Solution Manual for Principles of Microeconomics, 8th Edition canada N. Mankiw, Ronald Kneebone, Ken

INSTRUCTOR SOLUTIONS MANUAL to accompany

Prepared by Ron Kneebone and Ken McKenzie University of Calgary

Principles of Microeconomics, Eighth Canadian Edition

by N. Gregory Mankiw, Ronald D. Kneebone, and Kenneth J. McKenzie Instructor Solutions Manual by Ron Kneebone and Ken McKenzie Technical Check: Racquel Lindsay Copyeditor: Linda Szostak COPYRIGHT © 2020 by Nelson Education, Ltd. Nelson is a registered trademark used herein under license.

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CONTENTS PART 1: INTRODUCTION CHAPTER 1

Ten Principles of Economics .................................................................................. 1

CHAPTER 2

Thinking Like an Economist .................................................................................. 9

CHAPTER 3

Interdependence and the Gains from Trade ......................................................... 21

PART 2: SUPPLY AND DEMAND I: HOW MARKETS WORK CHAPTER 4

The Market Forces of Supply and Demand ......................................................... 37

CHAPTER 5

Elasticity and Its Application ............................................................................... 65

CHAPTER 6

Supply, Demand, and Government Policies ......................................................... 79

PART 3: SUPPLY AND DEMAND II: MARKETS AND WELFARE CHAPTER 7

Consumers, Producers, and the Efficiency of Markets ........................................ 93

CHAPTER 8

Application: The Costs of Taxation ................................................................... 109

CHAPTER 9

Application: International Trade ........................................................................ 121

PART 4: THE ECONOMICS OF THE PUBLIC SECTOR CHAPTER 10

Externalities ........................................................................................................ 137

CHAPTER 11

Public Goods and Common Resources .............................................................. 151

CHAPTER 12

The Design of the Tax System ........................................................................... 161

PART 5: FIRM BEHAVIOUR AND THE ORGANIZATION OF INDUSTRY CHAPTER 13

The Costs of Production ..................................................................................... 167

CHAPTER 14

Firms in Competitive Markets ............................................................................ 183

CHAPTER 15

Monopoly ........................................................................................................... 199

CHAPTER 16

Monopolistic Competition .................................................................................. 217

CHAPTER 17

Oligopoly ............................................................................................................ 229

PART 6: THE ECONOMICS OF LABOUR MARKETS CHAPTER 18

The Markets for the Factors of Production ........................................................ 241

CHAPTER 19

Earnings and Discrimination .............................................................................. 257

CHAPTER 20

Income Inequality and Poverty .......................................................................... 265

PART 7: TOPICS FOR FURTHER STUDY CHAPTER 21

The Theory of Consumer Choice ........................................................................273

CHAPTER 22

Frontiers of Microeconomics .............................................................................. 291

iii

Chapter 1 Ten Principles of Economics SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Describe an important tradeoff you recently faced. • Give an example of some action that has both a monetary and nonmonetary opportunity cost. • Describe an incentive your parents and/or guardians offered to you in an effort to influence your behaviour.

Usually students are able to come up with standard examples of tradeoffs: buy a textbook instead of a ticket to a favourite performance, go to a group study session instead of a birthday party, etc. Instructors may wish to point out less straightforward instances of how the principles work. For instance, when discussing incentives instructors may point out perverse effects of incentives. Other examples include the invention of the seat belt, or crosswalk countdown signals, discussed in the text. Examples of actions that have both monetary and nonmonetary opportunity costs are watching a movie (time + money) and driving a car (money + pollution + traffic congestion). Parents and/or guardians may offer their children gifts conditional on good results in school.

2.

Why is a country better off not isolating itself from all other countries? • Why do we have markets and, according to economists, what roles should government play in them?

A country is better off not isolating itself from other countries for the simple reason that doing so would prevent it from engaging in mutually beneficial trade, which gives consumers access to more diverse and cheaper products.

Markets are usually a good way of organizing economic activity because they allocate resources to their most efficient use, maximizing the size of the economic pie. This is because market prices convey information about the scarcity of various resources, which provides important signals to consumers and producers when making their decisions.

A fundamental role of government is to define and enforce property rights for scarce resources, to allow markets to work in an efficient manner. In some cases, however, markets may nonetheless fail to allocate resources in an efficient manner, and governments can intervene to improve market outcomes. This is the case when market failures exist, such as externalities and market power.

Another role for government can be to address concerns about the equitable distribution of the economic pie. While in the absence of market failures markets will lead to an efficient outcome (maximizing the size of the economic pie), there is no guarantee that the outcome will be equitable (result in a fair distribution of the pie). Governments can therefore play a role in pursuing equity objectives. However, this often requires interventions that may impinge upon efficiency, shrinking the overall size of the economic pie; thus the notion of the efficiency-equity tradeoff.

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2 • Chapter 1: Ten Principles of Economics

3.

List and briefly explain the three principles that describe how the economy as a whole works.

The three principles that describe how the economy as a whole works are: (1) a country’s standard of living depends on its ability to produce goods and services; (2) prices rise when the government prints too much money; and (3) society faces a short-run tradeoff between inflation and unemployment. A country’s standard of living depends on its ability to produce goods and services, which in turn depends on its productivity, which is a function of the education of workers and the access workers have to the necessary tools and technology. Prices rise when the government prints too much money because more money in circulation reduces the value of money, causing inflation. Society faces a short-run tradeoff between inflation and unemployment that is only temporary, and policymakers have some ability to exploit this relationship using various policy instruments.

Questions for Review 1.

What is a tradeoff? Give two examples of tradeoffs that you face in your life.

A tradeoff is what you give up in order to get something else. Examples of tradeoffs include time tradeoffs (such as studying one subject over another, or studying at all compared to engaging in social activities), and spending tradeoffs (such as whether to use your last $15 to purchase a pizza or to buy an online study guide for that tough economics course).

2.

What is the opportunity cost of seeing a movie?

The opportunity cost of seeing a movie includes the monetary cost of admission plus the time cost of going to the theatre and attending the show. The time cost depends on what else you might do with that time; if it’s staying home and watching TV, the time cost may be small, but if it’s working an extra three hours at your job, the time cost is the money you could have earned.

3.

Water is necessary for life. Is the marginal benefit of a glass of water large or small?

The marginal benefit of a glass of water depends on your circumstances. If you’ve just run a marathon, or you’ve been walking in the desert sun for three hours, the marginal benefit is very high. But if you’ve been drinking a lot of liquids recently, the marginal benefit is quite low. The point is that even the necessities of life, like water, don’t always have large marginal benefits.

4.

Why should policymakers think about incentives?

Policymakers need to think about incentives so they can understand how people will respond to the policies they put in place. The text’s examples of seat belts and crosswalk countdown signals show that policy actions can have quite unintended consequences. If incentives matter a lot, they may lead to a very different type of policy; for example, some economists have suggested putting knives in steering columns so that people will drive much more carefully! While this suggestion is silly, it highlights the importance of incentives.

5.

Why isn’t trade among countries like a game, with some winners and some losers?

Trade among countries isn’t a game with some losers and some winners because trade can make everyone better off. By allowing specialization, trade between people and trade between countries can improve everyone’s welfare.

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Chapter 1: Ten Principles of Economics • 3 6.

What does the “invisible hand” of the marketplace do?

The “invisible hand” of the marketplace represents the idea that even though individuals and firms are all acting in their own self-interest, prices and the marketplace guide them to do what is good for society as a whole.

7.

Explain the two main causes of market failure and give an example of each.

The two main causes of market failure are externalities and market power. An externality is the impact of one person’s actions on the well-being of a bystander, such as from pollution or the creation of knowledge. Market power refers to the ability of a single person (or small group of people) to unduly influence market prices, such as in a town with only one well or only one cable television company.

8.

Why is productivity important?

Productivity is important because a country’s standard of living depends on its ability to produce goods and services. The greater a country’s productivity (the amount of goods and services produced from each hour of a worker’s time), the greater will be its standard of living.

9.

What is inflation, and what causes it?

Inflation is an increase in the overall level of prices in the economy. Inflation is caused by increases in the quantity of a nation’s money.

10.

How are inflation and unemployment related in the short run?

Inflation and unemployment are negatively related in the short run. Reducing inflation entails costs to society in the form of higher unemployment in the short run.

Quick Check Multiple Choice

1.

Economics is best defined as the study of which of the following? a. how society manages its scarce resources b. how to run a business most profitably c. how to predict inflation, unemployment, and stock prices d. how the government can stop the harm from unchecked self-interest

2.

What is your opportunity cost of going to a movie? a. the price of the ticket b. the price of the ticket plus the cost of any soda and popcorn you buy at the theatre c. the total cash expenditure needed to go to the movie plus the value of your time d. zero, as long as you enjoy the movie and consider it a worthwhile use of time and money

3.

Which of the following describes a marginal change? a. one that is NOT important for public policy b. one that incrementally alters an existing plan c. one that makes an outcome inefficient d. one that does NOT influence incentives

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4 • Chapter 1: Ten Principles of Economics

4.

What is Adam Smith’s “invisible hand”? a. the subtle and often hidden methods that businesses use to profit at consumers’ expense b. the ability of free markets to reach desirable outcomes despite the self-interest of market participants c. the ability of government regulation to benefit consumers even if the consumers are unaware of the regulations d. the way in which producers or consumers in unregulated markets impose costs on innocent bystanders

5.

When policymakers make policies that change the costs and benefits that people face, what is the result for society? a. people’s behaviours are altered b. people ignore incentives c. inflation occurs d. government revenue is reduced

6.

If a nation has high and persistent inflation, what is the most likely explanation? a. the central bank is creating excessive amounts of money b. unions bargaining for excessively high wages c. the government is imposing excessive levels of taxation d. firms are using their monopoly power to enforce excessive price hikes

1. a 2. c 3. b 4. b 5. a 6. a Problems and Applications 1.

Describe some of the tradeoffs faced by each of the following. a. a family deciding whether to buy a new car b. a member of Parliament deciding how much to spend on national parks c. a company president deciding whether to open a new factory d. a professor deciding how much to prepare for class a.

A family deciding whether to buy a new car faces a tradeoff between the cost of the car and other things they might want to buy. For example, buying the car might mean they must give up going on vacation for the next two years. So the real cost of the car is the family’s opportunity cost in terms of what they must give up.

b.

For a member of Parliament deciding whether to increase spending on national parks, the tradeoff is between parks and other spending items or tax cuts. If more money goes into the park system, that may mean less spending on national defence or on the police force. Or, instead of spending more money on the park system, taxes could be reduced.

c.

When a company president decides whether to open a new factory, the decision is based on whether the new factory will increase the firm’s profits compared to other alternatives. For example, the company could upgrade existing equipment or expand existing factories. The bottom line is: Which method of expanding production will increase profit the most?

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Chapter 1: Ten Principles of Economics • 5 d.

2.

In deciding how much to prepare for class, a professor faces a tradeoff between the value of improving the quality of the lecture compared to other things she could do with her time, such as working on additional research.

You are trying to decide whether to take a vacation. Most of the costs of the vacation (airfare, hotel, forgone wages) are measured in dollars, but the benefits of the vacation are psychological.

How can you compare the benefits to the costs?

When the benefits of something are psychological, such as going on a vacation, it isn’t easy to compare benefits to costs to determine if it’s worth doing. But there are two ways to think about the benefits. One is to compare the vacation with what you would do in its place. If you didn’t go on vacation, would you buy something like a new set of golf clubs? Then you can decide if you’d rather have the new clubs or the vacation. A second way is to think about how much work you had to do to earn the money to pay for the vacation; then you can decide if the psychological benefits of the vacation are worth the psychological costs incurred to earn the money to pay for the vacation.

3.

You were planning to spend Saturday working at your part-time job, but a friend asks you to go skiing. What is the true cost of going skiing? Now suppose that you had been planning to spend the day studying at the library. What is the cost of going skiing in this case? Explain.

If you are thinking of going skiing instead of working at your part-time job, the cost of skiing includes its monetary and time costs, including the opportunity cost of the wages you are giving up by not working. If the choice is between skiing and going to the library to study, then the cost of skiing is its monetary and time costs, including the cost to you of getting a lower grade in your course.

4.

You win $100 in a hockey pool. You have a choice between spending the money now or putting it away for a year in a bank account that pays 5 percent interest. What is the opportunity cost of spending the $100 now?

If you spend $100 now instead of saving it for a year and earning 5 percent interest, you are giving up the opportunity to spend $105 a year from now. The idea that money has a time value is the basis for the field of finance, the subfield of economics that has to do with prices of financial instruments like stocks and bonds.

5.

The company that you manage has invested $5 million in developing a new product, but the development is not quite finished. At a recent meeting, your salespeople report that the introduction of competing products has reduced the expected sales of your new product to $3 million. If it would cost $1 million to finish development and make the product, should you go ahead and do so? What is the most that you should pay to complete development?

The fact that you’ve already sunk $5 million isn’t relevant to your decision anymore, since that money is gone. What matters now is the chance to earn profits at the margin. If you spend another $1 million and can generate sales of $3 million, you’ll earn $2 million in marginal profit, so you should do so. You’re right to think that the project has lost a total of $3 million ($6 million in costs and only $3 million in revenue), and you shouldn’t have started it. That’s true, but if you don’t spend the additional $1 million, you won’t have any sales and your losses will be $5 million.

So what matters is not the total profit, but the profit you can earn at the margin. In fact, you’d pay up to $3 million to complete development; any more than that and you won’t be increasing profit at the margin.

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6 • Chapter 1: Ten Principles of Economics

6.

7.

The welfare system provides income for people who are very poor, with low incomes and few assets. If a recipient of welfare payments decides to work and earn some money, the amount he or she receives in welfare payments is reduced. a. How does this affect the incentive to work? b. How does this feature of the welfare system represent the tradeoff between equality and efficiency? a.

The provision of welfare payments lowers an individual’s incentive to work by imposing an implicit tax on labour earnings. For example, if an individual who receives $100 in welfare payments loses 50 percent of those payments for each dollar in extra income earned, this is like a tax on labour earnings, which will discourage work.

b.

By targeting welfare payments at low-income people and reducing payments as their earned income increases, the system is addressing equity concerns. However, this comes at the cost of efficiency due to the decrease in work effort discussed in part a.

Your roommate is a better and faster cook than you are, but you can clean more quickly than your roommate can. If your roommate did all of the cooking and you did all of the cleaning, would your chores take you more or less time than if you divided each task evenly? Give a similar example of how specialization and trade can make two countries both better off.

By specializing in each task, you and your roommate can finish the chores more quickly. If you divided each task equally, it would take you more time to cook than it would take your roommate, and it would take him more time to clean than it would take you. By specializing, you reduce the total time spent on chores.

Similarly, countries can specialize and trade, making both better off. For example, suppose it takes Spanish workers less time to make clothes than French workers, and French workers can make wine more efficiently than Spanish workers. Then Spain and France can both benefit if Spanish workers produce all the clothes and French workers produce all the wine, and they exchange some wine for some clothes.

8.

Nations with corrupt police and court systems typically have lower standards of living than nations with less corruption. Why might that be the case?

These activities tend to lessen the efficiency of an economic system, hence reducing the economic productivity of a nation. Lower productivity means lower standards of living.

9.

Explain whether each of the following government activities is motivated by a concern about equity or a concern about efficiency. In the case of efficiency, discuss the type of market failure involved. a. regulating cable TV prices b. providing some poor people with free prescription drugs c. prohibiting smoking in public places d. preventing mergers between major banks e. imposing higher personal income tax rates on people with higher incomes f. instituting laws against driving while intoxicated a. b.

