thinking is that the losses that they accept when subsidizing consoles will be more than made up for if they attract a huge user base to their respective gaming networks (thereby allowing them to generate revenues from selling games on their respective platforms). For this same reason Microsoft and Sony give developers the programming tools necessary to make video games on their respective platforms. The platforms would be useless to gamers if they did not have a lot of games available to play on them, and Microsoft and Sony want developers to offer a wide variety of games that will attract a huge number of gamers. To encourage that proliferation of game options, Sony and Microsoft provide video game developers free programming tools so as to encourage as many game developers as possible to make games for their respective platforms.

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288. Why did many early analysts expect the Internet to become dominated by winnertake-all industries? What factors have made Internet industries more contestable than originally expected? LO14.4 Answer: Many early analysts expected the Internet to become dominated by winner-takeall monopolies because they overestimated the strength of positive network effects and underestimated the consumer benefits of product differentiation and multi-homing. If all networks are alike in every way except for size, then positive network effects will lead to a situation in which all consumers join the largest network, which will offer them the largest positive network effects. But networks differ not only in network size but also in user experience. YouTube and TikTok, for instance, are very different social media platforms for sharing videos. Thus, network effects are limited by consumers‘ preferences for things like interface design and whether the ―typical user‖ of one platform is different from the ―typical user‖ on other platforms. That said, the power of positive network effects should not be underestimated; it is the reason why these industries have become highly concentrated oligopolies with just a few dominant platforms competing against one another in each Internet category rather than highly competitive industries with hundreds or even thousands of small competitive firms in each category.

Another important factor that limits the power of positive network externalities to drive market concentration is consumers‘ ability to multi-home. For example, it is easy for people to be active simultaneously on two different social media networks. Thus, consumers are not forced to choose between them and may in fact decide that they prefer two, three, or even many options simultaneously rather than one option exclusively. This ability and desire to multi-home has also limited Internet industries‘ tendency to devolve into winner-take-all monopolies.

289. LAST WORD Why is Apple‘s insistence on processing in-app payments anticompetitive? What are the potential benefits of allowing alternative payment systems?

Answer: Apple‘s insistence on being the only company that can process in-app payments for apps bought through its App Store is anti-competitive because it makes Apple a monopoly provider of payment processing services for payments made within apps that have been purchased on Apple‘s App Store. As a monopoly (sole) provider of those services, Apple has no competition. The potential benefits of allowing alternative payment systems within Apple iOS apps is that payment processing fees will likely fall for the users of those apps.

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REVIEW QUESTIONS Which of the following are pricing strategies that Internet firms use to overcome highly elastic demand and the difficulty of raising their prices above zero? Select all that apply. LO14.1 bbbbbbbbbbbb. In-app purchases cccccccccccc.

Zero-MC pricing dddddddddddd. Price discrimination eeeeeeeeeeee.

Network effects ffffffffffff. Economies of scale Answer: a and c are the correct answers. In-app purchases allow an Internet firm to charge a zero price for its main product to all customers (thereby not causing customers with high price sensitivities to flee) while giving the firm the ability to charge a small fee to customers with lower price sensitivities (via in-app purchases). The goal is to generate enough revenue for the firm to be able to break even or make a profit. Price-discrimination strategies involve figuring out ways to charge a zero price to customers who are highly price sensitive while getting those who are less price sensitive to pay the firm, usually for premium services.

290.

If _ equals zero, then _ as long as fixed costs exceed zero. LO14.1 ATC; economies of scale gggggggggggg. ATC; MC hhhhhhhhhhhh. economies of scale; MC iiiiiiiiiiii. MC; ATC jjjjjjjjjjjj. P; economies of scale

will fall continuously

Answer: d is the correct answer. If fixed costs are greater than zero, then an increase in the number of users will lower AFC per user because AFC = FC divided by the number of users. At the same time, if MC = 0 , then there are no other costs to consider besides fixed costs and, as a result, ATC = AFC, meaning that ATC will also fall as the number of users increases.

291. Internet businesses often have: LO14.1 large variable costs and zero marginal costs. kkkkkkkkkkkk. large fixed costs and zero marginal costs. llllllllllll. large variable costs and large fixed costs. mmmmmmmmmmmm. large variable costs and zero fixed costs.

Answer: b is the correct answer. Internet firms have large fixed costs because software development is very expensive and software must be completed and working properly before anyone will want to use it. Once a piece of software is completed, it can be run over and over at marginal costs that are so low that they are essentially zero. Thus, Internet businesses often have large fixed costs and zero marginal costs.

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292. While the marginal cost of distributing a product like software over the Internet may be close to zero, the ATC per unit may be high due to: LO14.1 fixed costs being distributed over many users. nnnnnnnnnnnn. fixed costs being distributed over only a small number of users. oooooooooooo. free advertising. pppppppppppp. in-app purchases.

Answer: b is the correct answer. A product‘s total costs include its fixed costs. In the case of software, there are substantial software development costs. If a piece of software ends up being used by only a few users, then the average total cost per user will be very high because the fixed cost for software development will be spread over only a few users.

293.

The ability to spread the large development costs of complicated software projects over millions of users helps to generate _ . Choose the best answer.

LO14.1 economies of scale qqqqqqqqqqqq. network effects rrrrrrrrrrrr. duplication errors ssssssssssss. natural monopolies tttttttttttt. pure competition Answer: a is the correct answer. The Internet version of economies of scale is present when software development costs get spread over many users. Thanks to the Internet, millions of users can use the same piece of software simultaneously, implying that software development costs can be spread over millions of users, resulting in lower and lower costs per user as the number of users increases (which is the definition of the digital version of economies of scale).

294. A rural cell phone network that crashes when 200,000 people show up for a popup concert is an example of: LO14.2 network pollution. uuuuuuuuuuuu. network congestion. vvvvvvvvvvvv. economies of scale. wwwwwwwwwwww.

MC = 0.

Answer: b is the correct answer. Network congestion occurs when the capacity of a network is limited and its functionality decreases as additional users are added beyond a certain point. Here, a rural cell phone network gets overwhelmed when an unusually large number of people start using it at the same time. This overuse results in congestion on the network, in this case congestion that is so pronounced that the network crashes and becomes totally unusable.

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295.

Congress has passed a law that prohibits unsolicited telemarketing calls to cell phones. This law is intended to reduce _ . Choose the best answer. LO14.2 monopoly power xxxxxxxxxxxx. positive network effects yyyyyyyyyyyy. network pollution zzzzzzzzzzzz. network congestion aaaaaaaaaaaaa. tipping points Answer: c is the correct answer. Cell phone users do not like unsolicited telemarketing calls because those calls lower the value of being connected to the cell phone network. Those calls are therefore examples of network pollution, which occurs when the average quality of the information that users obtain from a network degrades.

296.

An online industry with hundreds of millions of potential users consists of multiple firms that run networks that, unfortunately, subject users to substantial negative network effects after any of the networks gets more than a few thousand users. Such an industry would most likely be populated by _ . Choose the best answer. LO14.2 many small firms bbbbbbbbbbbbb. one monopoly firm ccccccccccccc. a few oligopoly firms ddddddddddddd. foreign firms Answer: a is the correct answer because the negative network effects that kick in after a few thousand users will limit each firm in the industry to a few thousand users because additional potential users will prefer to join smaller networks (that don‘t yet have a few thousand users) so as to avoid the network congestion present in networks that already have a few thousand users.

297. Which of the following can help to offset the market power that can be generated by positive network effects? Select all that apply. LO14.2 Oligopoly power eeeeeeeeeeeee. Product differentiation fffffffffffff.

Monopoly power ggggggggggggg. Multi-homing hhhhhhhhhhhhh. Pure competition Answer: b and d are the correct answers. Product differentiation makes one network different from another and gives users a reason (besides the total number of users) to prefer one network over another. Multi-homing offsets the market power that can be generated by positive network effects by allowing people to be 1-301 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

members of multiple networks. As a result, they feel less pressure to join a particular network just because a lot of other people are already using it.

298. When only 10 percent of your friends were on Snapchat, you didn‘t see much point in joining. But when the percentage rose to 40, you changed your mind. Here, 40 percent is an example of: LO14.2 network switching costs. iiiiiiiiiiiii. technological lock-in. jjjjjjjjjjjjj. negative network externalities. kkkkkkkkkkkkk. a tipping point.

Answer: d is the correct answer. A tipping point is the point at which a network has become large enough that the positive network effects that have accumulated up to that point in time (due to the increasing size of the network) are large enough that many people who previously did not anticipate enough of a net benefit to compel them to join the network suddenly change their minds.

299. Which of the following firms could most easily switch all of its employees over from Microsoft Office to Google Workspace, assuming that all of the firms are equally interested in doing so? LO14.2 A firm with 78,324 employees lllllllllllll. A firm with 742,027 employees mmmmmmmmmmmmm. A firm with 72 employees nnnnnnnnnnnnn. A firm with 7 employees Answer: d is the correct answer: a firm with 7 employees. The firm with the fewest employees will have the fewest problems with technological lock-in because it will have the smallest network switching costs, all other things equal.

300. An increase in the number of developers making apps for the Android mobile platform causes more smartphone users to use Android phones, which increases the demand for Android apps. This is an example of: LO14.3 a congestion effect. ooooooooooooo. a direct network effect. ppppppppppppp. consumer surplus. qqqqqqqqqqqqq. an indirect network effect.

Answer: d is the correct answer: an indirect network effect. An indirect network effect occurs when an increase in the size of one network connected to a platform (here, the network of software developers making apps for the Android platform) indirectly benefits the members of that network by increasing the size of another network connected to the platform (here, users of Android apps).

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301. Governments that are considering regulations on digital businesses are often confronted with high _ on the one hand and low _ other. LO14.4 product prices; industry concentration rrrrrrrrrrrrr. industry concentration; multi-homing sssssssssssss. multi-homing; product differentiation ttttttttttttt. industry concentration; product prices uuuuuuuuuuuuu. multi-homing; industry concentration

on the

Answer: d is the correct answer: industry concentration; product prices. For traditional, non-digital products, it is typically the case that high industry concentration (such as with oligopoly or monopoly industries) is associated with high prices as the firms in highly concentrated industries use their market power to raise their selling prices above the marginal cost of production (which is the level at which perfectly competitive firms set their prices). By contrast, digital firms very often set the prices of their main products at or near zero even when they have significant market power.

PROBLEMS Moore‘s Law states that the maximum speed at which computer chips can process information doubles approximately every 2 years. If that relationship continues to hold true in the future, how much faster will computer chips be in 12 years? (Hint: You may want to think of this problem in terms of exponential notation, such as 2x.)

LO14.1 Answer: 64. In 12 years, there is enough time for 6 doublings due to the fact that each doubling in speed takes 2 years. In exponential math notation, 26 = 64. You can also obtain the correct answer by imagining that today‘s speed is equal to 1.

Two years from now, that speed will double to 2 (because 1 × 2 = 2). Then two years after that, there will be another doubling, to 4 (because 2 × 2 = 4). Then two years after that, there will be another doubling, to 8. Note that so far, six years have elapsed and the speed has increased from 1 to 8. If you do three more doublings (of two years each for the remaining six years), then you will see that the speed increases to 16, 32, and then 64.

302. The New York Times newspaper uses a metered subscription model in which anyone can look at up to 20 articles per month for free online but then must pay for a monthly subscription to read additional articles. In 2020, The New York Times had 130 million unique online readers per month but only 5 million digital subscribers.

What percentage of The New York Times‘ online readership is a subscriber? What does this suggest about the elasticity of demand for the newspaper‘s product? LO14.1 Answer: Only 3.8 percent (= 5 million divided by 130 million) of The New York Times readership are subscribers. This suggests that the elasticity of demand for 1-303 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the newspaper‘s product is quite high, meaning that a 1 percent increase in its price causes a much greater than 1 percent decrease in the number of users of the product.

303. Suppose that Instagram has a fixed cost of $1,200,000,000 and a variable cost that is constant at $0.02 per user. (Hint: In what follows, remember that a million is a 1 followed by six zeros and that a billion is a 1 followed by nine zeros. Also recall that ATC = AFC + AVC and that MC is the marginal change in ATC when you add an additional user.) LO14.1

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What is Instagram‘s marginal cost per user? vvvvvvvvvvvvv. What is Instagram‘s ATC for 1,000 users? wwwwwwwwwwwww. What is Instagram‘s ATC for 1 million users? xxxxxxxxxxxxx. What is Instagram‘s ATC for 1 billion users? yyyyyyyyyyyyy. If Instagram has 1 billion users, how much revenue per user would it have to collect in order to break even?

Answer: xxxxxx.

Instagram‘s marginal cost per user is $0.02 because each additional user brings with them a variable cost of $0.02 per user. yyyyyy.

Instagram‘s ATC for 1,000 users is $1,200,000.02 [ = ($1,200,000,000 of fixed cost) + ($0.02 per user * 1,000 users‘ worth of variable costs)/1,000 users]. zzzzzz. Instagram‘s ATC for 1,000,000 users is $1,200.02 [ = ($1,200,000,000 of fixed cost) + ($0.02 per user * 1,000,000 users‘ worth of variable costs)/1,000,000 users]. aaaaaaa.

Instagram‘s ATC for 1,000,000,000 users is $1.22 [ = ($1,200,000,000 of fixed cost) + ($0.02 per user times 1,000,000,000 users‘ worth of variable costs)/1,000,000,000 users]. bbbbbbb.

If Instagram has one billion users, it will need to collect $1.22 in revenue per user to break even. It could, for example, obtain such revenue by selling advertising.

304. The nearby game theory payoff matrix illustrates the competitive situation between two rival online e-mail providers, Zmail and Gotmail. Each of these firms has two pricing strategies (P = 0 or P > 0) to choose from, and their respective payoffs depend not only on the pricing strategy that each of them sets for its own product but also on its competitor‘s pricing strategy. LO14.1 Does Zmail have a dominant strategy (that is, one that Zmail will always want to follow no matter what pricing strategy Gotmail chooses)? If so, what is it? zzzzzzzzzzzzz. Does Gotmail have a dominant strategy (that is, one that Gotmail will always want to follow no matter what pricing strategy Zmail chooses)? If so, what is it? aaaaaaaaaaaaaa. Does the game have a Nash equilibrium (that is, an outcome from which neither firm will want to deviate because each is playing its own dominant strategy)? If so, what cell is the outcome of that Nash equilibrium? bbbbbbbbbbbbbb. Based on your answers to parts a, b, and c, what price will each firm choose?

Answer: v. Yes, Zmail has a dominant strategy. No matter which strategy its rival chooses, Zmail will want to choose the pricing strategy P = 0. To understand why, start by looking at the first column, in which the rival, Gotmail, sets P = 0. In that case, if Zmail sets a price of P = 0, then its payout will be the $100 million shown in the yellow triangle in Cell A, whereas if it sets a price of P > 0 , its payout will be only the $10 million shown in the yellow triangle in Cell C. Thus, if the rival sets a price P = 0, Zmail is better off setting its own price to P = 0 because $ 100 million > $ 10 million . Next, look at the second 1-305 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

column, in which the rival, Gotmail, sets a price of P > 0. If Zmail sets its own price at P = 0 , it will obtain a payoff of $120 million, as shown in the yellow triangle in Cell B. But if it sets its own price at P > 0 , it will obtain a payoff of only $15 million, as shown by the yellow triangle in Cell D. Thus, if its rival sets a price of P > 0, Zmail‘s best option is to set a price of P = 0. Then, looking over the results for both columns, we see that no matter what the rival does (by setting either P = 0 or P > 0 ), Zmail‘s best option is always to set its own price at P = 0 , which implies that P = 0 is a dominant strategy, which by definition is a strategy that a player should pursue no matter what strategy (here, the pricing decision) its rival selects. w. Yes, Gotmail has a dominant strategy. No matter which strategy its rival chooses, Gotmail will want to choose the pricing strategy P = 0. To understand why, start by looking at the first row, in which the rival, Zmail, sets P = 0. In that case, if Gotmail sets a price of P = 0 , then its payout will be the $100 million shown in the green triangle in Cell A, whereas if it sets a price of P > 0 , its payout will be only the $10 million shown in the green triangle in Cell B. Thus, if its rival sets a price of P = 0 , Gotmail is better off setting its own price to P = 0 because $ 100 million > $ 10 million . Next, look at the second row, in which the rival, Zmail, sets a price of P > 0. If Gotmail sets its own price at P = 0 , it will obtain a payoff of $120 million, as shown in the green triangle in Cell C. But if it sets its own price at P > 0 , it will obtain a payoff of only $15 million, as shown by the green triangle in Cell D. Thus, if its rival sets a price of P > 0 , Gotmail‘s best option is to set price at P = 0.

Looking over the results for both rows, we see that no matter what the rival does (by setting either P = 0 or P > 0), Gotmail‘s best option is always to set its own price at P = 0, which implies that P = 0 is Gotmail‘s dominant strategy, which by definition is a strategy that a player should pursue no matter what strategy (here, the pricing decision) its rival chooses. x. Yes, this strategic interaction (or ―game‖) has a Nash equilibrium, which is for both firms to set their price equal to zero and thereby end up in Cell A, where each firm earns $100 million. That combination (of both firms choosing P = 0) is one from which neither will wish to deviate because, if it did, its payout would be lower. To see why, consider starting in Cell A, where both firms are using the pricing strategy P = 0. Then, for example, let Zmail switch to P > 0.

The firms would end up in Cell C, where Zmail‘s payout will be reduced to only $10 million. Clearly, that is a bad thing for Zmail, so it will not want to switch away from selecting P = 0 as its pricing strategy. The same is true of Gotmail, which will be worse off financially if it unilaterally switches to P > 0 while Zmail continues to set its price at P = 0. Because it is in each firm‘s best interest not to switch its pricing strategy, the outcome should always remain Cell A, which means that the game has a Nash equilibrium (that is, an outcome from which neither firm will want to deviate because each is playing its dominant strategy, which in this game is P = 0 for both firms).

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y. Based on the answers to parts a, b, and c, it is clear that each firm will want to set its price at P = 0 no matter what the other firm does.]

305. Metcalf‘s Law states that the value V of a network is ―proportional‖ to the square of the number, n, of network users. Thus, V = n2 . Using that formula, what is the value of a network of 2 nodes? Of 3 nodes? By how much does the value of a network increase when it goes from having 2 nodes to 3 nodes? Now calculate the value of a network of 8 nodes and then the value of a network of 9 nodes. By how much does the value of a network increase when it increases from 8 nodes to 9 nodes?

Is the marginal value of an additional node constant, or does it increase as the number of nodes increases? Explain. LO14.2 Answer: The value of a network of 2 nodes is 22 = 4. The value of a network of 3 nodes is 32 = 9. Thus, the value of a network increases by 5 = 9 − 4 when going from 2 nodes to 3 nodes.

The value of a network of 8 nodes is 82 = 64. The value of a network of 9 nodes is 92 = 81. Thus, the value of a network increases by 17 = 81 − 64 when going from 8 nodes to 9 nodes.

The marginal value of an additional node is not constant. Instead, the marginal value of an additional node is increasing. The larger the number of nodes, the more marginal (additional) value each successive node brings to the network. In algebraic terms, the marginal value of an additional node can be calculated by imagining a generic situation in which a network first has n nodes and then increases by one additional node, to n + 1 nodes. In growing from n to n + 1 nodes, the value of the network grows from n2 to (n + 1)2. That means that the marginal (additional) value of going from n nodes to n + 1 nodes can be expressed as (n + 1)2 − n 2 = (n2 + 2n + 1) − n2 = 2n + 1. Because the marginal value of an additional node is 2n + 1, it is clearly the case that as the number of nodes, n, increases, so does the value of an additional node = 2n + 1.

306. Consider the nearby payoff matrix, which shows the situation facing two friends, Jared and Amanda, as they each ponder what type of video game platform to purchase for their respective apartments. Their choices are Xbox and PlayStation, and each of them enjoys not only playing games by themselves but also playing them with each other over the Internet. However, the games on the two platforms are typically proprietary, meaning that if Jared and Amanda get different platforms, they may not be able to play games with each other over the Internet. Answer the following questions based on the payoffs in the payoff matrix. LO14.3

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If Jared has already selected an Xbox, would it be better for Amanda to select an Xbox or a PlayStation?

If Jared has already selected a PlayStation, would it be better for Amanda to select an Xbox or a PlayStation?

Now suppose that Amanda chooses first and decides to get an Xbox. Would it be better for Jared to select an Xbox or a PlayStation?

Suppose that Amanda again chooses first but decides to go with a PlayStation. Would it be better for Jared to select an Xbox or a PlayStation?

Looking at your answers to parts a through d, are both Jared and Amanda better off if they decide on the same platform?

Assuming that both Jared and Amanda choose the same platform, which platform would make both of them better off?

Suppose that Jared and Amanda have both already selected an Xbox. If it will cost them $250 each to switch to the PlayStation platform, would it be worth their while to do so? (Hint: Think through each person‘s decision individually before answering the question.)

Again suppose that Jared and Amanda have both already selected an Xbox. If it will cost them $350 each to switch to the PlayStation platform, would it be worth their while to do so? (Hint: Think through each person‘s decision individually before answering the question.)

Looking at your answers to parts g and h, does the size of the network switching cost affect whether or not there is technological lock-in around the Xbox platform that both players initially selected?

Answer: If Jared has already selected an Xbox, it will be better for Amanda (see the first row) to select an Xbox, too, because her payoff for selecting an Xbox (when Jared already has selected an Xbox) will be the $1,200 shown in the blue part of Cell A rather than the $500 she would get in the blue part of Cell B if she selected a PlayStation.

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If Jared has already selected a PlayStation, it will be better for Amanda (see the second row) to select a PlayStation, too, because her payoff for selecting a PlayStation (when Jared already has selected a PlayStation) will be the $1,500 shown in the blue part of Cell D rather than the $800 she would get in the blue part of Cell C if she selected an Xbox.

If Amanda chooses first and decides to get an Xbox, it will be better for Jared (see the first column) to select an Xbox, too, because his payoff for selecting an Xbox (when Amanda already has selected an Xbox) will be the $1,000 shown in the yellow part of Cell A rather than the $900 he would get in the yellow part of Cell C if he selected a PlayStation.

If Amanda chooses first and decides to get a PlayStation, it will be better for Jared (see the second column) to select a PlayStation, too, because his payoff for selecting a PlayStation (when Amanda already has selected a PlayStation) will be the $1,300 shown in the yellow part of Cell D rather than the $600 he would get in the yellow part of Cell B if he selected an Xbox.

Looking at the answers to parts a through d, both Jared and Amanda will indeed be better off if they decide on the same platform.

If Jared and Amanda both choose the same platform, they would both be better off choosing PlayStation rather than Xbox. This becomes obvious when we compare their respective payoffs in Cell A (where both choose Xbox) with those in Cell D (where both choose PlayStation). Consider the comparison for Jared. If both choose an Xbox, then Jared‘s payout will be the $1,000 shown in the yellow part of Cell A, while if both choose a PlayStation, Jared‘s payoff will be the $1,300 shown in the yellow part of Cell D. Because $1,300 is greater than $1,000, Jared will be better off if both players choose a PlayStation.

If Jared and Amanda have both already selected an Xbox, then yes, it will be worth it for each of them to switch to a PlayStation even if making the switch costs each of them $250. Consider Amanda‘s decision first. If she stays with an Xbox, she gets the $1,200 payoff shown in the blue part of Cell A. But if she switches to a PlayStation at the same time that Jared does, she gets the $1,500 payoff shown in the blue part of Cell D. Thus, if she switches at the same time Jared does, her payoff increases by $300 (= $1,500 − $1,200).

Because that increase in payoff of $300 is larger than the switching cost of $250, she will be better off by $50 if both she and Jared switch simultaneously so that they can move from Cell A to Cell D. Next, consider Jared‘s decision.

If he stays with an Xbox, he gets the $1,000 payoff shown in the yellow part of Cell A. But if he switches to a PlayStation at the same time that Amanda does, he will get the $1,300 payoff shown in the yellow part of Cell D. Thus, if he switches at the same time Amanda does, his payout increases by $300 (= $ 1,300 − $ 1,000). Because that increase in payoff of $300 is larger than the 1-309 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

switching cost of $250, he will be better off by $50 if both he and Amanda switch simultaneously so that they can move from Cell A to Cell D. If Jared and Amanda have both already selected an Xbox, then it is NOT worth it for each of them to switch to a PlayStation when the cost of making that switch is $350 each. Consider Amanda‘s decision first. If she stays with an Xbox, she gets the $1,200 payoff shown in the blue part of Cell A. But if she switches to a PlayStation at the same time that Jared does, she gets the $1,500 payout shown in the blue part of Cell D. Thus, if she switches at the same time Jared does, her payoff increases by $300 (= $1,500 − $ 1,200). Because that increase in payoff of $300 is less than the switching cost of $350, she will be worse off by $50 if both she and Jared switch simultaneously from Xbox to PlayStation. Thus, Amanda will not want to make the switch when it costs $350. Next, consider Jared‘s decision. If he stays with an Xbox, he gets the $1,000 payoff shown in the yellow part of Cell A. But if he switches to a PlayStation at the same time that Amanda does, he will get the $1,300 payoff shown in the yellow part of Cell D. Thus, if he switches at the same time Amanda does, his payoff increases by $300 (= $1,300 − $1,000). Because that increased payoff of $300 is less than the switching cost of $350, he will be worse off by $50 if both he and Amanda switch simultaneously to PlayStation. Thus, Jared will not want to make the switch when it costs $350.

Looking at the answers to parts g and h, it is clear that the size of the network switching cost does affect whether or not there is technological lock-in around the Xbox platform that both players initially selected. If the switching cost is less than $300 per person, both Amanda and Jared will want to make the switch. But if the switching cost is more than $300 per person, neither will want to make the switch. Thus, if the switching cost is less than $300 per person, there will not be technological lock-in around the Xbox platform, whereas if the switching cost exceeds $300 per person, there will be technological lock-in around the Xbox platform. (And just to cover all possible cases, note that if the switching cost is exactly $300 per person, then Amanda and Jared will both be indifferent between staying with an Xbox or switching to a PlayStation. In that case, there is no technological lock-in.)

Chapter 15 - Technology, R&D, and Efficiency McConnell Brue Flynn 23e DISCUSSION QUESTIONS 307. What is technological advance, broadly defined? How does technological advance enter into the definition of the very long run? Which of the following are examples of technological advance, and which are not: an improved production process; entry of a firm into a profitable purely competitive industry; the imitation of a new production process by another firm; an increase in a firm‘s advertising expenditures? LO15.1 1-310 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: Technological advance is broadly defined as new and better goods and services and new and better ways of producing or distributing them. There is a distinction between the long run and the very long run: In the long run, technology is constant but firms can change their plant sizes and are free to enter or exit industries. In contrast, the very long run is a period in which technology can change and in which firms can introduce entirely new products. (a) An improved production process; Yes (innovation) (b) Entry of a firm into a profitable purely competitive industry; No (c) The imitation of a new production process by another firm; Yes (Diffusion) (d) An increase in a firm‘s advertising expenditures; No 308. Contrast the older and the modern views of technological advance as they relate to the economy. What is the role of entrepreneurs and other innovators in technological advance? How does research by universities and government affect innovators and technological advance? Why do you think some university researchers are becoming more like entrepreneurs and less like ―pure scientists‖? LO15.2 Answer: The older view of technological advance was that it was external to the economy; a random outside force to which the economy adjusted. Scientific and technological advances were fortuitous and helpful but largely external to the market system. Most contemporary economists have a different view. They see capitalism itself as the driving force of technological advance. In this view, invention, innovation, and diffusion occur in response to incentives provided by the market. The motivation to seek new products and processes is driven by the expectation of new profit opportunities.

An entrepreneur is an initiator, innovator, and risk bearer—the catalyst who combines land, labor, and capital resources in new and unique ways to produce new goods and services. Historically, these were individuals. In today‘s more technologically complex economy, this role is just as likely to be carried out by entrepreneurial teams. Unlike entrepreneurs, other innovators do not bear personal financial risk. These people include key executives, scientists, and other salaried employees engaged in commercial R&D activities.

New scientific knowledge is highly important to technological advance, but scientific principles, as such, cannot be patented. For this reason, entrepreneurs actively study the scientific output of university and government laboratories to find discoveries with commercial applications, obtaining information without paying for its development. Although, firms increasingly help fund university research that relates to their products, scientists increasingly realize their work may have commercial value.

309. Consider the effect that corporate profit taxes have on investing. Look back at Figure 15.4. Suppose that the r line is the rate of return a firm earns before taxes. If 1-311 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

corporate profit taxes are imposed, the firm‘s after-tax returns will be lower (and the higher the tax rate, the lower the after-tax returns). If the firm‘s decisions about R&D spending are based on comparing after-tax returns with the interest-rate costs of funds, how will increased taxes on corporate profits affect R&D spending? How, if at all, does this effect modify your views on corporate profit taxes? Discuss. LO15.3

Answer: If corporate profit taxes are imposed on the firm, this will reduce the after-tax return at each level of investment. This will cause the expected-rate-of-return schedule (after-tax return) to shift left, reducing investment.

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For example, if the tax rate is 50 percent, the firm only keeps 50 percent of the before-tax return. In the diagram above, the equilibrium level of R&D expenditure (investment) is $60 million at an interest rate and before tax rate of return of 8 percent.

However, with a tax rate of 50 percent, the firm only keeps half of the 8 percent return, which equals 4 percent. Thus, this is no longer the equilibrium because the firm‘s after-tax return of 4 percent is less than the 8 percent interest rate. The firm will reduce investment until the after-tax rate of return equals the interest rate of 8 percent. This occurs at the investment level of $20 million. The before-tax-rate of return equals 16 percent and the after-tax rate of return equals 8 percent (which equals the interest rate).

In conclusion, the implementation (or increase) in the corporate profit tax will reduce R&D expenditure because the firm considers the after-tax return, not the before tax return, when undertaking investment projects since this is what determines the profitability. This will likely cause the student to modify their views about corporate profit taxes if they originally thought they should be higher. However, they may not change their beliefs if they are considering equality and distribution issues.

310. Answer the following lettered questions on the basis of the information in this table: LO15.3

cccccccccccccc. If the interest-rate cost of funds is 8 percent, what is this firm‘s optimal amount of R&D spending? dddddddddddddd. Explain why $20 million of R&D spending is not optimal. eeeeeeeeeeeeee. Why isn‘t $60 million optimal either?

Answer: ccccccc. $50 million, where the interest-rate cost of funds equals the expected rate of return.

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ddddddd.

At $20 million in R&D, the expected rate of return of 14 percent exceeds the interest-rate cost of funds of 8 percent, thus there would be an underallocation of R&D funds. eeeeeee.

At $60 million, the expected rate of return of 6 percent is less than the interest-rate cost of funds of 8 percent, thus there would be an overallocation of R&D funds.

311. Explain: ―The success of a new product depends not only on its marginal utility but also on its price.‖ LO15.4 Answer: A new product may have a high level of marginal utility per unit consumed. However, if this product also has a high price, the marginal utility per dollar may still be low. For example, assume that you are already consuming good A. The marginal utility of the last unit consumed is 6, and the price of the good is $2. The marginal utility per dollar for good A (last unit consumed) equals 3 (= 6/$2).

Compare this to the case where a new, similar product is introduced in which the marginal utility of the last unit consumed is still 6 but the price of the good is $3.

The marginal utility per dollar for the new, similar product equals 2 (= 6/$3). In this case, the new, similar product would be less appealing, reducing its success.

Individuals compare marginal utility per dollar—not the marginal utility alone— when making consumption choices. The same logic applies to the case where the price is low for the product and marginal utility is low as well.

312. Learning how to use software takes time. So, after customers have learned to use a particular software package, it is easier to sell them software upgrades than to convince them to switch to new software. What implications does this conclusion have for expected rates of return on R&D spending for software firms developing upgrades versus firms developing imitative products? LO15.5 Answer: Expenditures on R&D carry a great deal of risk. Upgrading an existing product is likely to be less risky than developing an imitated product. Consumers value their time as well as money and are likely to prefer products that are familiar. Imitating a successful product may save the cost of R&D for development, but there are significant protections that may end up costing the ―copycat‖ firm dearly. Patents, copyrights, and brand name recognition all contribute to give the original innovator a major marketing advantage.

313. Why might a firm making a large economic profit from its existing product employ a fast-second strategy? What risks does it run in pursuing this strategy? What incentives does a firm have to engage in R&D when rivals can imitate its new product? LO15.5 1-314 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Answer: A dominant firm that is making large profits from its existing products may let smaller firms in the industry incur the high costs of product innovation while it closely monitors their successes and failures. In using this ―fast, second strategy,‖ the dominant firm counts on its own product improvement abilities, marketing prowess, or economies of scale to prevail.

A firm that attempts to imitate the new products of rival firms may encounter a variety of roadblocks. Patent rights for a secret process may stop the effort cold or lead to costly lawsuits.

Developing new products can be very profitable, and there are several protections, and advantages to taking the lead including: patent protection, copyrights and trademarks; lasting brand name recognition; trade secrets; cost reductions from learning by doing; high economic profits during the lag time between a product‘s introduction and its imitation; and the possibility of lucrative buyout offers from larger firms‘.

314. Do you think the overall level of R&D would increase or decrease over the next 20 to 30 years if the lengths of new patents were extended from 20 years to, say, ―forever‖? What would happen if the duration were reduced from 20 years to, say, 3 years?

LO15.5 Answer: If patent rights were extended indefinitely, the motivation to spend on R&D could increase for two reasons. First, the extended patent rights would add to their potential value, and second, perpetual patent rights would provide an additional incentive to find a way around these rights. Firms would be motivated to seek other products and processes not covered by the endless patent restrictions.

If the restriction were reduced to a much shorter period of three years, the spending on R&D would be likely to decrease. The short period of protection would make it difficult to recover the costs of development.

315. Make a case that neither pure competition nor pure monopoly is conducive to a great deal of R&D spending and innovation. Why might oligopoly be more favorable to R&D spending and innovation than either pure competition or pure monopoly?

What is the inverted-U theory of R&D, and how does it relate to your answers to these questions? LO15.6 Answer: For a purely competitive firm, the expected rate of return on R&D may be low or even negative. Because of easy entry, its profit rewards from innovation 1-316 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

may quickly be competed away by existing or entering firms that also produce the new product or adopt the new technology. The small size of the firm would make it difficult to finance the R&D as well. The pure monopoly market structure may provide the least incentive to engage in R&D. Absolute barriers prevent competition. The only incentive for R&D expenditures would be defensive, to reduce the risk of some new product or process that could destroy the monopoly.

The oligopoly market structure has many characteristics that are conducive to technological advance. First, the large size enables them to finance the often very expensive R&D costs associated with major product or process innovation. The typical firm in oligopoly is likely to realize ongoing economic profits, which provides a ready source of funds. The existence of barriers to entry gives some assurance that any economic profits earned from innovation can be maintained.

The large volume of sales allows the firm to spread the cost of R&D over a great many units of output. The large size of the firms in oligopoly also makes it easier to absorb the inevitable losses from ―misses‖ while waiting for compensation from the ―hits.‖ The inverted-U theory suggests that R&D expenditures as a percentage of sales rise with industry concentration until the four-firm concentration ratio reaches about 50%. Further increases in industry concentrations are associated with lower relative R&D expenditures. The inverted-U theory reiterates the assessment made above regarding likely R&D spending and market structure.

316. LAST WORD What balance of incentives was Congress attempting to get right when it chose 20 years as the length of time that a patent would last? How have drug companies managed to extend the monopoly on selling a particular drug past the 20year duration of the patent on that drug? If drug companies can maintain highly lucrative monopolies on existing drugs indefinitely, do they have much of an incentive to invest in R&D to invent new drugs that might not even sell well?

Answer: By setting a terms of 20 years for the duration of a patent, Congress was trying to create a long enough time period for an inventor to be able to reap monopoly profits to make it worth people‘s while to invest in R&D and try to invent things that would qualify for patents—but at the same time, Congress wanted to limit the duration of monopoly power to just 20 years so that even firms that already held patents would want to invest in R&D in anticipation of their current patents (and the associated monopoly profits) running out after 20 years.

Drug companies have managed to extend the ―effective life‖ of a drug patent past 20 years by patenting everything from how the drug is manufactured to how it is delivered so that even when the original patent on the chemical formula of the drug expires, the manufacturer will be the only firm that can continue to produce 1-317 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

and sell the drug (thanks to all the newer patents that create a ―patent fortress‖ around the chemical.)

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Under the inverted-U theory of R&D, monopoly firms by definition have no rivals and no threat of losing their monopoly profits. Thus, they have no incentive to spend a lot of money on R&D to stay ahead of rivals (since they don‘t have any). Thus, in the case of drug companies that are able to maintain highly lucrative monopolies on existing drugs indefinitely through the use of ―patent fortresses,‖ we should not be surprised if they do not spend much of their monopoly profits on R&D. Why invest in R&D (which is risky and may not pay off) when you can simply continue to enjoy large monopoly profits from your existing drugs?

REVIEW QUESTIONS Listed below are several possible actions by firms. Write ―INV‖ beside those that reflect invention, ―INN‖ beside those that reflect innovation, and ―DIF‖ beside those that reflect diffusion. LO15.1 An auto manufacturer adds full self-driving as a standard feature in its luxury cars to keep pace with a rival firm whose luxury cars already have this feature. ffffffffffffff.

A video game production company pioneers the first fully immersive 3D metaverse music video channel. gggggggggggggg. A firm develops and patents a working model of a self-erasing whiteboard for classrooms. hhhhhhhhhhhhhh. A light-bulb firm is the first to produce and market super-efficient laser-based lighting. iiiiiiiiiiiiii. A rival toy maker introduces a new Stacie doll to compete with Mattel‘s Barbie doll.

Answer: DIF: Another firm was already using heated seats in its automobiles. fffffff. INN: A new way of using existing technology ggggggg.

INV: A new product hhhhhhh.

INN: A new way of using existing technology iiiiiii. DIF: Another firm was already producing a doll using a given technology.

317. A firm is considering three possible one-year investments, which we will name X, Y, and Z.  Investment X would cost $10 million now and would return $11 million next year, for a net gain of $1 million.  Investment Y would cost $100 million now and would return $105 million next year, for a net gain of $5 million.  Investment Z would cost $1 million now and would return $1.2 million next year, for a net gain of $200,000.

The firm currently has $150 million of cash on hand that it can loan out at 15 percent interest. Which of the three possible investments should it undertake? LO15.3 1-319 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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X only jjjjjjjjjjjjjj. Y only kkkkkkkkkkkkkk. Z only llllllllllllll. X and Y mmmmmmmmmmmmmm. nnnnnnnnnnnnnn. X, Y, and Z

X and Z

Answer: Z only This firm should only invest in Z. This is true because only investment Z has an expected rate of return that exceeds the rate that the firm could get by lending out its cash at 15 percent interest.

To see this, note that investment Z has an expected rate of return of 20 percent (= $200,000 net gain divided by $1 million initial investment). Because that rate of return exceeds the 15 percent that the firm could earn by lending its cash, the firm would be better off investing $1 million in investment Z than it would be if it lent out that money at 15 percent.

By contrast, the firm would be better off lending out cash than investing in either investment X or Y. That is because both of those investments have expected rates of return that are less than the 15 percent that the firm could earn lending out its cash.

318. An additional unit of Old Product X will bring Cindy an M U of 15 utils, an additional unit of New Product Y will bring Cindy an MU of 30 utils, and an additional unit of New Product Z will bring Cindy an MU of 40 utils. If a unit of Old Product X costs $10, a until of New Product Y costs $30, and a unit of New Product Z costs $20, which product will Cindy prefer to spend her money on? LO15.4 Old Product X oooooooooooooo. New Product Y pppppppppppppp. New Product Z qqqqqqqqqqqqqq. More information is required.

Answer: New Product Z Cindy will prefer to spend her money on New Product Z. Her preference is based on the fact that New Product Z has the highest M U per dollar of any of the three options. To see this, note that purchasing an additional unit of New Product Z costs $20 but brings with it a MU of 40 utils. Thus, the MU per dollar is 2 utils per dollar (= 40 utils divided by $20). By contrast, Old Product X only offers an MU per dollar of 1.5 (= 15 utils divided by $10) while New Product Y offers an MU per dollar of just 1 (= 30 utils divided by $30).

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319.

The inverted-U theory suggests that R&D expenditures as a percentage of sales _ with industry concentration after the four-firm concentration ratio exceeds about 50 percent. LO15.6 Rise Fall Fluctuate flat-line Answer: Fall.

The inverted-U theory suggests that R&D expenditures as a percentage of sales fall with industry concentration after the four-firm concentration ratio exceeds about 50 percent.

According to the theory, this decline is the result of the firms in highly concentrated industries losing their motivation to fund R&D activities. This happens because the more concentrated an oligopolistic industry becomes, the less likely there is to be robust price competition. In fact, it is likely that the firms will collude to restrict output and maintain a high monopoly price. If they do so, they will have little incentive to engage in R&D because they will already be making high monopoly profits.

320. Which statement about market structure and innovation is true? LO15.7 Innovation helps only dominant firms. rrrrrrrrrrrrrr.

Innovation keeps new firms from ever catching up with leading firms. ssssssssssssss.

Innovation often leads to productive and allocative efficiency. tttttttttttttt. Innovation always leads to entrenched monopoly power.

Answer: Innovation often leads to productive and allocative efficiency.

In general, technological advance enhances both productive and allocative efficiency. But in some situations, patents and the advantages of being first with an innovation can increase monopoly power.

PROBLEMS Suppose a firm expects that a $20 million expenditure on R&D in the current year will result in a new product that can be sold next year. Selling that product next year will increase the firm‘s revenue next year by $30 million and its costs next year by $29 million. LO15.3 What is the expected rate of return on this R&D expenditure? uuuuuuuuuuuuuu. Suppose the firm can get a bank loan at 6 percent interest to finance its $20 million R&D project. Will the firm undertake the project?

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vvvvvvvvvvvvvv. Now suppose the interest-rate cost of borrowing falls to 4 percent because the firm decides to use its retained earnings to finance the R&D. Will this lower interest rate change the firm‘s R&D decision?

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wwwwwwwwwwwwww. Now suppose that the firm has savings of $20 million— enough money to fund the R&D expenditure without borrowing. If the firm has the chance to invest this money either in the R&D project or in government bonds that pay 3.5 percent per year, which should it choose? xxxxxxxxxxxxxx. What option should the company choose if the government bonds pay 6.5 percent per year rather than 3.5 percent per year?

Answers: (a) 0.05; (b) No; (c) Yes; (d) Invest in R&D; (e) Invest in bonds.

Feedback: The expected rate of return equals the (expected) profit from the R&D project divided by the expenditure.

Expected rate of return = profit/expenditure = $1/$20 = 0.05, or 5 percent (= 0.05 × 100) jjjjjjj. The firm will not borrow at a rate greater than the expected rate of return.

Since the bank loan has a 6 percent rate of interest, which exceeds the expected rate of return, the firm will not undertake this project. kkkkkkk.

The firm will borrow at a rate less than the expected rate of return.

Since the bank loan now has a 4 percent rate of interest, which is less than the expected rate of return, the firm will undertake this project. lllllll. The firm will invest its savings where the return is the highest. Since government bonds pay 3.5 percent per year and the expected rate of return on the R&D project is 5 percent, the firm should invest in the R&D project. mmmmmmm.

If government bonds pay 6.5 percent per year and the expected rate of return on the R&D project is 5 percent, the firm should invest in government bonds (not undertake the project).

321. ADVANCED ANALYSIS A firm faces the following cost: total cost of capital = $1,000; price paid for labor = $12 per labor unit; and price paid for raw materials = $4 per raw-material unit. LO15.4 Suppose the firm can produce 5,000 units of output this year by combining its fixed capital with 100 units of labor and 450 units of raw materials. What are the total cost and average total cost of producing the 5,000 units of output? yyyyyyyyyyyyyy. Now assume the firm improves its production process so that it can produce 6,000 units of output this year by combining its fixed capital with 100 units of labor and 450 units of raw materials. What are the total cost and average total cost of producing the 6,000 units of output? zzzzzzzzzzzzzz. If units of output can always be sold for $1 each, then by how much does the firm‘s profit increase after it improves its production process?

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aaaaaaaaaaaaaaa. Suppose that implementing the improved production process would require a one-time-only cost of $1,100. If the firm only considers this year‘s profit, would the firm implement the improved production process? What if the firm considers its profit not just this year but in future years as well?

Answers: The TC = $4,000 so that the ATC = $0.80. nnnnnnn.

The TC is unchanged at $4,000, but ATC = $0.67. ooooooo.

Profits are $1,000 higher. ppppppp.

No; Yes. Feedback: Total cost equals the total cost of capital plus the total cost of labor (price per labor unit × units of labor) plus the total cost of raw materials (price per raw material unit × units of raw material). Total cost = $1,000 + $1,200 ($12 × 100) + $1,800 ($4 × 450) = $4,000 Average total cost equals the total cost divided by the number of units produced. Average total cost = $4,000/5,000 = $0.80 per unit qqqqqqq.

The total cost does not change after the improvement in the production process. Total cost = $1,000 + $1,200 ($12 × 100) + $1,800 ($4 × 450) = $4,000 However, since the firm can produce more units with the same amount of inputs, the average total cost will fall. Average total cost = $4,000/6,000 = $0.67 per unit rrrrrrr.

The firm‘s profit equals total revenue (price × units produced and sold) minus total cost.

Prior to the improvement of the production process: profit = $5,000 − $4,000 = $1,000 After the improvement of the production process: profit = $6,000 − $4,000 = $2,000 Thus, the change (increase) in profits after the improvement of the production process equals $1,000 (= $6,000 − $5,000). sssssss.If the firm only considers this year‘s profit, the firm would choose not to implement the improved production process. The firm will only increase profit by $1,000 for the year, which is less than the $1,100 one-time-only cost.

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If the firm considers its profit not just this year but in future years as well, it will implement the improved production process under any reasonable scenario. The firm will earn $1,000 for the life of the project (every year), and it will only have a one-time-only cost of $1,100. Even after two years, the profit generated will exceed the cost unless the discount rate (interest rate) is excessively high.

Chapter 16 - The Demand for Resources McConnell Brue Flynn 23e DISCUSSION QUESTIONS 322. What is the significance of resource pricing? Explain how the factors determining resource demand differ from those determining product demand. Explain the meaning and significance of the fact that the demand for a resource is a derived demand. Why do resource demand curves slope downward? LO16.1 Answer: All resources that enter into production are owned by someone, including the most important resource of all for most people, self-owned labor.

The most basic significance of resource pricing is that it largely determines people‘s incomes. Resource pricing allocates scarce resources among alternative uses. Firms take account of the prices of resources in deciding how best to attain least-cost production.

Resource pricing has a great deal to do with income inequality and the debate as to what government should or should not do to lessen this inequality. It is here that the factors that determine resource demand are most different from those that determine demand for products. Demand for products is a question of income and tastes. But resource demand is more passive in the sense that it is derived from the demand for the products the resource can produce. If a resource can‘t be used in production of a desired product, there will not be any demand for it. Additionally, resources are often less mobile than products, so their geographic location relative to demand for the output they produce may be an important factor determining demand for resources in particular geographic areas.

Resources, factors of production, are not hired or bought because their employer or buyer desires them for themselves. The demand for resources is entirely derived from what the firm believes the resources can produce. If there were no demand for output, there would be no demand for input.

The demand for a resource depends, then, on how productive it is in producing output and on the price of the output. The demand for a resource is downward sloping because of the diminishing marginal product of the resource (because of 1-326 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the law of diminishing returns) and, in imperfectly competitive markets, also because the greater the output, the lower its price.

323. In 2021, Zillow, an online real estate marketplace, announced that it would reduce employment by 2,000 workers. What does this decision reveal about how Zillow viewed its marginal revenue product (MRP) and marginal resource cost (MRC)? Why didn‘t Zillow reduce employment by more than 2,000 workers or by fewer than 2,000 workers? LO16.3

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Answer: Zillow‘s decision suggests that the MRC of those 2,000 workers was greater than the MRP. Zillow didn‘t reduce employment further because the MRP of the remaining workers exceeded the MRC. Reducing employment by less than 2,000 workers would have left Zillow with some employees for whom the MRC exceeded the MRP, reducing the company‘s profits.

324. What factors determine the elasticity of resource demand? What effect will each of the following have on the elasticity or the location of the demand for resource C, which is being used to produce commodity X? Where there is any uncertainty as to the outcome, specify the causes of that uncertainty. LO16.4 bbbbbbbbbbbbbbb.

An increase in the demand for product X. ccccccccccccccc. An increase in the price of substitute resource D. ddddddddddddddd.

An increase in the number of resources substitutable for C in producing X. eeeeeeeeeeeeeee. A technological improvement in the capital equipment with which resource C is combined. fffffffffffffff.

A fall in the price of complementary resource E. ggggggggggggggg.

A decline in the elasticity of demand for product X due to a decline in the competitiveness of product market X. Answer: Elasticity of demand for a resource is determined by: (1) ease of resource substitutability, (2) elasticity of product demand, and (3) ratio of resource costs to total costs. ttttttt. An increase in the demand for good X means more of resource C will be needed for production. This is an increase in the demand for resource C. uuuuuuu.

Uncertainty relative to the change in demand for resource C; answer depends on which is larger—the substitution effect or the output effect. vvvvvvv.

An increase in the elasticity of resource C. This is because as other substitutes become available, a price increase in C (for example) means the quantity changes more as the producer switches inputs. wwwwwww. An increase in the demand for resource C. This is because producers can now use C more efficiently, lowering the marginal cost of production. This implies producers will increase production, and thus increase their demand for inputs (like C). xxxxxxx.

An increase in the demand for resource C. Because the complementary input's price has fallen, demand for that complement will go up. This means more of resource C also makes the production more efficient (due to the nature of complements). yyyyyyy.

A decrease in the elasticity of resource C. A drop in the competitiveness in the market for good X means that the elasticity of demand for product X will drop, which correlates directly with the elasticity of its 1-328 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

inputs, including resource C. The change in elasticity for the output is essentially "passed through" the production function to its inputs.

325. In each of the following four cases, MRPL and MRPC refer to the marginal revenue products of labor and capital, respectively, and PL and PC refer to their prices.

Indicate whether each of the following is consistent with maximum profits for the firm. If not, state which resource(s) should be used in larger amounts and which resource(s) should be used in smaller amounts.

LO16.5 MRPL = $8; PL = $4; MRPC = $8; PC = $4. hhhhhhhhhhhhhhh.

MRPL = $10; PL = $12; MRPC = $14; PC = $9. iiiiiiiiiiiiiii. MRPL = $6; PL = $6; MRPC = $12; PC = $12. jjjjjjjjjjjjjjj. MRPL = $22; PL = $26; MRPC = $16; PC = $19.

Answer: To answer this question, use the profit-maximization rule: MRPL/PL = MRPC/PC = 1. If MRPL/PL = 1, then it is optimal; if the answer is less than 1, use less of labor; if the answer is greater than 1, use more labor. If MRPK/PK = 1, then it is optimal; if the answer is less than 1, use less of capital; if the answer is greater than 1, use more capital.

Use more of both: Labor: MRPL ÷ PL = $8 ÷ $4 = 2 (which is > 1). Thus, use more labor.

Capital: MRPC ÷ PC = $8 ÷ $4 = 2 (which is > 1). Thus, use more capital. zzzzzzz.

Use less labor and more capital: Labor: MRPL ÷ PL = $10 ÷ $12 = 0.83 (which is < 1). Thus, use less labor.

Capital: MRPC ÷ PC = $14 ÷ $9 = 1.56 (which is > 1). Thus, use more capital. aaaaaaaa.

Maximum profits obtained: Labor: MRPL ÷ PL = $6 ÷ $6 = 1 (which is optimal labor).

Capital: MRPC ÷ PC = $12 ÷ $12 = 1 (which is optimal capital). bbbbbbbb. Use less of both: Labor: MRPL ÷ PL = $22 ÷ $26 = 0.85 (which is < 1). Thus, use less labor.

Capital: MRPC ÷ PC = $16 ÷ $19 = 0.84 (which is < 1). Thus, use less capital.

