Solution Manual for Microeconomics Principles & Policy 14th Edition by William J. Baumol, Alan S. Bl

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Part II/Solutions

PART II SOLUTIONS

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Chapter 1/What is Economics?

CHAPTER 1 WHAT IS ECONOMICS? DISCUSSION QUESTIONS 1. Think about a way you would construct a model of how your college is governed. Which officers and administrators would you include and exclude from your model if the objective were one of the following: a. To explain how decisions on financial aid are made b.To explain the quality of the faculty Relate this to the map example in the chapter.

This question is designed to make students construct their own version of the map example. A good answer is one in which (i) the people who are principally involved in the decision are identified, (ii) the flow of information and persuasion between those people is outlined and (iii) extraneous detail is eliminated. The ―model‖ is likely to be quite different for part (a) and part (b). Thus decisions on financial aid may depend upon the trustees, who set overall policy and attempt to raise funds; the president, who allocates the college budget; the admissions office, which determines what portion of each class is financially needy; and the counselors in the financial aid office, who make decisions about individual cases. Information about policy flows from the top of the bureaucratic hierarchy, and information about need from the bottom. In part (b), faculty quality may be determined by the trustees, who may be responsible for setting salary levels; the president or dean, who must agree to each faculty appointment and promotion; and the faculty committees in each department and division, that search for potential appointees. Instructors who assign this question may be amazed at the image of their institution’s structure held by the students.

2. Relate the process of abstraction to the way you take notes in a lecture. Why do you not try to transcribe every word uttered by the lecturer? Why don’t you write down just the title of the lecture and stop there? How do you decide, roughly speaking, on the correct amount of detail?

Most students are familiar with the need to abstract from detail, and take notes only about the essential points. The student will want enough detail to be able to reconstruct the instructor’s argument, but not so much detail as to obscure the main point. It is unlikely that simply writing down the title of the lecture will enable the student to recall the main arguments at a later date. The choices of how much detail, and what particular detail, are similar to the choices an economist makes in thinking about a problem, that is to say, in constructing a model. [This is a good opportunity to discuss note-taking with the students. While most understand the basic idea, few are skilled at it. Take a look at a few students’ lecture notes, and ask whether you would be comfortable learning economics from those notes.] © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

3. Explain why a government policy maker cannot afford to ignore economic theory.

Without theory, an economist (or anyone else) can only assemble facts, but she cannot understand the relationship between those facts, in particular the cause-and-effect relationships. For example, a person who ignores theory can notice that average prices sometimes rise a short time after the country’s money supply increases, but has no way of knowing whether there is a causal relationship between those two phenomena, or whether they are just coincidences. A government policy maker who wants to change something in the country only has a few policy ―tools‖ to use, and so she must have a theory to indicate to her whether changing one of those tools is likely to have the desired result in the country.

APPENDIX—USING GRAPHS: A REVIEW TEST YOURSELF 1. Portray the following hypothetical data on a two variable diagram: Academic Year Total Enrollment Enrollment in Economics Courses 2012–2013 3,000 300 2013–2014 3,100 325 2014–2015 3,200 350 2015–2016 3,300 375 2016–2017 3,400 400 Measure the slope of the resulting line, and explain what this number means Slope is 100 interpreted as 100 new students each academic year.

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Chapter 1/What is Economics?

Slope is 25 interpreted as 25 new economics students each academic year.

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Chapter 1/What is Economics?

2. From Figure 5, calculate the slope of the curve at point M. Slope is 0.

3. Arthur believes that the number of job offers he will get depends on the number of courses in which his grade is B+ or better. He concludes from observation that the following figures are typical: Number of grades of B+ 0 1 2 3 4 or better 1 3 4 5 6 Number of job offers Put these numbers into a graph like Figure 1(a). Measure and interpret the slopes between adjacent dots.

A marginal increase in the number of job offers is relatively larger with the first good grade compared to additional good grades.

4. In Figure 6, determine the values of X and Y at point K and at point E . What do you conclude about the slopes of the lines on which K and E are located?

K = (2,2); E = (2,1) The slope of 1 for the line on which K is located indicates that this is the steeper of the two curves. On this curve, the variable on the vertical axis responds more significantly to a change in the variable on the horizontal axis.

5. In Figure 8, interpret the economic meaning of points A and B. What do the two points have in common? What is the difference in their economic interpretation? © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

A => 30 hours labor and 40 yds. cloth = 20 units of output.

B => 40 hours labor and 28 yds. cloth = 20 units of output.

Common: 20 units of output; Difference: Amount of labor and cloth change—more labor, less cloth.

CHAPTER 2 THE ECONOMY: MYTH AND REALITY DISCUSSION QUESTIONS 1. Which is the biggest national economy on earth? Why has it remained bigger than other countries with much larger labor forces or those with higher per capita incomes?

The United States is the country with the largest economy in the world. The relatively large population in the U.S. is a contributing factor but productivity of workers and accumulated wealth are significant reasons why the U.S. economy is so large.

2. What is meant by a ―factor of production‖? Have you ever sold any on a market?

A factor of production, or input, is something that is used to produce a finished good known as ―output.‖ There are several possible answers, but probably most students have been employed in some capacity (babysitter, paperboy, or a campus job), so they have sold their labor in the market to produce output.

3. Why do you think per capita income in Maryland is nearly double that in Mississippi?

There are several possible answers to this question—the question is designed to get students to think about these differences before using models. One straightforward answer is that the factors of production in Maryland produce output that is worth more than what is produced in Mississippi. This could be because labor is more productive in Maryland because of a better educated workforce. Another answer is that the cost of living is higher in Maryland than it is in Mississippi.

4. Roughly speaking, what fraction of U.S. labor works in factories? In service businesses? In government?

Roughly 14 percent produce goods, 71 percent are service workers, and approximately 15 percent work in federal, state, and local government.

5. Most American businesses are small, but most of the output is produced by large businesses. That sounds paradoxical. How can it be true?

While there are many small businesses in the U.S. economy, the value of what they produce is relatively small. For example, a local grocer cannot produce the same amount © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

as a large national grocery store. It would take several small grocers to match the production of a large store. So, while a large retailer like Wal-Mart is considered to be one business, its production exceeds that of a smaller business.

6. What is the role of government in a mixed economy?

The government is a referee—it enforces laws and establishes order. The government is a business regulator—it imposes restrictions on businesses on society’s behalf. The government provides security through national defense. The government levies taxes to finance its spending. Finally, the government redistributes income from high income households to lower-income ones.

CHAPTER 3 THE FUNDAMENTAL ECONOMIC PROBLEM: SCARCITY AND CHOICE TEST YOURSELF 1. A person rents a house for $24,000 per year. The house can be purchased for $200,000, and the tenant has this much money in a bank account that pays 4 percent interest per year. Is buying the house a good deal for the tenant? Where does opportunity cost enter the picture?

This question asks the students to apply opportunity cost to a straightforward decision: to rent or buy. After buying the house, the person would no longer have to pay $24,000 annual rent. On the other hand, she would lose the $8,000 she currently earns in interest from her bank account. She would be ahead by $16,000, and the purchase is therefore a good deal. In order to get a service (housing) for which she had been willing to pay $24,000, she only has to give up (that is, the opportunity cost is) goods and services worth $8,000. It is worth pointing out to students that if she did continue to rent the house, it must be because the services she receives from the landlord are worth more than $16,000. Also, it is important to realize that this question is very simplified—it ignores home equity, property taxes, etc.

2. Graphically show the production possibilities frontier for the nation of Stromboli, using the data given in the following table. Does the principle of increasing cost hold in Stromboli?

Stromboli’s 2018 Production Possibilities Pizzas per Year Pizza Ovens per Year 75,000,000 0 60,000,000 6,000 45,000,000 11,000 30,000,000 15,000 © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

15,000,000 18,000 0 20,000 Figure 1 shows the production possibilities frontier. The principle of increasing cost holds, because the curve is concave. For example, begin at the point of producing 20 pizza ovens and 0 pizzas. To produce 15 pizzas we must give up the production of 2 pizza ovens; this brings us the point of 18 pizza ovens and 15 pizzas. To gain another 15 pizzas, we must now give up the production of 3 pizza ovens. As we continue to produce more pizzas we must give up increasing quantities of pizza ovens. There are diminishing returns as resources are shifted from pizzas to pizza ovens, or vice versa.

FIGURE 1 (Pizza numbers are in millions, ovens are in thousands)

3. Consider two alternatives for Stromboli is 2018. In one case (a) its inhabitants eat 60 million pizzas and build 6,000 pizza ovens. In case (b), the population eats 15million pizzas but builds 18,000 ovens. Which case will lead to a more generous production possibilities frontier for Stomboli in 2018?

In case (b), the production possibilities frontier will be further from the origin in future years, since Stromboli will have more pizza ovens with which it can produce more pizzas.

4. Jasmine’s Snack Shop sells two brands of potato chips. She produces them by buying them from a wholesale supplier. Brand X costs Jasmine $1 per bag, and Brand Y costs her $1.40. Draw Jasmine’s production possibilities frontier if she has $280 budgeted to spend on the purchase of potato chips from the wholesaler. Why is it not ―bowed out‖?

Figure 2 shows the production possibilities frontier. It is a straight line rather than a curve, because for each additional box of brand X that Jasmine buys, no matter how many boxes she already has, she must cut her purchases of Brand Y by the same amount.

The production possibilities frontier in this question is really like a budget constraint.

Brand X is $1.00, Brand Y is $1.40.

FIGURE 2

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Chapter 1/What is Economics?

DISCUSSION QUESTIONS 1. Discuss the resource limitations that affect a. the poorest person on earth b. the richest person in the United States c. a farmer in Kansas d. the government of Indonesia (a) The poorest person on earth has access to so few resources that she is in danger of perishing. The opportunity cost of any additional good or service is life threatening.

For example, if she takes the time to cut and sharpen a stick for hunting, she may not be able to gather the food she needs to stay alive. (b) Even the richest person in America faces resource limitations. If he buys a shipping company, he will lack the resources to buy an oil company. He is constantly approached for philanthropic donations; he cannot support them all, and if he increases his donations, he may lack the funds to expand into new business ventures. (c) A farmer in Kansas (or anywhere) has limited resources with which to produce goods, and therefore hard choices to make. If she produces more wheat, she will have to cut back its production of soybeans. (d) The government of Indonesia has the authority to command the use of a certain amount of labor and other productive resources. If it decides to increase the production of petroleum, it will have to shift some productive resources away from another use, thereby causing the output of coffee, for example, to fall.

2. If you were president of your college, what would you change if your budget were cut by 10 percent? By 25 percent? By 50 percent?

This question will help students begin to develop a better understanding of their institution. They may be surprised to learn that about 90 percent of the college’s budget goes to wages and benefits—and that therefore a reduction in the budget implies a reduction in programs and the laying off of people. An important trade-off to consider is between the level of services per student on the one hand and the size of the student body on the other.

3. If you were to leave college, what things would change in your life? What, then, is the opportunity cost of your education? © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

The answer to this question obviously depends upon the student. Students should be encouraged to think broadly. A student who leaves college would not have to pay tuition and fees, nor the college room and board expenses (on the other hand, these may be paid currently by her parents, so they would not represent a savings to her). She would earn money from a job, but she might have to pay for her own living expenses. The point to stress is that the opportunity cost of a college education includes indirect items (such as income foregone from a job) as well as costs that the student pays directly.

4. Raising chickens requires several types of feed, such as corn and soy meal. Consider a farm in the former Soviet Union. Try to describe how decisions on the number of chickens to be raised, and the amount of each feed to use in raising them, were made under the old communist regime. If the farm is now privately owned, how does the market guide the decisions that used to be made by the central planning agency?

Under the former communist regime, the farmer was allocated a certain amount of each type of feed, at a fixed cost, and was also given a quota for the number of chickens to be produced. The farmer did as he was told, and took few if any risks or innovations. Under private enterprise now, the farmer can get richer by producing more chickens. He is free to buy any combination of feed grains, subject only to the limit of his budget, at the going market prices. Through a process of trial and error, he will select the combination of feed grains that maximizes his profit—and if the price of soy meal rises, he will shift toward corn. The price of soy meal will in fact rise if soy meal becomes scarcer in the economy as a whole. Thus the market system leads the farmer to economize in his use of a resource that is becoming increasingly scarce—a task that used to be the responsibility of the central planning agency.

5. The United States is one of the world’s wealthiest countries. Think of a recent case in which the decisions of the U.S. government were severely constrained by scarcity.

Describe the trade-offs that were involved. What were the opportunity costs of the decisions that were actually made?

There are countless good answers to this question. An increase in defense purchases, for example, may require a reduction in educational expenditures. For some students, it may also be important to note that a larger deficit now may lead to a decrease in expenditures in the future.

CHAPTER 4 SUPPLY AND DEMAND: AN INITIAL LOOK TEST YOURSELF 1. What shapes would you expect for the following demand curves? a. A medicine that means life or death for a patient b. French fries in a food court with kiosks offering many types of food © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

(a) The demand curve for a medicine that means life or death for a patient will be vertical. One would not expect a decline in quantity demanded as the price rises, if that decline meant that the patient would die. (b) The demand curve for french fries in a food court with many other stands will be fairly flat, perhaps even horizontal. If the firm raises its price at all, many if not most of its customers will just move to a different stand. Thus a small change in price results in a large change in the amount of fries bought.

2. The following are the assumed supply and demand schedules for hamburgers in Collegetown: Demand Schedule Supply Schedule Price Quantity Price Quantity Demanded Supplied per Year per Year (thousands) (thousands) $2.75 14 $2.75 32 2.50 18 2.5 30 2.25 22 2.25 28 2 26 2 26 1.75 30 1.75 24 1.5 34 1.5 22 a. Plot the supply and demand curves and indicate the equilibrium price and quantity. b. What effect would a decrease in the price of beef (a hamburger input) have on the equilibrium price and quantity of hamburgers, assuming all other things remained constant? Explain your answer with the help of a diagram. c. What effect would an increase in the price of pizza (a substitute commodity) have on the equilibrium price and quantity of hamburgers, assuming again that all other things remain constant? Use a diagram in your answer.

The answers to all three parts are shown in Figure 1. (a) Initially, the equilibrium price is $2.00, and the equilibrium quantity is 26,000 hamburgers, as shown by the intersection of D0 and S0. (b) The decrease in the price of beef increases the supply of hamburgers, from S0 to S1.

So the equilibrium price falls and the equilibrium quantity rises. (c) Returning to the original supply curve, an increase in the price of pizza raises the demand for hamburgers, to D1. This raises the price and raises the quantity.

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Chapter 1/What is Economics?

FIGURE 1

3. Suppose the supply and demand schedules for bicycles are as they appear in the following table.

Price Quantity Quantity Demanded Supplied per per Year Year (millions) (millions) $170 43 27 210 39 31 250 35 35 300 31 39 330 27 43 370 23 47 a. Graph these curves and show the equilibrium price and quantity. b. Now suppose that it becomes unfashionable to ride a bicycle, so that the quantity demanded at each price falls by 8 million bikes per year. What is the new equilibrium price and quantity? Show this solution graphically. Explain why the quantity falls by less than 8 million bikes per year. c. Suppose instead that several major bicycle producers go out of business, thereby reducing the quantity supplied by 8 million bikes at every price. Find the new equilibrium price and quantity, and show it graphically. Explain again why quantity falls by less than 8 million. d. What are the equilibrium price and quantity if the shifts described in Test Yourself Questions 3(b) and 3(c) happen at the same time?

The answers to all three parts are shown in Figure 2. (a) Initially, the equilibrium price is $250, and the equilibrium quantity is 35 million bicycles, as shown by the intersection of D0 and S0. (b) If demand falls by 8 million bikes per year, the new demand curve is D1. The price falls to $210, and the quantity falls to 31 million, as shown by the intersection of D1 © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

and S0. Although demand falls by 8 million at each price, the quantity exchanged falls by only 4 million because the price fall has induced a movement out along the new demand curve, as well as a movement back along the old supply curve. (c) If supply falls by 8 million bikes per year, the new supply curve is S1. The price rises to $300, and the quantity falls to 31 million, as shown by the intersection of D0 and S1. Although supply falls by 8 million at each price, the quantity exchanged falls by only 4 million because the price increase has induced a movement out along the new supply curve, as well as a movement back along the old demand curve. (d) If demand and supply each fall by 8 million bikes per year, the equilibrium price is $250, and the equilibrium quantity is 27 million bicycles, as shown by the intersection of D1 and S1.

FIGURE 2

4.

The following table summarizes information about the market for principles of economics textbooks: Price Quantity Quantity Demanded per Supplied per Year Year $45 4,300 300 55 2,300 700 65 1,300 1,300 75 800 2,100 85 650 3,100 a. What is the market equilibrium price and quantity of textbooks? b. To quell outrage over tuition increases, the college places a $55 limit on the price of textbooks. How many textbooks will be sold now? c. While the price limit is still in effect, automated publishing increases the efficiency of textbook production. Show graphically the likely effect of this innovation on the market price and quantity.

The answers to all three parts are shown in Figure 3. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

(a) In market equilibrium, the price is $65 and the quantity is 1,300, as shown by the intersection of D0 and S0. (b) When the price ceiling of $55 is imposed, the quantity sold falls to 700, because this is all that sellers are willing to offer, even though buyers would prefer to buy 2,300 books. (c) When the efficiency of publishing improves, the supply curve will move out, perhaps to S1. As shown, the price is still $55, the quantity supplied has risen above 1,300, and there is still a shortage. There are two other possibilities, however. Supply could increase enough to intersect with demand at a price of $55, in which case 2,300 books would be sold and the shortage would disappear. If the increase in supply were even greater, the price ceiling would be ineffective, the price would fall below $55 and the quantity sold would rise above 2,300.

FIGURE 3

5. How are the following demand curves likely to shift in response to the indicated changes? a. The effect of a drought on the demand curve for umbrellas b. The effect of higher popcorn prices on the demand curve for movie tickets c. The effect on the demand curve for coffee of a decline in the price of Coca-Cola

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Chapter 1/What is Economics?

The same diagram, Figure 4, can be used for all three cases, because they all entail a decline in demand, from D0 to D1. Price falls from P0 to P1, and quantity falls from Q0 to Q1. (a) In a drought, people have less need for umbrellas, so demand falls. (b) Popcorn is a complement for movie tickets, so when popcorn prices rise, the demand for tickets falls. (c) Coca-Cola is a substitute for coffee, so when the price of the soda falls, the demand for coffee falls.

FIGURE 4

6.

7.

Which of the following items are likely to be normal goods for a typical consumer?

Which are likely to be inferior goods? a. Expensive perfume b. Paper plates c. Secondhand clothing d. Overseas trips Normal goods are goods for which demand increases (decreases) and income rises (falls).