Efficiency: The market failure comes from the market power of a small number of cable TV firms.

Equity

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Chapter 1: Ten Principles of Economics • 7

10.

c.

Efficiency: An externality arises because secondhand smoke harms nonsmokers in public places.

d.

Efficiency: The market failure comes from the market power that might occur from potential mergers.

e.

Equity

f.

Efficiency: An externality exists because of accidents caused by drunk drivers.

Discuss each of the following statements from the standpoints of equity and efficiency. a. “Everyone in society should be guaranteed the best health care possible.” b. “When workers are laid off, they should be able to collect unemployment benefits until they find a new job.”

11.

a.

If everyone were guaranteed the best health care possible, much more of our nation’s output would be devoted to health care than is now the case. Would that be efficient? If you believe that doctors have market power and restrict health care to keep their incomes high, you might think efficiency would increase by providing more health care.

But more likely, if the government mandated increased spending on health care, the economy would be less efficient because it would give people more health care than they would choose to pay for. From the point of view of equality, if poor people are less likely to have adequate health care, providing more health care would represent an improvement. Each person would have a more equal slice of the economic pie, though the pie would consist of more health care and fewer other goods.

b.

When workers are laid off, equality considerations argue for the unemployment benefits system to provide them with some income until they can find new jobs. After all, no one plans to be laid off, so unemployment benefits are a form of insurance. But there is an efficiency problemwhy work if you can get income for doing nothing? The economy is not operating efficiently if people remain unemployed for a long time, and unemployment benefits encourage unemployment. Thus, there is a tradeoff between equality and efficiency. The more generous unemployment benefits are, the less income is lost by an unemployed person, but the more that person is encouraged to remain unemployed. So greater equality reduces efficiency.

In what ways is your standard of living different from that of your parents or grandparents when they were your age? Why have these changes occurred?

Since average income in Canada has roughly doubled every 35 years, we are likely to have a better standard of living than our parents, and a much better standard of living than our grandparents. This is mainly the result of increased productivity, so that an hour of work produces more goods and services than it used to. Thus, incomes have continuously risen over time, as has the standard of living.

12.

Suppose Canadians decide to save more of their incomes. If banks lend this extra saving to businesses, which use the funds to build new factories, how might this lead to faster growth in productivity? Who do you suppose benefits from the higher productivity? Is society getting a free lunch?

If Canadians save more and it leads to more spending on factories, there will usually be an increase in production and productivity, since the same number of workers will have more equipment to work with. The benefits from higher productivity will go to both the workers, who will get paid more since they're producing more, and the factory owners, who will get a return on their investments. There is no such thing as a free lunch, however, because when people save more, they are giving up spending. They get higher incomes in the future at the cost of buying fewer goods today.

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Chapter 2 Thinking Like an Economist SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

In what sense is economics like a science? • Draw a production possibilities frontier for a society that produces food and clothing. Show an efficient point, an inefficient point, and an infeasible point. Show the effects of a drought. • Define microeconomics and macroeconomics.

Economics is like a science because economists devise theories, collect data, and analyze the data in an attempt to verify or refute their theories. In other words, economics is based on the scientific method.

Figure 1 shows the production possibilities frontier for a society that produces food and clothing.

Point A is an efficient point (on the frontier), point B is an inefficient point (inside the frontier), and point C is an infeasible point (outside the frontier).

Figure 1 The effects of a drought are shown in Figure 2. The drought reduces the amount of food that can be produced, shifting the production possibilities frontier inward.

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10 • Chapter 2: Thinking Like an Economist

Figure 2 Microeconomics is the study of how households and firms make decisions and how they interact in markets. Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth.

2.

Give an example of a positive statement and an example of a normative statement. • Name three parts of government that regularly rely on advice from economists.

An example of a positive statement is “higher taxes discourage work effort” (many other answers are possible). That is a positive statement because it describes the effects of higher taxes, describing the world as it is. An example of a normative statement is “the government should reduce tax rates.” That is a normative statement because it is a claim about how the world should be.

Parts of the government that regularly rely on advice from economists are Finance Canada in designing tax policy, Industry Canada in designing and enforcing Canada’s antimonopoly laws, and International Trade Canada in helping to negotiate trade agreements with other countries.

3.

Why might economic advisers to the Prime Minister disagree about a question of policy?

Economic advisers to the Prime Minister might disagree about a question of policy because of differing scientific judgments or differences in values.

Questions for Review 1.

In what ways is economics like a science?

Economics is like a science because economists use the scientific method. They devise theories, collect data, and then analyze these data in an attempt to verify or refute their theories about how the world works. Economists use theory and observation like other scientists, but they are limited in their ability to run controlled experiments. Instead, they must rely on natural experiments.

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Chapter 2: Thinking Like an Economist • 11 2.

Why do economists make assumptions?

Economists make assumptions to simplify problems without substantially affecting the answer.

Assumptions can make the world easier to understand.

3.

Should an economic model describe reality exactly?

An economic model cannot describe reality exactly because it would be too complicated to understand. A model is a simplification that allows the economist to see what is truly important.

4.

Name a way that your family interacts in the factor market and a way that it interacts in the product market.

There are many possible answers.

5.

Name one economic interaction that isn’t covered by the simplified circular-flow diagram.

There are many possible answers.

6.

Draw and explain a production possibilities frontier for an economy that produces milk and cookies. What happens to this frontier if disease kills half of the economy’s cows?

Figure 3 shows a production possibilities frontier between milk and cookies (PPF1). If a disease kills half of the economy’s cow population, less milk production is possible, so the PPF shifts inward (PPF2). Note that if the economy produces all cookies so that it doesn’t need any cows, then production is unaffected. But if the economy produces any milk at all, then there will be less production possible after the disease hits.

Figure 3

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12 • Chapter 2: Thinking Like an Economist 7.

Use a production possibilities frontier to describe the idea of “efficiency.”

The idea of efficiency is that an outcome is efficient if the economy is getting all it can from the scarce resources it has available. In terms of the production possibilities frontier, an efficient point is a point on the frontier, such as point A in Figure 4. A point inside the frontier, such as point B, is inefficient since more of one good could be produced without reducing the production of another good.

Figure 4 8.

What are the two subfields into which economics is divided? Explain what each subfield studies.

The two subfields in economics are microeconomics and macroeconomics. Microeconomics is the study of how households and firms make decisions and how they interact in specific markets.

Macroeconomics is the study of economy-wide phenomena.

9.

What is the difference between a positive and a normative statement? Give an example of each.

Positive statements are descriptive and make a claim about how the world is, while normative statements are prescriptive and make a claim about how the world ought to be. Here is an example. Positive: A rapid growth rate of money is the cause of inflation. Normative: The government should keep the growth rate of money low.

10.

Why do economists sometimes offer conflicting advice to policymakers?

One reason that economists may disagree is that they have different views regarding the validity of alternative positive theories about how the world works or the magnitude of incentive effects.

For example, some economists may interpret the evidence regarding the incentive effects of taxes on work effort differently. Another reason that economists may disagree is they have different normative views about what a policy should try to accomplish, most particularly concerning the equity-efficiency tradeoff.

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Chapter 2: Thinking Like an Economist • 13 Quick Check Multiple Choice

1. What is an economic model? a. a mechanical machine that replicates the functioning of the economy b. a fully detailed, realistic description of the economy c. a simplified representation of some aspect of the economy d. a computer program that predicts the future of the economy 2. What does the circular-flow diagram illustrate in terms of markets for the factors of production? a. Households are sellers and firms are buyers. b. Households are buyers and firms are sellers. c. Households and firms are both buyers. d. Households and firms are both sellers.

3. Is a point inside the production possibilities frontier efficient and feasible? a. efficient but not feasible b. feasible but not efficient c. both efficient and feasible d. neither efficient nor feasible 4. An economy produces hot dogs and hamburgers. If a discovery of the remarkable health benefits of hot dogs were to change consumers’ preferences, what would happen? a. expand the production possibilities frontier b. contract the production possibilities frontier c. move the economy along the production possibilities frontier d. move the economy inside the production possibilities frontier 5. Which of the following topics does NOT fall within the study of microeconomics? a. the impact of cigarette taxes on the smoking behaviour of teenagers b. the role of Microsoft’s market power in the pricing of software c. the effectiveness of antipoverty programs in reducing homelessness d. the influence of the government budget deficit on economic growth 6. Which of the following is a positive, rather than a normative, statement? a. Law X will reduce national income. b. Law X is a good piece of legislation. c. Parliament ought to pass law X. d. Law X will change the distribution of income unfairly.

1. c 2. a 3. b 4. c 5. d 6. a

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14 • Chapter 2: Thinking Like an Economist Problems and Applications 1.

Draw a circular-flow diagram. Identify the parts of the model that correspond to the flow of goods and services and the flow of dollars for each of the following activities. a. Selena pays a storekeeper $2 for a litre of milk. b. Stuart earns $15 per hour working at a fast-food restaurant. c. Shanna spends $30 to get a haircut. d. Salma earns $10 000 from her 10 percent ownership of Acme Industrial.

See Figure 5, where the four transactions are shown. a. $2 c. $30

a. $2 c. $30 Markets for Goods and Services a. litre of milk c. haircut

a. litre of milk c. haircut

Firms

Households

b. one hour of work d. Acme’s capital

b. one hour of work d. Acme’s capital

Markets for Factors of Production b. $15 d. $10 000

b. $15 d. $10 000

Figure 5 2.

Imagine a society that produces military goods and consumer goods, which we’ll call “guns” and “butter.” a. Draw a production possibilities frontier for guns and butter. Explain why it most likely has a bowed-out shape. b. Show a point that is impossible for the economy to achieve. Show a point that is feasible but inefficient. c. Imagine that the society has two political parties, called the Hawks (who want a strong military) and the Doves (who want a smaller military). Show a point on your production possibilities frontier that the Hawks might choose and a point the Doves might choose. d. Imagine that an aggressive neighbouring country reduces the size of its military. As a result, both the Hawks and the Doves reduce their desired production of guns by the same amount. Which party would get the bigger “peace dividend,” measured by the increase in butter production? Explain.

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Chapter 2: Thinking Like an Economist • 15 a.

Figure 6 shows a production possibilities frontier between guns and butter. It is bowed out because when most of the economy’s resources are being used to produce butter, the frontier is steep, and when most of the economy’s resources are being used to produce guns, the frontier is very flat. When the economy is producing a lot of guns, workers and machines best suited to making butter are being used to make guns, so each unit of guns given up yields a large increase in the production of butter. Thus, the production possibilities frontier is flat. When the economy is producing a lot of butter, workers and machines best suited to making guns are being used to make butter, so each unit of guns given up yields a small increase in the production of butter. Thus, the production possibilities frontier is steep.

Figure 6 b.

Point A is impossible for the economy to achieve; it is outside the production possibilities frontier. Point B is feasible but inefficient because it’s inside the production possibilities frontier.

c.

The Hawks might choose a point like H, with many guns and not much butter. The Doves might choose a point like D, with a lot of butter and few guns.

d.

If both Hawks and Doves reduced their desired quantity of guns by the same amount, the Hawks would get a bigger peace dividend because the production possibilities frontier is much flatter at point H than at point D. As a result, the reduction of a given number of guns, starting at point H, leads to a much larger increase in the quantity of butter produced than when starting at point D.

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16 • Chapter 2: Thinking Like an Economist 3.

The first principle of economics discussed in Chapter 1 is that people face tradeoffs. Use a production possibilities frontier to illustrate society’s tradeoff between a clean environment and the quantity of industrial output. What do you suppose determines the shape and position of the frontier? Show what happens to the frontier if engineers develop an automobile engine with almost no emissions.

See Figure 7. The shape and position of the frontier depend on how costly it is to maintain a clean environmentthe productivity of the environmental industry. Gains in environmental productivity, such as the development of a no-emission auto engine, lead to shifts of the production possibilities frontier, like the shift from PPF1 to PPF2 shown in the figure.

Figure 7 4.

Classify the following topics as relating to microeconomics or macroeconomics. a. a family’s decision about how much income to save b. the effect of government regulations on auto emissions c. the impact of higher national saving on economic growth d. a firm’s decision about how many workers to hire e. the relationship between the inflation rate and changes in the quantity of money a.

A family’s decision about how much income to save is microeconomics.

b.

The effect of government regulations on auto emissions is microeconomics.

c.

The impact of higher national saving on economic growth is macroeconomics.

d.

A firm’s decision about how many workers to hire is microeconomics.

e.

The relationship between the inflation rate and changes in the quantity of money is macroeconomics.

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Chapter 2: Thinking Like an Economist • 17 5.

6.

Classify each of the following statements as positive or normative. Explain. a. Society faces a short-run tradeoff between inflation and unemployment. b. A reduction in the rate of growth of money will reduce the rate of inflation. c. The Bank of Canada should reduce the rate of growth of money. d. Society ought to require welfare recipients to look for jobs. e. Lower tax rates encourage more work and more saving. a.

The statement that society faces a short-run tradeoff between inflation and unemployment is a positive statement. It deals with how the economy is, not how it should be. Since economists have examined data and found that there is a short-run negative relationship between inflation and unemployment, the statement is a fact; thus it is a positive statement.

b.

The statement that a reduction in the rate of growth of money will reduce the rate of inflation is a positive statement. Economists have found that money growth and inflation are very closely related. The statement thus tells how the world is, and so it is a positive statement.

c.

The statement that the Bank of Canada should reduce the rate of growth of money is a normative statement. It states an opinion about something that should be done, not how the world is.

d.

The statement that society ought to require welfare recipients to look for jobs is a normative statement. It doesn’t state a fact about how the world is. Instead, it is a statement of how the world should be and is thus a normative statement.

e.

The statement that lower tax rates encourage more work and more saving is a positive statement. Economists have studied the relationship between tax rates and work, as well as the relationship between tax rates and saving. They have found a negative relationship in both cases. The statement reflects how the world is, and is thus a positive statement.

If you were Prime Minister, would you be more interested in your economic advisers’ positive views or their normative views? Why? As the Prime Minister, you’d be interested in both the positive and normative views of economists, but you’d probably be most interested in their positive views. Economists are on your staff to provide their expertise about how the economy works. They know many facts about the economy and the interaction of different sectors. So you would be most likely to call on them about questions of factpositive analysis. Since you are the Prime Minister, you are the one who has to make the normative statements as to what should be done, with an eye to the political consequences. The normative statements made by economists represent their own views, not necessarily your views or the electorate’s views.

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18 • Chapter 2: Thinking Like an Economist 7.

An economy consists of three workers: Larry, Moe, and Curly. Each works for ten hours per day and can produce two services: mowing lawns and washing cars. In an hour, Larry can either mow one lawn or wash one car, Moe can either mow one lawn or wash two cars, and Curly can either mow two lawns or wash one car. a. Calculate how much of each service is produced under the following circumstances, which we label A, B, C, and D: • All three spend all their time mowing lawns. (A) • All three spend all their time washing cars. (B) • All three spend half their time on each activity. (C) • Larry spends half his time on each activity, while Moe only washes cars and Curly only mows lawns. (D) b. Graph the production possibilities frontier for this economy. Using your answers to part (a), identify points A, B, C, and D on your graph. c. Explain why the production possibilities frontier has the shape it does. d. Are any of the allocations calculated in part (a) inefficient? Explain. a.

The following table gives the outcomes in the four cases. For example, when each uses half their time in each sector, Larry washes 5 cars and mows 5 lawns in 10 hours, etc.

Lawn mowing Car washing b.

A 40 0

B 0 40

C 20 20

D 25 25

The following graph shows the production possibilities frontier based on the numbers in the table.

Figure 8 c.