326. Florida citrus growers say that the recent crackdown on illegal immigration is increasing the market wage rates necessary to get their oranges picked. Some are turning to $100,000 to $300,000 mechanical harvesters known as ―trunk, shake, and catch‖ pickers, which vigorously shake oranges from the trees. If widely adopted, what will be the effect on the demand for human orange pickers? What does that imply about the relative strengths of the substitution and output effects? LO16.5 1-329 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: The effect of the adoption of the mechanical pickers will be to decrease the demand for human pickers. If this occurs, the substitution effect will have been greater than the output effect.

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327. LAST WORD To save money, some fast food chains are now having their customers place their orders at computer kiosks. Will the kiosks necessarily reduce the total number of workers employed in the fast food industry?

Answer: Yes, ceteris paribus. Assuming demand is unchanged, replacing workers with kiosks is an attempt to set the ratio of the marginal product of capital to its price equal to the ratio of the marginal product of labor to its price.

Effectively, the kiosks (which are capital) offer a higher marginal product than labor does, and so the firm is able to more cheaply take orders using the kiosks than it would by paying workers.

In other words, before the kiosks were implemented, it must have been that MPL ÷ PL < MPC ÷ PC. To correct this imbalance, the company replaced its workers with capital. Less labor increases the MPL and more capital increases MPC. The replacement of workers by capital eventually stops with MPL ÷ PL = MPC ÷ PC. REVIEW QUESTIONS Pooja is a baker and runs a large cupcake shop. She has already hired 11 employees and is thinking of hiring a 12th. Pooja estimates that a 12th worker would cost her $100 per day in wages and benefits while increasing her total revenue from $2,600 per day to $2,750 per day. Should Pooja hire a 12th worker? Explain. LO16.2 Answer: Pooja should hire a 12th worker because the MRP exceeds the MRC for that 12th worker.

The MRP of a 12th worker is $150 per day: = Total revenue with the additional 12th worker − Total revenue with the 11th worker = $2,750 per day − $2,600 per day = $150.

The MRC of the 12th worker would be $100 per day. So, Pooja‘s profits would increase by $50 per day with the 12th worker: = MRP of the 12th worker − MRC of the 12th worker = $150 − $100 = $50 (since this number is positive, it indicates that the profits would increase).

Thus, Pooja should hire a 12th worker if she wants to increase her profits.

328. Complete the following labor demand table for a firm that is hiring labor competitively and selling its product in a competitive market. LO16.2 1-331 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

How many workers will the firm hire if the market wage rate is $27.95? $19.95?

Explain why the firm will not hire a larger or smaller number of units of labor at each of these wage rates. kkkkkkkkkkkkkkk.

Show this firm‘s labor demand curve in schedule form and graphically. lllllllllllllll. Now again determine the firm‘s demand curve for labor, assuming that it is selling in an imperfectly competitive market and that, although it can sell 17 units at $2.20 per unit, it must lower product price by 5 cents in order to sell the marginal product of each successive labor unit. Compare this demand curve with that derived in part b. Which curve is more elastic? Explain.

Answer:

Units of labor

Total product

Marginal product

Product price

Total revenue

Marginal revenue product

0 0 $2 $0 17 $34 1 17 2 34 14 28 2 31 2 62 12 24 3 43 2 86 10 20 4 53 2 106 7 14 5 60 2 120 5 10 6 65 2 130 The firm will hire two workers at $27.95 because the MRP of the first worker is $34 and the MRP of the second worker is $28, both exceeding the $27.95 wage. Four workers will be hired at $19.95 because workers 1 through 4 have MRPs exceeding the $19.95 wage. The fifth worker‘s MRP is only $14, so he or she will not be hired. The marginal revenue product curve for any resource is the demand curve for that resource because the firm equates resource price and MRP in determining its profit-maximizing level of resource employment.

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Thus, each point on the MRP curve indicates how many resource units the firm will hire at a specific resource price.

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cccccccc. table:

The demand schedule consists of the first and last columns of the

dddddddd.

New Table:

Units of labor

Total product

Marginal product

Product price

Total revenue

Marginal revenue product

0 0 $2.25 $0 17 $37.40 1 17 2.20 37.40 14 29.25 2 31 2.15 66.65 12 23.65 3 43 2.10 90.30 10 18.35 4 53 2.05 108.65 7 11.35 5 60 2.00 120.00 5 6.75 6 65 1.95 126.75 Unlike before, the price drops by $0.05 with each unit of labor used (from the same starting point of $2.20 when using 1 unit of labor). The total revenue earned is less than before (when labor is greater than 1), but the formula to find total revenue (TR = P × Q) is still the same. The marginal revenue product is also found the same way as before ((change in total revenue) ÷ (change in labor)), although the numbers are again different.

The new labor demand is less elastic. Here, MRP falls because of diminishing returns and because product price declines as output increases. A decrease in the wage rate will produce less of an increase in the quantity of labor demanded because the output from the added labor will reduce product price and thus MRP. 1-334 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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329. Alice runs a shoemaking factory that utilizes both labor and capital to make shoes.

Which of the following would shift the factory‘s demand for capital? You can select one or more answers from the choices shown. L O16.3 Many consumers decide to walk barefoot all the time. mmmmmmmmmmmmmmm.

New shoemaking machines are twice as efficient as older machines. nnnnnnnnnnnnnnn.

The wages that the factory has to pay its workers rise due to an economywide labor shortage.

Answer: All three of the choices offered in this question would in fact shift the shoemaking factory‘s demand for capital. That‘s because they are specific examples of the three general things that can shift a resource's demand curve: changes in product demand, changes in the productivity of the resource, and changes in the prices of other inputs. The decision by many consumers to walk barefoot reduces the demand for the factory‘s output. As a result, the factory‘s derived demand for capital also declines. The fact that new shoemaking machines are twice as efficient as older machines increases the factory‘s demand for capital.

This happens because the increased efficiency causes an increase in capital‘s MRP. If capital‘s MRC stays the same, this rightward shift in the factory‘s MRP curve will cause it to employ more shoemaking machines. Finally, the increase in wages caused by the labor shortage will also affect the factory‘s demand for capital. But this time we cannot tell without more information whether the increased price of labor will lead to an increase or a decrease in the demand for capital. That will depend on whether capital and labor are substitutes or complements in production. But either way, the increased price of labor will definitely cause some shift in the factory‘s demand for capital.

330. FreshLeaf is a commercial salad maker that produces ―salad in a bag‖ that is sold at many local supermarkets. Its customers like lettuce but don‘t care so much what type of lettuce is included in each bag of salad. Therefore, would you expect FreshLeaf‘s demand for iceberg lettuce to be elastic, inelastic, unit-elastic, or some combination of these elasticities? LO16.4 Answer: We would expect FreshLeaf‘s demand for iceberg lettuce to be highly elastic and therefore highly responsive to changes in price. That is because the relaxed preferences of FreshLeaf‘s customers allow it to easily substitute between different varieties of lettuce when the price of iceberg lettuce changes. As an example, consider what would happen if the price of iceberg lettuce fell.

FreshLeaf would save money and increase profits by substituting iceberg lettuce for other varieties whose prices had stayed the same. As a result, FreshLeaf‘s quantity demanded of iceberg lettuce will be highly sensitive to price—which is the same thing as saying that its demand for lettuce will be highly elastic.

331. Suppose the productivity of capital and labor are as shown in the table below. The output of these resources sells in a purely competitive market for $1 per unit. Both 1-336 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

capital and labor are hired under purely competitive conditions at $3 and $1, respectively. LO16.5

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What is the least-cost combination of labor and capital the firm should employ in producing 80 units of output? Explain. ooooooooooooooo.

What is the profit-maximizing combination of labor and capital the firm should use? Explain. What is the resulting level of output? What is the economic profit? Is this the least costly way of producing the profitmaximizing output?

Answer: To answer this question, we begin by finding the ratios of the marginal product of each input to their respective prices for the first unit of each input.

Capital (unit 1): 24   8 Labor (unit 1):11 1  11

Since the ratio is larger for labor, we employ the first unit of labor giving us 11 units of output.

The next step is to calculate the marginal product of labor to price ratio for the second unit of labor and compare this with the first unit of capital (which we did not select in the first step).

Capital (unit 1): 24  3  8 Labor (unit 2): 9 1  9

Since the ratio is once again larger for labor, we employ the second unit of labor giving us an additional 9 units of output and a total of 20 [=11 (for the first unit of labor) + 9 (for the second unit of labor)].

We continue the process comparing the third unit of labor with the first unit of capital.

Capital (unit 1): 24  3  8 Labor (unit 3) : 8 1  8

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Here, they are equal so we could choose either, or in this case both, to increase output. Since we now employ the first unit of capital, we add 24 units to our total and the third unit of labor adds 8. This gives is a total of 52 [= 20 (from above) + 24 + 8].

Since we are still not at 80 units of output, we continue on down the marginalproduct-of-labor and capital schedules choosing inputs based on the algorithm above.

We will end up employing 2 units of capital and 4 units of labor (the next step in the process above).

Capital (unit 2): 21  3  7 Labor (unit 4): 7 1  7

Total output is 80   52 (from above)  21 (unit 2 of capital)  7 (unit 4 of labor) 

Thus, the least-cost combination is found by equating the marginal product of each input to their respective prices. Or, employ the product that costs less per unit of output. eeeeeeee.

To determine the profit-maximizing combination of inputs, we use the same process above, except we now need to calculate total cost, total revenue, and profit.

The first step gave us 1 unit of labor and 0 units of capital with 11 units of output. Total revenue equals $11 and total cost equals $1, which gives us $10 in profit.

Step 2 gave us 2 units of labor and 0 units of capital with 20 units of output.

Total revenue equals $20 and total cost equals $2, which gives us $18 in profit.

Step 3 gave us 3 units of labor and 1 unit of capital with 52 units of output.

Total revenue equals $52 and total cost equals $6 [= $3 (capital) + $3 (3 units of labor)], which gives us $46 in profit.

Continuing on, Step 4 gives us 4 units of labor and 2 units of capital with 80 units of output. Total revenue equals $80 and total cost equals $10, which gives us $70 in profit.

This process will continue until we reach 7 units of labor and 7 units of capital with 142 units of output. Total revenue equals $142 and total cost equals $28, with a profit of $114. You can verify that profit falls adding one more unit of capital or labor.

A less time-intensive approach is to recognize that the marginal revenue 1-339 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

product (MRP) for labor and capital equal their respective marginal-product schedules, since the price of each unit of output is $1. Profit maximization occurs where the Marginal Resource Cost (MRC) equals Marginal Revenue Product (MRP). Since the MRC is $3 for capital and $1 for labor, equate these values with the MRP for capital and labor. This occurs at 7 units of capital (MRP = $3 = MRC) and 7 units of labor (MRP=$1=MRC). This rule is MRPL ÷ PL = MRPC ÷ PC =1.

Finally, since MPL ÷ PL = MPC ÷ PC for profit maximization the least-cost rule also applies.

332. A software company in Silicon Valley uses programmers (labor) and computers (capital) to produce apps for mobile devices. The firm estimates that when it comes to labor, MPL = 5 apps per month while PL = $1,000 per month. And when it comes to capital, MPC = 8 apps per month while PC = $1,000 per month. If the company wants to maximize its profits, it should: LO16.5 increase labor while decreasing capital.

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ppppppppppppppp. decrease labor while increasing capital. qqqqqqqqqqqqqqq. keep the current amounts of capital and labor just as they are. rrrrrrrrrrrrrrr. none of the above.

Answer: If this firm wants to maximize its profits, it should decrease labor while increasing capital. This is true because spending additional dollars on capital would yield a larger increase in output than would spending additional dollars on labor. To see why, let‘s first look at labor. The firm‘s estimates are that the MPL = 5 apps per month while PL = $1,000 per month. Those numbers imply that an extra (marginal) $1,000 per month spent hiring additional labor would yield an extra (marginal) 5 apps per month in output.

By comparison, the firm‘s estimates for capital are that the MPC = 8 apps per month while PC = $1,000 per month. So, an additional $1,000 spent on capital would yield an extra 8 apps per month in output.

If we now compare the number of extra apps the firm could get by spending on either labor or capital, we see that it should spend its money on capital rather than labor because an extra $1,000 spent on capital will yield 8 extra apps while an extra $1,000 spent on labor will yield only 5 extra apps. The best way for the firm to take advantage of this knowledge is by cutting spending on labor in order to increase spending on capital. That is because $1,000 transferred from labor to capital will result in a net increase of 3 apps (= 8 apps gained by spending an extra $1,000 on capital − 5 apps lost by spending $1,000 less on labor). More generally, the firm should continue to reallocate its spending from labor to capital until MPL ÷ PL = MPC ÷ PC because at that point there will be no further gains from reallocating spending.

PROBLEMS A delivery company is considering adding another vehicle to its delivery fleet, each vehicle is rented for $100 per day. Assume that the additional vehicle would be capable of delivering 1,500 packages per day and that each package that is delivered brings in 10 cents in revenue. Also assume that adding the delivery vehicle would not affect any other costs. LO16.2 What is the MRP? What is the MRC? Should the firm add this delivery vehicle? sssssssssssssss. Now suppose that the cost of renting a vehicle doubles to $200 per day. What are the MRP and MRC? Should the firm add a delivery vehicle under these circumstances? ttttttttttttttt. Next suppose that the cost of renting a vehicle falls back down to $100 per day but, due to extremely congested freeways, an additional vehicle would only be able to deliver 750 packages per day. What are the MRP and MRC in this situation? Would adding a vehicle under these circumstances increase the firm‘s profits?

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Answers: (a) The MRP = $150/1 since 1,500 packages at ten cents each will yield $150 per day in revenue. The MRC = $100 since renting the truck will add $100 per day to total costs. Since MRP > MRC, the firm should add this vehicle. (b) The MRP = $150; the MRC = $200; the firm should not add this vehicle because MRP < MRC. (c) The MRP = $75; the MRC = $100; the firm should not add a vehicle because MRP < MRC. Feedback: To find the marginal revenue product (MRP) of an additional truck, calculate the additional revenue this truck will generate for the company. Since the truck delivers 1,500 packages and each package generates ten cents in revenue, the truck generates $150 (= $0.10 × 1,500) in total revenue. Thus, the MRP of the truck is $150. The marginal resource cost is the cost of renting the truck for the day, which is $100. Given that the MRP = $150 and the MRC = $100 (MRP > MRC), you should add this delivery vehicle. ffffffff. Since the cost of renting the vehicle has doubled, the MRC = $200. The MRP has not changed and equals $150. The company should not add the vehicle (MRP < MRC). gggggggg.

Since the cost of renting the vehicle is $100 again, the MRC = $100. However, the truck only delivers 750 packages per day now and each package delivered still brings in ten cents in revenue. Thus, the truck generates $75 (= $0.10 × 750) in total revenue. Here the MRP = $75. This is less than the MRC, so adding the truck would reduce profits.

333. Suppose that marginal product tripled while product price fell by one-half in Table 16.1. What would be the new MRP values in Table 16.1? What would be the net impact on the location of the resource demand curve in Figure 16.1? LO16.2 Answer: MRP values equal: $21, $18, $15, $12, $9, $6, $3; resource demand schedule to shift to the right.

Feedback: Marginal product is the additional output from each additional unit of labor.

Total revenue equals output multiplied by product price. Marginal revenue product is the change in total revenue divided by the unit change in resource quantity.

New Table:

Units of Total Resource Product

Marginal Product

Product Price

Total Revenue

Marginal Revenue

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(Output) 0

0

1

21

2

(MP)

Product (MRP) $1

0

21

$1

$21

$21

39

18

$1

$39

$18

3

54

15

$1

$54

$15

4

66

12

$1

$66

$12

5

75

9

$1

$75

$9

6

81

6

$1

$81

$6

7

84

3

$1

$84

$3

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hhhhhhhh. Relative to the original resource demand schedule, the new demand schedule will lie to the right. That is, the scenario above will cause the resource demand schedule to shift to the right because the marginal revenue product is higher for each unit of the resource.

334. Suppose that a monopoly firm finds that its MR is $50 for the first unit sold each day, $49 for the second unit sold each day, $48 for the third unit sold each day, and so on. Further suppose that the first worker hired produces 5 units per day, the second 4 units per day, the third 3 units per day, and so on. LO16.3 What is the firm‘s MRP for each of the first five workers? uuuuuuuuuuuuuuu.

Suppose that the monopolist is subjected to rate regulation and the regulator stipulates that it must charge exactly $40 per unit for all units sold. At that price, what is the firm‘s MRP for each of the first five workers? vvvvvvvvvvvvvvv.

If the daily wage paid to workers is $170 per day, how many workers will the unregulated monopoly demand? How many will the regulated monopoly demand? Looking at those figures, will the regulated or the unregulated monopoly demand more workers at that wage? wwwwwwwwwwwwwww.

If the daily wage paid to workers falls to $77 per day, how many workers will the unregulated monopoly demand? How many will the regulated monopoly demand? Looking at those figures, will the regulated or the unregulated monopoly demand more workers at that wage? xxxxxxxxxxxxxxx.

Comparing your answers to parts c and d, does regulating a monopoly‘s output price always increase its demand for resources?

Answers: The answers for parts (a) and (b) are included in the following table.

(c) At a daily wage of $170, the unregulated firm will demand 2 workers while the regulated firm will demand 1 workers. So at that wage, the unregulated firm will demand more workers. (d) At a daily wage of $77, the unregulated firm would demand 3 workers while the regulated firm would demands 4 workers. So at that wage, the regulated firm will demand more workers (e) No; the effect depends on resource prices 1-344 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Feedback: a and b.

To find the marginal revenue product for the first unit of labor in the unregulated economy, we need to add up the marginal revenue for each sequential worker given that the first unit can be sold for $50, the second for $49, and so on.

Since the first worker can produce 5 units and each of these sequential units sell for $50, $49, $48, $47, and $46, the MRP for the first worker is $240 (= $50 + $49 + $48 + $47 + $46).

The second worker can produce 4 units and each of these sequential units sell for $45, $44, $43, and $42, the MRP for the first worker is $174 (= $45 + $44 + $43 + $42). The same procedure is applied to the next 3 workers, where the third worker produces 3 units, the fourth 2 units, and the fifth 1 unit. Be sure to reduce the price by $1 for each additional unit sold.

To find the marginal revenue product for the first unit of labor in the regulated economy, we just multiply the regulated price, $40, by the number of units this worker produces, which is 5. Thus, the MRP for this worker is $200 (=$40 × 5).

The second worker has an MRP = $160 (=$40 × 4), the third's MRP = $120 (= $40 × 3), and so on.

All the values are in the table above for the unregulated and regulated economies. iiiiiiii. Now assume the daily wage rate is $170. The firm will employ additional workers as long as the marginal revenue product (MRP) is greater than or equal to the marginal resource cost (MRC). In this case, the MRC is $170, the 1-346 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

wage rate. Based on this MRC, the unregulated firm will employ the first worker where the MRP = $240 and the second worker where MRP = $174.

This unregulated firm will not employ the third worker because the MRP = $120. The unregulated firm will demand 2 workers.

We can apply the same process to the regulated firm (price regulated at $40).

The regulated firm will employ the first worker where MRP = $200 but will not employ the second worker because MRP = $160. The regulated firm will demand 1 worker.

Thus, the unregulated firm will demand more workers. d and e. Now assume the daily wage rate is $77. Using the same logic applied in part c we see that the unregulated firm will employ the first 3 workers where MRP > MRC = $77. The regulated firm will employ the first 4 workers where MRP > MRC = $77. In this case the regulated firm will employ more workers. So, we can conclude that regulating a monopoly does not always increase the demand for resources. The direction will depend on the resource price.

335. Consider a small landscaping company run by Mr. Viemeister. He is considering increasing his firm‘s capacity. If he adds one more worker, the firm‘s total monthly revenue will increase from $50,000 to $58,000. If he adds one more tractor, monthly revenue will increase from $50,000 to $62,000. Additional workers each cost $4,000 per month while an additional tractor would also cost $4,000 per month. LO16.5 What is the marginal product of labor? The marginal product of capital? yyyyyyyyyyyyyyy.

What is the ratio of the marginal product of labor to the price of labor (MRPL ÷ PL)?

What is the ratio of the marginal product of capital to the price of capital (MRPC ÷ PC)? zzzzzzzzzzzzzzz. Is the firm using the least-costly combination of inputs? aaaaaaaaaaaaaaaa. Does adding an additional worker or adding an additional tractor yield a larger increase in total revenue for each dollar spent?

Answers: (a) The MRPL = $8,000. The MRPC = $12,000. (b) MRPL ÷ PL = $8,000/$4,000 = 2. MRPC ÷ PC = $12,000/$4,000 = 3. (c) No because MRPC ÷ PC > MRPL ÷ PL. (d) Because 3 > 2, total revenue is increased more by spending money on an additional tractor rather than an additional worker.

Feedback: The marginal (revenue) product of labor is the increase in total revenue generated by the additional worker MRPL=$8,000 (=$58,000 − $50,000). The marginal product of capital can be found the same way. The change in total revenue 1-347 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

generated by the additional tractor is $12,000 (=$62,000 − $50,000). So, we have: MRPL = $8,000 and MRPC = $12,000 jjjjjjjj. The ratio of the marginal product of labor to the price of labor is: MRPL  PL  $8, 000  $4, 000  2

The ratio of the marginal product of capital to the price of capital is: MRPC  PC  $12, 000  $4, 000  3

kkkkkkkk. Since MRPC ÷ PC = 3 > MRPL ÷ PL = 2, this is not the least-cost combination of inputs. llllllll. Because 3 > 2, total revenue is increased more by spending money on an additional tractor rather than an additional worker. Thus, the landscaping firm should invest in an additional tractor that will generate more revenue per dollar (compared to labor).

Chapter 17 - Wage Determination McConnell Brue Flynn 23e DISCUSSSION QUESTIONS 336. Explain why the general level of wages is high in the United States and other industrially advanced countries. What is the single most important factor underlying the long‐run increase in average real‐wage rates in the United States? LO17.1 Answer: The general level of wages is higher in the United States and other industrially advanced nations because of the high demand for labor in relation to supply. Labor productivity is high in the United States and other industrially advanced countries because: (1) capital per worker is very high; (2) natural resources are abundant relative to the size of the labor force particularly in the United States; (3) technology is advanced in the United States and other industrially advanced countries relative to much of the rest of the world; (4) labor quality is high because of health, vigor, training, and work attitudes. Other factors contributing to high American productivity are the efficiency and flexibility of American management; the business, social, and political environment that greatly emphasizes production and productivity; and the vast domestic market, which facilitates the gaining of economies of scale.

The most important single factor underlying the long-run increase in average real wage rates in the United States is the increase in output per worker, that is, in productivity.

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337. Why is a firm in a purely competitive labor market a wage taker? What would happen if it decided to pay less than the going market wage rate? LO17.2 Answer: A firm in a purely competitive labor market is a wage taker because there are a large number of firms wanting to buy the labor services of the workers in that market and a large number of workers with identical skills wanting to sell their labor services. As a result, the individual firm has no control over the price of labor. If a firm attempted to pay a wage below the going wage, no workers would offer their services to that firm.

338. Describe wage determination in a labor market in which workers are unorganized and many firms actively compete for the services of labor. Show this situation graphically, using W1 to indicate the equilibrium wage rate and Q1 to show the number of workers hired by the firms as a group. Show the labor supply curve of the individual firm, and compare it with that of the total market. Why the differences? In the diagram representing the firm, identify total revenue, total wage cost, and revenue available for the payment of nonlabor resources. LO17.2

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Answer: The green area below the wage rate of $25 is its total wage cost. The blue area above the wage line is its nonlabor cost, which includes a normal profit—that is, the firm‘s payments to the suppliers of land, capital, and entrepreneurship. The combined green and blue area therefore represents the firm's total cost. The labor market is made up of many firms desiring to purchase a particular labor service and of many workers with that labor service.

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The market demand curve is downward sloping because of diminishing returns and the market supply curve is upward sloping because a higher wage will be necessary to attract additional workers into the market. Whereas the individual firm‘s supply curve is perfectly elastic because it can hire any number of workers at the going wage, the market supply curve is upward sloping.

The total wage costs to the firm is the wage rate × the quantity of labor hired = $25 × 20 = $500 339. Suppose the formerly competing firms in question 3 form an employers‘ association that hires labor as a monopsonist would. Describe verbally the effect on wage rates and employment. Adjust the graph you drew for question 3, showing the monopsonistic wage rate and employment level as W2 and Q2, respectively. Using this monopsony model, explain why hospital administrators sometimes complain about a ―shortage‖ of nurses. How might such a shortage be corrected? LO17.3 Answer: The equilibrium wage in the monopsonistic market declines from the competitive market‘s Wl rate to W2. The employment level in this market will decline from Q1 to Q2. See graph below: (Wage falls from Wc to Wm and the employment level falls from Qc to Qm).

If there are only one or two hospitals in an area, there exists a monopsonistic market for nurses. Their wages would be less than those for nurses where there is competition among employers (numerous hospitals and/or clinics). Because hospitals prefer to hire more nurses at a wage Wm, they view the difference between Qc and Qm as a shortage. However, since their profits are maximized at Wc, they are unwilling to raise wages voluntarily. The hospital administrator might offer a higher wage, but this wage would not be profit maximizing.

Another solution would be for nurses to organize and demand higher wages. This 1-351 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

would allow nurses to earn wages closer to their MRP and as wages rise toward Wc, the shortage would disappear.

340. Assume a monopsonistic employer is paying a wage rate of Wm and hiring Qm workers, as indicated in Figure 17.8. Now suppose an industrial union is formed that forces the employer to accept a wage rate of Wc. Explain verbally and graphically why in this instance the higher wage rate will be accompanied by an increase in the number of workers hired. LO17.5

Answer: The union wage rate Wc becomes the firm‘s MRC, which would be shown as a horizontal line to the left of the labor supply curve. Each unit of labor now adds only its own wage rate to the firm‘s costs. The firm will employ Qc workers, the quantity of labor where MRP = MRC (= Wc). Qc is greater than the Qm workers it would employ if there were no union and if the employer did not have any monopsonistic power – that is, more workers are willing to offer their labor services when the wage Wc is greater than Wm. 341. Have you ever worked for the minimum wage? If so, for how long? Would you favor increasing the minimum wage by a dollar? By two dollars? By five dollars?

Explain your reasoning. LO17.6 Answer: Student answers will vary. Those students that have worked for minimum wage probably didn‘t stay at that job for long and would probably describe their performance and that of their co-workers as relatively unproductive (an absence of efficiency wages). Support for an increase will depend on factors such as their perception of how much employment would be lost versus the income gains of those retaining employment.

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342. ―Many of the lowest‐paid people in society—for example, short‐order cooks— also have relatively poor working conditions. Hence, the notion of compensating wage differentials is disproved.‖ Do you agree? Explain. LO17.7 Answer: Short-order cooks generally need few specific skills—that is, practically anyone is thought to be capable of flipping burgers. Since the supply of unskilled workers is high relative to the demand for them, their wages are low. In this case, the concept of compensating wage differentials is swamped by the excess supply of low-wage workers. Compensating wage differentials must be paid to compensate for nonmonetary differences in various jobs. Jobs with high risk of injury or death pay more than comparable, safer jobs. Jobs lacking employer-paid health insurance plans, pension plans, and vacation time pay more than comparable jobs that provide these ―fringe benefits.‖ 343. What is meant by investment in human capital? Use this concept to explain (a) wage differentials and (b) the long‐run rise of real-wage rates in the United States. L O17.7 Answer: Investment in human capital is educational activity that improves individual productivity. z. The concept of human capital investment explains wage differentials to some extent. There is a strong, positive correlation between time spent acquiring formal education and lifetime earnings. Investments in human capital, such as education and training, enable a worker to build specialized skills that have additional wage value in the labor market. Of course, it can be said that the brain surgeon who spent 20 years in training, starting in grade 1, had the qualities to succeed in the labor market without spending over 20 years in school. Though this counterargument has some merit, the point still is that this highly-skilled individual would never have become a brain surgeon without the over 20 years in school and might not have achieved the particular high income that goes with being a medical specialist. aa. The long-run rise in real wage rates in the United States is positively correlated to investment in human capital. Without the increase in education and training of the American labor force that has occurred over the years, productivity (output per person per hour) would still have risen because of the investment in real capital, improved technology, and our abundant natural resource base. But the real wage would undoubtedly now be very much lower because an unskilled labor force could not possibly have made efficient use of the material resources and the advancing technology of the economy.

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344. What is the principal‐agent problem? Have you ever worked in a setting where this problem has arisen? If so, do you think increased monitoring would have eliminated the problem? Why don‘t firms simply hire more supervisors to eliminate shirking?

LO17.8 Answer: Business owners who hire workers because they are needed to help produce the goods or services of the firm face the dilemma of the principal-agent problem. Workers are the agents; they are hired to promote the interests of the firm's owners (the principals). Owners and workers both have a common goal in the survival of the firm, but their interests are not identical. A principal-agent problem arises when those interests diverge. Workers may seek to increase their utility by shirking their responsibilities and providing less than the agreed-upon effort. Owners of firms have a profit incentive to reduce or eliminate shirking.

Hiring more supervisory personnel can be costly and there is no guarantee that it will eliminate the problem.

345. LAST WORD Speculate as to why we see unnecessary occupational licensing only in some industries but not others. Consider who gets the costs, who enjoys the benefits, and how hard it would be to organize opposition to unnecessary licensing in various industries.

Answer: Licensing regulation generally occurs with jobs where skilled training or degrees are required (lawyers), where the government is directly involved (local governments' taxi cab markets), where improper services could result in safety hazard (electricians or pilots), or where services are infrequently used, meaning customers have little time for reputation-building with the workers (plumbers).

REVIEW QUESTIONS Brenda owns a construction company that employs bricklayers and other skilled tradespeople. Her firm‘s MRP for bricklayers is $22.25 per hour for each of the first seven bricklayers, $18.50 for an eighth brick layer, and $17.75 for a ninth bricklayer.

Given that she is a price taker when hiring bricklayers, how many bricklayers will she hire if the market equilibrium wage for bricklayers is $18.00 per hour? LO17.2 Answer: Eight.

Firms that are price takers in a competitive labor market will hire all units of labor for which MRP exceeds the equilibrium wage. Thus, Brenda will hire exactly eight bricklayers because each of their MRPs exceeds the equilibrium wage of $18.00 per hour.

By contrast, she would not hire a ninth bricklayer because the ninth bricklayer‘s MRP of $17.75 per hour is less than the $18.00 per hour that she would have to pay him. Stated a bit less formally, she would not hire a ninth bricklayer because 1-354 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

doing so would lose her $0.25 per hour (= the $18.00 per hour cost of hiring the ninth bricklayer - the $17.75 per hour that his output would increase total revenues).

346.

Because a perfectly competitive employer‘s MRC curve is _ , it will hire _ workers than would a monopsony employer with the same MRP curve.

LO17.3 bbbbbbbbbbbbbbbb. upsloping; more. cccccccccccccccc. upsloping; fewer. dddddddddddddddd. flat; more. eeeeeeeeeeeeeeee. flat; fewer. ffffffffffffffff. downsloping; more. gggggggggggggggg. downsloping; fewer.

Answer: c. flat; more.

The wage that is paid to employees is determined for both perfectly competitive employers and monopsony employers by the intersection of MRC and MRP. The difference between the two types of employers is that monopsony employers have upsloping MRC curves whereas perfectly competitive employers have horizontal MRC curves.

This difference is due to the fact that perfectly competitive employers are able to hire as many workers as they please at the market equilibrium wage. By contrast, a monopsony employer faces the upsloping market supply curve for labor, which implies that the only way for the monopsony employer to increase the number of workers it employs is by raising wages.

The fact that it must raise wages to hire additional workers will make it less willing to hire additional workers than the perfectly competitive firm that can hire as many workers as it pleases at the fixed market equilibrium wage. This difference in MRCs will cause the monopsony employer to hire fewer workers than would a purely competitive firm with the same MRP curve.

347. True or False. When a labor market consists of a single monopsony buyer of labor interacting with a single monopoly seller of labor (such as a trade union), the resulting quantity of labor that is hired will always be inefficiently low. LO17.5 Answer: False.

This assertion is false because the interaction of a monopsony buyer and a monopoly seller may in fact lead to a negotiated wage that happens to be very close to the market equilibrium wage that would prevail if this were a perfectly competitive labor market. If that happens, the monopsony buyer will end up employing as many workers as would be hired in a competitive market, which would mean that this market between a monopoly seller and a monopsony buyer 1-355 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

would in this case end up delivering an efficient outcome with respect to the number of workers employed.

But be careful. There is no guarantee that the negotiated wage will be near the competitive level. If it ends up really low (as would be the preference of the monopsony buyer) or really high (as would be the preference of the monopoly seller), the number of workers employed will be significantly less than the efficient number that would be hired in a perfectly competitive labor market. For more, see Figure 17.8.

348. The market equilibrium wage is currently $12 per hour among hairdressers. At that wage, 17,323 hairdressers are currently employed in the state. The state legislature then sets a minimum wage of $11.50 per hour for hairdressers. If there are no changes to either the demand or supply for hairdressers when that minimum wage is imposed, the number of hairdressers employed in the state will be: LO17.6 fewer than 17,323. hhhhhhhhhhhhhhhh. still 17,323. iiiiiiiiiiiiiiii. more than 17,323. jjjjjjjjjjjjjjjj.

This is a bilateral monopsony so you can‘t tell.

Answer: b. Still 17,323.

The state‘s minimum wage of $11.50 per hour for hairdressers is below the current market equilibrium wage of $12 per hour. So it will affect neither the behavior of demanders or suppliers. Thus, the wage will continue to be determined by the intersection of the demand and supply curves, which implies that the market equilibrium will not change, and that the equilibrium wage and the equilibrium number of hairdressers employed will stay the same (at 17,323).

Another way to see this is to realize that minimum wages are price floors below which wages are not allowed to fall. But since the market equilibrium wage is already above the $11.50 per hour price floor that the state legislature is imposing, it will not be affected. Thus, the market equilibrium is unchanged and the same number of hairdressers are employed (17,323).

349. On average, 50-year-old workers are paid several times more than workers in their teens and twenties. Which of the following options is the most likely explanation for that huge difference in average earnings? LO17.7 Older workers have more human capital and higher MRPs. kkkkkkkkkkkkkkkk.

Employers engage in widespread discrimination against younger workers. llllllllllllllll.

Young people lack information about the existence of the highpaying jobs occupied by older workers. mmmmmmmmmmmmmmmm. Older workers receive compensating differences because they do jobs that are more risky than the jobs done by younger workers.

Answer: a. Older workers have more human capital and higher MRPs. 1-356 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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The best explanation is that older workers have more human capital and higher MRPs than younger workers.

To begin with, we know that this is in fact true. It takes many decades of training and job experience to become a top manager, a top surgeon, or a top engineer.

Only a very small fraction of young workers possess the skills and experience needed to succeed at those sorts of high-paying jobs.

There is also little evidence for widespread discrimination against younger workers. In fact, aged-based discrimination is illegal and punishable by large fines and even jail time.

Next, there is little evidence that young people lack information about the highpaying jobs occupied by older workers. The media regularly presents TV shows and movies with characters occupying such jobs and, in addition, a quick trip to any Internet job site will present younger people with employment ads for those sorts of positions.

Finally, there is little evidence that older workers are paid more because they do jobs that are more risky. On the contrary, young people do most of society‘s most dangerous jobs, including serving in the military, working as police officers and firefighters, and occupying other high-risk jobs in logging, construction, and sanitation. Very few of these jobs are done by 50-year-old workers.

350.

Manny owns a local fast-food franchise. Angel runs it for him. In this situation, Manny is the _ and Angel is the _ . LO17.8 free rider; entrepreneur nnnnnnnnnnnnnnnn. agent; principal oooooooooooooooo. principal; agent pppppppppppppppp. producer; consumer Answer: c. Principal; agent.

Manny and Angel are engaged in a principal-agent relationship. Manny is the principal in the relationship. As owner, he wishes to maximize profits and has hired Angel to run the business for him with that goal in mind. Angel is therefore the agent, the person whose job it is to execute on the goals set by the principal.

However, labor markets feature many examples of the principal-agent problem in which agents such as Angel pursue their own agendas to the detriment of the goals set out by their respective principals.

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351. A principal is worried that her agent may not do what she wants. As a solution, she should consider: LO17.8 commissions. qqqqqqqqqqqqqqqq. bonuses. rrrrrrrrrrrrrrrr. profit sharing. ssssssssssssssss. all of the answer choices are correct.

Answer: d. All of the answer choices are correct.

Commissions, bonuses, and profit sharing are all methods by which a principal can encourage her agent to act in a manner consistent with the principal‘s goal of profit maximization.

That is true because the size of an agent‘s commission, bonus, or profit share depends upon the size of his or her firm‘s profit. The larger the profit, the larger the agent‘s commission, bonus, or profit share. Thus, each of these three incentive plans helps to encourage agents to act in a manner consistent with the principal‘s goal of profit maximization.

PROBLEMS Firms compensate workers with ―benefits‖ in addition to wages and salaries. The most prominent benefit offered by many firms is health insurance. Suppose that in 2010, workers at one steel plant were paid $20 per hour and in addition received health benefits at the rate of $4 per hour. Also suppose that by 2020 workers at that plant were paid $21 per hour but received $9 in health insurance benefits. LO17.1 By what percentage did total compensation (wages plus benefits) change at this plant from 2010 to 2020? What was the approximate average annual percentage change in total compensation? tttttttttttttttt.

By what percentage did wages change at this plant from 2010 to 2020? What was the approximate average annual percentage change in wages? uuuuuuuuuuuuuuuu.

If workers value a dollar of health benefits as much as they value a dollar of wages, by what total percentage will they feel that their incomes have risen over this time period? What if they only consider wages when calculating their incomes? vvvvvvvvvvvvvvvv.

Is it possible for workers to feel as though their wages are stagnating even if total compensation is rising? Explain Answers: (a) Total compensation rose from $24 in 2010 to $30 in 2020. This is a 25% increase. Dividing that number by 10 we see that the average annual growth rate was approximately 2.5% per year. (b) Wages went up by 5% over this time period (= $1 ÷ $20). Dividing that number by the number of years (10), we see that the approximate average annual growth rate of total compensation was 0.5% per year. (c) If workers value health benefits as much as wages, then they will feel that their incomes have risen by 25%. If they exclude health benefits and focus only on wages, they will feel that their incomes went up 5%. (d) Yes, this is possible. See answers to part c.

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Feedback: mmmmmmmm.

Total compensation in 2010 was $24 (= $20 (wage rate) + $4 (health benefits)) and in 2020 total compensation is $30 (= $21 + $9).

The percentage increase in total compensation is ($30 − $24) ÷ $24 = $6 ÷ $24 = 0.25, or 25 percent. This implies the approximate average annual percentage change in total compensation is 0.25 ÷ 10 = 0.025, or 2.5 percent. nnnnnnnn. The percentage increase in wages alone is ($21 − $ 20) ÷ 20 = 1 ÷ 20 = 0.05, or 5 percent. This implies the approximate average annual percentage change in wages is 0.05 ÷ 10 = 0.005, or 0.5 percent. oooooooo.

If workers value a dollar of health benefits as much as they value a dollar of wages, they feel that their incomes have risen by 25 percent (part a) over this time period. If they only consider wages when calculating their incomes, they feel that their incomes have risen by 5 percent (part b) over this time period. pppppppp. Yes, if workers only look at their wages, they may feel as if their wages are stagnating.

352. Complete the following labor supply table for a firm hiring labor competitively: LO17.2

Show graphically the labor supply and marginal resource (labor) cost curves for this firm. Are the curves the same or different? If they are different, which one is higher? wwwwwwwwwwwwwwww.

Plot the labor demand data of review question 2 in Chapter 16 on the graph used in part a above. What are the equilibrium wage rate and level of employment?

Answers: (a) The supply curve and the MRC are the same.

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Units of labor 0 1 2 3 4 5 6

Wage Rate

Total labor cost

Marginal resource (labor) cost

$0 14 28 42 56 70 84

$14 14 14 14 14 14

$14 14 14 14 14 14 14

(b) Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labor.

Feedback: The labor supply curve and MRC curve coincide as a single horizontal line at the market wage rate of $14. The firm can employ as much labor as it wants, each unit costing $14. Wage rate = MRC because the wage rate is constant to the firm.

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Units of labor 0 1 2 3 4 5 6

Wage Rate

Total labor cost

$14 14 14 14 14 14 14

$0 14 28 42 56 70 84

Marginal resource (labor) cost $14 14 14 14 14 14

qqqqqqqq. Graph: Equilibrium is at the intersection of the MRP and MRC curves. Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labor. From the tables: MRP exceeds MRC for each of the first four units of labor; MRP = MRC for the fifth unit; MRP is less than MRC for the sixth unit.

353. Assume a firm is a monopsonist that can hire its first worker for $6 but must increase the wage rate by $3 to attract each successive worker (so that the second worker must be paid $9, the third $12, and so on). LO17.3 Draw the firm‘s labor supply and marginal resource cost curves. Are the curves the same or different? If they are different, which one is higher? xxxxxxxxxxxxxxxx.

On the same graph, plot the labor demand data of review question 2 in Chapter 16. What are the equilibrium wage rate and level of employment? yyyyyyyyyyyyyyyy.

Compare these answers with those you found in problem 2.

By how much does the monopsonist reduce wages below the competitive wage?

By how much does the monopsonist reduce employment below the competitive level?

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Answers: Graph: (approximate shape below. Also note that the discreet nature of the problem requires that the marginal revenue product (MRP) be greater than or equal to the marginal resource cost (MRC)):

The curves are different; the MRC curve is higher than the labor supply curve. rrrrrrrr.

The firm will employ three workers in this situation. Here the MRP = $24 is greater than the MRC = $18. For the fourth worker the MRP = $20 and the MRC = $24. ssssssss.

The monopsonist reduces the wage by $2 (from $14 to $12) and reduces employment by two workers (from 5 to 3).

Feedback: a and b.

Table for part a and table for part b (from review question 2 in Chapter 14 and problem 2 above).

Units of labor

Wage Rate

Total Marginal labor cost resource (wage bill) (labor) cost

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0 1 2 3 4 5 6 Units of labor 0 1 2 3 4 5 6

$NA 6 9 12 15 18 21

Total product 0 17 31 43 53 60 65

$0 6 18 36 60 90 126

Marginal product 17 14 12 10 7 5

Product price $2 2 2 2 2 2 2

$6 12 18 24 30 36

Total revenue $0 34 62 86 106 120 130

Marginal revenue product $34 28 24 20 14 10

Graph: (approximate shape below. Also note that the discreet nature of the problem requires that the marginal revenue product (MRP) be greater than or equal to the marginal resource cost (MRC)).

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The MRC schedule lies above the labor supply schedule because employing the next worker requires a higher wage in this market and you must pay all workers this higher wage.

The firm will employ three workers in this situation. To see this look at the MRP and MRC columns in the table above. The first worker will generate a MRP = $34 and will have a MRC = $6, thus the firm will employ this worker (the marginal revenue product for this worker is greater than his or her marginal cost). For the second worker we have MRP = $28 and MRC = $12, so we employ this worker. For the third worker we have MRP = $24 is greater than the MRC = $18, so we employ this worker as well. For the fourth worker we have MRP = $20 and the MRC = $24. In this case the marginal cost of this worker is greater than the worker's marginal revenue product, so we do not employ this worker. c. The monopsonist decreases employment by 2 units and the equilibrium wage rate is $2 less than the competitive wage.

354. Suppose that low‐skilled workers employed in clearing woodland can each clear one acre per month if each is equipped with a shovel, a machete, and a chainsaw.

Clearing one acre brings in $1,000 in revenue. Each worker‘s equipment costs the worker‘s employer $150 per month to rent and each worker toils 40 hours per week for four weeks each month. LO17.5 What is the marginal revenue product of hiring one low‐skilled worker to clear woodland for one month? zzzzzzzzzzzzzzzz. How much revenue per hour does each worker bring in? aaaaaaaaaaaaaaaaa.

If the minimum wage were $11.20, would the revenue per hour in part b exceed the minimum wage? If so, by how much per hour? bbbbbbbbbbbbbbbbb.

Now consider the employer‘s total costs, which include the equipment costs as well as a normal profit of $50 per acre. If the firm pays workers the minimum wage of $11.20 per hour, what will the firm‘s economic profit or loss be per acre? ccccccccccccccccc.

At what value would the minimum wage have to be set so that the firm would make zero economic profit from employing an additional low‐ skilled worker to clear woodland?

Answers: (a) $1,000. (b) $6.25 (= $1000/160 hours). (c) No, it is less by $4.95 per hour. (d) The firm’s loss per acre will be −2,942.00 dollars (= $1000 in revenue − $150 in rental cost for equipment − $50 in normal profit − $1792 in wages for 160 hours at $11.20 per hour). (e) If X is the firm’s labor cost per worker for one month to clear one acre, then we need $1000 − $150 − $50 − X = 0. Solving this equation for X yields X = $800. Dividing X by 160 hours yields a minimum wage of $5 per hour as what would be needed for the firm to earn zero profit.

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Feedback: The marginal revenue is $1,000. This is the revenue each worker can generate for the firm by clearing one acre. tttttttt. Since the worker generates $1,000 per month and works a total of 160 hours (40 hours per week for 4 weeks), revenue per hour equals $6.25 (= 1,000 ÷ 160). uuuuuuuu. If the minimum wage were $11.20, revenue per hour in part b is less than the minimum wage by $4.95 per hour (= $6.25 − $11.20). vvvvvvvv.

Now consider the employer‘s total costs. These include the equipment costs as well as a normal profit of $50 per acre. The total equipment cost for the firm per acre equals $150. Thus, the economic profit per worker at the minimum wage equals $1,000 (revenue) − $150 − $50 (normal profit) − 160 × $11.20 (hours of labor multiplied by the minimum wage = $1,792) = (− $992). The firm suffers a loss per acre of $992. wwwwwwww.

To determine the minimum wage necessary for the firm to earn zero economic profit, we first calculate the revenue left over for labor after accounting for a normal profit and equipment cost. The revenue left over after these components have been removed is $800 (= $1,000 − $150 − $50).

This leaves $800 left to pay each unit of labor for the month (clears one acre).

Since each worker works 160 hours a month, the highest the break-even wage can be is $5 (= $800 ÷ 160). This is the highest the minimum wage can be set in the industry without exit.

355. Suppose that a car dealership wishes to see if efficiency wages will help improve its salespeople‘s productivity. Currently, each salesperson sells an average of one car per day while being paid $20 per hour for an eight‐hour day. LO17.8 What is the current labor cost per car sold? ddddddddddddddddd.

Suppose that when the dealer raises the price of labor to $30 per hour the average number of cars sold by a salesperson increases to two per day. What is now the labor cost per car sold? By how much is it higher or lower than it was before? Has the efficiency of labor expenditures by the firm (cars sold per dollar of wages paid to salespeople) increased or decreased? eeeeeeeeeeeeeeeee.

Suppose that if the wage is raised a second time to $40 per hour the number of cars sold rises to an average of 2.5 per day. What is now the labor cost per car sold? fffffffffffffffff.

If the firm‘s goal is to maximize the efficiency of its labor expenditures, which of the three hourly salary rates should it use: $20 per hour, $30 per hour, or $40 per hour? ggggggggggggggggg.

By contrast, which salary maximizes the productivity of the car dealer‘s workers (cars sold per worker per day)?

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Answers: (a) $160 (b) $120 per vehicle; $40 less per vehicle; increased. (c) $128 per vehicle. (d) $30 per hour (e) $40 per hour.

Feedback: The current labor cost per car is $160 (= $20 per hour × 8 hours per day ÷ 1 car sold per day on average). xxxxxxxx.

The labor cost per hour falls to $120 per vehicle [= ($30 × 8) ÷ 2].

It is now $40 less per vehicle (= $160 − $120). Efficiency has increased. yyyyyyyy.

The labor cost per car is now $128 per vehicle [= ($40 × 8) ÷ 2.5].

zzzzzzzz.

The dealer should pay $30 per hour if it wants to maximize the efficiency of labor expenditures, which is the least amount of labor cost per car. aaaaaaaaa. If the dealer wants to maximize output per worker per day, it should pay $40 per hour, which is the most cars sold per day.

Chapter 17 Appendix McConnell Brue Flynn 23e APPENDIX DISCUSSION QUESTIONS 356. Which industries and occupations have the highest rates of unionization? Which the lowest? Speculate on the reasons for such large differences. LO17.9 Answer: Figure 1a shows that government and transportation are the two highest by industry. Figure 1b shows that protective services and teachers are the two highest by occupation. These figures also show that the two lowest unionization rates are agriculture and finance (industry) and food workers and sales workers (occupation).

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357. What percentage of wage and salary workers are union members? Is this percentage higher, or is it lower, than in previous decades? Which of the factors explaining the trend do you think is most dominant? LO17.9 Answer: In 2018, the Bureau of Labor Statistics estimated that 14.7 million U.S. workers, or 10.5 percent of employed wage and salary workers, belonged to unions. This is lower than in past decades.

Potential answers for explaining the trend: structural changes in economy (movement away from manufacturing in the U.S.), consumer demand for foreign goods, and an increase in managerial opposition to unionization.

358. Explain how featherbedding and other restrictive work practices can reduce labor productivity. Why might strikes reduce the economy‘s output less than the loss of production by the struck firms? LO17.9 Answer: This type of activity may block the introduction of output increasing machinery and equipment. Seniority rules may also reduce productivity by placing less effective workers in certain positions. Firms not impacted by the strike may increase their output.

359. What is the estimated size of the union wage advantage? How might this advantage diminish the efficiency with which labor resources are allocated in the 1-369 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

economy? Normally, labor resources of equal potential productivity flow from lowwage employment to high-wage employment. Why does that not happen to close the union wage advantage? LO17.9 Answer: The size of the union wage advantage is 15 percent. The higher wages that unions achieve reduce employment, displace workers, and increase the marginal revenue product in the union sector. Labor supply increases in the nonunionized sector, reducing wages and decreasing marginal revenue product there. Because of the lower nonunion marginal revenue product, the workers added in the nonunion sector contribute less to GDP than they would have in the unionized sector. The gain of GDP in the nonunionized sector does not offset the loss of GDP in the unionized sector, so there is an overall efficiency loss. The union also restricts employment to ensure this gap is not eliminated.

360. Contrast the voice mechanism and the exit mechanism for communicating dissatisfaction. In what two ways do labor unions reduce labor turnover? How might such reductions increase productivity? LO17.9 Answer: The voice mechanism lets the employer know dissatisfaction is present through communication, whereas the exit mechanism signals dissatisfaction by workers quitting their jobs. Labor unions may reduce turnover by increasing the desirability of the job and maintaining a significant wage gap. This may increase productivity because less training is required and experience is accumulated.

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REVIEW QUESTIONS True or False. In the United States, unions have been gaining in membership and power for several decades. LO17.9 Answer: False.

This statement is false because union membership and power have been falling steadily since the 1950‘s.

Membership, for example, has fallen from 25 percent of U.S. workers in the mid1950s to only about 10.5 percent in 2018. In addition, corporations have taken many actions to reduce the power of unions. These include aggressive negotiation tactics during collective bargaining sessions, hiring strikebreakers, substituting machinery for unionized workers, and subcontracting work to nonunionized suppliers.

361. Suppose that you are president of a newly established local union. You are about to bargain with an employer for the first time. List the basic areas you want covered in the work agreement. Why might you begin with a larger wage demand than you actually are willing to accept? What is the logic of a union threatening an employer with a strike during the collective bargaining process? Of an employer threatening the union with a lockout? What is the role of the deadline in encouraging agreement in collective bargaining? LO17.9 Answer: Areas to be included in a work agreement are: 1. Wage rates with automatic increases over time, preferably in the form of a cost-of-living adjustment 2. Regulations governing hours of work that ensure employees are entitled to paid vacation time and the choice to engage in overtime work at a substantial premium 3. A liberal fringe-benefits package provided by the firm, including pension plans, health care, and job security provisions 4. Rules governing promotions, layoffs and recalls that are based on worker seniority 5. A stipulated grievance procedure with mandatory union participation in rulings.

6. A provision that requires all workers to join or monetarily support the union.

Asking for a higher-than-expected wage increase is a tactical decision. The law requires that bargaining must occur. The higher-than-expected-wage demand allows for the give-and-take of bargaining and for compromises in other areas of the initial proposal. The union may threaten a strike if it thinks its demands are not being met. The deadline forces negotiation. There is a 1-371 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

possibility of a strike—a work stoppage by the union. But there is also the possibility that at the deadline the firm may engage in a lockout, in which it forbids the workers to return to work until a new contract is signed. In this setting of uncertainty prior to the deadline, both parties feel pressure to find mutually acceptable terms.