Inferior goods are goods for which demand increases (decreases) and income falls (rises). (a) Normal (b) Inferior (c) Inferior (d) Normal The two accompanying diagrams show supply and demand curves for two substitute commodities: regular cell phones and smartphones. a. On the right-hand diagram, show what happens when rising raw material prices make it costlier to produce regular cell phones. b. On the left-hand diagram, show what happens to the market for

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Chapter 1/What is Economics?

smartphones. (a) As Figure 5 (b) shows, the supply of regular cell phones falls from S0 to S1. This leads to an increase in price to P1 and a reduction in quantity to Q1. (b) In Figure 5 (a), the demand for smartphones, a substitute for regular cell phones, rises when the price of regular cell phones rises. Therefore there is both a higher price and a higher quantity of smartphones.

FIGURE 5

8. Consider the market for beef discussed in this chapter (Tables 1 through 3 and Figures 1 and 8). Suppose that the government decides to fight cholesterol by levying a tax of 50 cents per pound on sales of beef. Follow these steps to analyze the effects of the tax: a. Construct the new supply schedule (to replace Table 2) that relates quantity supplied to the price that consumers pay. b. Graph the new supply curve constructed in Test Yourself Question 7(a) on the supply-demand diagram depicted in Figure 7. c. Does the tax succeed in its goal of reducing the consumption of beef? d. Is the price rise greater than, equal to, or less than the 50-cent tax? e. Who actually pays the tax, consumers or producers? (This may be a good question to discuss in class.) (a) With a 50-cent tax per pound of beef, Table 2 in the text must be adjusted: Price Paid by Consumers (dollars per pound) 8.00 7.90 7.80 7.70 7.60 7.50 7.40

Price Received by Farmers (dollars per pound) 7.50 7.40 7.30 7.20 7.10 7.00 6.90

Quantity Supplied (pounds per year) 90 80 70 60 50 40 30

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Chapter 1/What is Economics?

(b) Using the new Table 4-2, Figure 6 shows that the new supply curve, S1 lies above the original curve, S0, by a distance of 50 cents at each output. The new equilibrium price is approximately $7.53, and the new equilibrium quantity is approximately 43 pounds.

FIGURE 6

9.

(c) Yes, beef consumption falls by approximately 17 pounds. (d) The equilibrium price rises by approximately 23 cents, which is less than the tax. (e) Both consumers and producers will be paying the tax. Consumers pay a greater portion because demand was more inelastic, meaning that the quantity demanded did not change as much as the price changed. Producers pay a smaller portion because supply was somewhat more elastic meaning that the quantity supplied changed a bit more as price changed.

(More difficult) The demand and supply curves for T-shirts in Touristtown, U.S.A., are given by the following equations: Q = 24,000 − 500P Q = 6,000 + 1,000P where P is measured in dollars and Q is the number of T-shirts sold per year. a. Find the equilibrium price and quantity algebraically. b. If tourists decide they do not really like T-shirts that much, which of the following might be the new demand curve?

Q = 21,000 − 500P Q = 27,000 + 500P Find the equilibrium price and quantity after the shift of the demand curve. c. If, instead, two new stores that sell T-shirts open up in town, which of the following might be the new supply curve?

Q = 4,000 + 1,000P Q = 9,000 + 1,000P Find the equilibrium price and quantity after the shift of the supply curve. (a) In equilibrium, quantity demanded equals quantity supplied: 24,000 – 500P = 6,000 + 1,000P 1,500P = 18,000 P = 12 Substitute P = 12 in either the supply or the demand equation to derive Q = 18,000.

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Chapter 1/What is Economics?

(b) If tourists like t-shirts less, the new demand curve might be Q = 21,000 – 500P. Using the same method as in part (a), in equilibrium, P = 10 and Q = 16,000. (c) Opening of the new stores might lead to an increase in the supply curve to Q = 9000 + 1000P. Set equal to the original demand curve, and using the method of part (a), this yields equilibrium price and quantity of P = 10 and Q = 19000.

DISCUSSION QUESTIONS 1. How often do you rent videos? Would you do so more often if a rental cost half as much? Distinguish between your demand curve for home videos and your ―quantity demanded‖ at the current price.

This question is intended to help students develop an intuitive sense of the origins of the demand curve. If you deal with this question in class or discussion section, it will be revealing to aggregate the students’ answers, and derive a ―market‖ demand curve. It is also interesting to see whose purchases are sensitive to the price increase, and whose are not, and to speculate upon the reasons for the difference.

2. A bottle of wine you bought 15 years ago for $20 now has a market value of $1,500.

Would you sell your bottle at that price or keep it for an important occasion? Would you purchase another bottle of such old wine at that high price?

The opportunity cost of keeping the wine would be $1,500. Most people would sell the wine. Moreover, most people would not purchase another bottle at such a high price as predicted by the law of demand.

3. Discuss the likely effects of the following: a. Rent ceilings on the market for apartments b. A price floor in the market for wheat Use supply-demand diagrams to show what may happen in each case. (a) Figure 7 (a) is the market for apartments. Without rent control, the equilibrium rent is PE and the equilibrium quantity is QE. When the rent ceiling of PC is imposed, the quantity offered on the market falls, eventually, to QC. At this low rent, there is considerable excess demand, or a shortage, for apartments. (b) 7 (b) is the market for wheat. Without a price floor, the equilibrium price is PE and the equilibrium quantity is QE. When the price floor of PF is imposed, the quantity demanded in the market falls to QF. At this high price, there is an excess supply of wheat, and if the government is determined to maintain the price floor, it will have to absorb this surplus in one way or another.

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FIGURE 7

4.

U.S. government price supports for milk led to an unceasing surplus of milk. In an effort to reduce the surplus about a decade ago, Congress offered to pay dairy farmers to slaughter cows. Use two diagrams, one for the milk market and one for the meat market, to illustrate how this policy should have affected the price of meat.

(Assume that meat is sold in an unregulated market.)

In Figure 8 (a), the equilibrium price of milk is PE. The government wishes to raise the price to PF, and it therefore pays farmers to slaughter cattle. As a consequence, the supply curve falls to S1 and the price rises. The market for meat is shown in (b), where the added slaughters increase the supply to S1, cut the price to P1 and raise the quantity to Q1.

FIGURE 8

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Chapter 1/What is Economics?

5.

It is claimed in this chapter that either price floors or price ceilings reduce the actual quantity exchanged in a market. Use a diagram or diagrams to test this conclusion, and explain the common sense behind it.

Figure 9 shows three different prices. P1 is an effective price ceiling, at which the quantity demanded, G, exceeds the quantity supplied, F. P2 is the equilibrium price, at which the quantity supplied and the quantity demanded are equal, at E. P 3 is an effective price floor, at which the quantity supplied, I, exceeds the quantity demanded, H. Consider first the price ceiling, P1. Since supply curves are positively sloped, at this price the quantity supplied must be less than at the equilibrium P2. And since sellers cannot be forced to sell any more than they wish, the quantity exchanged will be F, which is lower than the equilibrium quantity E, in spite of the fact that buyers wish to buy more, G. Consider next the price floor, P3. Since demand curves are negatively sloped, the quantity demanded at this high price will be less than the quantity demanded at the equilibrium.

Since buyers cannot be forced to buy more than they want, the quantity exchanged at this price is H, which is less than the equilibrium quantity E. These results follow from the common-sense observation that exchange is voluntary. At any price above or below the market equilibrium price, the quantity exchanged is less than it would be at the equilibrium.

FIGURE 9

6. The same rightward shift of the demand curve may produce a very small or a very large increase in quantity, depending on the slope of the supply curve. Explain this conclusion with diagrams.

Figures 10 (a) and (b) show the same increase in the demand curve, from D0 to D1. In (a) the supply curve is quite flat, and the resulting quantity increase, from Q0 to Q1, is large, while in (b) the supply curve is steep, and the quantity increase small. The difference is that in (a) the quantity supplied is very sensitive to small changes in price, while in (b) it is hardly sensitive at all.

FIGURE 10

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Chapter 1/What is Economics?

7. Show in diagrams that if a speculator were to buy when price is high and sell when price is low, he would increase price fluctuations. Why would it be in his best interest not to do so? (Hint: Draw two supply-demand diagrams, one for the high-price period and one for the low-price period. How would the speculator’s activities affect these diagrams?)

Figure 1(a) shows a high price, Pa1, while Figure 1(b) shows a low price, Pb1. In (a), if speculation raises demand from Da1 to Da2, the price will rise to Pa2, while in (b), speculative sales will increase supply from Sb1 to Sb2, and lower the price to Pb2. With speculation, the price change from Pa2 to Pb2 is greater than the price change would be without speculation, from Pa1 to Pb1. A speculator who behaved in this way—buying at a high price and selling at a low price—would lose money.

FIGURE 1

8. In 1981, when regulations were holding the price of natural gas below its freemarket level, then-Congressman Jack Kemp of New York said the following in an interview with The New York Times: ―We need to decontrol natural gas, and get production of natural gas up to a higher level so we can bring down the price.‖ Evaluate the congressman’s statement. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

One part of the congressman’s statement was incorrect. Removing the price controls through deregulation would lead to an increase in price to Pe in Figure 11 below. Such deregulation would also cause an increase in the quantity supplied (movement along the existing supply curve) and eliminate the shortage but it would do so at a higher price.

The other part of the congressman’s statement may be correct depending on the interpretation. If we could get production of natural gas to increase – by any means other than an increase in price – we would expect to see an increase in supply which would be depicted as a movement to an entirely new supply curve like S1 depicted below. That would lead to a decrease in the equilibrium price to P1 FIGURE 11

9. From 2000 to 2010 in the United States, the number of working men fell by 0.6 percent, while the number of working women grew by almost 4 percent. During this time, average wages for men grew by roughly 3 percent, whereas average wages for women grew by slightly more than 6 percent. Which of the following two explanations seems more consistent with the data? a. Women decided to work more, raising their relative supply (relative to men). b. Discrimination against women declined, raising the relative (to men) demand for female workers.

Explanation (b) is more consistent with the data. If the principal change in the market had been an increase in supply of female workers, i.e., explanation (a), then female wages would have fallen. The fact that they increased while employment also increased means that demand for female workers must have grown.

CHAPTER 5 CONSUMER CHOICE: INDIVIDUAL AND MARKET DEMAND © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

TEST YOURSELF 1. Which gives you greater total utility: 14 gallons of water per day or 22 gallons per day?

Why? The total utility from 22 gallons is greater, since it is equal to the total utility (or usefulness) of the first 14 gallons, plus the total utility of the next 8.

2. At which level do you get greater marginal utility: 14 gallons per day or 22 gallons per day? Why? The marginal utility at 12 gallons is greater. You use the first 12 gallons for your highest priorities. The next gallons are used for purposes of decreasing importance. This is the ―law‖ of diminishing marginal utility.

3. Emily buys an air conditioner that costs $700. Because the air in her home is cleaner, its use saves her $250 in curtain cleaning costs over the lifetime of the air conditioner. In money terms, what is the opportunity cost of the air conditioner?

Since the $700air conditioner saves Emily $250 in cleaning costs, the opportunity cost of the air conditioner is only $450.

4. Suppose that strawberries sell for $3 per basket. Jim is considering whether to buy zero, one, two, three, or four baskets. On your own, create a plausible set of total and marginal utility numbers for the different quantities of strawberries (as we did for pizza in Table 1), and arrange them in a table. From your table, calculate how many baskets Jim would buy.

Baskets Marginal Utility ($) Total Utility ($) 0 — — 1 6 6 2 4 10 3 3 13 4 1 14 At a price of $3 per basket Jim will buy 3 baskets.

5. Draw a graph showing the consumer’s surplus Jim would get from his strawberry purchase in Test Yourself Question 5, and check your answer with the help of your marginal utility table.

Figure 1 shows that Jim buys 3 boxes of berries, where marginal utility equals price. On the first box, his consumer’s surplus is the excess of MU (6) above P (2), or the dotted line AB. Similarly his surplus on the second box is CD (4 - 2), and the total consumer’s surplus is the sum of the two lines, 4 + 2, or 6.

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Chapter 1/What is Economics?

FIGURE 1

6. Consider a market with two consumers, Jasmine and Jim. Draw a demand curve for each of the two consumers, and use those curves to construct the demand curve for the entire market.

FIGURE 2

DISCUSSION QUESTIONS 1. Describe some of the different ways you use water. Which would you give up if the price of water were to rise a little? If it were to rise by a fairly large amount? If it were to rise by a very large amount?

In descending order of importance, water is used for drinking, for cooking, for bathing, to feed pets, to wash clothes, to water lawns, to store in swimming pools, etc. (the students’ order may differ). As the price of water rose, you might give up some of these uses, beginning at the end of the list. Alternatively, you might retain all or most of these uses, but cut down on the amount for each.

2. Suppose that you wanted to measure the marginal utility of a commodity to a consumer by directly determining the consumer’s psychological attitude or strength of feeling toward the commodity rather than by seeing how much money the consumer would give up for the commodity. Why would you find it difficult to make such a © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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psychological measurement?

You could ask the consumer to construct a scale, from 1 to 100, then reveal where on the scale each commodity falls. Or you could try measuring blood pressure or pulse as the consumer gets different commodities. But there is no guarantee that either procedure would be meaningful. The self-constructed scale might be biased and inconsistent; the consumer’s physiological response might have little to do with satisfaction. There are some obvious (and not so obvious) objections to using the amount of money a person is willing to give up as a measure of utility, but there does not seem to be a better solution.

3. Some people who do not understand the optimal purchase rule argue that if a consumer buys so much of a good that its price equals its marginal utility, the consumer could not possibly be behaving optimally. Rather, they say, the consumer would be better off quitting while ahead or buying a quantity such that marginal utility is much greater than price. What is wrong with this argument? (Hint: What opportunity would the consumer then miss? Is it maximization of marginal or total utility that serves the consumer’s interests?)

It is reasonable to assume that rational consumers are trying to get the most possible consumer’s surplus for themselves, that is, the most total utility less expenditure—not the most possible average utility per good or marginal utility. If a consumer quit buying when the marginal utility was higher than the price, then he or she would be forgoing the opportunity to increase consumer’s surplus: By buying one more unit, the consumer could accumulate more utility than he or she would be giving up in terms of money forgone. This will continue to be true until so much is bought that the marginal utility of the next good has fallen to a level equal to the price.

4. You have $20,000 to invest in the stock market, which has been rising rapidly for the past 18 months. What course of action seems rational?

Perhaps you should invest in the stock market now on the expectation that stock prices will continue to rise. On the other hand, if you expect prices to fall then you would want to wait to purchase stock.

ANSWERS TO APPENDIX QUESTIONS TEST YOURSELF 1. John Q. Public spends all of his income on tacos and hot dogs. Draw his budget line under several conditions: a. His income is $100, and one taco and one hot dog each cost $2. b. His income is $150, and the two prices remain the same. c. His income is $100, hot dogs cost $2 each, and tacos cost $2.50 each.

FIGURE 3

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Chapter 1/What is Economics?

2. Draw some hypothetical indifference curves for John Q. Public on a diagram identical to the one you constructed for Test Yourself Question 1. a. Approximately how many tacos and how many hot dogs will Mr. Public buy? b. How will these choices change if his income increases to $150? Is either good an inferior good? c. How will these choices change if the price of a taco rises to $3.00?

FIGURE 4

(a) 25 tacos and 25 hot dogs. (b) approximately 37.5 tacos and 37.5 hot dogs; Since the consumption of both goods increased when his income increased, both goods are normal goods which means that neither is an inferior good. (c) approximately 16 tacos and 26 hot dogs 3. Explain the information that the slope of an indifference curve conveys about a consumer’s preferences. Use this relationship to explain the typical U-shaped curvature of indifference curves.

The slope of an indifference curve is the maximum number of units of the good on the Yaxis (say, cookies) the consumer is willing to give up to get one more unit of the good on the X-axis (say, compact discs). An indifference curve that is U-shaped with respect to the origin has a relatively large slope towards the upper left side and a relatively small slope towards the lower right. This indicates that a consumer who has many cookies but few compact discs is willing to give up a lot of cookies in order to get one more compact disc—but when the tables are turned, the consumer who has many compact discs and © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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only a few cookies is willing to give up only a small number of cookies to get an additional compact disc. This is consistent with the idea of diminishing marginal utility in the case of one good considered alone.

CHAPTER 6 DEMAND AND ELASTICITY TEST YOURSELF 1. What variables other than price and advertising are likely to affect the quantity demanded of a product?

The answer depends upon the product, but general variables include tastes, prestige value of the product, income levels, population, prices of substitutes and complements, and new uses to which the product can be put.

2. Describe the probable shifts in the demand curves for a. Airplane trips when airlines’ on-time performance improves b. Automobiles when airplane fares double c. Automobiles when gasoline prices double d. Electricity when the average temperature in the United States rises during a particular year (Note: The demand curve for electricity in Maine and the demand curve for electricity in Florida should respond in different ways. Why?) (a) Increase: shift to the right. Airplane trips are more attractive when their punctuality improves. (b) Increase: shift to the right. Airplane trips are a substitute for automobiles; thus automobiles are more attractive when airplane fares increase. (c) Reduction: shift to the left. Gasoline is a complement to automobiles; thus automobiles are less attractive when gasoline prices increase. (d) Demand will decrease (shift to the left) in Maine because less electricity will be wanted for heating buildings in winter. Demand will increase (shift to the right) in Florida, because more electricity will be wanted for air conditioning. The rise in temperature is unlikely to have much effect on air conditioning in Maine or on home heating in Florida.

3. Taxes on particular goods discourage their consumption. Economists say that such taxes ―distort consumer demands.‖ In terms of the elasticity of demand or elasticity of supply for the commodities in question, what sort of goods would you choose to tax to achieve the following objectives? a. Collect a large amount of tax revenue b. Distort demand as little as possible c. Discourage consumption of harmful commodities d. Discourage production of polluting commodities (a) Goods with low price elasticity of demand (inelastic demand). (b) Goods with low price elasticity of demand (inelastic demand). (c) Goods with high price elasticity of demand (elastic demand). (d) Goods with high price elasticity of demand (elastic demand). © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

4. Give examples of commodities whose demand you would expect to be elastic and commodities whose demand you would expect to be inelastic.

Elastic: Any particular food, like carrots or pork chops (since there are close substitutes), apartments in a particular building (since they require a lot of a consumer’s budget, and since there are close substitutes), vacation trips to the Caribbean (since they are not really needed, and since there are close substitutes).

Inelastic: Food in general (there is no substitute), housing in general (people resist reducing the quality of their housing when prices rise), salt (so insignificant in a budget that one hardly notices a price change), tobacco and liquor (many consumers are addicted).

5. A rise in the price of a certain commodity from $20 to $25 reduces quantity demanded from 25,000 to 10,000 units. Calculate the price elasticity of demand.

Using the formula in the text, (change in quantity/change in price) times (price/quantity), where price and quantity are the average of the beginning and ending values, the elasticity is (15,000/17,500) / (5/22.5) = 0.857/0.222 = 3.86 6. If the price elasticity of demand for gasoline is 0.3 and the current price is $3.20 per gallon, what rise in the price of gasoline will reduce its consumption by 10 percent?