The upper part is flatter because the opportunity cost of increasing the number of cars from 0 to 25 is less than 1 lawn per car; moving from 0 cars takes advantage of Moe’s better ability to wash cars than to mow lawns. However, when the number of cars exceeds 25, we start losing Curly’s better skill in mowing lawns; therefore, the opportunity cost of an extra car increases above 1 forgone mowed lawn per extra washed car.

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Chapter 2: Thinking Like an Economist • 19 d.

Allocation C is inefficient. Although all workers use all their time, they do not use their specific skills wisely.

Appendix Problems and Applications A1.

Consider the linear demand curve:

Q D = 56 – 4 P

a. Determine the x- and y-intercepts of this demand curve. b. Determine the slope of this demand curve.

A2.

a.

To determine the x - intercept, set P = 0 and solve for Q D , giving Q D = 56; so the x-intercept is 56. To determine the y - intercept, set Q D = 0 and solve for P, giving 0 = 56 – 4P, P = 56/4, P = 14.

b.

The slope is the rise over the run, where “rise” is the y-intercept and “run” is the xintercept. Thus, slope = –14/56 = –1/4.

Using the general functional form for a linear demand curve, Q D = a – bP, and the data in Table 2A.1, a. Determine the values for a and b for Emma when her income is $30 000. b. Determine the x- and y-intercepts of this demand curve. c. Determine the slope of this demand curve. d. Draw it on a diagram along with the demand curves when her income is $40 000 and $50 000, identifying the x- and y-intercepts in each case. a.

At P = 10, Q = 2 and at P = 9, Q = 6. Therefore, 2 = a – 10b 6 = a – 9b Solve simultaneously for a and b: the first equation gives a = 2 + 10b; substitute into the second equation to get 6 = 2 + 10b – 9b, and solve for b = 4; therefore a = 2 + (10)(4) = 42. Thus, Q D = 42 – 4P.

b.

x-intercept = 42, y-intercept = 10.5

c.

slope = –10.5/42 = –1/4

d.

Figure 9

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Chapter 3 Interdependence and the Gains from Trade SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Draw an example of a production possibilities frontier for Robinson Crusoe, a shipwrecked sailor who spends his time gathering coconuts and catching fish. Does this frontier limit Crusoe’s consumption of coconuts and fish if he lives by himself? Does he face the same limits if he can trade with natives on the island?

Figure 1 shows a production possibilities frontier for Robinson Crusoe between gathering coconuts and catching fish. If Crusoe lives by himself, this frontier limits his consumption of coconuts and fish, but if he can trade with natives on the island, he will be able to consume at a point outside his production possibilities frontier.

Figure 1 2.

Robinson Crusoe can gather 10 coconuts or catch 1 fish per hour. His friend Friday can gather 30 coconuts or catch 2 fish per hour. What is Crusoe’s opportunity cost of catching one fish?

What is Friday’s? Who has an absolute advantage in catching fish? Who has a comparative advantage in catching fish?

Crusoe’s opportunity cost of catching one fish is 10 coconuts, since he can gather 10 coconuts in the same amount of time it takes to catch one fish. Friday’s opportunity cost of catching one fish is 15 coconuts, since he can gather 30 coconuts in the same amount of time it takes to catch two fish. Friday has an absolute advantage in catching fish, since he can catch two per hour while Crusoe can only catch one per hour. But Crusoe has a comparative advantage in catching fish, since his opportunity cost of catching a fish is less than Friday’s.

3.

Suppose that a skilled brain surgeon also happens to be the world’s fastest typist. Should he do his own typing or hire a secretary? Explain.

If the world’s fastest typist happens to be trained in brain surgery, he should hire a secretary. He has an absolute advantage in typing but a comparative advantage in brain surgery, since his opportunity cost in brain surgery is low compared to the opportunity cost for other people.

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22 • Chapter 3: Interdependence and the Gains from Trade Questions for Review 1.

Under what conditions is the production possibilities frontier linear rather than bowed out?

The production possibilities frontier is linear when the opportunity cost of increasing the production of one good is always the same irrespective of the current level of production. This constant opportunity cost reflects the homogeneity of the factors of production: all workers spend the same amount of time in both activities, and no resources are more suitable for producing one good as compared to the other.

2.

Explain how absolute advantage and comparative advantage differ.

Absolute advantage reflects a comparison of the productivity of one person, firm, or nation to that of another, while comparative advantage is based on the relative opportunity costs of the persons, firms, or nations. While a person, firm, or nation may have an absolute advantage in producing every good, they can’t have a comparative advantage in every good.

3.

Give an example in which one person has an absolute advantage in doing something but another person has a comparative advantage.

Many examples are possible. Suppose, for example, that Roger can prepare a fine meal of hot dogs and macaroni in just 10 minutes, while it takes Anita 20 minutes. And Roger can do all the wash in 3 hours, while it takes Anita 4 hours. Roger has an absolute advantage in both cooking and doing the wash, but Anita has a comparative advantage in doing the wash (the wash takes the same amount of time as 12 meals, while it takes Roger 18 meals’ worth of time).

4.

Is absolute advantage or comparative advantage more important for trade? Explain your reasoning using the example in your answer to question 3.

Comparative advantage is more important for trade than absolute advantage. In the example in question 3, Anita and Roger will complete their chores more quickly if Anita does at least some of the wash and Roger cooks the fine meals for both, because Anita has a comparative advantage in doing the wash, while Roger has a comparative advantage in cooking.

5.

If two parties trade based on comparative advantage and both gain, in what range must the price of the trade lie?

In order for trade to benefit both parties, the price for the trade must lie between the parties’ opportunity costs.

6.

Why do economists tend to oppose policies that restrict trade among nations?

Economists oppose policies that restrict trade among nations because trade allows all countries to achieve greater prosperity by allowing them to receive the gains from comparative advantage.

Restrictions on trade can hurt all countries.

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Chapter 3: Interdependence and the Gains from Trade • 23 Quick Check Multiple Choice

1. In an hour, Ken can wash 2 cars or mow 1 lawn, and Ron can wash 3 cars or mow 1 lawn. Who has the absolute advantage in car washing, and who has the absolute advantage in lawn mowing? a. Ken in washing, Ron in mowing b. Ron in washing, Ken in mowing c. Ken in washing, neither in mowing d. Ron in washing, neither in mowing 2. Once again, in an hour, Ken can wash 2 cars or mow 1 lawn, and Ron can wash 3 cars or mow 1 lawn. Who has the comparative advantage in car washing, and who has the comparative advantage in lawn mowing? a. Ken in washing, Ron in mowing b. Ron in washing, Ken in mowing c. Ken in washing, neither in mowing d. Ron in washing, neither in mowing 3. What results when two individuals produce efficiently and then make a mutually beneficial trade based on comparative advantage? a. they both obtain consumption outside their production possibilities frontier b. they both obtain consumption inside their production possibilities frontier c. one individual consumes inside her production possibilities frontier, while the other consumes outside hers d. each individual consumes a point on her own production possibilities frontier 4. Which goods will a nation typically import? a. those goods in which the nation has an absolute advantage b. those goods in which the nation has a comparative advantage c. those goods in which other nations have an absolute advantage d. those goods in which other nations have a comparative advantage 5. Suppose that in Canada, producing an aircraft takes 10 000 hours of labour and producing a shirt takes 2 hours of labour. In China, producing an aircraft takes 40 000 hours of labour and producing a shirt takes 4 hours of labour. What will these nations trade? a. China will export aircraft, and Canada will export shirts. b. China will export shirts, and Canada will export aircraft. c. Both nations will export shirts. d. There are no gains from trade in this situation.

6. Mark can cook dinner in 30 minutes and wash the laundry in 20 minutes. His roommate takes half as long to do each task. How should the roommates allocate the work? a. Mark should do more of the cooking based on his comparative advantage. b. Mark should do more of the washing based on his comparative advantage. c. Mark should do more of the washing based on his absolute advantage. d. There are no gains from trade in this situation.

1. d 2. b 3. a 4. d 5. b 6. d

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24 • Chapter 3: Interdependence and the Gains from Trade Problems and Applications 1.

Maria can read 20 pages of economics in an hour. She can also read 50 pages of sociology in an hour. She spends 5 hours per day studying. a. Draw Maria’s production possibilities frontier for reading economics and sociology. b. What is Maria’s opportunity cost of reading 100 pages of sociology? a.

See Figure 2. If Maria spends all 5 hours studying economics, she can read 100 pages, so that is the vertical intercept of the production possibilities frontier. If she spends all 5 hours studying sociology, she can read 250 pages, so that is the horizontal intercept.

The time costs are constant, so the production possibilities frontier is a straight line.

Figure 2 b.

2.

It takes Maria 2 hours to read 100 pages of sociology. In that time, she could read 40 pages of economics. So the opportunity cost of 100 pages of sociology is 40 pages of economics.

Canadian and Japanese workers can each produce 4 cars per year. A Canadian worker can produce 10 tonnes of grain per year, whereas a Japanese worker can produce 5 tonnes of grain per year. To keep things simple, assume that each country has 100 million workers. a. For this situation, construct a table analogous to panel (a) in Figure 3.1. b. Graph the production possibilities frontier of the Canadian and Japanese economies. c. For Canada, what is the opportunity cost of a car? Of grain? For Japan, what is the opportunity cost of a car? Of grain? Put this information in a table analogous to Table 3.1. d. Which country has an absolute advantage in producing cars? In producing grain? e. Which country has a comparative advantage in producing cars? In producing grain? f. Without trade, half of each country’s workers produce cars and half produce grain.

What quantities of cars and grain does each country produce? g. Starting from a position without trade, give an example in which trade makes each country better off.

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Chapter 3: Interdependence and the Gains from Trade • 25 a.

Workers needed to make: One car One tonne of grain 1/4 1/10 1/4 1/5

Canada Japan b.

See Figure 3. With 100 million workers and 4 cars per worker, if either economy were devoted completely to cars, it could make 400 million cars. Since a Canadian worker can produce 10 tonnes of grain, if Canada produced only grain it would produce 1000 million tonnes. Since a Japanese worker can produce 5 tonnes of grain, if Japan produced only grain, it would produce 500 million tonnes. These are the intercepts of the production possibilities frontiers shown in the figure. Note that since the tradeoff between cars and grain is constant, the production possibilities frontier is a straight line.

Figure 3 c.

Since a Canadian worker produces either 4 cars or 10 tonnes of grain, the opportunity cost of 1 car is 2-1/2 (or 2.5) tonnes of grain, which is 10 divided by 4. Since a Japanese worker produces either 4 cars or 5 tonnes of grain, the opportunity cost of 1 car is 1-1/4 (or 1.25) tonnes of grain, which is 5 divided by 4. Similarly, the Canadian opportunity cost of 1 tonne of grain is 2/5 (or 0.4) car (4 divided by 10), and the Japanese opportunity cost of 1 tonne of grain is 4/5 (or 0.8) car (4 divided by 5). This gives the following table:

Canada Japan d.

Opportunity Cost of: 1 car (in terms of tonnes 1 tonne of grain (in terms of grain given up) of cars given up) 2-1/2 or 2.5 2/5 or 0.4 1-1/4 or 1.25 4/5 or 0.8

Neither country has an absolute advantage in producing cars, since they’re equally productive (the same output per worker); Canada has an absolute advantage in producing grain, since it is more productive (greater output per worker).

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26 • Chapter 3: Interdependence and the Gains from Trade

3.

e.

Japan has a comparative advantage in producing cars, since it has a lower opportunity cost in terms of grain given up. Canada has a comparative advantage in producing grain, since it has a lower opportunity cost in terms of cars given up.

f.

With half the workers in each country producing each of the goods, Canada would produce 200 million cars (that is, 50 million workers times 4 cars each) and 500 million tonnes of grain (50 million workers times 10 tonnes each). Japan would produce 200 million cars (50 million workers times 4 cars each) and 250 million tonnes of grain (50 million workers times 5 tonnes each).

g.

From any situation with no trade, in which each country is producing some cars and some grain, suppose Canada changed 1 worker from producing cars to producing grain.

That worker would produce 4 fewer cars and 10 additional tonnes of grain. Then suppose Canada offers to trade 7 tonnes of grain to Japan for 4 cars. Canada will do this because it values 4 cars at 10 tonnes of grain, so it will be better off if the trade goes through. Suppose Japan changes 1 worker from producing grain to producing cars. That worker would produce 4 more cars and 5 fewer tonnes of grain. Japan will take the trade because it values 4 cars at 5 tonnes of grain, so it will be better off. With the trade and the change of 1 worker in both Canada and Japan, each country gets the same number of cars as before and both get additional tonnes of grain (3 for Canada and 2 for Japan).

Thus, by trading and changing their production, both countries are better off.

Pat and Kris are roommates. They spend most of their time studying (of course), but they leave some time for their favourite activities: making pizza and brewing root beer. Pat takes 4 hours to brew 5 L of root beer and 2 hours to make a pizza. Kris takes 6 hours to brew 5 L of root beer and 4 hours to make a pizza. a. What is each roommate’s opportunity cost of making a pizza? Who has the absolute advantage in making pizza? Who has the comparative advantage in making pizza? b. If Pat and Kris trade products with each other, who will trade away pizza in exchange for root beer? c. The price of pizza can be expressed in terms of litres of root beer. What is the highest price at which pizza can be traded that would make both roommates better off? What is the lowest price? Explain. a.

Pat’s opportunity cost of making a pizza is 2.5 litres of root beer, since she could brew 2.5 litres in the time (2 hours) it takes her to make a pizza. Pat has an absolute advantage in making pizza since she can make one in 2 hours, while it takes Kris 4 hours. Kris’s opportunity cost of making a pizza is 3-1/3 litres of root beer, since she could brew 3-1/3 litres in the time (4 hours) it takes her to make a pizza. Since Pat’s opportunity cost of making pizza is less than Kris’s, Pat has a comparative advantage in making pizza.

b.

Since Pat has a comparative advantage in making pizza, she will make pizza and exchange it for root beer that Kris makes.

c.

The highest price of pizza in terms of root beer that will make both roommates better off is 3-1/3 litres of root beer. If the price were higher than that, then Kris would prefer making her own pizza (at an opportunity cost of 3-1/3 litres of root beer) rather than trading for pizza that Pat makes. The lowest price of pizza in terms of root beer that will make both roommates better off is 2-1/2 litres of root beer. If the price were lower than that, then Pat would prefer making her own root beer (she can make 2-1/2 litres of root beer instead of making a pizza) rather than trading for root beer that Kris makes.

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Chapter 3: Interdependence and the Gains from Trade • 27 4.

Suppose that there are 10 million workers in Canada, and that each of these workers can produce either 2 cars or 30 tonnes of wheat in a year. a. What is the opportunity cost of producing a car in Canada? What is the opportunity cost of producing a tonne of wheat in Canada? Explain the relationship between the opportunity costs of the two goods. b. Draw Canada’s production possibilities frontier. If Canada chooses to consume 10 million cars, how much wheat can it consume without trade? Label this point on the production possibilities frontier. c. Now suppose that the United States offers to buy 10 million cars from Canada in exchange for 20 tonnes of wheat per car. If Canada continues to consume 10 million cars, how much wheat does this deal allow Canada to consume? Label this point on your diagram. Should Canada accept the deal? a.

Since a Canadian worker can make either 2 cars a year or 30 tonnes of wheat, the opportunity cost of a car is 15 tonnes of wheat. Similarly, the opportunity cost of a tonne of wheat is 1/15 of a car. The opportunity costs are the reciprocals of each other.

b.