362. True or False. ―To the extent that they succeed in their goals, unions only ever reduce productivity and efficiency.‖ LO17.9 Answer: False.

Unions do engage in many activities that reduce productivity and efficiency. But unions may also increase productivity in other ways.

Restrictive union work rules and featherbedding, output losses from strikes, and labor misallocations from the union wage advantage are ways that unions may reduce efficiency, output, and productivity. But the efficiency losses from unions may be partially offset in the long run by productivity increases deriving from reduced labor turnover.

APPENDIX PROBLEMS Suppose that a delivery company currently uses one employee per vehicle to deliver packages. Each driver delivers 50 packages per day, and the firm charges $20 per package for delivery. LO17.9 hhhhhhhhhhhhhhhhh.

What is the MRP per driver per day? iiiiiiiiiiiiiiiii.

Now suppose that a union forces the company to place a supervisor in each vehicle at a cost of $300 per supervisor per day. The presence of the supervisor causes the number of packages delivered per vehicle per day to rise to 60 packages per day. What is the MRP per supervisor per day? By how much per vehicle per day do firm profits fall after supervisors are introduced? jjjjjjjjjjjjjjjjj.

How many packages per day would each vehicle have to deliver in order to maintain the firm‘s profit per vehicle after supervisors are introduced? kkkkkkkkkkkkkkkkk.

Suppose that the number of packages delivered per day cannot be increased beyond 60 packages per day but that the price per delivery might potentially be raised. What price would the firm have to charge for each delivery in order to maintain the firm‘s profit per vehicle after supervisors are introduced?

Answers: bb. Each driver‘s MRP is $1,000 per day. cc. The MRP here is $200 per day. Firm profits will fall by $100 per vehicle per day. dd. 65 ee. $26 per delivery

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Feedback: To find the marginal revenue product (MRP) for each driver, multiply the number of packages the driver delivers by the price of each package delivered.

MRP = number of packages × price = 50 × $20 = $1,000 bbbbbbbbb. By placing a supervisor in each truck, the total number of packages delivered increases from 50 to 60 per truck. This implies that the addition of the supervisor increases deliveries by 10 units.

The additional revenue the supervisor generates—the marginal revenue product of the supervisor (MRP)—is $200.

MRP supervisor = 10 (additional units) × $20 (price) = $200 Since the supervisor increases the firm's cost by $300 per vehicle and only generates $200 in additional revenue, the firm's profits will fall by $100 per vehicle [= $200 (revenue) $300 (cost)]. ccccccccc.

By adding the supervisor to the vehicle, the company will need to generate $300 in additional revenue to cover the additional cost. This implies that each vehicle will need to generate a total of $1,300 in revenue [= $1,000 (original revenue) + $300 (revenue needed to cover cost of supervisor)].

Given that the price the firm charges for each package is $20, each vehicle will need to deliver 65 packages (= $1,300 ÷ $20) to maintain profit per vehicle. Note that total revenue per vehicle is 65 × $20 = $1,300. ddddddddd. Again, by adding the supervisor to the vehicle, the company will need to generate $300 in additional revenue to cover the additional cost. This implies that each vehicle will need to generate a total of $1,300 in revenue [= $1,000 (original revenue) + $300 (revenue needed to cover cost of supervisor)].

Now we assume that 60 packages are delivered (no change in packages delivered, supervisor MRP = 0), but the firm can adjust price. Given that 60 packages are delivered by each vehicle the firm will need to charge $21.67 per package to maintain profit per vehicle (= $1,300 ÷ 60). Note that total revenue per vehicle is 60 × $21.67 = $1,300.

363. Suppose that a car factory initially hires 1,500 workers at $30 per hour and that each worker works 40 hours per week. Then the factory unionizes, and the new union demands that wages be raised by 10 percent. The firm accedes to that request in collective bargaining negotiations but then decides to cut the factory‘s labor force by 20 percent due to the higher labor costs. LO17.9 1-373 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

What is the new union wage? How many workers does the factory employ after the agreement goes into effect?

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lllllllllllllllll.

How much in total did the factory‘s workers receive in wage payments each week before the agreement? How much do the factory‘s remaining workers receive in wage payments each week after the agreement? mmmmmmmmmmmmmmmmm.Suppose that the workers who lose their jobs as a result of the agreement end up unemployed. By how much do the total wages received each week by the initial 1,500 workers (both those who continue to be employed at the factory and those who lose their jobs) change from before the agreement to after the agreement? nnnnnnnnnnnnnnnnn.

If the workers who lose their jobs as a result of the agreement end up making $15 per hour at jobs where they work 40 hours per week, by how much do the total wages received each week by the initial 1,500 workers change from before the agreement to after the agreement?

Answers: (a) $33 is the new union wage. The factory employs 1200 workers at that wage. (b) $1,800,000 before. $1,584,000 by remaining workers after. (c) Total wages fall by $216,000. (d) Total wages fall by $36,000.

Feedback: The original wage rate was $30 per hour. The new union wage is 10% higher, or $33 (= 1.10 × $30). The original level of employment was 1,500. After unionization, the car factory reduces its work force by 20% due to higher labor costs. Thus, the unionized level of employment is 1,200 (= 0.8 × 1,500).

Note the company cuts 20% of its labor force, which equals 300 (= 0.2 × 1,500). eeeeeeeee.

Total earnings = hourly wage × hours worked × number of workers. We have total earnings before unionization of $1,800,000 (= $30 × 40 × 1,500). We have total earnings after unionization of $1,584,000 (= $33 × 40 × 1,200). fffffffff.

Since the workers no longer employed with the car factory after unionization remain unemployed, their effective earnings from employment are zero. Thus, the total wages received each week by the initial 1,500 workers (both those who continue to be employed at the factory and those who lose their jobs) decreases by $216,000 (= $1,584,000 ‒ $1,800,000) from before the agreement to after the agreement. That is, the workers as a group earn $216,000 less than before the agreement. ggggggggg. The 1,200 workers who continue to work for the company earn $1,584,000 (= $33 × 40 × 1,200). The 300 workers who are no longer employed earn $180,000 (= $15 × 40 × 300). The 1,500 workers combined earn $1,764,000 ($1,584,000 (car factory) + $180,000 (other employment)).

The change in total compensation in this case is $36,000 less than before unionization (= $1,764,000 − $1,800,000).

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Chapter 18 - Rent, Interest, and Profit McConnell Brue Flynn 23e DISCUSSION QUESTIONS 364. How does the economist‘s use of the term ―rent‖ differ from everyday usage?

Explain: ―Though rent need not be paid by society to make land available, rental payments are very useful in guiding land into the most productive uses.‖ L O18.1 Answer: In everyday usage, ―rent‖ is the term used to describe the payment that must be paid for the legal borrowing of some good or service. One pays rent for the use of a house or an apartment; or one rents a tool from the equipment rental company. When paying this rent, one is paying for part of the capital cost of the commodity, plus its maintenance, plus a share of the taxes on it, plus profit to the owner. An economist defines rent much more restrictively: Economic rent is the price paid for the use of land and other natural resources that are completely fixed in total supply.

Land is completely fixed in total supply. No matter how high the rent, no more can be brought into use. Thus, rent serves no incentive function; the same amount of land will be available no matter how high the rent. But the resulting argument that rent is a surplus that could be eliminated without reducing the supply is to look at it from the viewpoint of society only. The fact is that land has alternative uses. To get land into its most productive use, individuals and firms must compete, and the winners are those who will pay the highest rent. It only makes sense to outbid someone else for any particular land if the winner expects to make more profitable use of it than the losers, that is, employ it in its most productive use.

365. Explain why economic rent is a surplus payment when viewed by the economy as a whole but a cost of production from the standpoint of individual firms and industries. Explain: ―Land rent performs no ‗incentive function‘ for the overall economy.‖ LO 18.1 Answer: Land is completely fixed in total supply. As population expands and the demand for land increases, rent first appears and then grows. From society‘s perspective this rent is a surplus payment unnecessary for ensuring that the land is available to the economy as a whole.

If rent declined or disappeared, the same amount of land would be available. If it increased, no more land would be forthcoming. Thus, rent does not function as an incentive for adding land to the economy. But land does have alternative uses. To get it to its most productive use, individuals and firms compete and the winners 1-376 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

are those who pay the highest rent. To the high bidders, rent is a cost of production that must be covered by the revenue gained through the sale of the commodities produced on that land.

366. If money is not an economic resource, why is interest paid and received for its use? What considerations account for the fact that interest rates differ greatly on various types of loans? Use those considerations to explain the relative sizes of the interest rates on the following: LO18.2 ooooooooooooooooo.

A 10-year $1,000 government bond. ppppppppppppppppp.

A $20 pawnshop loan. qqqqqqqqqqqqqqqqq.

A 30-year mortgage loan on a $225,000 house. rrrrrrrrrrrrrrrrr.

A 24-month $18,000 commercial bank loan to finance the purchase of an automobile. sssssssssssssssss. A 60-day $100 loan from a personal finance company.

Answer: Though money is not in itself productive, it is useful for acquiring resources that are productive. In borrowing money, businesses get the use of it to buy factories, machines, and equipment that are productive and with which the businesses hope to make a profit. Thus, it makes economic sense to pay for the use of money. It would make no economic sense to lend money without charging interest, for the lender has the alternative of buying productive real capital or consumer goods with it.

There are many considerations involved in the fact that interest rates differ greatly on various types of loans. (1) Risk: The greater the chance the borrower will not repay, the higher the interest rate. (2) Maturity: The longer the term of the loan, the higher the interest rate to compensate the lender for the risk of being without the use of the money for an extended period of time. (3) Loan size: The smaller the loan, the higher the interest rate because the administrative costs of large and small loans are about the same absolute amounts. (4) Taxability: The interest payments on certain state and municipal bonds being nontaxable, the interest that lenders require as payment is lower. hhhhhhhhh. A 10-year $1,000 government bond will have a relatively low rate of interest because it is risk-free: The Federal government cannot default (since its promise to repay is in currency that the government can have printed). However, the term to maturity normally would lead to a higher interest rate than a shorter-term government bond. The loan size is irrelevant here because the government pays the same interest regardless of the bond‘s denomination. iiiiiiiii. A $20 pawnshop loan will have a high rate of interest. There‘s good chance the good pawned will not be redeemed but, in this case, the pawnbroker is not really at risk. The pawned article undoubtedly has a resale value greater than $20. The high interest rate in fact helps ensure that the good 1-377 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

will not be redeemed—to the pawnbroker‘s benefit. The high interest rate also compensates for the small size of the loan. jjjjjjjjj.

Mortgages are generally large loans at a relatively low interest rate.

The loan is for a very long term. And the house is pledged as collateral. Under certain circumstances, the loan may qualify for a government-subsidized mortgage insurance program, which insures the lender against default.

Additionally, the borrower may deduct the interest from his/her taxable income. These contrasting considerations result in a lower interest rate than most types of long-term loans. kkkkkkkkk. A 24-month $18,000 commercial bank loan to finance the purchase of an automobile will certainly have a higher interest rate than a government bond, but its risk is reduced by the fact that the automobile serves as collateral for the loan. However, the bank would rather get its money back than a used car, so the bank certainly does not consider the loan risk-free. The loan is of a relatively large size; this will tend to lower the interest rate. The outcome of these conflicting considerations is an interest rate lower than for a straight, unsecured, consumer loan but higher than for a loan to a well-established business. lllllllll. A 60-day $100 loan from a personal finance company will have the highest rate of all, except possibly for the pawnshop loan. Though it is very short term, it is considered relatively high risk, because otherwise the borrower would have gotten the loan from a bank; and the loan size is very small, making the administrative costs high in relation to the loan size. Also, the fact that it is a personal loan implies there is no collateral like a car or home to back it up.

367. Why does the supply of loanable funds slope upward? Why does the demand for loanable funds slope downward? Explain the equilibrium interest rate. List some factors that might cause it to change. LO18.3 Answer: The supply of loanable funds slopes upward because savers will make more funds available at higher interest rates than lower interest.

The demand for loanable funds slopes downward because there are few investment and R&D projects that yield a high rate of return and many more that will yield a lower rate of return.

The equilibrium interest rate is determined where the interest rate (cost of borrowing the funds) is equal to the expected rate of return (the expected benefit from borrowing the funds and engaging in the investment or R&D project).

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The supply of loanable funds may change because of a change in households‘ Attitudes about saving (tax policies, macroeconomic conditions, etc.) or changes in Federal Reserve policies relative to the money supply. The demand for loanable funds could change as a result of a change in technology or a change in the demand for the final product. If there is either a change in supply of or demand for loanable funds, the interest rate will change.

368. Here is the deal: You can pay your college tuition at the beginning of the academic year or the same amount at the end of the academic year. You either already have the money in an interest-bearing account or will have to borrow it. Deal, or no deal? Explain your financial reasoning. Relate your answer to the time-value of money, present value, and future value. LO18.4 Answer: The answer is you pay at the end of the academic year in both cases. For example, assume your college tuition costs $10,000 and the interest rate over the academic year is 10 percent (not an annual rate). If you already have the $10,000 and you put it in an interest-bearing account, you will have $11,000 (= 1.10 × $10,000) at the end of the academic year. You pay the $10,000 in tuition and pocket $1,000. If you paid the $10,000 tuition at the beginning of the year, you would lose this $1,000 (The future value of the $10,000 is $11,000).

On the other hand, if you had to borrow the $10,000 to pay your tuition, you would still pay at the end of the academic year. Using the values as above, you borrow the $10,000 today and put it in an interest-bearing account, which gives you $11,000 at the end of the academic year. You pay your tuition of $10,000, which leaves you an additional $1,000 dollars. If you paid at the beginning of the academic year, you would once again lose this $1,000. This implies you could reduce your remaining debt burden to $9,000 (assuming a government-financed, interest-free student loan) by using the $1,000 in interest to pay down the principal on the original loan.

369. What are the major economic functions of the interest rate? How might the fact that many businesses finance their investment activities internally affect the efficiency with which the interest rate performs its functions? LO18.5 Answer: There are two major economic functions of the interest rate. (1) Interest rates affect the level of domestic output as the monetary authorities deliberately vary them by changing the money supply. Low interest rates encourage investment, and this tends to expand the economy. High interest rates discourage investment, and this tends to restrain inflation or contract the economy. (2) Interest rates allocate capital to its most productive uses. When interest rates are, say, at 10 percent, a project that expects to earn 8 percent after the payment of all costs will not be undertaken, because the cost of the borrowed money is greater than the return expected on it. This is true even if the firm is using its own money.

Why make 8 percent on the project with the firm‘s money when lending it will 1-379 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

earn 10 percent? On the other hand, all projects that are expected to return more than the interest rate will be undertaken. The interest rate thus allocates money capital to those investments that are most productive, that is, which have the highest rate of return.

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To the extent that firms truly are profit maximizers, the internal financing of investment should make no difference to the investment decision. One invests if the expected rate of return is greater than the rate of interest; one does not if the rate of interest is greater. However, firms are probably somewhat less anxious about what happens to money that they do not have to pay back. In other words, the efficiency with which the interest rate performs its functions is probably lessened the more firms finance their investments internally.

370. Distinguish between nominal and real interest rates. Which is more relevant in making investment and R&D decisions? If the nominal interest rate is 12 percent and the inflation rate is 8 percent, what is the real rate of interest? LO18.5 Answer: The nominal interest rate is the interest rate stated in dollars of current value (unadjusted for inflation). The real interest rate is the nominal interest rate adjusted for inflation (or deflation). The real interest rate is more relevant for making investment decisions—it reflects the true cost of borrowing money. It is compared to the expected return on the investment in the decision process.

Real interest rate = nominal interest rate − inflation rate = 4 percent (= 12 percent − 8 percent) 371. How do the concepts of accounting profit and economic profit differ? Why is economic profit smaller than accounting profit? What are the three basic sources of economic profit? Classify each of the following according to those sources: LO18.6 A firm‘s profit from developing and patenting a new medication that greatly reduces cholesterol and thus diminishes the likelihood of heart disease and stroke. ttttttttttttttttt.

A restaurant‘s profit that results from the completion of a new highway past its door. uuuuuuuuuuuuuuuuu.

The profit received by a firm due to an unanticipated change in consumer tastes.

Answer: Accounting profit is what remains of a firm‘s total revenues after it has paid for all the factors of production employed by the firm (its explicit costs) but not for the use of the resources owned by the business itself. Economists also take into consideration implicit costs—the payment the owners could have received by using the resources they own in some other way. The economist adds these implicit costs to the accountant‘s explicit costs to arrive at total cost. Subtracting the total cost from total revenue results in a smaller profit (the economic profit) than the accountant‘s profit.

Sources of economic profit: (1) creating popular new products; (2) reduce production costs below rivals' costs; and (3) create and maintain a profitable monopoly.

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Profit from creating a popular new product as well as monopoly profit from the patent mmmmmmmmm. Creating and maintaining a monopoly as a result of its locational advantage nnnnnnnnn. Profit from creating a popular 'new' product. Note here that the change in consumer preferences has made the good 'popular'. The term 'new' is relative; it may have been around for a while, but people just did not want to buy it in the quantities they do now 372. Why is the distinction between insurable and uninsurable risks significant for the theory of profit? Carefully evaluate: ―All economic profit can be traced to either uncertainty or the desire to avoid it.‖ What are the major functions of economic profit? LO18.6 Answer: An insurable risk does not fatally affect the profit and loss of a firm. The firm insures against fire and theft and so on and then goes about its business, secure in the knowledge that it cannot suffer an irreparable loss if one of the insured-against events occurs. Economic profit (and serious loss) occurs when the firm takes uninsurable risks. Such risks relate to uncontrollable and unpredictable changes in demand and supply conditions. An insurance company is most unlikely to insure against a serious recession occurring in the next year or so or against the price of oil skyrocketing—or, if one did, the premium the insurance company would demand would be greater than the profit a firm could expect to make by forecasting these events correctly. Thus, firms must risk that the demand for their products in the future will give them adequate revenue to cover their future costs that, too, they must take the risk of estimating. If the firms are successful, they have earned their economic profits. ―All economic profits can be traced to either uncertainty or the desire to avoid it.‖ A considerable amount of economic profits can be traced to either uncertainty or the desire to avoid it, but not all. There is clearly uncertainty in trying to estimate future demand and supply conditions. A firm cannot be sure what it will get for its output, what the input will cost, and the consequent economic profit or loss. There is also much uncertainty with regard to innovation. Will it fly, literally, or figuratively in the sense of being able to convince people to buy the new or redesigned product? Or will all of the revenue needed to pay back the development costs be gained before freeloading copiers come on the market with their versions? However, though monopoly economic profits may be the product of the same types of uncertainty just discussed, they are by no means entirely so.

It is De Beers‘ tight control of the supply of diamonds that has ensured its continuing economic profits, not favorable changes in the public‘s demand for diamonds.

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The major functions of profits include providing an incentive for entrepreneurial initiative in combining resources to produce a good or service; for innovation in the form of new products or production processes; and for taking the risks which the entrepreneur bears by operating in a dynamic and uncertain environment.

Profits also allocate resources among alternative lines of production.

Entrepreneurs seek profits and shun losses, which means industries will expand as long as they experience economic profits and contract when they experience losses.

373. What are the combined rent, interest, and profit share of the income earned by Americans in a typical year if proprietors‘ income is included within the labor (wage) share? LO18.7 Answer: If proprietors‘ income is included within the labor share of income, wages would be almost 80 percent of national income. That leaves about 20 percent of the national income in the form of rent, interest, and profit—a relatively small share and a share that has been remarkably stable in the United States since 1900.

374. LAST WORD Assume that you borrow $5,000, and you pay back the $5,000 plus $250 in interest at the end of the year. Assuming no inflation, what is the real interest rate? What would the interest rate be if the $250 of interest had been discounted at the time the loan was made? What would the interest rate be if you were required to repay the loan in 12 equal monthly installments?

Answer: Simple interest in the first case is 5 percent (= $250 ÷ $5,000 × 100).

In the second case, the amount received at the time of borrowing would be $4,750, so the interest rate is slightly higher at 5.26% (= $250 ÷ $4,750 × 100) If you repaid the loan in twelve monthly installments and the interest payments still were equal to $250, then you have repaid $5,250 in total, but you have repaid part of the principal each month. Therefore, you did not borrow the entire $5,000 for the whole year. Without having the exact equation to solve this problem, you could estimate that you borrowed on average $2,500 for the whole year, since you would have paid back about half by the sixth month and reduced the principal by about 1/12 for every month thereafter. This means that the $250 is about 10 percent of the average amount borrowed.

REVIEW QUESTIONS When using a supply-and-demand model to illustrate how land rents are set, economists typically draw the supply curve as a vertical line because: LO18.1 the supply of land is fixed.

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vvvvvvvvvvvvvvvvv. the supply of land is perfectly inelastic. wwwwwwwwwwwwwwwww. the quantity supplied of land does not increase when rents go up. xxxxxxxxxxxxxxxxx. all of the answer choices.

Answer: d. All of the answer choices.

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The correct answer to this question is ―all of the answer choices‖ because the three choices offered are all true: the supply of land is fixed; the supply of land is perfectly inelastic; and the quantity supplied of land does not increase when rents go up.

To begin with, the supply of land is indeed fixed. As the old joke goes: ―Invest in land; they ain‘t makin‘ more of it!‖ Next, land‘s fixed supply implies that the supply of land is perfectly inelastic, meaning that the quantity supplied of land is completely insensitive to price changes. To see this, note that the fixed supply of land implies that changes in rent—the price of land—will not affect the quantity of land that is supplied. Whether rents are high or low, the amount of land will always be the same. Finally, the fact that the supply of land is fixed also obviously implies that rents have no effect on how much is supplied. The total quantity of land is always the same no matter what rents are.

375. In the 1980s, land prices in Japan surged upward in a ―speculative bubble.‖ Land prices then fell for 11 straight years between 1990 and 2001. What can we safely assume happened to land rent in Japan over those 11 years? Use graphical analysis to illustrate your answer. L O18.1 Answer: Given that the supply of land is perfectly inelastic, the drop in prices must have resulted from decreased demand for land. The demand for land would fall if there were less of a return on the land (i.e., rent), so we can safely assume that land rent fell in Japan between 1990 and 2001. The shifts from D1 to D2 to D3 in Figure 18.1 demonstrate graphically what happened in Japan.

376. Fanwei puts $1,000 in a savings account that pays 3 percent per year. What is the future value of her money one year from now? LO18.4 $970. yyyyyyyyyyyyyyyyy. $1,000. zzzzzzzzzzzzzzzzz. $1,003.

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aaaaaaaaaaaaaaaaaa.

Answer: d. $1,030.

$1,030.

The future value one year from now of the $1,000 that Fanwei invests today at 3 percent interest is $1,030. That is because her present value of $1,000 will grow into $1,030 in one year‘s time if it is invested at 3 percent interest. This is true because 3 percent of $1,000 is $30. So next year Fanwei will have the amount she invested ($1,000) plus an additional $30 of interest, or $1,030 in total.

Note, however, that future values depend upon the time horizon and the interest rate. For instance, while the one-year-from-now future value of Fanwei‘s money is $1,030 if it is invested at 3 percent, the two-years-from-now future value would be $1,060.90 if it is invested at 3 percent because that is how much money in total Fanwei would have in her savings account if she allowed her initial deposit of $1,000 to compound for two full years at 3 percent interest.

In a similar fashion, a higher interest rate would also change the future value. For instance, future value of $1,000 in one year is $1,030 if invested at 3 percent but $1,060 if invested at 6 percent. Thus, the relationship between present values and future values depends crucially on the interest rate.

377. As shown in Table 18.2, $1,000 invested at 10 percent compound interest will grow into $1,331 after three years. What is the present value of $2,662 in three years if it is discounted back to the present at a 10 percent compound interest rate? (Hint: $2,662 is twice as much as $1,331.) LO18.4

Answer: $2,000.

The correct answer to this question is $2,000 because $2,000 invested at 10 percent compound interest will grow into $2,662 after three years. The easiest way to get the answer is to realize that twice as much invested today should yield twice as much in three years. Thus, with $1,000 today growing into $1,331 after three years, twice as much invested today should grow into twice as much in three years. Plugging in the numbers, this logic implies that $2,000 invested today should become $2,662 in three years. It thus becomes clear that the present value of $2,662 in three years is exactly $2,000 today.

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378. Entrepreneurs are the residual claimants at their respective firms. This means that they: LO18.6 get paid only if there is any money left over after all the other factors of production have been paid. bbbbbbbbbbbbbbbbbb. must bear the financial risks of running their firms. cccccccccccccccccc. receive whatever accounting profits or losses their firms generate. dddddddddddddddddd. all of the above.

Answer: d. All of the answer choices.

These statements about entrepreneurs as residual claimants are all true.

To understand why, recall that as residual claimants, entrepreneurs will only get paid if there is any money left over after paying all of the other factors of production. As an example, wages and salaries have to be paid first. So does the rent. And so do any loan repayments due to creditors. Only if there is any money left over after paying everyone else to whom the firm owes money will the entrepreneurs receive anything. And sometimes, of course, firms lose money because payments to resource providers exceed revenues. In those cases, it is the entrepreneurs who lose money. As a result, it is also the entrepreneurs who ultimately bear the financial risks of running their firms.

379. True or False. As a capitalist economy, the vast majority of U.S. national income flows to the owners of capital. LO18.7 Answer: False.

The vast majority of U.S. national income flows to labor. Defined narrowly as ―wages and salaries,‖ labor‘s share is about 70 percent of national income.

Defined more broadly to include ―proprietor‘s income,‖ labor receives 79 percent of national income. That leaves only about 20 percent of U.S. national income to flow to the providers of land, capital, and entrepreneurship as rent, interest, and profit.

PROBLEMS Suppose that you own a 10-acre plot of land that you would like to rent out to wheat farmers. For them, bringing in a harvest involves $30 per acre for seed, $80 per acre for fertilizer, and $70 per acre for equipment rentals and labor. With these inputs, the land will yield 40 bushels of wheat per acre. If the price at which wheat can be sold is $5 per bushel and if farmers want to earn a normal profit of $10 per acre, what is the most that any farmer would pay to rent your 10 acres? What if the price of wheat rose to $6 per bushel? LO18.1 Answers: At a wheat price of $5 per acre, the revenue from the land would be $200 per acre (= 40 bushels per acre times $5 per bushel) or $2000 for all 10 acres. The cost including a normal profit would be $190 per acre (= $30 + 1-387 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

$80 + $70 + $10) or $1,900 for all 10 acres. Thus, the most anyone would pay to rent the land would be $10 per acre (= $200 per acre − $190 per acre) or $100 for all 10 acres. At a wheat price of $6 per acre, the revenue from the land would be $240 per acre (= 40 bushels per acre times $6 per bushel) or $2400 for all 10 acres. Since the costs will remain unchanged at $190 per acre, the most anyone would pay to rent the land would be $50 per acre (= $240 per acre − $190 per acre) or $500 for all 10 acres.

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Feedback: To answer this question, we begin by calculating the revenue generated per acre.

A bushel of wheat sells for $5, and each acre produces 40 bushels of wheat. Thus, revenue per acre equals $200 (= $5 × 40). Since there are 10 acres of land on the farm, total revenue equals $2,000 (= 10 × $200). The total cost per acre equals $190 (= $30 + $80 + $70 + $10), which is the sum of the seed cost, fertilizer cost, equipment rental, and normal profit, respectively. Thus, the total cost for the 10acre farm is $1,900 (= 10 × $190).

To find the most any farmer would pay to rent the 10-acre farm (land), we subtract the total cost from total revenue. This equals $100 [= $2,000 (revenue) − $1,900 (cost)]. So, the most the farmer would be willing to pay to rent the land is $100 since anything more would result in a loss (negative economic profit).

If the price of wheat increased to $6 a bushel, then total revenue per acre would equal $240 (= $6 × 40). Total revenue for the farm would equal $2,400 (= 10 × $240). The total cost remains the same, $1,900. This implies $500 remains for potential land payment (= $2,400 − $1,900), which is the most any farmer would be willing to pay to rent the land.

380. Suppose that the demand for loanable funds for car loans in the Milwaukee area is $10 million per month at an interest rate of 10 percent per year, $11 million at an interest rate of 9 percent per year, $12 million at an interest rate of 8 percent per year, and so on. If the supply of loanable funds is fixed at $15 million, what will be the equilibrium interest rate? LO18.3 Answers: The equilibrium interest rate is 5 percent per year.

Feedback:

Interest rate on Demand for Supply of Loan Loanable Funds Loanable Funds 10%

$10 million

$15 million

9%

$11 million

$15 million

8%

$12 million

$15 million

7%

$13 million

$15 million

6%

$14 million

$15 million

5%

$15 million

$15 million

4%

$16 million

$15 million 1-389

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3%

$17 million

$15 million

2%

$18 million

$15 million

1%

$19 million

$15 million

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The table demonstrates that the quantity demanded for loanable funds increases by $1 million for every 1 percent reduction in the interest rate.

The equilibrium interest rate occurs where the quantity demanded for loanable funds equals the quantity supplied of loanable funds. This occurs at the interest rate of 5 percent.

381. Advanced Analysis To fund its wars against Napoleon, the British government sold consol bonds. They were referred to as ―perpetuities‖ because they would pay £3 every year in perpetuity (forever). If a citizen could purchase a consol for £25, what would the consol‘s annual interest rate be? What if the price were £50? £100? Bonds are known as ―fixed income‖ securities because the future payments that they will make to investors are fixed by the bond agreement in advance. Do the interest rates of bonds and other investments that offer fixed future payments vary positively or inversely with their current prices? Explain. LO18.4 Answers: 12 percent; 6 percent; 3 percent; inversely.

Feedback: To calculate the price of a perpetuity, we use the formula, price = (payment/interest rate). To calculate the interest rate, we use the formula, interest rate = (payment/price). Remember that when you are solving for a rate, multiply the answer by 100 to get it out of a decimal and into a rate.

Consol for £25: interest rate = (£3 ÷ £25) = 0.12 (12%) Consol for £50: interest rate = (£3 ÷ £50) = 0.06 (6%) Consol for £100: interest rate = (£3 ÷ £100) = 0.03 (3%) The interest rates vary inversely with current prices.

382. Suppose that the interest rate is 4 percent. What is the future value of $100 four years from now? How much of the future value is total interest? By how much would total interest be greater at a 6 percent interest rate than at a 4 percent interest rate? L O18.4 Answers: $116.99; $16.99; $9.26 Feedback: To calculate the future value of $100 four years from now, we compound the interest for the four years. The future value for each successive year is: Year 1: $100 × (1.04) = $104 (carry this amount forward to year two).

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Year 2: $104 × (1.04) = $108.16 (carry this amount forward to year three).

Year 3: $108.16 × (1.04) = $112.49 (carry this amount forward to year four).

Year 4: $112.49 × (1.04) = $116.99 (future value in four years).

Note that this answer could also be found via substitution back to Year 1, which gives us the formula: Future value = initial amount × (1 + interest rate)t, where t is the number of years of compounding. For the values above, we have future value = $100 × (1.04)4 = $100 × 1.1699 = $116.99.

To calculate the future value of total interest, subtract the principal (the initial amount) from the total future value. This is $16.99 (= $116.99 − $100).

To find out how much greater total interest would be at a 6 percent interest rate than at a 4 percent interest rate, first find the future value at the 6 percent interest rate.

Using the formula above, future value = $100 × (1.06)4 = $100 × 1.2635 = $126.25. Second, find the future value of total interest. This is $26.25 (= $126.25 − $100). Finally, subtract the total interest at the 4 percent rate from the total interest at the 6 percent rate. This equals $9.26 (= $26.25 − $16.99).

383. You are currently a worker earning $60,000 per year but are considering becoming an entrepreneur. You will not switch unless you earn an accounting profit that is on average at least as great as your current salary. You look into opening a small grocery store. Suppose that the store has annual costs of $150,000 for labor, $40,000 for rent, and $30,000 for equipment. There is a one-half probability that revenues will be $200,000 and a one-half probability that revenues will be $400,000.

LO18.6 In the low-revenue situation, what will your accounting profit or loss be? In the highrevenue situation? eeeeeeeeeeeeeeeeee.

On average, how much do you expect your revenue to be?

Your accounting profit? Your economic profit? Will you quit your job and try your hand at being an entrepreneur? Explain. ffffffffffffffffff. Suppose the government imposes a 25 percent tax on accounting profits. This tax is only levied if a firm is earning positive accounting profits.

What will your after-tax accounting profit be in the low-revenue case? In the high-revenue case? What will your average after-tax accounting profit be? What about your average after-tax economic profit? Will you now want to quit your job and try your hand at being an entrepreneur? Explain. gggggggggggggggggg. Other things equal, does the imposition of the 25 percent profit tax increase or decrease the supply of entrepreneurship in the economy?

Answers: (a) Explicit costs are $220,000 (= $150,000 + $40,000 + $30,000).

Thus accounting profits in the low-revenue case are −$20,000 (= $200,000 − 1-392 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

$220,000) while accounting profits in the high-revenue case are $180,000 (= $300,000 − $220,000). (b) On average, revenues will be $300,000 per year (= 0.5 × $400,000 + 0.5 × $200,000). Thus, on average, accounting profits will be $80,000 per year (= $300,000 in average revenue − $220,000 in explicit costs). This means that on average economic profits will be $20,000 per year (= $80,000 of average accounting profits − $60,000 opportunity costs of foregone wages). You WILL want to quit your job to become an entrepreneur. (c) In the low-revenue case, the after-tax accounting profit will be the same since the firm is making a loss of −$20,000 and the tax is only applied if the firm is making a profit. In the high-revenue case, the after-tax accounting profit will be $135,000 (= 0.75 × $180,000).

Given those numbers, the average after-tax accounting profit will be $57,500 (= 0.5 × [−$20,000] + 0.5 × $135,000). The average after-tax economic profit will be − $2,500 (= $57,500 in average after-tax accounting profit − $60,000 in foregone wages). You will NOT want to quit your job and become an entrepreneur. (d) The profit tax decreases the supply of entrepreneurship in the economy.

Feedback: The accounting profit in each scenario equals revenue minus explicit costs.

The explicit costs in both cases (independent of state) equal $220,000 [= $150,000 (labor) + $40,000 (rent) + $30,000 (equipment)].

Scenario 1 (low-revenue case, revenue equals $200,000): Here the accounting profit is −$20,000 (= $200,000 − $220,000).

Scenario 2 (high-revenue case, revenue equals $400,000): Here the accounting profit is $180,000 (= $400,000 − $220,000). ooooooooo. The average revenue will be a weighted average of the two cases above, where the weights are the probabilities of each case. Here we assume that each case, or scenario, is equally likely (probability of 0.5 for each).

Average revenue equals $300,000 (= 0.5 × $200,000 + 0.5 × $400,000).

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Average profit equals $80,000 [= $300,000 (average revenue) − $220,000 (explicit cost)]. Note that the explicit cost is the same in both scenarios.

You will quit your job because the average profit of $80,000 exceeds your current income of $60,000. (Note: we ignore risk here.) ppppppppp. If the government were to impose a 25 percent tax on all accounting profits, this would only affect scenario 2. The government does not subsidize losses.

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Scenario 1 (low-revenue case, revenue equals $200,000): Here the accounting profit is −$20,000 (= $200,000 − $220,000).

Scenario 2 (high-revenue case, revenue equals $400,000): Here the accounting profit is $180,000 (= $400,000 − $220,000). With the 25 percent tax, the aftertax profit equals $135,000 (= 0.75 × $180,000). This is the percentage of the accounting profit the firm receives after paying taxes.

Next, we calculate the firm's average profit by taking a weighted average of the 'after-tax' profits for the two scenarios. Average after-tax profits equal $57,500 [= 0.5 × (−$20,000) + 0.5 × $135,000].

You will not quit your job because the average profit of $57,500 is less than your current income of $60,000. (Note: we ignore risk here.) qqqqqqqqq. Yes, the reduction in after-tax profits induces some individuals not to undertake investments or decisions that are pre-tax profitable.

Chapter 19 - Environmental Economics McConnell Brue Flynn 23e DISCUSSION QUESTIONS 384. Describe Thomas Malthus‘ theory of human reproduction. Does it make sense for some species—say bacteria or rabbits? What do you think makes humans different?

LO19.1 Answer: Thomas Malthus‘ theory of reproduction is that as living standards (specifically the food supply from Malthus‘ perspective) rise above subsistence, people will tend to have more children (they can afford them) and population will grow. Eventually, however, the population growth will overwhelm food supply growth, and living standards will be pushed back to subsistence.

Malthus‘ theory works well for non-human life forms – bacteria and rabbit populations will continue to expand so long as there is a food supply to support them. They have a biological drive to procreate and lack any ability to reason that unchecked population growth might eventually have adverse effects.

Humans also have a biological drive to procreate (or at least to engage in the activities that lead to procreation) but also have the technology (birth control) and self-control to limit the number of children born. In less developed economies (including pre-industrial times in the U.S., Europe, etc.), a large number of births 1-395 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

was a way to hedge against high rates of infant / childhood mortality. As living standards rise and the risk of premature death falls significantly, families tend to focus more on quality (providing less children more opportunities) than quantity (maximizing family size).

385. Demographers have been surprised that total fertility rates have fallen below 2.0, especially because most people in most countries tell pollsters that they would like to have at least two children. Can you think of any possible economic factors that may be motivating biological women in so many countries to average fewer than two children per lifetime? What social or political changes may play a role? LO19.1 Answer: There are a number of factors that could lead to the decline, including greater participation by women in the paid labor force, the transformation of children from an economic asset (e.g., on the farm) to a liability, higher divorce rates, and changed attitudes and access to birth control.

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386. Resource consumption per person in the United States is either flat or falling, depending on the resource. Yet living standards are rising because of technological improvements that allow more output to be produced for every unit of input used in production. What does this say about the likelihood of our running out of resources?

Could we possibly maintain or improve our living standards even if the population were expected to rise in the future rather than fall? Explain. LO19.1 Answer: The fact that we are able to raise living standards without using as many resources reduces the likelihood that we will run out of resources. Even if we run out of a specific resource, substitutes exist and technological advance increases the quantity and viability of substitutes.

Even if population continues to rise indefinitely, technological advances that reduce inputs per unit of output make it possible to maintain or improve living standards.

387. A community has a nighttime energy demand of 50 megawatts but a peak daytime demand of 75 megawatts. It has the chance to build a 90-megawatt coal-fired plant that could easily supply all of its energy needs even at peak daytime demand. Should it proceed, or might there be lower-cost options? Explain. LO19.2 Answer: A large coal-fired plant likely has high fixed costs. It may have lower operating costs than other energy sources, but if those lower costs (economies of scale) are only achieved when the plant is at or near capacity, actual operating costs may not be lower than the alternatives. Natural gas or hydroelectric plants, for example, might have lower fixed costs and be able to operate efficiently on a smaller scale than a coal-fired plant. A community should look at the net benefits of each energy option, including using a combination of energy sources. Only by comparing the net benefits can a community find the method(s) of power generation that is most economically efficient.

388. Suppose that you hear two people arguing about energy. One says that we are running out of energy. The other counters that we are running out of cheap energy.

Explain which person is correct and why. LO19.3 Answer: The second person may be correct; the first is not. There will always be sources of energy available (flowing water, the wind, and the sun, if nothing else), but some aren‘t cheap to use. In recent decades, oil has been one of the cheapest sources, but as growing demand begins to outstrip our ability to increase production, prices rise and it becomes less cheap. As oil prices rise, other sources of energy (solar, wind, and biodiesel) become economically viable. They are not necessarily cheap energy sources as oil was, but they are energy sources.

Technological advances may also discover new cheap sources of energy, in which case neither of our two people will be correct.

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389. Recall the model of nonrenewable resource extraction presented in Figure 19.5.

Suppose that a technological breakthrough means that extraction costs will fall in the future (but not in the present). What effect will this breakthrough have on future profits and, therefore, on current user cost? Will current extraction increase or decrease? Compare this situation to one in which future extraction costs remain unchanged but current extraction costs fall. In the latter situation, does current extraction increase or decrease? Does the firm‘s behavior make sense in both situations? That is, does its response to the changes in production costs in each case maximize the firm‘s stream of profits over time? Explain. LO19.4

Answer: A reduction in future extraction costs will increase future profits, increasing the user cost for present extraction. This will cause current extraction to decrease as firms wait to take advantage of the new technology.

In contrast, if only current extraction costs fall, it is more profitable to extract in the present, and current extraction will increase.

The firm‘s behavior in both situations makes economic sense. The firm is trying to maximize the firm‘s stream of profits over time; changes that make current extraction more profitable will cause greater extraction now; changes increasing the profitability of future extraction will lead firms to extract less in the present.

390. If the current market price rises, does current extraction increase or decrease?

What happens if the future market price rises? Do these changes in current extraction help to ensure that the resource is extracted and used when it is most valuable?

Explain.

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Answer: An increase in the current market price, all else equal, would increase the profitability of current extraction. This would lead firms to extract more in the present. Conversely, an increase in future prices increases the user cost of present extraction and will discourage current extraction. As long as the firms have good information about current and future profitability (including current and future resource prices and extraction costs), these changes in current extraction assure that resources will be extracted when their economic value is greatest. (Note that this also assumes the absence of externalities that, if considered, would alter extraction patterns.)

391. ADVANCED ANALYSIS Suppose that a government wants to reduce its economy‘s dependence on coal and decides as a result to tax coal mining companies $1 per ton for every ton of coal that they mine. Assuming that coal-mining companies treat this tax as an increase in extraction costs this year, what effect will the tax have on current extraction in the model used in Figure 19.5? Now, think one step ahead.

Suppose that the tax will be in place forever, so that it will also affect extraction costs in the future. Will the tax increase or decrease user cost? Does this effect increase or decrease the change in current extraction caused by the shift of the EC curve? Given your finding, should environmental taxes be temporary? Explain. LO19.4

Answer: If the tax only increases current extraction costs (i.e., will not be extended into the next period), current extraction will be less profitable and less will occur. If, however, the tax is permanent, it will also increase future extraction costs, lower future profits, and reduce the user cost considered for current extraction decisions. Referring to the model represented by the figure, while the EC curve will shift up the total cost curve (TC), the decrease in user cost (UC) will shift it back down, but not by the full amount (the present value of a $1 tax in the future is less than $1). The result will be some reduction in current extraction, but not as much as if the tax were temporary. If the government wants to better discourage current extraction, environmental taxes should be temporary.

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Although that leaves the question of what to do next year; if the government keeps imposing ―temporary‖ taxes, eventually there will be an expectation of permanency, regardless of the official status of the tax.

392. ADVANCED ANALYSIS User cost is equal to the present value of future profits in the model presented in Figure 19.5. Will the optimal quantity to mine in the present year increase or decrease if the market rate of interest rises? Explain. Does your result make any intuitive sense? (Hint: If interest rates are up, would you want to have more or less money right now to invest at the market interest rate?) LO19.4

Answer: An increase in market interest rates will reduce the present value of a future payment (including future profits from extraction), so an increase in interest rates will reduce the user cost and increase the optimal quantity of current extraction. Intuitively, higher interest rates mean that it is even more valuable to have a dollar to invest now than in the future, so altering production to generate more current profits yields a greater long-run stream of profits than delaying extraction (and profits) to a later period.

393. Various cultures have come up with their own methods to limit catch size and prevent fishery collapse. In old Hawaii, certain fishing grounds near shore could be used only by certain individuals. And among lobstermen in Maine today, strict territorial rights are handed out so that only certain people can harvest lobsters in certain waters.

Discuss specifically how these systems provide incentives for conservation. Then think about the enforcement of these property rights. Do you think similar systems could be successfully enforced for deep-sea fishing, far off shore? Explain. LO19.5 Answer: Those given rights to a certain fishery have an incentive to harvest at a sustainable rate so that they can generate a long-run stream of profits. If the area to be fished is carefully defined and reasonably small, enforcing the property rights over a given fishery should be relatively easy. The further the fishing 1-401 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

moves from shore, the more difficult and costly it would be to enforce these rights. Illegal fishers could go undetected more easily, and the added time and fuel costs to patrol further from shore would greater limit the ability to enforce.

394. Aquaculture is the growing of fish, shrimp, and other seafood in enclosed cages or ponds. The cages and ponds not only keep the seafood from swimming away but also provide aquaculturists with strong property rights over their animals. Does this provide a good incentive for low-cost production as compared with fishing in the open seas where there are few if any property rights? LO19.5 Answer: By having property rights over the fish, aquaculturists have strong incentives to care for the fish, including finding ways to raise the seafood using low-cost techniques. Aquaculturists have little incentive to invest in fish in open waters, as the likelihood of someone else benefiting from their efforts is high.

395. LAST WORD The figure in the Last Word section shows that a 10-fold increase in a country‘s GDP per person is associated with about a 20-point increase in EPI. However, GDP per person was $63,414 in the United States in 2020 but $28,377 in Greece; yet Greece had an EP I score of 69.1, that was almost as high as the United States‘ EP I score of 69.3. So is getting rich absolutely necessary to maintaining a clean environment? Discuss.

Answer: Higher living standards are strongly related to better environmental outcomes because most people like having a cleaner environment. Thus, as living standards rise and people can afford to ―purchase‖ cleaner outcomes, they do (with much of those cleaner outcomes being ―purchased‖ by paying the higher amounts of taxes necessary to run government agencies charged with setting and enforcing environmental standards.) It is the case, however, that countries with 1-402 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

lower incomes can also choose to ―purchase‖ better environmental outcomes, too, even though their lower incomes make those purchases more costly as a fraction of their incomes. Thus, we see that Greece, despite having average incomes that are less than half of those in the United States, has allocated the resources necessary to ―purchase‖ environmental outcomes that are nearly as good as those in the United States, as measured by EP I. REVIEW QUESTIONS The long-run downward trend in commodity prices is consistent with the idea that: LO19.1 hhhhhhhhhhhhhhhhhh. we are quickly running out of resources. iiiiiiiiiiiiiiiiii. resource demands have been increasing faster than resource supplies. jjjjjjjjjjjjjjjjjj. birthrates will soon increase due to the falling cost of living. kkkkkkkkkkkkkkkkkk. resource supplies have increased faster than resource demands.

Answer: d. Resource supplies have increased faster than resource demands.

For the last 200 years, the demand for resources has been growing steadily, driven by an increasing world population and by increasing per-capita consumption. The only way that commodity prices could have shown the long-run downward trend that they have is if the supply of commodities increased faster than the demand for commodities (so that equilibrium prices would have fallen as a result of supply increasing faster than demand).

Thus, the correct answer to this question is that the long-run downward trend in commodity prices is consistent with the idea that resources supplies have increased faster than resource demands.

396. It would cost the town of Irondale $50 million to build a gas-powered generator that could produce a maximum of 5 megawatts of electricity at 15 cents per hour.

Another alternative is for Irondale to build a $100 million coal-fired generator that could produce a maximum of 15 megawatts of electricity at 5 cents per hour. Irondale should: LO19.2 build the coal-fired generator because its hourly operating costs are so much lower. llllllllllllllllll. build the gas-powered generator since it is less expensive to build. mmmmmmmmmmmmmmmmmm. build the coal-fired generator because, while it would cost twice as much to build, it would produce three times as much electricity. nnnnnnnnnnnnnnnnnn. obtain more information before deciding what to do.

Answer: d. Obtain more information before deciding what to do.

The correct answer is that Irondale should obtain more information before deciding what to do. This is true because it is not possible to determine which of these two plant sizes would be the best way to supply Irondale‘s electricity needs without knowing what those needs are.

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For example, suppose that Irondale‘s maximum electricity demand over the course of a day is never greater than 5 megawatts of electricity. Then it would likely be very wasteful to build a plant with a 15-megawatt capacity, as two-thirds of the plant‘s capacity would never be used.

Alternatively, suppose that Irondale‘s demand for electricity is 20 megawatts.

Then the best option would likely be to build one coal-fired plant and one gasfired plant. But, again, it is not possible to know what the best thing to do is without getting more information about Irondale‘s demand situation.

397. After mining 9,273 tons of coal, Blue Sky Mining‘s managers note that the marginal cost of mining the next ton of coal would be $40 per ton. They also calculate that the user cost of mining that next ton of coal would be $35. If the market price of coal is $72, should Blue Sky mine an additional ton of coal? LO19.4 Yes, it should mine. oooooooooooooooooo. No, it should not mine. pppppppppppppppppp. More information is needed.

Answer: No it should not mine.

Blue Sky should not mine another ton of coal because the total cost of doing so would exceed the price at which that ton could be sold.

To see this, note that the total cost of mining the next ton of coal is the sum of its extraction cost of $40 per ton and its user cost of $35 per ton. So, the total cost would be $75 per ton. That value exceeds coal‘s selling price of $72 per ton. So, Blue Sky should not mine the next ton of coal as doing so would result in a loss of $3.

398. Good methods for helping to protect natural resources include: LO19.5 establishing property rights and giving them to local users. qqqqqqqqqqqqqqqqqq. encouraging first-come, first-served harvesting. rrrrrrrrrrrrrrrrrr. teaching people to consider user cost. ssssssssssssssssss. having the government set up and enforce ITQs. Answer: a, c, and d are correct.

Assigning property rights to local users creates incentives for them to conserve.

The basic idea is that property rights allow local users to benefit from not using a resource up as quickly as possible. That is because people who possess property rights know that anything that they do not use this year will be available for them to use and benefit from in the future. That gives them an incentive to harvest their resource at a sustainable rate.

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incentive to harvest as much of the resource as possible, as quickly as possible, before anyone else can. The unfortunate result is that the resource is quickly depleted.

That tendency can also be slowed by teaching people to consider user cost so that they can see an incentive to reduce current consumption and by having the government set up and enforce individual transferrable quotas (ITQs) so that the total amount harvested will be set at a sustainable level and the harvesting will be done by the lowest-cost fishers or harvesters.

399.

Ingvar and Olaf are the only two fishermen in their area. Each has been assigned an ITQ that allows him to catch 20 tons of salmon.

Ingvar‘s MC of catching salmon is $6 per ton, while Olaf‘s MC of catching salmon is $7 per ton. If the price of salmon is $10 per ton, then to maximize efficiency, the two fishers should trade ITQs until Ingvar is in charge of catching _ tons while Olaf catches _ tons. LO19.5 20; 20. tttttttttttttttttt. 30; 10. uuuuuuuuuuuuuuuuuu. 40; 0. vvvvvvvvvvvvvvvvvv. 0; 40.

Answer: c. 40; 0.

To maximize efficiency, the two guys should trade ITQ s until Ingvar is in charge of catching 40 tons while Olaf catches 0 tons.

This is true because Ingvar is the more efficient fisher, the one with the lower MC of catching salmon. In particular, efficiency would be greater if he were the one catching all the fish because his lower MC implies that he can get the job done while using up less resources.

PROBLEMS Suppose that the current (first) generation consists of 1 million people, half of whom are biological women. If the total fertility rate is 1.3 and the only way people die is of old age, how big will the fourth generation (the great-grandchildren) be? How much smaller (in percentage terms) is each generation than the previous generation? How much smaller (in percentage terms) is the fourth generation than the first generation?

Are you surprised by how quickly the population declines? LO19.1 Answer: fourth generation = 274,625; each successive generation will be 35% smaller than the previous one; the fourth generation will be 72.53% smaller; no.

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Feedback: To answer this question, we first note that the total fertility rate is the average number of children a biological woman is expected to have during her lifetime. This implies that the total fertility rate of 1.3 translates into a population growth rate of (1.3/2) − 1 = −0.35 (approximate decline of 35%). The reason is that each biological woman must have 2 children on average to replace one male and one female (ignoring mortality).

Using the rate of population growth above, we can calculate the size of each sequential generation.

Second generation (our children): 1,000,000 × [1 + (−0.35)] = 1,000,000 × (1 − 0.35) = 1,000,000 × .65 = 650,000 Third Generation (our grandchildren): 650,000 × (1 − 0.35) = 650,000 × .65 = 422,500 Fourth Generation (our great-grandchildren): 422,500 × (1 − 0.35)) = 422,500 × .65 = 274,625 Note you could use the formula: Future Population = (First) Initial Population × (1 + Rate of Growth)t , where t is the number periods into the future.