The elasticity is the percentage change in quantity divided by the percentage change in price and is equal to 0.3. Since the desired percentage change in quantity is 10%, the percentage change in price is 10%/0.3 = 33.3%. In finding the new gasoline price, however, there is an ambiguity. A 33.3% increase above $3.20 a gallon would bring the price to $4.27. On the other hand, the text recommends that the base for calculating a percentage change should be half way between the beginning and ending values. In that case (P1 – P0)/[(P1 + P0)/2] = 0.33; (P1 – P0) = 0.33[(P1 + P0)/2]; therefore (P1 – $3.20)/[(P1 + $3.20)/2] = 0.33; and the new price is $4.46.

7. Which of the following product pairs would you expect to be substitutes, and which would you expect to be complements? a. Shoes and sneakers b. Gasoline and sport-utility vehicles c. Tacos and hot sauce d. Music steaming services and music downloads Complements: (b) and (c) Substitutes: (a) and (d) 8. For each of the product pairs given in Test Yourself Question 7, what would you guess about the products’ cross elasticity of demand? a. Do you expect it to be positive or negative? b. Do you expect it to be a large or small number? Why? Shoes and sneakers: The cross elasticity is positive because they are substitutes, but likely to be rather low because the two are normally used on quite different occasions for very different purposes.

Gas and sport utility vehicles: The cross elasticity is negative because they are complements, and high, because when gas prices rise it becomes much more expensive to operate a sport utility vehicle.

Tacos and hot sauce: The cross elasticity is negative because they are complements, but low because there are many uses for each which do not require the other. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Music streaming services and music downloads: The cross elasticity is positive because they are substitutes, and probably quite high because the degree of substitutability is high; both can provide quite good music.

DISCUSSION QUESTIONS 1. Explain why elasticity of demand is measured in percentages.

Elasticity is calculated in percentages so that it can be a measure of responsiveness that is not influenced by the units chosen. Suppose, for example, that the quantity of steel bought rises from 1 to 3 tons when the price falls from $300 to $100. Calculating the absolute change in units divided by the absolute change in price gives a value of 2/200 = 0.01. If, instead, steel is measured in pounds, the value is 4000/200 = 20. No one could say which is the true measure of elasticity. If the changes in both quantity and price are measured in percentage terms, then it does not matter what units are used—the percentage change in quantity divided by the percentage change in price (using the numbers in this example) will always be 200%/200% = 1.

2. Explain why the elasticity of demand formula normally eliminates minus signs.

In the calculation of the price elasticity of demand, the sign of the percentage price change is almost always the opposite of the sign of the percentage quantity change: if one goes up, the other goes down. Therefore the ratio of the two would always have a minus sign. Since this is well understood, it is convenient to omit the minus sign. Thus a higher value of elasticity indicates that quantity is more responsive to price.

3. Explain why the elasticity of a straight-line demand curve varies from one part of the curve to another.

Along a straight-line demand curve, the same absolute price reduction (say, $1) is always associated with the same absolute quantity increase (say, 2 pounds). When price is high and quantity low, a reduction in price of $1 is a small percentage change in the price, but an increase in quantity of 2 pounds is a large percentage increase in quantity, so the elasticity is high. When price is low and quantity high, on the other hand, the situation is reversed, and the elasticity is low. The price elasticity of demand falls as one moves down along a straight-line demand curve.

4. A rise in the price of a product whose demand is elastic will reduce the total revenue of the firm. Explain.

Revenue is equal to price times quantity. When the demand curve is elastic, the percentage decline in quantity exceeds the percentage rise in price, and therefore the product of the two falls. In other words, if demand is elastic and the seller increases price, a large percentage of existing customers will no longer purchase that good. The remaining customer will pay the higher price. However, the substantial number of customers that no longer purchase the good will result in a decrease in total revenue.

5. Name some events that will cause a demand curve to shift.

Changes in tastes, incomes, population, prices of substitutes and complements, advertising, uses of the product, etc.

6. Explain why the following statement is true: ―A firm with a demand curve that is inelastic at its current output level can always increase its profits by raising its price and selling less.‖ (Hint: Refer back to ―Price Elasticity of Demand: Its Effect on Total Revenue and Total Expenditure.‖) © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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If the demand curve is inelastic, the percentage decline in quantity will be less than the percentage increase in price. Therefore revenue will rise when price rises. Costs will not increase as quantity declines; at the very least they will stay constant, and they will probably decline. If revenues rise while costs stay constant or decline, profits must rise.

CHAPTER 7 PRODUCTION, INPUTS, AND COSTS: BUILDING BLOCKS FOR SUPPLY ANALYSIS TEST YOURSELF 1. A firm’s total fixed cost is $360,000. Construct a table of its total and average fixed costs for output levels varying from zero to six units. Draw the corresponding TFC and AFC curves.

Output 0 1 2 3 4 5 6

TFC (thousands of dollars) 360 360 360 360 360 360 360

AFC (thousands of dollars) — 360 180 120 90 72 60

FIGURE 1

2. With the following data, calculate the firm’s AVC and MVC and draw the graphs for TVC, AVC, and MVC. Why is MVC the same as MC? Quantity Total Variable Costs 1 $ 40,000 2 80,000 © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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3 4 5 6

120,000 176,000 240,000 360,000 Output 1 2 3 4 5 6

TVC (thousands of dollars) 40 80 120 176 240 360

AVC (thousands of dollars) 40 40 40 44 48 60

MVC (thousands of dollars) 40 40 40 56 64 120

FIGURE 2

MVC is the change in TVC divided by the change in output. MC is the change in TC divided by the change in output. Since fixed costs by definition do not change as output changes, the only change in TC will be the change in TVC. 3. From the data in Test Yourself Questions 1 and 2, calculate TC and AC for each of the output levels from one to six units and draw the two graphs.

Output 0 1 2 3 4 5 6

TC (thousands of dollars) 360 400 440 480 536 600 720

AC (thousands of dollars) — 400 220 160 134 120 120

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Chapter 1/What is Economics?

FIGURE 3

4. If a firm’s commitments in 2011 include machinery that will need replacement in five years, a factory building rented for 12 years, and a three-year union contract specifying how many workers it must employ, when, from its point of view in 2011, does the firm’s long run begin?

The firm’s long run begins in 12 years, in 2023, when the last of its commitments, its building lease, has ended.

5. If the marginal revenue product of a gallon of oil used as input by a firm is $2.20 and the price of oil is $2.07 per gallon, what can the firm do to increase its profits?

It can raise its profits by increasing its use of oil. Adding 1 gallon of oil will raise its revenues by $2.20, and its cost by only $2.07. It should continue increasing its use of oil as long as the marginal revenue product is greater than the cost.

6. A firm hires two workers and rents 15 acres of land for a season. It produces 150,000 bushels of crop. If it had doubled its land and labor, production would have been 325,000 bushels. Does it have constant, decreasing, or increasing returns to scale?

Increasing returns to scale: when inputs double, output more than doubles.

7. Suppose that wages are $20,000 per season per person and land rent per acre is $3,000. Calculate the average cost of 150,000 bushels and the average cost of 325,000 bushels, using the figures in Test Yourself Question 6. (Note that average costs increase when output increases.) What connection do these figures have with the firm’s returns to scale? © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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150,000 Bushels 325,000 Bushels Wages $40,000 $80,000 Rent $45,000 $90,000 Total Cost $85,000 $170,000 Average Cost 0.57 0.52 The lower average cost at 325,000 confirms the previous conclusion that there was increasing returns to scale because the firm is essentially getting more out of each unit of input which drives down the average cost per unit.

8. Naomi has stockpiled a great deal of chicken feed. Suppose now that she buys more chicks, but not more chicken feed, and divides the feed she has evenly among the larger number of chickens. What is likely to happen to the marginal physical product of feed? What, therefore, is the role of input proportions in the determination of marginal physical product?

When Naomi bought a great deal of feed, the MPP of feed was low because of diminishing returns. The ratio of feed to chicks was high: More feed could not produce much more output. Now, she buys more chicks. This reduces the ratio of feed to chicks, and raises the MPP of feed because there is less feed per chick and diminishing returns have not proceeded as far. The conclusion is that the MPP of a factor is inversely related to the proportion of that factor to other factors.

9. Labor costs $12 per hour. Nine workers produce 180 bushels of product per hour, whereas 10 workers produce 196 bushels. Land rents for $1,200 per acre per year.

With 10 acres worked by nine workers, the marginal physical product of an acre of land is 1,400 bushels per year. Does the farmer minimize costs by hiring nine workers and renting 10 acres of land? If not, which input should he use in larger relative quantity?

For labor, the MPP is 16, the price is $12, and the ratio of the two is a bit more than 1.3; for land, the MPP is 1,400, the price is $1,200, and the ratio of the two is less than 1.2.

Since the two ratios are not equal, the farmer is not minimizing costs. She should use a larger relative quantity of labor.

10. Remember Al, the builder of inexpensive garages? Suppose that his total costs increase by $5,000 per year at every input level. Modify Table 2 to show how this change affects his total and average costs.

Number of Carpenters (Input) 0 1 2 3 4 5 6

Old Total Cost 0 50,000 100,000 150,000 200,000 250,000 300,000

Old Average Cost 0 12,500 8,333 6,250 6,250 7,143 10,000

New Total Cost 5,000 55,000 105,000 155,000 205,000 255,000 305,000

New Average Cost 0 13,750 8,750 6,458 6,406 7,286 10,167

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DISCUSSION QUESTIONS 1. A firm experiences a sudden increase in the demand for its product. In the short run, it must operate longer hours and pay higher overtime wage rates to satisfy this new demand. In the long run, the firm can install more machines instead of operating fewer machines for longer hours. Which do you think will be lower, the short-run or the long-run average cost of the increased output? How is your answer affected by the fact that the long-run average cost includes the new machines the firm buys, whereas the short-run average cost includes no machine purchases?

The long-run average cost will be lower than the short-run average cost, even though the former includes the cost of new machines. In the long run, the firm will have lower labor costs because it does not have to pay higher overtime wages, and it will avoid the costs of machines breaking down because they are being worked too intensively. These savings will outweigh the added costs of new machines. If the long-run average cost were not less than the short-run average cost, the firm would not buy the new machines.

ANSWERS TO APPENDIX QUESTIONS TEST YOURSELF 1. Compound Consolidated Corporation (CCC) produces containers using two inputs: labor and glue. If labor costs $10 per hour and glue costs $5 per gallon, draw CCC’s budget line for a total expenditure of $100,000. In this same diagram, sketch a production indifference curve indicating that CCC can produce no more than 1,000 containers with this expenditure.

FIGURE 4

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Chapter 1/What is Economics?

2. With respect to Test Yourself Question 1, suppose that wages rise to $20 per hour and glue prices rise to $6 per gallon. How are CCC’s optimal input proportions likely to change? (Use a diagram to explain your answer.)

The price ratio of glue to labor falls from 0.5 to 0.3. The slope of the budget line flattens, as shown in Figure 4. Consequently, the ratio of glue to labor employed will rise.

3. What happens to the location of the expansion path of the firm in Test Yourself Question 2?

When the price ratio of glue to labor falls, the ratio of glue to labor used rises. Therefore, the expansion path, which shows the amounts of glue and labor used as output rises, given unchanging factor prices, becomes flatter, or closer to the glue axis.

CHAPTER 8 OUTPUT, PRICE, AND PROFIT: THE IMPORTANCE OF MARGINAL ANALYSIS TEST YOURSELF 1. Suppose that the firm’s demand curve indicates that at a price of $10 per unit, customers will demand 2 million units of its product. Suppose that management decides to pick both price and output; the firm produces 3 million units of its product and prices them at $18 each. What will happen?

Unfortunately for the firm, exchange is voluntary. Assuming that the demand curve is negatively sloped, when the firm prices its product at $18, it will find buyers for less than 2 million units, and it will discover its inventory rising by more than 1 million units.

2. Suppose that a firm’s management would be pleased to increase its share of the market but if it expands its production, the price of its product will fall. Will its profits necessarily fall? Why or why not?

If the firm was previously in a profit-maximizing situation, then a decision to expand output and reduce price will lower profits. But it may have been in a non-optimal position. If so, it may be able to expand output and, even thought its price falls, earn marginal revenue from the new output that is greater than its marginal costs. If so, its profits will rise.

3. Why does it make sense for a firm to seek to maximize total profit rather than to © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

maximize marginal profit?

One presumes that the owners of the firm would like to get as rich as possible. As such their goal is not to make as much profit as possible on one unit which would be the result if they maximized marginal profit. Their goal is to make as much profit as possible which would mean looking for any additional profit on any additional units. A marginal profit greater than zero implies that the owners can make more money by increasing output.

4. A firm’s marginal revenue is $133 and its marginal cost is $90. What amount of profit does the firm fail to pick up by refusing to increase output by one unit? $43 ($133 - $90 = $43)

5. Calculate average revenue (AR) and average cost (AC) in Table 3. How much profit does the firm earn at the output at which AC = AR? Why? Garages TR AR TC AC TP 0 0 0 12 -–12 1 30 30 40 40 –10 2 56 28 56 28 0 3 78 26 66 22 12 4 96 24 74 18.5 22 5 110 22 80 16 30 6 120 20 87 14.5 33 7 126 18 96 13.7 30 8 128 16 112 14 16 9 126 14 144 16 –18 10 120 12 190 19 –70 When average cost is equal to average revenue (at 2 garages in this example), the firm makes no profit. This is because for average revenue to equal average cost total revenue must equal total cost.

6. A firm’s total cost is $1,000 if it produces one unit, $1,600 if it produces two units, and $2,000 if it produces three units of output. Draw up a table of total, average, and marginal costs for this firm.

Output 1 2 3

Total Cost 1000 1600 2000

Average Cost 1000 800 667

Marginal Cost 1000 600 400

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Chapter 1/What is Economics?

7. Draw an average and marginal cost curve for the firm in Test Yourself Question 6.

Describe the relationship between the two curves.

At one unit, average and marginal cost are identical. Beyond one unit, since average cost is falling; marginal cost lies below average cost, as shown in Figure 1.

FIGURE 1

8. A firm has the demand and total cost schedules given in the following table. If it wants to maximize profits, how much output should it produce?

Quantity Price Total Cost 1 $6 $ 1.00 2 5 2.50 3 4 6.00 4 3 7.00 5 2 11.00 See the table below. Profits are maximized at an output of 2 units, where revenue is $10, cost is $2.50 and profit is $7.50. At any output level greater than 2, marginal revenue is less than marginal cost and total profit declines.

Quantity Price Total Total Marginal Marginal Total Cost Revenue Revenue Cost Profit 1 $6 $ 1.00 $6 $6 $1.00 $5.00 2 5 2.50 10 4 1.50 7.50 3 4 6.00 12 2 3.50 6.00 4 3 7.00 12 0 1.00 5.00 5 2 11.00 10 -2 4.00 -1.00

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Chapter 1/What is Economics?

DISCUSSION QUESTIONS 1. ―It may be rational for the management of a firm not to try to maximize profits.‖ Discuss the circumstances under which this statement may be true.

Some firms are non-profit firms, and they definitely do not maximize profits. A nonprofit hospital may maximize service to its community, while a worker-owned cooperative may maximize wages. But even for-profit firms may have other objectives as well as profits—such as size of the firm, community responsibility, or avoidance of risk—any of which may conflict with profit maximization. The managers of the firm may have goals such as salary maximization, prestige or job security, and these may lead them to decisions that are not necessarily in the best interests of the stockholders who may wish to maximize profits. So rational behavior is not necessarily equivalent to profit maximization. One way of defining rational behavior, however, is to say that the decision maker has some goal in mind, and acts in such a way as to optimize, or maximize, with respect to that goal.

ANSWERS TO APPENDIX QUESTIONS TEST YOURSELF 1. Suppose that the following table is your record of exam grades in your Principles of Economics course.

Exam Date September 30 October 28 November 26 December 13 January 24

Grade 65 75 90 85 95

Comment A slow start A big improvement Happy Thanksgiving!

Slipped a little A fast finish!

Use these data to make up a table of total, average, and marginal grades for the five classes.

Total Average Marginal Date Grade Grade Grade 9/30 65 65 65 10/28 140 70 75 11/26 230 77 90 12/13 315 79 85 1/24 410 82 95 Note: numbers are rounded for simplicity.

2. From the data in your exam-grade table in Test Yourself Question 1, illustrate each of the rules mentioned in this appendix. Be sure to point out an instance where the marginal grade falls but the average grade rises. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

Rule 1a is illustrated on each line of the table. For example, on 11/26, the average grade, 77, is equal to the total grade, 230, divided by the number of exams, 3. Rule 1b is illustrated on each line. On 1/24, the total grade, 410, is equal to the average grade, 82, times the number of exams, 5. Rule 2a: The marginal grade of the third exam, 90, is equal to the total grade after three exams, 230, minus the total grade after two exams, 140. Rule 2b: The total grade of three exams, 230, equals the marginal grade of the first exam, 65, plus the marginal grade of the second, 75, plus the marginal grade of the third, 90. Rule 3: On 9/30, the marginal, average and total grades are all equal for the first exam, at 65.

Rule 4: After the first exam, the marginal grade exceeds the average grade for each exam, and therefore the average rises continuously. Note that the marginal grade falls on the fourth exam, but because it is still above the average, it pulls the average up.

CHAPTER 9 THE FINANCIAL MARKETS AND THE ECONOMY: THE TAIL THAT WAGS THE DOG? TEST YOURSELF 1. Suppose that interest rates are 6 percent in the economy and a safe bond promises to pay $3 per year in interest forever. What do you think the price of the bond will be? Why? The value of the bond times the interest rate (0.06) equals the annual payment ($3.00). So the price of the bond is the annual payment divided by the interest rate: $3.00/0.06 = $50.00.

2. Suppose that in the economy described in Test Yourself Question 1, interest rates suddenly fall to 3 percent. What will happen to the price of the bond that pays $3 per year?

In this case, the price of the bond will rise; the new price will be $3.00/0.03 = $100.00.

3. For whom are stocks riskier than bonds? For whom are bonds riskier than stocks?

For corporations, bonds are riskier than stocks. For individual investors, stocks are riskier than bonds.

4. Explain the role of subprime mortgages and mortgage-based securities in the financial crisis of 2007–2009.

Subprime mortgages to borrowers with limited abilities to repay were packages and sold to financial institutions as mortgage-backed securities in an effort to diversify risk.

However, when the entire housing market experienced a significant decline with a substantial number of foreclosures, the value of the mortgage-backed securities dropped tremendously creating an extremely adverse effect for all institutions holding these securities.

5. Jenny purchases some stocks of Company X that initially cost $1,000 and pays for them in cash. Jim makes the same purchase but leverages his investment by borrowing $500 for the purpose at 10 percent interest, using the stocks as security for repayment.

If the stock’s price rises 20 percent, how much money do Jenny and Jim each make on their investments? If the stock declines in value by 20 percent, how much money will © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Jenny and Jim each have? (Remember that, in both instances, Jim must repay his $500 loan with interest.)