See Figure 4. If all 10 million workers produce 2 cars each, they produce a total of 20 million cars, which is the vertical intercept of the production possibilities frontier. If all 10 million workers produce 30 tonnes of wheat each, they produce a total of 300 million tonnes, which is the horizontal intercept of the production possibilities frontier. Since the tradeoff between cars and wheat is always the same, the production possibilities frontier is a straight line.

If Canada chooses to consume 10 million cars, it will need 5 million workers devoted to car production. That leaves 5 million workers to produce wheat, who will produce a total of 150 million tonnes (5 million workers times 30 tonnes per worker). This is shown as point A on Figure 4.

c.

If the United States buys 10 million cars from Canada and Canada continues to consume 10 million cars, then Canada will need to produce a total of 20 million cars. So Canada will be producing at the vertical intercept of the production possibilities frontier. But if Canada gets 20 tonnes of wheat per car, it will be able to consume 200 million tonnes of wheat, along with the 10 million cars. This is shown as point B in the figure. Canada should accept the deal because it gets the same number of cars and 50 million more tonnes of wheat.

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28 • Chapter 3: Interdependence and the Gains from Trade

Figure 4 5.

England and Scotland both produce scones and sweaters. Suppose that an English worker can produce 50 scones per hour or 1 sweater per hour. Suppose that a Scottish worker can produce 40 scones per hour or 2 sweaters per hour. a. Which country has the absolute advantage in the production of each good? Which country has the comparative advantage? b. If England and Scotland decide to trade, which commodity will Scotland trade to England? Explain. c. If a Scottish worker could produce only 1 sweater per hour, would Scotland still gain from trade? Would England still gain from trade? Explain. a.

English workers have an absolute advantage over Scottish workers in producing scones, since English workers produce more scones per hour (50 vs. 40). Scottish workers have an absolute advantage over English workers in producing sweaters, since Scottish workers produce more sweaters per hour (2 vs. 1). Comparative advantage runs the same way. English workers, who have an opportunity cost of 1/50 sweater per scone (1 sweater per hour divided by 50 scones per hour), have a comparative advantage in scone production over Scottish workers, who have an opportunity cost of 1/20 sweater per scone (2 sweaters per hour divided by 40 scones per hour). Scottish workers, who have an opportunity cost of 20 scones per sweater (40 scones per hour divided by 2 sweaters per hour), have a comparative advantage in sweater production over English workers, who have an opportunity cost of 50 scones per sweater (50 scones per hour divided by 1 sweater per hour).

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Chapter 3: Interdependence and the Gains from Trade • 29

6.

b.

If England and Scotland decide to trade, Scotland will produce sweaters and trade them for scones produced in England. A trade with a price between 20 and 50 scones per sweater will benefit both countries, as they’ll be getting the traded good at a lower price than their opportunity cost of producing the good in their own country.

c.

Even if a Scottish worker produced just 1 sweater per hour, the countries would still gain from trade, because Scotland would still have a comparative advantage in producing sweaters. Its opportunity cost for sweaters would be higher than before (40 scones per sweater, instead of 20 scones per sweater before). But there are still gains from trade since England has a higher opportunity cost (50 scones per sweater).

The following table describes the production possibilities of two cities:

Montreal Toronto

Red Sweaters per Worker per Hour

Blue Sweaters per Worker per Hour

3 2

3 1

a. Without trade, what is the price of blue sweaters (in terms of red sweaters) in Montreal?

What is the price in Toronto? b. Which city has an absolute advantage in the production of each colour of sweater? Which city has a comparative advantage in the production of each colour of sweater? c. If the cities trade with each other, which colour of sweater will each export? d. What is the range of prices at which trade can occur? a.

With no trade, the price of 1 blue sweater is 1 red sweater in Montreal since productivity is the same for the two sweaters. The price in Toronto is 2 red sweaters for 1 blue sweater.

b.

Montreal has an absolute advantage in the production of both colours of sweater, since a worker in Montreal produces more (3 sweaters per hour) than a worker in Toronto (2 red sweaters per hour or 1 blue sweater per hour).

Toronto has a comparative advantage in producing red sweaters, since the opportunity cost of producing red sweaters in Toronto is 1/2 of a blue sweater, while the opportunity cost of producing a red sweater in Montreal is 1 blue sweater. Montreal has a comparative advantage in producing blue sweaters, since the opportunity cost of producing a blue sweater in Montreal is 1 red sweater, while the opportunity cost of producing a blue sweater in Toronto is 2 red sweaters.

c.

If they trade sweaters, Montreal will produce blue sweaters for export, since it has the comparative advantage in blue sweaters, while Toronto produces red sweaters for export, which is Toronto’s comparative advantage.

d.

Trade can occur at any price between 1 and 2 red sweaters per blue sweater. At a price lower than 1 red sweater per blue sweater, Montreal will choose to produce its own red sweaters (at a cost of 1 red sweater per blue sweater) instead of buying them from Toronto. At a price higher than 2 red sweaters per blue sweater, Toronto will choose to produce its own blue sweaters (at a cost of 2 red sweaters per blue sweater) instead of buying them from Montreal.

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30 • Chapter 3: Interdependence and the Gains from Trade 7.

8.

Are the following statements true or false? Explain in each case. a. “Two countries can achieve gains from trade even if one of the countries has an absolute advantage in the production of all goods.” b. “Certain very talented people have a comparative advantage in everything they do.” c. “If a certain trade is good for one person, it can’t be good for the other one.” d. “If a certain trade is good for one person, it is always good for the other one.” e. “If trade is good for a country, it must be good for everyone in the country.” a.

True; two countries can achieve gains from trade even if one of the countries has an absolute advantage in the production of all goods. All that’s necessary is that each country has a comparative advantage in some good.

b.

False; it is not true that some people have a comparative advantage in everything they do. In fact, no one can have a comparative advantage in everything. Comparative advantage reflects the opportunity cost of one good or activity in terms of another. If you have a comparative advantage in one thing, you must have a comparative disadvantage in the other thing.

c.

False; it is not true that if a trade is good for one person, it can’t be good for the other one. Trades can and do benefit both sidesespecially trades based on comparative advantage. If both sides didn’t benefit, trades would never occur.

d.

True. If a trade were not good for both persons, it wouldn’t take place.

e.

False; trade liberalization may hurt some people in import-competing industries. Trade liberalization may make some people lose their jobs or some business owners see their profits diminished. Overall, though, a country benefits from lower prices and more diversity of imported goods.

Canada exports oil and pulp and paper to the rest of the world, and it imports computers and clothing from the rest of the world. Do you think this pattern of trade is consistent with the principle of comparative advantage? Why or why not?

Yes, this trade pattern is consistent with comparative advantage because oil and wood are abundant in Canada. This has determined Canadian producers to become more efficient than foreigners in extracting oil and producing pulp and paper, while having less time left for learning how to produce good computers and clothing.

9.

Conrad and Barbara produce food and clothing. In an hour, Conrad can produce 1 unit of food or 1 unit of clothing, while Barbara can produce 2 units of food or 3 units of clothing. They each work 10 hours a day. a. Who has an absolute advantage in producing food? Who has an absolute advantage in producing clothing? Explain. b. Who has a comparative advantage in producing food? Who has a comparative advantage in producing clothing? Explain. c. Draw the production possibilities frontier for the household (that is, Conrad and Barbara together), assuming that each spends the same number of hours each day as the other producing food and clothing. d. Barbara suggests that, instead, she specialize in making clothing. That is, she will do all of the clothing production, unless her time is fully devoted to clothing, and then Conrad will chip in. What does the household production possibilities frontier look like now?

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Chapter 3: Interdependence and the Gains from Trade • 31

e. Conrad suggests that Barbara specialize in producing food. That is, Barbara will do all the food production, unless her time is fully devoted to food, and then Conrad will chip in. What does the household production possibilities frontier look like under Conrad’s proposal? f. Comparing your answers to parts (c), (d), and (e), which allocation of time makes the most sense? Relate your answer to the theory of comparative advantage. a.

Barbara has an absolute advantage in the production of both food and clothing because she can produce more of each in an hour than Conrad can.

b.

Conrad has a comparative advantage in the production of food: his opportunity cost of producing 1 unit of food is 1 unit of clothing, while Barbara’s opportunity cost of producing 1 unit of food is 3/2 = 1.5 units of clothing. By the reversed logic, Barbara has a comparative advantage in the production of clothing.

c.

The two spend equal amounts of time on both activities:

Figure 5 d.

Barbara does the clothing: Figure 6 shows both production possibilities frontiers and their combination. As the graph shows, Barbara does all the clothing and some food when they want to do fewer than 30 units of clothing. If they want to produce more than 30 units of clothing, Barbara does only clothing, while Conrad does some food and some clothing. For example, suppose they want to produce 15 units of clothing and food for the remaining time. Barbara will work 5 hours to produce the 15 units of clothing, and 5 hours to produce 5 × 2 = 10 units of food; in the meantime, Conrad will work 10 hours only on food, producing 10 units of food. The result is 15 units of clothing and 10 + 10 = 20 units of food.

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32 • Chapter 3: Interdependence and the Gains from Trade

Figure 6 e.

If Barbara does the food and Conrad the clothing, Barbara will produce only food if the desired quantity is less than or equal to 20 units, the maximum Barbara can produce in 10 hours. At 20 units of food, the most clothing that can be produced is how much Conrad can produce in 10 hours, which is 10 units. If they want more than 10 units of clothing, then Barbara should produce correspondingly less food and help Conrad do more clothing. Figure 7 shows this arrangement.

Figure 7 f.

The most efficient allocation is the one at point d, with Barbara specializing in clothing and Conrad in food. Thus, typically Barbara does all the clothing and some food, while Conrad does only food and occasionally, when not too much food is needed, he does some clothing. This is consistent with the theory of comparative advantage, which predicts that the person having comparative advantage specializes in the production of that good, but the other person can also contribute to the total production.

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Chapter 3: Interdependence and the Gains from Trade • 33 10.

Suppose that in a year, a Canadian worker can produce 100 shirts or 20 computers, while a Chinese worker can produce 100 shirts or 10 computers. a. Graph the production possibilities curve for the two countries. Suppose that without trade, the workers in each country spend half their time producing each good. Identify this point in your graph. b. If these countries were open to trade, which country would export shirts? Give a specific numerical example and show it on your graph. Which country would benefit from trade? Explain. c. Explain at what price of computers (in terms of shirts) the two countries might trade. d. Suppose that China catches up with Canadian productivity so that a Chinese worker can produce 100 shirts or 20 computers. What pattern of trade would you predict now? How does this advance in Chinese productivity affect the economic well-being of the citizens of the two countries? a.

If the two countries devote half of their time to produce both goods, they produce a total of 100 shirts and 15 computers. This is point A in Figure 8.

Figure 8 b.

China’s cost of producing a computer is 100/10 = 10 shirts. Canada’s cost is 100/20 = 5 shirts. China has a comparative advantage in the production of shirts. Starting at point A’, the initial production and consumption point, if China produces 20 extra shirts and 2 fewer computers, it can buy from Canada up to 4 computers, thus ending up consuming the same number of shirts as before, but up to 2 more computers. Canada would have to produce up to 4 computers to sell to China, which costs it up to 20 shirts.

Thus, China gains some additional computers and Canada some additional shirts. The new consumption points are B’ for China and B’’ for Canada (Figure 9).

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34 • Chapter 3: Interdependence and the Gains from Trade

Figure 9

11.

c.

Trade can take place at any price between the costs of production in each country. The cost of a computer in China is 100/10 = 10 shirts; the cost of a computer in Canada is 100/20 = 5 shirts. Thus, any price between 5 and 10 shirts allows for trade.

d.

With increased productivity in the computer sector, the Chinese can now consume the same number of shirts as before and more computers. Therefore, they must be better off. Canadians see now the price of their shirts increasing, so they must be worse off than before. Since the two countries are now identical in terms of productivity, trade based on comparative advantage in the two sectors does not benefit them.

An average worker in Brazil can produce 30 mL of soy milk in 20 minutes and 30 mL of coffee in 60 minutes, while an average worker in Peru can produce 30 mL of soy milk in 50 minutes and 30 mL of coffee in 75 minutes. a. Who has the absolute advantage in coffee? Explain. b. Who has the comparative advantage in coffee? Explain. c. If the two countries specialize and trade with each other, who will import coffee?

Explain. d. Assume that the two countries trade and that the country importing coffee trades 60 mL of soy milk for 30 mL of coffee. Explain why both countries will benefit from this trade. a.

Brazil can produce each of the two commodities in less time than Peru. Brazil has, therefore, an absolute advantage in both commodities.

b.

In Brazil, it takes longer to produce coffee than soy. Thus, the cost of soy should be less than an ounce of coffee. This cost is precisely 20/60 = 1/3 mL of coffee/mL of soy. In Peru, the same price is 50/75 = 2/3 coffee/soy. Since the (opportunity) cost of producing soy is greater in Peru, Brazil has a comparative advantage in soy and Peru in coffee.

c.

Brazil will specialize in the production of soy; therefore, it imports coffee.

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Chapter 3: Interdependence and the Gains from Trade • 35 d.

12.

The cost of a mL of coffee in Brazil is 3 mL of soy. By importing it at only 2 mL of soy per mL of coffee, Brazil gains 1 mL of soy for each mL of coffee imported. The cost of coffee in Peru is 3/2 = 1.5 mL of soy per mL of coffee. By exporting it at 2 mL of soy per 1 mL of coffee, Peru gains 0.5 mL of soy for each mL of coffee exported.

A German worker takes 400 hours to produce a car and 2 hours to produce a case of wine. A French worker takes 600 hours to produce a car and X hours to produce a case of wine. a. For what values of X will gains from trade be possible? Explain. b. For what values of X will Germany export cars and import wine? Explain. a.

Gains from trade will be possible when X does not equal 3. Gains from trade are possible when a comparative advantage exists. The opportunity cost of 1 car in Germany is 200 cases of wine (400 hours/2 hours per case of wine). Likewise, the opportunity cost of 1 case of wine in Germany is 1/200 car. When X = 3, the opportunity cost of 1 car in France is 200 cases of wine (600 hours/3 hours per case of wine). In this instance, neither country has a comparative advantage. At all other values of X, a comparative advantage will exist.

b.

Germany will export cars and import wine for all values of X < 3. For Germany to export cars, it must have the comparative advantage in producing cars, and France must have the comparative advantage in producing wine. This occurs when Germany has a smaller opportunity cost of producing cars than France does. We know the opportunity cost of 1 car in Germany is 200 cases of wine. When X < 3, the opportunity cost of 1 car in France is greater than 200 cases of wine. For example, when X = 2, the opportunity cost of 1 car in France is 300 cases of wine (600 hours/2 hours per case = 300 cases).

Therefore, Germany, having the comparative advantage in cars, will export cars and import wine for all values of X < 3.

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Chapter 4 The Market Forces of Supply and Demand SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

What is a market? • What are the characteristics of a competitive market?

A market is a group of buyers (who determine demand) and a group of sellers (who determine supply) of a particular good or service. A competitive market is one in which there are many buyers and many sellers of an identical product so that each has a negligible impact on the market price.

2.

Make up an example of a monthly demand schedule for pizza, and graph the implied demand curve. • Give an example of something that would shift this demand curve. • Would a change in the price of pizza shift this demand curve?

Here’s an example of a demand schedule for pizza: Price of Pizza Slice $ 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 The demand curve is graphed in Figure 1.

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Number of Pizza Slices Demanded 10 9 8 7 6 5 4 3 2 1 0

38 • Chapter 4: The Market Forces of Supply and Demand

Figure 1 Examples of things that would shift the demand curve include changes in income, prices of related goods like soda or hot dogs, tastes, expectations about future income or prices, and the number of buyers.