Our example is: Future Population = 1,000,000 × (1 − 0.35)3 = 1,000,000 × 0.274625 = 274,625 From the rate of decline found above, each successive generation will be 35 percent smaller.

The fourth generation will be 72.53 percent smaller [= (274,625 − 1,000,000) / 1,000,000)].

This shouldn't be a surprise given the student‘s understanding of compounding over time.

400. A coal-fired power plant can produce electricity at a variable cost of 4 cents per kilowatt-hour when running at its full capacity of 30 megawatts per hour, 16 cents per 1-406 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

kilowatt-hour when running at 20 megawatts per hour, and 24 cents per kilowatt-hour when running at 10 megawatts per hour. A gas-fired power plant can produce electricity at a variable cost of 12 cents per kilowatt-hour at any capacity from 1 megawatt per hour to its full capacity of 5 megawatts per hour. The cost of constructing a coal-fired plant is $50 million, but it costs only $10 million to build a gas-fired plant. LO19.2

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Consider a city that has a peak afternoon demand of 80 megawatts of electricity. If it wants all plants to operate at full capacity, what combination of coal-fired plants and gas-fired plants would minimize construction costs? wwwwwwwwwwwwwwwwww. How much will the city spend on building that combination of plants? xxxxxxxxxxxxxxxxxx. What will the average cost per kilowatt-hour be if you average over all 80 megawatts that are produced by that combination of plants?

(Hint: A kilowatt is one thousand watts while a megawatt is one million watts). yyyyyyyyyyyyyyyyyy. What would be the average cost per kilowatt-hour be if the city had instead built three coal-fired plants?

Answers: ff. Two coal-fired plants plus 4 gas-fired plants gg. The city will spend $140 million building the plants hh. 6 cents per kilowatt-hour ii. 7 cents per kilowatt-hour Feedback: Parts a and b: To operate at full capacity, we have three choices. Choice 1: 2 coal-fired plants and 4 gas-fired plants; Choice 2: 1 coal-fired plant and 10 gas-fired plants; Choice 3: 16 gas-fired plants (max capacity needs to add up to 80 megawatts per hour).

Choice 1 will cost $140 million [= $100 million (coal) + $40 million (gas)].

Choice 2 will cost $150 million [= $50 million (coal) + $100 million (gas)].

Choice 3 will cost $160 million [(= $160 million (gas)].

The city should build 2 coal-fired plants and 4 gas-fired plants to minimize production costs. The total cost of construction is $140 million.

You could also recognize that it takes 6 gas-fired plants to replace 1 coal-fired plant to produce a 30-megawatt capacity. Since the cost of building 6 gas-fired plants ($60 million) is greater than the $50 million for the coal-fired plant, build coal-fired plants until the remainder of necessary capacity is less than 30. Then fill this remainder with gas-fired plants. c. To calculate the average cost per kilowatt hour, we first recognize that 75 percent of our energy will be produced by the 2 coal-fired plants (30megawatt capacity) and 25 percent of our energy will be produced by 4 gasfired plants (5-megawatt capacity). The cost per kilowatt-hour for the coalfired plants is 4 cents, and the cost per kilowatt-hour for the gas-fired plants is 12 cents.

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Taking a weighted average of the two costs per kilowatt-hour using the percentages of energy production as weights, we have: Average cost per kilowatt-hour = 0.75 × $0.04 + 0.25 × 0.12 = $0.03 + $0.03 = $0.06 (or 6 cents).

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d. If the city built three coal-fired plants, then two would operate at full capacity (30 megawatts) at a cost of 4 cents per kilowatt-hour and the second would operate at two-thirds capacity (20 megawatts) at a cost of 16 cents per kilowatt-hour.

They average cost per kilowatt-hour is $0.07 or 7 cents (= 0.75 × $0.04 + 0.25 × $0.16).

401. Suppose that Sea Shell Oil Company (SS) is pumping oil at a field off the coast of Nigeria. At this site, it has an extraction cost of $30 per barrel for the first 10 million barrels it pumps each year and then $60 per barrel for all subsequent barrels that it pumps each year, up to the site‘s maximum capacity of 90 million barrels per year.

LO19.4 Suppose the user cost is $50 per barrel for all barrels and that the current market price for oil is $90 per barrel. How many barrels will S S pump this year? What is the total accounting profit on the total amount of oil it pumps? What is the total economic profit on those barrels of oil? zzzzzzzzzzzzzzzzzz. What will happen if the current market price for oil rises to $120 per barrel while the user cost remains at $50 per barrel? How many barrels will SS pump and what will be its accounting profit and its economic profit? aaaaaaaaaaaaaaaaaaa. If the current market price remains at $120 per barrel but the user cost rises to $95 per barrel, how many barrels will S S pump this year? What will be its accounting profit and its economic profit?

Answers: (a) SS will pump only 10 million barrels. The accounting profit would be $600 million, while the economic profit would be $100 million. (b) At $120 per barrel, the firm would now produce its maximum capacity of 90 million barrels per year. Accounting profits will be $5.7 billion, and economic profits will be $1.2 billion. (c) SS will pump zero barrels of oil. For instance, the total cost of pumping any of the first 10 million barrels is no $125 per barrel (= $30 of extraction cost + $95 of user cost), which exceeds the market price of $120 per barrel.

Feedback: rrrrrrrrr.

Only produce the first 10 million barrels. To approach this problem, solve for the total cost, then the accounting and economic profits for the first 10 million barrels. If the revenues are greater than the costs, then produce.

Total cost per barrel = $80 = $50 (implicit user costs) + $30 (explicit costs)

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Accounting profit per barrel = $60 = $90 (market price it is sold at i.e., the revenue) − $30 (explicit cost of extraction)

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Total Accounting Profit = $600 million = $90 per barrel × $10 million barrels Economic Profit per barrel = $10 = $90 (revenue) − $30 (explicit costs) − $50 (implicit cost) Total Economic Profit = $100 million = $10 per barrel × $10 million barrels Now do this again but for the next barrel of oil which costs $60 to extract instead of $30.

Total cost per barrel = $110 = $50 (implicit user costs) + $60 (explicit costs) Since the total costs are greater than the revenues per barrel, it is not worth producing the next barrel. sssssssss.

At $120 per barrel, the firm would now produce its maximum capacity of 90 million. The revenue has increased per barrel, thus produce the first 10 million barrels of oil.

Now do this again but for the next barrel of oil which costs $60 to extract instead of $30.

Total cost per barrel = $110 = $50 (implicit user costs) + $60 (explicit costs) Since revenues are $120 per barrel, which is greater than the total costs per barrel of $110, they should produce all 90 million barrels.

Total Accounting Profit = $5.7 billion = $120(revenues per barrel) × 90 million barrels − $60 (explicit costs per barrel after the first 10 million) × 80 million barrels − $30 (explicit costs for the first 10 million barrels) × 10 million barrels Total Economic Profit = $1.2 billion = $120 (revenues per barrel) × 90 million barrels − $60 (explicit costs per barrel after the first 10 million barrels) × 80 million barrels − $30 (explicit costs for the first 10 barrels) × 10 million barrels − $50 (implicit user cost) × 90 million barrels

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ttttttttt.

SS will pump zero barrels of oil this year and will have $0 economic and $0 accounting profit. This is because the total economic cost of pumping barrels exceeds the revenue per barrel. For instance, the total cost of pumping any of the first 10 million barrels is now $125 per barrel (= $30 of extraction cost + $95.00 of user cost), which exceeds the market price of $120 per barrel.

402. Eric and Kyle are fishermen with different equipment and, as a result, different costs for catching fish. Eric‘s costs for catching fish are $1,000 per ton for the first five tons and then $2,500 per ton for any additional tons. Kyle can harvest fish at a cost of $3,000 for the first 15 tons and then $1,400 for any additional tons. LO19.5 If society wants 30 tons of fish and for some reason will only allow one of the two fishers to do all the fishing, which one should society choose if it wants to minimize the cost of catching those 30 tons of fish? How much will the total cost of catching the fish be? What will the average cost per ton be for the 30 tons? bbbbbbbbbbbbbbbbbbb. If society wants 30 tons of fish and wants them for the least cost regardless of which guy is catching them, how much should Eric and Kyle each catch? How much will the total cost of catching 30 tons be? What will the average cost per ton be for the 30 tons? ccccccccccccccccccc. Suppose that Eric and Kyle can both sell whatever amount of fish they catch for $3,000 per ton. Also suppose that Eric is initially given ITQ s (individual transferable quotas) for 30 tons of fish while Kyle is given ITQs for zero tons of fish. Suppose that Kyle is willing to pay Eric $550 per ton for as many tons of ITQs as Eric is willing to sell to Kyle. How much profit would Eric make if he used all the ITQs himself? What if Eric sold 25 tons‘ worth of his ITQ s to Kyle while using the other 5 tons of ITQs to fish for himself? ddddddddddddddddddd. What price per ton can Kyle offer to pay Eric for 25 tons of ITQ s such that Eric would make exactly as much money from that deal (in which he sells 25 tons‘ worth of his ITQs to Kyle while using the rest to fish for himself) as he would by using 30 tons of ITQs for himself?

Answers: Kyle should catch all the fish; total cost will be $66,000. The average cost per ton will be $2200. jj. Eric should catch 5 tons and Kyle should catch 25 tons. The total cost will be $64,000. The average cost per ton will be $2,133.33. kk. If Eric used the ITQs himself his profit would be $22,500. By contrast, if he fished with 5 tons‘ worth of permits and sold the rest for $550 each, he would make $23,750. ll. $500 per ton of ITQ s Feedback: The first step is to calculate the total cost of catching 30 tons of fish for both Eric and Kyle.

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The total cost for Eric is $67,500 [= $1,000 × 5 (first 5 tons) + $2,500 × 25 (next 25 tons)].

The total cost for Kyle is $66,000 [= $3,000 × 15 (first 15 tons) + $1,400 × 15 (next 15 tons)].

Kyle should harvest the fish. The average cost per ton equals $2,200 (= $66,000 ÷ 30).

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uuuuuuuuu. The first step is to recognize that Eric can catch the first 5 tons of fish at the lowest cost. Thus, Eric will catch the first 5 tons of fish.

The second step is to determine the lowest cost for the next 25 tons of fish.

The total cost for Eric is $62,500 [= $2,500 × 25 (next 25 tons)].

The total cost for Kyle is $59,000 [= $3,000 × 15 (first 15 tons) + $1,400 × 10 (next 10 tons)].

Thus, Kyle should harvest the next 25 tons.

Note: We could also compare the average cost per ton for the next 25 tons.

Here the average cost per ton for Eric is $2,500 (= $62,500 ÷ 25) and the average cost per ton for Kyle is $2,360 (= $59,000 ÷ 25).

The total cost for the 30 tons of fish is $64,000 [= $5,000 (Eric's 5 tons) + $59,000 (Kyle's 25 tons)].

The average cost per ton is $2133.33 (= $64,000 ÷ 30). vvvvvvvvv. If Eric harvested the 30 tons himself, his revenue would be $90,000 (= $3,000 × 30). The total cost of harvesting 30 tons is $67,500 (see part a). Thus, Eric's profit is $22,500 (= $90,000 − $67,500).

If Eric harvests 5 tons of fish, his revenue will be 15,000 (= $3,000 × 5). His cost from harvesting 5 tons will be $5,000 (see part a). His profit from harvesting the 5 tons of fish is $10,000 (= $15,000 − $5,000). Now Eric also sells Kyle 25 ITQs for a price of $550. This brings in the additional revenue of $13,750 (= $550 × 25) at zero cost.

Thus, Eric's profit is $23,750 [= $10,000 (harvesting) + $13,750 (sale of ITQs)].

Eric should harvest 5 tons and sell 25 tons worth of ITQs. wwwwwwwww.

The profit per-ton Eric can make on his next 25 tons is $500 [= $3,000 (sale price per ton) − $2,500 (cost per ton, next 25 tons)].

Thus, $500 per ton is the lowest price that Kyle could pay Eric. At that price, Eric makes exactly as much money using the permits himself as he would by selling them to Kyle.

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Chapter 20 - Public Finance: Expenditures and Taxes McConnell Brue Flynn 23e DISCUSSION QUESTIONS 403. Use a circular flow diagram to show how the allocation of resources and the distribution of income are affected by each of the following government actions.

LO20.1 eeeeeeeeeeeeeeeeeee.

The construction of a new high school. fffffffffffffffffff. A 2-percentage-point reduction of the corporate income tax. ggggggggggggggggggg. An expansion of preschool programs for disadvantaged children. hhhhhhhhhhhhhhhhhhh. The levying of an excise tax on polluters.

Answer: xxxxxxxxx. In building the school, the effect would be an increase in government expenditures to the product market (5) and an increase in business revenues (3). The owners of the resources used to build the school will have an increase in income (1). Resources will be diverted away from the private sector (flows 3 and 4 will shrink, 5 and 6 will increase). To pay for the high school, taxes may have to be increased (11 and 12). If the economy is experiencing unemployment, the increase in government spending (5) may increase total output and employment. The effect on the distribution of income 1-416 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

(the flows within 1 and 12) will depend on the progressivity of the tax system versus the distribution of the compensation to the resources building the school. yyyyyyyyy. Business taxes will be reduced (11). Business owners will receive a larger percent of the money income (1). If businesses use the increased profits to buy capital goods, labor and the owners of the other resources could benefit. If the reduction in the corporate income taxes results in a decrease in government spending (5) and an increase in corporate spending (1), there would be a reallocation of resources. If the economy is experiencing unemployment and government spending does not decrease, there could be an increase in spending if businesses increase their spending on capital goods (1).

The effect on distribution will depend largely on whether the profits go directly to high-income owners or are reinvested into the capital and labor of the company. zzzzzzzzz.

This is shown as an increase in goods and services from government to households (9) or as a decrease in net taxes, which is equivalent to an increase in transfer payments (12). In either case, this is a redistribution of income or services in favor of the less well off. As additional teachers are hired and paid, there will be an increase in resources paid by the government (7).

There will be some reallocation of resources from private enterprise to government and some decrease in unemployment, unless the economy is already at full employment. In this case, there will some upward pressure on prices since, to the extent the program is a transfer payment, there will be no increase in production. aaaaaaaaaa. This will be an increase in net taxes paid by business (11). Since business will regard this as an increase in costs, it will decrease its demand for resources (2), leading to a decreased flow of income to the resource markets (1). With less money income, households will decrease their consumption demand for goods and services from businesses (4) and business receipts (3) will be less. Also, the decrease in household income will lead to a decrease in net household taxes paid to government (12).

The distribution of income will be slightly away from profits and therefore toward the other three categories. To the extent that total tax revenues increase (11) - (12), there will be a slight increase in allocation of resources to government away from private enterprise. There will also likely be a reallocation of resources toward pollution-control equipment. The increased costs to business, having caused decrease in supply, will tend to increase unemployment and prices.

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404. What do economists mean when they say government purchases are ―exhaustive‖ expenditures whereas government transfer payments are ―non-exhaustive‖ expenditures? Cite an example of a government purchase and a government transfer payment. LO20.2 Answer: Exhaustive expenditures are for products that directly absorb resources and are part of domestic output—they ―exhaust‖ or use resources. Nonexhaustive expenditures do not directly absorb resources or create output; they merely change ownership of financial resources. Government purchases include building bridges, buying tanks and missiles, and hiring troops and teachers. Transfer payments include welfare checks, Social Security payments, and subsidies to large corporations.

405. What are the main categories of government spending? What are the main categories of government revenue? LO20.2 Answer: The main categories of Federal spending are pensions and income security, national defense, health, and interest on the public debt. Federal revenues come primarily from personal income taxes, payroll taxes, and corporate income taxes.

406. What is the most important source of revenue and the major type of expenditure at the federal level? LO20.3 Answer: At the Federal level, the most important source of revenue is the personal income tax. The main expenditure is for income security.

407. For state and local governments, what are the three most important sources of revenue and types of expenditure? LO20.4 Answer: At the state level, the most important sources of revenue are sales and excise taxes (46 percent), followed by personal income taxes (38 percent), and then licenses and other taxes (10 percent). The main expenditures are for welfare (38 percent) and education (37 percent). States also spend heavily on health and hospitals (8 percent), highway maintenance and construction (8 percent), and public safety (4 percent). That leaves about 5 percent of all state spending for a variety of other purposes.

At the local level, the most important source of revenue is, by far, property taxes.

Sales and excise taxes, and personal and corporate income taxes are the next two largest sources of local tax revenue. Education is by far the most important expenditure.

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408. How do the top two categories of federal employment differ from the top two categories of local and state employment? LO20.5

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Answer: Half of federal government jobs are in national defense or the postal service. Over half of state and local government employment is focused on education, with elementary and secondary education first and higher education second.

409. Distinguish between the benefits-received and the ability-to-pay principles of taxation. Which philosophy is more evident in our present tax structure? Justify your answer. To which principle of taxation do you subscribe? Why? LO20.6 Answer: The benefits-received principle holds that governments should supply public goods and services in much the same manner as a private business would.

Those who make use of government services should pay for them. This principle is at work in the gasoline tax, with the proceeds going to the building and upkeep of roads, and in the sale of postage stamps. However, even here the principle is hardly fully respected. Some drivers get paved highways, while others who drive just as much, do so on dirt roads. And the same first-class postage stamp will move a letter ten miles or three thousand.

The redistribution of income by government—transfer payments—would be impossible with the benefits-received principle. People on welfare receive benefits because they need more from government than they could possibly contribute in taxes.

The ability-to-pay principle of taxation takes account of this fact and assesses tax liability based on a person‘s ability to pay: The higher one‘s income, the higher the tax and the higher the percentage of one‘s income paid in tax. The objection to this principle is that it cannot be decided in principle how much more a wealthy person should pay than one of restricted means. The decision then becomes a political one—with the decision everywhere being not to make the wealthy pay fully in accordance with their ability to pay. In summary, it seems that the ability-to-pay principle is the one that is the most, if half-heartedly, respected in the United States.

410. What is meant by a progressive tax? A regressive tax? A proportional tax?

Comment on the progressivity or regressivity of each of the following taxes, indicating in each case where you think the tax incidence lies: (a) the federal personal income tax, (b) a 4 percent state general sales tax, (c) a federal excise tax on automobile tires, (d) a municipal property tax on real estate, (e) the federal corporate income tax, (f) the portion of the payroll tax levied on employers. LO20.6 Answer: A progressive tax is one whose average rate increases as income increases. One pays in tax a larger proportion of one‘s income as income increases.

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A regressive tax is one whose average rate declines as income increases. One pays in tax a smaller and smaller proportion of one‘s income as income increases, though it is possible for the absolute amount to increase.

A proportional tax is one whose average rate remains the same regardless of the size of income. mm. Mildly progressive (―mildly‖ because of loopholes). Incidence is usually on the taxpayer. However, those who charge a fee for services (that is, the self-employed) may be able to increase their fees enough to have the fee-payer in effect pay the tax. Also, some unions may be able to get big enough wage increases to pay increased income tax. nn. Regressive. The poor spend all their income, mostly on commodities subject to the sales tax. Thus, the sales tax is, in effect, on all their income. The wealthier one is, the smaller the proportion of one‘s income is spent on commodities subject to the sales tax. (Stocks and bonds and real estate are not subject to this tax.) Thus, the average tax rate declines as income increases.

The incidence of the tax is mostly on the consumers who buy the taxed commodities. oo. Regressive for the same reasons as for state general sales taxes. The incidence, again, is mostly on the buyer. There are no substitutes for automobile tires (assuming one does not give up driving a car), so the demand is relatively inelastic. pp. The incidence is on (1) owners in the case of an owner-occupied residence or land; (2) tenants if the property is rented; (3) consumers if the property is used in business. In the case of (1) and (2), the tax tends to be proportional since the tax is based on the value of the property, and the lower one‘s income, the lower the value of the property one owns or rents. In the case of (3), the tax will be regressive for the same reasons the state general sales tax is regressive. qq. The incidence is probably shared between the corporation‘s shareholders and the buyers of the corporation‘s products. To the extent it is on the shareholders, the tax is proportional. To the extent it is on the consumers, it is regressive for the same reasons the general sales tax is regressive. rr. The incidence is probably shared by both the worker and the employer. The actual distribution of the tax incidence will depend on the relative labor supply and demand elasticities.

411. What is the tax incidence of an excise tax when demand is highly inelastic?

Highly elastic? What effect does the elasticity of supply have on the incidence of an 1-421 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

excise tax? What is the efficiency loss of a tax, and how does it relate to elasticity of demand and supply? LO20.7

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

The efficiency loss of a sales or excise tax is the net benefit society sacrifices because consumption and production of the taxed product are reduced below the level of allocative efficiency which would occur without the tax. Other things equal, the greater the elasticities of demand and supply, the greater the efficiency loss of a particular tax.

412. Given the inelasticity of cigarette demand, discuss an excise tax on cigarettes in terms of efficiency loss and tax incidence. LO20.7 Answer: Since cigarette demand is relatively inelastic, the slope of the (inverse) demand schedule will be relatively steep. This implies that the actual tax incidence will fall on the consumer and the efficiency loss will be relatively small (when compared to a good with a higher elasticity).

In the diagram above, the (per-unit) tax equals the after-tax price the consumer pays minus the after-tax price received by the firm.

The consumer incidence of this equals the after-tax price the consumer pays minus original price prior to the tax.

The producer incidence equals the original price prior to the tax minus the aftertax price received by the firm.

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Given that demand is relatively inelastic, most of the burden falls on the consumer.

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The efficiency loss is the area shown in the triangle above.

413. ADVANCED ANALYSIS Suppose the equation for the demand curve for some product X is P = 8 − 0.6Q and the supply curve is P = 2 + 0.4Q. What are the equilibrium price and quantity? Now suppose an excise tax is imposed on X such that the new supply equation is P = 4 + 0.4Q. How much tax revenue will this excise tax yield the government? Graph the curves, and label the area of the graph that represents the tax collection ―TC‖ and the area that represents the efficiency loss of the tax ―E L.‖ Briefly explain why area EL is the efficiency loss of the tax but TC is not. LO20.7 Answer: To determine the equilibrium quantity we equate the supply schedule with the demand schedule (in equilibrium the price must be the same for both schedules).

8  0.6Q  2  0.4Q or 8  2  0.6Q  0.4Q, thus Q*  6

We can solve for the equilibrium price by substituting the equilibrium quantity back into the supply or demand schedule.

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

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

8  0.6Q  4  0.4Q or 8  4  0.6Q  0.4Q, thus Q*  4

We can solve for the equilibrium price by substituting the equilibrium quantity back into the NEW supply or demand schedule.

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

The area EL represents the loss to society that results from the reduction in consumption and production of good X. The loss occurs because the fifth and 1-425 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

sixth units are no longer produced. The area TC represents a shifting from buyers and sellers in the market to government and, by extension, the beneficiaries of public goods provided with the taxes collected. There is no loss of output to society in area TC.

414. Is it possible for a country with a regressive tax system to have a tax-spending system that transfers resources from the rich to the poor? LO20.8 Answer: Yes. The rich may be paying a lower fraction of their incomes in taxes (because the country has a regressive tax system) but just as long as the spending of the country is tilted sufficiently toward the poor that the poor get more in spending than they pay in taxes (and vice versa for the rich), the country can have a tax-spending system that transfers resources from the rich to the poor.

415. LAST WORD Does a progressive tax system by itself guarantee that resources will be redistributed from the rich to the poor? Explain. Is the tax system in the United States progressive, regressive, or proportional? Does the tax-spending system in the United States redistribute resources from higher income earners to lower income earners? Explain Answer: No, a progressive tax system by itself does not guarantee that resources will be distributed from the rich to the poor. It is quite possible that the tax revenue is returned to the rich in terms of the goods, services, and transfers provided by the government.

However, it does appear that the tax-spending system in the United States is progressive. That is, not only is the tax system progressive in the United States 1-426 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

(there is a higher average tax rate on individuals with higher incomes), but the tax revenue collected is disproportionately spent (relative to taxes paid) on the lower quintiles of the income distribution.

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REVIEW QUESTIONS The city of Joslyn has three sources of revenue: borrowing, proprietary income from running the local electric power utility, and taxes. If it received $10 million from running the electric power utility and borrowed $40 million, how much did it collect in taxes? LO20.2 $140 million. iiiiiiiiiiiiiiiiiii. $110 million. jjjjjjjjjjjjjjjjjjj. $100 million. kkkkkkkkkkkkkkkkkkk. Nothing.

Answer: c. $100 million.

Joslyn collected $100 million in taxes. We know this must be the case because Joslyn‘s total revenue of $150 million could come from only three sources: taxes, borrowing, and proprietary income. Thus, the fact that borrowing and proprietary income were, respectively, $40 million and $10 million, implies that taxes had to be the source of the other $100 million.

In terms of math, $100 million from taxes = $150 million in revenues − $40 million in borrowing − $10 million in proprietary income.

416.

Suppose George made $20,000 last year and that he lives in the country of Harmony. The way Harmony levies income taxes, all citizens must pay 10 percent in taxes on their first $10,000 in earnings and then 50 percent in taxes on anything else they might earn. Given that George earned $20,000 last year, his marginal tax rate on the last dollar he earns will be _ and his average tax rate for his entire income will be _ . LO20.3 50 percent; 50 percent lllllllllllllllllll.

50 percent; less than 50 percent mmmmmmmmmmmmmmmmmmm. 10 percent; 50 percent nnnnnnnnnnnnnnnnnnn. 10 percent; less than 50 percent Answer: b. 50 percent; less than 50 percent.

George‘s marginal tax rate will be 50 percent, and his average tax rate will be less than 50 percent.

To see why this is true, begin by looking at the marginal tax rate that George must pay on the last dollar he earns. Because his income is $20,000 per year, we know that the higher 50 percent rate will apply to the last dollar he earned because that last dollar is above the $10,000 cutoff at which the higher 50 percent rate applies.

With respect to the average tax rate that George will pay, it has to be less than 50 percent because it will be the average of the 10 percent rate that he is required to pay on his first $10,000 income and the 50 percent rate that he is required to pay on the rest of his income. If you average a higher number (like 50 percent) with a 1-428 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

lower number (like 10 percent), you will always get something in between—in this case, a number that has to be less than 50 percent.

Another way to see why George‘s average tax rate must be less than 50 percent is to do the math and calculate his average tax rate. To begin with, since the tax rate on the first $10,000 of income is 10 percent, George will owe $1,000 in taxes on that first $10,000 in income (because 10 percent of $10,000 is $1,000). And since the tax rate on the rest of George‘s income is 50 percent, he will owe $5,000 in taxes on the next $10,000 of his income. Thus, in total, George will owe $6,000 in taxes on his $20,000 income. That makes for an average tax rate of 30 percent (= $6,000 ÷ $20,000 times 100 to turn the fraction into a percent). And 30 percent is of course less than 50 percent.

417. The nation of Upstandia uses kroner for money and its tax code is such that a person making 100,000 kroner per year pays 40,000 kroner per year in income taxes; a person making 200,000 kroner per year pays 70,000 kroner per year in income taxes; and a person making 300,000 kroner per year pays 90,000 kroner per year in income taxes. Upstandia‘s income tax system is: L O20.6 progressive. ooooooooooooooooooo. regressive. ppppppppppppppppppp. proportional.

Answer: b. Regressive.

Upstantia‘s income tax system is regressive because those with higher incomes pay a smaller fraction of their incomes in taxes. To convince yourself that this is true, compute the average tax rates for each of the three income groups.

The person making 100,000 kroner per year who pays 40,000 kroner per year in income taxes has an average tax rate of 40 percent (= 40,000 ÷ 100,000 × 100 to convert the fraction into a percent.)

Similarly, the person making 200,000 kroner per year who pays 70,000 kroner per year in income taxes has an average tax rate of 35 percent (= 70,000 ÷ 200,000 × 100 to convert the fraction into a percent).

Finally, the person making 300,000 kroner per year who pays 90,000 kroner per year in income taxes has an average tax rate of 30 percent (= 90,000 ÷ 300,000 × 100 to convert the fraction into a percent).

From these numbers, it becomes clear that Upstandia‘s income tax system is regressive because those with higher incomes pay lower average tax rates.

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418. Identify whether each of the following taxes is either progressive or regressive.

LO20.6 Personal income tax qqqqqqqqqqqqqqqqqqq. Sales taxes rrrrrrrrrrrrrrrrrrr. Payroll taxes sssssssssssssssssss.

Property taxes Answer: Personal income tax: Progressive bbbbbbbbbb. Sales taxes: Regressive cccccccccc. Payroll taxes: Regressive dddddddddd. Property taxes: Regressive The personal income tax is progressive because average tax rates rise with income.

Sales taxes, payroll taxes, and property taxes, however, are all regressive because their average tax rates fall with income.

419. The efficiency loss of imposing an excise tax is due to: LO20.7 paying a higher price per unit. ttttttttttttttttttt. producing and consuming fewer units.

Answer: b. producing and consuming fewer units.

The efficiency loss of imposing an excise tax is due to producing and consuming fewer units after the tax is imposed. This is true because all efficiency losses are the result of the equilibrium quantity being reduced to a value that is less than the socially optimal quantity. So, when an excise tax causes the equilibrium quantity to fall (by shifting the supply curve), a deadweight loss results.

There will also be a higher equilibrium price per unit after the tax is imposed, but that higher price does not represent an efficiency loss. There is no efficiency loss because the increase in price becomes revenue to the government, which can then spend the money elsewhere in the economy on public goods that are of high value.

420. True or False. The incidence of property taxes that are levied on rented houses and apartments is high—meaning that those property taxes are paid almost entirely by the landlords. LO20.8 Answer: False. The incidence of property taxes levied on rented properties is in fact low—meaning that very little is paid by the landlords.

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

PROBLEMS Suppose a tax is such that an individual with an income of $10,000 pays $2,000 of tax, a person with an income of $20,000 pays $3,000 of tax, a person with an income of $30,000 pays $4,000 of tax. What is each person‘s average tax rate? Is this tax regressive, proportional, or progressive? LO20.7 Answer: For the individual with an income of $10,000, the average tax rate is 0.2 or 20%; for $20,000, the average tax rate is 0.15 or 15%; for $30,000, the average tax rate is 0.1333 or 13.33%; regressive.

Feedback: To calculate the average tax an individual pays, divide the tax payment by the individual's income. Remember when you are finding a rate to multiple your answer by 100.

For the individual with an income of $10,000, the average tax rate is 20% (= $2,000 ÷ $10,000 × 100).

For the individual with an income of $20,000, the average tax rate is 15% (= $3,000 ÷ $20,000 × 100).

For the individual with an income of $30,000, the average tax rate is 13.33% (= $4,000 ÷ $30,000 × 100).

This tax is regressive because the average tax rate declines as individual income increases.

421. Suppose in Fiscalville there is no tax on the first $10,000 of income, but a 20 percent tax on earnings between $10,000 and $20,000 and a 30 percent tax on income between $20,000 and $30,000. Any income above $30,000 is taxed at 40 percent. If your income is $50,000, how much will you pay in taxes? Determine your marginal and average tax rates. Is Fiscalville‘s income tax progressive? Explain. LO20.7 1-433 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: $13,000; the marginal tax rate is 40%; the average tax rate is 26% (= $13,000 ÷ $50,000); progressive.

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Feedback: Since the individual has an income of $50,000, we must calculate the taxes paid over each of the relevant tax brackets.

From $0 to $10,000, the tax rate is 0%. So, the individual pays $0 on his or her income from $0 to $10,000.

From $10,000 to $20,000, the tax rate is 20%. So, the individual pays $2,000 on his or her income from $10,000 to $20,000. (= 0.2 × $10,000).

From $20,000 to $30,000, the tax rate is 30%. So, the individual pays $3,000 on his or her income from $20,000 to $30,000. (= 0.3 × $10,000).

From $30,000 to higher, the tax rate is 40%. So, the individual pays $8,000 on his or her income from $30,000 to $50,000. (= 0.4 × $20,000).

Adding up the taxes paid over this income range, the total tax paid by this individual is $13,000 [= $0 (first $10,000) + $2,000 (second $10,000) + $3,000 (third $10,000) + $8,000 (last $20,000)].

The marginal tax rate is 40%. This is the tax rate on the last dollar earned.

The average tax rate is 26% (= $13,000 ÷ $50,000).

This tax rate is progressive because the average tax rate will increase with income. This follows from the fact that the marginal tax rate is higher for higherincome brackets. As income increases above $30,000, the average tax rate will get closer and closer to the marginal rate of 40%.

422. For tax purposes, ―gross income‖ is all the money a person receives in a given year from any and all sources. But income taxes are levied on ―taxable income‖ rather than gross income. The difference between the two is the result of many exemptions and deductions. To see how they work, suppose you made $60,000 last year in wages, earned $10,000 from investments, and were given $5,000 as a gift by your grandmother. Also assume that you are a single parent with one small (4-year-old) child living with you. L O20.7 What is your gross income? uuuuuuuuuuuuuuuuuuu. Gifts up to $16,000 per year are not counted as taxable income. Given that exemption, what is your taxable income? vvvvvvvvvvvvvvvvvvv. Next, assume you paid $700 in interest on your student loans last year, put $2,000 into a health savings account (HSA), and deposited $4,000 into an individual retirement account (IR A). These expenditures are all tax 1-435 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

exempt, meaning that any money spent on them reduces taxable income dollarfor-dollar. Knowing that fact, now what is your taxable income? wwwwwwwwwwwwwwwwwww.

Next, you can either take the so-called standard deduction or apply for itemized deductions (which involve a lot of tedious paperwork). You opt for the standard deduction that allows you as head of your household to exempt another $19,400 from your taxable income. Taking that into account, what is your taxable income? xxxxxxxxxxxxxxxxxxx. Apply the tax rates shown in Table 20.1 to your taxable income. How much federal tax will you owe? What is the marginal tax rate that applies to your last dollar of taxable income? yyyyyyyyyyyyyyyyyyy. As the parent of a dependent child, you qualify for the government‘s $3,600 per-child ―tax credit‖ for children aged 5 and under. (For older children, the credit is a little less.) Like all tax credits, this $3,600 credit ―pays‖ for $3,600 of whatever amount of tax you owe. Given this credit, how much money will you have to pay in taxes? Using that actual amount, what is your average tax rate relative to your taxable income? What about your average tax rate relative to your gross income?

Answers: $75,000. ss. $70,000 [= $75,000 − $5,000]. tt. $63,300 [= $70,000 − $2,000 − $4,000 − $700]. uu. $43,900 [= $63,300 − $19,400]. vv. You will owe the Feds $4,857 (= $2,055 + $2,802). The marginal tax rate on your last dollar of taxable income is 12 percent. ww. You will pay only $1,257 (= $4,857 − $3,600). Thus, your average tax rate on taxable income will be is 2.9 percent [= 100 × ($1,257 ÷ $43,900)]. And your average tax rate on gross income will be 1.7 percent [= 100 × ($1,257 ÷ $75,000].

Feedback: To calculate gross income, add up income from the different sources. You made $60,000 in wages plus $10,000 from investments plus a $5,000 gift from your grandmother. Thus, your gross income was $75,000. eeeeeeeeee. Your taxable income equals your gross income minus any gifts up to $16,000. Thus, your taxable income equals $70,000 [= $75,000 (gross income) − $5,000 (gift)]. ffffffffff.

The additional deductions from taxable income result in a NEW taxable income of $63,300 [= $70,000 − $700 (interest on student loan) − $2,000 (HSA) − $4,000 (IRA)]. gggggggggg. Your taxable income after taking the standard deduction is $43,900 [= $63,300 (from part c) − $19,400 (standard deduction)]. hhhhhhhhhh. Your taxable income is $43,900.

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The tax schedule is:

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From $0 to $20,550, the tax rate is 10 percent. So, you will pay $2,055 on your income from $0 − $20,550.

From $20,550 to $83,550, the tax rate is 12 percent. So, you will pay $1,830 on your income from $20,550 to $43,900. [= 0.12 × ($43,900 − $20,550) = 0.12 × $23,350 = $2,802].

The total taxes you will pay are $4,857 (= $2,055 + $2,802).

The marginal tax rate that applies to your last dollar of taxable income is 12 percent. iiiiiiiiii.

From part e, the taxes owed are $4,857. After subtracting the child tax credit from taxes owed, the final tax obligation is $1,257 (= $4,857 − $3,600).

Using that actual amount, the average tax rate relative to your taxable income is 2.9 percent [= 100 × ($1,257 ÷ $43,900)] Your average tax rate relative to your gross income is 1.7 percent [= 100 × ($1,257 ÷ $75,000].

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Chapter 21 - Antitrust Policy and Regulation McConnell Brue Flynn 23e DISCUSSION QUESTIONS 423. Both antitrust policy and industrial regulation deal with monopoly. What distinguishes the two approaches? How does government decide to use one form of remedy rather than the other? LO21.1, LO21.3 Answer: One of the goals of government in a market economy is to promote competition as a way of achieving efficiency. One approach is to maintain competition by using antitrust laws to discourage the creation of excess monopoly power such as through mergers or by taking action against a firm that is abusing its monopoly power. The other approach, particularly in cases where there is a natural monopoly, is for the government to regulate the firm.

The government will choose an approach by analyzing the structure of the industry, the cost structure of the firm, the impact of the firm‘s actions on its competitors and customers, industry technology, and the likelihood of new competitors entering the industry.

424. Describe the major provisions of the Sherman and Clayton acts. What government entities are responsible for enforcing those laws? Are firms permitted to initiate antitrust suits against other firms? LO21.1 Answer: Sherman Act: Section 1 prohibits conspiracies to restrain trade; Section 2 outlaws monopolization. Clayton Act (as amended by Celler-Kefauver Act of 1950): Section 2 outlaws price discrimination; Section 3 forbids tying contracts; Section 7 prohibits mergers which substantially lessen competition; Section 8 prohibits interlocking directorates.

The acts are enforced by the Department of Justice, Federal Trade Commission, and state attorneys general.

Private firms can bring suit against other firms under these laws.

425. Contrast the outcomes of the Standard Oil and U.S. Steel cases. What was the main antitrust issue in the DuPont cellophane case? In what major way do the Microsoft and Standard Oil cases differ? LO21.2 Answer: In the Standard Oil case the government ruled that Standard Oil has monopolized the petroleum industry through abusive and anticompetitive actions.

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Standard Oil was divided into several competing firms, but the court decision did not resolve the issue of whether every monopoly was illegal, or just those formed by anticompetitive practices. The U.S. Steel case determined that not every monopoly violated the Sherman Act. U.S. Steel, though large and possessing monopoly power, had not obtained its monopoly power illegally, and therefore had not violated the law.

The issue in the DuPont cellophane case was the size of the relevant market.

Because it was ruled to be operating in the ―flexible wrapping materials‖ market and only held a 20 percent market share (versus 100 percent in the cellophane market), DuPont was not considered to be a monopoly.

The major difference between the Standard Oil and the Microsoft cases was the remedy. Standard Oil was broken up into several firms; Microsoft was ordered to change its behavior but was otherwise left intact.

426. Why might one administration interpret and enforce the antitrust laws more strictly than another? How might a change of administrations affect a major monopoly case in progress? LO21.2 Answer: One administration might take an active antitrust perspective, believing that government intervention is necessary to stop the anticompetitive and sometimes illegal actions of firms. Another administration, believing that competitive forces and the process of creative destruction will resolve any monopoly problems, is more likely to take a laissez-faire perspective. The former will enforce the laws more strictly than the latter.

If an administration actively pursuing an antitrust case is replaced by one with the laissez-faire perspective, the case may end up being dropped.

427. Suppose a proposed merger of firms would simultaneously lessen competition and reduce unit costs through economies of scale. Do you think such a merger should be allowed? Explain. LO21.2 Answer: Abstracting from other issues (for example, the relative sizes of the two firms in the market), such a merger should only be allowed if it can be shown that price reductions associated with the decrease in unit costs will outweigh the probable increase in price associated with the reduced level of competition in the industry.

428. In the 1980s, PepsiCo Inc., which then had 28 percent of the soft-drink market, proposed to acquire the Seven-Up Company. Shortly thereafter the Coca-Cola 1-440 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Company, with 39 percent of the market, indicated it wanted to acquire the Dr Pepper Company. Seven-Up and Dr Pepper each controlled about 7 percent of the market. In your judgment, was the government‘s decision to block these mergers appropriate?

Why or why not? LO21.2 Answer: The government‘s decision was justified. Each of the proposed merged companies would have resulted in a Herfindahl index of well over 1800, the guideline used by the federal government for horizontal mergers. Furthermore, the mergers would have significantly increased the level of concentration in the soft-drink industry, with only two firms effectively controlling four-fifths of the market. Proponents of the merger might argue that economies of scale in the industry necessitate the formation of large firms such as PepsiCo and Coca-Cola, but this is unlikely. (Note: Later Dr Pepper and Seven-Up merged and in 1995 were in turn purchased by a Canadian firm.)

429. Why might a firm charged with violating the Clayton Act, Section 7, try arguing that the products sold by the merged firms are in separate markets? Why might a firm charged with violating Section 2 of the Sherman Act try convincing the court that none of its behavior in achieving and maintaining its monopoly was illegal? LO21.2 Answer: Section 7 of the Clayton Act prohibits the acquisition of stocks of competing corporations when the outcome would be less competition. By arguing that the products are sold in separate markets, the firm is arguing that the acquired firm is not a competitor, and that the acquisition will not reduce competition.

Based on the ruling on the U.S. Steel case, not every monopoly is in violation of Section 2 of the Sherman Act. Only those that behave inappropriately by attempting to ―monopolize, or combine or conspire … to monopolize‖ are in violation.

430. ―The social desirability of any particular firm should be judged not on the basis of its market share but on the basis of its conduct and performance.‖ Make a counterargument, referring to the monopoly model. LO21.2 Answer: Market share is a good indication of a firm‘s monopoly power. A firm with substantial monopoly power will likely use the power to restrict output, charge high prices, generate excessive profits, and act in predatory ways toward competitors and potential competitors. The mere fact that a firm has significant monopoly power is a strong indication that it is violating antitrust laws. Even if it is not, the inefficiencies of monopoly firms warrant action against them.

431. What types of industries, if any, should be subjected to industrial regulation?

What specific problems does industrial regulation entail? LO21.3 1-441 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: Industries composed of firms with natural monopolies conditions are most likely to be subjected to industrial regulation.

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Regulation based on ―fair-return‖ prices creates disincentives for firms to minimize costs since cost reductions lead regulators to force firms to change a lower price. Regulated firms may also use ―creative‖ accounting to boost costs and hide profits. Because regulatory commissions depend on information provided by the firms themselves, and commission members are often recruited from the industry, the agencies may in effect be controlled by the firms they are supposed to oversee. Also, industrial regulation sometimes is applied to industries that are not, or no longer are, natural monopolies. Regulation may lead to the conditions of a cartel, conditions that are illegal in an unregulated industry.

432. In view of the problems involved in regulating natural monopolies, compare socially optimal (marginal-cost) pricing and fair-return pricing by referring again to Figure 11.8. Assuming that a government subsidy might cover any loss resulting from marginal-cost pricing, which pricing policy would you favor? Why? What problems might such a subsidy entail? LO21.3

Answer: Many of the regulatory problems associated with fair-return pricing also apply to a policy of marginal-cost pricing. In the unlikely case that a marginal-cost pricing policy does not entail public subsidies, it is subject to fewer regulatory problems. While there is an incentive for firms to artificially inflate marginal-cost estimates, there is no disincentive to contain costs and efficiencyenhancing substitutions of capital for labor are not encouraged. Some of these conclusions do not hold in the more likely case where public subsidies are required.

Because marginal-cost pricing fosters allocative efficiency, it is preferable to fair-return pricing. However, if the firm requires public subsidies to produce at the socially optimal point, the same disincentive exists to minimize actual and estimated unit costs as with fair-return pricing, since cost reductions will simply 1-443 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

lead to a lower subsidy. Efficiency-enhancing substitutions of capital for labor are not encouraged, since regulators are not attempting to enforce a stipulated rate of return. While public subsidies to ensure allocative efficiency can be worthwhile from an economic perspective, they are usually politically unpopular, since voters are reluctant to provide large monopolistic firms with scarce public funds.

433. How does social regulation differ from industrial regulation? What benefits and costs are associated with social regulation? LO21.4 Answer: Industrial regulation is concerned with prices, output, and profits in specific industries, whereas social regulation deals with the broader impact of business on consumers, workers, and third parties.

Benefits: increased worker and product safety, less environmental damage, reduced economic discrimination.

Two types of costs: administrative costs, because regulations must be administered by costly government agencies, compliance costs, because firms must increase spending to comply with regulations.

434. Use economic analysis to explain why the optimal amount of product safety may be less than the amount that would totally eliminate risks of accidents and deaths. Use automobiles as an example. LO21.4 Answer: To produce an automobile that would totally eliminate the risk of accidents and death would be extremely expensive in terms of materials.

Additionally, the cost of operating such a vehicle would likely be expensive because of the weight of the car. As additional design changes are considered, engineers should balance the marginal cost of providing the extra units of safety with the expected marginal benefit received from the design change.

435. LAST WORD On what basis were the airlines found guilty of violating antitrust laws in the Airline Tariff Publishing case? What was the remedy? By contrast, why might it be hard to prosecute algorithmic collusion, which also uses prices posted electronically?

Answer: The airlines in the Airline Tariff Publishing Case were accused of using prices posted to an electronic bulletin board to collude and fix prices. The remedy was a behavioral remedy: any air fares posted online would have to become available to consumers immediately, rather than being tentatively posted by one airline in the hopes of other airlines matching those prices and thereby colluding to fix prices. By contrast, it would be harder to prosecute algorithmic collusion because computer software cannot act with intent. Under current law, two parties 1-444 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

must explicitly intend to collude in order to be found guilty of price fixing. But software cannot act with intent. So, it would be hard to prosecute software for collusion.

REVIEW QUESTIONS True or false. Under the ―rule of reason‖ established by the Supreme Court in the U.S. Steel case, a monopoly seller should be found guilty of violating antitrust laws even if it is charging low prices to consumers and acting the same way a competitive firm would act. LO21.2 Answer: False This statement is false because being a monopoly is not be itself illegal under the rule of reason. Rather, the rule of reason argues that a monopoly has to actually do something anticompetitive (like charging high monopoly prices) in order to be found guilty of violating the antitrust laws.

The rule of reason is part of an ongoing debate about the regulation of monopolies that has taken place between two groups that are now known as structuralists and behavioralists. Structuralists assume that nay firm with a very high market share will behave like a monopoly. Thus, Structuralists want the courts to apply the full force of the antitrust laws to break up or regulate any firm with a very high market share. By contrast, Behavioralists believe that the relationship between market share and monopoly behavior can vary substantially form case to case. As a result, they believe that firms should only be prosecuted under the antitrust laws if they have actually engaged in anticompetitive practices.

436. How would you expect antitrust authorities to react to: LO21.2 zzzzzzzzzzzzzzzzzzz. a proposed merger of Ford and General Motors. aaaaaaaaaaaaaaaaaaaa. evidence of secret meetings by contractors to rig bids for highway construction projects. bbbbbbbbbbbbbbbbbbbb. a proposed merger of a large shoe manufacturer and a chain of retail shoe stores. cccccccccccccccccccc. a proposed merger of a small life-insurance company and a regional candy manufacturer. dddddddddddddddddddd. an automobile rental firm that charges higher rates for lastminute rentals than for rentals reserved weeks in advance.

Answer: jjjjjjjjjj.

They would block this horizontal merger (violation of Section 7 of the Clayton Act). kkkkkkkkkk. They would charge these firms with price fixing (violation of Section 1 of the Sherman Act).

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llllllllll.

They would allow this vertical merger, unless both firms had very large market shares and the resultant merger substantially lessens competition. mmmmmmmmmm. They would allow this conglomerate merger. nnnnnnnnnn. They would not interfere with this price discrimination.

437. When confronted with a natural monopoly that restricts output and charges monopoly prices, the two methods that governments have for promoting better outcomes are: LO21.3 public ownership and public regulation. eeeeeeeeeeeeeeeeeeee. sole proprietorships and public goods. ffffffffffffffffffff. antitrust law and horizontal mergers. gggggggggggggggggggg. creative destruction and laissez-faire.

Answer: a. Public ownership and public regulation.

The two methods that governments have for promoting better outcomes when confronting a natural monopoly are public ownership and public regulation.

Under public ownership, the government purchases and then runs, the natural monopoly. Because the government is not interested in maximizing profit, it sets a lower price and produces a higher output than the natural monopoly would if it were allowed to continue as a private, profit maximizing firm.

Under public regulation, the natural monopoly remains a private company but is placed under a government regulator who specifies how much the firm can charge and how much it should produce. This method also fixes the problem of high price and low output that exist when a profit maximizing natural monopoly remains unregulated.

438. True or False. Economists believe that social regulation is an exception to the MB = MC rule because social regulation should in every case extend as far as possible in order to ensure safe products, less pollution, and improved working conditions.

LO21.4 Answer: False.

This statement is false because what economists actually believe is that the optimal amount of social regulation is determined by where MB = MC. In particular, social regulation should only be increased if the marginal benefit exceeds the marginal cost.

Economists argue for the MB = MC level of regulation because any smaller level of regulation leaves room for additional net benefits while any greater level of regulation results in net losses.

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The key factor to keep in mind is that regulation is costly. Significant resources in terms of time and labor must be devoted to both developing and enforcing a particular social regulation. If the benefits of that particular social regulation do not exceed its costs, it will not make sense to take resources away from the production of other goods and services in order to devote them to the creation and enforcement of that particular social regulation.

So, while we all like safe products, less pollution, and improved working conditions, we must in each instance judge whether a specifics social regulation‘s marginal benefit exceeds its marginal cost.

PROBLEMS Suppose that there are only three types of fruit sold in the United States. Annual sales are 1 million tons of blueberries, 5 million tons of strawberries, and 10 million tons of bananas. Suppose that of those total amounts, the Sunny Valley Fruit Company sells 900,000 tons of blueberries, 900,000 tons of strawberries, and 7.9 million tons of bananas. LO21.2 What is Sunny Valley‘s market share in blueberries? If a court applies the ―90-60-30 rule‖ when considering just the blueberry market, would it rule that Sunny Valley is a monopoly? hhhhhhhhhhhhhhhhhhhh. What is Sunny Valley‘s market share in the market for all types of berries? Would the court rule Sunny Valley to be monopolist in that market? iiiiiiiiiiiiiiiiiiii.

What if the relevant market is all types of fruit and would the court consider Sunny Valley to be a monopolist?

Answers: (a) Sunny Valley’s market share in blueberries is 90 percent; yes. (b) If the relevant market is all berries, then Sunny Valley’s market share is 30.0%; no. (c) If the relevant market is all fruit, then Sunny Valley’s market share is 61%; likely.

Feedback: Courts often decide whether or not market power exists by considering the share of the market held by the dominant firm. They have roughly adhered to a ―90-60-30 rule‖ in defining monopoly: If a firm has a 90 percent market share, it is definitely a monopolist; if it has a 60 percent market share, it probably is a monopolist; if it has a 30 percent market share, it clearly is not a monopolist. The market share will depend on how the market is defined.

Sunny Valley's market share is 90 percent of the relevant market is blueberries.

Annual sales of blueberries are 1 million tons and Sunny Valley sells 900,000 tons of blueberries in the market: 1-447 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

900,000 100  90 percent 1,000,000 Based on the 90-60-30 rule, Sunny Valley would be ruled a monopolist. oooooooooo. Sunny Valley's market share is 30 percent of the relevant market is all berries. Annual sales of blueberries are 1 million tons and annual sales of strawberries are 5 million tons. Sunny Valley sells 900,000 tons of blueberries in the market and sells 900,000 tons of strawberries in the market.

(900,000 blueberries  900,000 strawberries) 1,800,000 berries 100  100  30 percent (1,000,000 blueberries market  5,000,000 strawberries market ) 6,000,000 berries market Based on the 90-60-30 rule Sunny Valley would not be ruled a monopolist. pppppppppp. Sunny Valley's market share is 61 percent of the relevant market is all types of fruit. Annual sales of blueberries are 1 million tons, annual sales of strawberries are 5 million tons, and annual sales of bananas are 10 million tons. Sunny Valley sells 900,000 tons of blueberries in the market, sells 900,000 tons of strawberries in the market, and sells 7.9 million tons of bananas.