When the price of the stock rises by 20 percent, Jenny makes $200 on top of her original $1,000 investment—a 20 percent profit on her investment. Jim’s investment also makes a direct gain of $200, but after he has paid back his $500 loan (plus $50 interest), he is actually left with $650—a 30 percent profit ($150) on the $500 of his own money that he invested. In contrast, when the value of the stock declines by 20 percent, Jenny loses $200 and is left with $800, or 80 percent, of her initial investment. Jim also loses $200, but after he pays back his loan with interest ($550), he is left with only $250—that is, he is left with only 50 percent, of his original $500 investment.

6. If the price of a company’s stock constitutes a random walk, next year its price will equal today’s price plus what?

With a random walk pricing model of stocks, next year’s price will be equal to this year’s price plus or minus a random and therefore, unpredictable amount.

DISCUSSION QUESTIONS 1. If you hold shares in a corporation and management decides to plow back the company’s earnings some year instead of paying dividends, what are the advantages and disadvantages to you?

The disadvantage of the plowback is that you do not get the cash income that you might like, in the form of dividends. The advantage is that if the firm invests the funds productively, the profitability of the firm will increase and with it the value of your shares. At a later date, you will earn higher dividends or be able to sell your stock for a higher price. Furthermore, you postpone paying taxes on your earnings until you get them in the form of cash, and in the meantime your postponed tax payments can be working for you.

2. If stock prices really do take a random walk, can you nevertheless think of good reasons for getting professional advice before investing?

If stock prices really are a random walk, a professional advisor will not be able to help you predict stock prices accurately. She may, however, be able to give you other information that would be useful to you in making your decision—such as the likely riskiness of the stock (how much its price has fluctuated), past decisions of the company with respect to dividends versus plowback, and the social responsibility policies of the company.

3. Hostile takeovers often end up in court when management attempts to block such a maneuver and raiders accuse management of selfishly sacrificing the stockholders’ © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

interests. The courts often look askance at ―coercive‖ offers by raiders—an offer to buy, say, 20 percent of the company’s stock by a certain date from the first stockholders who offer to sell. By contrast, they take a more favorable attitude toward ―noncoercive‖ offers to buy any and all stock supplied at announced prices. Do you think the courts are right to reject ―coercive offers‖ and prevent management from blocking ―noncoercive‖ offers? Why? Students will have various answers to this question. The argument against ―coercive‖ offers is that stockholders may feel pressured to make a decision to sell earlier than they would prefer, before they have a chance to assess the pros and cons of the deal adequately. On the other hand, one could argue that ―coercive‖ offers are no different from many other transactions in the economy. For example, you may have only an uncertainly short time to buy tickets to a rock concert before they are sold out. In any case, no one can force a stockholder to sell.

4. Discuss ―herd behavior‖ among investors. Explain how it can sometimes take what would otherwise have been a modest fall in the price of the stocks of a single company and transform that into a precipitate collapse in the price of many stocks.

When a few investors begin to sell off stocks it can lead to other investors following the same pattern. In such a case investors might be willing to sell their shares for any price they can get, even if it is very low.

5. Some observers claim that laxity of the rules governing the creation, sale, and purchase of some types of securities bear much of the guilt for the Great Recession of the early twenty-first century. Can you suggest some specific types of activity that may bear much of this responsibility? Explain how these activities may have increased the problem, and suggest rules that could have reduced the severity of the financial crisis of 2007–2009 and ensuing recession.

Answers may vary. Responses could focus on banking regulations and government requirements on lending including loan-to-value and debt-to-income ratios. Responses might also mention greater regulation of financial derivatives to prevent firms and other investors from using these instruments to essentially gamble on the results in some market like real estate.

APPENDIX TEST YOURSELF 1. Company A sells heaters and Company B sells air conditioners. Which is the safer investment, Company A stock, Company B stock, or a portfolio containing half of each?

Ultimately the answer to this question depends on whether or not either of these two company stocks has no risk or infinite risk. Barring those possibilities, a portfolio containing half of each will lower the risk.

2. If you make a lucky prediction about the prices of the stocks of the two companies in © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Question 1, will you earn more or less if you invest in that company rather than the portfolio?

If you make a lucky prediction about the weather trend or other trends within the industry, you would make more money if you invested in the one stock that appreciated more than if you had diversified into a portfolio with both stocks.

DISCUSSION QUESTIONS 1. In program trading, computers decide when to buy or sell stocks on behalf of large, institutional investors. The computers then carry out those transactions with electronic speed. Critics claim that this practice is a major reason why stock prices rose and fell sharply in the 1980s. Is this idea plausible? Why or why not?

The idea is plausible because a very fast fall in demand, as guided by the computer, can drive stock prices down with comparable speed and can frighten other investors to rush to sell their securities, thereby speeding up any collapse of stock prices.

CHAPTER 10 THE FIRM AND THE INDUSTRY UNDER PERFECT COMPETITION TEST YOURSELF 1. Under what circumstances might you expect the demand curve of the firm to be a. Vertical? b. Horizontal? c. Negatively sloping? d. Positively sloping? (a) A demand curve might be vertical for a good that is absolutely necessary to the continuance of life, or for a good which is so cheap and which has so few close substitutes that a rise in price would barely be noticed by the consumer. (b) A demand curve facing a firm in a perfectly competitive industry is horizontal.

Because the products of the different firms are identical, and because there are so many firms, no single firm can take a production decision that is large enough to affect industry supply enough to alter the price. (c) A firm’s demand curve will be negatively sloping if the firm’s output is a relatively large portion of the industry’s output, or if the firm’s output is differentiated from the output of the other firms and is identifiable. Under such circumstances, if the firm seeks to sell a significantly higher output, it will have to lower its selling price in order to attract new business. (d) A firm’s demand curve might be positively sloping if it could somehow persuade the public that the quality of the good it was selling was signaled by its price.

2. Explain why P = MC in the short-run equilibrium of the perfectly competitive firm, whereas in long-run equilibrium P = MC = AC. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

In the short run, a profit-maximizing firm sets output at a point where MR = MC. In the case of a purely competitive firm, however, MR = P, and therefore the optimal output level is where P = MC. In the long run, P is still equal to MC, but P is also equal to AC. If P exceeded AC, profits would be positive, new firms would enter the industry and the increase in supply would reduce P. If P were less than AC, profits would be negative, firms would leave the industry and the reduction in supply would increase P. Therefore, in long-run equilibrium, P = MC = AC. 3. Explain why it is not sensible to close a business firm if it earns zero economic profits.

If a firm is earning zero economic profit, the owner’s invested capital is earning the same return it could earn in another use, while the owner’s labor (if she is working in the firm) is earning the same income it could earn elsewhere, so the owner has no incentive to close the firm.

4. If the firm’s lowest average cost is $52 and the corresponding average variable cost is $26, what does it pay a perfectly competitive firm to do if a. The market price is $51? b. The price is $36? c. The price is $12? (a) If the market price is $51, the firm should reduce output to produce at the point where MC = $51. The firm will lose money, but the price is more than AVC, and therefore it loses less money than if it quit altogether, and had to pay its fixed costs with no income coming in. In the long run, when all costs are variable costs, the firm will shut down. (b) If the market price is $36, in the short run, the firm should cut back production, so that MC is only $36. It will lose money, but the price exceeds AVC, and therefore it loses less money than if it quit altogether, and had to pay its fixed costs with no income coming in. In the long run, when all costs are variable costs, the firm will close down. (c) If the market price is $12, the firm cannot even cover its variable costs by producing.

It will lose less money if it quits business immediately, and only has to pay the fixed costs, not a portion of the variable costs as well.

5. If the market price in a competitive industry were above its equilibrium level, what would you expect to happen?

If the market price is above equilibrium, profits will attract new firms into the industry.

The increase in supply will reduce the price to its equilibrium, zero-profit level.

DISCUSSION QUESTIONS 1. Explain why a perfectly competitive firm does not expand its sales without limit if its horizontal demand curve indicates that it can sell as much as it desires at the current market price.

A profit-maximizing firm produces output at the point where marginal revenue equals marginal cost. A perfectly competitive firm does not face the phenomenon of declining marginal revenue, but it does experience rising marginal costs as its output rises. Once marginal costs have reached the level of the price, any further expansion of output would reduce profits. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

2. Explain why a demand curve is also a curve of average revenue. Recalling that when an average revenue curve is neither rising nor falling, marginal revenue must equal average revenue, explain why it is always true that P = MR = AR for the perfectly competitive firm.

The demand curve shows the price, P, at which different levels of output can be sold. But P = PQ/Q, (where Q is output), and PQ is equal to total revenue, TR. Therefore, P = TR/Q = AR, or average revenue. So the demand curve is a curve of average revenue.

When MR, marginal revenue, is less than AR, MR is pulling AR down and AR is falling; when MR exceeds AR, AR is rising. Therefore, when AR is horizontal, as it is for a purely competitive firm, MR = AR. More intuitively, P = MR for a purely competitive firm, because each extra unit adds its full price to total revenue, and there is no deduction from revenue caused by a declining price on earlier units. Thus: P = AR = MR. 3. Regarding the four attributes of perfect competition (many small firms, freedom of entry, standardized product, and perfect information): a. Which is primarily responsible for the fact that the demand curve of a perfectly competitive firm is horizontal? b. Which is primarily responsible for the firm’s zero economic profits in long-run equilibrium? (a) The fact that all firms sell a standardized product is primarily responsible in that customers have no reason to stay with one supplier if its price is higher than others.

Perfect information also plays a role in that consumers know the prices being charged by different producers. (b) The fact that there is freedom of entry is primarily responsible in that new competitors can enter the industry easily if profits are positive.

4. We indicated in this chapter that the MC curve cuts the AVC (average variable cost) curve at the minimum point of the latter. Explain why this must be so. (Hint: Because marginal costs are, by definition, entirely composed of variable costs, the MC curve can be considered the curve of marginal variable costs. Apply the general relationships between marginals and averages explained in the appendix to Chapter 8.)

Total costs are equal to total fixed costs plus total variable costs. Marginal costs are equal to the change in fixed costs plus the change in variable costs. However, since fixed costs, by definition, do not vary, marginal costs are equal to marginal variable costs. So if MC is less than AVC, it is pulling AVC down, while if MC is above AVC, it is pulling AVC up—and consequently if MC is just equal to AVC, AVC must be neither rising nor falling but at a minimum.

5. (More difficult) In this chapter we stated that the firm’s MC curve goes through the lowest point of its AC curve and also through the lowest point of its AVC curve.

Because the AVC curve lies below the AC curve, how can both of these statements be true? Why are they true? (Hint: See Figure 4.)

The MC curve consists only of variable costs, and so it goes through the low point of the AVC curve. It also goes through the low point of the AC curve. The AC curve lies above the AVC curve. Since the MC curve is positively sloped, this implies that the minimum point of the AC curve occurs when output is higher than it is at the minimum point of the © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

AVC curve. This makes sense economically. The minimum point of the AC curve is delayed, because declining average fixed costs keep exerting a downward pull on AC, while they are not a part of and have no influence on AVC.

CHAPTER 11 THE CASE FOR FREE MARKETS: THE PRICE SYSTEM TEST YOURSELF 1. What possible social advantages of price increases arise in the following cases? a. Charging higher prices for electrical power on very hot days when many people use air conditioners b. Raising water prices in drought-stricken areas (a) If there is enough electrical generating capacity to run all the air conditioners on very hot days, much of that capacity will be idle, and therefore wasted, on most days.

Charging higher prices on the hot days will restrict usage at those times and therefore reduce the power generating capacity that must be built. The resources saved can be used for something else. (b) In a drought-stricken area, there has to be a way to reduce water usage; otherwise, the society will simply run out and not have water for its most critical, life-saving uses.

Raising the price of water can accomplish this, by inducing people to use water only for high-priority purposes.

2. In the discussion of Figure 3, there is a set of numbers indicating how much different buyers would be willing to pay for a book. Construct a table for these buyers like the first three columns in Table 1, indicating their consumer surpluses.

3. As in the previous question, use the numbers in Figure 3 to determine the producer’s surpluses and complete your table to correspond to the remaining columns of Table 1.

Solutions for 2. and 3.

Buyers 1 2 3 4 5 6 7

Buyers Acceptable Price 70 60 50 40 30 20 10

Individual Buyers Surplus 30 20 10 0 -10 -20 -30

Actual Price 40 40 40 40 40 40 40

Cumulative Total Surplus $60=30+30 100=60+20+20 120=100+10+10 120=100+0+0 100=120-10-10 60=100-20-20 0=60-30-30

Individual Firm’s Surplus 30 20 10 0 -10 -20 -30

Firms Acceptable Price 10 20 30 40 50 60 70

Firms 1 2 3 4 5 6 7

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Chapter 1/What is Economics?

DISCUSSION QUESTIONS 1. Discuss the fairness of the two proposals included in Test Yourself Question 1.

Both proposals may be unfair to the poor, because they have less discretionary income and may have to cut back their usage more than others do. Other groups who may be unfairly harmed are those who use large quantities of electricity or water and have difficulty cutting back. Students should understand that it is difficult for an economist to deal with questions of fairness because, while there are objective criteria for efficiency, there are only subjective criteria for fairness. The best one can do is to be explicit about those criteria.

2. Using the concepts of marginal cost (MC) and marginal utility (MU), discuss the nature of the inefficiency in each of the following cases: a. An arrangement that offers relatively little coffee and much tea to people who prefer coffee and does the reverse for tea lovers b. An arrangement in which skilled mechanics are assigned to ditch digging and unskilled laborers to repairing cars c. An arrangement that produces a large quantity of trucks and few cars, assuming that both cost about the same amount to produce and to run but that most people in the community prefer cars to trucks (a) Both tea lovers and coffee lovers could be made better off, and no one would be worse off, if the tea lovers swapped coffee for tea with the coffee lovers. Therefore the current situation (without the swaps) is inefficient. (b) The situation is inefficient because both ditch digging and car repair are being badly done. If the jobs were switched, both would be well done. (c) There are more trucks and fewer cars than people would prefer. With the same resources, the community could get more cars (which they want) by giving up trucks that they do not want.

3. In reality, which of the following circumstances might give rise to each of the situations described in Discussion Question 2? a. Regulation of output quantities by a government b. Rationing of commodities c. Assignment of soldiers to different jobs in an army (a) If the government regulates output quantities, it may decree quantities that differ from the community’s preferences, for example, too many trucks and not enough cars. (b) If commodities are rationed, the quantities that people are allowed to buy may have nothing to do with their preferences; for example, tea lovers may lack tea and have more coffee than they want, and vice versa for coffee lovers. (c) If soldiers are assigned to different jobs in the army, those jobs may have nothing to do with their aptitudes: skilled mechanics may be assigned to dig ditches, and people with strong backs but no skills may be assigned to repair machines.

4. We have said that the economy’s three coordination tasks are output selection, © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

production planning, and product distribution. Which of these is done badly in the cases described in Discussion Questions 2a, 2b, and 2c?

Question 2(a) is a case of the inefficient distribution of product. Question 2(b) is a case of inefficient production planning. Question 2(c) is a case of inefficient output selection.

5. In a free market, how will the price mechanism deal with each of the inefficiencies described in Discussion Question 2? (a) In a free market, people can buy as much of different goods as they want, given their budget. Tea lovers can buy more tea, coffee lovers more coffee. (b) In a free market, a firm that hired skilled workers to do unskilled work would go out of business, because a competitor would hire unskilled labor at a lower wage to do the same job, and be able to sell its products at a lower price. (c) In a free market, if there was an excess supply of trucks and an excess demand for cars, the price of the former would fall and the price of the latter would rise. This would lead producers to switch toward car production, and it would lead consumers to switch toward truck purchases.

6. China’s transition to a market economy is arguably the greatest modern economic

success story. What sorts of policies have made China’s incredible economic growth possible? How have China’s citizens benefited from this growth? What additional reforms are needed if China is to sustain its strong economic growth well into the future?

Economic reforms, combined with China's opening to international trade and investment in the 1980s, spurred China's initial economic development. Then, in the 1990s, new reforms that allowed private and state-owned enterprises to compete as equals in the market and the Chinese government's withdrawal from pricing and resource allocation decisions encouraged even further growth. Most recently, China's formal adoption, in 2003, of market-based regulation, followed by the introduction, in 2006, of stronger antitrust laws, new bankruptcy protections, and new securities trading laws to protect investors led to yet another economic growth spurt. Despite this incredible growth, Chinese citizens still have comparatively low incomes—per capita income in China was $6,700 in 2009, compared with $46,000 in the United States and $34,200 in Germany.

However, since the 1970s, living standards have risen universally and markedly in China.

Perhaps most important, poverty in China has fallen from over 50 percent in the 1970s to below 10 percent by the end of the last decade. Still, China must continue its reforms, if the country is to sustain its remarkable growth. These include deregulation of several state-owned sectors (e.g., electricity, water, and transportation), reduction of widespread corruption, and stronger enforcement of laws—especially those governing intellectual property.

CHAPTER 12 MONOPOLY © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

TEST YOURSELF 1. Which of the following industries are pure monopolies? a. The only supplier of heating fuel in an isolated town b. The only supplier of IBM notebook computers in town c. The only supplier of digital cameras Explain your answers. (a) Pure monopolist. There is no good substitute for heat (bulky sweaters don’t help a great deal), and one firm controls the source. (b) Not a pure monopolist. Consumers can buy close substitutes—that is to say, other types of personal computers—from other firms. (c) Not a pure monopolist. The one supplier of digital cameras is likely to have more market power than the suppliers of some other goods, but still many other types of cameras and even phones are substitutes for digital cameras.

2. The following are the demand and total cost schedules for Company Town Water, a local monopoly: Output in Gallons

Price per Gallon

Total Cost

50,000

$0.28

$ 6,000

100,000

0.26

15,000

150,000

0.22

22,000

200,000

0.20

32,000

250,000

0.16

46,000

300,000

0.12

64,000

How much output will Company Town Water produce, and what price will it charge? Will it earn a profit? How much? (Hint: First compute the firm’s MR and MC schedules.)

From the data given, one can calculate total revenue, marginal revenue, marginal cost and profit as shown below. (The calculation for MR and MC are per gallon, although one may choose to calculate MR and MC per 50,000-gallon units.)

Output 50,000 100,000

Price TR 0.28 14,000 0.26 26,000

MR TC 0.28 6,000 0.24 15,000

MC 0.12 0.18

Profit 8,000 11,000

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150,000 200,000 250,000 300,000

0.22 0.20 0.16 0.12

33,000 40,000 40,000 36,000

0.14 0.14 0 -0.08

22,000 32,000 46,000 64,000

0.14 0.20 0.28 0.36

11,000 8,000 –6,000 –28,000

The profit maximizing output is 150,000 gallons, where marginal revenue equals marginal cost. The price charged is $0.22 a gallon, and the total profit is $11,000.

3. Show from the following table that for this water company, marginal revenue (per 50,000-gallon unit) is always less than price.