A change in the price of pizza would not shift this demand curve; it would only lead us to move from one point to another along the same demand curve.

3.

On the appropriate diagram, show what happens to the market for pizza if the price of tomatoes rises. • On a separate diagram, show what happens to the market for pizza if the price of hamburgers falls.

If the price of tomatoes rises, the supply curve for pizza shifts to the left because of the increased price of an input into pizza production, but there is no effect on demand. The shift to the left of the supply curve causes the equilibrium price to rise and the equilibrium quantity to decline, as Figure 2 shows.

Figure 2

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Chapter 4: The Market Forces of Supply and Demand • 39 If the price of hamburgers falls, the demand curve for pizza shifts to the left because the lower price of hamburgers will lead consumers to buy more hamburgers and less pizza, but there is no effect on supply. The shift to the left of the demand curve causes the equilibrium price to fall and the equilibrium quantity to decline, as Figure 3 shows.

Figure 3 Questions for Review 1.

What is a competitive market? Briefly describe the types of markets other than perfectly competitive markets.

A competitive market is a market in which there are many buyers and many sellers of an identical product so that each has a negligible impact on the market price. Other types of markets include monopoly, in which there is only one seller, markets in which there are a few sellers that do not always compete aggressively, and markets in which there are many sellers, each offering a slightly different product.

2.

What are the demand schedule and the demand curve, and how are they related? Why does the demand curve slope downward?

The demand schedule is a table that shows the relationship between the price of a good and the quantity demanded. The demand curve is the downward sloping line relating price and quantity demanded. The demand schedule and demand curve are related because the demand curve is simply a graph showing the points in the demand schedule.

The demand curve slopes downward because of the law of demand—other things equal, when the price of a good rises, the quantity demanded of the good falls. People buy less of a good when its price rises, both because they cannot afford to buy as much and because they switch to purchasing other goods.

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40 • Chapter 4: The Market Forces of Supply and Demand 3.

Does a change in consumers’ tastes lead to a movement along the demand curve or a shift in the demand curve? Does a change in price lead to a movement along the demand curve or a shift in the demand curve?

A change in consumers’ tastes leads to a shift in the demand curve. A change in price leads to a movement along the demand curve.

4.

Popeye’s income declines and, as a result, he buys more spinach. Is spinach an inferior or a normal good? What happens to Popeye’s demand curve for spinach?

Since Popeye buys more spinach when his income falls, spinach is an inferior good for him. Since he buys more spinach but the price of spinach is unchanged, his demand curve for spinach shifts out as a result of the decrease in his income.

5.

What are the supply schedule and the supply curve, and how are they related? Why does the supply curve slope upward?

A supply schedule is a table showing the relationship between the price of a good and the quantity a producer is willing and able to supply. The supply curve is the upward sloping line relating price and quantity supplied. The supply schedule and the supply curve are related because the supply curve is simply a graph showing the points in the supply schedule.

The supply curve slopes upward because when the price is high, suppliers’ profits increase, so they supply more output to the market. The result is the law of supply—other things equal, when the price of a good rises, the quantity supplied of the good also rises.

6.

Does a change in producers’ technology lead to a movement along the supply curve or a shift in the supply curve? Does a change in price lead to a movement along the supply curve or a shift in the supply curve?

A change in producers’ technology leads to a shift in the supply curve. A change in price leads to a movement along the supply curve.

7.

Define the equilibrium of a market. Describe the forces that move a market toward its equilibrium.

The equilibrium of a market is the point at which the quantity demanded is equal to the quantity supplied. If the price is above the equilibrium price, sellers want to sell more than buyers want to buy, so there is a surplus. Sellers try to increase their sales by cutting prices. That continues until they reach the equilibrium price. If the price is below the equilibrium price, buyers want to buy more than sellers want to sell, so there is a shortage. Sellers can raise their price without losing customers. That continues until they reach the equilibrium price.

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Chapter 4: The Market Forces of Supply and Demand • 41 8.

Beer and pizza are complements because they are often enjoyed together. When the price of beer rises, what happens to the supply, demand, quantity supplied, quantity demanded, and the price in the market for pizza?

When the price of beer rises, the demand for pizza declines, because beer and pizza are complements and people want to buy less beer. When we say the demand for pizza declines, we mean that the demand curve for pizza shifts to the left as in Figure 4. The supply curve for pizza is not affected. With a shift to the left in the demand curve, the equilibrium price and quantity both decline, as the figure shows. Thus the quantity of pizza supplied and demanded both fall. In sum, supply is unchanged, demand is decreased, quantity supplied declines, quantity demanded declines, and the price falls.

Figure 4 9.

Describe the role of prices in market economies.

Prices play a vital role in market economies because they bring markets into equilibrium. If the price is different from its equilibrium level, quantity supplied and quantity demanded are not equal. The resulting surplus or shortage leads suppliers to adjust the price until equilibrium is restored. Prices serve as signals that guide economic decisions and allocate scarce resources.

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42 • Chapter 4: The Market Forces of Supply and Demand Quick Check Multiple Choice

1. A change in which of the following will NOT shift the demand curve for hamburgers? a. the price of hot dogs b. the price of hamburgers c. the price of hamburger buns d. the income of hamburger consumers 2. An increase in ___ will cause a movement along a given demand curve, which is called a change in ____. a. supply, demand b. supply, quantity demanded c. demand, supply d. demand, quantity supplied 3. Movie tickets and film streaming services are substitutes. If the price of film streaming increases, what happens in the market for movie tickets? a. The supply curve shifts to the left. b. The supply curve shifts to the right. c. The demand curve shifts to the left. d. The demand curve shifts to the right.

4. The discovery of a large new reserve of crude oil will shift the ___ curve for gasoline, leading to a ___ equilibrium price. a. b. c. d.

supply, higher supply, lower demand, higher demand, lower

5. If the economy goes into a recession and incomes fall, what happens in the markets for inferior goods? a. prices and quantities both rise b. prices and quantities both fall c. prices rise, quantities fall d. prices fall, quantities rise 6. Which of the following might lead to an increase in the equilibrium price of jelly and a decrease in the equilibrium quantity of jelly sold? a. an increase in the price of peanut better, a complement to jelly b. an increase in the price of Marshmallow Fluff, a substitute for jelly c. an increase in the price of grapes, an input into jelly d. an increase in consumers’ incomes, as long as jelly is a normal good

1. b 2. b 3. d 4. b 5. a 6. c

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Chapter 4: The Market Forces of Supply and Demand • 43 Problems and Applications 1.

Explain each of the following statements using supply-and-demand diagrams. a. When a cold snap hits Florida, the price of orange juice rises in supermarkets throughout Canada. b. When the weather turns warm in Quebec every summer, the prices of hotel rooms in Caribbean resorts plummet. c. When a war breaks out in the Middle East, the price of gasoline rises, while the price of a used SUV falls. a.

Cold weather damages the orange crop, reducing the supply of orange juice. This can be seen in Figure 5 as a shift to the left in the supply curve for orange juice. The new equilibrium price is higher than the old equilibrium price.

Figure 5

b.

People often travel to the Caribbean from Quebec to escape cold weather, so demand for Caribbean hotel rooms is high in the winter. In the summer, fewer people travel to the Caribbean, since northern climes are more pleasant. The result, as shown in Figure 6, is a shift to the left in the demand curve. The equilibrium price of Caribbean hotel rooms is thus lower in the summer than in the winter, as the figure shows.

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44 • Chapter 4: The Market Forces of Supply and Demand

Figure 6

c.

When a war breaks out in the Middle East, many markets are affected. Since much oil production takes place there, the war disrupts oil supplies, shifting the supply curve for gasoline to the left, as shown in Figure 7. The result is a rise in the equilibrium price of gasoline. With a higher price for gasoline, the cost of operating a gas-guzzling automobile, like an SUV, will increase. As a result, the demand for used SUVs will decline, as people in the market for cars will not find SUVs as attractive. In addition, some people who already own SUVs will try to sell them. The result is that the demand curve for used SUVs shifts to the left, while the supply curve shifts to the right, as shown in Figure 8.

The result is a decline in the equilibrium price of used SUVs.

Figure 7

Figure 8

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Chapter 4: The Market Forces of Supply and Demand • 45 2.

“An increase in the demand for notebooks raises the quantity of notebooks demanded, but not the quantity supplied.” Is this statement true or false? Explain.

The statement that “an increase in the demand for notebooks raises the quantity of notebooks demanded, but not the quantity supplied,” in general, is false. As Figure 9 shows, the increase in demand for notebooks results in an increased quantity supplied. The only way the statement would be true is if the supply curve were a vertical line, as shown in Figure 10.

Figure 9

Figure 10 3.

Consider the market for minivans. For each of the events listed below, identify which of the determinants of demand or supply are affected. Also indicate whether demand or supply is increased or decreased. Then show the effect on the price and quantity of minivans. a. People decide to have more children. b. A strike by steelworkers raises steel prices. c. Engineers develop new automated machinery for the production of minivans. d. The price of SUVs rises. e. A stock market crash lowers people’s wealth.

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46 • Chapter 4: The Market Forces of Supply and Demand a.

If people decide to have more children (a change in tastes), they will want larger vehicles for hauling their kids around, so the demand for minivans will increase. Supply won’t be affected. The result is a rise in both price and quantity, as Figure 11 shows.

Figure 11 b.

If a strike by steelworkers raises steel prices, the cost of producing a minivan rises (a rise in input prices), so the supply of minivans decreases. Demand won’t be affected. The result is a rise in the price of minivans and a decline in the quantity, as Figure 12 shows.

Figure 12

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Chapter 4: The Market Forces of Supply and Demand • 47 c.

The development of new automated machinery for the production of minivans is an improvement in technology. The reduction in firms’ costs results in an increase in supply.

Demand isn’t affected. The result is a decline in the price of minivans and an increase in the quantity, as Figure 13 shows.

Figure 13 d.

The rise in the price of sport utility vehicles affects minivan demand because sport utility vehicles are substitutes for minivans (that is, there is a rise in the price of a related good). The result is an increase in demand for minivans. Supply is not affected. In equilibrium, the price and quantity of minivans both rise, as Figure 11 shows.

e.

The reduction in people’s wealth caused by a stock market crash reduces their income, leading to a reduction in the demand for minivans since minivans are likely a normal good. Supply isn’t affected. As a result, both price and quantity decline, as Figure 14 shows.

Figure 14

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48 • Chapter 4: The Market Forces of Supply and Demand 4.

Over the past 40 years, technological advances have reduced the cost of computer chips. How do you think this has affected the market for computers? For computer software? For typewriters?

Technological advances that reduce the cost of producing computer chips represent a decline in an input price for producing a computer. The result is a shift to the right in the supply of computers, as shown in Figure 15. The equilibrium price falls and the equilibrium quantity rises, as the figure shows.

Figure 15 Because computer software is a complement to computers, the lower equilibrium price of computers increases the demand for software. As Figure 16 shows, the result is a rise in both the equilibrium price and quantity of software.

Figure 16

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Chapter 4: The Market Forces of Supply and Demand • 49 Because typewriters are substitutes for computers, the lower equilibrium price of computers reduces the demand for typewriters. As Figure 17 shows, the result is a decline in both the equilibrium price and quantity of typewriters.

Figure 17 5.

Using supply-and-demand diagrams, show the effect of the following events on the market for sweatshirts. a. A hurricane in South Carolina damages the cotton crop. b. The price of leather jackets falls. c. All universities require morning calisthenics in appropriate attire. d. New knitting machines are invented. a.

When a hurricane in South Carolina damages the cotton crop, it raises input prices for producing sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown in Figure 18. The new equilibrium has a higher price and lower quantity of sweatshirts.

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50 • Chapter 4: The Market Forces of Supply and Demand

Figure 18 b.

A decline in the price of leather jackets leads more people to buy leather jackets, reducing the demand for sweatshirts. The result, shown in Figure 19, is a decline in both the equilibrium price and quantity of sweatshirts.

Figure 19 c.

The effects of universities requiring students to engage in morning calisthenics in appropriate attire raises the demand for sweatshirts, as shown in Figure 20. The result is an increase in both the equilibrium price and quantity of sweatshirts.

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Chapter 4: The Market Forces of Supply and Demand • 51

Figure 20 d.

The invention of new knitting machines increases the supply of sweatshirts. As Figure 21 shows, the result is a reduction in the equilibrium price and an increase in the equilibrium quantity of sweatshirts.

Figure 21

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52 • Chapter 4: The Market Forces of Supply and Demand 6.

Suppose that in the year 2010, the number of births was temporarily high. How will this baby boom affect the price of baby-sitting services in 2015 and 2025? (Hint: Five-year-olds need babysitters, whereas fifteen-year-olds can be baby-sitters.)

A temporarily high birth rate in the year 2010 leads to opposite effects on the price of babysitting services in the years 2015 and 2025. In the year 2015, there are more 5-year-olds who need sitters, so the demand for babysitting services rises, as shown in Figure 22. The result is a higher price for babysitting services in 2015. However, in the year 2025, the increased number of 15-year-olds shifts the supply of babysitting services to the right, as shown in Figure 23. The result is a decline in the price of babysitting services.

Figure 22

Figure 23

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Chapter 4: The Market Forces of Supply and Demand • 53 7.

Ketchup is a complement (as well as a condiment) for hot dogs. If the price of hot dogs rises, what happens to the market for ketchup? For tomatoes? For tomato juice? For orange juice?

Since ketchup is a complement for hot dogs, when the price of hot dogs rises, the quantity demanded of hot dogs falls, thus reducing the demand for ketchup, causing both price and quantity of ketchup to fall. Since the quantity of ketchup falls, the demand for tomatoes by ketchup producers falls, so both price and quantity of tomatoes fall. When the price of tomatoes falls, producers of tomato juice face lower input prices, so the supply curve for tomato juice shifts out, causing the price of tomato juice to fall and the quantity of tomato juice to rise. The fall in the price of tomato juice causes people to substitute tomato juice for orange juice, so the demand for orange juice declines, causing the price and quantity of orange juice to fall. Now you can see clearly why a rise in the price of hot dogs leads to a fall in the price of orange juice!

8.

The market for pizza has the following demand and supply schedules: Price $4 5 6 7 8 9

Quantity Demanded 135 104 81 68 53 39

Quantity Supplied 26 53 81 98 110 121

Graph the demand and supply curves. What is the equilibrium price and quantity in this market?

If the actual price in this market was above the equilibrium price, what would drive the market toward the equilibrium? If the actual price in this market was below the equilibrium price, what would drive the market toward the equilibrium?

Quantity supplied equals quantity demanded at a price of $6 and quantity of 81 pizzas (Figure 24). If price were greater than $6, quantity supplied would exceed quantity demanded, so suppliers would reduce their price to gain sales. If price were less than $6, quantity demanded would exceed quantity supplied, so suppliers could raise their price without losing sales. In both cases, the price would continue to adjust until it reached $6, the only price at which there is neither a surplus nor a shortage.

Figure 24

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54 • Chapter 4: The Market Forces of Supply and Demand 9.

Because bagels and cream cheese are often eaten together, they are complements. a. We observe that both the equilibrium price of cream cheese and the equilibrium quantity of bagels have risen. What could be responsible for this pattern—a fall in the price of flour or a fall in the price of milk? Illustrate and explain your answer. b. Suppose instead that the equilibrium price of cream cheese has risen but the equilibrium quantity of bagels has fallen. What could be responsible for this pattern—a rise in the price of flour or a rise in the price of milk? Illustrate and explain your answer. a.