(900,000 blueberries  900,000 strawberries  7,900,000 bananas) 9,700,000 fruit  100   100  60.63 or 61 percent (1,000,000 blueberries market  5,000,000 strawberries market  10,000,000 bananas market ) 16,000,000 fruit market

Based on the 90-60-30 rule Sunny Valley would likely be ruled a monopolist.

439. Carrot Computers and its competitors purchase touch screens for their tablet computers from several suppliers. The six makers of touch screens have market shares of, respectively, 19 percent, 18 percent, 14 percent, 16 percent, 20 percent, and 13 percent. LO21.2 What is the Herfindahl index for the touch screen manufacturing industry? jjjjjjjjjjjjjjjjjjjj.

By how much would a proposed merger between the two smallest touch screen makers increase the Herfindahl index? Is the government likely to challenge that proposed merger? kkkkkkkkkkkkkkkkkkkk. If Carrot Computers horizontally merges with its competitor Blueberry Handhelds, by how much would the Herfindahl index change for the touch screen industry?

Answers: 1,706 1-448 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

qqqqqqqqqq. The Herfindahl index would rise by 364; yes, the government would likely challenge the proposed merger. rrrrrrrrrr. Zero Feedback: The Herfindahl index for an industry is found by squaring the market share of each firm in the industry and adding these together.

The Herfindahl index for the firms above equals 1,706 (= 192 + 182 + 142 + 162 + 202 + 132). ssssssssss.

The two smallest firms make up 13 percent and 14 percent, thus if they merge they will make up 27% of the market.

The Herfindahl index after the merger is 2,070 (=192 + 182 +162 + 202 + (13 + 14)2) The increase in the Herfindahl index is 364 (= 2,070 (after merger − 1706 (prior to merger)) The government would likely challenge this merger because a Herfindahl index above 1,800 suggests that the market is too concentrated. tttttttttt.

The answer is zero (no change) because the market shares for the touch screen industry have not changed, therefore the Herfindahl index won‘t change for the touch screen industry.

Chapter 22 - Agriculture: Economics and Policy McConnell Brue Flynn 23e DISCUSSION QUESTIONS 440. Carefully evaluate: ―The supply and demand for agricultural products are such that small changes in agricultural supply result in drastic changes in prices. However, large changes in agricultural prices have modest effects on agricultural output.‖ (Hint: A brief review of the distinction between supply and quantity supplied may be helpful.) Do exports increase or reduce the instability of demand for farm products?

Explain. LO22.1 Answer: First sentence: Shifts in the supply curve of agricultural goods (changes in supply) relative to fixed inelastic demand curves produce large changes in equilibrium prices. Second sentence: But these drastic changes in prices produce only small changes in equilibrium outputs (where quantities demanded equals 1-449 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

quantities supplied) because demands are inelastic. Because exports are volatile from one year to the next, they increase the instability of demand for farm products.

441. What relationship, if any, can you detect between the facts that farmers‘ fixed costs of production are large and the supply of most agricultural products is generally inelastic? Be specific in your answer. LO22.1 Answer: Because fixed costs are a significant portion of total costs, average variable costs for agricultural producers will tend to be small and shut-down points will occur only at relatively low prices. As long as prevailing prices exceed these levels, farmers will produce close to capacity to recoup as much of their fixed costs as possible.

442. Explain how each of the following contributes to the farm problem: LO22.1, L O22.2 llllllllllllllllllll.

The inelasticity of demand for farm products. mmmmmmmmmmmmmmmmmmmm. The rapid technological progress in farming. nnnnnnnnnnnnnnnnnnnn. The modest long-run growth in demand for farm commodities. oooooooooooooooooooo. The volatility of export demand.

Answer: uuuuuuuuuu. Because the demand for most farm products is inelastic, the frequent fluctuations in supply brought about by weather and other factors have relatively small effects on quantity demanded, but large effects on equilibrium prices of farm products. Farmers‘ sales revenues and incomes therefore are unstable. vvvvvvvvvv. The rapid technological progress in farming has decreased production costs, increased long-run supply for most agricultural goods, and reduced the prices of farm output. These declines in prices have put a downward pressure on farm income. wwwwwwwwww.

The modest long-run growth in the demand for farm products has not been sufficient to offset the expansion of supply, resulting in stagnant farm income. xxxxxxxxxx. Foreign demand has been unpredictable. Any change in demand will affect farm prices but farmers cannot easily adjust production.

443. The key to efficient resource allocation is shifting resources from lowproductivity to high-productivity uses. In view of the high and expanding physical productivity of agricultural resources, explain why many economists want to divert 1-450 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

additional resources away from farming in order to achieve allocative efficiency. L O22.2 Answer: Economic efficiency is only partly a matter of high productivity or low marginal costs. Allocative efficiency depends on the requirement that the marginal benefit to society of producing another unit of a particular good exceeds the marginal cost. Even though total benefits to society from the production of most agricultural goods are high, low marginal costs are matched by low marginal benefits. In the case of agricultural markets subject to support prices, marginal costs at prevailing production levels exceed marginal benefits as measured by free market prices. This is the reason many economists contend resources should be moved out of these sectors.

444. Explain and evaluate: ―Industry complains of the higher taxes it must pay to finance subsidies to agriculture. Yet the trend of agricultural prices has been downward while industrial prices have been moving upward, suggesting that on balance agriculture is actually subsidizing industry.‖ LO22.3 Answer: According to this statement, one can distinguish transfers of income by using the concept of price parity. Since the parity ratio for farmers has declined, they have necessarily been subsidizing industry. Changes in relative prices cannot be used to make these sorts of statements. Agricultural prices have declined relative to industrial prices largely because of decreases in costs in agriculture.

Subsidies to agriculture have also increased the supply of many agricultural products. Lower agricultural prices are therefore partially the result of subsidies from industry to agriculture.

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445. ―Because consumers as a group must ultimately pay the total income received by farmers, it makes no real difference whether the income is paid through free farm markets or through price supports supplemented by subsidies financed out of tax revenue.‖ Do you agree? Why or why not? LO22.3 Answer: This argument is fallacious for two reasons. First, not all consumers of a particular good are taxpayers or vice versa. Taxpayers are forced to fund pricesupport programs for agricultural goods (e.g., peanuts or sugar) whether or not they choose to consume these particular items. Second, and more important, price-support programs do not allow us to subsidize through taxation what we would otherwise be spending at the checkout counter since these programs increase both prices and taxes as well as taking resources away from more efficient domestic uses, lessening the rate of exodus from farming and distorting world agricultural markets.

446. If in a given year the indexes of prices received and paid by farmers were 120 and 165, respectively, what would the parity ratio be? Explain the meaning of that ratio.

LO22.32 Answer: Prices received by farmers would have increased by 20 percent since the base year (1910) whereas price paid by farmers would have increased by 65 percent during the same time period.

Parity ratio = prices received by farmers/prices paid by farmers = 120/165 = 73 percent In this year, a unit of farm output can buy only 73 percent of other goods relative the base year.

447. Explain the economic effects of price supports. Explicitly include environmental and global impacts in your answer. On what grounds do economists contend that price supports cause a misallocation of resources? LO22.3 Answer: Price supports benefit farmers, harm consumers, impose costs on society, and contribute to problems in world agriculture. Farmers benefit because the prices they receive and the output they produce both increase, expanding their gross incomes. Consumers lose because the prices they pay for farm products rise and quantities purchased decline. Society as a whole bears several costs.

Surpluses of farm products will have to be bought and stored, leading to a greater burden on taxpayers. Domestic economic efficiency is lessened as the artificially high prices of farm products lead to an overallocation of resources to agriculture.

The environment suffers: the greater use of pesticides and fertilizers contributes to water pollution; farm policies discourage crop rotation; and price supports encourage farming of environmentally sensitive land. The efficient use of world 1-452 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

resources is also distorted because of the import tariffs or quotas that such programs often require. Finally, domestic overproduction leads to supply increases in international markets, decreasing prices and causing a decline in the gross incomes of foreign producers.

448. Do you agree with each of the following statements? Explain why or why not.

LO22.3, LO22.4 The problem with U.S. agriculture is that there are too many farmers. That is not the fault of farmers but the fault of government programs. pppppppppppppppppppp. The federal government ought to buy up all U.S. farm surpluses and give them away to developing nations. qqqqqqqqqqqqqqqqqqqq. All industries would like government price supports if they could get them; agriculture has obtained price supports only because of its strong political clout.

Answer: Yes, historically the problem has been one of too many farmers, and public policy has been oriented toward supporting farm prices and incomes rather than fixing the resource allocation problem. Further, price and income supports have kept people in agriculture that otherwise would have moved to nonfarm occupations. yyyyyyyyyy. No, this is not the best way for the U.S. to provide foreign aid. This policy would contribute to the misallocation of resources in the U.S. and prevent a more efficient solution. Farmers elsewhere in the world who might have a comparative advantage over American farms would be harmed, perhaps forcing them to leave the industry. zzzzzzzzzz. While strong political clout has played a role in the price supports given to farmers, there were other more important factors. Government has subsidized American agriculture since the 1930s. Agricultural prices and incomes are more volatile than in most other industries. Small changes in farm output translate into a relatively large change in price because the demand for these products is price inelastic. In the absence of government intervention, agricultural markets are highly competitive and farmers have no control over the price they receive for their goods. However, farmers must buy their supplies and capital equipment in markets where producers have a high degree of control over price. This disparity and disadvantage along with a variety of other arguments has been used to justify farm subsidies over the years.

Likewise, government support programs come with government intervention into management decisions by farmers.

449. What are the effects of farm subsidies such as those of the United States and the European Union on (a) domestic-agricultural prices, (b) world agricultural prices, and (c) the international allocation of agricultural resources? LO22.3 1-453 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: Domestic agricultural prices are obviously higher than they would be in the absence of subsidies. The reason for the subsidies in the first place is that market equilibrium prices were lower than farmers believed they should be.

Without subsidies farm product prices would initially fall to the lower equilibrium price. It is also argued that subsidies protect inefficient farmers, and without such programs only the efficient, low-cost producers would remain. To the extent that this is true, farm prices would remain lower than the current support prices that exist for many products.

The situation on world markets is somewhat more complex because the European Union (EU) subsidizes its exports of agricultural products on world markets.

Thus, the supply of these products is greater than it would be under competitive market conditions, and the world prices of many products are depressed.

There is an international misallocation of agricultural resources. Wherever there is a farm subsidy program without programs restricting supply, there will be an expansion of production in response to the above-market price supported. Without such restrictions, continuing farm subsidies would mean that more than the efficient amount of resources is devoted to production of subsidized products. The over-allocation occurs both within and among countries. Farmers in countries that might more efficiently import agricultural products and use these resources more productively in other pursuits are encouraged to remain in agriculture as long as their governments subsidize this type of production. Meanwhile, farmers in countries without farm programs face artificially depressed world market prices and find it is not profitable to raise farm products for export. In a free-market world, they might be more efficient producers than their subsidized neighbors.

450. What was the major intent of the Freedom to Farm Act of 1996? Do you agree with the intent? Why or why not? Did the law succeed in reducing overall farm subsidies?

Why or why not? LO22.5 Answer: The intent of the Freedom to Farm Act of 1996 was to allow markets, not government programs, to determine what products farmers grow, where they are grown, and their total outputs. To ease the transition away from farm subsidies, farmers were to receive guaranteed, but declining, annual ―transition payments‖ through 2002.

Most economists agree that market allocation of resources is more efficient than the use of government programs. The overall output of agricultural products is likely to increase although prices are likely to be more volatile. This will increase the risk to farmers but will benefit consumers and taxpayers.

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During 1998 and 1999, agricultural prices were low and farm incomes fell.

Farmers, who had gotten used to financial help from the government-support programs, realized that there was a downside to allowing the market to determine prices and, therefore, farm incomes. Emergency aid payments caused farm subsidies to average $20 billion annually for 1999–2002, more than before the Freedom to Farm Act was passed.

451. Distinguish between price loss coverage and agricultural risk coverage. How do they help reduce the volatility of farm income? In what way do farm subsidies perpetuate the longstanding problem of too many resources in agriculture? LO22.5 Answer: The Agricultural Act of 2014 created two new crop insurance programs:  

Under price loss coverage, farmers who pay the insurance premium are guaranteed an insurance payment if the price of their crop falls below a specified value, such as $3.50 per bushel of wheat.

By contrast, agricultural risk coverage depends on the total revenue generated by all of the farmers in a given county who plant the same crop in a given year. The program makes insurance payments to participating farmers if the total revenue collectively received by all the farmers planting the crop in the county falls below a specific value, such as $150 million for corn producers in Kossuth County, Iowa.

Under the 2014 Act, farmers interested in these new crop insurance programs had to make a one-time decision (binding for the rest of their lives) about which program they wanted to use.

452. LAST WORD What groups benefit and what groups have lost from the U.S. Conservation Reserve Program? Are the intended beneficiaries of the program actually doing better as a result of the program? Explain.

Answer: The Conservation Reserve Program was started in 1986. It paid farmers $30 to $50 per acre for up to 15 years for farmland that was converted into forests by planting seedlings. This subsidy prompted farmers across the country to get into commercial forestry. They planted seedlings that when full-grown would be felled for lumber, electrical poles, and paper pulp.

Since the program‘s inception, over 22 million acres have been converted to commercial forestry as a result of the Conservation Reserve Program and other similar federal programs. The result has been a huge decline in the price of wood as a mountain of mature trees began to come onto the market in the late 2010s. By 2018, the price of saw timber (the quality of wood that can be used for making 1-455 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

lumber) had fallen to a 50-year low. And that was true despite the growing economy and high demand for lumber in construction. Demand was up. But supply was way up. The result was plummeting prices for nearly every type of wood. The value of pine trees ―on the stump,‖ for example, fell from $45 per ton in 1987 to just $14 per ton in 2019.

The Conservation Reserve Program has handed out over $49.7 billion since its inception in 1986 and currently pays farmers $82 per acre for any farmland they convert to forestry. The glut of trees and the associated collapse in the price of wood has, however, defeated the original purpose of the program—which was to help bolster farm incomes. The prices of lumber, wooden telephone poles, and pulp have fallen so low that, in retrospect, the farmers who converted farmland into woodland would probably have made more money continuing to farm agricultural crops than they are going to make harvesting the trees that they were subsidized into producing.

REVIEW QUESTIONS Suppose that the demand for olive oil is highly inelastic. Also suppose that the supply of olive oil is fixed for the year. If the demand for olive oil suddenly increases because of a shortage of corn oil, you would expect a _ in the price of olive oil.

LO22.2 large increase rrrrrrrrrrrrrrrrrrrr. small increase ssssssssssssssssssss. large decrease tttttttttttttttttttt. small decrease uuuuuuuuuuuuuuuuuuuu. no change Answer: a. Large increase.

Agricultural prices and incomes are volatile in the short run because an inelastic demand converts small changes in farm output and demand into relatively larger changes in prices and income.

453. Use supply and demand curves to depict equilibrium price and output in a competitive market for some farm product. Then show how an above-equilibrium price floor (price support) would cause a surplus in this market. Demonstrate in your graph how government could reduce the surplus through a policy that (a) changes supply or (b) changes demand. Identify each of the following actual government policies as primarily affecting the supply of or the demand for a particular farm product: acreage allotments; the food-stamp program; the Food for Peace program; a government buyout of dairy herds; export promotion. LO22.3

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Answer:

Average allotments: decrease supply Food stamp program: increase demand Food-for-Peace: increase demand Government buyout of dairy herds: decrease in supply Export promotion: increase in demand 454. Suppose that the government has been supporting the price of corn. Its free market price is $2.50 per bushel, but the government has been setting a support price of $3.50 per bushel. Which of the following programs might the government use in an effort try to reduce the size of the corn surplus? LO22.3 (Select one or more answers from the choices shown.)

Decrease the support price. vvvvvvvvvvvvvvvvvvvv. Institute an acreage allotment program. wwwwwwwwwwwwwwwwwwww.

Decrease demand by taxing purchases of corn. xxxxxxxxxxxxxxxxxxxx. Raise the support price.

Answer: Decrease the support price, aaaaaaaaaaa. Institute an acreage allotment program.

If the price support was decreased the difference between QD and QS would decrease.

Acreage allotments - In return for guaranteed prices for their crops, farmers had to agree to limit the number of acres they planted in that crop which decreased QS and decreased the difference between QD and QS. An increase in taxes would decrease QD and thus create a larger gap between QD and QS which would lead to a greater surplus.

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455. subsidies flow toward _ poor, small-scale farmers yyyyyyyyyyyyyyyyyyyy. rich, large-scale farmers zzzzzzzzzzzzzzzzzzzz. government employees aaaaaaaaaaaaaaaaaaaaa. grain wholesalers

The majority of farm . LO22.4

Answer: b. Rich, large-scale farmers.

Because price supports were on a per-bushel basis the large, prosperous farmer reaped the benefits because of sizable output.

456. Which of the following are elements of current U.S. farm policy? Select all that apply. LO22.5 Farmers are free to choose how much to plant of any particular crop. bbbbbbbbbbbbbbbbbbbbb.

Direct payments. ccccccccccccccccccccc. Price supports. ddddddddddddddddddddd.

Countercyclical payments.

Answer: Farmers are free to choose how much to plant of any particular crop.

Price supports.

Current subsidy programs continue the ―freedom to plant‖ approach. The Agricultural Act of 2014 provided marketing loans (based on a specified crop price and an option to either pay back the loan or forfeit the crop to the government lender), price loss coverage (insurance payments if crops fall below a specified value), and agricultural risk coverage (insurance payments if the total revenue of farmers in a given county falls below a certain value).

PROBLEMS Suppose that corn currently costs $4 per bushel and that wheat currently costs $3 per bushel. Also assume that the price elasticity of corn is 0.10 while the price elasticity of wheat is 0.15. For the following questions about elasticities, simply use the percentage changes that are provided rather than attempting to calculate those percentage changes yourself using the midpoint formula given in Chapter 6. LO22.1 If the price of corn fell by 25 percent to $3 per bushel, by what percentage would the quantity demanded of corn increase? What if the price of corn fell by 50 percent to $2 per bushel? eeeeeeeeeeeeeeeeeeeee. To what value would the price of wheat have to fall in order to induce consumers to increase their purchases of wheat by 5 percent? fffffffffffffffffffff. If the government imposes a $0.40 per bushel tax on corn so that the price of corn rises by10 percent to $4.40 per bushel, by what percentage would the quantity demanded of corn decrease? If the initial quantity demanded is 10 billion bushels per year, by how many bushels would the quantity demanded decrease in response to this tax?

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1-459 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answers: 2.5 percentage points, 5 percentage points bbbbbbbbbbb.

The price of wheat would have to fall to $2 per bushel. ccccccccccc. The quantity demanded of corn would decrease by 1 percent; the quantity demanded would decline by 100 million bushels.

Feedback: To find the percentage change in the quantity of corn demanded multiply the percentage change in price by the elasticity. Note that the quantity direction is opposite of the price movement.

When the price of corn falls by 25 percent, the percentage increase is quantity demanded equals 25 percent × 0.10 = 2.5 percent.

When the price of corn falls by 50 percent, the percentage increase is quantity demanded equals 50 percent × 0.10 = 5 percent. ddddddddddd.

Here we can use the same formula as above (note the negative in front of the price change. A fall in the price will be recorded as a negative percentage change algebraically). % quantity   % price  elasticity

Rearranging, we have  % price  % quantity / elasticity

Substituting the values given above, −%Δ price = 5 percent / 0.15 = −33.33 percent. Thus, a price decrease of 33.33 percent will induce a 5 percent increase in the quantity of wheat demanded.

Since the original price of wheat was $3.00, a 33.33 percent decline in the price of wheat results in a new price of $2.00 [= ($3.00 − 0.3333) × $3.00] eeeeeeeeeee. Using the formula discussed in part a, an increase in the price of corn via the tax results in a 1 percent decrease in the quantity of corn demanded (= 15% × 0.1).

Given the initial quantity demanded was 10 billion, a 1 percent decrease in quantity demanded implies a fall of 100 million bushels demanded after the tax (= 0.01 × 10,000,000,000).

457.

Suppose that both wheat and corn have an income elasticity of 0.1. LO22.1 1-460 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

If the average income in the economy increases by 2 percent each year, by how many percentage points does the quantity demanded of wheat increase each year, holding all other factors constant? Holding all other factors constant, if 10 billion bushels are demanded this year, by how many bushels will the quantity demanded increase next year if incomes rise by 2 percent? ggggggggggggggggggggg.

Given that average personal income doubles in the United States about every 30 years, by about how many percentage points does the quantity demanded of corn increase every 30 years, holding all other factors constant?

Answers: (a) The quantity demanded would increase by .2 percentage points; the quantity demanded would increase by 20 million bushels (= .2 percentage points times 10 billion). (b) By about 10 percentage points.

Feedback: To calculate the percentage change in quantity demanded multiply the percentage change in income by the income elasticity. % quantity  % income  income elasticity

The increase in income by 2 percent per year results in an increase in quantity demanded for wheat is 0.2 percent per year (= 2 percent × 0.10).

Given that 10 billion bushels were demanded last year, the 0.2 percent increase in demand results in an increase of 20 million bushels demanded at each price this year. fffffffffff.

Using the same formula as above, the doubling of income implies a 100 percent increase in income every 30 years. This implies the demand for corn will increase by 10 percent over the same 30 years (= 100 percent × 0.1).

458. Suppose that 10 workers were required in 2020 to produce 40,000 bushels of wheat on a 1,000-acre farm. LO22.2 What is the average output per acre? Per worker? hhhhhhhhhhhhhhhhhhhhh.

If in 2030 only 8 workers produce 44,000 bushels of wheat on that same 1,000-acre farm, what will be the average output per acre? Per worker? iiiiiiiiiiiiiiiiiiiii. By how many percentage points does productivity (output per worker) increase over those10 years? Over those 10 years, what is the average annual percentage increase in productivity?

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Average output per acre will be 40 bushels per acre; average output per worker will be 4,000 bushels per worker. ggggggggggg. Average output per acre will be 44 bushels per acre; average output per worker will be 5,500 bushels per worker. hhhhhhhhhhh.

Productivity has increased by 37.5 percentage points; the average annual increase in productivity was 3.75 percent per year.

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Feedback: Average output per acre will be 40 bushels per acre (= 40,000 bushels divided by 1000 acres); average output per worker will be 4,000 bushels per worker (= 40,000 bushels divided by 10 workers). iiiiiiiiiii.

Average output per acre will be 44 bushels per acre (= 44,000 bushels divided by 1,000 acres); average output per worker will be 5,500 bushels per worker (= 44,000 bushels divided by 8 workers). jjjjjjjjjjj.

Productivity has increased by 37.5 percentage points [= 100 × (5,500 − 4,000)/4,000]; the average annual increase in productivity was 3.75 percent per year (= 37.5 percentage points divided by 10).

459. In 2019, it was estimated that the total value of all corn-production subsidies in the United States was about $2.7 billion. The population of the United States was approximately 328 million people that year. On average, how much did corn subsidies cost per person in the United States in 2019? (Hint: A billion is a 1 followed by nine zeros. A million is a 1 followed by six zeros.) LO22.3 Answers: $8.23 Feedback: $8.23 (= $2.7 billion/328 million).

Chapter 23 - Income Inequality, Poverty, and Discrimination McConnell Brue Flynn 23e DISCUSSION QUESTIONS 460. Use quintiles to briefly summarize the degree of income inequality in the United States. How and to what extent does government reduce income inequality? LO23.1 Answer: The income share received by the highest 20 percent was 50 percent in 2008, which is more than ten times the 3.4 percent received by the lowest 20 percent. The middle three quintiles receive fewer than 50 percent of the total before-tax income. The top two quintiles receive twice as much as the bottom three quintiles combined; in fact, the top 20 percent receives as much as the bottom 80 percent (Figure 20.1).

The effect of government on the distribution of income occurs through both taxes and transfer payments. The total effect of federal, state, and local taxes on income distribution is mildly progressive in that high-income households pay a somewhat higher proportion of their incomes in taxes than low-income families. But about 1-463 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

80 percent of government‘s contribution to income equality takes place through transfer programs. This contribution is particularly significant for those in the lowest quintile, for whom government transfer payments comprise over 75 percent of total income.

These statistics do not necessarily mean that the contribution of government in furthering equality is entirely positive. To the extent that transfer programs aimed at lower-income households decrease the incentive to work, the earned incomes of these households will be less than otherwise. Also, some transfer programs go to the non-poor. For example, most farm subsidies go to the wealthiest farmers, and higher education funding tends to benefit middle to high-income students.

461. Assume that Amir, Beth, Carol, David, and Ed receive incomes of $500, $250, $125, $75, and $50, respectively. Construct and interpret a Lorenz curve for this fiveperson economy. What percentage of total income is received by the richest quintile and by the poorest quintile? LO23.1 Answer: See the figure below. In this simple economy each person represents a complete income quintile—20 percent of the total population. The richest quintile (Al) receives 50 percent of total income; the poorest quintile (Ed) receives 5 percent.

This follows from the calculations below.

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Total Income equals $1000 (= $500 + $250 + $125 + $75 + $50).

The lowest quintile (Ed) is 5% of total income (= $50/$1,000) The second quintile (David) is7.5% of total income (= $75/$1,000) The third quintile (Carol) is 12.5% of total income (= $125/$1,000) The fourth quintile (Beth) is 25% of total income (= $250/$1,000) The upper quintile (Amir) is 50% of total income (= $500/$1,000)

462. How does the Gini ratio relate to the Lorenz curve? Why can‘t the Gini ratio exceed 1? What is implied about the direction of income inequality if the Gini ratio declines from 0.42 to 0.35? How would one show that change of inequality in the Lorenz diagram? LO1 Answer: The Gini ratio is the numerical measurement of the inequality depicted by the Lorenz curve. It is calculated by dividing the area between the curve and the diagonal by the total area below the diagonal.

The Gini ratio can‘t exceed 1 because if the Lorenz curve is as far as possible from the diagonal (line of equality), the area between the curve and the diagonal will equal the total area below the diagonal. The equality will result in a Gini ratio of 1.

A decline in the Gini ratio implies less income inequality; and it would be graphically depicted by moving the Lorenz curve closer to the diagonal.

463. Why is the lifetime distribution of income more equal than the distribution in any specific year? LO23.1 1-465 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: The disparity of incomes in a single year reflects the income distribution at a point in time. The very young and very old will receive lower incomes, while the middle-aged tend to receive higher incomes, giving a picture of great inequality. However, if we view these same groups over time, there is considerable income mobility both up and down the income quintile groups, suggesting that income is more equally distributed over a five-, ten-, or twentyyear period for these same households.

464. Briefly discuss the major causes of income inequality. With respect to income inequality, is there any difference between inheriting property and inheriting a high IQ? Explain. LO23.2 Answer: The reasons for income inequality are: differences in abilities and talents among individuals, differences in the amount of education and training an individual obtains, labor market discrimination, differences in tastes and preferences toward work and job attributes, inequality in the distribution of wealth, the ability to use market power to transfer income to oneself, luck, connections, and misfortune.

A high IQ normally does not lead to high income unless it is combined with personal initiative and favorable social circumstances. Inherited property—as long as it is competently managed—provides income irrespective of one‘s character and personal attributes. Both factors are largely a matter of the luck of being born into a family with good ability genes and/or wealth. What one does with the genes or wealth is up to the recipient.

465. What factors have contributed to increased income inequality since 1985? L O23.3 Answer: Several factors have contributed to the increase in income inequality since 1985. The overriding factor is the structural changes that have occurred in the U.S. economy. There has been an increase in the demand for high-skill and well-educated workers relative to lesser-skilled workers. Several industries requiring highly skilled workers have either recently emerged or expanded greatly, such as the computer software, business consulting, biotechnology, health care, and space exploration industries. Highly skilled workers remain relatively scarce, so their wages have been bid up and the wage differences between them and less-skilled workers have increased.

There has been a rapidly rising pay for chief executive officers (CEOs), sizable increases in income from stock options, substantial increases in income for professional athletes and entertainers, and huge fortunes for successful entrepreneurs. This growth of ―superstar‖ pay has also contributed to rising income inequality.

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During the 1970s and 1980s less experienced, younger people entered the labor force in large numbers, thus reducing their incomes. There also was a rise in the number of single mothers with children, but few labor market skills. More recently, there has been a tendency for well-educated men and women to marry, thus placing these families in the highest quintile and increasing the income to those in that quintile. Increased divorce rates have tended to push female-headed households into poverty. Other structure changes include more import competition resulting in a reduction in the demand for and employment of less-skilled workers who used to command high-paying, often union, jobs in manufacturing and an increased the immigration of unskilled workers.

Stronger international competition from imports has reduced the demand for and employment of less-skilled (but highly paid) workers in the automobile and steel industries. The decline in such jobs has reduced the average wage for less-skilled workers. It also has swelled the ranks of workers in already low-paying industries, placing further downward pressure on wages there.

Similarly, The transfer of jobs to lower-wage workers in developing countries has exerted downward wage pressure on less-skilled workers in the United States. An upsurge in the immigration of unskilled workers has increased the number of low-income households in the United States.

Finally, the decline in unionism in the United States has undoubtedly contributed to wage inequality, because unions tend to equalize pay within firms and industries.

466. Should a nation‘s income be distributed to its members according to their contributions to the production of that total income or according to the members‘ needs? Should society attempt to equalize income or economic opportunities? Are the issues of equity and equality in the distribution of income synonymous? To what degree, if any, is income inequality equitable? LO23.4 Answer: The answer to this question is inextricably tied to value judgments, but most of us probably favor a combination of the two types of income distribution.

A purely capitalist system, in which incomes are determined exclusively by the market mechanism, would mean that those who, for whatever reason, are unable to contribute to production would have to depend exclusively on private charity for their livelihood. A (hypothetical) communist state also leads to a seemingly intractable problem—if income is to be distributed purely on the basis of need, why would anyone engage in production? Most modern societies attempt to seek a compromise of one sort or another between these two extremes. The compromise that is actually found often differs markedly from what prevailing political rhetoric in that society might suggest. Socialist economies, which 1-468 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

historically have had large differences in income distribution, also have wider-ranging government transfer programs than most capitalist economies.

Conservatives contend that because of the tradeoff between equality and efficiency, society should content itself with attempting to ensure equality of opportunity. Liberals argue that income redistribution is essential since equality of economic opportunity is impossible in an economy with wide differences in income, especially when these differences are related to the inheritance of property.

Income equity refers to how fairly income is distributed. One can argue that some inequality of income is not only necessary for reasons of efficiency but is fairer than an equal distribution of income, since those who produce more deserve to be rewarded for their efforts. But unequal incomes are not necessarily related to differences in individual ability or effort. It is difficult to defend the inequalities that result from market power and discrimination as being equitable. The justness of inherited wealth is also questionable. Liberals argue that by creating inequality of opportunity, property inheritance is inherently unjust. Conservatives contend that allowing individuals to pass on wealth to whomever they wish is much fairer than having wealth appropriated by the government.

467. Do you agree or disagree? Explain your reasoning. ―There need be no trade-off between equality and efficiency. An ‗efficient‘ economy that yields an income distribution that many regard as unfair may cause those with meager incomes to become discouraged and stop trying. So efficiency may be undermined. A fairer distribution of rewards may generate a higher average productive effort on the part of the population, thereby enhancing efficiency. If people think they are playing a fair economic game and this belief causes them to try harder, an economy with an equitable income distribution may be efficient as well.‖ LO23.4 Answer: While there is certainly an ―efficiency wages‖ aspect to a more equal distribution, it is hard to imagine that the disincentive effects on both high- and low-income earners of income redistribution will be swamped by an increased interest on the part of some of the poor in ―playing the economic game.‖ Without the prospect of higher incomes, few individuals in an economy—including the poor—would choose to increase their productivity. What would increase individual effort and hence aggregate efficiency is the perception that opportunities for all are equal in every respect. In other words, it is not so much an unequal distribution of income that causes some members of society to become discouraged and stop participating in the market, but rather the wide-ranging perception that the deck is stacked against them. Many feel they can never earn incomes commensurate with their abilities and efforts because of a lack of financial resources, restricted access to education, or barriers in the workplace.

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468. Comment on or explain: LO23.4 jjjjjjjjjjjjjjjjjjjjj. Endowing everyone with equal income will make for very unequal enjoyment and satisfaction. kkkkkkkkkkkkkkkkkkkkk.

Equality is a ―superior good‖; the richer we become, the more of it we can afford. lllllllllllllllllllll. The mob goes in search of bread, and the means it employs is generally to wreck the bakeries. mmmmmmmmmmmmmmmmmmmmm.

Some freedoms may be more important in the long run than freedom from want on the part of every individual. nnnnnnnnnnnnnnnnnnnnn.

Capitalism and democracy are really a most improbable mixture. Maybe that is why they need each other—to put some rationality into equality and some humanity into efficiency. ooooooooooooooooooooo.

The incentives created by the attempt to bring about a more equal distribution of income are in conflict with the incentives needed to generate increased income.

Answer: kkkkkkkkkkk.

The distribution of income can ensure equal enjoyment.

Using marginal utility theory, it can be argued that by equalizing incomes in an economy, there is the probability of maximizing total utility for all individuals. This assumes that everyone has identical diminishing-marginalutility-of-money schedules. lllllllllll.

The lessening of poverty provides a host of indirect benefits to affluent members of society—social peace, physical security, and perhaps the intangible satisfaction of living in a more equitable society. The better off the affluent become, the more they are willing to spend in order to purchase these benefits. mmmmmmmmmmm.

Mobs commonly exhibit a marked preference for present over future consumption. Many conservatives contend that the income redistribution schemes resulting from democratic decision making suffer from a similar failing by decreasing the incentive to accumulate capital in order to provide present consumption to the poor. Is this view valid? Perhaps. Does this mean that such redistribution schemes are misguided? Not necessarily. nnnnnnnnnnn.

This is a common conservative view, that civil and political liberties are more important than the universal eradication of poverty. Liberals are likely to contend that ensuring universal freedom from want does not necessarily detract from these fundamental freedoms. ooooooooooo. The principles underlying the two systems can be summarized as follows: Each dollar has a vote in the marketplace, and each person has a vote at the ballot box. These principles are similar enough that the presence of one often leads to the other. They are dissimilar enough so that the type of society that arises from a combination of the two represents a workable social compromise.

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ppppppppppp.

Incentives created in the attempt to bring about more equal distribution of income may cause a tradeoff in decreased economic efficiency.

Higher marginal taxes may reduce the efforts of those at the top to work harder and produce more. Greater benefits to those at the bottom may reduce their incentive to do the same as they receive benefits without the productive effort. In so far as this tradeoff occurs, there will be a reduction in economic growth and therefore, damage to incentives leading to increased incomes.

469. How could the poverty rate fall while the number of people in poverty rises? Which group in each of the following pairs has the higher poverty rate: (a) children or people age 65 or over? (b) African Americans or foreign-born noncitizens? (c) Asians or Hispanics? LO23.5 Answer: The poverty rate is a ratio of (persons in poverty/total persons) so this ratio could fall if the number of persons in poverty increases so long as the number of persons in total increases more. xx. Children have a higher poverty rate (16) than persons 65 or over (90). yy. African-Americans have a higher poverty rate (19.5) than foreign-born noncitizens (13.4). zz. Hispanics have a higher rate (17.9) than Asians (8.1).

470. What are the essential differences between social insurance and public assistance programs? Why is Medicare a social insurance program whereas Medicaid is a public assistance program? Why is the earned-income tax credit considered to be a public assistance program? LO23.6 Answer: Social insurance programs provide aid to those who are retired or suffering from temporary distress. They are usually financed through payroll levies and are viewed to be earned rights because they are paid for by recipients.

Public assistance programs provide benefits for those who are unable to earn income because of permanent handicaps or who have no or very low income and have dependent children. To receive assistance, an individual must pass a ―means‖ test. The cash payments are paid for out of general tax revenues. Most of these revenues come from individuals other than the recipients.

The Medicare program is a part of the Social Security program and is financed with a 2.9 percent tax on wage and salary earnings. Those who have reached 65 years of age are eligible to participate in the program. Medicaid is a program for individuals who are participating in the SSI and TANF programs. It is financed from general tax revenues and is available only to qualified individuals.

The earned-income tax credit is considered a public assistance program because it is targeted at low-income families.

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471. The labor demand and supply data in the following table relate to a single occupation.

Use them to answer the questions that follow. Base your answers on the taste-fordiscrimination model. LO23.7

Plot the labor demand and supply curves for Hispanic workers in this occupation. ppppppppppppppppppppp.

What are the equilibrium Hispanic wage rate and quantity of Hispanic employment? qqqqqqqqqqqqqqqqqqqqq.

Suppose the white wage rate in this occupation is $16. What is the Hispanic-to-white wage ratio? rrrrrrrrrrrrrrrrrrrrr. Suppose a particular employer has a discrimination coefficient d of $5 per hour. Will that employer hire Hispanic or white workers at the Hispanicwhite wage ratio indicated in part c? Explain. sssssssssssssssssssss.

Suppose employers as a group become less prejudiced against Hispanics and demand 14 more units of Hispanic labor at each Hispanic wage rate in the table. What are the new equilibrium Hispanic wage rate and level of Hispanic employment? Does the Hispanic-white wage ratio rise or fall?

Explain. ttttttttttttttttttttt. Suppose Hispanics as a group increase their labor services in that occupation, collectively offering 14 more units of labor at each Hispanic wage rate. Disregarding the changes indicated in part e, what are the new equilibrium Hispanic wage rate and level of Hispanic employment? Does the Hispanic-white wage ratio rise, or does it fall?

Answer:

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qqqqqqqqqqq.

The equilibrium Hispanic wage rate is $12; the equilibrium quantity of Hispanic employment is 35,000 workers. rrrrrrrrrrr. The Hispanic-to-white wage ratio is .75 (= $12/$16). sssssssssss. The employer will hire only white workers because the $5 discrimination coefficient exceeds the $4 difference between the wage rates of whites and Hispanics. ttttttttttt.

The new equilibrium Hispanic wage rate is $14 and the new equilibrium quantity of Hispanic employment is 44,000 workers. The Hispanic-white wage ratio rises to .875 (= $14/$16) because of the increased demand for Hispanic labor in relation to the unchanging supply of Hispanic labor. uuuuuuuuuuu.

The new equilibrium Hispanic wage rate is $10 and the new equilibrium quantity of Hispanic employment is 42,000. This Hispanicwhite wage ratio falls to .625 (= $10/$16).

472. Statistical discrimination implies that discrimination can persist indefinitely, while the taste-for-discrimination model suggests that competition might reduce discrimination in the long run. Explain the difference. LO23.7 Answer: Statistical discrimination occurs when people are judged on the basis of the average characteristics of the group to which they belong. Insurance companies base auto insurance premiums on the statistical information available, and the consequent discrimination will continue as long as there is a difference in accident rates by gender in this age group.

The taste-for-discrimination model suggests that competition will reduce discrimination in the long run. Firms that do not discriminate will have lower actual wage costs per unit of output and lower average total costs than will the firms that discriminate. These lower costs will allow non-discriminating firms to 1-476 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

charge lower prices. This should eventually drive the discriminating firms out of the market.

473. Use a demand and supply model to explain the impact of occupational segregation or ―crowding‖ on the relative wage rates and earnings of men and women. Who gains and who loses from the elimination of occupational segregation? Is there a net gain or a net loss to society? Explain. LO23.7 Answer: See Figure 23.6. Discrimination against women in two of the three occupations will crowd women into the third occupation. Labor supply in the ―men‘s occupations‖ (X and Y) decreases, making them high-wage occupations.

Labor supply in the ―women‘s occupation‖ (Z) increases creating a low-wage occupation.

Eliminating occupational segregation would entice women into the high-wage occupations, increasing labor supply there and reducing it in the low-wage occupation. The wage rates in the three occupations would converge to B. Women would gain, men would lose. Society would gain because the increase in output in the expanding occupations would exceed the loss of output in the contracting occupation.

474. LAST WORD What are the main arguments for and against UB I? What was the reaction of millions of U.S. workers during the pandemic to being offered the chance to make more in unemployment benefits than they could working? What is your personal opinion on the probable effects of UBI? Answer: The basic idea universal basic income, or UB I, is simple: the government would guarantee a minimum monthly income to every citizen, with the money arriving by automatic deposits into recipients‘ bank accounts.

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After Congress began offering unprecedentedly large unemployment compensation during the Covid pandemic, millions of American workers choose to remain unemployed and collect more in unemployment benefits each week than they would have earned if they had returned to paid employment.

Advocates assert a wide variety of benefits, including a reduction in poverty, a reduction in income inequality, and a reduction in income insecurity, or the negative feelings that come with having to worry about the possibility of becoming unable to support oneself financially. Advocates also argue that it would be much less costly for the government to administer a single monthly UBI payment than it is to administer the large and sometimes confusing array of payment and reimbursement systems that we currently use to deliver welfare and public assistance. Instead of tax credits, food stamps, disability payments, housing subsidies, unemployment benefits, and cash payments made through EBT cards, the government would only have to administer a single monthly UB I payment.

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Detractors have cited high costs, unfairness, and unintended consequences as reasons for opposition. With respect to costs, they point out that sending every American a check for $1,000 each month would cost $3.96 trillion, or substantially more than the $3.4 trillion that the federal government currently collects each year in taxes. Thus, they argue that UBI is politically impossible because voters would not accept the massive tax increase that would be necessary to fund UB I. Opponents point out that most people are employed so why should they get a government welfare check each month? They go on to argue that giving everybody a guaranteed $1,000 per month would reduce the incentive to work.

REVIEW QUESTIONS Suppose that the United States has a Gini ratio of 0.41 while Sweden has a Gini ratio of 0.31. Which country has a more equal distribution of income? Explain. LO23.1 The United States. uuuuuuuuuuuuuuuuuuuuu.

Sweden. vvvvvvvvvvvvvvvvvvvvv.

They are actually equal.

Answer: b. Sweden The higher the Gini ratio the more unequal a country‘s income distribution is.

Thus, Sweden‘s lower ratio implies that is has less inequality of incomes—which is the same thing as saying that is has more equality of incomes.

475. Some part of income inequality is likely to be the result of discrimination. But other factors responsible for inequality include (select as many as apply): L O23.2 differences in abilities and talents. wwwwwwwwwwwwwwwwwwwww. differences in education and training. xxxxxxxxxxxxxxxxxxxxx. different preferences for work versus leisure. yyyyyyyyyyyyyyyyyyyyy. different preferences for low-paying but safe jobs relative to high-paying but dangerous jobs.

Answer: a, b, c, and d are all correct.

476. Suppose that a society contains only two members, a lawyer named Monique and a handyman named James. Five years ago, Monique made $100,000 while James made $50,000. This year, Monique will make $300,000 while James will make $100,000. Which of the following statements about this society‘s income distribution are true?

LO23.3 Select one or more answers from the choices shown.

In absolute dollar amounts, the entire distribution of income has been stagnant. zzzzzzzzzzzzzzzzzzzzz. The relative distribution of income has become more equal. aaaaaaaaaaaaaaaaaaaaaa. The relative distribution of income has become less equal. bbbbbbbbbbbbbbbbbbbbbb.

The relative distribution of income has remained constant.

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cccccccccccccccccccccc. The rich are getting richer while the poor are getting poorer. dddddddddddddddddddddd.

The rich are getting richer faster than the poor are getting richer.

Answer: In absolute dollar amounts, the entire distribution of income has been moving upward.

The relative distribution of income has become less equal.

The rich are getting richer faster than the poor are getting richer.

The following three statements about this society‘s income distribution are true: In absolute dollar amounts, the entire distribution of income has been moving upward. We know this to be true because each person in this society has seen his or her income rise over the past five years.

The relative distribution of income has become less equal. This is true because Monique‘s share of total income has been rising. Five years ago, Monique‘s $100,000 of income represented 2/3 of the society‘s total income of $150,000 (= Monique‘s $100,000 + James‘ $50,000). But this year, Monique‘s $300,000 of income will represent ¾ of the society‘s total income of $400,000 (= Monique‘s $300,000 + James‘ $100,000). Thus, income inequality has risen because the share of income earned by the richest member of this society has increased.

The rich are getting richer faster than the poor are getting richer. This is true because while James and Monique have both gotten richer, Monique‘s increase in income is larger than James‘ increase in income. In particular, Monique‘s income has tripled from $100,000 to $300,000 while James‘ income has only doubled from $50,000 to $100,000. So the rich are getting richer faster than the poor are getting richer.

477. Suppose that the last dollar that Victoria receives as income brings her a marginal utility of 10 utils while the last dollar that Fredrick receives as income brings him a marginal utility of 15 utils. If our goal is to maximize the combined total utility of Victoria and Fredrick, we should: LO23.4 redistribute income from Victoria to Fredrick. eeeeeeeeeeeeeeeeeeeeee. redistribute income from Fredrick to Victoria. ffffffffffffffffffffff. not engage in any redistribution because the current situation already maximizes total utility. gggggggggggggggggggggg. none of the above.

Answer: a. Redistribute income from Victoria to Fredrick.

If our goal is to maximize the combined total utility of Victoria and Fredrick, we should redistribute income from Victoria to Fredrick.

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This is true because the marginal utility of 15 that Fredrick receives from the last dollar of his income is higher than the marginal utility of 10 that Victoria receives from the last dollar of her income. So, if we took one dollar away from Victoria and redistributed it to Fredrick, the combined total utility of Victoria and Fredrick would rise because while Victoria‘s total utility would fall by 10 utils when we took that dollar away from her, Fredrick‘s total utility would rise by 15 utils when he was given that dollar. Thus, there would be a net increase of 5 utils (= 15 utils gained by Fredrick minus 10 utils lost by Victoria).

In a similar fashion, if our only goal is to maximize their combined total utility, then we should continue to take dollars away from Victoria and give them to Fredrick just as long as Fredrick‘s marginal utility remains greater than Victoria‘s marginal utility.

478. True or false. If women are crowded into elementary education and away from fire fighting, wages in fire fighting will tend to be lower than if women weren‘t crowded into elementary education. LO23.7 False. hhhhhhhhhhhhhhhhhhhhhh.

True.

Answer: a. False.

Crowding women into elementary education and away from fire fighting will raise wages in fire fighting because the supply of labor flowing to fire fighting will be reduced relative to what it would have been if women were not crowded away from fire fighting and more women were attempting to become fire fighters.

479.

In the taste-fordiscrimination model, an increase in employer prejudice against African-American workers would cause the discrimination coefficient to _ and the demand curve for African-American labor to shift _ . LO23.7 decrease; right iiiiiiiiiiiiiiiiiiiiii. decrease; left jjjjjjjjjjjjjjjjjjjjjj. increase; right kkkkkkkkkkkkkkkkkkkkkk. increase; left Answer: d. Increase; left.

In the taste-for-discrimination model, an increase in employer prejudice against African-American workers would cause the discrimination coefficient to increase and the demand curve for African-American labor to shift left.

The discrimination coefficient increases because it puts a dollar amount on the disutility felt by racist employers when confronted with the possibility of hiring African-American workers rather than white workers. Increased employer 1-481 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

prejudice translates into higher disutility and therefore a higher discrimination coefficient.

The demand curve for African-American labor shifts left when employer prejudice increases because racist employers will be less willing to higher African-American workers relative to white workers. With a higher discrimination coefficient, only those African-American workers whose productivity is high enough to compensate for the increased disutility felt by racist employers will still be demanded by those racist employers. Those AfricanAmerican workers with lower productivity will no longer be demanded. Thus, the total demand for African-American labor will fall.

PROBLEMS In 2019, Forbes magazine listed Jeff Bezos, the founder of Amazon, as the richest person in the United States. His personal wealth was estimated to be $177 billion. Given that there were about 333 million people living in the United States that year, how much could each person have received if Bezos‘ wealth had been divided equally among the population of the United States? (Hint: A billion is a 1 followed by nine zeros while a million is a 1 followed by six zeros.) LO23.1 Answer: $531.53 Feedback: Simply divide Jeff Bezos‘ wealth, $177 billion, by the number of people in the United States, 333 million. The answer is $531.53 (= $177,000,000,000/33000,000).

480. Imagine an economy with only two people. Lakshmi earns $20,000 per year while Roger earns $80,000 per year. As shown in the following figure, the Lorenz curve for this two-person economy consists of two line segments. The first runs from the origin to point a while the second runs from point a to point b. LO23.1

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Calculate the Gini ratio for this two-person economy using the geometric formulas for the area of a triangle (= ½ × base × height) and the area of a rectangle (= base × height). (Hint: The area under the line segment from point a to point b can be thought of as the sum of the area of a particular triangle and the area of a particular rectangle.) llllllllllllllllllllll. What would the Gini ratio be if the government taxed $20,000 away from Roger and gave it to Lakshmi? (Hint: The figure will change.) mmmmmmmmmmmmmmmmmmmmmm.

Start again with Lakshmi earning $20,000 per year and Roger earning $80,000 per year. What would the Gini ratio be if both their incomes doubled? How much has the Gini ratio changed from before the doubling in incomes to after the doubling in incomes?

Answers: The Gini ratio is 0.300. vvvvvvvvvvv. The Gini ratio here is 0.100. wwwwwwwwwww. The Gini ratio will remain as it was in part (a) at 0.300; the ratio has not changed.

Feedback: The Gini ratio is the area between the perfect equality line and the Lorenz curve divided by the area under the perfect equality line.

First, we find the area under the equality line. Using our formula for the area of a right triangle we have an area of 5,000 [= (1/2) × 100 (base or x-axis) × 100 (height or y-axis)].

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Second, we find the area between the two curves. To do this we start by finding the area UNDER the Lorenz curve (we have easy to use formulas for triangles and rectangles). See the graph below.

The area of triangle A is 500 [= (1/2) × 50 (base) × 20 (height)].

The base of the triangle is 50 (at 50 percent) because there are only two people in the economy. The height of the triangle is 20 (at 20 percent) because the lowest income is $20,000, which is 20 percent of the total income earned in society [= ($20,000 / $100,000) × 100].

The area of rectangle B is 1,000 [= 50 (base) × 20 (height)].

The area of triangle C is 2,000 [= (1/2) × 50 (base) × 80 (height)].

The total area under the Lorenz Curve is 3,500 (= 500(area of triangle A) + 1,000 (area of rectangle B) + 2,000(area of triangle C). We can now find the area between the two curves, which is 1,500 [= 5,000 (the area under the equality curve) − 3,500 (the area under the Lorenz curve)].

The final step of this procedure is to take the ratio of the area between the two curves and the area under the equality curve, which gives us the Gini ratio.

The Gini ratio for this example is 0.3 (=1,500/5,000). xxxxxxxxxxx. After the tax and redistribution program Lakshmi‘s new income is $40,000 and Roger‘s new income is $60,000. This implies that Lakshmi (50 1-484 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

percent of the population) now controls 40 percent of society‘s income rather than the 20 percent before the program.

To calculate the new Gini ratio we use the same procedure as above.

However, we use 40 percent rather than the 20 percent shown in the diagram.

With this new value we have: The area of triangle A is 1,000 [= (1/2) × 50 (base) × 40 (height)].

The area of rectangle B is 2,000 [= 50 (base) × 40 (height)].

The area of triangle C is 1,500 [= (1/2) × 50 (base) × 60 (height)].

The total area under the Lorenz Curve is 4,500. We can now find the area between the two curves, which is 500 [= 5,000 (the area under the equality curve, note this does not change) − 4,500 (the area under the Lorenz curve)].

The Gini ratio for this income distribution is 0.1 (= 500/5,000). yyyyyyyyyyy. If incomes double, Lakshmi earns $40,000 and Roger earns $160,000. The total income in society is now $200,000. Lakshmi still only controls 20 percent of the society‘s income [(= $40,000/$200,000) × 100].

Since the doubling of incomes does not change the percentage of income controlled by Lakshmi (or Roger) the Gini ratio will not change. The answer will be the same as in part a.

481. In 2018, many unskilled workers in the United States earned the federal minimum wage of $7.25 per hour. By contrast, average earnings in 2018 were about $27 per hour, and certain highly skilled professionals, such as doctors and lawyers, earned $100 or more per hour. L O23.7 If we assume that wage differences are caused solely by differences in productivity, how many times more productive was the average worker than a worker being paid the federal minimum wage? How many times more productive was a $100per-hour lawyer compared to a worker earning minimum wage? nnnnnnnnnnnnnnnnnnnnnn.