Output in Gallons

Price per Gallon

Total Cost

50,000

$0.28

$ 6,000

100,000

0.26

15,000

150,000

0.22

22,000

200,000

0.20

32,000

250,000

0.16

46,000

300,000

0.12

64,000

The price per 50,000-gallon unit is found by multiplying by 50,000, which really gives us total revenue (TR) per 50,000 gallon unit. The marginal revenue per 50,000-gallon unit is found by taking the change in total revenue per 50,000-gallon unit. As the following table shows, for each level of output, marginal revenue is less than price (except for the first unit sold).

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Chapter 1/What is Economics?

Price per Unit of 50,000 gallons Output in

(Price x Output = Total Revenue)

Gallons

Price per Gallon

TR

MR

50,000

$0.28

$14,000

14,000

100,000

0.26

26,000

12,000

150,000

0.22

33,000

7,000

200,000

0.20

40,000

7,000

250,000

0.16

40,000

0

300,000

0.12

36,000

-4,000

4. A monopoly sells Frisbees to two customer groups. Group A has a downward-sloping straight-line demand curve, whereas the demand curve for Group B is infinitely elastic.

Draw the graph determining the profit-maximizing discriminatory prices and sales to the two groups. What will be the price of Frisbees to Group B? Why? How is the price to Group A determined?

Group B has an infinitely elastic demand curve; hence P = MR. Since the firm maximizes profits, it sets output at, for example, QB, where MC = MR. To maximize overall profits, the firm must have the same marginal revenue in both markets, and this must be equal to PB. In Group A, when marginal revenue is equal to PB, the price is higher, as shown, PA.

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Chapter 1/What is Economics?

FIGURE 1

DISCUSSION QUESTIONS 1. Suppose that a monopoly industry produces less output than a similar competitive industry. Discuss why this may be considered socially undesirable. Is this because it is always socially beneficial to produce more of some product?

There are many ways of discussing this question. For example: (a) It is obvious that consumers are hurt if they get less output and at the same time have to pay a higher price. (b) The monopoly’s market power allows it to earn a profit in the long run, that is to say an economic profit, over and above the income that would be necessary to attract the firm into the industry. This is an unnecessary payment or penalty that consumers pay the firm. (c) The text shows that the price charged by the monopolist is greater than the marginal cost. Therefore marginal utility exceeds marginal cost, and the monopolist is restricting output below its optimal level.

2. If competitive firms earn zero economic profits, explain why anyone would invest money in them. (Hint: What is the role of the opportunity cost of capital in economic profit?)

If a firm earns zero economic profits, money invested in it earns just as high a return as it would in its best alternate use. Thus the investment is just as good as another investment.

The point is that monopoly profits are not needed in order to attract capital into an industry.

3. Suppose that a tax of $28 is levied on each item sold by a monopolist, and as a result, it decides to raise its price by exactly $28. Why might this decision be against its own best interests?

Any price increase by the monopolist will result in a reduction in sales, because of the negatively sloping demand curve. When a tax of $28 per item is levied, if the monopolist © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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raises the price by $28, sales will be reduced to such an extent that marginal revenue will exceed marginal cost (even though marginal cost has risen by $28). A more moderate price increase, with a smaller reduction in sales, will allow the monopolist to maximize profits.

4. Use Figure 2 to show that Adam Smith was wrong when he claimed that a monopoly would always charge ―the highest price which can be got.‖ The highest price a monopolist can charge is the price at which one unit is sold. Sales are so low that profits are low, probably negative. A monopolist wishing to maximize profits will not charge ―the highest price which can be got,‖ but an intermediate price.

5. General Motors declared bankruptcy in 2009 but exited bankruptcy just 40 days later, after streamlining its operations and selling the U.S. government a majority stake in the company. If GM had gone out of business altogether, why might that not have reduced the competition facing rival automaker Ford? (Hint: At what price would the assets of the bankrupt companies be offered for sale?)

If General Motors went out of business, its assets would be offered for sale at relatively low prices. This type of sale could allow an existing auto maker or a new firm to produce and sell in the segment of the market vacated by GM. As such, a rival like Ford might not see a substantial decrease in competition.

6. What does your answer to the previous question tell you about the ease or difficulty of entry into the automobile industry?

Generally, there are significant barriers to entry into the automobile industry. The sale of the assets of a firm exiting the market would be a unique situation that would greatly reduce those barriers.

7. A firm cannot break even by charging uniform (nondiscriminatory) prices, but with price discrimination it can earn a small profit. Explain why in this case consumers must be better off if the firm is permitted to charge discriminatory prices.

The gains from exchange are mutual. Firms generate income for themselves, and consumers benefit as well, gaining more in utility than they give up in payment for the goods they buy. If they did not benefit, they would not buy. If a firm is forced to charge uniform prices and as a consequence goes out of business, consumers are denied any benefit at all from buying its products. If it is allowed to discriminate, and as a result continues to exist, consumers will purchase its goods and therefore benefit.

8. It can be proved that, other things being equal, under price discrimination the price charged to some customer group will be higher the less elastic the demand curve of that group is. Why is that result plausible?

The more inelastic the demand, the more committed consumers are to buying the good, regardless of its price. A firm can raise its price in such a market, without losing much © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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business. The lower the elasticity, therefore, the higher a price discriminator will push the price.

CHAPTER 13 BETWEEN COMPETITION AND MONOPOLY TEST YOURSELF 1. Using game theory, set up a payoff matrix similar to one that Volkswagen’s management might employ in analyzing the problem presented in Discussion Question 5.

The payoff matrix might be Table 1: TABLE 1 Hire Singer Ford

Volkswagon Cut Price

New Product

Hire Singer Cut Price New Product

It is, of course, hard to tell what the entries in the payoff matrix will be.

2. In the payoff matrix in Table 2, which is Firm B’s dominant strategy? Show the calculation that leads to that conclusion.

In Table 2, we can see that if Firm A chooses the Cell Phone option, Firm B would be better off choosing the Smart Phone option since it would get a payoff of $12 million (vs. $10 million if it chooses the Cell Phone). If Firm A chooses the Smart phone option, Firm B would be better off choosing the Smart Phone -Tech option once again because it would get a payoff of $3 million (vs. negative $2 million for the Cell Phone option).

Therefore, the Smart Phone option is Firm B’s dominant strategy since it is the best strategy regardless of Firm A’s strategy.

3. You are given a payoff matrix for a zero-sum game. You see that for one pair of strategy choices by the two firms, A’s payoff is 9 and B’s payoff is 6. For a second set of strategy choices, A’s payoff is 7. What is B’s payoff?

Since it is a zero-sum game and A has lost 2 of its original payoff, B must have gained 2 and now will have a payoff of 8.

DISCUSSION QUESTIONS 1. How many real industries can you name that are oligopolies? How many operate under monopolistic competition? Perfect competition? Which of these is most difficult © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

2.

3.

4.

5.

to find in reality? Why do you think this is so?

Some oligopolistic industries are wireless service, steel, chemicals, automobiles, cigarettes, beer, petroleum, home appliances, aircraft and tires. Some industries in monopolistic competition are groceries, shoemakers, laundries, print shops, novelty stores, restaurants, gas stations and bicycle shops. It is hard to find a perfectly competitive industry because it is a polar case; almost every firm has some distinguishing feature. But the industries that come closest are farming and the sales of corporate stocks and bonds.

Consider some of the products that are widely advertised on television. By what kind of firm is each produced—a perfectly competitive firm, an oligopolistic firm, or another type of firm? How many major products can you think of that are not advertised on TV? Most TV advertising is done by oligopolistic firms, for example beer, automakers, and computer companies. A smaller firm, and particularly a perfect competitor, does not have the resources to advertise and in any case it would not make sense for such a firm to advertise on TV since most of the additional demand that was generated would go to other firms in the industry. Goods that are not advertised, such as agricultural products, are usually produced under conditions close to pure or monopolistic competition. (Note that whenever such goods are advertised it is by a trade association or combination of firms, not by a single small firm.)

In what ways may the small retail sellers of the following products differentiate their goods from those of their rivals to make themselves monopolistic competitors: hamburgers, radios, cosmetics?

In all three products, retailers differentiate themselves by the location and design of their shops, by the service they provide and by their local advertising. Hamburger stores offer different condiments and flavors and different side dishes. Radio stores offer products that differ in certain features. Cosmetics retailers differ in their products and also in their packaging.

Pricing of securities on the stock market is said to be carried out under conditions in many respects similar to perfect competition. The auto industry is an oligopoly. How often do you think the price of a share of Ford Motor Company’s common stock changes? How about the price of a Ford Escape? How would you explain the difference?

The price of Ford common stock changes many times a day. The price of a Ford Escape changes usually once a year—perhaps more often if there are discount schemes or if there is inflation. The continuous movements in supply and demand explain the frequent changes in stock prices on the stock market. The stickiness of the auto price may be due to the ―kinked demand curve.‖ Ford knows that if it raises its price, GM will not follow suit, but if it lowers its price, GM will. Hence the demand curve is kinked and the marginal revenue curve is discontinuous at the current output and price. Even if marginal costs change, it will be advantageous for Ford to hold to its current price.

Suppose that Volkswagen hires a popular singer to advertise its compact automobiles. The campaign is very successful, and the company increases its share of the compact-car market substantially. What is Ford likely to do?

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If Volkswagon’s advertising campaign succeeds in increasing its market share, Ford is likely to take action to recover its market share. This may include increased advertising, and may also include lowering its prices and developing new products. The point is that Volkwagon has to expect retaliation.

6. A new entrant, Bargain Airways, cuts air fares between Eastwich and Westwich by 20 percent. Biggie Airlines, which has been operating on this route, responds by cutting fares by 35 percent. What does Biggie hope to achieve?

This is an example of ―predatory pricing.‖ Biggie hopes to set a price so low that Bargain will be unable to compete and be driven out of business. Furthermore, other potential entrants will be scared off. Biggie may actually suffer losses while this is happening.

Eventually however, when Bargain has left, Biggie hopes to act like a monopolist and set a high price. This strategy will only be effective if Biggie can prevent new competitors from entering the market.

7. If air transportation were perfectly contestable, why would Biggie Airlines (see Discussion Question 6) fail to achieve the ultimate goal of its price cut?

If air transportation were perfectly contestable, Bargain could exit the industry while the price was low, use its assets on some other routes for a while, then return to the EastwichWestwich route when Biggie raised prices. So Biggie would never succeed in setting high monopoly prices.

8. Which of the following industries are most likely to be contestable? Explain your answers. a. Aluminum production b. Barge transportation c. Computer manufacturing Barge transportation is likely to be contestable, because barges can easily be moved into or out of any geographical area, without a big expense. Aluminum and computer production, however, require large fixed capital investments that are not easily mobile, and therefore those two industries are unlikely to be contestable.

9. Since the deregulation of air transportation, a community served by a single airline is no longer protected by a regulatory agency from monopoly pricing. What market forces, if any, restrict the ability of the airline to raise prices as a pure monopolist would? How effective do you think those market forces are in keeping airfares down?

A single airline serving a community is not a pure monopoly. It is restricted from setting a monopoly price by the competition from other forms of transportation, such as cars, buses, and trains. Furthermore, the barriers to entry into the market are not absolute, so if the profits are sufficiently high the original airline is likely to face competition from another airline. While they are not perfect, these market forces would be relatively effective in keeping airfares from rising to exorbitant levels.

10. Explain, for a repeated game: a. Why it may be advantageous to have the reputation of being a tough guy who always takes revenge against anyone who harms your interests. b. Why it may be advantageous to have a reputation of irrationality (a) If Firm A is a ―tough guy,‖ it will always strike back at hostile actions by Firm B, even if those hostile acts harm its own interests. Once B becomes convinced that this will happen, it may cease its hostile behavior against A, and A will benefit. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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(b) If Firm A has a reputation for irrationality, Firm B may think it best to adopt a conservative strategy, not threatening A’s profits, lest A strike out against it even at a cost to itself. A may not do this, but B never knows.

CHAPTER 14 LIMITING MARKET POWER: REGULATION AND ANTITRUST DISCUSSION QUESTIONS 1. Why is an electric company in a city often considered to be a natural monopoly?

What would happen if two competing electric companies were established? How about telephone companies? How can changes in technology affect your answer?

Electric companies and telephone companies usually have declining average costs as more customers are added and more use is made of their services. A large part of the costs are fixed, in the form of the distribution network. It would be wasteful to add a second or third distribution network that covers the same routes as the first. Costs to consumers would have to rise. So a monopoly can serve the public interest, provided that the firm does not use its market power to exploit its customers. Changes in technology can significantly alter the cost structure of an industry and potentially eliminate a natural monopoly. An example is the impact of small satellite TV dishes on cable TV networks.

2. Suppose that a 20 percent cut in the price of coast-to-coast telephone calls brings in so much new business that it permits a long-distance telephone company to cut its charges for service from Chicago to St. Louis, but only by 2 percent. In your opinion, is this practice equitable? Is it a good idea or a bad one?

If a cut in the price of coast-to-coast telephone calls brings in so much business that it allows the long-distance carrier to reduce the price of Chicago to St. Louis calls, then both the long-distance carrier and the consumers benefit. Other long-distance competitors may be hurt, but then they have an added incentive to improve efficiency and provide better service to the public. Most observers would endorse such a rate reduction.

3. In some regulated industries, regulatory agencies prevented prices from falling, and as a result many firms opened for business in those industries. In your opinion, is this kind of regulation competitive or anticompetitive? Is it a good idea or a bad one?

When a regulatory agency imposes a price floor, it may encourage more firms to enter the industry, but it does not really encourage competition. The point of having many firms compete against each other is to force them to be efficient and to keep costs and prices low. In the case of the regulated price floor, the regulatory agency creates the appearance of competition, but at the expense of providing its benefits to the consumer.

4. Regulators are highly concerned about the prevention of ―predatory pricing.‖ The U.S. Court of Appeals has noted, however, that ―the term probably does not have a well-defined meaning, but it certainly bears a sinister connotation.‖ How might one © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

5.

6.

7.

8.

distinguish ―predatory‖ from ―nonpredatory‖ pricing? What would you do about it?

A court should not find a price predatory and illegal simply because it is lower than other competitors can meet, if the low price can be sustained by the company. In such a case, consumers benefit in the long run. In contrast, if the firm with the lower price is incurring a sustained economic loss, that would be a better indication that the firm is engaging in predatory pricing.

Do you think that it is fair or unfair for rural users of telephone service to be crosssubsidized by other telephone users?

Students will have their own criteria for fairness. But it is helpful to approach this question by thinking of what the alternative is to having urban telephone users subsidize rural telephone users. One alternative is that rural rates would be higher than urban rates—this could be seen as fairer (because rural average costs are higher than urban) or less fair (because people are being charged different prices for the same service). One consequence of higher rural rates might be that some rural households would choose to go without telephone service, and students may feel this is an undue burden. Another alternative, however, is that rural rates could be kept at the urban level by means of a government subsidy—this would impose the burden of the subsidy upon all taxpayers, in proportion to their capacity to pay income taxes, rather than upon urban phone users, and students may feel that this is more fair.

To provide incentives for increased efficiency, several regulatory agencies have eliminated ceilings on the profits of regulated firms but instead put caps on their prices. Suppose that a regulated firm manages to cut its prices in half, but in the process it doubles its profits. Should rational consumers consider this to be a good or a bad development? Why? Rational consumers should consider any fall in price to be a good development, because it increases their utility. They are in no way harmed by the increase in the company’s profitability. In fact, it may well have been the incentive of the increased profits that led the firm to figure out how to reduce costs and prices.

A shopkeeper sells his store and signs a contract that restrains him from opening another store in competition with the new owner. The courts have decided that this contract is a reasonable restraint of trade. Can you think of any other types of restraint of trade that seem reasonable? Can you think of any that seem unreasonable?

An agreement between a library and construction firms under which the firms agree to limit their hours of work in the neighborhood would seem to be a reasonable restraint on trade. So would a voluntary agreement among owners of fishing boats to limit the size of their catch in order to preserve the long-run yield of the fishery. But many commercial agreements are deemed by the law to be unreasonable, for example a cartel arrangement in which a small group of large firms agrees to limit their output in order to raise the market price.

Which of the following industries do you expect to have high concentration ratios: automobile production, aircraft manufacture, computer and electronics production, pharmaceuticals, production of expensive jewelry? Compare your answers with the data in Table 2.

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Chapter 1/What is Economics?

As of 2007, aircraft manufacture had the highest concentration ratio (81.3), followed by automobile production (67.6), then pharmaceuticals (34.5), then production of expensive jewelry (28.5), and finally by computer and electronics production (17.3).

9. Why do you think the specific industries you selected in Discussion Question 8 are highly concentrated?

Automobiles and aircraft are two industries that are highly mechanized and in which huge fixed costs lead to substantial economies of scale. In these cases, therefore, large companies have an advantage over small companies, and the industries tend to be quite highly concentrated. The production of computers and electronics do not require significant economies of scale and therefore these industries are relatively unconcentrated. The pharmaceutical industry is characterized by very high research and development costs as well as high sales costs. However, once created, many pharmaceutical products can be produced at a low marginal cost. The result is the drug industry is somewhat concentrated.

10. Do you think it is in the public interest to launch an antitrust suit that costs $1 billion? What leads you to your conclusion?

Costly antitrust suits may be justified if the activities they are attacking cause major harm to the public. But since antitrust suits do tend to be very expensive, the Department of Justice is well advised not to embark upon suits that are ill founded or frivolous.

11. In Japan and a number of European countries, the antitrust laws were once much less severe than those in the United States. Do you think that this difference helped or harmed American industry in its efforts to compete with foreign producers?

Why? American companies argue that they are harmed in their competition with foreign companies by the strict U.S. antitrust laws. They are sometimes correct, when American laws seem to prevent cooperation between firms in research and development, market research, and other areas. On the other hand, the intent of antitrust laws is to promote competition and to keep prices low, and to the extent that they are effective they should therefore help American companies to compete against foreigners.

12. Can you think of some legal rules that may discourage the use of antitrust laws to prevent competition while at the same time not interfering with legitimate antitrust actions?

Antitrust laws can discourage competition if they are used against a company that has grown larger simply because it has performed better than other firms in the industry, by developing better products, selling at a lower price, improving its marketing, etc. If the management of a firm fears prosecution under these circumstances, it may decide against innovation. The most obvious way to discourage the use of antitrust laws in such a way is to insist that the criterion of prosecution be illegal conduct, not simply market structure.

Another possibility is to require the plaintiff to pay the legal costs of the defendant if the plaintiff does not prevail.

13. During the oil crisis in the 1970s, long lines at gas stations disappeared soon after price controls were removed and gas prices were permitted to rise. Should this event be interpreted as evidence that the oil companies have monopoly power? Why or © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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why not?