If the price of flour falls, since flour is an ingredient in bagels, the supply curve for bagels would shift to the right. The result, shown in Figure 25, would be a fall in the price of bagels and a rise in the equilibrium quantity of bagels.

Figure 25 Since cream cheese is a complement to bagels, the fall in the equilibrium price of bagels increases the demand for cream cheese, as shown in Figure 26. The result is a rise in both the equilibrium price and quantity of cream cheese. So, a fall in the price of flour indeed raises both the equilibrium price of cream cheese and the equilibrium quantity of bagels.

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Chapter 4: The Market Forces of Supply and Demand • 55

Figure 26 What happens if the price of milk falls? Since milk is an ingredient in cream cheese, the fall in the price of milk leads to an increase in the supply of cream cheese. This leads to a decrease in the price of cream cheese (see Figure 27), rather than a rise in the price of cream cheese. So a fall in the price of milk could not have been responsible for the pattern observed.

Figure 27

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56 • Chapter 4: The Market Forces of Supply and Demand b.

In part (a), we found that a fall in the price of flour led to a rise in the price of cream cheese and a rise in the equilibrium quantity of bagels. If the price of flour rose, the opposite would be true: it would lead to a fall in the price of cream cheese and a fall in the equilibrium quantity of bagels. Since the question says the equilibrium price of cream cheese has risen, it could not have been caused by a rise in the price of flour.

What happens if the price of milk rises? From part (a), we found that a fall in the price of milk caused a decline in the price of cream cheese, so a rise in the price of milk would cause a rise in the price of cream cheese. Since bagels and cream cheese are complements, the rise in the price of cream cheese would reduce the demand for bagels, as Figure 28 shows. The result is a decline in the equilibrium quantity of bagels. So a rise in the price of milk does cause both a rise in the price of cream cheese and a decline in the equilibrium quantity of bagels.

Figure 28 10.

Suppose that the price of hockey tickets at your school is determined by market forces. Currently, the demand and supply schedules are as follows: Price $4 8 12 16 20

Quantity Demanded 10 000 8 000 6 000 4 000 2 000

Quantity Supplied 8000 8000 8000 8000 8000

a. Draw the demand and supply curves. What is unusual about this supply curve? Why might this be true? b. What are the equilibrium price and quantity of tickets? c. Your school plans to increase total enrollment next year by 5000 students. The additional students will have the following demand schedule:

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Chapter 4: The Market Forces of Supply and Demand • 57

Price $4 8 12 16 20

Quantity Demanded 4 000 3 000 2 000 1 000 0

Now add the old demand schedule and the demand schedule for the new students to calculate the new demand schedule for the entire school. What will be the new equilibrium price and quantity? a.

As Figure 29 shows, the supply curve is vertical. The constant quantity supplied makes sense because the hockey arena has a fixed number of seats no matter what the price.

Figure 29 b.

Quantity supplied equals quantity demanded at a price of $8. The equilibrium quantity is 8000 tickets.

c.

Price $4 8 12 16 20

Quantity Demanded 14 000 11 000 8 000 5 000 2 000

Quantity Supplied 8000 8000 8000 8000 8000

The new equilibrium price will be $12, which equates quantity demanded to quantity supplied. The equilibrium quantity is 8000 tickets.

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58 • Chapter 4: The Market Forces of Supply and Demand 11.

Consider the markets for film streaming services, TV screens, and tickets to movie theatres. a. For each pair, identify whether they are complements or substitutes: • Film streaming and TV screens • Film streaming and movie tickets • TV screens and movie tickets b. Suppose a technological advance reduces the cost of manufacturing TV screens. Draw a diagram to show what happens to the market for TV screens. c. Draw two more diagrams to show how the change in the market for TV screens affects the markets for film streaming and movie tickets. a.

Film streaming and TV screens are complements, because you need a TV screen to watch a film. Film streaming and movie tickets are substitutes, and TV screens and movie tickets are substitutes as well.

b.

Lower costs of manufacturing TV screens shift the supply curve to the right, which decreases the equilibrium price and increases the quantity demanded and supplied. (See Figure 30.)

Figure 30

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Chapter 4: The Market Forces of Supply and Demand • 59 c.

The decrease in the price of TV screens increases the demand for film streaming and decreases the demand for movie tickets, as Figure 31 shows. The price and quantity demanded of film streaming will increase. The price and quantity demanded of movie tickets will decrease.

Figure 31 12.

A survey shows an increase in drug use by young people. In the ensuing debate, two hypotheses are proposed: • Reduced police efforts have increased the availability of drugs on the street.

• Cutbacks in educational efforts have decreased awareness of the dangers of drug addiction. a. Use supply-and-demand diagrams to show how each of these hypotheses could lead to an increase in the quantity of drugs consumed. b. How could information on what has happened to the price of drugs help us distinguish between these explanations? a.

Reduced police efforts would shift the supply curve to the right, while cutbacks in education would shift the demand curve to the right. Both imply higher quantity demanded.

b.

As Figure 32 shows, reduced police efforts will reduce the price of drugs, while cutbacks in education will increase it.

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60 • Chapter 4: The Market Forces of Supply and Demand

Figure 32 13.

Consider the following events: Scientists reveal that consumption of oranges decreases the risk of diabetes and, at the same time, farmers use a new fertilizer that makes orange trees more productive. Illustrate and explain what effect these changes have on the equilibrium price and quantity of oranges.

The first event increases the demand for oranges, which increases both the equilibrium price and quantity. In Figure 33, this first change corresponds to a move from point A to B. The second event increases the supply of oranges, which decreases the equilibrium price and increases the equilibrium quantity even further (a move from B to C in Figure 33). Thus, the cumulative effect on price is ambiguous (we cannot tell whether the increase in price is larger than the decrease).

The effect on quantity is, however, unambiguous: the quantity traded in the market is higher.

Figure 33

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Chapter 4: The Market Forces of Supply and Demand • 61 Appendix Problems and Applications A1.

A2.

Say that the demand schedule for a good is given by QD = 20 – 2P and the supply schedule is given by QS = –10 + 4P. a. Graph the demand and supply curves, showing the x- and y-intercepts for each. b. Determine the equilibrium price and quantity. a.

Supply: x-intercept = –10, y-intercept = 10/4 = 5/2 = 2.5.

Demand: x-intercept = 20, y-intercept = 20/2 = 10.

b.

Equate supply and demand and solve for P: 20 – 2P = –10 + 4P, 6P = 30, P = 30/6 = 5.

Then Q = 20 – 2(5) = 10.

The demand and supply functions for hockey sticks are given by QD = 286 – 20P QS = 88 + 40P

a. Graph the supply and the demand curves, clearly showing the intercepts and indicating the slopes of the two curves. b. Determine the equilibrium price and quantity of hockey sticks. c. Suppose that both the men’s and the women’s teams win Olympic gold medals, causing an increase in the demand for hockey sticks across the country to QD = 328 – 20P. What impact does this have on the price of hockey sticks and the quantity sold? a.

The slopes are –1/20 and 1/40, respectively. The horizontal intercepts are found by setting P = 0 in each equation: Q D(P = 0) = 286; Q S(P = 0) = 88. The vertical intercepts are found by calculating the price that makes the two quantities zero: P (Q D = 0) = 286/20 = 14.30; P(Q S = 0) = –88/40 = –2.20. (See Figure 34.)

b.

The equilibrium price is the solution to equation Q D = Q S, 286 – 20P = 88 + 40P, which gives the result P E = 3.30. Using the demand equation, we can determine the equilibrium quantity: Q E = 286 – 20 × 3.3 = 220.

The increase in demand determines a shift to the right of the demand curve so that the new horizontal intercept is 328 instead of 286. The slope of the demand remains the same. The equilibrium price increases to 4, while the equilibrium quantity increases to 248.

c.

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62 • Chapter 4: The Market Forces of Supply and Demand

Figure 34 A3.

Suppose that the demand curve for concert tickets is linear. When the price of a ticket is $5.00, the number of tickets purchased is 1000; when the price of a ticket is $15.00, the number of tickets purchased is 200. Find the slope of the demand curve.

The slope of the demand curve is equal to the change in price over the change in quantity demanded: Slope = (15 – 5)/(200 – 1000) = 10/(–800) = –1/80.

A4.

At a price of $320 per tonne, the supply of wheat in Canada is 25 million tonnes and the demand is 26 million tonnes. When the price increases to $340 per tonne, the supply increases to 27 million tonnes and the demand decreases to 22 million tonnes. Assume that both the demand and supply curves are linear. a. What is the equation for the demand curve for wheat? b. What is the equation for the supply curve for wheat? c. Using these equations, what is the equilibrium price and quantity of wheat? a.

A demand equation has the general form Q D = a – bP. When two price–quantity pairs are known, one can calculate b = –(Q D1 – Q D0)/(P1 – P0). With the numbers given, b = –(22 – 26)/(340 – 320) = 4/20 = 0.20. The intercept is a = Q D0 + bP0 = 26 + 0.20 × 320 = 90. Thus, the demand equation is Q D = 90 – 0.20P.

b.

A supply equation has the general form Q S = c + dP, where d = (Q S1 – Q S0)/(P1 – P0) = (27 – 25)/(340 – 320) = 2/20=0.10. The horizontal intercept is c = Q S0 – dP0 = 25 – 0.10 x 320 = –7. With c and d calculated, the supply equation is Q S = –7 + 0.10P.

c.

The equilibrium price is determined where Q D = Q S, or 90 – 0.20P = –7+ 0.10P. The solution to this equation is P E = 323.33. Now, using the demand equation, we can determine the equilibrium quantity: Q E = 90 – (0.20)(323.33) = 25.33.

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Chapter 4: The Market Forces of Supply and Demand • 63 A5.

Market research has revealed the following information about the market for chocolate bars: The demand schedule can be represented by the equation QD = 1600 – 300P, where QD is the quantity demanded and P is the price. The supply schedule can be represented by the equation QS = 1400 + 700P, where QS is the quantity supplied. a. Calculate the equilibrium price and quantity in the market for chocolate bars. b. Say that in response to a major industry ad campaign, the demand schedule for chocolate bars shifted to the right, as represented by the equation QD = 1800 – 300P. What happens to the equilibrium price and quantity of chocolate bars in this case? c. Returning to the original demand schedule, say that the price of cocoa beans, a major ingredient in the production of chocolate bars, increased because of a drought in subSaharan Africa, a major producer of cocoa, changing the supply schedule to QS = 1100 + 700P. What happens to the equilibrium price and quantity in this case? a.

Equilibrium occurs where quantity demanded is equal to quantity supplied:

QD = QS

1600 – 300P = 1400 + 700P 200 = 1000P P = $0.20

Q D = 1600 – 300(0.20) = 1600 – 60 = 1540 Q S = 1400 + 700(0.20) = 1400 + 140 = 1540

The equilibrium price of a chocolate bar is $0.20 and the equilibrium quantity is 1540 bars. b.

Given the change in demand, equilibrium occurs where quantity demanded is equal to quantity supplied:

QD = QS

1800 – 300P = 1400 + 700P 400 = 1000P P = $0.40

Q D = 1800 – 300(0.40) = 1800 – 120 = 1680 Q S = 1400 + 700(0.40) = 1400 + 280 = 1680

The equilibrium price of a chocolate bar is $0.40 and the equilibrium quantity is 1680 bars. c.

Given the change in supply, equilibrium occurs where quantity demanded is equal to quantity supplied:

QD = QS

1600 – 300P = 1100 + 700P 500 = 1000P P = 500/1000 = $0.50

Q D = 1600 – 300(0.50) = 1600 – 150 = 1450 Q S = 1100 + 700(0.50) = 1100 + 350 = 1450 The equilibrium price of a chocolate bar is $0.50 and the equilibrium quantity is 1450 bars.

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Chapter 5 Elasticity and Its Application SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Define the price elasticity of demand. • Explain the relationship between total revenue and the price elasticity of demand.

The price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.

The relationship between total revenue and the price elasticity of demand is (1) when demand is inelastic (a price elasticity less than 1), a price increase raises total revenue, and a price decrease reduces total revenue; (2) when demand is elastic (a price elasticity greater than 1), a price increase reduces total revenue, and a price decrease raises total revenue; and (3) when demand is unit elastic (a price elasticity equal to 1), a change in price does not affect total revenue.

2.

Define the price elasticity of supply. • Explain why the price elasticity of supply might be different in the long run than in the short run.

The price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price.

The price elasticity of supply might be different in the long run than in the short run because, over short periods of time, firms cannot easily change the size of their factories to make more or less of a good. Thus, in the short run, the quantity supplied is less responsive to the price.

However, over longer periods, firms can build new factories, expand existing factories, or close old ones, or they can enter or exit a market. So, in the long run, the quantity supplied can respond substantially to the price.

3.

How might a drought that destroys half of all farm crops be good for farmers? If such a drought is good for farmers, why don’t farmers destroy their own crops in the absence of a drought?

A drought that destroys half of all farm crops could be good for farmers (at least those unaffected by the drought) if the demand for the crops is inelastic. The shift to the left of the supply curve leads to a price increase that raises total revenue because the price elasticity is less than one.

Even though a drought could be good for farmers, they would not destroy their crops in the absence of a drought because no one farmer would have an incentive to destroy his crops, since he takes the market price as given. Only if all farmers destroyed their crops together, for example, through a government program, would this plan work to make farmers better off.

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66 • Chapter 5: Elasticity and Its Application Questions for Review 1.

Define the price elasticity of demand and the income elasticity of demand.

The price elasticity of demand measures how much the quantity demanded responds to a change in price. The income elasticity of demand measures how much the quantity demanded responds to changes in consumer income.

2.

List and explain the four determinants of the price elasticity of demand discussed in the chapter.

Here are four examples of factors determining the price elasticity of demand: (i) if close substitutes are available, people buy more of those if the price increases; (ii) if the good is necessary, such as medication, people keep buying it even when its price increases; (iii) narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods; and finally, (iv) elasticity is higher when there is enough time for consumers to adjust to a change in price. For instance, if gasoline becomes more expensive than diesel, people will buy more diesel vehicles in the long run.

3.

If the elasticity is greater than 1, is demand elastic or inelastic? If the elasticity equals zero, is demand perfectly elastic or perfectly inelastic?

An elasticity greater than one means that demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price.

When the elasticity equals zero, demand is perfectly inelastic. There is no change in quantity demanded when there is a change in price.

4.

On a supply-and-demand diagram, show equilibrium price, equilibrium quantity, and the total revenue received by producers.

Figure 1 presents a supply-and-demand diagram showing equilibrium price, equilibrium quantity, and the total revenue received by producers. Total revenue equals the equilibrium price times the equilibrium quantity, which is the area of the rectangle shown in the figure.

Figure 1

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Chapter 5: Elasticity and Its Application • 67 5.

If demand is elastic, how will an increase in price change total revenue? Explain.

If demand is elastic, an increase in price reduces total revenue. With elastic demand, the quantity demanded falls by a greater percentage than the percentage increase in price. As a result, total revenue declines.

6.

What do we call a good whose income elasticity is less than zero?

A good with income elasticity less than zero is called an inferior good because as income rises, the quantity demanded declines.

7.

How is the price elasticity of supply calculated? Explain what it measures.

The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. It measures how much the quantity supplied responds to changes in the price.

8.

If a fixed quantity of a good is available, and no more can be made, what is the price elasticity of supply?

If a fixed quantity of a good is available and no more can be made, the price elasticity of supply is zero. Regardless of the percentage change in price, there will be no change in the quantity supplied.

9.

A storm destroys half of the apple crop. Is this event more likely to hurt apple farmers if the demand for apples is very elastic or very inelastic? Explain.