Assume that there are 20 minimum-wage workers in the economy for each $100-per-hour lawyer. Also assume that both lawyers and minimum-wage workers work the same number of hours per week. If everyone works 40 hours per week, how much does a $100-per hour lawyer earn a week? How much does a minimum-wage worker earn in a week? oooooooooooooooooooooo.

Suppose that the government pairs each $100-perhour lawyer with 20 nearby minimum-wage workers. If the government taxes 25 percent of each lawyer‘s income each week and distributes it equally among the 20 minimum-wage workers with whom each lawyer is paired, how much will each of those minimum-wage workers receive each week? If we divide by the number of hours worked each week, how much does each minimum-wage worker‘s weekly transfer amount to on an hourly basis?

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pppppppppppppppppppppp.

Suppose the government taxes each lawyer 100 percent before dividing the money equally among the 20 minimum-wage workers with whom each lawyer is paired. How much per week will each minimum wage worker receive (assuming the lawyer continues to work)? And how much is that on an hourly basis?

Answers: The average worker is 3.72 times more productive than a minimum wage worker. A $100-per-hour lawyer is 13.79 times more productive than a minimum wage worker. zzzzzzzzzzz. The lawyer will earn $4,000 per week while each minimum wage worker will earn $290 per week. aaaaaaaaaaaa.

Each minimum-wage worker will receive $50 each week. If we divide that $50 per week received by each worker by the number of hours per week that each works, we see that the transfer comes out to $1.25 per hour. bbbbbbbbbbbb.

If the government taxes each lawyer 100 percent, then each worker would receive $200 per week. That works out to $5.00 per hour.

Feedback: Since wage differences are solely due to differences in productivity, in the current example we can determine how many times more productive one group is relative to another by taking the ratio of wages. This implies the average worker is 3.72 times more productive than a minimum-wage worker (= $27/$7.25). The high-wage worker is 13.79 times more productive than the minimum-wage worker (= $100/$7.25). The high wage worker is 13.79 more productive than the minimum wage worker (= $100 / $7.25). cccccccccccc. The lawyer earns $4,000 per week [= $100 (hourly wage) × 40 (hours worked per week)].

The minimum wage worker earns $290 (= $7.25 × 40).

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dddddddddddd.

First, calculate government revenue from the tax on lawyers. At the tax rate of 25 percent on the $4,000 earnings per week, government revenue is $1,000 (= 0.25 × $4,000). This $1,000 is then distributed to 20 minimum wage workers, thus each worker receives $50 per week from the government. Finally, converting this transfer to an hourly basis by dividing the weekly transfer by the hours worked per week, we have a transfer of $1.25 per hour (= $50/40). eeeeeeeeeeee. For this case government revenue will equal $4,000 assuming the lawyer continues to work. Dividing this by the 20 workers implies a weekly transfer of $200 (= $4,000/20). The hourly transfer is $5 (= $200/40).

482. The desire to maximize profits can work against racial and other types of discrimination. To see why, consider two equally productive accountants named Ted and Jared. Ted is black, and Jared is white. Both can complete 10 audits per month.

LO23.7 Suppose that for any accounting firm that hires either Ted or Jared, all the other costs of performing an audit (besides paying either Ted or Jared) come to $1,000 per audit. If the going rate that must be paid to hire an accountant is $7,000 per month, how much will it cost an accounting firm to produce one audit if it hires either Ted or Jared to do the work? qqqqqqqqqqqqqqqqqqqqqq.

If the market price that accounting firms charge their clients for an audit is $1,800, what would the accounting profit per audit be for a firm that hired either Ted or Jared? What is the profit rate as a percentage? rrrrrrrrrrrrrrrrrrrrrr.

Suppose that firm A dislikes hiring black accountants while firm B is happy to hire them. So, Ted ends up working at firm B rather than firm A. If Ted works 11 months per year, how many audits will he complete for firm B each year? How much in accounting profits will firm B earn each year from those audits? ssssssssssssssssssssss.

Since firm A passed on hiring Ted because he was black, firm A is forgoing the profits it could have earned if it had hired Ted. If the firm is willing to forgo up to $5,000 per year in profit to avoid hiring blacks, by how many dollars will firm A regret its decision not to hire Ted? Answers: The cost of producing one audit will be $1,700. ffffffffffff.

The accounting profit per audit would be $100 per audit. The rate of profit per audit is approximately 5.9 percent. gggggggggggg.

Ted will complete 110 audits each year. Firm B will earn $11,000 in profit each year from Ted’s work. hhhhhhhhhhhh.

Firm A will regret its decision not to hire Ted by $6,000.

Feedback: The cost of producing one audit is $1,700. Each audit has a cost of $1,000 and the cost of employing one accountant is $7,000. However, this accountant can complete 10 audits per month, which implies an additional cost per audit of 1-487 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

$700. Thus, the total cost of one audit is $1,000 + $700 = $1,700. This cost applies to Ted or Jared. iiiiiiiiiiii.

Since the cost per audit is $1,700 (from part a) and the price the firm charges per audit is $1,800, the profit per audit is $100 (= $1,800 − $1,700).

The profit rate is approximately 5.88% [= $100 (profit per audit) / $1,700 (cost per audit)]. jjjjjjjjjjjj.

Ted will complete 110 audits working 11 months per year [= 10 (audits per month) × 11 (months)].

Firm B will earn $11,000 a year in accounting profits by hiring Ted [= 110 (audits per year) × $100 (profit per audit, part b)]. kkkkkkkkkkkk.

Firm A will regret its decision not to hire Ted by $6,000 [= $11,000 (accounting profit) − $5,000 (discrimination amount)].

Chapter 24 - Health Care McConnell Brue Flynn 23e DISCUSSION QUESTIONS 483. Why would increased spending as a percentage of GDP on, say, household appliances or education in a particular economy be regarded as economically desirable? Why, then, is there so much concern about rising expenditures as a percentage of GDP on health care? LO24.1 Answer: Increasing expenditures on goods such as household appliances or education is regarded as desirable because production is expanding under relatively competitive market conditions. Thus, not only are output and employment expanding, but presumably these are happening because of allocative efficiency. Consumers are choosing to buy appliances or education because they are willing to pay the price for these goods.

There is concern about the same rising expenditures in the health care industry because of the unique factors that characterize the market for health care services.

On the demand side, there is imperfect competition in that buyers do not have good information about the services needed or the fees that will be charged for the services; doctors control much of this information and, in fact, order the services for the consumer in most cases. Third-party insurance companies pay the direct costs of most health care on a fee-for-service basis, and therefore the consumer 1-488 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

pays less than the full price at the time of consumption, leading to overconsumption; overconsumption by the insured may also be encouraged by the ―moral hazard‖ problem. On the supply side, technology is encouraged without much regard for its cost by insurance providers; doctors also control much of the provision of health care in an imperfectly competitive supply structure, since they really don‘t compete on the basis of price. In other words, many of the unique factors of the health care market lead economists to believe that overconsumption is occurring and that society is losing because resources are not being allocated efficiently in a way that maximizes society‘s welfare.

484. What are the ―twin problems‖ of the health care industry as viewed by society?

How are they related? LO24.1 Answer: The ―twin problems‖ are rising prices for all and limited access (lack of insurance) for about 9 percent of the population, or 29 million Americans, in 2017. The problems are related since rising costs make insurance unaffordable for many individuals and families. This also makes it difficult for some businesses to insure their workers.

485. What are the implications of rapidly rising health care prices and spending for (a) the growth of real wage rates, (b) government budgets, and (c) offshoring of U.S. jobs? Explain. LO24.2 Answer: The real total compensation package, wages plus benefits, can only rise as fast as productivity does. If health insurance benefits rise more rapidly than productivity, then the real wage component of the compensation package is squeezed and it must fall. Workers feel the burden of rising health care costs as their take-home wages fall.

Government budgets are also stretched by rising health care costs, because social security recipients qualify for federally financed Medicare benefits, which grow as a result of higher health care costs and a greater proportion of the population qualifying for these benefits. All levels of government are affected by Medicaid payments, which are financed by a combination of state and federal funds.

Finally, local governments may also be affected through their support of public hospital and other health care facilities, because the uninsured and underinsured need to have their health care costs subsidized.

Off shoring is likely to increase as firms attempt to avoid rising health care costs.

Outsourcing and off shoring production to firms with lower health care costs (particularly those outside the U.S.) reduces the total cost of doing business.

486.

What are the main groups without health insurance? LO24.3 1-489 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: One group of uninsured is the working poor, who make too much to qualify for Medicaid but not enough to afford health insurance. Both they and their employers find it difficult to support this cost for minimum-wage and other low-income workers. Another group includes part-time workers and those who work for small firms, or who are self-employed in small businesses or farms.

Those who believe they are healthy and can avoid accidents, such as young adults, may refuse to spend money on insurance, and on the opposite extreme, the chronically ill, who are unable to get insurance coverage at all or at any reasonable price, are often without insurance.

487. List the special characteristics of the U.S. health care market and specify the problems created by each. LO24.4 Answer: The health care market has many characteristics that differentiate it from a perfectly competitive market. (1) There are ethical questions connected with health care services that don‘t arise when people are unable to afford other types of goods and services—in general, society regards access to basic health care as a right. (2) Buyers of health care typically have little information about the services they need and should acquire, creating the unusual situation in which the doctor (supplier) orders the services for the patient (consumer). (3) There are significant spillover or external benefits connected with health care, suggesting that society should be willing to pay more than the amount coming from the private sector alone. (4) Third-party payments are common because the patient (consumer) has prepaid for insurance benefits, and about three-fourths of all health care expenses are paid in this way. Consumers directly pay lower ―out-of-pocket‖ expenses than if they were not insured, which causes them to overconsume.

488. What are the estimated income and price elasticities of demand for health care?

How does each relate to rising health care costs? LO24.4 Answer: Several studies for industrially advanced countries suggest that the income elasticity coefficient for health care is about 1. In other words, per capita health care spending rises approximately in proportion to increases in per capita income. For example, a 3 percent increase in income will generate a 3 percent increase in health care expenditures. Some evidence suggests that income elasticity may be higher in the United States, perhaps as high as 1.5. Because health care is a normal good, increases in domestic income have increased the demand for health care.

Estimates of the price elasticity of demand for health care imply that it is quite inelastic, with this coefficient being as low as 0.2. Thus, the quantity of health care consumed declines relatively little as price increases. For example, a 10 percent increase in price will reduce quantity demanded by only 2 percent. An important consequence is that total health care spending increases as the price of health care rises.

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489. Briefly discuss the demand and supply factors that contribute to rising health costs. Specify how might (a) asymmetric information, (b) fee-for-service payments, (c) defensive medicine, and (d) medical ethics increase health care costs? LO24.4 Answer: aaa. Asymmetric information refers to the fact that consumers of health care often have very little understanding or access to the information about the health care services that they need. Therefore, they must depend on health care professionals to order the services for them. This creates the unusual market situation in which producers have the power to create demand for what they produce. Even when patients understand and do create the demand, it is difficult for them to find price information about health care services.

Obviously, this situation is not a competitive one on the production side, and consequently there is less pressure to keep prices low, as would be the case in a competitive industry.

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bbb. Fee-for-service payments can contribute to rising health care costs by making it possible for providers to increase their incomes by simply ordering more services for the patient. If an attempt were made to legally control prices, for example, the provider could simply require the patient to purchase more tests, more exams, etc. The administrative costs of billing on a fee-forservice basis are also higher than would be the case if there were other types of reimbursement for services. ccc. Defensive medicine refers to the practice that physicians follow to avoid malpractice charges. To defend against such concerns, they may order more tests and procedures than would be warranted medically or economically. ddd. Medical ethics, which require the ―best practice‖ techniques, may result in the use of costly medical practices with only marginal benefits. Also, the values that promote the support of a human life as long as possible, regardless of the cost or condition of life, add to the cost of health care.

490. How do advances in medical technology and health insurance interact to drive up the cost of medical care? LO24.4 Answer: Significant advances in medical technology have occurred and have been encouraged by the willingness of public and private insurance to pay for new treatments without regard to cost. There appears to be an interplay among the availability of new medical technology, increases in health care costs, increases the demand for health insurance, and finally increases in the demand for the new services. This process is continuous. One illustration of this occurred when Medicare programs agreed to pay for magnetic resonance imaging (MRI) scans in 1985; the sales of such scanners then rose dramatically.

Many experts agree that as much as one-half of the increase in health care expenditures is the result of advances in medical technology.

491. Using the concepts in Chapter 7‘s discussion of consumer behavior, explain how health care insurance results in an overallocation of resources to the health care industry. Use a demand and supply diagram to specify the resulting efficiency loss.

LO24.4 Answer: Health care insurance removes or greatly lessens a person‘s budget constraint at the time health care is purchased, raising health care utility per dollar spent and causing an overconsumption of health care. In Figure 24.3b, insurance reduces the price of health care at the time of purchase from Pa to Pc, increasing the quantity consumed from Qa to Qc. At Qc the marginal cost of health care is represented by point b and exceeds the marginal benefit represented by c, indicating an over allocation of resources. The efficiency loss is area cab.

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492. How is the moral hazard problem relevant to the health care market? LO24.4 Answer: The moral hazard problem is relevant to the health care market in two basic ways. First, the insured individual may neglect preventive health care, knowing that the costs of illness and/or injury are covered. Second, when health care is needed, the insured may over consume, because the out-of-pocket expense for any single service is subsidized by the insurance. Providers may also be encouraged to order more tests or treatments than are really necessary when the patient is not having to bear the entire cost directly.

493. What is the rationale for exempting a firm‘s contribution to its workers‘ health insurance from taxation as worker income? What is the impact of this exemption on allocative efficiency in the health care industry? LO24.4 Answer: The underlying rationale is that spillover benefits exist from a healthy, productive workforce. Therefore, it is appropriate to make health care more widely available to workers and their families.

The impact of the exemption is to make private health care insurance more accessible to more people, but it also contributes to the overconsumption problem.

Workers in the 28 percent marginal tax bracket can essentially receive $1.00 worth of insurance for a contribution of $0.72, which is the after-tax value of that $1.00 in income spent on health insurance. The tax subsidy costs the Federal government an estimated $65 billion in forgone revenue and boosts private health insurance spending by about one-third. Health care spending may be 10–20 percent higher than it would be without the tax break.

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494. What are (a) preferred provider organizations and (b) health maintenance organizations? In your answer, explain how each is designed to alleviate the overconsumption of health care. LO24.5 Answer: Preferred provider organizations (P POs) are collective agreements among hospitals, doctors, and insurance companies in which the providers (hospitals and doctors) agree in advance to provide discounts on their services in exchange for receiving the business of those insured by the company in question. Policy holders are given a list of those cooperating hospitals, clinics, and physicians and will receive greater reimbursement by patronizing those members of the PPO. Usually, the patient has a choice to receive care elsewhere, but at a lower insurance reimbursement level. eee. Health maintenance organizations (HMOs) are organizations which contract with employers, insurance companies, labor unions, or other groups to provide medical care for their members. HM Os alter the traditional fee-forservice arrangement by providing prepaid health plans, which usually cover preventive care as well as sickness and injury.

PPOs lower costs by the agreement to lower fees in exchange for the contract from the insurance company. The use of one organization can also lower administrative costs substantially, as uniform medical forms and bills are streamlined. HMOs are considered ―managed care‖ systems, because utilization and spending are ―managed‖ or controlled by close monitoring of physician and provider behavior to eliminate unneeded tests and treatments, since HMOs operate on a fixed budget. The existence of a budget for HMOs, which don‘t charge on a fee-for-service basis, provides an incentive to economize on services offered to each patient. Furthermore, by encouraging patients to receive preventive care, HMOs might also reduce the higher cost of the hospitalization of ill patients.

495. What are health savings accounts (HSAs)? How might they reduce the overconsumption of health care resulting from traditional insurance? How might they introduce an element of price competition into the health care system? LO24.5 Answer: Health savings accounts are accessible to those with qualifying insurance plans with annual deductibles of $1,000 or more, and without other first-dollar coverage. It allows employees and employers to make tax-deductible contributions to an account that can be accumulated and/or withdrawn tax-free for medical expenses. Funds can also be withdrawn for nonmedical expenses, but those withdrawal face income taxes and a 10 percent penalty.

Because the funds belong to the worker, it provides an incentive to consume health care only as needed (reducing overconsumption).

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It also creates an incentive to seek out lower prices, and to avoid costly procedures that are unnecessary. If consumers are more conscientious in the health care expenditures, health care providers have more incentive to compete for those health care dollars.

496. Why is the ACA‘s attempt to extend insurance coverage to all Americans so costly?

How does the ACA attempt to obtain the funds needed to extend insurance coverage to all Americans? LO24.6 Answer: The fact is that many of those without insurance are known to suffer from extremely costly medical conditions. Indeed, these individuals were without insurance precisely because private insurance companies (which have to either break-even or go bankrupt) considered them too expensive to insure. The ACA now makes it illegal for insurance companies to deny coverage to anyone on the basis of a preexisting medical condition. This ban will lead to the enrollment of millions of individuals with very costly health conditions as these individuals will be almost certain to enroll as soon as the ban goes into effect. The ACA also increases the amount of money that insurance companies will be spending in the future by prohibiting them from imposing annual or lifetime expenditure caps.

Thus, the program is likely to be expensive.

The ACA aims to obtain the needed revenue from two main sources: a personal mandate to buy insurance and an assortment of new taxes.

The ACA has an employer mandate (requirement) that every firm with 50 or more employees must either purchase health insurance for their employees or pay a fine of $2,000 per employee. The ACA also contains a personal mandate (requirement) that individuals must purchase health insurance for themselves and their dependents unless they are already covered by either government insurance or employer-provided insurance. Forcing healthy individuals to participate in the health insurance market reduces the cost of program. These individuals, on average, will pay more for insurance than they will receive in health benefits.

Thus, these individuals will subsidize the cost of the unhealthy (previously uninsured).

In addition, the government will impose several new taxes. The more prominent include: (1) A 0.9 percentage point increase in the Medicare payroll tax for individuals earning more than $200,000 per year and for married couples earning more than $250,000 per year.

(2) A 3.8 percentage point increase in the capital gains tax for individuals earning more than $200,000 per year and for married couples earning more than $250,000 per year.

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(3) A 40 percent tax payable by employers on any employer-provided insurance policy whose premium exceeds $10,200 per year for individual coverage or $27,500 per year for family coverage.

(4) A 2.9 percent excise tax applied to everything sold by medical device manufacturers.

(5) A 10 percent tax levied on indoor tanning.

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497. How does the ACA attempt to ensure affordable insurance for the poor? LO24.6 Answer: The ACA attempts to cover those with lower incomes in three ways.

First, the employer mandate will induce many larger employers to provide insurance for all of their employees, including the poorer ones. Second, the law expands the Medicaid system to cover anyone whose income is less than 133 percent of the poverty level. Third, the ACA subsidizes the purchase price of health insurance for those who must buy their own health insurance in order to comply with the individual mandate.

498. LAST WORD What are the three major cost-reducing features of the Singapore health care system? Which one do you think has the largest effect on holding down the price of medical care in Singapore? What element of the Singapore system is shared by the and State of Indiana systems? What elements are missing? How difficult do you think it would be to implement those missing elements in the United States? Explain.

Answer: The three major cost-reducing features of the Singapore health care system are: (1) Competition is encouraged by forcing hospitals to post prices for each of their services. Armed with this information, patients can shop around for the best deal. The government also publishes the track record of each hospital on each service so that consumers can make informed decisions about quality as well as price.

(2) Singapore insists upon high out-of-pocket costs in order to avoid the overconsumption and high prices that result when insurance policies pick up most of the price for medical procedures.

(3) Singapore‘s citizens are required to save about six percent of their incomes into ―MediSave‖ accounts. MediSave deposits are private property so that people have an incentive to spend the money in their accounts wisely. In addition, the citizens of Singapore also know that they won‘t be left helpless if the money in their MediSave accounts runs out. The government subsidizes the health care of those who have exhausted their MediSave accounts as well as the health care of the poor and others who have not been able to accumulate much money in their MediSave accounts.

Which one do you think has the largest effect on holding down the price of medical care in Singapore? The answer will depend on the student, but the most likely candidate is the high out-of-pocket costs.

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The State of Indiana system shares the high out-of-pocket expenses element with the Singapore system. Requiring individuals to use personal wellness accounts makes them think about opportunity cost. The information aspect of the Singapore system and the forced savings accounts however are absent (although one might think of the personal wellness accounts as a substitute for forced savings). These elements may be difficult to implement in the U.S. because of the belief in limited government (on average). However, this answer will vary across students.

REVIEW QUESTIONS Which of the following best describes the United States‘ level of health care spending as compared to that of other nations? LO24.1 tttttttttttttttttttttt. The lowest of all nations. uuuuuuuuuuuuuuuuuuuuuu.

A bit lower than average. vvvvvvvvvvvvvvvvvvvvvv.

Average. wwwwwwwwwwwwwwwwwwwwww. A bit higher than average. xxxxxxxxxxxxxxxxxxxxxx.

The highest of all nations.

Answer: e. The highest of all nations.

International data on health care spending as a percentage of GDP reveals that the United States‘ level of health care spending is the highest of all nations.

499. Which of the following make a person less likely to have health insurance? L O24.3 Select one or more answers from the choices shown.

Working for a larger firm. yyyyyyyyyyyyyyyyyyyyyy.

Being a low-wage worker. zzzzzzzzzzzzzzzzzzzzzz. Being employed. aaaaaaaaaaaaaaaaaaaaaaa. Having excellent health. bbbbbbbbbbbbbbbbbbbbbbb.

Being chronically ill.

Answer: b. Being a low-wage worker. d. Having excellent health. e. Being chronically ill.

About 29 million Americans, or 9 percent of the population, did not have health insurance in 2017. The uninsured were concentrated among the poor, the chronically ill, the unemployed, the young, those employed by small firms, and low-wage workers.

Being a low-wage worker is associated with a lower likelihood of having health insurance because low-wage workers tend to work in low-productivity industries where labor simply does not generate much in the way of valuable output.

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Confronted with expensive insurance premiums, firms in such industries often eliminate health insurance benefits because keeping them would be so costly (relative to the firms‘ low productivity and output) as to make the firms unprofitable. Thus, low-wage workers often have no health insurance.

Having excellent health is also associated with a lower likelihood of having health insurance because so many young, healthy workers choose to go without health insurance. They do so because paying for an expensive health insurance policy seems very wasteful when they are unlikely to use it thanks to being young and healthy.

Finally, being chronically ill is also associated with a lower likelihood of having health insurance because the high cost of caring for chronically ill people causes insurances companies to either refuse to write policies for chronically ill people or charge them such high premiums that many of the chronically ill cannot afford insurance.

500. A patient named Jen visits Dr. Jan. Dr. Jan is nearly certain that Jen only has a cold. But because Dr. Jan is afraid of malpractice lawsuits, she orders an extensive battery of tests just to make sure that Jen can never claim—if she turns out to have something more severe—that Dr. Jan shirked her duties as a medical professional. Dr. Jan‘s behavior is an example of: LO24.4 asymmetric information. ccccccccccccccccccccccc. fee-for-service. ddddddddddddddddddddddd. defensive medicine. eeeeeeeeeeeeeeeeeeeeeee. positive externalities.

Answer: c. Defensive medicine.

Dr. Jan‘s behavior is an example of defensive medicine because she is recommending more tests than is warranted medically or economically in order to protect herself against malpractice lawsuits.

While Dr. Jan may indeed charge her patients on a fee-for-service basis, her motivation in this case is protecting herself from lawsuits rather than generating more income from fees. So, fee-for-service is not a correct answer.

Neither is asymmetric information, because while Dr. Jan does know more than her patients about medical illnesses, her extra medical knowledge is not what is causing her to order these tests for Jen. Finally, there are no positive externalities here. So, positive externalities is not a correct answer, either.

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501. All MegaCorp employees who stay on the job for more than three years are rewarded with a 10 percent pay increase and coverage under a private health insurance plan that MegaCorp pays for. Tai just passed three years as a MegaCorp employee and reacts to having health insurance by taking up several dangerous sports because now she knows that the insurance plan will pay for any injuries that she may sustain. This change in Tai‘s behavior is an example of: LO24.4 defensive medicine. fffffffffffffffffffffff. asymmetric information. ggggggggggggggggggggggg. the moral hazard problem. hhhhhhhhhhhhhhhhhhhhhhh. the personal mandate.

Answer: c. The moral hazard problem This change in Tai‘s behavior is known as the moral hazard problem.

The moral hazard problem arises anytime one party to an agreement changes his or her behavior in a way that adversely affects the other party to an agreement. In this case, the two parties are Tai and the health insurance company and the change in Tai‘s behavior is her deciding to take up dangerous sports where she is very likely to sustain costly injuries. Because the insurance company will have to pay for those costly injuries, it will be adversely affected.

But please note that others will also be adversely affected as well. That will happen because when Tai does eventually get injured and drive up costs, the insurance company will have to raise its premiums, copays, and deductibles to pay for those higher costs. Thus, Tai‘s decision to engage in dangerous sports will raise the price of health insurance for her coworkers and anyone else who gets their health insurance from the same insurance company. In terms of economic terminology, Tai‘s risky behavior is a negative externality that must be borne by everyone else who gets their health insurance from Tai‘s insurance company.

502. By increasing demand, health insurance creates: LO24.4 a deadweight loss related to overconsumption. iiiiiiiiiiiiiiiiiiiiiii. a deadweight loss related to underconsumption. jjjjjjjjjjjjjjjjjjjjjjj. neither of the above.

Answer: a. A deadweight loss related to overconsumption.

By increasing demand, health insurance creates a deadweight loss related to overconsumption. This happens because health insurance increases the demand for medical care by lowering the out-of-pocket marginal costs actually paid by consumers for any given medical procedure.

For instance, if the price you had to pay to visit a doctor were $100 per visit, you would probably only go to the doctor when you were really sick. But if you have a health insurance policy that covers 90% of the cost, then you will only have to pay $10 (= 10 percent of $100) for a visit. That low out-of-pocket price will incentivize you to go to the doctor more often.

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In fact, you will go to the doctor on any occasion where the MB of going exceeds the trip‘s $10 out-of-pocket cost. But this will lead to overconsumption and a deadweight loss to society because while the out-of-pocket price to you of a doctor‘s visit is only $10, the actual underlying cost of providing you with the doctor‘s time, access to his facilities, the services of his assistants, and so on is actually the $100 price that the doctor charges.

Thus, the low out-of-pocket prices paid by people with medical insurance cause them to demand and receive many medical procedures for which the total MC exceeds their individual MB. The end result is a deadweight loss related to overconsumption.

503. Raul will consume any health care service just as long as its MB exceeds the money he must pay out of pocket. His insurance policy has a zero deductible and a10 percent copay, so Raul only has to pay 10 percent of the price charged for any medical procedure. Which of the following procedures will Raul choose to consume?

LO24/5 An $800 eye exam that has an MB of $100 to Raul. kkkkkkkkkkkkkkkkkkkkkkk.

A $90 hearing test that has an MB of $5 to Raul. lllllllllllllllllllllll. A $35,000 knee surgery that has an MB of $3,000 for Raul. mmmmmmmmmmmmmmmmmmmmmmm. A $10,000 baldness treatment that has an MB of $16,000 for Raul.

Answer: a. An $800 eye exam that has an MB of $100 to Raul. and d. A $10,000 baldness treatment that has an MB of $16,000 for Raul. llllllllllll.

An $800 eye exam that has an MB of $100 to Raul.

MC: $800 10%  $80  MB : $100 Therefore do

mmmmmmmmmmmm.

A $90 hearing test that has an MB of $5 to Raul.

MC: $90 10%  $9  MB: $5 Therefore do not do

nnnnnnnnnnnn.

A $35,000 knee surgery that has an MB of $3,000 for Raul.

MC: $35, 000 10%  $3,500  MB: $3, 000 Therefore do not do

oooooooooooo. for Raul.

A $10,000 baldness treatment that has an MB of $16,000

MC: $10, 000 10%  $1, 000  MB: $16, 000 Therefore do

Please note, though, that Raul‘s choices would be different if he had to pay the full price for medical procedures. In that case, he would not get the eye exam because its MB to him of $100 is less than the full price of $800. But he would still get the baldness treatment because its $16,000 MB exceeds the full price of 1-503 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

$10,000. The key point to remember is that low copays increase the consumption of health care by making MC look artificially low. If consumers were confronted with the full prices, they would consume less.

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504. True or False. Under the ACA as originally passed, Americans were free to decide for themselves whether or not they should have health insurance coverage. L O24.6 Answer: False.

This statement is false because the ACA also contained a personal mandate (requirement) that individuals had to purchase health insurance for themselves and their dependents unless they were already covered by either government insurance or employer-provided insurance. Anyone refusing would be fined the larger of either $695 per uninsured family member or 2.5 percent of family income.

PROBLEMS Suppose that the price elasticity for hip replacement surgeries is 0.2. Further suppose that hip replacement surgeries are originally not covered by health insurance and that at a price of $50,000 each, 10,000 such surgeries are demanded each year. LO24.2 Suppose that health insurance begins to cover hip replacement surgeries and that everyone interested in getting a hip replacement has health insurance. If insurance covers 50 percent of the cost of the surgery, by what percentage would you expect the quantity demanded of hip replacements to increase? What if insurance covered 90 percent of the price? (Hint: Do not bother to calculate the percentage changes using the midpoint formula given in Chapter 6. If insurance covers 50 percent of the bill, just assume that the price paid by consumers falls 50 percent.) nnnnnnnnnnnnnnnnnnnnnnn.

Suppose that with insurance companies covering 90 percent of the price, the increase in demand leads to a jump in the price per hip surgery, from $50,000 to $100,000. How much will each insured patient now pay for a hip replacement surgery? Compared to the original situation where hip replacements cost $50,000 each but people had no insurance to help subsidize the cost, will the quantity demanded increase or decrease? By how much?

Answers: If insurance covers 50 percent of the cost, the quantity demanded will increase by 10 percent. Similarly, 90 percent fall in the price caused by insurance picking up the tab for 90 percent of the bill means that quantity demanded will rise by 18 percent. pppppppppppp.

With a price of $100,000 and insurance companies picking up 90 percent of the price, insured individuals will now pay $10,000 out of pocket for a hip surgery. Quantity demanded increases (rises) by 1,600.

Feedback: We can apply the elasticity relationship discussed above to health care and insurance. However, for the price elasticity we need to take into account the inverse relationship between quantity demanded and price movement.

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% hip replacement surgeries  price elasticity  % price

If insurance covers 50 percent of the cost of the surgery, this is an effective reduction in price by 50 percent (fall in price by 50 percent or −50 percent change in price). Also note that the price elasticity is given above and equals 0.2. % hip replacement surgeries  0.2  50%  10%

Thus, hip replacement surgeries increase by 10%.

If insurance covered 90 percent of the price, then we have the following result. % hip replacement surgeries  0.2  90%  18%

qqqqqqqqqqqq.

To answer this part of the question we must first calculate the change in cost (price) to the consumer.

Original price = $50,000 With a new price of $100,000 after insurance covers 90%, we have cost to the consumer of: New price = 0.1 (fraction of cost directly borne by consumer) × $100,000 = $10,000 Change in price (borne by consumer) = [($10,000 + −$50,000)/$50,000] = −0.8 This implies that the price of hip surgeries falls by 80% (= −0.8 × 100) for consumers.

Using our formula above: % hip replacement surgeries  0.2  80%  16% Thus, hip replacement surgeries increase by 16%.

Since we originally had 10,000 surgeries prior to insurance, the 16% increase in hip surgeries results in 11,600 (=1.16 × 10,000) after insurance. There is an increase of 1,600.

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505. The federal tax code allows businesses but not individuals to deduct the cost of health insurance premiums from their taxable income. Consider a company named HeadBook that could either spend $5,000 on an insurance policy for an employee named Vanessa or could increase her annual salary by $5,000 instead. LO4 As far as the tax code is concerned, HeadBook will increase its expenses by $5,000 in either case. If HeadBook pays for the policy, it incurs a $5,000 health care expense. If it raises Vanessa‘s salary by $5,000, it incurs $5,000 of salary expense. If HeadBook is profitable and pays corporate profit taxes at a marginal 35 percent rate, by how much will HeadBook‘s tax liability be reduced in either case? ooooooooooooooooooooooo.

Suppose that Vanessa pays personal income tax at a marginal 20 percent rate. If Head Book increases her salary by $5,000, how much of that increase will she have after paying taxes on that raise? If Vanessa can devote what remains after paying taxes on the $5,000 only to purchasing health insurance, how much will she be able to spend on health insurance for herself? ppppppppppppppppppppppp.

If HeadBook spends the $5,000 on a health insurance policy for Vanessa instead of giving it to her as a raise, how many more dollars will HeadBook be able to spend on Vanessa‘s health insurance than if she had to purchase it herself after being given a $5,000 raise and paying taxes on that raise? qqqqqqqqqqqqqqqqqqqqqqq.

Would Vanessa prefer to have the raise or to have HeadBook purchase insurance for her? Would HeadBook have any profit motive for denying Vanessa her preference? rrrrrrrrrrrrrrrrrrrrrrr.

Suppose the government changes the tax law so that individuals can now deduct the cost of health insurance from their personal incomes. If Vanessa gets the $5,000 raise and then spends all of it on health insurance, how much will her tax liability change? How much will she be able to spend on health insurance? Will she now have a preference for HeadBook to buy insurance on her behalf?

Answers: The firms will pay $1,750 less in taxes. rrrrrrrrrrrr. $4,000; $4,000 ssssssssssss. $1,000 tttttttttttt.

Vanessa would prefer to have HeadBook purchase insurance for her. Headbook would not have any profit motive to deny Vanessa’s preference. uuuuuuuuuuuu.

Vanessa’s tax liability will not change. She will have $5,000 to spend on health insurance. She will no longer have a preference for HeadBook to buy insurance.

Feedback: Corporate profit tax is paid on accounting profit, which is the difference between revenue and expenses. Since either option will increase the firm‘s expenses by $5,000, it will lower the firm‘s accounting profit by $5,000. This means that the firms will pay 0.35 × $5,000 = $1,750 less in taxes in either case.

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vvvvvvvvvvvv.

Since her marginal tax rate is 20 percent, Vanessa will pay $1,000 of taxes on her $5,000 raise (= 0.2 × $5,000). That will leave her with only $4,000 to spend on health insurance. wwwwwwwwwwww. If HeadBook uses the $5,000 to purchase health insurance for Vanessa, it will be able to spend $1,000 more than Vanessa would after paying income taxes on a $5,000 raise. Recall from part b, Vanessa only had $4,000 after taxes to purchase insurance. xxxxxxxxxxxx.

Vanessa would prefer to have HeadBook purchase insurance for her rather than receiving the raise and having to pay 20 percent of it as taxes before spending the remainder on health insurance. Since HeadBook‘s profit is the same in either case, it would not have any profit motive to deny Vanessa‘s preference. yyyyyyyyyyyy.

Since individuals can now deduct the cost of health insurance, Vanessa‘s taxable income will not change. She will therefore owe exactly as much income tax as before (so that her taxes paid will increase by zero dollars.) She will spend $5,000 on health insurance. She will no longer have a preference for HeadBook to buy insurance for her as she can now buy just as much if HeadBook gives her the $5,000 raise as if HeadBook spends the $5,000 directly buying her health insurance.

506. Preventive care is not always cost effective. Suppose that it costs $100 per person to administer a screening exam for a particular disease. Also suppose that if the screening exam finds the disease, the early detection given by the exam will avert $1,000 of costly future treatment. LO24.4 Imagine giving the screening test to 100 people. How much will it cost to administer those 100 tests? Imagine a case in which 15 percent of those receiving the screening exam test positive. How much in future costly treatments will be averted? How much is saved by setting up a screening system? sssssssssssssssssssssss. Imagine that everything is the same as in part a except that now only 5 percent of those receiving the screening exam test positive. In this case, how much in future costly treatments will be averted? How much is lost by setting up a screening system?

Answers: It will cost $10,000 to give those 100 tests. If 15 percent test positive, then $15,000 will be saved in future medical expenses. $5,000 will be saved by setting up a screening system. zzzzzzzzzzzz. It will still cost $10,000 to give the 100 tests. But now only $5,000 in costly future treatments will be avoided. In this case, $5,000 is lost by setting up a screening system.

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It will cost $10,000 to administer the screening exam [= $100 (cost per person) × 100 (number of people)].

In the case where 15 percent of those receiving the test come back positive for a particular disease (assuming the test is 100% accurate, no false positives), this implies that 15 people have the disease (= 0.15 × 100). Since early identification of the disease reduces future medical costs by $1,000 per person, $15,000 of future medical costs will be averted [= 15 (number of people identified with disease) × $1,000 (savings from early identification)].

Thus, by administering early screening $5,000 in medical expenses will be saved [= $15,000 (reduction in future cost) − $10,000 (total cost of screening program)]. aaaaaaaaaaaaa.

In this case, only 5 percent of the those receiving the test come back positive for a particular disease (assuming the test is 100 percent accurate, no false positives), this implies that 5 people have the disease (= 0.05 × 100). Since early identification of the disease reduces future medical costs by $1,000 per person, $5,000 of future medical costs will be averted [= 5 (number of people identified with disease) × $1,000 (savings from early identification)].

Thus, by administering early screening $5,000 in additional medical expenses will be incurred [= $5,000 (reduction in future cost) − $10,000 (total cost of screening program)]. Thus, from a purely financial perspective, the cost of the program exceeds the dollar benefits to the company or industry.

Chapter 25 - Immigration McConnell Brue Flynn 23e DISCUSSION QUESTIONS 507. Which of the following statements are true? Which are false? Explain why the false statements are untrue. LO25.1 ttttttttttttttttttttttt. More immigrants arrive to the United States each year illegally than legally. uuuuuuuuuuuuuuuuuuuuuuu.

The majority of legal immigrants are men. vvvvvvvvvvvvvvvvvvvvvvv.

Over half the new legal immigrants to the United States each year come from Mexico. wwwwwwwwwwwwwwwwwwwwwww.

Most legal immigrants to the United States gain their legal status through employment-based preferences.

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bbbbbbbbbbbbb.

False. The number of legal immigrants between 2008 and 2017 was approximately 1.1 million each year. The number of illegal immigrants over the same time period is an estimated 250,000 per year. ccccccccccccc.

False. 54 percent are women.

ddddddddddddd.

False. The number is close to 15 percent.

eeeeeeeeeeeee.

False. Most are through family-based sponsorship.

508. In what respect is the economic decision to move across international borders an investment decision? Why do economic migrants move to some countries but not to others? Cite an example of an explicit cost of moving and an implicit cost of moving.

How do distance and age affect the migration decision? How does the presence of a large number of previous movers to a country affect the projected costs and benefits of subsequent movers? LO25.2 Answer: The decision to migrate is an investment decision because the individual is expecting to earn a wage rate that will payoff over time sufficient to cover the explicit and implicit costs of moving.

Typically, individuals migrate to countries with the highest wage differential (home and foreign country). It doesn‘t make sense to move to a country with the same wage rate given the cost of moving is positive.

An explicit cost is physically getting to the country (airline ticket, gas, shoes and food). An implicit cost is moving away from your family.

If there is a large number of immigrants already in-country, this may reduce the benefits because of a decrease in the wage rate. On the other hand, this may also reduce the costs by increasing access to friends, culture, etc…

509. Suppose that the projected lifetime earnings gains from migration exceed the costs of moving. Explain how the decision to move might be reversed when a person considers present value. LO25.2 Answer: If this person were adding up earnings per year without taking into account discounting, they would be overestimating the benefit of moving. Recall $10,000 a year from now is worth less than $10,000 today because interest could be earned on the $10,000 today. By using present value calculations this would reduce benefits relative to the ‗linear‘ calculation of lifetime earnings. This reduction may be sufficient to reduce benefits below the costs.

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510. How might the output and income gains from immigration shown by the simple immigration model be affected by (a) unemployment in the originating nation, (b) remittances by immigrants to the home country, and (c) backflows of migrants to the home country? LO25.3 Answer: fff. If there is unemployment in the originating nation output may not fall after some migrate abroad because these workers may have been already idle (jobs may also be filled by the unemployed if someone working decides to migrate). ggg. Income may not fall in the immigrants‘ country, or at least not as much, because some of the income earned abroad is being sent home. hhh. The change in output may not be severe because individuals return to the home country.

511. Suppose initially that immigrant labor and native-born labor are complementary resources. Explain how a substantial immigration might change the demand for native-born workers, altering their wages. (Review the relevant portion of Chapter 16 if necessary.) Next, suppose that new immigrant labor and previous immigrant labor (not native-born) are substitute resources. Explain how a substantial immigration of new workers might affect the demand for previous immigrants, altering their wages.

LO25.3 Answer: If immigrant labor and native-born labor are complementary resources then we would expect to see an increase in demand for native-born labor with an increase in immigration. The reason for this increase is because productivity increases for the native-born workers given that they are complementary in the production process. If, on the other hand, new immigrant labor and previous immigrant labor (not native-born) are substitute resources then we would expect to see an increase in the supply of labor and a drop in the real wage rate. This will increase the quantity of labor demanded in total. The overall effect on native born workers will depend on the demand elasticity, but the most likely scenario is that native-born employment will fall.

512. What is a ―brain drain‖ as it relates to international migration? If emigrants are highly educated and received greatly subsidized education in the home country, is there any justification for that country to levy a ―brain drain‖ tax on them? Do you see any problems with this idea? LO25.3 Answer: The ‗brain drain‘ is when well educated (or the best educated) in poor countries migrate to the U.S. and Europe to increase their return on their human capital investment. One could argue that the educated migrant should compensate his or her home country for the education if this individual chooses to leave, this country did pay for the education (this is true if the home country paid for the 1-511 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

education abroad as well). However, if there is this potential tax, it may discourage education investments.

513. In September 2018 The Wall Street Journal (WSJ) reported that a growing shortage of labor in Eastern European countries such as Hungary was driving up wages and reducing business income. The reason for the shortages was a large migration of Eastern European workers to Western European countries. Use the simple immigration model to demonstrate the key elements of the WSJ story as just described. LO25.3 Answer: Initially, there were higher wages in the Western European countries for labor. Eastern European workers recognized they could earn more in Western Europe, so they decided to immigrate to the West. This decreased the supply of workers in Eastern Europe, putting upward pressure on the wage rate for labor in these Eastern European countries such as Hungary.

514. Why is each of these statements somewhat misleading? (a) ―Unauthorized immigrants take only jobs that no American wants.‖ (b) ―Deporting 100,000 undocumented immigrants would create 100,000 job openings for Americans.‖ L O25.4 Answer: Both of these statements are misleading. (a) Illegal immigrants probably do lower wages by increasing the supply of unskilled workers, thus some jobs that native-born unskilled workers are displaced and/or receive lower wages. (b) This is also misleading because if we deport 100,000 illegal immigrants the supply of unskilled labor will decrease. This will cause wages to rise and the quantity of labor demanded to fall, so not all of the ‗100,000 jobs‘ will still be available.

515. Why are so many state and local governments greatly concerned about the federal government‘s allegedly lax enforcement of the immigration laws and Congressional proposals to grant legal status (amnesty) to non-lawful immigrants in the United States? How might an amnesty program affect the flow of future border crossings?

LO25.4 Answer: The fiscal impact on local and state governments on average (government benefits minus taxes paid) for each low-skilled immigrant household may be as high as $19,500 per household per year. An amnesty program would most likely exacerbate the problem because there would be more claims on the local and state authorities 516. If someone favors the free movement of labor within the United States, is it inconsistent for that person to also favor restrictions on the international movement of labor? Why or why not? LO25.4 1-512 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: If one is just as concerned with the economic well-being of citizens of foreign countries as one is with the welfare of one‘s national compatriots, then to argue for free labor mobility nationally but not internationally is logically inconsistent. Arguments in favor of restrictions on international labor mobility take account of the fact that immigration can lead to a loss of income for some domestic residents. While total output in the host country is increased, wage rates will fall, hurting laborers already working in that country. The loss of economic welfare for these individuals is often considered to be more important than the benefits accruing to businesses and the migrants themselves, even though the total benefits exceed losses in the host country.

517. LAST WORD What is the relative importance of family sponsorship (of permanent residency applications) in the United States as compared with Australia and Canada? What factor do Australia and Canada emphasize when selecting legal immigrants? What are the positives and negatives of emphasizing that factor?

Answer: Two-thirds of all immigrants legally admitted to the United States each year are family sponsored. That is, they are granted permanent residency not because they have job skills or educational backgrounds that are good fits for their new country but simply because they happened to have had relatives in the United States who were willing to sponsor them. This tilt towards family sponsorship has attracted criticism on economic grounds. Many of the sponsored relatives are elderly or even retired, for instance, so that they will make little or no payroll tax contributions before becoming eligible to receive government healthcare subsidies. Many others have job skills and educational backgrounds that make it difficult for them to find employment in the United States. Yet others are unable to work effectively from the get-go because of a lack of proficiency in English.

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Australia and Canada avoid these problems by opting instead for immigration systems that are heavily tilted toward jobs skills and, work experience, and educational achievement. The application process is similar in both countries.

Applicants take a quiz online, answering questions about their age, job skills, educational attainment, work experience, language skills, whether they have studied or worked in Australia or Canada, and whether they already have a job offer waiting for them in Australia or Canada. A crucial point about these skillbased immigration systems is that they are not biased toward the highly educated or towards immigrants from particular countries.

Proponents of skills-based immigration argue that many of the problems that the United States is currently experiencing with respect to its immigration system would be resolved by switching to a system that matches immigrants with the needs of the U.S. economy. Among other things, every immigrant would have an easy time finding work and Americans would not have to worry about a glut of immigrants driving down wages. There would also be less financial burden placed on social services because the vast majority of immigrants would be workingaged adults paying taxes.

REVIEW QUESTIONS Each year, the number of legal immigrants to the United States is _ number of unauthorized immigrants. LO25.1 less than xxxxxxxxxxxxxxxxxxxxxxx. equal to yyyyyyyyyyyyyyyyyyyyyyy. greater than zzzzzzzzzzzzzzzzzzzzzzz. less than, but only in most years, not every year

the

Answer: c. Greater than Then number of legal immigrants to the United States runs at over 1 million per year. By contrast, illegal immigrant in recent decades has never been more than a few hundred thousand per year and in recent years the flow may have reversed, so that the number of illegal immigrants in the United States at any one time is declining.

518. The primary reason people immigrate to the United States is: LO25.2 to escape political or religious oppression back home. aaaaaaaaaaaaaaaaaaaaaaaa. to reunite with family members. bbbbbbbbbbbbbbbbbbbbbbbb. to improve earnings and living standards. cccccccccccccccccccccccc. none of the above.

Answer: c. To improve earnings and living standards.

The primary reason people immigrate to the United States is to improve earnings and living standards.

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While the United States does take in many political and religious refugees each year, and while many other immigrants to the United States do have as their primary motivation to be reunited with family members, the large majority of immigrants to the United States come primarily to take advantage of superior economic opportunities. These include higher wages, ready access to higher education, and an economic system in which it is easy to set up a new business.

519. True or False. Because older adults have more human capital, they are more likely to migrate to another country than younger adults. LO25.2 Answer: False.

This statement is false because the large majority of immigrants are younger adults rather than older adults. While it is true that a major motivation for migrants to move to another country is to earn higher returns on their human capital, we have to remember that the decision to migrate is based not only on benefits but also on costs—and that the mix of benefits and costs is very different for younger people than older people.

For instance, a younger person has many more working years to enjoy higher wages in the country to which she is migrating. Also, a younger person likely has fewer strong family ties and financial responsibilities to fulfill in her home country. Thus, while an older person may have more human capital to transfer to another country, he or she likely also has many more factors weighing against a decision to migrate as compared to a younger person.

520. Use the accompanying tables for Neon and Zeon to answer the questions that follow. Assume that the wage rate shown equals hourly output and income. Also assume that the accumulated output and income are the sum of the marginal revenue products (MRPs) of each worker. LO25.3 Neon:

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Zeon:

Which country has the greater stock of capital and technological prowess? How can you tell? dddddddddddddddddddddddd. Suppose the equilibrium wage rate is $19 in Neon and $7 in Zeon. What is the domestic output (= domestic income) in the two countries? eeeeeeeeeeeeeeeeeeeeeeee.

Assuming zero migration costs and initial wage rates of $19 in Neon and $7 in Zeon, how many workers will move to Neon? Why will more than that number of workers not move to Neon? ffffffffffffffffffffffff.

After the move of workers, what will be the equilibrium wage rate in each country? What will be the domestic output after the migration?

What is the amount of the combined gain in domestic output produced by the migration? Which country will gain output? Which will lose output? How will the income of native-born workers be affected in each country?

Answer: Neon. Neon produces more per worker. fffffffffffff. Output in Neon is 40 because the equilibrium wage rate is $19.

Recall that equilibrium is where MRP = MFC (or MRP = equilibrium wage rate). Using the same logic Zeon‘s output is 55. ggggggggggggg.

In equilibrium, without migration, 2 workers are employed in Neon and 5 workers are employed in Zeon. If three workers leave Zeon (those employed) the wage rate will rise to $13. These three additional workers will cause the wage to fall to $13 in Neon. Thus, only three workers will move since any more movement would give them a lower wage than they can earn in their home country (Zeon). hhhhhhhhhhhhh.

The equilibrium wage rate will be $13 in both countries.

Output in Neon will be 85 and in Zeon 28. Total Output (sum of both 1-518 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

countries) was 40 + 55 = 95 before migration. After migration Total Output is 85 + 28 = 113. Thus, the gain in output is 113 − 95 = 18. Obviously, Neon gains and Zeon loses. Income per worker will fall in Neon and rise in Zeon.

521. Migration between North Korea and South Korea has been prohibited since the end of the Korean War in 1953. South Korea is now much richer than North Korea and has a much higher marginal product of labor and a much higher wage rate than North Korea. If workers could migrate from North Korea to South Korea, we would expect: LO25.3 Output to fall in South Korea but rise in North Korea. gggggggggggggggggggggggg. Output to rise in each country. hhhhhhhhhhhhhhhhhhhhhhhh. Total combined output in the two countries to fall. iiiiiiiiiiiiiiiiiiiiiiii. Total combined output in the two countries to rise.

Answer: d. Total combined output in the two countries to rise.

If workers could migrate from North Korea to South Korea, we would expect total combined output in the two countries to rise.

This will happen because labor will be moving from a nation in which it has a low marginal product to a nation in which it has a high marginal product. Thus, while it is true that output will fall in North Korea as workers migrate away to South Korea, that decline in output will be dwarfed by the increase in output that will take place in South Korea as those migrant workers being producing output there.

The total combined output in the two countries will rise because the increase in output in South Korea will vastly exceed the decrease in output in North Korea.

522. True or false. Research indicates that immigration causes large decreases in the average American wage. LO25.3 Answer: False.

This statement is false because the overall effect of immigration on the average American wage appears to be quite modest, with scholarly estimates ranging from minus 3 percent to plus 2 percent. That being said, the effects of immigration on wages may be stronger in particular labor markets. For instance, research indicates that immigration reduces the wages of native-born Americans who do not have high school diplomas as well as the wages of native-born Americans who hold doctorate degrees. That is because both groups have faced competition from substantial numbers of immigrant workers—unskilled immigrant labor in the one case and highly-educated immigrant labor in the other.

523. True or false. The MB = MC level of immigration is likely to be achieved if we simply let in every person who wishes to immigrate to the United States. LO25.4 Answer: False.

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This statement if false because individual immigrants base their decisions upon the MB and MC that immigration has for them personally. By contrast, U.S. residents will want to know the overall MB and MC that includes any negative externalities that immigrants might impose in terms of using up more dollars‘ worth of public resources like hospitals and schools than they pay in taxes.

The underlying problem is that what is in the best interest of an individual is sometimes not in the best interest of those around him. Thus, simply letting in every person who wishes to immigrate to the United States is unlikely to lead to the MB = MC level of immigration that takes into account all the costs of immigration, including negative externalities.