Nothing in the question indicates that oil companies have monopoly power. The supply and demand curves might be as shown in Figure 1 below. A price ceiling of PC might cause a shortage, that is to say an excess of quantity demanded, Q D, over quantity supplied, QS, and consequently long lines at gas stations. When the ceiling is removed, the price would naturally rise to its market equilibrium level, P1; this would increase the quantity supplied, reduce the quantity demanded and eliminate the shortage and the lines.

There is no evidence that the companies have monopoly power to raise prices.

FIGURE 1

14. Some economists believe that firms rarely attempt predatory pricing because it would be a very risky act even if it were legal. Why may this be so?

Predatory pricing exists when a firm temporarily reduces its price below the profitmaximizing level, in order to force other, weaker firms to reduce their prices, in the expectation that those firms will go out of business, thus allowing the initial firm to have greater power, set a higher price, gain market share and increase profits. The risk is that the predatory firm itself may incur losses and even go out of business, because it has chosen such low prices.

15. Firm X cuts its prices, and competing Firm Y soon goes out of business. How would you judge whether this price cut was an act of legitimate and vigorous competition or an anticompetitive act?

This is very similar to question 4 about predatory pricing. To distinguish between an anticompetitive act and a legitimate competitive act one should identify potential barriers to entry, determine if the market is contestable, estimate the relevant demand elasticities, estimate the firm’s average and marginal cost curves, and identify the number of potential and actual competitors. If Firm X is able to profitably sustain the new low price and if new, more efficient firms enter the market this action was a result of legitimate competition that resulted in the elimination of the inefficient Firm Y. If Firm X incurs a loss as a result of the initially low price, raise its price after the exit of Firm Y and is able to prevent new firms from entering the market, this price cut was an anti-competitive act. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

CHAPTER 15 THE SHORTCOMINGS OF FREE MARKETS TEST YOURSELF 1. What is the opportunity cost to society of shipping some goods 100 miles by truck? Why may the price of the gasoline used by the truck not adequately represent that opportunity cost?

The opportunity cost to society of a trip by a truck is the goods and services that would have been available had the trip not been made. Some of these are forgone because the gasoline used to fuel the truck is not available for other uses. The price paid for the gasoline likely represents this part of the opportunity cost quite well. But some part of the opportunity cost consists of the clean environment forgone because of the truck’s pollutants. This is not included in the price of the gas.

2. Suppose that because of a new disease that attacks coffee plants, far more labor and other inputs are required to harvest a pound of coffee than before. How may that change affect the efficient allocation of resources between tea and coffee?

How would the prices of coffee and tea react in a free market?

The disease raises the opportunity cost of a pound of coffee. It will be efficient for people to switch away from coffee, in order to produce and consume more tea. The increased cost of coffee will be reflected in an increased price, and this in turn will cause consumers to switch to tea. The increased demand for tea will cause an increase in the price of tea also.

3. Give some examples of goods whose production causes detrimental externalities and some examples of goods whose production creates beneficial externalities.

Examples of goods causing detrimental externalities: substances in spray cans the use of which depletes the atmosphere’s ozone layer, minerals that are strip-mined, forest products that destroy natural habitats when the trees are cut. Examples of goods creating beneficial externalities: freshly painted houses, workers who are trained in one firm and then work for another.

4. Compare cleaning a dormitory room with cleaning the atmosphere of a city.

Which is a public good and which is a private good? Why? Cleaning a dorm room is a private good, while cleaning the atmosphere is a public good.

In the former case, the resident can be excluded from access to the service and use of the room will make it dirty. A clean atmosphere is a public good, because people cannot be excluded from it, and because additional use (by more people coming into the city) does not deplete it. Consequently, no individual has an incentive to pay for it.

5. (More difficult) A firm holds a patent that is estimated to be worth $20 million.

The patent is repeatedly challenged in the courts by a large number of (moneyseeking) firms, each hoping to grab away the patent. If anyone is free to challenge the patent so that there is free entry into the litigation process, how much will end up being spent in the legal battles? (Hint: Under perfect © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

competition, should firms expect to earn any economic profit?)

About $20 million will be spent in the legal battles. If any less were spent, it would be advantageous for another litigant to spend more, since the prize is worth $20 million.

Perfect competition eliminates economic profits.

DISCUSSION QUESTIONS 1. Give some other examples of public goods. In each case, explain why additional users do not deplete the good and why it is difficult to exclude people from using it.

There are many examples. A country’s diplomatic service is a public good. It is intended to produce friendly relations with other countries. If it does so, no citizen of the diplomatic service’s country can be excluded from the benefits of friendship, and those benefits are not diminished as the population grows. Another example would be a stop sign. It is not possible to exclude one driver from the benefits of the sign without excluding all others. If one driver can use the sign for traffic management and safety, that does not mean that other drivers are less able to do so.

2. Think about the goods and services that your local government provides. Which are “public goods” as economists use the term?

Public goods provided by a local government include police protection and road maintenance. But some services do not fall into the category of public goods even though they may be provided free, because people could be excluded from them through a pricing mechanism, and because the provision of the service to more people uses up more resources: examples are schools, water supply, and garbage collection.

3. Explain why the services of a lighthouse are sometimes used as an example of a public good.

A lighthouse is a public good because its use by one ship does not diminish its value to other ships, and because ships cannot be excluded from access to it.

4. Explain why education is not a very satisfactory example of a public good.

Education has some aspects of a public good because some of the value of a person’s education accrues to that person’s fellow citizens who find their lives improved by living in a society in which other people are educated. They cannot be excluded from this benefit, and they share it equally. But the greatest value of education accrues to the individual who is educated. That person could be excluded from education, by tuition and other charges. And the provision of education to more people requires more resources. So it is better to think of education as having a beneficial externality, rather than as being a public good.

5. In recent decades, college tuition costs have risen more rapidly than the general price level, even though the wages of college professors have failed to keep pace with the price level. Can you explain why?

College tuition fees have risen because the productivity of faculty members—measured, for example, by the number of students educated per professor—has not risen, at a time when productivity in the rest of the economy has risen substantially. Moreover, costs © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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other than faculty wages have risen faster than inflation: for example, plant maintenance, wages of support staff, library acquisitions.

CHAPTER 16 THE ECONOMICS OF THE ENVIRONMENT AND NATURAL RESOURCES TEST YOURSELF 1. Production of Commodity X creates 10 pounds of emissions for every unit of X produced. The demand and supply curves for X are described by the following table: Price Quantity Quantity Demanded Supplied $10

80

100

9

85

95

8

90

90

7

95

85

6

100

80

5

105

75

What is the equilibrium price and quantity, and how much pollution will be emitted?

At equilibrium, the price is $8, and 90 units of X are sold. Consequently 900 pounds of pollution are emitted.

2. Using the data in Test Yourself Question 1, if the price of X to consumers is $9, and the government imposes a tax of $2 per unit, show that because suppliers get only $7, they will produce only 85 units of output, not the 95 units of output they would produce if they received the full $9 per unit.

When suppliers receive a price of $7, they produce 85 units. Consumers pay a price of $9 and demand 85 units. With a tax of $2 a unit, there must be a gap between the consumers’ © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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price and the producers’ price of $2. Reading along the table, one can see that with this $2 gap, supply and demand are equal at a market price of $9, with sales equal to 85 units.

3. With the tax described in Test Yourself Question 2, how much pollution will be emitted?

There are now 850 pounds of emissions.

4. Compare your answers to Test Yourself Questions 1 and 3 and show how large a reduction in pollution emissions occurs because of the $2 tax on the polluting output.

The $2 tax reduces emissions by 50 pounds.

DISCUSSION QUESTIONS 1. What sorts of pollution problems would you expect in a small African village? In a city in India? In the People’s Republic of China? In New York City?

A small African village may exist in a very delicate balance with its surrounding environment. Thus increased intensity of animal grazing may lead to destruction of the grasslands and encroachment of the desert. An increase the local population could have an impact on the water supply as well. In an Indian city, the most pressing pollution problems may lie in the area of sanitation and garbage disposal, with consequent serious effects upon public health. In many communist countries such as China, it appears that the public commitment to industrialization, together with an absence of forums in which people could express their real interests, led to the neglect of the pollution caused by industrial wastes. In New York City, although there is concern for the environment, nevertheless the intense level of industrialization, auto traffic, and population lead to high levels of noise and atmospheric pollution, and crowding.

2. Suppose you are assigned the task of drafting a law to impose a tax on smoke emissions. What provisions would you put into the law? a. How would you decide the size of the tax? b. What would you do about smoke emitted by a municipal electricity plant? c. Would you use the same tax rate in densely and sparsely settled areas? d. What information will you need to collect before determining what you would do about each of the preceding provisions? (a) The tax per unit of emissions should equal the money value of the damage caused by a marginal unit of those emissions. Of course this is easier said than done. It may be difficult to measure the value of the damage done, and it may even be difficult to figure out what kind of damage is being done. Estimates will have to be made. If estimates of damage are too difficult, then a second-best solution is to pick an amount by which you wish pollution to fall, and then select the tax that will achieve this reduction. (b) The best course to pursue with a municipal plant depends upon the behavior of the plant. If the plant is short of money (as is usually the case), then the imposition of a tax will lead it to try to avoid the tax by reducing pollution, just as a private firm would. On the other hand, if the plant managers are not concerned with profitability, © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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and simply pass additional costs on to the customers, then a tax will not induce any change in their behavior, and the authorities will have to resort to regulation, mandating a certain cut in smoke emissions. (c) The tax should depend upon the value of the damage, and this is likely to vary positively with the density of the population. One could, however, imagine the opposite situation, in which smoke pollution altered a pristine landscape in a major way but made little difference to an already smoggy city; in this case the tax should be greater in the rural area. (d) Before making these decisions, you would need to know how the tax would be levied (e.g. per-unit of production or emission, thus adding to the firm’s marginal costs), the basis for the firm’s decision (e.g. profit-maximizing, regulated monopoly), and the actual amount of damage the pollution caused in the surrounding environment.

3. Discuss some valid and some invalid objections to letting rising prices eliminate shortages of supplies of scarce resources.

Valid objections to a price increase of a scarce resource have to do with its impact upon income distribution. The price increase hurts poor people more than rich, and it may be a windfall gain to some producers. But it is not valid to object to a price increase of a scarce resource on the grounds that it hurts all consumers or that it is a result of manipulation by speculators—since the price increase is actually a consequence of the scarcity of the resource, and since it will produce desirable results, namely conservation of the resource and substitution of alternative resources.

4. Why may an increase in fuel prices lead to more conservation after several years

have passed than it does in the months following the price increase? What does your answer imply about the relative sizes of the long-run and short-run elasticity of demand for fuel?

Initially when fuel prices rise, people are stuck with their existing equipment, and cannot reduce fuel consumption unless they are prepared to reduce their output, consumption, travel, etc. But over time, they can switch to more fuel-efficient cars, buildings, machines and so forth, and as a consequence they can enjoy the same level of output with less use of fuel. In other words, the price elasticity of demand for fuel is likely to be greater in the long run than it is in the short run.

CHAPTER 17 TAXATION AND RESOURCE ALLOCATION TEST YOURSELF 1. Using the following hypothetical income-tax table, compute the marginal and average tax rates. Is the tax progressive, proportional, or regressive?

Income Income Tax $20,000 $2,000 © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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30,000 40,000 50,000

2,700 3,200 3,500

The tax is regressive, since the average tax rate falls as income rises: Income $20,000 30,000 40,000 50,000

Tax $2,000 2,700 3,200 3,500

Tax Rate Marginal Average .10 .10 .07 .09 .05 .08 .03 .07

2. Which concept of tax equity, if any, seems to be served by each of the following? a. The progressive income tax b. The excise tax on cigarettes c. The gasoline tax The answers to these questions are not obvious, and students may be able to argue various points of view. (a) The progressive income tax promotes vertical equity, if one believes that income differentials should be reduced. It promotes horizontal equity, unless one thinks that the exemptions and deductions (―loopholes‖) are too large. (b) The excise tax on cigarettes serves no principle of tax equity. Since the poor spend a higher proportion of their income on cigarettes than do the rich, it violates vertical equity. Since people with the same income spend different amounts on cigarettes, it violates horizontal equity. And since the revenue is not used for smoking-related health costs, it violates the benefit principle. The tax still may be justified, if one believes the government has a legitimate interest in reducing smoking. (c) The gasoline tax is consistent with the benefit principle of taxation: highway users pay a tax that is used to build and repair highways.

3. Suppose the supply-and-demand schedules for cigarettes are as follows: Price per Carton Quantity Demanded Quantity Supplied $3.00 360 160 3.25 330 180 3.50 300 200 3.75 270 220 4.00 240 240 4.25 210 260 4.50 180 280 © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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4.75 5.00

150 120

300 320

NOTE: Quantity is in millions of cartons per year.

a. What are the equilibrium price and equilibrium quantity? b. Now the government levies a $1.25 per carton excise tax on cigarettes. What are the new equilibrium price paid by consumers, the price received by producers, and the quantity? c. Explain why it makes no difference whether Congress levies the $1.25 tax on the consumer or the producer. (Relate your answer to the discussion of the payroll tax in the text.) d. Suppose the tax is levied on the producers. How much of the tax are producers able to shift onto consumers? Explain how they manage to do so. e. Will there be any excess burden from this tax? Why? Who bears this excess burden? f. By how much has cigarette consumption declined on account of the tax? Why might the government be happy about this outcome, despite the excess burden? (a) Before the tax is imposed, the equilibrium price is $4.00 and the equilibrium quantity is 240 million cartons. (b) After the tax is imposed, the supply curve shifts up by the amount of the tax to: Price Price Quantity Quantity (including tax) (excluding tax) Demanded Supplied $4.25 $3.00 210 160 4.50 3.25 180 180 4.75 3.50 150 200 5.00 3.75 120 240 So the new equilibrium quantity will be 180 million cartons. The new equilibrium price paid by the consumers (including the tax) will be $4.50, while the price received by the producers (excluding the tax) will be $3.25. (c) Regardless of who pays it, the tax is a wedge of $1.25 between the price paid by the consumer and the price received by the seller. In the situation described in part (b), the seller may list the price at $3.25, and then require the buyer to pay a tax of $1.25 above this. Or the seller may list the price at $4.50, including tax, and give $1.25 of this to the government. In either case, the net price paid by the consumer is $4.50, the net price received by the seller is $3.25, and the equilibrium quantity is 180. (d) The sellers shift $0.50 of the tax to the buyers, since the market price rises from $4.00 to $4.50. They do this by reducing output, which raises the market price. (e) There is excess burden borne by both buyers and sellers. The buyers’ excess burden arises from the fact that they are purchasing fewer cigarettes than before the tax. The sellers’ excess burden arises from the fact that they are producing fewer cigarettes than before. (f) Cigarette consumption has fallen from 240 million cartons to 180 million cartons.

This may actually be the goal that the government sought, in its attempt to improve health.

4. Now suppose the supply schedule is instead as follows: © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Price per Carton

Quantity Supplied

$3.00 3.25 3.50 3.75 4.00 4.25 4.50 4.75 5.00

60 105 150 195 240 285 330 375 420

NOTE: Quantity is in millions of cartons per year.

a. What are the equilibrium price and equilibrium quantity in the absence of a tax? b. What are the equilibrium price and equilibrium quantity in the presence of a $1.25 per carton excise tax? c. Explain why your answer to part b differs from your answer to part b of the previous question, and relate this difference to the discussion of the incidence of an excise tax in this chapter. (a) Without the tax, the equilibrium is still a price of $4.00 and a quantity of 240. (b) When the tax is imposed, the supply shifts up by the amount of the tax, but in this case the supply curve is more elastic. The new equilibrium is at a price of $4.75 and a quantity of 150: Price (including tax) $4.25 4.50 4.75 5.0

Price (excluding tax) $3.00 3.25 3.50 3.75

Quantity Demanded 210 180 150 120

Quantity Supplied 60 105 150 195

(c) In this case, the price is higher and the quantity lower. Because the supply curve is more elastic, suppliers have been able to shift more of the burden of the tax to buyers, by cutting back production more.

5. The country of Taxmania produces only two commodities: rice and caviar. The poor spend all their income on rice, whereas the rich purchase both goods. Both demand for and supply of rice are quite inelastic. In the caviar market, both supply and demand are quite elastic. Which good would be heavily taxed if Taxmanians cared mostly about efficiency? What if they cared mostly about vertical equity? © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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If Taxmanians care mostly about efficiency, they will tax rice most heavily. Since the elasticities of supply and demand are both low, there will be little reduction in the quantity of rice traded as a consequence of the tax, and therefore little excess burden. If they care mostly about vertical equity, they will tax caviar most heavily, since this tax will fall only on the rich, not the poor. A tax on rice would be vertically inequitable, since the poor spend all of their income on rice while the rich spend only part of their income on rice.

DISCUSSION QUESTIONS 1. ―Americans are overtaxed. The federal government should continue cutting taxes.‖ Comment.

Federal tax revenues have increased, but only in proportion to the increase in national income. Figure 1 in the text shows that the ratio of federal taxes to GDP has stayed roughly constant for half a century. Furthermore, the level of taxation in the U.S. is fairly low in comparison to other industrialized countries. So there is little evidence to indicate that current tax rates will ruin the country.

2. Soon after taking office in 2017, President Donald Trump proposed a series of large tax cuts, including reduction is upper-bracket rates, in the estate tax, and in the corporate tax rate. Critics, including many Democrats, have argued that these tax cuts were excessive in magnitude and regressive in their distributional impact. Why did they say that? Do you agree more with President Trump or with his critics?

Critics opposed President Trump’s tax cuts for many reasons. Some argued that tax cuts would increase the already high federal government budget deficit and add to the national debt. Another criticism was that the tax cuts were skewed towards the rich, thereby increasing the gap between the rich and the poor. The counter to these concerns is that the Trump tax cuts would stimulate spending and investment and therefore the economy.

That is, when you cut taxes on the ―job creators‖ this would ―trickle down‖ and thereby create more jobs over time.

3. Use the example of Mr. Figg (see the box, ―The American Way of Tax‖) to explain the concepts of efficient taxes and excess burden.

The taxes that the government tried to levy on Mr. Figg led to inefficiencies, because Figg changed his behavior away from activities that he preferred. The burden of the taxes on Figg was substantial, since it would require a lot of money to compensate him for the changes in his life. Almost this entire burden is in the form of excess burden; because Figg changed his activities he ends up paying little if any money to the government.

4. Think of some tax that you personally pay. What steps have you taken or could you © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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take to reduce your tax payments? Is there an excess burden on you? Why or why not?

Students could take steps to avoid taxes (legally) by buying fewer consumer goods, driving less, or working less. The annoyance, or the decline in utility, caused by these changes is the excess burden of the tax.

5. Discuss Justice Holmes’s statement on taxes quoted at the beginning of this chapter. Do you agree with him?

Students may or may not agree with the Justice Holmes. Most taxes are in fact levied only for the purpose of raising revenue. If they lead to behavior changes, these create excess burdens and cause inefficiencies. In such cases, most people would agree that these effects should be avoided (to the extent possible). But some taxes are imposed in order to change behavior (for example, effluent charges). Many people would regard these as legitimate. Stated more broadly, many people would argue that taxes serve a ―legitimate government purpose‖ to ―regulate the economy or bring about social change.‖ 6. Use the criteria of equity and efficiency in taxation to evaluate the idea of taxing capital

gains at a lower rate than other sources of income.