Destruction of half of the apple crop is more likely to hurt apple farmers if the demand for apples is very elastic. Destruction of half of the crop causes the supply curve to shift to the left, resulting in a higher price for apples. When demand is very elastic, an increase in price leads to a decrease in total revenue because the decrease in quantity demanded outweighs the increase in price.

Quick Check Multiple Choice

1. Which of the following will a life-saving medicine without any close substitutes tend to have? a. a small elasticity of demand b. a large elasticity of demand c. a small elasticity of supply d. a large elasticity of supply 2. The price of a good rises from $8 to $12, and the quantity demanded falls from 110 to 90 units.

Calculated with the midpoint method, what is the elasticity? a. 1/5 b. 1/2 c. 2 d. 5

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68 • Chapter 5: Elasticity and Its Application

3. Which of the following describes a linear, downward-sloping demand curve? a. inelastic b. unit elastic c. elastic d. inelastic at some points, and elastic at others 4. The ability of firms to enter and exit a market over time means that which of the following occurs in the long run? a. the demand curve is more elastic b. the demand curve is less elastic c. the supply curve is more elastic d. the supply curve is less elastic 5. An increase in the supply of a good will decrease the total revenue producers receive in which of the following circumstances? a. the demand curve is inelastic b. the demand curve is elastic c. the supply curve is inelastic d. the supply curve is elastic 6. The price of coffee rose sharply last month, while the quantity sold remained the same. Each of five people suggests an explanation: TOM: Demand increased, but supply was perfectly inelastic.

DICK: Demand increased, but it was perfectly inelastic.

HARRY: Demand increased, but supply decreased at the same time.

LARRY: Supply decreased, but demand was unit elastic.

MARY: Supply decreased, but demand was perfectly inelastic.

Who could possibly be right? a. Tom, Dick, and Harry b. Tom, Dick, and Mary c. Tom, Harry, and Mary d. Dick, Harry, and Larry 1. a 2. b 3. d 4. c 5. a 6. c

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Chapter 5: Elasticity and Its Application • 69 Problems and Applications 1.

For which of the following pairs of goods would you expect to have more elastic demand, and why? a. required textbooks or mystery novels b. Beethoven recordings or classical music recordings in general c. heating oil during the next six months or heating oil during the next five years d. root beer or water a.

Mystery novels have more elastic demand than required textbooks, because mystery novels have close substitutes and are a luxury good, while required textbooks are a necessity with few close substitutes. If the price of mystery novels were to rise, readers could substitute other types of novels, or buy fewer novels altogether. But if the price of required textbooks were to rise, students would have little choice but to pay the higher price. Thus the quantity demanded of required textbooks is less responsive to price than the quantity demanded of mystery novels.

b.

Beethoven recordings have more elastic demand than classical music recordings in general. Beethoven recordings are a narrower market than classical music recordings, so it is easy to find close substitutes for them. If the price of Beethoven recordings were to rise, people could substitute other classical recordings, like Mozart. But if the price of all classical recordings were to rise, substitution would be more difficult. Thus the quantity demanded of classical recordings is less responsive to price than the quantity demanded of Beethoven recordings.

c.

Heating oil during the next five years has more elastic demand than heating oil during the next six months. Goods have a more elastic demand over longer time horizons. If the price of heating oil were to rise temporarily, consumers could not switch to other sources of fuel without great expense. But if the price of heating oil were to be high for a long time, people would gradually switch to gas or electric heat. As a result, the quantity demanded of heating oil during the next six months is less responsive to price than the quantity demanded of heating oil during the next five years.

d.

Root beer has more elastic demand than water. Root beer is a luxury with close substitutes, while water is a necessity with no close substitutes. If the price of water were to rise, consumers would have little choice but to pay the higher price. But if the price of root beer were to rise, consumers could easily switch to other sodas. So the quantity demanded of root beer is more responsive to price than the quantity demanded of water.

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70 • Chapter 5: Elasticity and Its Application 2.

Suppose that business travellers and vacationers have the following demand for airline tickets from Toronto to Montreal: Price $150 200 250 300

Quantity Demanded (business travellers) 2100 tickets 2000 1900 1800

Quantity Demanded (vacationers) 1000 tickets 800 600 400

a. As the price of tickets rises from $200 to $250, what is the price elasticity of demand for (i) business travellers and (ii) vacationers? (Use the midpoint method in your calculations.) b. Why might vacationers have a different elasticity than business travellers?

3.

a.

For business travellers, the price elasticity of demand when the price of tickets rises from $200 to $250 is [(2000 – 1900)/1950]/[(250 – 200)/225] = 0.05/0.22 = 0.23. For vacationers, the price elasticity of demand when the price of tickets rises from $200 to $250 is [(800 – 600)/700]/[(250 – 200)/225] = 0.29/0.22 = 1.32.

b.

The price elasticity of demand for vacationers is higher than the elasticity for business travellers because vacationers can choose more easily a different mode of transportation (like driving or taking the train). Business travellers are less likely to do so since time is more important to them and their schedules are less adaptable.

Suppose that your demand schedule for DVDs is as follows: Price $8 10 12 14 16

Quantity Demanded (income = $10 000) 40 32 24 16 8

Quantity Demanded (income = $12 000) 50 45 30 20 12

a. Use the midpoint method to calculate your price elasticity of demand as the price of DVDs increases from $8 to $10 if (i) your income is $10 000, and (ii) your income is $12 000. b. Calculate your income elasticity of demand as your income increases from $10 000 to $12 000 if (i) the price is $12, and (ii) the price is $16. a.

If your income is $10 000, your price elasticity of demand as the price of DVDs rises from $8 to $10 is [(40 – 32)/36]/[(10 – 8)/9] = 0.22/0.22 = 1. If your income is $12 000, the elasticity is [(50 – 45)/47.5]/[(10 – 8)/9] = 0.11/0.22 = 0.5.

b.

If the price is $12, your income elasticity of demand as your income increases from $10 000 to $12 000 is [(30 – 24)/27]/[(12 000 – 10 000)/11 000] = 0.22/0.18 = 1.22. If the price is $16, your income elasticity of demand as your income increases from $10 000 to $12 000 is [(12 – 8)/10]/[(12 000 – 10 000)/11 000] = 0.40/0.18 = 2.2.

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Chapter 5: Elasticity and Its Application • 71 4.

5.

Emily has decided always to spend one-third of her income on clothing. a. What is her income elasticity of clothing demand? b. What is her price elasticity of clothing demand? c. If Emily’s tastes change and she decides to spend only one-fourth of her income on clothing, how does her demand curve change? What are her income elasticity and price elasticity now? a.

If Emily always spends one-third of her income on clothing, then her income elasticity of demand is one, since maintaining her clothing expenditures as a constant fraction of her income means the percentage change in her quantity of clothing must equal her percentage change in income. For example, suppose the price of clothing is $30, her income is $9000, and she purchases 100 clothing items. If her income rose 10 percent to $9900, she’d spend a total of $3300 on clothing, which is 110 clothing items, a 10 percent increase.

b.

Emily’s price elasticity of clothing demand is also one, since every percentage point increase in the price of clothing would lead her to reduce her quantity purchased by the same percentage. Again, suppose the price of clothing is $30, her income is $9000, and she purchases 100 clothing items. If the price of clothing rose 1 percent to $30.30, she would purchase 99 clothing items, a 1 percent reduction. [Note: This part of the problem can be confusing to students if they have an example with a larger percentage change and they use the point elasticity. Only for a small percentage change will the answer work with an elasticity of one. Alternatively, they can get the second part if they use the midpoint method for any size change.]

c.

Since Emily spends a smaller proportion of her income on clothing, then for any given price, her quantity demanded will be lower. Thus her demand curve has shifted to the left. But because she will again spend a constant fraction of her income on clothing, her income and price elasticities of demand remain one.

The Globe and Mail (December 16, 1997) reported that milk consumption declined following price increases: “Since the early 1980s, the price of milk in Canada has increased 22 per cent. As prices rose, the demand for milk fell off. Total [consumption] of milk on a per capita basis dropped . . . to 2.62 hectolitres in 1995 from 2.92 hectolitres in 1986.” a. Use these data to estimate the price elasticity of demand for milk. b. According to your estimate, what happens to milk producers’ revenue when the price of milk rises? c. Why might your estimate of the elasticity be unreliable? (Hint: Notice that The Globe and Mail is careless about the distinction between demand and quantity demanded.) a.

The percent change in quantity demand is (2.92 – 2.62)/2.77, which is 10.8 percent. The price elasticity of demand is 10.8/22 = 0.49.

b.

Given that the price elasticity of demand is inelastic (less than one), an increase in the price of milk will increase total revenue.

c.

Recall from Chapter 4 that a movement along a demand curve is called a “change in quantity demanded,” brought about by a change in the price of the good we are considering. So, in this article, it states that a price increase leads to a fall in demand when it should have stated a fall in quantity demanded. A movement up the demand curve due to the price increase may put you into the elastic range of the demand elasticity as opposed to the inelastic demand that we calculated.

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72 • Chapter 5: Elasticity and Its Application 6.

Two drivers—Walt and Jesse —each drive up to a gas station. Before looking at the price, each places an order. Walt says, “I’d like 40 litres of gas.” Jessie says, “I’d like $40 worth of gas.”

What is each driver’s price elasticity of demand?

Walt’s price elasticity of demand is zero, because he wants the same quantity regardless of the price. Jesse’s price elasticity of demand is one, because he spends the same amount on gas no matter what the price, which means his percentage change in quantity is equal to the percentage change in price.

7.

You are the curator of a museum. The museum is running short of funds, so you decide to increase revenue. Should you increase or decrease the price of admission? Explain.

The answer depends on the elasticity of demand. If the demand for visits is inelastic, then an increase in the price of admission would increase total revenue. But if the demand is elastic, then an increase in price would cause the number of visitors to fall by so much that total revenue would decrease.

8.

9.

Consider public policy aimed at smoking. a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of cigarettes currently costs $10 and the government wants to reduce smoking by 20 percent, by how much should it increase the price? b. If the government permanently increases the price of cigarettes, will the policy have a greater effect on smoking one year from now or five years from now? c. Studies also find that teenagers have a higher price elasticity than do adults. Why might this be true? a.

With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20 percent requires a 50 percent increase in the average price using the midpoint method, since 20/50 = 0.4. With the price of cigarettes currently $10, this would require an increase in the price to X, where X is determined by [(X–10)/[(X+10)/2] = 0.5.

Solving for X gives X = $16.67. So, the price of a pack of cigarettes would need to increase from $10 to $16.67.

b.

The policy will have a larger effect five years from now than it does one year from now.

The elasticity is larger in the long run, since it may take some time for people to reduce their cigarette usage. The habit of smoking is hard to break in the short run.

c.

Since teenagers do not have as much income as adults, they are likely to have a higher price elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it more difficult to reduce their quantity demanded in response to a higher price.

Suppose that the price elasticity of demand for heating oil is 0.2 in the short run and 0.7 in the long run. a. If the price of heating oil rises from $0.45 to $0.55 per litre, what happens to the quantity of heating oil demanded in the short run? In the long run? (Use the midpoint method in your calculations.) b. Why might this elasticity depend on the time horizon?

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Chapter 5: Elasticity and Its Application • 73

10.

a.

With a price elasticity of demand of 0.2 in the short run, increasing the price from $0.45 to $0.55 would cause the quantity demanded of heating oil to drop by 4 percent, since 0.04/0.2 = 0.2. In the long run, the same increase in price would cause the quantity demand to drop by 14 percent, since 0.14/0.2 = 0.7.

b.

In the short run, households cannot easily switch from heating oil to other alternative fuels, so the quantity demanded drops only slightly given the price increase. In the long run, households can search for or use other means to heat their homes, so the quantity demanded for heating oil tends to drop more significantly.

Pharmaceutical drugs have an inelastic demand, and computers have an elastic demand.

Suppose that technological advance doubles the supply of both products (that is, the quantity supplied at each price is twice what it was). a. What happens to the equilibrium price and quantity in each market? b. Which product experiences a greater change in price? c. Which product experiences a greater change in quantity? d. What happens to total consumer spending on each product? a.

As Figure 2 shows, in both markets, the increase in supply reduces the equilibrium price and increases the equilibrium quantity.

Figure 2 b.

In the market for pharmaceutical drugs, with inelastic demand, the increase in supply leads to a relatively large decline in the price and not much of an increase in quantity.

c.

In the market for computers, with elastic demand, the increase in supply leads to a relatively large increase in quantity and not much of a decline in price.

d.

In the market for pharmaceutical drugs, since demand is inelastic, the percentage increase in quantity will be less than the percentage decrease in price, so total consumer spending will decline. In contrast, since demand is elastic in the market for computers, the percentage increase in quantity will be greater than the percentage decrease in price, so total consumer spending will increase.

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74 • Chapter 5: Elasticity and Its Application 11.

12.

Some years ago, flooding along the Red River in Manitoba destroyed thousands of hectares of wheat. a. Farmers whose crops were destroyed by the floods were much worse off, but farmers whose crops were not destroyed benefited from the floods. Why? b. What information would you need about the market for wheat to assess whether farmers as a group were hurt or helped by the floods? a.

Farmers whose crops were not destroyed benefited because the destruction of some of the crops reduced the supply causing the equilibrium price to rise.

b.

To tell whether farmers as a group were hurt or helped by the floods, you would need to know the price elasticity of demand. It could be that the additional income earned by farmers whose crops were not destroyed because of higher prices was greater than the loss in income for the farmers whose crops were destroyed. This would be the case if demand is inelastic.

Explain why the following might be true: A drought around the world raises the total revenue that farmers receive from the sale of grain, but a drought only in Alberta reduces the total revenue that Alberta farmers receive.

A worldwide drought could increase the total revenue of farmers if the price elasticity of demand for grain is inelastic. The drought reduces the supply of grain, but if demand is inelastic, the reduction of supply causes a large increase in price. Total farm revenue would rise as a result. If there is a drought in Alberta only, Alberta’s production is not a large enough proportion of the total farm product to have much impact on the price. As a result, price does not change (or changes by only a slight amount), while the output of Alberta farmers declines, thus reducing their income.

13.

A price change causes the quantity demanded of a good to decrease by 30 percent, while the total revenue of that good increases by 15 percent. Is the demand curve elastic or inelastic?

Explain.

The decrease in quantity must have been determined by an increase in price. Since the increase in price makes revenue increase, the demand curve must be inelastic.

14.

Cups of coffee and donuts are complements. Both have inelastic demand. A hurricane destroys half the coffee bean crop. Use appropriately labelled diagrams to answer the following questions: a. What happens to the price of coffee beans? b. What happens to the price of a cup of coffee? What happens to total expenditure on cups of coffee? c. What happens to the price of donuts? What happens to total expenditure on donuts? a.

The effect on the market for coffee beans is shown in Figure 3. When a hurricane destroys half of the crop, the supply of coffee beans decreases, the price of coffee beans increases, and the quantity decreases.

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Chapter 5: Elasticity and Its Application • 75

S2

Price

S1

Demand Quantity Figure 3

b. The effect on the market for cups of coffee is shown in Figure 3. When the price of coffee beans, an important input into the production of a cup of coffee, increases, the supply of cups of coffee decreases, the price of a cup of coffee increases, and the quantity decreases.

Because cups of coffee have an inelastic demand, when the price of a cup of coffee increases, the total expenditure on coffee increases. c.

The effect on the market for donuts is shown in Figure 4. When the price of coffee increases and the quantity demanded of coffee decreases, consumers demand fewer donuts because coffee and donuts are complements. When demand decreases, the price of donuts decreases.