PROBLEMS Mexico has labor laws that specify a daily (rather than hourly) minimum wage. In 2022, the daily minimum wage in Mexico was about 173 pesos per day, and the exchange rate between Mexican pesos and U.S. dollars was about 20 pesos per dollar. LO25.3 In 2022, what was the Mexican minimum daily wage in terms of dollars? jjjjjjjjjjjjjjjjjjjjjjjj. Given that Mexican employees typically work 8-hour days, about how much per hour is the Mexican minimum wage in terms of dollars? kkkkkkkkkkkkkkkkkkkkkkkk. In 2018, the Federal minimum wage in the United States was $7.25 per hour. How many times larger was the hourly U.S. federal minimum wage than the hourly Mexican minimum wage? llllllllllllllllllllllll. If unskilled workers have a tendency to migrate to where they can obtain the highest compensation for their labor, which country is more likely to be receiving low-skilled immigrants?

Answers: $8.65 per day iiiiiiiiiiiii. $1.08 per hour jjjjjjjjjjjjj. 6.71 times larger kkkkkkkkkkkkk.

The United States Feedback: To convert the 173 pesos per day to U.S. dollars, we need to multiply this value by the dollar price of the peso (= $/peso). That is, how many U.S. dollars I need to give up to get one peso. The exchange rate given above is the peso price of the dollar (= peso/$), or how many pesos I must give up for one U.S. dollar. Since the exchange rate is peso/$ = 20, this implies that the exchange rate $/peso = 1/20. The answer is 173 pesos is equivalent to $8.65 [= (1/20) × 173] per day. A quick rule-of-thumb to determine the appropriate exchange rate to use in the conversion is to put the currency you‘re converting in the denominator. For the example above, we are converting pesos to dollars, so the peso goes in the denominator ($/peso). This will give us ($/peso) × number of pesos = number of dollars (or ($/peso) × pesos = $ because the peso "cancels out"). If we wanted to convert dollars to pesos, we would put $ 1-521 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

in the denominator (peso/$). For example, $8.65 converts to 173 pesos [= (peso/$) × $ = 20 × $8.65 = 173 pesos]. lllllllllllll.

To convert the $8.65 a day minimum wage to an hourly rate divide by the number of hours worked in a day. Thus, the hourly minimum wage in Mexico is $1.08 (= $8.65/8). mmmmmmmmmmmmm. The U.S. federal minimum wage is 6.71 (= $7.25/$1.08) times larger than the hourly Mexican minimum wage. nnnnnnnnnnnnn.

The United States will be receiving low-skilled workers because of the higher wage.

524. Differences in productivity are usually the major force behind differences in wages and unit labor costs. Suppose that a single unskilled worker at a pottery factory in Mexico can produce 1 mug per hour. By comparison, suppose that a single unskilled worker at a pottery factory in the United States can produce 14 mugs per hour because more and better machinery generates higher labor productivity. The Mexican mugs and the American mugs are identical in quality and durability and sell for the same price. LO25.3 If unskilled pottery workers are paid the local minimum wage in both countries, how much is the labor cost per mug for mugs produced in Mexico? For mugs produced in the United States? (Use the minimum wages from problem 1 and make all calculations in dollars.) mmmmmmmmmmmmmmmmmmmmmmmm. With regard to mug production, how much higher are labor costs per hour in the United States? nnnnnnnnnnnnnnnnnnnnnnnn. With regard to mug production, how much higher are labor costs per unit in Mexico? oooooooooooooooooooooooo. Do higher labor costs per hour always imply higher labor costs per unit? pppppppppppppppppppppppp. If firms with lower labor costs per unit expand while those with higher labor costs per unit contract, in which country will mugmaking firms be increasing in size and hiring more employees? If unskilled pottery workers relocate to where they can find jobs, to which country will they be moving?

Answers: The labor cost per mug in Mexico is $0.64. The labor costs per mug in the United States are $0.52 per mug. ooooooooooooo.

Labor costs per hour are $6.61 higher in the United States than Mexico. ppppppppppppp.

The labor cost per unit of output when producing mugs is higher in Mexico by $0.13 per chair. qqqqqqqqqqqqq.

No

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rrrrrrrrrrrrr.

The mug making factories in the United States will be expanding and hiring workers. Unskilled pottery workers will be relocating to the United States.

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Feedback: We have an hourly minimum wage in the U.S. of $7.25 and an hourly minimum wage in Mexico of $0.644 (U.S. dollar equivalent). The cost per mug in the U.S. is $0.518 [= $7.25 (wage per hour) / 14 (mugs per hour)].

The cost per mug in Mexico is $0.644 [= $0.644 (wage per hour) / 1 (mugs per hour)]. sssssssssssss. Labor cost per hour are $6.61 higher in the U.S., which is the difference in hourly wage rates (= $7.25 − $0.644). ttttttttttttt. Labor cost per unit (or per mug) is $0.126 higher in Mexico (= $0.644 − $0.518). uuuuuuuuuuuuu.

No, labor cost per unit includes productivity differentials.

This is shown in parts b and c. vvvvvvvvvvvvv.

The mug making factories in the United States will be expanding and hiring workers. Unskilled pottery workers will tend to be relocating to the United States.

525. There is evidence that, other things equal, a 10 percent increase in the number of workers having a particular skill level leads to about a 4 percent decline in wages for workers with that skill level. In addition, this 10-to-4 ratio appears to hold true whether the increase in labor supply is caused by domestic changes in labor supply or by an influx of immigrant workers. LO25.3 Suppose 42,000 computer programmers work in Silicon Valley. If the number of computer programmers in Silicon Valley increases by 1,260 because of a change in U.S. immigration laws, by how many percentage points would you expect the wage of computer programmers to fall in Silicon Valley? qqqqqqqqqqqqqqqqqqqqqqqq. Suppose that 8,000 full-time cooks work in restaurants in the Denver area. If Denver becomes popular both with U.S. citizens and with foreigners such that 400 full-time cooks move to Denver from other parts of the United States while 480 full-time cooks move to Denver from other countries, by how much would you expect the wages of full-time cooks to fall in Denver?

Answers: Wages will fall by 1.2 percent. wwwwwwwwwwwww.

There will be a 2.4 percent decline in wages among cooks in Denver.

Feedback: The percentage increase in computer programmers is 3% [= (1,260/42,000) × 100)]. This implies the wage will fall by 1.2% [= (4/10) × 3%)].

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xxxxxxxxxxxxx.

Since the number of cooks in Denver increase by 480, the percentage increase in the number of cooks is 6% (= 480/8,000). This implies that wage rate for cooks will fall by 2.4% [= (4/10) × 11%)].

526. In 2022, an estimated 7.7 million Mexican-born immigrants were employed in the United States. LO25.3 If 60 percent of the Mexican-born immigrants remitted money to family members in Mexico in 2022, and if they each sent $100 per month, how much money did they remit in total in 2022? rrrrrrrrrrrrrrrrrrrrrrrr.

If, instead, 100 percent of the Mexican-born immigrants remitted money to family members in Mexico in 2022, and if they each sent $250 per month, how much money did they remit in total in 2022? ssssssssssssssssssssssss. The actual amount remitted to Mexico in 2022by Mexicanborn immigrants living in the United States was about $31 billion. If we assume that 75 percent of the Mexican-born immigrants remitted money to Mexico that year and if we further assume that each of those immigrants remitted an equal amount each month, how much per month did each of those immigrants have to remit to total $53 billion for the year?

Answers: $5.544 billion would be remitted. yyyyyyyyyyyyy. $23.1 billion would be remitted. zzzzzzzzzzzzz.

Each immigrant would need to remit $764.13 per month.

Feedback: $5.544 billion would be remitted.

First, we calculate the number of Mexican-born immigrants that will remit money to family members in Mexico, which is 4.62 million (= 60 percent × 7.7 million).

A total of $5.544 billion will be remitted [= 4.62 million (number remitting money to Mexico) × $1,200 (annual amount = $100 per month × 12 months)] aaaaaaaaaaaaaa. $23.1 billion would be remitted under these assumptions First, we calculate the number of Mexican-born immigrants that will remit money to family members in Mexico, which is 7.7 million (= 100 percent × 7.7 million). A total of $23.1 billion will be remitted [= 7.7 million × ($250 per month × 12 months)]. bbbbbbbbbbbbbb. Each immigrant would need to remit $764.13 per month. First, we calculate the number of Mexican-born immigrants that will remit money to family members in Mexico, which is 5.78 million (= 75 1-526 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

percent × 7.7 million potential remitters = 5.78 million actual remitters). The monthly remittance would be $764.13 [= ($53 billion/5.78 million actual remitters)/12 months].

Chapter 26 - International Trade McConnell Brue Flynn 23e DISCUSSION QUESTIONS 527. Quantitatively, how important is international trade to the United States relative to the importance of trade to other nations? What country is the United States‘ most important trading partner, quantitatively? With what country does the United States have the largest trade deficit? LO26.1 Answer: In 2018, United States exports of goods and services were about 12 percent of GDP. That percentage is much lower than the percentage in many other nations, including Belgium, the Netherlands, Germany, Canada, and the United Kingdom.

Canada is the United States‘ most important trading partner as measured by volume of trade. In 2018, about 15 percent of U.S. exported goods were sold to Canadians, who in turn provided 12 percent of the U.S. import of goods. The United States has a sizable trade deficit with China (largest trade deficit for the United States). In 2018, it was $419 billion.

528. Distinguish among land-, labor-, and capital-intensive goods, citing an example of each without resorting to the examples in the text. How do these distinctions relate to international trade? How do distinctive products, unrelated to resource intensity, relate to international trade? LO26.2 Answer: Land-intensive commodities include agricultural products such as corn and wheat. Labor-intensive commodities require much skilled labor in production, such as transistor radios and clothing. Capital-intensive products are produced with a large amount of capital equipment and include manufactured items such as aircraft and automobiles.

These distinctions are important because if a nation has an abundant supply of particular type of resources, it can produce items that are intensive in these resources with a comparative cost advantage. On the other hand, if it has a relative scarcity of certain resources, such as land, then it will be relatively expensive to produce land-intensive products such as corn and wheat. The difference in relative resource abundance among nations leads to a difference in comparative costs of production, which is the basis for international trade and specialization.

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Distinctive products—those associated with a particular country (perhaps because of a reputation for quality)—can provide an export niche for a country. Even though the country may have no cost advantage in producing the good, the ―label‖ on the good is enough to attract buyers willing to pay more than for potentially comparable substitutes.

529. Explain: ―The United States can make certain toys with greater productive efficiency than China can. Yet we import these toys from China.‖ Relate your answer to the ideas of Adam Smith and David Ricardo. L O26.2 Answer: A country is said to have an absolute advantage over other producers of a product if it is the most efficient producer of that product (by which we mean that it can produce more output of that product from any given amount of resource inputs than can any other producer.) A country is said to have a comparative advantage over other producers of a product if it can produce the product at a lower opportunity cost (by which we mean that it must forgo less output of alternative products when allocating productive resources to producing the product in question).

In the case of toys, the United States may have an absolute advantage in producing toys relative to China, but it will still import toys from China because China has a comparative advantage in producing toys (lower opportunity cost). In other words, the United States can produce toys with the same inputs, but China has to sacrifice fewer other goods to make the toys. Thus, China should make the toys and the U.S. should import the toys and produce other goods.

In 1776, Adam Smith used the concept of absolute advantage to argue for international specialization and trade. His point was that nations would be better off if they each specialized in the production of those products in which they had an absolute advantage and were therefore the most efficient producers.

In the early 1800s, David Ricardo extended, and modified, Smith‘s idea by demonstrating that it is advantageous for a country to specialize and trade even if it is more productive in all economic activities than some trading partner. A nation does not need Smith‘s absolute advantage—total superiority in producing some good—to benefit from specialization and trade. It needs only a comparative advantage.

In summary, it is the relative cost of producing the good not the absolute cost that drives trade.

530. Suppose Big Country can produce 80 units of X by using all its resources to produce X or 60 units of Y by devoting all its resources to Y. Comparable figures for Small Nation are 60 units of X and 60 units of Y. Assuming constant costs, in which 1-528 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

product should each nation specialize? Explain why. What are the limits of the terms of trade between these two countries? LO26.2

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Answer: To answer this question, we find the opportunity cost of the two goods.

The opportunity cost of good X (in terms of good Y) in Big Country is 3/4 (= 60/80) unit of Y for each unit of X. That is, Big Country needs to give up 3/4 unit of Y to produce 1 more unit of X. Note, this is the slope of Big Country‘s production possibilities curve with Y on the vertical axis. The opportunity cost of good X (in terms of good Y) in Small Nation is 1 (= 60/60) unit of Y for each unit of X. That is, Small Nation needs to give up 1 unit of Y to produce 1 more unit of X. Note, this is the slope of Small Nation‘s production possibilities curve with Y on the vertical axis.

Given these opportunity costs, Big Country should produce good X (only needs to give up 3/4 unit of Y for 1 X) and Small Nation should produce good Y (needs to give up 1 unit of X for 1 unit of Y). That is, Big Country has a comparative advantage in producing good X because it has to give up less Y to produce X per unit.

The limits of the terms of trade depend on the opportunity costs. For example, Big Country will never pay more than 4/3 a unit of good X for a unit of good Y. Big Country can always produce a unit of Y itself by giving up 4/3 a unit of good X. Small Nation will never accept less than 1 unit of good X for a unit of good Y because it can always produce a unit of X for a unit of good Y. The terms of trade will be between 1 unit of good X for a unit of good Y and 4/3 a unit of X for a unit of good Y. 531. What is an export supply curve? What is an import demand curve? How do such curves relate to the determination of the equilibrium world price of a tradable good?

LO26.3 Answer: The export supply curve for a particular country is the difference between quantity supplied and quantity demanded in the domestic market for a price above the domestic equilibrium price (the price that would occur in the market if trade were not possible).

The import demand schedule works in the other direction, it is the difference between quantity supplied and quantity demanded in the domestic market for a price below the domestic equilibrium price (the price that would occur in the market if trade were not possible). Here the negative values (quantity supplied minus quantity demanded) are translated into positive values (absolute value) graphically.

The intersection of the world supply and demand schedules determines the equilibrium world price for a tradable good.

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532. Why is a quota more detrimental to an economy than a tariff that results in the same level of imports as the quota? What is the net outcome of either tariffs or quota for the world economy? LO26.4 Answer: The reason why a quota is more detrimental to an economy than a tariff that results in the same level of imports (as the quota) is that the government loses revenue. Under the tariff the government collects tax revenue and under a quota this tax revenue is lost.

Tariffs and quotas impose costs on domestic consumers but provide gains to domestic producers and, in the case of tariffs, revenue to the federal government.

The consumer costs of trade restrictions are calculated by determining the effect the restrictions have on consumer prices. Protection raises the price of a product in several ways: (1) The price of the imported product goes up; (2) the higher price of imports causes some consumers to shift their purchases to higher-priced domestically produced products. Study after study finds that the costs to consumers substantially exceed the gains to producers and government. A sizable net cost or efficiency loss to society arises from trade protection. Conclusion: The gains that trade barriers create for protected industries and their workers come at the expense of much greater losses for the entire economy. The result is economic inefficiency, reduced consumption, and lower standards of living. Extending this to the world economy is straightforward. If all domestic economies lose because of trade barriers, the world loses (efficiency) as well.

533. ―The potentially valid arguments for tariff protection—military self-sufficiency, infant industry protection, and diversification for stability—are also the most easily abused.‖ Why are these arguments susceptible to abuse? LO26.4 Answer: Each of these valid arguments is often misapplied. The argument relating to military self-sufficiency is questionable when applied to sectors other than those directly related to defense. Almost all industries can claim to play a role in a wartime economy. As a rule, direct government subsidies are a more equitable means of protecting military security than trade protection, since taxpayers as a whole, rather than just consumers of protected industries will shoulder the burden. Direct subsidies also make the costs of these programs obvious rather than hiding them in the form of higher import prices.

The protection of new ―infant‖ domestic industries to allow them to develop efficient production techniques is questionable in an advanced economy such as the United States. There is a tendency for trade barriers to remain in place even after the industry becomes established.

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For some highly specialized economies, there is some truth in the diversificationfor-stability argument. However, the argument has little or no relevance to the United States and other advanced economies with highly diversified economies.

534. Evaluate the effectiveness of artificial trade barriers, such as tariffs and import quotas, as a way to achieve and maintain full employment throughout the U.S. economy. How might such policies reduce unemployment in one U.S. industry but increase it in another U.S. industry? LO26.4 Answer: Artificial trade barriers may protect U.S. jobs that need to compete with the foreign sector. This would tend to move the U.S. economy towards full employment. However, it is likely that foreign countries would impose, or implement, non-tariff barriers on U.S. goods. This response would reduce U.S. exports and cost U.S. jobs in the exporting sector of the economy. This would tend to move the U.S. economy away from full employment. In effect, the artificial trade barriers will likely reduce unemployment in one industry (import sector) and increase unemployment in another industry (export sector).

535. In 2018, manufacturing workers in the United States earned average compensation of $21.86 per hour. That same year, manufacturing workers in Mexico earned average compensation of $3.20 per hour. How can U.S. manufacturers possibly compete? Why isn‘t all manufacturing done in Mexico and other low-wage countries? LO26.4 Answer: The United States can compete if its workers are more productive, that is, if the productivity level for U.S. workers is higher. If this is the case, then some manufacturing will take place in the United States (with productivityadjusted wages equalized). Other reasons that all manufacturing doesn‘t take place in the low-wage countries may be due to trade barriers or other issues such as significant transportation costs or political instability.

536. How might protective tariffs reduce both the imports and the exports of the nation that levies tariffs? How might the import competition lead to quality improvements and cost reductions by U.S. firms? LO26.4 Answer: If a country imposes import tariffs, other countries may follow with their own import tariffs. These foreign import tariffs will reduce the exports of the nation that originally imposed the import tariffs.

If domestic firms need to compete with imports, this may lead to quality improvements in domestic goods to differentiate themselves from the imports and may result in cost reductions in the U.S. as firms try to compete on the cost side of the ledger (allows the firm to lower price).

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537. Identify and state the significance of each of the following trade-related entities: (a) the WTO; (b) the EU; (c) the eurozone; and (d) N AFTA. LO26.6

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Answer: cccccccccccccc.

The WTO oversees trade agreements reached by member nations and arbitrates trade disputes among them. dddddddddddddd. The EU is a trading bloc of 27 (not 28) European countries who have agreed to abolish tariffs and import quotas on most products and have liberalized the movement of labor and capital within the EU. eeeeeeeeeeeeee.

The euro is the common currency that is used by 19 of the EU countries (known as the eurozone). A common currency facilitates trade between the countries of the eurozone. ffffffffffffff. NAFTA is a trade bloc made up of the United States, Canada, and Mexico whose purpose is to reduce tariffs and other trade barriers among the three countries.

538. What form does trade adjustment assistance take in the United States? How does such assistance promote political support for free trade agreements? Do you think workers who lose their jobs because of changes in trade laws deserve special treatment relative to workers who lose their jobs because of other changes in the economy, say, changes in patterns of government spending? LO26.6 Answer: The Trade Adjustment Assistance Act of 2002 introduced some new novel elements to help those hurt by shifts in international trade patterns. These include cash assistance for up to 78 weeks; relocation allowances; refundable tax credits for health insurance; training programs or remedial education; and for those workers over the age of 50 ―wage insurance‖ which replaces a fraction of the worker‘s wages. These programs create political support for free-trade agreements. The answers to the last part of this question depend on the individual.

539. What is offshoring of white-collar service jobs and how does that practice relate to international trade? Why has offshoring increased over the past few decades? Give an example (other than that in the textbook) of how offshoring can eliminate some U.S. jobs while creating other U.S. jobs. LO26.6 Answer: The offshoring of white-collar service jobs refers to jobs relating to data entry, book composition, and software coding. This reflects a growing specialization and international trade in services. These types of jobs are moving to countries with an educated labor force such as India. Offshoring may increase the demand for complementary jobs in the United States.

540. LAST WORD What was the central point that Bastiat was trying to make in his imaginary petition of the candlemakers?

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Answer: Bastiat‘s objective was to discredit the arguments in favor of protectionism by carrying the arguments to logical but absurd conclusions. Bastiat was demonstrating that there are numerous forces that create competitive challenges for firms and industries, but that doesn‘t necessarily justify the imposition of protectionist measures.

REVIEW QUESTIONS In Country A, a worker can make 5 bicycles per hour. In Country B, a worker can make 7 bicycles per hour. Which country has an absolute advantage in making bicycles? L O26.2 tttttttttttttttttttttttt. Country A uuuuuuuuuuuuuuuuuuuuuuuu. Country B Answer: b. Country B. Feedback: Country B has an absolute advantage in making bicycles because Country B is more efficient in the sense of being able to convert the same amount of input into a larger amount of output.

Please note that the definition of absolute advantage focuses on the efficiency with which countries can turn input into output. It says nothing at all about the opportunity costs of producing a particular type of output or how much of other products must to be forgone in order to produce a unit of that particular type of output. The concept of comparative advantage deals with those opportunity-cost issues.

541. In Country A, the production of 1 bicycle requires using resources that could otherwise be used to produce 11 lamps. In Country B, the production of 1 bicycle requires using resources that could otherwise be used to produce 15 lamps. Which country has a comparative advantage in making bicycles? LO26.2 Country A vvvvvvvvvvvvvvvvvvvvvvvv. Country B Answer: a. Country A. Feedback: Country A has a comparative advantage in making bicycles because Country A has a lower opportunity cost of producing bicycles when we measure opportunity cost in terms of the amount of alternative products that must be forgone in order to produce 1 bicycle.

To produce 1 bicycle, Country A only has to give up the production of 11 lamps.

By contrast, Country B has to give up the production of 15 lamps. Thus, if we had to decide which country should be producing bicycles, we would go with 1-536 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Country A because it can produce bicycles at a lower opportunity cost in terms of lamps forgone.

542. True or False: If Country B has an absolute advantage over Country A in producing bicycles, it will also have a comparative advantage over Country A in producing bicycles. LO26.2 Answer: False.

Feedback: This statement is false because the possession of an absolute advantage does not necessarily imply that a country will also have a comparative advantage.

A country can have an absolute advantage but not a comparative advantage because the definitions of absolute advantage and comparative advantage focus on different things. Absolute advantage focuses on costs as measured by the amount of inputs required to make a single unit of given product. Thus, the country that can produce a single bicycle using the least amount of labor input is the country that has the absolute advantage in producing bicycles.

By contrast, comparative advantage focuses on costs as measured by the amounts of other products that a country has to forgo in order to free up the resources necessary to make single unit of a given product. Thus, even if a country is really efficient at making bicycles in the sense of being able to make a single bicycle using only a very small amount of labor, it may still be really inefficient at making bicycles in the sense of having to give up a lot of other goods and services in order to free up the labor needed to make a single bicycle. That is, it may have an absolute advantage but not a comparative advantage.

543. Suppose that the opportunity-cost ratio for sugar and almonds is 4S ≡ 1A in Hawaii but 1S ≡ 2A in California. Which state has the comparative advantage in producing almonds? LO26.2 Hawaii wwwwwwwwwwwwwwwwwwwwwwww.

California xxxxxxxxxxxxxxxxxxxxxxxx. Neither Answer: b. California.

Feedback: California has the comparative advantage in producing almonds.

This is true because California has to give up less sugar in order to produce a ton of almonds. The easiest way to see this is to begin by dividing both sides of California‘s opportunity-cost ratio by 2. That will give you ½S ≡ 1A. That version 1-538 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

of California‘s opportunity-cost ratio makes it clear that for every ton of almonds that California produces, it must forgo ½ ton of sugar. By contrast, Hawaii‘s opportunity-cost ratio of 4S ≡ 1A indicates that for every ton of almonds that Hawaii produces, it must forgo 4 tons of sugar. As a result, California has a comparative advantage in producing almonds because it can produce them at a lower opportunity cost as measured by the amount of sugar that must be forgone in order to free up enough resources to produce one ton of almonds.

544.

Suppose that the opportunity-cost ratio for fish and lumber is 1F ≡ 1L in Canada but 2F ≡ 1L in Iceland. Then _ should specialize in producing fish while should specialize in producing lumber. LO26.2 Canada; Iceland yyyyyyyyyyyyyyyyyyyyyyyy. Iceland; Canada Answer: b. Iceland; Canada Feedback: The correct answer is that Iceland should specialize in producing fish while Canada should specialize in producing lumber. This is true because Iceland has a comparative advantage in producing fish while Canada has a comparative advantage in producing lumber. Those comparative advantages imply that if each country specializes in the production of the product for which it has a comparative advantage, total output between the two countries can rise. It is for that reason— increasing the total amount of output that can be produced—that the two countries should specialize and trade.

To see that Iceland has a comparative advantage in producing fish, divide both sides of its opportunity-cost ratio by 2. Doing so yields, 1F ≡ ½L. That version of Iceland‘s opportunity cost ratio demonstrates that in order to produce one ton of fish, Iceland has to give up only ½ ton of lumber. By contrast, Canada‘s opportunity cost ratio of 1F ≡ 1L indicates that in order to produce one ton of fish, Canada must give up one ton of lumber. Thus, Iceland has the comparative advantage in producing fish because it can produce fish at a lower opportunity cost in terms of lumber forgone.

A similar analysis demonstrates that Canada has the comparative advantage in producing lumber because it has the lower opportunity cost in terms of fish forgone. You can see this by comparing Canada‘s opportunity-cost ratio of 1F ≡ 1L with Iceland‘s opportunity cost ratio of 2F ≡ 1L. Canada only has to give up one ton of fish to produce a ton of lumber whereas Iceland has to give up 2 tons of fish to produce a ton of lumber.

545. Suppose that the opportunity-cost ratio for watches and cheese is 1C ≡ 1W in Switzerland but 1C ≡ 4W in Japan. At which of the following international exchange 1-539 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

ratios (terms of trade) will Switzerland and Japan be willing to specialize and engage in trade with each other. LO26.2

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Select one or more answers from the choices shown.

1C = 3W zzzzzzzzzzzzzzzzzzzzzzzz. 1C = 1/2 W aaaaaaaaaaaaaaaaaaaaaaaaa. 1C = 5W bbbbbbbbbbbbbbbbbbbbbbbbb. ½ C = 1W ccccccccccccccccccccccccc.

2C = 1W Answers: a. 1C ≡ 3W and d. ½C ≡ 1W Feedback: These are the only two correct answers because they are the only two international exchange ratios (terms of trade) that will be advantageous to both countries. One way to see this is to note that only international exchange ratios that lie between the domestic opportunity-cost ratios of the two countries will be acceptable to both. That is, only international exchange ratios between Switzerland‘s opportunity cost ratio of 1C ≡ 1W and Japan‘s opportunity cost ratio of 1C ≡ 4W will be beneficial to both countries and therefore acceptable as international exchange ratios at which both countries would be willing to trade.

For a deeper understanding of why that is true, recall that specialization and trade will only happen if each country feels that the international exchange ratio is better than what the country could do if it shut its borders and did not engage in international trade.

To see how this works, consider the first possible answer, in which the international exchange ratio is 1C ≡ 3W. Switzerland will find that ratio attractive because it will allow greater consumption than its domestic opportunity-cost ratio.

To see why, note that its domestic opportunity-cost ratio of 1C ≡ 1W implies that for every watch that Switzerland wants, it will have to give up a unit of cheese if it limits itself to domestic production and does not engage in international trade.

But if Switzerland instead opts for international trade, it will be able to get three watches for each unit of cheese that it produces and then trades for watches at the international exchange ratio of 1C ≡ 3W. Because getting three watches for each unit of cheese is better than getting only one watch for each unit of cheese, Switzerland will want to trade at the international exchange ratio of 1C ≡ 3W. For similar reasons, Japan will also find this international trade ratio attractive. To see why, note that if Japan did not trade, its domestic opportunity-cost ratio of 1C ≡ 4W implies that it would have to give up four watches for each unit of cheese that it wants. By contrast, if it took advantage of the international exchange ratio of 1C ≡ 3W, it would be able to get one unit of cheese through trade by producing and then trading away only three watches. Clearly it is better to have to give up only three watches to get a unit of cheese than to have to give up four watches to get a unit of cheese. And so, Japan will also want to trade at the international exchange ratio of 1C ≡ 3W rather than ban trade and produce domestically.

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Finally, note that international trade will not take place if the international exchange ratio lies outside of the range that lies between each country‘s own domestic opportunity cost ratio. International trade will not take place in such cases because any such international exchange ratios will be acceptable to only one—but not both—of the countries. As a result, one of them won‘t be willing to trade.

546. Which of the following are benefits of international trade? LO26.2 Choose one or more answers from the choices shown.

A more efficient allocation of resources ddddddddddddddddddddddddd. A higher level of material well-being eeeeeeeeeeeeeeeeeeeeeeeee.

Gains from specialization fffffffffffffffffffffffff.

Promoting competition ggggggggggggggggggggggggg. Deterring monopoly hhhhhhhhhhhhhhhhhhhhhhhhh. Reducing the threat of war Answer: All of the choices are correct.

Feedback: All of the answers are correct because each one is indeed a benefit of international trade.

547. We see quite a bit of international trade in the real world. And trade is driven by specialization. So why don‘t we see full specialization—for instance, all cars in the world being made in South Korea, or all the mobile phones in the world being made in China? Choose the best answer from among the following choices. LO26.2 High tariffs iiiiiiiiiiiiiiiiiiiiiiiii. Extensive import quotas jjjjjjjjjjjjjjjjjjjjjjjjj. Increasing opportunity costs kkkkkkkkkkkkkkkkkkkkkkkkk. Increasing returns Answer: c. Increasing opportunity costs.

Feedback: The correct answer is that we don‘t see full specialization because of increasing opportunity costs.

International trade is indeed driven by specialization, but the benefits of specialization can dissipate as a country specializes more and more in the production of one good. What happens is that diminishing returns set in so that the country will face increasingly high opportunity costs for producing the good in question. As costs rise, so will the price that it has to charge to foreigners for additional units of the good.

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At some point, the price will rise so high that foreigners will no longer want to buy any more because it will be cheaper for them to produce additional units domestically or purchase them yet another country whose production has not yet been affected by diminishing returns and increasing costs. As a result, what we see in the real world is incomplete specialization, with several countries often dominating an industry but no single country achieving full specialization and 100% control of global production.

As an example, consider cars, which are exported to other countries from South Korea, the United States, Japan, Germany, France, Sweden, and so on. Each of these countries has specialized some of its industrial capacity into the production of cars, but the concept of diminishing returns implies that none of them has been able to capture 100% of the world car market.

548. True or False: If a country is open to international trade, the domestic price of a product can differ from the international price of that product. LO26.3 Answer: False.

Feedback: If a country is open to international trade, the domestic price for a homogeneous good will always be equal to the international price. That is because anyone in the country who wants to buy or sell will be participating in the international market and paying the international price that equates the quantities demanded and supplied globally. By contrast, if a country is closed to international trade, the domestic price can differ substantially from the international price because the domestic price will be affected only by domestic demand and domestic supply.

549. Suppose that the current international price of wheat is $6 per bushel and that the United States is currently exporting 30 million bushels per year. If the United States suddenly became a closed economy with respect to wheat, would the domestic price of wheat in the United States end up higher or lower than $6? LO26.3 Higher lllllllllllllllllllllllll. Lower mmmmmmmmmmmmmmmmmmmmmmmmm.

It will stay the same Answer: b. Lower.

Feedback: If the United States suddenly became a closed economy, the domestic price of wheat would end up being lower than the current international price of wheat.

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That is because from the perspective of U.S. farmers, closing the U.S. economy to international trade in wheat would mean drastically lowering the overall demand for their product. That is, the total demand for U.S. wheat would fall sharply because U.S. wheat farmers would now be cut off from all of the foreigner consumers who had previously been consuming all of the wheat that the U.S. had been exporting. That reduction of the total demand for U.S. wheat would result in a lower equilibrium domestic price of wheat if the U.S. were to become a closed economy with respect to wheat.

550. Suppose that if Iceland and Japan were both closed economies, the domestic price of fish would be $100 per ton in Iceland and $90 per ton in Japan. If the two countries decided to open up to international trade with each other, which of the following could be the equilibrium international price of fish once they begin trading? LO26.3 $75 nnnnnnnnnnnnnnnnnnnnnnnnn. $85 ooooooooooooooooooooooooo. $95 ppppppppppppppppppppppppp. $105 Answer: $95.

Feedback: The correct answer is that $95 could be the equilibrium international price of fish if Iceland and Japan began trading fish with each other. That is true because an equilibrium in international trade can only exist if the international price can adjust so that one country becomes the exporter, the other country becomes the importer, and the quantity exported and supplied by the exporting country exactly equals the quantity imported and demanded by the other country. The $95 price is the only price that could possibly make that happen because it‘s the only price at which one of the countries will want to export and the other will want to import.

In particular, Iceland will want to import at the $95 price because that price for fish is less than its domestic price of $100. At the same time, Japan will want to export at the $95 price because that price is more than the $90 domestic price at which fish can be sold. Thus, it is possible that $95 could be the equilibrium international price because one country will want to export while the other will want to import.

By contrast, none of the other prices could possibly work because for each of them, you wouldn‘t end up with one country wanting to import and one country wanting to export.

551. Draw a domestic supply-and-demand diagram for a product in which the United States does not have a comparative advantage. What impact do foreign imports have 1-547 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

on domestic price and quantity? On your diagram show a protective tariff that eliminates approximately one-half of the assumed imports. What are the pricequantity effects of this tariff on (a) domestic consumers, (b) domestic producers, and (c) foreign exporters? How would the effects of a quota that creates the same amount of imports differ? LO26.4 Answer:

The United States does not have a comparative advantage in this product so the world price Pworld is below the U.S. domestic price of Pdomestic. Imports will reduce the domestic price, increasing consumption from nontrade, and decreasing domestic production. See the graph. A tariff (a) harms domestic consumers by increasing price and decreasing consumption; (b) aids domestic producers through the increase in price and the expansion of domestic production; (c) harms foreign exporters by decreasing exports (assuming that the country imposing the tariff is a small part of the world market. If not, price could also be affected.)

552. American apparel makers complain to Congress about competition from China.

Congress decides to impose either a tariff or a quota on apparel imports from China.

Which policy would Chinese apparel manufacturers prefer? LO26.4 Tariff qqqqqqqqqqqqqqqqqqqqqqqqq. Quota Answer: b. Quota Feedback: Chinese apparel manufacturers would prefer a quota because it would generate higher per-unit prices for the goods they sell in the United States.

With either a tariff or a quota, China will see its total volume of sales to the United States decline. But the question then becomes: Which policy would offer China the greater amount of benefits to help compensate for the decline in sales?

A tariff won‘t help the Chinese at all because the money from the tariff will be collected by the U.S. government. But a quota can actually increase China‘s per1-548 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

unit selling price because the reduction in supply caused by the quota will raise the equilibrium price of apparel in the United States. As a result, while the quota will mean that China will be selling fewer units of clothing in America, it will also mean that each of the units of clothing that it does continue to sell will be sold at a higher per-unit price.

Thus, China will prefer a quota over a tariff because it will at least be getting more per unit despite selling fewer units. (Whether or not the increase in per-unit price can make up for the decline in the number of units sold will depend on the elasticities of the demand and supply curves.)

PROBLEMS Assume that the comparative-cost ratios of two products—baby formula and tuna fish— are as follows in the nations of Canswicki and Tunata: Canswicki: 1 can baby formula ≡ 2 cans tuna fish Tunata: 1 can baby formula ≡ 4 cans tuna fish In what product should each nation specialize? Which of the following terms of trade would be acceptable to both nations: (a) 1 can baby formula ≡ 2 1/2 cans tuna fish; (b) 1 can baby formula ≡ 1 can tuna fish; (c) 1 can baby formula ≡ 5 cans tuna fish?

LO26.2 Answer: Canswicki should produce baby food, and Tunata should produce tuna; (a) acceptable; (b) not acceptable; (c) not acceptable.

Feedback: The opportunity cost of producing 1 can of baby formula in Canswicki is 2 cans of tuna fish.

The opportunity cost of producing 1 can of baby formula in Tunata is 4 cans of tuna fish.

Since the opportunity cost of producing baby formula is lower in Canswicki, this implies Canswicki should produce baby formula. This also implies that Tunata should specialize in producing Tuna.

We can also look at the opportunity cost of producing cans of tuna fish (in terms of forgone cans of baby formula).

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The opportunity cost of producing 1 can of tuna fish in Canswicki is 1/2 a can of baby formula.

The opportunity cost of producing 1 can of tuna fish in Tunata is 1/4 a can of baby formula.

Since the opportunity cost of producing tuna fish is lower in Tunata, this implies Tunata should produce tuna fish. This also implies that Canswicki should specialize in producing baby formula.

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Which of the following terms of trade would be acceptable to both nations: iii. 1 can baby formula ≡ 2 1/2 cans tuna fish?

These terms of trade are acceptable. The best Canswicki can do without trade is produce 2 cans of tuna fish for each can of baby formula. If it trades 1 can of baby formula for 2.5 cans of tuna fish it will be better off. Tunata will also trade because it only needs to give up 2.5 cans of tuna fish for each can of baby formula. If Tunata produced baby formula, it would need to give up 4 cans of tuna fish for each can of baby formula. jjj. 1 can baby formula ≡ 1 can tuna fish?

These terms of trade would not be acceptable. Canswicki would not be willing to trade 1 can of baby formula for 1 can of tuna fish. It can do better themselves by producing 2 cans of tuna fish for each can of baby formula. kkk. 1 can baby formula ≡ 5 cans tuna fish?

These terms of trade would not be acceptable. Tunata would not be willing to trade (give up) 5 cans of tuna fish for 1 can of baby formula. It could do better themselves by producing a can of baby food and giving up 4 cans of tuna fish.

553. The accompanying hypothetical production possibilities tables are for New Zealand and Spain. Each country can produce apples and plums. Plot the production possibilities data for each of the two countries separately. Referring to your graphs, answer the following: L O26.2

What is each country‘s opportunity cost ratio of producing plums and apples? rrrrrrrrrrrrrrrrrrrrrrrrr.

Which nation should specialize in each product?

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sssssssssssssssssssssssss. Show the trading possibilities lines for each nation if the actual terms of trade are 1 plum for 2 apples. (Plot these lines on your graph.) ttttttttttttttttttttttttt. Suppose the optimum product mixes before specialization and trade were alternative B in New Zealand and alternative S in Spain. What would be the gains from specialization and trade?

Answer: New Zealand: cost of producing 1 apple is 0.25 plums; cost of producing 1 plum is 4 apples; Spain: cost of producing 1 apple is 1 plum; cost of producing 1 plum is 1 apple. gggggggggggggg. produce plums.

New Zealand should produce apples and Spain should

hhhhhhhhhhhhhh. See graphs:

iiiiiiiiiiiiii. − 50)

Total Gain Apples = 20 (= 60 − 40); Total Gain Plums = 10 (= 60

Feedback: The opportunity cost of producing 1 apple in New Zealand is 0.25 plum. That is, for each apple produced in New Zealand the country must give up 0.25 plum.

The opportunity cost of producing 1 apple in Spain is 1 plum. That is, for each apple produced in Spain the country must give up 1 plum.

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We can also look at the opportunity cost of producing plums.

The opportunity cost of producing 1 plum in New Zealand is 4 apples. That is, for each plum produced in New Zealand the country must give up 4 apples.

The opportunity cost of producing 1 plum in Spain is 1 apple. That is, for each plum produced in Spain the country must give up 1 apple. jjjjjjjjjjjjjj. The opportunity cost of producing apples in New Zealand is lower than Spain‘s opportunity cost of producing apples. Therefore, New Zealand should produce apples and Spain should produce plums. kkkkkkkkkkkkkk. The graphs below show each country‘s production possibilities schedules with and without trade. Apples are on the vertical axis and plums are on the horizontal axis.

New Zealand has a vertical intercept of 60 apples (produce only apples) and a horizontal intercept of 15 plums (produce only plums). The slope of production possibilities schedule equals −4 (negative 4). This slope is the opportunity cost of producing plums. That is, for each plum produced by New Zealand they must give up 4 apples.

However, after trade, New Zealand‘s horizontal intercept will be 30 apples.

Since the terms of trade are 1 plum for 2 apples, New Zealand could specialize in apple production and trade 2 apples for each plum (produce 60 apples and receive 30 plums). The slope of the after-trade production possibilities schedule is -2 (negative 2). New Zealand must now only give up 2 apples for each additional plum consumed (trade 2 apples for additional plum).

The same logic applies to Spain. Before trade the vertical intercept is 60 apples and the horizontal intercept 60 plums. The slope of the production possibilities schedule is −1, which is the opportunity cost of 1 more plum in terms of apples.

After trade Spain‘s vertical intercept is now 120 apples and the horizontal intercept remains at 60 plums. Spain will produce only plums and can trade now 1 plum for 2 apples (terms of trade). If they trade all 60 plums for apples they will receive 120 apples. The new slope of the production possibilities schedule is −2, which is the opportunity cost of consuming (not trading) 1 more plum.

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(NOTE: The intercepts above reflect possibilities not actual equilibrium consumption bundles. For example, if Spain produced only plums and traded these for apples, they should be able to consume 120 apples (vertical intercept after trade). The problem is that New Zealand is only producing 60 apples (the most it possibly can). This is not a flaw in the logic of the problem because we are only considering the construction of the production possibilities schedules.

The next step would be to allow terms of trade to adjust in response to shortages and surpluses of goods based on country preferences. We do not do this step here.) llllllllllllll.

The first step is to determine total production before any trade takes place.

New Zealand‘s optimal product mix before trade is alternative B (given above): Apples = 20 Plums = 10 Spain‘s optimal product mix before trade is alternative S (given above): Apples = 20 Plums = 40 1-554 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Combined, the optimal mix before trade is: Before Trade Total Apples = 40 (20 New Zealand plus 20 Spain) Before Trade Total Plums = 50 (10 New Zealand plus 40 Spain) The next step is to determine total production after specialization. Recall New Zealand will specialize in apple production (produce only apples) and Spain will specialize in plum production (produce only plums).

After Trade Total Apples = 60 (New Zealand alternative D) After Trade Total Plums = 60 (Spain alternative R) The final step is to determine the total gain for each good, which is the difference between total production before trade and total production after trade.

Total Gain Apples = 20 (= 60 − 40) Total Gain Plums = 10 (= 60 − 50) 554. The following hypothetical production possibilities tables are for China and the United States. Assume that before specialization and trade the optimal product mix for China is alternative B and for the United States is alternative U. LO26.2

Are comparative-cost conditions such that the two areas should specialize? If so, what product should each produce? uuuuuuuuuuuuuuuuuuuuuuuuu. What is the total gain in apparel and chemical output that would result from such specialization? vvvvvvvvvvvvvvvvvvvvvvvvv. What are the limits of the terms of trade? Suppose that the actual terms of trade are 1 unit of apparel for 1.5 tons of chemicals and that the actual amount traded is 4 units of apparel for 6 tons of chemicals. What are the gains from specialization and trade for each nation?

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Answer: Yes; China should produce apparel and the United States should produce chemicals. mmmmmmmmmmmmmm. Total Gain apparel = 6,000; Total Gain chemicals = 2. nnnnnnnnnnnnnn. Limits of the terms of trade = 1,000 units of apparel for 1 ton of chemicals and 1,000 units of apparel for 2 tons of chemicals; gain of 2,000 units of apparel and 2 tons of chemicals.

Feedback: Yes, the two areas should specialize.

The opportunity cost of producing 1,000 units of apparel is 1 ton of chemicals in China. The opportunity cost of producing 1,000 units of apparel is 2 tons of chemicals in the United States.

Thus, the opportunity cost for apparel is lower in China. This implies China should produce apparel and the United States should produce chemicals. oooooooooooooo.

The first step is to determine total production before any trade takes place.

China‘s optimal product mix before trade is alternative B (given above): Apparel = 24,000 Chemicals = 6 The United States‘ optimal product mix before trade is alternative U (given above): Apparel = 4,000 Chemicals = 12 Combined, the optimal mix before trade is: Before Trade Total Apparel = 28,000 (24,000 China plus 4,000 U.S.) Before Trade Total Chemicals = 18 (6 China plus 12 U.S.) The next step is to determine total production after specialization. Recall China will specialize in apparel production (produce only apparel) and the United States will specialize in Chemical production (produce only chemicals).

After Trade Total Apparel = 30,000 (China alternative A) After Trade Total Chemicals = 20 (U.S. alternative W) The final step is to determine the total gain for each good, which is the difference between total production before trade and total production after trade.

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Total Gain Apparel = 2,000 (= 30,000 − 28,000) Total Gain Chemicals = 2 (= 20 − 18)

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pppppppppppppp. To determine the limits of the terms of trade we look at opportunity cost. The opportunity cost of producing 1,000 units of apparel is 1 ton of chemicals in China. The opportunity cost of producing 1,000 units of apparel is 2 tons of chemicals in the United States.

The most China will trade (give up) is 1,000 units of apparel for 1 ton of chemicals. If the US required more China could do better producing the chemicals themselves.

The most the US is willing to trade (give up) is 2 tons of chemicals for 1000 units of apparel. If China required more the US could do better producing the apparel themselves.

This implies the range, or limits, of the terms of trade.

1,000 units of apparel for 1 ton of chemicals 1,000 units of apparel for 2 tons of chemicals Now assuming the actual terms are 1,000 units of apparel for 1.5 tons of chemicals and that the ACTUAL amount traded (exchanged) is 4,000 units of apparel for 6 tons of chemicals we can find the new consumption levels for each country.

The U.S. produces all 20 tons of chemicals. It then trades 6 tons of chemicals for 4,000 units of apparel. So, after trade the United States consumes 14 tons of chemicals and 4,000 units of apparel.

China produces all 30,000 units of apparel. It trades 4,000 units of apparel for 6 tons of chemicals. So, after trade China consumes 6 tons of chemicals and 26,000 units of apparel.

The gain to China comes in apparel. Before trade, China consumed 24,000 units of apparel and after trade they consume 26,000. This is a gain of 2,000 units of apparel.

The gain to the United States comes in chemicals. Before trade, the U.S. consumed 12 tons of chemicals, while after trade it consumes 14 tons of chemicals. This is a gain of 2 tons of chemicals.

555. Refer to Figure 3.6. Assume that the graph depicts the U.S. domestic market for corn. How many bushels of corn, if any, will the United States export or import at a world price of $1, $2, $3, $4, and $5? Use this information to construct the U.S. export supply curve and import demand curve for corn. Suppose that the only other 1-558 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

corn-producing nation is France, where the domestic price is $4. Which country will export corn; which county will import it? LO26.3

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Answer: At a price of $1: −15,000 (import 15,000); Price $2: −7,000 (import 7,000); Price $3: 0; Price $4: 6,000 (export); Price $5: 10,000 (export).

At a price of $4, the U.S. will export corn and France will import corn.

Feedback: To calculate the amount of imports or exports, subtract quantity supplied from the quantity demanded at each price: Price $1: quantity supplied − quantity demanded = 1,000 − 16,000 = −15,000 (on the import supply schedule below this value will be positive) Price $2: 4,000 − 11,000 = −7,000 Price $3: 7,000 − 7,000 = 0 Price $4: 10,000 − 4,000 =6,000 Price $5: 12,000 − 2,000 = 10,000

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At a price of $4 the U.S. will export corn and France will import corn.

Chapter 27 - The Balance of Payments, Exchange Rates, and Trade Deficits McConnell Brue Flynn 23e DISCUSSION QUESTIONS 556. Do all international financial transactions necessarily involve exchanging one nation‘s distinct currency for another? Explain. Could a nation that neither imports goods and services nor exports goods and services still engage in international financial transactions? LO27.1 Answer: The answer is almost certainly a yes. Only in rare cases would you find barter exchanges (the exchange of goods and services for other goods and services). Yes, they could engage in financial transactions (the exchange of assets across countries).

557. Explain: ―U.S. exports earn supplies of foreign currencies that Americans can use to finance imports.‖ Indicate whether each of the following creates a demand for or a supply of European euros in foreign exchange markets: LO27.1 wwwwwwwwwwwwwwwwwwwwwwwww. A U.S. airline firm purchases several Airbus planes assembled in France. xxxxxxxxxxxxxxxxxxxxxxxxx. A German automobile firm decides to build an assembly plant in South Carolina. yyyyyyyyyyyyyyyyyyyyyyyyy. A U.S. college student decides to spend a year studying at the Sorbonne in Paris. zzzzzzzzzzzzzzzzzzzzzzzzz.

An Italian manufacturer ships machinery from one Italian port to another on a Liberian freighter. aaaaaaaaaaaaaaaaaaaaaaaaaa.

The U.S. economy grows faster than the French economy. bbbbbbbbbbbbbbbbbbbbbbbbbb. A U.S. government bond held by a Spanish citizen matures, and the loan amount is paid back to that person.

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cccccccccccccccccccccccccc. the near future.

It is widely expected that the euro will depreciate in

Answer: American exports lead to an increase in the foreign-currency bank deposit holdings of Americans. These holdings will be decreased through American purchases of imports. Hence, the foreign-currency assets earned through exports can be used to finance imports. qqqqqqqqqqqqqq. A demand for euros: The U.S. airline must purchase euros before purchasing the Airbus planes. rrrrrrrrrrrrrr.

A supply of euros: The German automobile firm must purchase U.S. dollars, or supply euros, before building the plant. ssssssssssssss. A demand for euros: The U.S. college student must purchase euros before studying in France.

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tttttttttttttt. A supply of euros: The Italian manufacturer must purchase U.S. dollars, or supply euros, to pay the Liberian freighter (which requires payment in U.S. dollars). uuuuuuuuuuuuuu. A demand for euros: Since the U.S. economy grows faster than the French economy, U.S. imports from France will grow faster than France's imports from the U.S. holding everything else constant. To buy these additional French goods the U.S. will purchase more (net) euros. vvvvvvvvvvvvvv.

A demand for euros: The U.S. pays the Spanish citizen in U.S. dollars. The Spanish citizen then purchases euros so she has currency she can use in her home country. wwwwwwwwwwwwww.

A supply of euros: Since individuals holding euros expect the currency to depreciate in the near future they sell (supply) the euros today in an attempt to avoid the loss in the future.

558. What do the plus signs and negative signs signify in the U.S. balance-of-payments statement? Which of the following items appear in the current account and which appear in the capital and financial account: U.S. purchases of assets abroad; U.S. services imports; foreign purchases of assets in the United States; U.S. goods exports, U.S. net investment income. Why must the current account and the capital and financial account sum to zero? LO27.2 Answer: The plus sign (+) indicates a credit to the U.S. balance of payments. The negative sign (−) indicates a debit to the U.S balance of payments.

U.S. purchases of assets abroad: capital and financial account U.S. services imports: current account foreign purchases of assets in the United States: capital and financial account U.S. good exports: current account U.S. net investment income: current account The balance on the current account and the balance on the capital and financial account must always sum to zero because any deficit or surplus in the current account automatically creates an offsetting entry in the capital and financial account. People can only trade one of two things with each other: currently produced goods and services or preexisting assets. Therefore, if trading partners 1-563 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

have an imbalance in their trade of currently produced goods and services, the only way to make up for that imbalance is with a net transfer of assets from one party to the other.

559. ―Exports pay for imports. Yet in 2021 the nations of the world exported about $861 billion more of goods and services to the United States than they imported from the United States.‖ Resolve the apparent inconsistency of these two statements. L O27.2 Answer: Exports pay for imports in the long run. In the short term, a country can import more goods and services than it exports through external borrowing or the sale of domestic assets to foreigners. Both activities increase the country‘s capital account balance and cause an inflow of foreign currency that can be used to finance import purchases. Depletion of a country‘s official reserves can also be used as a short-term measure to finance imports, since the sale of foreign monies for domestic currency has the same financial effect as an export transaction.

560. Generally speaking, how is the dollar price of euros determined? Cite a factor that might increase the dollar price of euros. Cite a different factor that might decrease the dollar price of euros. Explain: ―A rise in the dollar price of euros necessarily means a fall in the euro price of dollars.‖ Illustrate and elaborate: ―The dollar-euro exchange rate provides a direct link between the prices of goods and services produced in the Euro Zone and in the United States.‖ Explain the purchasing-power-parity theory of exchange rates, using the euro-dollar exchange rate as an illustration. LO27.3 Answer: The dollar price of the euro is determined in a currency exchange market that equates the supply of euros with the demand for euros.

A factor that might increase the dollar price of the euro could be the result of an increase in the demand for the euro or a decrease in the supply of the euro.