Many would argue that on both horizontal and vertical equity grounds, the proposal to reduce capital gains taxation is a bad idea. From a horizontal perspective, it would mean that people with equal incomes would pay different taxes, depending upon the source of their income. From a vertical perspective, it would mean a tax reduction for the rich, who are more likely to have capital gains than the poor. If the proposal has merit, therefore, it is on the grounds of efficiency. It is claimed that the capital gains tax cut would lead to more savings and investment, and thus to improvements in productivity and economic growth. On efficiency grounds, one could evaluate this argument in various ways. It could be seen as inefficient, and creating an excess burden, because it leads people to behave differently than they would under a neutral tax system. On the other hand, many people would see it as efficient, because it leads to greater productivity and eventually more goods and services for the country. Some people might even carry the argument a step further and say that a capital gains tax cut will eventually lead to vertical equity, since the greater output will allow the country to attack poverty more effectively in the future.

CHAPTER 18 PRICING THE FACTORS OF PRODUCTION TEST YOURSELF 1. Which of the following inputs do you think include relatively large economic rents in their earnings? a. Nuts and bolts b. Petroleum c. A champion racehorse © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Use supply-demand analysis to explain your answer. (a) Nuts and bolts: no economic rent. Many manufacturers easily produce nuts and bolts, and in the long run their costs are constant, that is to say, the supply curve is close to horizontal. If the price were lower, they would not be produced. (b) Petroleum: some economic rent. Petroleum has a positively sloped supply curve; some would be produced at a low price and as the price increases, more is produced (from wells that are more expensive to drill and maintain). When demand conditions are such that the price is above the minimum price, therefore, some of the oil is earning economic rent, that is, income greater than would be needed to have it produced. (c) A champion racehorse: almost all economic rent. The supply curve is vertical at a quantity of 1; no matter what the price, the racehorse will still exist. Possibly at very low prices it might not be worth it to the owner and trainer to bring the horse to its full racing potential, but with that exception, all the rest of the horse’s earnings are economic rent.

2. Three machines are employed in an isolated area. They each produce 2,000 units of output per month, the first requiring $20,000 in raw materials, the second $25,000, and the third $28,000. What would you expect to be the monthly charge for the first and second machines if the services of the third machine can be hired at a price of $9,000 per month? Which parts of the charges for the first two machines are economic rent?

In equilibrium, the prices of the first two machines will be bid up, so that their use conveys no advantage over the third machine. The charge for the first machine will be $17,000, of which $8,000 is rent, and the charge for the second machine will be $12,000, of which $3,000 is rent.

3. Economists conclude that a tax on the revenues of firms will be shifted in part to consumers of the products of those firms in the form of higher prices. However, they believe that a tax on the rent of land usually cannot be shifted and must be paid entirely by the landlord. What explains the difference? (Hint: Draw the supply-demand graphs.)

Firms can shift part of a tax on their revenue by reducing their output and raising the price to the consumers. But owners of land cannot reduce the amount of land when a land tax is imposed, and therefore they cannot raise the price and shift the tax.

4. Many economists argue that a tax on apartment buildings is likely to reduce the supply of apartments, but that a tax on all land, including the land on which apartment buildings stand, will not reduce the supply of apartments. Can you explain the difference? How is this answer related to the answer to Test Yourself Question 3?

The answer is basically the same as the answer to question 3. When apartments (and not the land they sit on) are taxed, landlords (who find their after-tax returns reduced) lower the quantity offered for sale, by cutting maintenance, limiting new building, etc. But a tax on the land itself cannot reduce the quantity of land supplied to the market. With demand © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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unchanged, the price of the land will not change. Therefore the cost of land to apartment owners (landlords) will not change, and apartments will not be reduced when the tax is imposed on the land itself.

5. Distinguish between investment and capital.

Capital is means of production that was previously been produced. Investment is an addition to capital.

6. Explain the difference between an invention and an innovation. Give an example of each.

An invention is a new idea that can be put into operation. An innovation is the bringing of a new idea into full operation. The computer chip was an invention. The process of designing a personal computer and bringing it to market was an innovation.

7. What is the difference between interest and profit? Who earns interest and in return for what contribution to production? Who earns economic profit and in return for what contribution to production?

Interest is the return to the suppliers of capital or the lenders of funds. Profit is the return to entrepreneurship, and it accrues to people who take risks, who innovate, and/or who secure a monopoly position.

DISCUSSION QUESTIONS 1. A profit-maximizing firm expands its purchase of any input up to the point where diminishing returns have reduced the marginal revenue product so that it equals the input price. Why does it not pay the firm to ―quit while it is ahead,‖ buying so small a quantity of the input that the input’s MRP remains greater than its price?

If a firm buys so small a quantity of an input that its MRP exceeds its price, the firm will be forgoing the profit it could gain by buying one more unit of the input for which the MRP the firm receives is greater than the price the firm pays.

2. If you have a contract under which you will be paid $10,000 two years from now, why do you become richer if the rate of interest falls?

The current value of your contract is less than $10,000, by an amount reflecting the current rate of interest. If the interest rate falls, some people who find their opportunities for future earnings are reduced will buy contracts like yours, as a way of maintaining their future earnings. They will continue doing this until the higher price of contracts like yours reflects the new, lower interest rate. Your contract has become more valuable, and you are therefore richer.

3. Do you know any entrepreneurs? How do they earn a living? How do they differ from managers? © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Entrepreneurs are people who take risks with their funds, who could lose it all or who could make great gains. Managers are in charge of running an operation, and they generally work for a salary (or a base salary plus some incentive compensation), so they are risking much less.

4. ―Marginal productivity does not determine how much a worker will earn—it determines only how many workers will be hired at a given wage. Therefore, marginal productivity analysis is a theory of demand for labor, not a theory of distribution.‖ What, then, do you think determines wages? Does marginal productivity affect their level? If so, how?

Marginal productivity determines only the demand for labor, while the wage of labor is determined by the interaction of both supply and demand. The quotation is correct if the supply of labor is horizontal at the prevailing wage (as it often is for a small firm); in such a case the supply conditions determine the wage, and marginal productivity determines only the number of workers hired. In the opposite case, in which the supply is completely inelastic, marginal productivity determines the wage. In intermediate cases, in which the supply curve of labor is positively sloped, marginal productivity is one of the determinants of the wage, along with the supply conditions.

5. (More difficult) American savings rates are among the lowest of any industrial country. This has caused concern about our ability to finance new plants and equipment for U.S. industry. Some politicians and others have advocated lower taxes on saving as a remedy. Do you expect such a program to be very effective?

Why? Lower taxes on saving would raise the reward to people for saving and would therefore induce some people to save more. On the other hand, some people whose goal is to save a particular sum of money would find that the reduced taxes would allow them to achieve that goal while saving less. Since the two effects work in opposite directions, the reduction in taxes is not likely to be very effective in raising saving.

6. If rent constitutes only 2 percent of the incomes of Americans, why may the concept nevertheless be significant?

The return to land is only about 2 percent of the incomes of Americans, but the principle of rent applies to any factor of production that is in limited supply, and in which a reduction in payment would not lead to a complete disappearance of the factor.

7. Litigation in which one company sues another often involves costs for lawyers and other court costs literally amounting to hundreds of millions of dollars per case.

What does the concept of an economic rent have to do with the matter?

When one company sues another, it is often seeking to capture or protect economic rent.

Thus Company A may sue Company B for what it regards as an illegal infringement of a patent A has taken out on an invention. The earnings received on account of that investment are economic rent, and are in danger of being lost if B is allowed to produce the item. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

ANSWERS TO APPENDIX QUESTIONS TEST YOURSELF 1. Compute the present value of $1,000 to be received in three years if the rate of interest is 11 percent.

The present value of $1,000 to be received in 3 years, when the rate of interest is 11%, is $1,000 divided by (1.11)3, or $1,000/1.368 ≈ $731.

2. A government bond pays $100 in interest each year for three years and also returns the principal of $1,000 in the third year. How much is it worth in terms of today’s money if the rate of interest is 8 percent? If the rate of interest is 12 percent?

The present value is: $100 $100 $1100   (1  r ) [(1  r )(1  r )] [(1  r )(1  r)(1  r)]

When the interest rate is 8%, this is equal to 100/1.08 + 100/1.166 + 1100/1.260 ≈ $1051.

When the interest rate is 12%, this is equal to 100/1.12 + 100/1.254 + 1100/1.405 ≈ $951.

CHAPTER 19 LABOR AND ENTREPRENEURSHIP: THE HUMAN INPUTS TEST YOURSELF 1. The following table shows the number of pizzas that can be produced by a large pizza parlor employing various numbers of pizza chefs.

Number of Number of Pizzas per Day Chefs 1 40 2 64 3 82 4 92 5 100 6 92 a. Find the marginal physical product schedule of the pizza chefs. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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b. Assuming a price of $9 per pizza, find the marginal revenue product schedule. c. If chefs are paid $100 per day, how many chefs will this pizza parlor employ? How would your answer change if chefs’ wages rose to $125 per day? d. Suppose the price of pizza increases from $9 to $12. Show what happens to the derived demand curve for chefs.

Number of Chefs 1 2 3 4 5 6

Number of Pizzas per Day 40 64 82 92 100 92

Marginal Physical Product 40 24 18 10 8 –8

Marginal Revenue Product when P = $9 $360 216 162 90 72 –72

Marginal Revenue Product when P = $12 $480 288 216 120 96 –96

(a) The MPP schedule is in the third column. (b) The fourth column contains the MRP schedule, when pizzas sell for $9. (c) If the wage rate is $100, the pizza parlor hires 3 chefs. It would not pay to hire the fourth, because the wage would exceed the MRP. If the wage rose to $125, employment would still be 3 chefs. (d) If the price of pizzas is $12, the MRP schedule, which is the derived demand schedule for chefs, is shown in the fifth column. At a wage of $100, the firm hires 4 chefs, and at a wage of $125, employment would be cut to 3 chefs.

2. Discuss the concept of the financial rate of return on a college education. If this return is less than the return on a bank account, does that mean you should quit college? Why might you want to stay in school anyway? Are there circumstances under which it might be rational not to go to college, even when the financial returns to college are very high?

Going to college entails considerable expenses—the out of pocket expenses for tuition, books, etc., plus the opportunity cost of earnings forgone. On the other hand, going to college today is likely to lead to higher earnings in the future. If the future improved earnings are greater in money terms than the current expenses, then one can compute a rate of interest which, when used to discount the future earnings, would make them equal to the current expenses. This is the financial rate of return on one’s college education. If the financial rate of return on a college education is less than the interest on a bank account, then a student could do better financially by quitting college and putting an amount equal to the current costs into the bank account. This may not, however, be the best choice. Students may get non-financial advantages from being in college. They may, for example, enjoy learning for its own sake, or they may like the lifestyle or enjoy their friends. In this case, going to college may be worth the financial loss. Conversely, a student may hate being in college, in which case the financial advantage may not be worth the aggravation, and she may be better off quitting. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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3. In which of the following industries is wage determination most plausibly explained by the model of perfect competition? The model of bilateral monopoly? a. Odd-job repairs in private homes b. Manufacture of low-priced clothing for children c. Auto manufacturing (a) Odd-job repairs in private homes: perfect competition. (b) Low-priced clothing for children: neither perfect competition nor bilateral monopoly. (c) Auto manufacturing: bilateral monopoly.

4. Can you think of some types of workers whose marginal products probably were raised by computerization? Are there any whose marginal products were probably reduced?

Can you characterize the difference between the two types of jobs in general terms?

Many secretaries found their marginal productivities considerably increased by computerization. With modern word processing equipment they could produce more letters and documents, faster and more elegantly. Some telephone operators found their marginal productivity reduced: with the advent of automatic, computerized switches, there was no further need for their skill of plugging wires into holes on black boards.

Those whose productivity was increased were in areas in which they could cooperate with and use the new technology. Those whose productivity was decreased were in areas in which the new technology simply replaced their skills.

5. Suppose you are the sole producer of commodity X, which was just invented to clean the snow from sidewalks more efficiently, and you have produced enough to sell for two winters. If the quantity you expect to sell in 2012 would yield MR = $400 and in 2013 it will be $300, what can you do to try to increase your total profit?

This involves price discrimination between different dates: high prices before competition as the new product arrives in the market and ever lower prices at later dates as more and more competitors enter. The quantities supplied at the two dates must be such that the marginal costs at the two dates are equal to their marginal revenues.

6. Explain what a doubling of the number of customers for your snow cleaner will do to the R&D component of your marginal costs.

Once the entrepreneur has spent the R&D funding, this amount will be fixed. The quantity of money will be the same whether the product has 100 purchasers or 100 million. Added sales will not require any additional R&D expenditures. The marginal R&D costs will be zero.

7. If two jobs are available, one of which is fun and very respectable and the other unpleasant and dangerous, where would you expect wages to be higher? Is that really so in practice?

Wage is expected to be higher in the latter case. Supply-demand analysis implies that wages are relatively high in markets where demand is high relative to supply. Jobs that people find pleasant and satisfying will attract a large supply of labor and will © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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consequently pay a relatively low wage. In contrast, a premium will have to be paid to attract workers to jobs that are onerous, disagreeable, or dangerous.

8. Assume the inventor of the snow cleaner gets only 3 percent of the benefits, the remainder consisting of reduced medical bills for back pain. In the general public, explain why this is an externality. How large is it? Is it a beneficial externality? How will it affect the number of snow cleaners it is most profitable to manufacture, as compared to the number that best contributes to the general welfare?

It is a beneficial externality as the use of snow cleaners reduces the medical bills for people with back pain. The externality is large because a major part of the benefit of the invention is accrued to the general public. As such the market demand curve would not reflect the total benefits to society and the firm will produce a lesser amount than that which would best contribute to general welfare.

DISCUSSION QUESTIONS 1. Colleges are known to pay rather low wages for student labor. Can this trend be explained by the operation of supply and demand in the local labor markets? Is the concept of monopsony of any use? How might things differ if students formed a union?

The supply of youthful, (fairly) unskilled labor is relatively high in colleges and college towns. This leads one to expect that the marginal productivity of such labor is driven to fairly low levels, and the consequence is low wages. The college itself may be such a major employer of student labor that it can act as a monopsonist, and reduce the wage below the value of the marginal product. If students formed a union they might be able to withhold labor, and/or insist on a minimum wage that is higher than the prevailing wage.

They would face the danger, however, of reduced employment.

2. College professors are highly skilled (or at least highly educated!) laborers, yet their wages are not very high. Is this a refutation of the marginal productivity theory?

No, marginal productivity determines the demand schedule for labor, but the actual wage is determined by the interaction of supply with that demand schedule. Since college teaching appears to be an attractive profession, the supply of potential teachers is ample, and the wage therefore not very high. Put differently, the wage is equal not to the average productivity but to the marginal product, and if there are many teachers the marginal product can be driven down to a relatively low level.

3. It seems to be a well-established fact that workers with more years of education typically receive higher wages. What are some possible reasons for this trend?

There are many possible reasons for the positive relation between years of education and wages: (a) People may have learned more by staying in school longer and therefore have higher marginal productivity. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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(b) People who were smarter to begin with may have stayed in school longer. Although they learned nothing of practical use in school, still they have higher marginal productivities than those who left school early, and therefore higher earnings. (c) Employers cannot tell which workers are more productive. They therefore use number of years in school as a proxy or a sorting device and pay people who have more education higher wages, with the expectation that the more highly educated workers will also have the higher marginal productivities. (d) The costs and time that it takes to get a lot of education discourages people, and reduces the supply of highly educated people. Therefore the productivity of the marginal highly educated person is increased, and wages are higher. (e) Many years of education are available only to the well off, and so education is intended to, and has the effect of, preserving the country’s class structure.

4. Approximately what fraction of the U.S. labor force belongs to unions? (Try asking this question of a person who has never studied economics.) Why do you think this fraction is so low?

Currently only about 13 percent of the U.S. labor force belongs to unions. Many different reasons have been advanced for this low figure, some of the reasons being contradictory.

For example, some argue that unions have not been able to secure significant improvements for workers, and so the workers have lost interest in them. From the other side, others argue that unions have been so successful in raising the living standards of American workers that the workers have forgotten the reasons why the unions were necessary in the first place. Other explanations include a tradition of individualism as opposed to collective action in American culture, a shift of employment away from manufacturing toward the service sector (where unionization has always been weak), and an increase in the proportion of women in the labor force (whom unions have always had a more difficult time organizing).

5. What are some reasonable goals for a union? Use the tools of supply and demand to explain how a union might pursue its goals, whatever they are. Consider a union that has been in the news recently. What was it trying to accomplish?

A union might try to maximize the wage rate of its members. To achieve this, it could try to restrict the supply of workers, or negotiate a high wage floor. In any case, it will probably have to sacrifice employment. A different goal might be to increase employment. In this case, the union will probably have to sacrifice something in terms of the wage rate. Another goal, which is a compromise between the first two, is to maximize the total wage earnings of its members, that is to say, wages times employment. It could advance all of these goals by taking action to increase the demand curve for its labor, for example by cooperating with the firm’s advertising campaigns, or by lobbying for import restrictions. Unions may also have many goals that are independent of wages and employment. They may, for example, want an improved grievance procedure, more flexible hours, improved safety conditions, more recreational facilities, improved opportunities for internal promotion, etc.

6. ―Strikes are simply intolerable and should be outlawed.‖ Comment on this statement. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Strikes often hurt third parties, that is to say the public, as well as the workers and the employers, so one can understand the interest that some people have in outlawing them.

And in fact, governments do outlaw strikes in some areas of public sector employment, where it is judged that the public would be harmed too much. But the threat of striking (and the corresponding threat on a firm’s part of a lockout) is what gives the parties to a labor negotiation their power. If strikes are outlawed, the ability that unions have to get a better deal from their employers would be severely curtailed. Strikes actually occur very seldom in the United States, but many people consider the right of a union to strike to be a fundamental freedom, one that was fought for and secured at great cost.

7. In a bitter strike battle between Eastern Airlines and several of its unions, it was clear from the beginning that the airline was in serious financial trouble. The airline was, indeed, eventually forced to close down, costing many jobs. Discuss what might nevertheless have led the unions to hold out so tenaciously.

In the Eastern Airlines strike, the unions took a high-risk strategy, by holding out so firmly when the company was in danger of going bankrupt. One could have understood their backing off. But they had some good reasons for taking a tough position. One was that there was a chance that the company would survive in some form, and that the workers would benefit from having higher paying jobs. Another was that they thought it was important to keep a strong position in the airline industry, so that other airlines would not take advantage of their unions. A third reason was that the management style of Eastern Airlines made them angry.

8. Since about 1980, GDP per capita (that is, the average real income per person) in the United States has risen fairly substantially. Yet real wages have failed to rise.

What do you think may explain this phenomenon?

While GDP per capita has risen, real wages have not. There may be many reasons for this, among them increased labor force participation rates and a shift away from wages toward other forms of non-wage income.

9. If you were the youngest son of an English nobleman in the Middle Ages, what could you do to make your fortune? What kinds of innovation would be appreciated by people in power?

Student answers will vary. Innovation appreciated by those in power would have included anything that could aid the royalty in its expansion (military) or increasing its trade.

10. How did Julius Caesar attain his position in Rome and in history? In what sense can his activities be said to have been entrepreneurial?

Julius Caesar finds his place on our records for his contributions to warfare, standardizing Roman law, establishing uniform municipal governments, as well as the implementation of the Julian calendar among others. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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11. Why do you think medieval China, with all its incredible inventions, fell behind economically?

Students should analyze historical facts pertaining to the medieval Chinese economy.

Explanations could include the agricultural nature of the economy, lack of investment in human capital, and limited innovation with regard to industrialization.

12. What are some of the U.S. laws and other rules that played a critical role in the attainment of leadership in per capita income and innovation?

Student answers may vary. Strong intellectual property laws, fair trade legislation, piracy laws, and relatively low government interference are prime contenders.

13. What steps should the United States consider undertaking to protect itself from the fate of other countries that once were economic leaders of the world and then fell far behind?

Constant innovation holds the key. What holds good for a leading company also holds good for a leading economy. Most of the erstwhile leading economies stagnated and failed to adapt, because of which the mantle passed over to eager competitors.

14. Why do you think, even though high school education in other countries is widely

considered to be better than that in the United States, every country sends its best and brightest to the United States to get their doctorate degrees?

United States is considered to be the land of opportunity and innovations. Development of higher education in the United States has not happened overnight—it is the output of efforts over three centuries. More than anything else, the opportunities provided and the resulting exposure prompts every country to send its best and brightest to the United States to get their Doctorate degrees.

CHAPTER 20 POVERTY, INEQUALITY, AND DISCRIMINATION TEST YOURSELF 1.

Define the poverty rate. Does it rise or fall during recessions?

The poverty rate is the percentage of families whose annual income falls below the poverty line. The rate increases during recessions.

2. Since the official poverty line was set at $3,000 in 1964, prices have risen by about a factor of 8. If the poverty line was adjusted only for inflation, what would it be now?

How does that compare with the actual poverty line? © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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If prices have risen by a factor of 8, the official poverty line would be $24,000 since it is adjusted for inflation (cost of living). This is close to the actual poverty line for a family of four, which was $24,858 in 2017.

DISCUSSION QUESTIONS 1. Discuss the ―leaky bucket‖ analogy (―The Trade-Off between Equality and Efficiency‖ section) with your classmates. What maximum amount of income would you personally allow to leak from the bucket in transferring money from the rich to the poor? Explain why people differ in their answers to this question.

Students will have different responses to this question. It would be interesting to collect the responses and calculate their distribution. Those who are most interested in equity would be willing to accept a greater leakage in percentage terms; those who are most interested in efficiency, would be willing to accept a much lesser percentage.

2. Suppose you were to design a negative income tax system for the United States. Pick a guaranteed income level and a tax rate that seem reasonable to you. What break-even level of income is implied by these choices? Construct a version of Table 4 for the plan you have just devised.

There can be many choices. If the tax rate is constant, then the break-even income level will be equal to the guaranteed income level divided by the tax rate.

3. Suppose the War on Poverty were starting anew and you were part of a presidential commission assigned the task of defining the poor. Would you choose an absolute or a relative concept of poverty? Why? What would be your specific definition of poverty?

Although students will have a variety of answers, a relative concept of poverty almost certainly makes more sense. A relative concept of poverty says that the poor are those who fall too far behind the average income.

4. Discuss the concept of the ―optimal amount of inequality.‖ What are some of the practical problems in determining how much inequality really is optimal?

One could think of output and equality as two goods that can be bought. If one knew their relative costs and the relative utility associated with each, then one would purchase good A (equality) until the point at which its marginal cost was just equal to the marginal utility of good B (output) that is being given up. In fact, there are many practical, and even theoretical, problems inherent in making such a calculation. First, we do not really know what the trade-off between equality and output is, so we cannot determine their relative costs. Second, we do not know how much benefit each gives us. More fundamentally, we each may have different assessments of the benefits from each, and it is impossible to aggregate these assessments. One would not be surprised, for example, to learn that a currently poor person puts a higher value on equality than does a currently rich person.

5. A number of conservative politicians and economists advocate replacing the progressive © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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income tax with a ―flat tax‖ what would apply the same, low tax to all income above a certain exempt amount. One argument against making this change is that the distribution of income has grown much more unequal since the 1970s. Does the evidence support that view? Is it a decisive argument against a flat tax? How is the trade-off between equality and efficiency involved here?

The distribution of income in the United States has indeed grown more unequal since the 1970s. A flat tax would be less effective in reducing inequality than would a progressive income tax, since people with the top incomes would pay (almost) the same tax rate as people in the middle. If low incomes are exempted, the flat tax could have some progressive effect. One argument in favor of the flat tax is that it would promote efficiency by eliminating loopholes and lowering the marginal tax rate; if so, the tax would be an example of the trade-off between equality and efficiency: sacrificing equality for the sake of efficiency.

CHAPTER 21 INTERNATIONAL TRADE AND COMPARATIVE ADVANTAGE TEST YOURSELF 1. The following table describes the number of yards of cloth and barrels of wine that can be produced with a week’s worth of labor in England and Portugal. Assume that no other inputs are needed.

In England In Portugal Cloth

8 yards

12 yards

Wine

2 barrels

6 barrels

a. If there is no trade, what is the price of wine in terms of cloth in England? b. If there is no trade, what is the price of wine in terms of cloth in Portugal? c. Suppose each country has 1 million weeks of labor available per year. Draw the production possibilities frontier for each country. d. Which country has an absolute advantage in the production of which good(s)? Which country has a comparative advantage in the production of which good(s)? e. If the countries start trading with each other, which country will specialize and export which good? f. What can be said about the price at which trade will take place? (a) In the absence of trade, 1 barrel of wine costs 4 yards of cloth in England. (b) In the absence of trade, 1 barrel of wine costs 2 yards of cloth in Portugal. (c) © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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FIGURE 1

(d) Portugal has the absolute advantage in the production of both goods, and the comparative advantage in wine. England has the comparative advantage in cloth. (e) When trade opens, England will specialize in cloth and export it to Portugal, which in turn will specialize in wine and export it to England. (f) In the international market, the price of a barrel of wine will wind up somewhere between 4 yards and 2 yards of cloth, perhaps 3. Stated another way, the price of 1 yard of cloth will be between 1/2 gallon of wine and 1/4 gallon of wine.

2. Suppose that the United States and Mexico are the only two countries in the world and that labor is the only productive input. In the United States, a worker can produce 12 bushels of wheat or 2 barrels of oil in a day. In Mexico, a worker can produce 2 bushels of wheat or 4 barrels of oil per day. a. What will be the price ratio between the two commodities (that is, the price of oil in terms of wheat) in each country if there is no trade? b. If free trade is allowed and there are no transportation costs, which commodity would the United States import? What about Mexico? c. In what range would the price ratio have to fall under free trade? Why? d. Picking one possible post-trade price ratio, show clearly how it is possible for both countries to benefit from free trade. (a) In the absence of trade, in the United States 1 barrel of oil will cost 6 bushels of wheat, while in Mexico 1 barrel of oil will cost one half bushel of wheat. Stated another way, in the United States 1 bushel of wheat will cost 1/6 barrel of oil, while in Mexico 1 bushel of wheat will cost 2 barrels of oil. (b) If there were free trade between the two countries, the U.S. would import oil while Mexico would import wheat. (c) In free trade, the price ratio of oil to wheat will lie between 1:6 and 1:0.5. The price ratio of wheat to oil will lie between 1:2 and 1:0.167. This will provide an incentive for each country to specialize in production and to trade. (d) Suppose the international price ratio of oil to wheat is 1:3. In the United States, one worker moves from oil to wheat, so the United States gives up 2 barrels of oil and produces 12 more bushels of wheat. With a price ratio of 1:3, the 12 bushels can be traded for 4 barrels of oil, and the United States comes out 2 barrels ahead of where it © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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started. Similarly in Mexico, a worker shifts from wheat to oil, sacrificing 2 bushels of wheat for 4 barrels of oil. With a price ratio of 1:3, the 4 barrels of oil can be traded for 12 bushels of wheat, and Mexico comes out 10 bushels of wheat ahead of where it started. Further shifts of workers will provide similar gains, provided costs stay constant.

DISCUSSION QUESTIONS 1. You have a dozen shirts and your roommate has six pairs of shoes worth roughly the same amount of money. You decide to swap six shirts for three pairs of shoes. In financial terms, neither of you gains anything. Explain why you are nevertheless both likely to be better off.

You are better off by swapping shirts for shoes, since you need to wear both, not just shirts alone. In terms of utility analysis, you are giving up shirts that have a low marginal utility (since you have a lot of them) in return for shoes that have a high marginal utility (since you have none). The same is true (in reverse) for your roommate, and so the swap will increase the total utility of both people.

2. In the eighteenth century, some writers argued that one person in a trade could be made better off only by gaining at the expense of the other. Explain the fallacy in this argument.

The argument has to be fallacious, provided that exchange is voluntary (one of the Ideas for Beyond the Final Exam from Chapter 1), since people would not willingly enter a trade that left them worse off. Both parties to a trade benefit, since people give up goods that are worth less to them than the goods they acquire.

3. Country A has a cold climate with a short growing season, but a highly skilled labor force (think of Finland). What sorts of products do you think it is likely to produce?

What are the characteristics of the countries with which you would expect it to trade?

Country A is likely to produce and export manufactured goods that embody high technology, and to import agricultural products and goods that require a more favorable climate and do not require skilled labor.

4. After the removal of a quota on sugar, many U.S. sugar farms go bankrupt. Discuss the pros and cons of removing the quota in the short and long runs.

In the short run, consumers benefit because the price of sugar falls. Domestic sugar producers and their labor force are hurt in the short run, because of increased foreign competition. In the long run, however, workers will find new jobs in sectors of higher productivity. Capital that wears out in the sugar sector will not be replaced, but new capital will be developed in stronger sectors. In time, therefore, the reduction in the sugar quota will help shift the U.S. economy toward sectors that are more efficient and can generate more income.

5. Country A has a mercantilist government that believes it is always best to export more © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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than it imports. As a consequence, it exports more to Country B every year than it imports from Country B. After 100 years of this arrangement, both countries are destroyed in an earthquake. What were the advantages or disadvantages of the surplus to Country A? To Country B? The advantage lies with Country B, which for 100 years had access to more goods than it produced. Country A experienced 100 years of sacrifice, being a net donor of goods to Country B. Of course it is likely that B built up a debt to A, but since both were destroyed in an earthquake, this is irrelevant. The moral of the story is that countries benefit from imports, not exports.

6. Under current trade law, the president of the United States must report periodically to Congress on countries engaging in unfair trade practices that inhibit U.S. exports. How would you define an ―unfair‖ trade practice? Suppose Country X exports much more to the United States than it imports, year after year. Does that constitute evidence that Country X’s trade practices are unfair? What would constitute such evidence?

This is a controversial subject. There are, however, rules for fair trade to which most countries have agreed. They prohibit government subsidies of export industries, using non-tariff barriers such as health and environmental regulations for trade protection, discriminating against imports from a country to which most-favored-nation status has been given, dumping (i.e., selling abroad at an artificially low and therefore predatory price), etc. Just because a country has run a trade surplus with the United States does not mean that it has engaged in unfair practices. Unfair trade practices are often claimed but they can be difficult to prove. For example, for price discrimination to be considered ―predatory‖ and therefore unfair, the export market (the United States in this case) must not be contestable.

7. Suppose the United States finds Country X guilty of unfair trade practices and penalizes it with import quotas. So U.S. imports from Country X fall. Suppose, further, that Country X does not alter its trade practices in any way. Is the United States better or worse off? What about Country X? The point of U.S. penalties against a country guilty of unfair trade practices is to force it to abandon those practices. If it does not do so, then the United States has only hurt itself by imposing the penalties. It has less access to the imports of country X, and probably has to pay a higher price for them. Country X is hurt too, by having its access to the U.S. market reduced.

APPENDIX TEST YOURSELF 1. The following table presents the demand and supply curves for laptop computers in Japan and the United States.

Price per Quantity Quantity Quantity Quantity © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Computer Demanded Supplied Demanded Supplied in United in in Japan in Japan States United States $ 200 90 30 50 50 400 80 35 40 55 600 70 40 30 60 800 60 45 20 65 1,000 50 50 10 70 1,200 40 55 0 75 NOTE: Quantity is in thousands. a. Draw the demand and supply curves for the United States on one diagram and those for Japan on another one. b. If the United States and Japan do not trade, what are the equilibrium price and quantity in the laptop market in the United States? In Japan? c. Now suppose trade is opened up between the two countries. What will be the equilibrium price in the world market for laptops? What has happened to the price of laptops in the United States? In Japan? d. Which country will export laptops? How many? e. When trade opens, what happens to the quantity of laptop computers produced, and therefore employment, in the computer industry in the United States? In Japan?

Who benefits and who loses initially from free trade? (a) FIGURE 2

(b) If there is no trade, in the United States the equilibrium price is $1,000 and the equilibrium quantity is 50,000 units. In Japan, the price is $200 and the quantity is 50,000. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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(c) The new world price will be $600 because, at that price, world quantity demanded is 100,000 units (70,000 plus 30,000) and world quantity supplied is also 100,000 units (40,000 plus 60,000). The price of computers has fallen in the United States and risen in Japan. (Note: To arrive at the answer graphically, construct world demand and supply curves. The equilibrium will be found at a world price of $600.) (d) Japan will export 30,000 computers. (e) In the United States, computer production falls from 50,000 to 40,000, and therefore employment in the computer industry falls. In Japan, computer production rises from 50,000 to 60,000, with a consequent increase in employment. Initially, American consumers and Japanese computer producers (both employers and employees) are helped by free trade, while American computer producers and Japanese consumers are hurt.

CHAPTER 22 CONTEMPORARY ISSUES IN THE U.S. ECONOMY DISCUSSION QUESTIONS 1. You probably bank online, rather than go to the bank. When your parents went to college, hardly anyone did that. What jobs did online banking destroy? What jobs did it create? How might artificial intelligence change the banking business?

Students’ answers will vary. However, many clerical workers lost their jobs as they were replaced by machines, like ATM machines. Artificial intelligence will likely replace ever more sophisticated jobs.

2. What platform markets do you participate in? Do network effects there seem important to you? Why or why not? If you pay to participate in a platform, would you still participate if the price was doubled?

Students’ answers will vary. However, most people will reduce their participation in any activity as its price rises, just as the law of demand would predict.

3. Do you think it is ―fair‖ that gig workers have no minimum wage, no health insurance, and no pension? Is it efficient?

Students’ answers will vary. Issues of fairness are normative issues for which equally reasonable people may disagree. The efficiency issue would require that all benefits and costs be taken into consideration, and this would include measures of consumer and producer surplus.

4. How much student debt do you expect to have on graduation day? Could you have attended your college without incurring this debt?

Students’ answers will vary.

5. You are probably covered by your parents’ health insurance policy. Where do they get health insurance? © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

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Students’ answers will vary.

6. The Affordable Care Act (known as ―Obamacare‖) tried to solve the adverse selection problem by getting everyone into the insurance pool. How? How well did it succeed?

President Trump opposes Obamacare. Why? (You may want to do some Internet searching on this question.)

The ACA tried to minimize adverse selection in two main ways. First, it forbade insurers from charging higher rates or refusing coverage to people with pre-existing conditions.

Second, it imposed an individual mandate, requiring everyone to purchase some health insurance policy, and enforcing that mandate by a tax on anyone who did not. The Trump administration eliminated the individual mandate tax but retained the protections for those with pre-existing conditions. Experts wondered how long such an inconsistent treatment of adverse selection could endure. The reason for President Trump’s opposition to Obamacare is debatable.

7. President Trump has said that he doesn’t see why the U.S. economy cannot grow at 3 or 4 percent per annum (or maybe higher) indefinitely. Do you see why?

Economic growth in the United States has been much slower than our post-World War II average in recent decades. One major factor behind this slower economic growth is slower population growth, which continues. The other contributing factor, productivity growth, is more amenable to policy initiatives, such as more R&D spending. But there are no magic bullets.

8. What are some policies the U.S. government could pursue to ease the burden on the losers from globalization?

The ―right‖ solution to ease the burden on the losers from globalization, many economists maintain, is to cushion the blow for the losers by using trade adjustment assistance (mentioned in Chapter 21) and/or more general income support—such as unemployment insurance and the Earned Income Tax Credit—for citizens who fare poorly in the modern economy. More could be done to help trade’s victims, if society wanted to. But, apparently, we don’t. So certain groups of citizens, certain communities, and certain industries, are damaged by trade.

9. If the U.S. government wants to pursue a ―trade war‖ against Country X, what weapons does it have? Would using those weapons hurt the United States as well? What if Country X retaliates in kind?

Trade wars can be waged by imposing higher tariffs on imported products or implementing other various non-tariff barriers (like quotas). Higher tariffs imposed on foreign goods drives their prices up. As a result, American consumers will increase their demand for American-made substitute goods. This increased demand for these Americanmade goods increases their prices up as well. American consumers are the unequivocal losers of trade wars. American business can also be hurt in a couple of ways. First, if inputs required to manufacture their products are imported then their higher input costs will eventually have to be passed on to their customers in the form of higher prices, hurting these American companies’ sales and job opportunities for their workers. In addition, when other countries retaliate with their own tariffs (or other non-trade protectionist barriers) this reduces U.S. exports, and American exporting businesses and their workers suffer. Trade wars hurt nations. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.

Chapter 1/What is Economics?

10. Budget projections show the debt-to-GDP ratio of the U.S. government topping its World War II high before too long. What problems does that pose?

A growing national debt is the result of continued deficits which must be financed by borrowing, pushing up interest rates that can creating some crowding out effect reducing investment spending which is a key ingredient for economic growth. Therefore, fiscal deficits adding to the national debt can stifle economic growth. In addition, the higher interest expense associated with a growing debt represents billions of dollars used to service the national debt that otherwise could have been spent elsewhere (a large opportunity cost). Eventually, higher taxes and/or reduced government spending will be required which will have a contractionary impact on the U.S. economy at that point in the future.

11. One member of the Federal Open Market Committee says, ―With the unemployment rate below 4 percent, inflation is bound to rise.‖ A second member objects: ―There is very little reason to believe that.‖ Comment on their dispute.

There no longer appears to be a predictable negative relationship between unemployment and inflation. Otherwise stated, the Phillips Curve appears to have disappeared. So, the second member is more likely correct.

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school approved learning management system for classroom use.