(Examples) Increase in Demand: There are more Airbus aircraft purchased by U.S. airlines. Decrease in supply: There are less Boeing aircraft purchased by European airlines.

A factor that might decrease the dollar price of the euro could be the result of a decrease in the demand for the euro or an increase in the supply of the euro.

(Examples) Decrease in Demand: There are less Airbus aircraft purchased by U.S. airlines. Increase in supply: There are more Airbus aircraft purchased by European airlines.

If the euro appreciates relative to the dollar, it takes more dollars to purchase one euro. At the same time, it takes fewer euros to buy a dollar, meaning that the euro price of dollars has fallen.

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Through exchange rates, residents of all trading nations can express the prices of goods and services in other trading nations in terms of their domestic currencies.

A change in the exchange rate between any two countries will automatically lead to an adjustment in the prices of all goods and services in both countries in terms of the other‘s currency. The determination of these price conversions represents the most basic and visible function of exchange rates.

The purchasing power parity theory of exchange rates holds that exchange rates change to equal the ratios of the nations‘ price levels. If a certain item costs $100 in the U.S. and 50 euros in Germany, then the exchange rate should be $1 = 0.5 euros. It should take the same amount of dollars to buy the item anywhere in the world if exchange rates adjust to maintain purchasing power parity.

561. Suppose that a Swiss watchmaker imports watch components from Sweden and exports watches to the United States. Also suppose the dollar depreciates, and the Swedish krona appreciates, relative to the Swiss franc. Speculate as to how each would hurt the Swiss watchmaker. LO27.3 Answer: If the dollar depreciated relative to the franc, this means that it took more dollars to get the francs necessary to buy a watch. In other words, the watch becomes more expensive in dollar terms, which would cause a decline in imported watches purchased in the United States. Second, if the krona appreciated relative to the Swiss franc, this is the same thing as saying that the franc depreciated relative to the krona. In other words, it took more Swiss francs to buy parts in Sweden than it did previously. As a result, the imported components for the watches became more expensive to the Swiss company. The Swiss watchmaker was hurt twice. Its costs rose while its export sales declined.

562. Explain why the U.S. demand for Mexican pesos slopes downward and the supply of pesos to Americans slopes upward. Assuming a system of flexible exchange rates between Mexico and the United States, indicate whether each of the following would cause the Mexican peso to appreciate or depreciate, other things equal: LO27.3 The United States unilaterally reduces tariffs on Mexican products. dddddddddddddddddddddddddd. Mexico encounters severe inflation. eeeeeeeeeeeeeeeeeeeeeeeeee.

Deteriorating political relations reduce American tourism in Mexico. ffffffffffffffffffffffffff.

The U.S. economy moves into a severe recession. gggggggggggggggggggggggggg. The United States engages in a high-interest-rate monetary policy. hhhhhhhhhhhhhhhhhhhhhhhhhh. Mexican products become more fashionable to U.S. consumers. iiiiiiiiiiiiiiiiiiiiiiiiii. The Mexican government encourages U.S. firms to invest in Mexican oil fields.

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jjjjjjjjjjjjjjjjjjjjjjjjjj. The rate of productivity growth in the United States diminishes sharply.

Answer: The U.S. demand for pesos is downsloping: When the peso depreciates in value (relative to the dollar), the United States finds that Mexican goods and services are less expensive in dollar terms and purchases more of them, demanding a greater quantity of pesos in the process. The supply of pesos to the United States is upsloping: As the peso appreciates in value (relative to the dollar), U.S. goods and services become cheaper to Mexicans in peso terms.

Mexicans buy more dollars to obtain more U.S. goods, supplying a larger quantity of pesos.

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The peso will appreciate. Mexican goods will become cheaper, so U.S. demand for pesos for will increase. xxxxxxxxxxxxxx.

The peso will depreciate. The high rate of inflation in Mexico (relative the U.S.) will cause the price Mexican goods and services to increase (relative the U.S.). The U.S. demand for pesos will fall. The supply of pesos will also increase because U.S. goods are relatively cheaper. This will reinforce the depreciation of the peso. yyyyyyyyyyyyyy.

The peso will depreciate. The reduction in U.S. tourism in Mexico reduces the demand for pesos. zzzzzzzzzzzzzz.

The peso will depreciate. The recession in the U.S. economy will reduce imports from Mexico. This, in turn, will decrease the demand for the peso. aaaaaaaaaaaaaaa. The peso will depreciate. The high interest rate in the U.S. will attract investors from Mexico. This will increase the demand for U.S. dollars or the supply of pesos. bbbbbbbbbbbbbbb. The peso will appreciate. U.S. consumers purchase more goods from Mexico. This increases the demand for the peso. ccccccccccccccc.

The peso appreciates. The U.S. firms must purchase pesos to invest in Mexico. This increases the demand for pesos. ddddddddddddddd. The peso appreciates. The sharp decline in U.S. productivity reduces investment in the U.S. by firms in Mexico. This decreases the supply of pesos.

563. Explain why you agree or disagree with the following statements. Assume other things equal. LO27.3 A country that grows faster than its major trading partners can expect the international value of its currency to depreciate. kkkkkkkkkkkkkkkkkkkkkkkkkk. A nation whose interest rate is rising more rapidly than interest rates in other nations can expect the international value of its currency to appreciate. llllllllllllllllllllllllll. A country‘s currency will appreciate if its inflation rate is less than that of the rest of the world.

Answer: This statement is true. If high rates of economic growth mean that the real incomes of a country‘s citizens are rising more rapidly than in other countries, its imports will rise more than its exports. The demand for foreign currency by its citizens will increase more than the supply of foreign currency, causing the value of the domestic currency to decline.

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eeeeeeeeeeeeeee.

This statement is true. If domestic real interest rates are increasing more quickly than those in other countries, foreign financial investment will be attracted to the country, causing a rise in the supply of foreign currency and therefore an appreciation of the country‘s currency. fffffffffffffff. This statement is true. If a country‘s inflation rate is lower than rates in other countries, the foreign prices of its products will decline relative to the prices of foreign-made products, increasing exports and the supply of foreign currency. The domestic prices of foreign imports will increase relative to the prices of domestically made goods, decreasing the demand for foreign currency. Both factors will cause the country‘s currency to appreciate.

564. Is it accurate to think of a fixed exchange rate as a simultaneous price ceiling and price floor? Explain. LO27.4 Answer: It is not accurate to think of a fixed exchange rate as a simultaneous price ceiling and price floor. That is because price ceilings and price floors are imposed on markets in which buyers and sellers can interact with each other. By contrast, under a fixed exchange rate regime, there is no foreign exchange market. Buyers and sellers do not interact with each other. They only interact, separately, with the central bank, which is acting as a monopoly currency dealer. As a result, buyers buy only from the central bank and sellers sell only to the central bank.

With no market existing to connect buyers and sellers, there is no way for the government to impose price ceilings and price floors to keep the exchange rate at the desired peg value. Instead, the fixed exchange rate is maintained in an entirely different fashion. On the one hand, the central bank uses its ability to print an infinite amount of the local currency to satisfy any requests by sellers of foreign currency to exchange foreign currency into local currency at the fixed exchange rate. On the other hand, the central bank uses its FX reserves to satisfy any requests to convert local money into foreign money at the fixed exchange rate. As long as the central bank can satisfy all of these requests, the fixed exchange rate can persist.

565. What have been the major causes of the large U.S. trade deficits in recent years?

What are the major benefits and costs associated with trade deficits? Explain: ―A trade deficit means that a nation is receiving more goods and services from abroad than it is sending abroad.‖ How can that considered to be ―unfavorable‖? LO27.6

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Answer: (4) The U.S. economy has grown more rapidly than the economies of several major trading nations. Thus U.S. exports have not kept pace with the rise in U.S. imports.

(5) Large trade deficits with China have contributed, with incomes in China too low to result in a significant increase in imports from the U.S. (6) Increases in oil prices have increased the trade deficit with OPEC nations.

(7) Finally, a declining savings rate in the U.S. (while investment has remained stable) has also contributed to the trade deficit. These lower saving rates (and high investment rates) have allowed for increased consumption including increased imports.

A trade deficit allows the Unites States to consume outside its production possibilities curve. But, the gain in current consumption comes at the expense of reduced future consumption.

A trade deficit is considered ―unfavorable‖ because it must be financed by borrowing from the rest of the world, selling off assets, and dipping into foreign currency reserves. Financing of the U.S. trade deficit has resulted in a larger foreign accumulation of claims against U.S. financial and real assets than the U.S. claim against foreign assets.

566. LAST WORD Explain why Policy #1 precludes the achievement of Goal B while promoting the success of Goals A and C. Then explain why Policy #3 makes it impossible for a country to achieve Goal A while simultaneously helping it to achieve Goals C and B. Answer: Policy #1 (Exchange Controls) directly contradicts Goal B (Free Financial and Trade Flows) because if the central bank is putting limits (controls) on the amount of foreign exchange that it will allow during any given period, there may not be enough foreign exchange available to facilitate all of the international trade and asset transactions that people wish to undertake. By contrast, Policy #1 (Exchange Controls) makes it much easier for the central bank to achieve Goal A (Exchange Rate Stability) since the central bank can use exchange controls to limit the demand and supply for foreign exchange and thereby control the intersection point of the demand and supply curves for foreign exchange and thus the exchange rate.

Similarly, Policy #1 (Exchange Controls) also helps a central bank to achieve Goal C (Independent Monetary Policy) because it can tailor interest rates and monetary policy to the needs of the domestic economy without having to worry about how any such actions might affect the demand and supply curves for foreign currency since it can just use exchange controls to offset any such changes in demand or supply.

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Policy #3 (a Floating Exchange Rate) directly contradicts Goal A (Exchange Rate Stability) because a floating exchange rate is by definition very prone to rapid changes since it is affected by any and all changes in the demand or supply of foreign currency, no matter how large or small. Thus, whenever a central bank is allowing a Floating Exchange Rate, the currency is unlikely to be very stable. By contrast, Policy #3 (a Floating Exchange Rate) helps to achieve Goal C (an Independent Monetary Policy) because when a central bank is allowing the exchange rate to float, it implicitly doesn't have to care or react in any way if the exchange rate changes. That in turn gives the central bank the flexibility to make any changes in interest rates or monetary policy that may be necessary to help the domestic economy without having to worry about what those changes might do to the demand or supply of foreign currency and thus, to the exchange rate. Policy #3 (a Floating Exchange Rate) also helps to achieve Goal B (Free Financial and Trade Flows) because when the exchange rate is floating, the foreign exchange market will always achieve equilibrium wherever the demand and supply curves cross. Since equilibrium implies that the demand for foreign exchange will always equal the supply of foreign exchange, there will consequently always be exactly enough foreign exchange supplied to facilitate any and all international trade or asset transactions that people may wish to undertake.

REVIEW QUESTIONS An American company wants to buy a television from a Chinese company. The Chinese company sells its TVs for 1,200 yuan each. The current exchange rate between the U.S. dollar and the Chinese yuan is $1 = 6 yuan. How many dollars will the American company have to convert into yuan to pay for the television? LO27.1 $7,200. mmmmmmmmmmmmmmmmmmmmmmmmmm. $1,200. nnnnnnnnnnnnnnnnnnnnnnnnnn. $200. oooooooooooooooooooooooooo. $100.

Answer: c. $200.

Feedback: The American company will have to convert $200 into yuan in order to pay for the television. With the exchange rate at $1 = 6 yuan, it will take $200 (= 200 times $1) to buy the 1,200 yuan (= 200 times 6 yuan) that will be needed to purchase the television set. Another way to see that the company will need to covert $200 into yuan is to note that 1,200/6 = 200. That is, 1,200 yuan can be converted into $200 at the current exchange rate of 6 yuan = $1.

567. Suppose that a country has a trade surplus of $50 billion, a balance on the capital account of $10 billion, and a balance on the current account of −$200 billion. The balance on the capital and financial account is: LO27.2 $10 billion. pppppppppppppppppppppppppp. $50 billion.

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qqqqqqqqqqqqqqqqqqqqqqqqqq. $200 billion. rrrrrrrrrrrrrrrrrrrrrrrrrr. −$200 billion.

Answer: c. $200 billion.

Feedback: The correct answer is that the balance on the capital and financial account will be $200 billion. We know this must be true because the balance on the current account and the balance on the capital and financial account must always sum to zero.

Thus, in this case where the balance on the current account is −$200 billion, the balance on the capital and financial account must be $200 billion (because $200 billion and −$200 billion sum to zero).

Note that the other information given in the problem (that the country has a trade surplus of $50 billion and a balance on its capital account of $10 billion) is irrelevant because all you need to know to answer this problem correctly is that the balance on the current account is −$200 billion.

Finally, make sure to remember that the current account balance and the capital and financial account balance always sum to zero because any current account imbalance automatically generates an offsetting international asset transfer. In this case where the country is running a −$200 billion deficit in its current account, $200 billion of its assets must be transferred to foreigners in order to compensate them for the imbalance in the trade of currently produced goods and services.

568.

The exchange rate between the U.S. dollar and the British pound starts at $1 = £0.5. It then changes to $1 = £0.75. Given this change, we would say that the U.S. dollar has _ while the British pound has _ . LO27.3 depreciated; appreciated ssssssssssssssssssssssssss. depreciated; depreciated tttttttttttttttttttttttttt. appreciated; depreciated uuuuuuuuuuuuuuuuuuuuuuuuuu. appreciated; appreciated Answer: c. appreciated; depreciated.

Feedback: The correct answer is that the U.S. dollar has appreciated, while the British pound has depreciated.

The U.S. dollar has appreciated because it has gained purchasing power. Whereas a single U.S. dollar could only purchase one-half of a British pound when the 1-571 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

exchange rate was $1 = £0.5, it can now purchase three-quarters of a British pound because of the change in the exchange rate to $1 = £0.75.

At the same time, this change in the exchange rate means that the British pound has lost purchasing power and has therefore depreciated in value. Whereas before it only took half a British pound to purchase a dollar when the exchange rate was $1 = £0.5, it now takes three-quarters of a British pound to purchase a dollar at the new exchange rate of $1= £0.75. With more British pounds now needed to purchase a dollar, the pound has weakened in value.

569. A meal at a McDonald‘s restaurant in New York costs $8. The identical meal at a McDonald‘s restaurant in London costs £4. According to the purchasing-power-parity theory of exchange rates, the exchange rate between U.S. dollars and British pounds should tend to move toward: LO27.3 $2 = £1. vvvvvvvvvvvvvvvvvvvvvvvvvv. $1 = £2. wwwwwwwwwwwwwwwwwwwwwwwwww. $4 = £1. xxxxxxxxxxxxxxxxxxxxxxxxxx. $1 = £4.

Answer: a. $2 = £1.

Feedback: The correct answer is that the purchasing-power-parity theory of exchange rates predicts that the exchange rate between U.S. dollars and British pounds should tend to move toward $2 = £1.

According to the theory, exchange rates should adjust so that they equate the purchasing powers of various currencies. Applying that logic to our McDonald‘s example, if a particular meal costs $8 in New York and £4 in London, the exchange rate should move to $2 = £1 so that a dollar spent in the United States will buy exactly as much output as it would if it were first converted into British pounds at the $2 = £1 exchange rate and then used to buy the identical meal at a McDonald‘s in London.

In this case, $8 if converted into pounds at the $2 = £1 exchange rate will yield £4, which is exactly enough to purchase the same meal at a McDonald‘s in London. Please remember, though, that actual exchange rates do not always move to equate the purchasing power of various currencies, even in the long run. Thus, economists only use purchasing power parity to give them a general sense of which way exchange rates are most likely to move.

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570. Suppose that the Fed is fixing the dollar-pound exchange rate at $2.50 = £1. If the Fed's reserve of pounds falls by £500 million, by how much would the supply of dollars increase, all other things equal? LO27.4 Answer: $1.25 billion (= 2.5 dollars per pound × 500 million pounds) Feedback: With the exchange rate fixed at $2.50 = £1, the Fed‘s supply of dollars would increase based upon the fixed value of the currency multiplied by the change in reserves (In this instance, 2.5 dollars per pound × 500 million pounds).

571. Suppose that the government of China is currently fixing the exchange rate between the U.S. dollar and the Chinese yuan at a rate of $1 = 6 yuan. Also suppose that at this exchange rate, the people who want to convert dollars to yuan are asking to convert $10 billion per day of dollars into yuan, while the people who are wanting to convert yuan into dollars are asking to convert 36 billion yuan per day into dollars.

What will happen to the size of China‘s official reserves of dollars? LO27.4 They will increase. yyyyyyyyyyyyyyyyyyyyyyyyyy. They will decrease. zzzzzzzzzzzzzzzzzzzzzzzzzz.

They will stay the same.

Answer: a. They will increase.

Feedback: The correct answer is that the size of China‘s official reserves of dollars will increase. To see why this is true, note that the people wanting to convert dollars into yuan will be showing up each day with $10 billion. At the same time, the people who wish to convert yuan into dollars will only be demanding $6 billion because at the exchange rate of $1 = 6 yuan, the 36 billion yuan that they want to convert into dollars each day equals exactly $6 billion. As a result, the official reserves of China will be increasing by $4 billion per day (= $10 billion of dollars arriving minus $6 billion of dollars leaving).

Keep in mind, however, that this increase in official reserves is caused entirely by China‘s decision to fix its exchange rate at its current level. If it were to allow the exchange rate to float and be determined by the forces of supply and demand, then the exchange rate would move to the market equilibrium level at which the quantity supplied of dollars would exactly equal the quantity demanded of dollars.

Thus, at the equilibrium exchange rate, there would be neither an increase nor a decrease in official reserves.

572. Suppose that a country follows a managed-float policy but that its exchange rate is currently floating freely. In addition, suppose that it has a massive current account deficit. Other things equal, are its official reserves increasing, decreasing, or staying the same? If it decides to engage in a currency intervention to reduce the size of its 1-573 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

current account deficit, will it buy or sell its own currency? As it does so, will its official reserves of foreign currencies get larger or smaller? LO27.5 Answer: Official reserves will stay the same, because under a float, there is no need to either buy or sell FX to affect the exchange rate.

If this country wishes to reduce its current account deficit, it must make its currency ―cheaper‖ in the market. That is, it must intervene in a way that causes its currency to depreciate, which will make this county‘s goods and services ―cheaper‖ in the international market. To accomplish this, the country will purchase foreign currency by selling its own currency (increasing the supply of home currency in the market), which will cause it to accumulate more foreign reserves.

573.

If the economy booms in the United States while going into recession in other countries, the U.S. trade deficit will tend to _ . LO27.6 increase aaaaaaaaaaaaaaaaaaaaaaaaaaa. decrease bbbbbbbbbbbbbbbbbbbbbbbbbbb. remain the same Answer: a. increase.

Feedback: If the U.S. economy booms while recessions start in other countries, the U.S. trade deficit will tend to increase. This will happen because rising incomes in the United States will increase the overall U.S. demand for goods and services—including foreign-made goods and services. Thus, U.S. imports of foreign-made goods and services will increase. That increase in imports will increase the size of the U.S. trade deficit.

At the same time, recessions in other countries will mean that incomes abroad will be falling. As a result, consumers in those other countries will demand less goods and services—including foreign-made goods and services. That implies that they will want less in the way of U.S.-made goods and services. Thus, U.S. exports will fall, thereby also increasing the size of the U.S. trade deficit. With U.S. imports increasing and U.S. exports decreasing, two factors will be simultaneously causing the U.S. trade deficit to increase.

574.

Other things equal, if the United States continually runs trade deficits, foreigners will own _ U.S. assets. LO27.6 more and more ccccccccccccccccccccccccccc. less and less ddddddddddddddddddddddddddd. the same amount of 1-574 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: a. more and more.

Feedback: If the U.S. continually runs trade deficits, foreigners will own more and more U.S. assets. This is true because U.S. purchases of foreign goods have to be paid for either with U.S. exports or with pre-existing U.S. assets. If the U.S. has a trade deficit, then, by definition, the value of U.S. exports is less than the value of U.S. imports—meaning that the U.S. is not able to fully pay for all of its imports with its current volume of exports. The remainder—the trade deficit— must then be paid for with pre-existing U.S. assets.

As a concrete example, if Ford exports $5 billion of cars but imports $6 billion of parts, then it must pay for the $1 billion difference with cash or some other preexisting asset acceptable to its foreign trading partners. To keep things simple, suppose that Ford pays the $1 billion difference with cash. Then $1 billion of cash has gone from U.S. ownership to foreign ownership. The foreigners may then use that $1 billion of cash to purchase U.S. real estate, U.S. government bonds, or any other type of U.S. asset. But the key point is that if the U.S. as a whole runs a trade deficit, then any excess of imports over exports must be paid for by transferring assets of equal value from U.S. ownership to foreign ownership. As a result, if the U.S. continually runs trade deficits, foreigners will own more and more U.S. assets.

PROBLEMS Alpha‘s balance-of-payments data for 2020 are shown below. All figures are in billions of dollars. What are the (a) balance on goods, (b) balance on goods and services, (c) balance on current account, and (d) balance on capital and financial account? LO27.2

Answer: a. $10; b. $15; c. $20; d. −$20 Feedback: 1-575 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Balance on goods: goods exports minus goods imports (reported as a negative value in table) = $40 − $30= $10 (surplus) ggggggggggggggg. Balance on goods and services: (goods exports minus goods imports) plus (service exports minus service imports (reported as a negative value in table)) = ($40 − $30) + ($15 − $10) = $10 + $5 = $15 (surplus) hhhhhhhhhhhhhhh. Balance on current account: (goods exports minus goods imports) plus (service exports minus service imports) plus net transfers (positive in table above because there was a greater inflow than outflow of transfers) plus net investment income (negative in table above because there was a greater outflow than inflow of investment income) = ($40 − $30) + ($15 − $10) + $10 + (−$5) = $20 (surplus) iiiiiiiiiiiiiii.

Balance on capital and financial account: Balance on the capital account plus (foreign purchases of assets minus domestic purchases of assets abroad) = $0 + ($20 − $40) = −$20 (deficit) 575. China had a $49.1 billion overall current account surplus in 2018. Assuming that China‘s net debt forgiveness was zero in 2018 (its capital account balance was zero), by how much did Chinese purchases of financial and real assets abroad exceed foreign purchases of Chinese financial and real assets. LO27.2 Answer: −$49.1 billion Feedback: To offset the current account surplus, China would have to have a deficit in the capital and financial account. Given the zero balance on the capital account, the surplus could only be achieved if China‘s purchases of financial and real assets abroad exceeded foreign purchases of Chinese assets. The surplus foreign currency generated by the trade surplus would either have to go to purchase foreign assets or be accumulated as official reserves in an amount equal to the current account surplus. Thus, the financial account balance would be a deficit of $49.1 billion (or −$49.1 billion).

576. Refer to following table, in which Qd is the quantity of loonies demanded, P is the dollar price of loonies, Qs is the quantity of loonies supplied in year 1, and Qs' is the quantity of loonies supplied in year 2. All quantities are in billions and the dollarloonie exchange rate is fully flexible. LO27.3

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What is the equilibrium dollar price of loonies in year 1? eeeeeeeeeeeeeeeeeeeeeeeeeee. What is the equilibrium dollar price of loonies in year 2? fffffffffffffffffffffffffff. Did the loonie appreciate or did it depreciate relative to the dollar between years 1 and 2? ggggggggggggggggggggggggggg.

Did the dollar appreciate or did it depreciate relative to the loonie between years 1 and 2? hhhhhhhhhhhhhhhhhhhhhhhhhhh.

Which one of the following could have caused the change in relative values of the dollar (used in the United States) and the loonie (used in Canada) between years 1 and 2: (1) More rapid inflation in the United States than in Canada; (2) an increase in the real interest rate in the United States but not in Canada; or (3) faster growth of income in the United States than in Canada.

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Answers: a. 115; b. 120; c. loonie appreciated; d. dollar depreciated; (1) More rapid inflation in the United States than in Canada.

Feedback: The equilibrium is 115, where Qd equals Qs (Qd = Qs =20). jjjjjjjjjjjjjjj. The equilibrium is 120, where Qd equals Q's (Qd = Q's =15). kkkkkkkkkkkkkkk. Since the price of the loonie increased (more dollars must now be given up to purchase one more loonie), the loonie appreciated. lllllllllllllll.

Since the price of the loonie increased (more dollars must now be given up to purchase one more loonie), the dollar depreciated. mmmmmmmmmmmmmmm.

(1) More rapid inflation in the United States than in Canada. The increase in the relative price of goods and services in the United States, as a result of inflation, reduces the quantity of loonies supplied to the market as Canadian consumers buy more 'home' goods and services.

577. Suppose that the current Canadian dollar (CAD) to U.S. dollar exchange rate is $0.85 CAD = $1 US and that the U.S. dollar price of an iPhone is $300. What is the Canadian dollar price of an iPhone? Next, suppose that the CAD to US dollar exchange rate moves to $0.96 CAD = $1 US. What is the new Canadian dollar price of an iPhone? Other things equal, would you expect Canada to import more or fewer iPhones at the new exchange rate? Explain. LO27.3 Answers: $255 CAD; $288; less.

Feedback: The exchange rate is $0.85 Canadian dollars for $1 U.S dollar. As a simple example, assume a candy bar costs $1 in the U.S. An individual with $0.85 Canadian cents could use this to purchase a U.S. dollar and buy the candy bar.

Thus, the candy bar only costs $0.85 in Canadian dollars (= 0.85 × $1).

We apply the same logic to the iPhone. The iPhone costs $300 U.S. dollars, which implies it costs $255 Canadian dollars (= 0.85 × $300).

If the CAD to US dollar exchange rate moves to $.96 CAD = $1 US, the price of the iPhone increases for Canadians (or individuals with Canadian currency) to $288 Canadian dollars (= 0.96 × $300).

Since the price of the iPhone increases for Canadians (the Canadian currency has depreciated), they will likely buy fewer (less) iPhones.

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578. Advanced Analysis Return to problem 3 and assume that the exchange rate is fixed at 110. In year 1, what would be the minimum initial size of the U.S. reserve of loonies such that the United States could maintain the peg throughout the year? What about the minimum initial size that would be necessary at the start of year 2? Next, consider only the data for year 1. What peg should the U.S. set if it wants the fixed exchange rate to increase the domestic money supply by $1.2 trillion? LO27.4 Answers: Minimum initial size of the U.S. reserve would be 10 billion loonies for year 1, 20 billion loonies for year 2, and the United States should set the exchange rate to 120 dollars per loonie.

Feedback: First, with the exchange rate fixed at 110 dollars = 1 loonie, the U.S. will need to begin year 1 with at least 10 billion loonies if it wants to maintain the fixed exchange rate because the quantity demanded of loonies Qd exceeds the quantity supplied Qs by 10 billion loonies in the bottom row of the table.

Second, with the exchange rate still fixed at 110 dollars = 1 loonie, the U.S. will need to begin year 2 with at least 20 billion loonies if it wants to maintain the fixed exchange rate because there is a 20 billion difference in the bottom row of the table between Qs' and Qd. Third, if the U.S. wants the fixed exchange rate regime to increase the domestic money supply by $1.2 trillion in year 1, it should set the fixed exchange rate at 120 dollars = 1 loonie. To see why, look in the table at the second row from the top. In that row, the exchange rate is 120 dollars = 1 loonie. But it is also the case in that row that the quantity supplied of loonies Qs exceeds the quantity demanded of loonies Qd by 10 billion loonies. To accommodate that excess supply of 10 billion loonies, the U.S. will have to increase the domestic money supply by 120 times as much, since the exchange rate is fixed at 120 dollars = 1 loonie. That implies that the U.S. domestic money supply will increase by $1.2 trillion (= 120 dollars per loonie times 10 billion loonies).

Appendix to Chapter 27: Previous International Exchange-Rate Systems McConnell Brue Flynn 23e DISCUSSION QUESTIONS 579. Compare and contrast the Bretton Woods system of exchange rates with that of the gold standard. What caused the collapse of the gold standard? What caused the demise of the Bretton Woods system? LO27.7 1-579 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer: The gold standard collapsed during the Great Depression because countries wanted to have free reign to print money to stimulate their economies.

They either abandoned the gold standard all together or re-pegged at lower gold valuations in order to depreciate their currencies and gain a leg up in international trade by making their products cheaper vis-a-vis foreign products.

The Bretton Woods system ended because the United States had run up large, annual current account deficits that increased the number of dollars in the world.

But the amount of gold backing them had not increased. So, it was either reduce the number of dollars (and thus likely hurt world trade and worldwide economic growth) or eliminate the current account deficit (which would have been politically unpopular in the United States as it would have necessitated austerity measures such as a permanently higher interest rate that would have slowed the U.S. economy).

REVIEW QUESTIONS 580. Think back to the gold standard period. If the United States suffered a recession, to what degree could it engage in expansionary monetary policy? LO27.7 Answer: The money supply could be expanded only to the extent that some fraction of current gold reserves had not previously been committed to backing currency or by increasing the government‘s gold reserves so as to back more money. In the first case, there is a specific limit (an uncommitted amount of gold) to how much new money can be created. In the second case, the government‘s ability to tax or borrow limits how much gold can be purchased to back new money issuance.

PROBLEMS Suppose Zeeland pegs its currency, the zee, at 1 zee = 36 grains of gold. Aeeland pegs its currency, the aeellar, at 1 aeellar = 10 grains of gold. LO27.7 iiiiiiiiiiiiiiiiiiiiiiiiiii.

What is the exchange rate be between the zee and the aellar? jjjjjjjjjjjjjjjjjjjjjjjjjjj.

How many aeellars could you get for 7 zees? kkkkkkkkkkkkkkkkkkkkkkkkkkk.

In terms of gold, would you rather have 14.5 zees or 53 aeellars?

Answer: a. The exchange rate would be 3.6 aeellars per 1 zee. b. You could get 25.2 aeellars per 1 zee. c. You would rather have 53 aeellears (= 530 grains of gold) than 14.5 zees (= 522 grains of gold).

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nnnnnnnnnnnnnnn. The exchange rate would be 3.6 aeellars per 1 zee. Let a = the number of aeellars per zee. 1 zee/36 grains = a/10 grains. Multiply both sides by 36 grains to get 1 zee = 3.6 aeellars. ooooooooooooooo.

You could get 25.2 aeellars for 7 zees (= 7 zees × 36 grains/zee = 252 grains of gold; 252 grains/10 grains per aeellar = 25.2 aeellars). ppppppppppppppp. You would rather have 53 aeellars (= 53 aeellars × 10 grains per aeellar = 530 grains of gold) than 14.5 zees (14.5 zees × 36 grains per zee = 522 grains of gold).

Chapter 28 - The Economics of Developing Countries McConnell Brue Flynn 23e DISCUSSION QUESTIONS 581. What are the four categories used by the World Bank to classify nations on the basis of national income per capita? Identify two nations for each of the four categories.

LO28.1 Answer: The World Bank classifies countries into high-income, upper-middleincome, lower-middle-income, and low-income categories on the basis of national income per capita. Answers will come from the list or map in this chapter.

582. Explain how the absolute per capita income gap between rich and poor nations might increase, even though per capita income (or output) is growing faster in DVCs than in IACs. LO28.1 Answer: Because base incomes are so much higher in IACs than in DVCs, slower growth as a proportion of GDP in these countries can still translate into higher absolute gains in per capita living standards, causing the absolute per capita income gap between IACs and DVCs to increase rather than decline.

For example, assume country A has a 1 percent rate of growth and current per capita income is $10,000. One year from now, this country will have a per capita income of $10,100 (= $10,000 + $100).

Now consider country B. This country‘s rate of growth is 3 percent and per capita income is $2,000. One year from now this country will have a per capita income of $2,060 (= $2,000 + $60).

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Although country B grew at a faster rate, it has become relatively poorer than country A in terms of absolute per capita income. Before economic growth, the per capita income difference between countries A and B was $8,000 (= $10,000 − $2,000). The difference after growth is $8,040 (= $10,100 − $2,060).

583. Explain how each of the following can be obstacles to the growth of income per capita in the DVCs: lack of natural resources, large populations, low labor productivity, poor infrastructure, and capital flight. LO28.2 Answer: A weak resource base can be a serious obstacle to growth. Real capital can be accumulated and the quality of the labor force improved through education and training. But it is not as easy to augment the natural resource base. Without access to natural resources, countries do not have the raw materials for large-scale production.

Large populations can reduce per capita income levels in a number of ways. First, high population growth reduces the amount of capital and raw materials available to future workers (reduced investment and lower productivity). Second, large populations tend to overuse natural resources (overgraze, etc.). Third, large populations may lead to urban congestion, which might increase crime and corruption. Finally, large populations might reduce investment in human capital (education) because large families have fewer resources per child.

Low labor productivity (which may be the result from the problems discussed above) can slow economic growth because workers produce less than their respective counterparts in the IACs with the same amount of resources. This could be the result of human capital accumulation differences and the quality of education.

Poor infrastructure will reduce the return to private investments because transportation costs are high. The transportation costs may be so high that no investment takes place for a particular industry.

Capital flight, human and physical, reduces the quantity and quality of capital available for production. This will slow growth as well.

584. What is the demographic transition? Contrast the demographic transition view of population growth with the traditional view that slower population growth is a prerequisite for rising living standards in the DVCs. LO28.2 Answer: The demographic transition is the process that a country‘s population goes through as the economy develops. The typical pattern is one where initial 1-582 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

growth is followed by a reduction in the mortality rate (better nutrition, sanitation, etc.). This reduction in the mortality rate results in an increase in population size and population growth. After households adjust their reproductive behavior to the new mortality rate and the higher per capita income level, the population growth rate falls and the population size stabilizes (see answer below).

Demographic transition view: Expanded output and income in developing countries will result in lower birthrates and slower growth of population. As incomes of primary family members expand, they begin to see the marginal cost of a larger family exceeding the marginal benefit. The policy emphasis should therefore be on economic growth. Traditional view: Developing nations should reduce population growth as a first priority. Slow population growth enables the growth of per capita income.

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585. As it relates to the vicious circle of poverty, what is meant by the saying ―Some DVCs stay poor because they are poor‖? Change the box labels as necessary in Figure 28.3 to explain rapid economic growth in countries such as South Korea and Chile.

What factors other than those contained in the figure might contribute to that growth?

LO28.3

Answer: The vicious circle of poverty concept implies that the poor countries of the world will remain poor because they do not have the resources (per capita income) necessary to invest in the factors required for sustained economic growth.

These factors could be education (human capital), physical capital, physical infrastructure, or social infrastructure (institutions).

To describe countries such as South Korea and Chile, we would need to change the labels on three boxes, leading to a change in the ―results‖ boxes. ―Rapid‖ population growth would change to ―low‖ rate of population growth; ―low‖ level of saving would change to ―high‖ level of saving; ―low‖ levels of investment in physical and human capital would change to ―high‖ levels of investment in physical and human capital. These three changes would result in higher productivity and higher per capita income, which would produce a rising level of demand. Other factors include a stable national government, a homogeneous population, extensive investment in infrastructure, a "will to develop," and strong private incentives..

586. Because real capital is supposed to earn a higher return where it is scarce, how do you explain the fact that most international investment flows to the IACs (where capital is relatively abundant) rather than to the DVCs (where capital is very scarce)?

LO28.3 Answer: Capital earns a higher return where it is scarce, other things equal.

However, when comparing investment opportunities between IACs and DVCs, other things are not equal. Advanced factories filled with specialized equipment 1-584 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

require a productive work force. IACs have an abundance of educated, experienced workers; these workers are scarce in DVCs. Also, IACs have extensive public infrastructures that increase the returns on private capital.

Example: a network of highways makes it more profitable to produce goods that need to be widely transported. Finally, investment returns must be adjusted for risk. IACs have stable governments and ―law and order,‖ reducing the risk of capital being ―nationalized‖ or pilfered by organized crime.

587. What factors cause failed states? List and discuss five policies that DVC governments might undertake to promote economic development and expansion of income per capita in their countries? LO28.4 Answer: Factors causing failed states include: banditry or intertribal warfare, political instability, corruption, and war or fear of war with neighboring countries; A failed state is a government that lacks the capacity to provide even basic government services such as elementary education, basic sanitation, and effective levels of law enforcement. Banditry or intertribal warfare, political instability, corruption, and war or fear of war with neighboring countries are all factors which divert attention and resources from the task of basic economic development.

Answers may include other factors as well.

The policies described below are policies that DVC governments might undertake to promote economic development and expansion of income per capita in their countries.

Establishing the rule of law Some of the poorest countries of the world are plagued by banditry and intertribal warfare that divert attention and resources from the task of development. A strong, stable national government is needed to establish domestic law and order and to achieve peace and unity.

Building Infrastructure Many obstacles to economic growth are related to an inadequate infrastructure. Sanitation and basic medical programs, education, irrigation and soil conservation projects, and construction of highways and transportation communication facilities are all essentially nonmarketable goods and services that yield widespread spillover benefits.

Embracing Globalization Other things equal, open economies that participate in international trade grow faster than closed economies.

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Building human capital Government programs that encourage literacy, education, and labor market skills enhance economic growth by building human capital. In particular, policies that close the education gap between women and men spur economic growth in developing countries. Promoting the education of women pays off in terms of reduced fertility, greater productivity, and greater emphasis on educating children.

Promoting Entrepreneurship The lack of a sizable and vigorous entrepreneurial class, ready and willing to accumulate capital and initiate production, indicates that in some DVCs private enterprise is not capable of spearheading the growth process.

Developing credit systems The banking systems in some of the poorest DVCs are nearly nonexistent and that makes it difficult for domestic savers and international lenders to lend money to DVC borrowers, who in turn wish to create capital goods.

Controlling population growth Government can provide information about birth control options. We have seen that slower population growth can convert increases in real output and income to increases in real per capita output and income. Families with fewer children consume less and save more; they also free up time for women for education and participation in the labor market. As women participate in the labor market, they tend to reduce their fertility rate, which further helps to control population growth.

Making peace with neighbors Countries at war or in fear of war with neighboring nations divert scarce resources to armaments, rather than to private capital or public infrastructure.

588. Do you think that the nature of the problems the DVCs face require a government-directed or a private-sector directed development process? Explain your reasoning.

LO28.4 Answer: Positive government contributions to development are evident in Japan, South Korea, and Taiwan. In contrast, Mobutu‘s Zaire, Somoza‘s Nicaragua, Marcos‘ Philippines, and Haiti under the Duvaliers are examples of corrupt and inept governments that functioned as impediments to economic progress. The revolutionary transformations of the former Soviet Union away from communism and toward market-oriented economies make clear that central planning is no longer recognized as an effective mechanism for development. Therefore, government focus should be on fostering an environment of economic incentives 1-586 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

and promoting competition among economic players for the purpose of sustainable growth.

589. Why do you think there is so much government corruption in some developing countries? LO28.4 Answer: There are a number of potential reasons why there is so much government corruption in some developing countries. (1) A small group of controlling elite (2) Low pay in the government sector (3) Lack of enforcement and punishment for corruption (4) Gains to the foreign sector.

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590. What types of products do the DVCs typically export? How do those exports relate to the law of comparative advantage? How do tariffs by IACs reduce DVCs‘ standard of living? LO28.5 Answer: DVCs export primarily raw materials and agricultural goods to IACs in return for imported manufactured goods and services. This pattern of trade follows from the law of comparative advantage. As far as the extraction of nonrenewable resources is concerned, past depletion of deposits in the IAC s has meant that DVCs are often the lowest-cost producers of these goods. As for renewable resources such as agricultural products, the production of these goods is usually labor intensive. The large pools of low-wage labor in DVCs give them a comparative advantage in many of these products.

It is important to note that the law of comparative advantage does not necessarily consign DVCs to be raw materials exporters forever. The production of many manufactured goods is also fairly labor-intensive, giving DVCs an opportunity to become low-cost producers and hence exporters of these products. Many have already begun to develop thriving manufacturing sectors based on this cost advantage, and if trade barriers in IACs continue to be lowered, this trend will be intensified, living standards will rise, and more efficient use of world resources will result. Tariffs by IA Cs can reduce the standard of living in DVCs by making DVCs exports less competitive, thus reducing trade opportunities.

591. Do you favor debt forgiveness to all DVCs, just the poorest ones, or none at all? What incentive problem might debt relief create? Would you be willing to pay $20 a year more in personal income taxes for debt forgiveness? How about $200? How about $2,000? LO28.5 Answer: Debt forgiveness to the poorest nations may allow them to devote these interest payments to needed social programs—especially investment in human capital programs like education. Countries requesting forgiveness could be required to submit a plan for using these funds for productive purposes before the debt is forgiven. Debt relief might reduce incentives for careful borrowing and saving for future growth. If countries believe loans are gifts, it might encourage reckless spending.

The answers to the last 3 questions are based on personal views, but students should realize that the U.S. currently grants $15-28 billion per year in total foreign aid or about $66 per person per year.

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592. Do you think that IACs such as the United States should open their doors wider to the immigration of low-skilled DVC workers as a way to help the DVCs develop? Do you think that it is appropriate for students from DVC nations to stay in IAC nations to work and build careers? LO28.5 Answer: IACs could help the DVCs by accepting more temporary workers from the DVCs. Temporary migration is not only an outlet for surplus DVC labor but also a source of income in the form of migrant remittance to their families in the home country.

If the goal of IACs is to encourage development in the DVCs, then the IACs should discourage ―brain drains‖ from the DVCs. If IACs recruit the best and brightest students from DVC nations and try to train these students in the workforce, DVCs human capital stock will be drained. In the long run, the DVCs development will be slowed.

593. LAST WORD Explain the differences among microcredit, conditional cash transfers, and unconditional cash transfers. Then explain how effective each policy has been.

Answer: Microcredit provides small loans directly to individuals to invest in items to help them improve their ability to earn income. Conditional cash transfers provide poor families with cash (transfers or grants) provided they meet conditions such as sending their children to school or accepting proper preventive medical care. Unconditional cash transfer programs give cash to poor adults with no conditions attached.

Randomized experiments show that, on average, the households and individuals receiving microcredit usually do no better than nonrecipients on economic, health, and social outcomes such as family income, the total number of calories consumed, or rates of school attendance.

Conditional cash transfer programs have been in existence only since the early 1990s, but some very positive outcomes have already been demonstrated. The programs have been shown to increase school enrollment by up to 30 percent and to improve health and nutrition so much that rates of illness among young children fall more than 10 percent while children enrolled in the program end up significantly taller than children not in the program. Unfortunately, the effectiveness of conditional cash transfer programs in relieving poverty is limited by other factors in developing countries. As just one example, school enrollment goes up but test scores stay the same—probably because the schools themselves are poorly funded and often ineffective. Similarly, the wages earned by the students who stay in school longer don‘t seem to be much higher than those of the students who dropped out earlier.

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Early testing of unconditional cash transfers has shown some promise. However, because unconditional cash transfer programs are quite new, it is not clear yet whether their early promise can be replicated in other places or even why granting cash unconditionally to the poor seems to work better than either conditional cash transfers or microfinance. Experiments are underway to find out.

REVIEW QUESTIONS True or False: The term developing country (DVC) is applied to rich nations like the United States and Germany because their economies are always growing quickly by developing new technologies. LO28.1 Answer: False.

Feedback: This statement is false because rich countries like the United States and Germany are actually categorized as industrially advanced economies (IACs) due to their utilizing the most technologically sophisticated industrial and productive technologies.

By contrast, poorer countries that are not yet using the most cutting-edge industrial technologies and that have not yet managed to raise living standards by applying high productivity production methods are referred to as developing countries (DVCs) because they are currently developing those capabilities.

594. True or False: A DVC that has little in the way of natural resources is destined to remain poor. LO28.2 Answer: False.

Feedback: This statement is false because the examples of Japan, Singapore, South Korea, the Netherlands, and Belgium all indicate that a country that is poor in resources may still develop and become rich.

The key is making sure that even if a country lacks natural resources, its population is well educated and able to utilize the most advanced technologies.

Resources that the country does not itself possess can then be imported, converted into useful products, and either used domestically or exported at a profit.

Thus, while things are easier for countries that are blessed with abundant natural resources, a lack of resources in no way condemns a country to be poor or to remain poor.

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595. Suppose a country‘s total output is growing 10 percent per year but its population is growing 11 percent per year. What will happen to living standards? LO28.2 lllllllllllllllllllllllllll.

They will rise. mmmmmmmmmmmmmmmmmmmmmmmmmmm. They will fall. nnnnnnnnnnnnnnnnnnnnnnnnnnn.

They will remain the same.

Answer: b. They will fall.

Feedback: If a country‘s population is growing faster than its output, average living standards will fall as there will be less output per person.

To avoid this problem, most DVCs have put a strong emphasis on reducing their population growth rates so that output increases can have a good chance of outpacing population increases and thereby raising the average standard of living.

596. A DVC‘s population is growing 2 percent per year and its output is growing 3 percent per year. If the government wants to improve living standards over coming decades, which of the following would probably be the best savings rate for the economy?

LO28.2 0 percent ooooooooooooooooooooooooooo.

2 percent ppppppppppppppppppppppppppp.

5 percent qqqqqqqqqqqqqqqqqqqqqqqqqqq.

10 percent Answer: d. 10 percent.

Feedback: Because higher savings rates lead to more investment and more output, the best answer to this question is the largest savings rate found among the four options: 10 percent.

That is the best answer because a DVC will want to save a great deal in order to fund a large amount of investment so that in coming years its workers will be able to work with more and better capital and thereby be more productive.

By contrast, an economy that has a low savings rate will not be able to increase the quantity or quality of the capital used by its workers—and thus will not be able to increase productivity or living standards.

Consequently, of the four savings rates listed here, the best one is the one that is largest, 10 percent.

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597.

Compare a hypothetical DVC with a hypothetical IAC. In the DVC, average per capita income is $500 per year. In the IAC, average per capita income is $40,000 per year. If both countries have a savings rate of 10 percent per year, the amount of savings per capita in the DVC will be _ per person per year while in the IAC it will be _ per person per year. LO28.3 $50; $4,000. rrrrrrrrrrrrrrrrrrrrrrrrrrr. $5; $400. sssssssssssssssssssssssssss. $450; $36,000. ttttttttttttttttttttttttttt.

None of the above.

Answer: a. $50, $4,000.

Feedback: The correct answer is that the amount of savings per capita in the DVC will be $50 per person per year (= 10 percent savings rate times $500 per person per year of income) while in the IAC it will be $4,000 per person per year (= 10 percent savings rate times $40,000 per person per year of income).

The key point to take away from these computations is just how bad poverty is for getting out of poverty. The poorer a country is, the harder it becomes for it to substantially increase its capital stock and, by extension, the amount of output per worker that it will be able to generate for its population.

598. Which of the following policies would economists consider to be actions by a DVC government that will improve growth prospects? LO28.4 Choose one or more answers from the choices shown.

Helping to extend the banking system to the rural poor. uuuuuuuuuuuuuuuuuuuuuuuuuuu.

Passing high tariffs against foreign products. vvvvvvvvvvvvvvvvvvvvvvvvvvv.

Constructing better ports, roads, and Internet networks. wwwwwwwwwwwwwwwwwwwwwwwwwww.

Charging high fees for public elementary schools.

Answer: a. Helping to extend the banking system to the rural poor; and c.

Constructing better ports, roads, and Internet networks.

Feedback: The two policies that economists would consider to be likely to improve a DVC‘s growth prospects are helping to extend the banking system to the rural poor and constructing better ports, roads, and Internet networks.

Helping to extend the banking system to the rural poor would make it much easier for impoverished rural entrepreneurs to get the loans that they need to fund new businesses.

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Currently, the rural poor that live in DVCs often lack access to banks and other institutions that can help them obtain the credit that they need to start new businesses and improve their own economic prospects. By extending the banking system to rural areas, the government can help to mitigate these ―credit constraints.‖

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Constructing better ports, roads, and Internet networks is very likely to improve a DVC‘s growth prospects because better infrastructure lowers the cost doing business. For instance, better ports and roads make it much less expensive to move inputs from resource suppliers to the firms that will transform them into desirable products. Better infrastructure also makes it much less expensive to distribute the output produced by domestic firms to both local and foreign consumers. At the same time, better Internet networks allow for improved communication both domestically and with the rest of the world so that ideas can flow more quickly and Internet-based service businesses can flourish.

By contrast, passing high tariffs against foreign products will reduce international trade and typically lessen economic growth by preventing the adoption of good ideas from abroad and by allowing inefficient local firms to keep on being inefficient without any real threat of competition.

Charging high fees for public elementary schools is also bad for growth because it is likely to discourage parents from sending their children to school. That will lower future growth rates because the average worker will be less educated and, consequently, less able to successfully utilize the most advanced technologies.

In addition, fewer people will have the training necessary for them to become innovators and inventors. Thus, the country will also reduce its ability to generate growth through invention and innovation.

599. True or False: Economists are unanimous that foreign aid greatly helps DVCs. LO28.5 Answer: False.

Feedback: This statement is false because a number of economists have argued that foreign aid often ends up doing little good for the average person living in a DVC that receives foreign aid.

These critics argue that foreign aid often fails to improve the situation in DVCs due to corruption and dependency. With respect to corruption, a large fraction of foreign aid is often misdirected by local governments toward powerful individuals or toward well-connected interest groups. With respect to dependency, the presence of foreign aid can remove the immediate financial pressure that would otherwise force a DVC‘s government to make the fundamental institutional changes that would be necessary for sustained, independent economic growth.

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600. True or False: Some economists argue that the single best thing that IACs could do for DVCs in terms of economic growth is to eliminate trade barriers between IACs and DVCs. LO28.5 Answer: True.

Feedback: This statement is true because many economists do indeed argue that the single best thing that IACs could do for DVCs is to eliminate trade barriers between IACs and DVCs. The benefits to DVCs come two in major categories. First, many industries in DVCs, especially agricultural industries and natural-resource extraction industries, would do very well and could support a lot of relatively good-paying jobs if trade restrictions with richer nations were removed. Second, increased trade between IACs and DVCs tends to increase the rate at which advanced technology flows from IACs to DVCs. This often happens because firms in IACs will open up factories in DVCs, hoping to combine highly productive IAC technologies with inexpensive DVC labor costs. But in just a few years, locals learn how to operate the new technologies and often found competing firms of their own that displace the foreign companies, and in some cases even go on to export products back to the DVCs and compete with DVC firms in their home territories. Thus, international trade also helps the growth of DVCs by increasing the rate at which highly productive IAC technology is adopted by DVC firms.

PROBLEMS Assume a DVC and an IAC presently have real per capita outputs of $500 and $50,000, respectively. If both nations have a 3 percent increase in their real per capita outputs, by how much will the per capita output gap change? LO28.1 Answer: $1,485 Feedback: First, we need to calculate the new levels of real per capita output for each county.

DVC: Initial real per capita output = $500; real per capita output after growth = $515 [= (1 + 0.03)$500].

IAC: Initial real per capita output = $50,000; real per capita output after growth = $51,500 [= (1 + 0.03)$50,000].

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Second, calculate the actual output gaps.

Prior to growth, the gap in real per capita output was $49,500 (= $50,000 − $500).

After growth, the gap in real per capita output is $50,985 (= $51,500 − $515).

Finally, calculate the change in the output gap.

The change in the output gap is $1,485 (= $50,985 − $49,500) 601. Assume that a very tiny and very poor DVC has income per capita of $300 and total national income of $3 million. How large is its population? If its population grows by 2 percent in some year while its total income grows by 3 percent, what will be its new income per capita rounded to full dollars? If population had not grown during the year, what would have been its income per capita? LO28.2 Answers: 10,000; $303; $309.

Feedback: To find the population, divide the country‘s total national income by the country‘s per capita income.

Population = Total National Income / per capita Income = $3,000,000/$300 = 10,000 If the country‘s population grows at 2% a year, its population next year is 10,200 [= (1 + 0.02) × 10,000] If the country‘s total income grows at 3% a year its total income next year is $3,090,000 [= (1 + 0.03) × $3,000,000].

The country‘s new per capita income equals total national income divided by the population size.

Per Capita Income = Total National Income / Population = $3,090,000/10,200 = $302.94 (or rounded to the nearest dollar = $303) The country‘s new per capita income equals total national income divided by the original population size if the population does not grow.

Per Capita Income = Total National Income / Population = $3,090,000/10,000 = $309 (or rounded to the nearest dollar = $309) 1-598 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

1-599 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.