Because donuts have an inelastic demand, when the price of donuts decreases, the total expenditure on donuts decreases.

Price Supply

D2

Figure 4

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D1

76 • Chapter 5: Elasticity and Its Application 15.

You have the following information about good X and good Y: • Income elasticity of demand for good X: –3 • Cross-price elasticity of demand for good X with respect to the price of good Y: 2 Would an increase in income and a decrease in the price of good Y unambiguously decrease the demand for good X? Why or why not?

Yes. First, the negative income elasticity of good X shows that X is an inferior good: when income increases, the demand for X decreases. Second, goods X and Y are substitutes, as the positive cross-price elasticity shows. This implies that a decrease in the price of Y decreases the demand for X. Thus, both events, an increase in income and a decrease in the price of Y, make the demand for X shift in the same direction, namely toward lower quantities.

16.

Consider two demand curves. The first is linear, with the demand curve given by QD = 100 – 20P. The second is nonlinear, with the demand curve given by QD = 60/P. For each of these demand curves, compute the quantity demanded at prices of $1, $2, $3, $4, $5, and $6. Graph each of the demand curves. Use the midpoint method to calculate the price elasticity of demand between $1 and $2, and between $4 and $5 for each demand curve. Compare the price elasticities in these cases. In particular, how does the elasticity of the nonlinear demand curve for the two price movements differ from the elasticity of the linear demand curve for the same price movements?

First, for the demand curve Q D = 60/P : The quantity demanded at different prices is calculated in Table 1. Figure 5 shows the corresponding graph. The midpoint price elasticity of demand between P = 1 and P = 2 is equal to [(30 – 60)/45]/[(2 – 1)/1.5] = –1. The midpoint price elasticity between the prices 5 and 6 is equal to [(10 – 12)/11]/[(6 – 5)/5.5] = –1. The demand curve has constant elasticity.

Price Price

Quantity= 60/Price

$1 2 3 4 5 6

60 30 20 15 12 10 Table 1

6 5 4 3 2 1 10 20 30 40 50 60 Quantity Demanded

Figure 5

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Chapter 5: Elasticity and Its Application • 77 Now, let us do the same for the linear demand curve Q D = 100 – 20P : to draw the curve, we only need its intercepts. When P = 0, Q D = 100; when Q D = 0, P = 100/20 = 5. Figure 6 shows the linear demand curve. To calculate the elasticities, we need the quantities corresponding to the given prices: Q D(1) = 100 – 20 × 1 = 80; similarly, Q D(2) = 60, Q D(5) = 0, and Q D(6) = –20. Since quantity cannot be negative, we approximate the elasticity in that area by considering P = 4, at which Q D(4) = 20. For the change in price from 1 to 2, elasticity = [(60 – 80)/70] / [(2 – 1)/1.5] = –0.43; for the second set of prices, elasticity = [(0 – 20)/10]/[(5 – 4)/4.5] = –9.

Unlike in the previous case, the elasticity for a linear demand is not constant; it depends on the price.

P 0 1 2 3 4 5

QD 100 80 60 40 20 0

P 5

QD Figure 6

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100

Chapter 6 Supply, Demand, and Government Policies SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Define price ceiling and price floor, and give an example of each. Which leads to a shortage?

Which leads to a surplus? Why? A price ceiling is a legal maximum on the price at which a good can be sold. Examples of price ceilings include rent control, price controls on gasoline in the 1970s, and price ceilings on water during a drought. A price floor is a legal minimum on the price at which a good can be sold.

Examples of price floors include the minimum wage and farm-support prices. A price ceiling leads to a shortage—if the ceiling is binding—because suppliers will not produce enough goods to meet demand unless the price is allowed to rise above the ceiling. A price floor leads to a surplus—if the floor is binding—because suppliers produce more goods than are demanded unless the price is allowed to fall below the floor.

2.

Assume you are to levy a tax on yachts. Should you impose it on yacht buyers or yacht producers? Explain.

Since the revenue raised by the tax and the incidence on buyers and producers is independent of the side of the market the tax is imposed on, from an economic perspective, it does not matter whether the tax is imposed on yacht buyers or yacht producers.

3.

In a supply-and-demand diagram, show how a tax on car buyers of $1000 per car affects the quantity of cars sold and the price of cars. In another diagram, show how a tax on car sellers of $1000 per car affects the quantity of cars sold and the price of cars. In both of your diagrams, show the change in the price paid by car buyers and the change in price received by car sellers.

With no tax, as shown in Figure 1, the demand curve is D1 and the supply curve is S. The equilibrium price is P1 and the equilibrium quantity is Q1. If the tax is imposed on car buyers, the demand curve shifts down by the amount of the tax ($1000) to D2. The downward shift in the demand curve leads to a decline in the equilibrium price to P2 (the amount received by sellers from buyers) and a decline in the equilibrium quantity to Q2. The price received by sellers declines by P1 – P2—shown in the figure as PS. Buyers pay a total of P2 + $1000, an increase in what they pay of P2 + $1000 – P1—shown in the figure as PB.

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80 • Chapter 6: Supply, Demand, and Government Policies

Figure 1 If the tax is imposed on car sellers, as shown in Figure 2, the supply curve shifts up by the amount of the tax ($1000) to S2. The upward shift in the supply curve leads to a rise in the equilibrium price paid by buyers to P2 and a decline in the equilibrium quantity to Q2. The price paid by buyers therefore increases by P2 – P1—shown in the figure as PB. Sellers receive P2 and pay taxes of $1000, receiving a net of P2 – $1000, a decrease in what they receive of P1 – (P2 – $1000)—shown in the figure as PS.

Figure 2

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Chapter 6: Supply, Demand, and Government Policies • 81 Questions for Review 1.

Give an example of a price ceiling and an example of a price floor.

An example of a price ceiling is the rent control system in Vancouver. An example of a price floor is the minimum wage. Many other examples are possible.

2.

Which causes a shortage of a good—a price ceiling or a price floor? Which causes a surplus?

A shortage of a good arises when there is a binding price ceiling. A surplus of a good arises when there is a binding price floor.

3.

What mechanisms allocate resources when the price of a good is not allowed to bring supply and demand into equilibrium?

When the price of a good is not allowed to bring supply and demand into equilibrium, some alternative mechanism must allocate resources. If quantity supplied exceeds quantity demanded so that there is a surplus of a good, as in the case of a binding price floor, sellers may try to appeal to the personal biases of the buyers. If quantity demanded exceeds quantity supplied, so that there is a shortage of a good, as in the case of a binding price ceiling, sellers can ration the good according to their personal biases, or make buyers wait in line.

4.

Explain why economists usually oppose controls on prices.

Economists usually oppose controls on prices because prices have the crucial job of coordinating economic activity by balancing demand and supply. When policymakers set controls on prices, they obscure the signals that guide the allocation of society’s resources. Further, price controls often hurt those they are trying to help.

5.

Suppose the government removes a tax on buyers of a good and levies a tax of the same size on sellers of the good. How does this change in tax policy affect the price that buyers pay sellers for this good, the amount buyers are out of pocket (including any tax payments they make), the amount sellers receive (net of any tax payments they make), and the quantity of the good sold?

Removing a tax paid by buyers and replacing it with a tax paid by sellers raises the price that buyers pay sellers by the amount of the tax, has no effect on the amount buyers are out of pocket, has no effect on the amount sellers receive net of any tax payments they make, increases the price received by sellers, and has no effect on the quantity of the good sold.

6.

How does a tax on a good affect the price paid by buyers, the price received by sellers, and the quantity sold?

A tax on a good raises the price buyers pay, lowers the price sellers receive, and reduces the quantity sold.

7.

What determines how the burden of a tax is divided between buyers and sellers? Why? The burden of a tax is divided between buyers and sellers, depending on the elasticity of demand and supply. Elasticity represents the willingness of buyers or sellers to leave the market, which in turn depends on their alternatives. When a good is taxed, the side of the market with fewer good alternatives cannot easily leave the market and thus bears more of the burden of the tax.

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82 • Chapter 6: Supply, Demand, and Government Policies Quick Check Multiple Choice

1. When the government imposes a binding price floor, it causes which of the following to occur? a. the supply curve to shift to the left b. the demand curve to shift to the right c. a shortage of the good to develop d. a surplus of the good to develop 2. In a market with a binding price ceiling, an increase in the ceiling will ___ the quantity supplied, ___ the quantity demanded, and reduce the ___. a. increase, decrease, surplus b. decrease, increase, surplus c. increase, decrease, shortage d. decrease, increase, shortage 3. A $1 per unit tax levied on consumers of a good is equivalent to which of the following? a. a $1 per unit tax levied on producers of the good b. a $1 per unit subsidy paid to producers of the good c. a price floor that raises the good’s price by $1 per unit d. a price ceiling that raises the good’s price by $1 per unit 4. Which of the following would increase quantity supplied, decrease quantity demanded, and increase the price that consumers pay? a. the imposition of a binding price floor b. the removal of a binding price floor c. the passage of a tax levied on producers d. the repeal of a tax levied on producers 5. Which of the following would increase quantity supplied, increase quantity demanded, and decrease the price that consumers pay? a. the imposition of a binding price floor b. the removal of a binding price floor c. the passage of a tax levied on producers d. the repeal of a tax levied on producers 6. When a good is taxed, in which scenario does the burden of the tax fall mainly on consumers? a. when the tax is levied on consumers b. when the tax is levied on producers c. when supply is inelastic, and demand is elastic d. when supply is elastic, and demand is inelastic 1. d 2. c 3. a 4. a 5. d 6. d

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Chapter 6: Supply, Demand, and Government Policies • 83 Problems and Applications 1.

Lovers of classical music persuade Parliament to impose a price ceiling of $40 per concert ticket.

As a result of this policy, do more or fewer people attend classical music concerts? Explain.

If the price ceiling of $40 per ticket is below the equilibrium price, then quantity demanded exceeds quantity supplied, so there will be a shortage of tickets. The policy decreases the number of people who attend classical music concerts, since the quantity supplied is lower because of the lower price.

2.

The government has decided that the free-market price of cheese is too low. a. Suppose the government imposes a binding price floor in the cheese market. Use a supply-and-demand diagram to show the effect of this policy on the price of cheese and the quantity of cheese sold. Is there a shortage or surplus of cheese? b. Farmers complain that the price floor has reduced their total revenue. Is this possible?

Explain. c. In response to farmers’ complaints, the government agrees to purchase all of the surplus cheese at the price floor. Compared to the basic price floor, who benefits from this new policy? Who loses? a.

The imposition of a binding price floor in the cheese market is shown in Figure 3. In the absence of the price floor, the price would be P1 and the quantity would be Q1. With the floor set at P f , which is greater than P1, the quantity demanded is Q2, while quantity supplied is Q3, so there is a surplus of cheese in the amount Q3 – Q2.

Figure 3 b.

The farmers’ complaint that their total revenue has declined is correct if demand is elastic. With elastic demand, the percentage decline in quantity would exceed the percentage rise in price, so total revenue would decline.

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84 • Chapter 6: Supply, Demand, and Government Policies c.

3.

If the government purchases all the surplus cheese at the price floor, producers benefit and taxpayers lose. Producers would produce quantity Q3 of cheese, and their total revenue would increase substantially. But consumers would buy only quantity Q2 of cheese, so they are in the same position as before. Taxpayers lose because they would be financing the purchase of the surplus cheese through higher taxes.

A recent study found that the demand and supply schedules for Frisbees are as follows: Price per Frisbee $11 10 9 8 7 6

Quantity Demanded 1 million 2 4 6 8 10

Quantity Supplied 15 million 12 9 6 3 1

a. What are the equilibrium price and quantity of Frisbees? b. Frisbee manufacturers persuade the government that Frisbee production improves scientists’ understanding of aerodynamics and thus is important for national security. A concerned Parliament votes to impose a price floor $2 above the equilibrium price.

What is the new market price? How many Frisbees are sold? c. Irate students march on Ottawa and demand a reduction in the price of Frisbees. An even more concerned Parliament votes to repeal the price floor and impose a price ceiling $1 below the former price floor. What is the new market price? How many Frisbees are sold?

4.

a.

The equilibrium price of Frisbees is $8 and the equilibrium quantity is 6 million Frisbees.

b.

With a price floor of $10, the new market price is $10 since the price floor is binding. At that price, only 2 million Frisbees are sold, since that is the quantity demanded.

c.

If there is a price ceiling of $9, it has no effect, since the market equilibrium price is $8, below the ceiling. So the equilibrium price is $8 and the equilibrium quantity is 6 million Frisbees.

Suppose the provincial government requires beer drinkers to pay a $2 tax on each case of beer purchased. a. Draw a supply-and-demand diagram of the market for beer without the tax. Show the price paid by consumers, the price received by producers, and the quantity of beer sold. What is the difference between the price paid by consumers and the price received by producers? b. Now draw a supply-and-demand diagram for the beer market with the tax. Show the price paid by consumers, the price received by producers, and the quantity of beer sold. What is the difference between the price paid by consumers and the price received by producers? Has the quantity of beer sold increased or decreased?

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Chapter 6: Supply, Demand, and Government Policies • 85 a.

Figure 4 shows the market for beer without the tax. The equilibrium price is P1 and the equilibrium quantity is Q1. The price paid by consumers is the same as the price received by producers.

Figure 4 b.

When the tax is imposed, it drives a wedge of $2 between supply and demand, as shown in Figure 5. The price paid by consumers is P2, while the price received by producers is P2 – $2. The quantity of beer sold declines to Q2.

Figure 5 5.

An MP wants to raise tax revenue and make workers better off. A staff member proposes raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax paid by workers. Would this accomplish the MP’s goal?

Raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax paid by workers would not make workers better off because the division of the burden of a tax depends on the elasticity of supply and demand, and not on who must pay the tax. Since the tax

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86 • Chapter 6: Supply, Demand, and Government Policies wedge would be larger, it is likely that both firms and workers, who share the burden of any tax, would be worse off.

6.

If the government places a $500 tax on luxury cars, will the price paid by consumers rise by more than $500, less than $500, or exactly $500? Explain.

If the government imposes a $500 tax on luxury cars, the price paid by consumers will rise less than $500 in general. The burden of any tax is shared by both producers and consumers: The price paid by consumers rises and the price received by producers falls, with the difference between the two equal to the amount of the tax. The only exceptions would be if the supply curve were perfectly elastic or the demand curve were perfectly inelastic, in which case consumers would bear the full burden of the tax and the price paid by consumers would rise by exactly $500.

7.

Parliament decides that Canada should reduce air pollution by reducing its use of gasoline. It imposes a $0.50 tax for each litre of gasoline sold. a. Should it impose this tax on producers or consumers? Explain carefully, using a supply-and-demand diagram. b. If the demand for gasoline were more elastic, would this tax be more effective or less effective in reducing the quantity of gasoline consumed? Explain with both words and a diagram. c. Are consumers of gasoline helped or hurt by this tax? Why? d. Are workers in the oil industry helped or hurt by this tax? Why? a.

It does not matter whether the tax is imposed on producers or consumers—the effect will be the same. With no tax, as shown in Figure 6, the demand curve is D1 and the supply curve is S1. If the tax is imposed on producers, the supply curve shifts up by the amount of the tax (50 cents) to S2. Then the equilibrium quantity is Q2, the price paid by consumers is P2, and the price received (after taxes are paid) by producers is P2 – 50 cents. If the tax is instead imposed on consumers, the demand curve shifts down by the amount of the tax (50 cents) to D2. The downward shift in the demand curve (when the tax is imposed on consumers) is exactly the same magnitude as the upward shift in the supply curve when the tax is imposed on producers. So again, the equilibrium quantity is Q2, the price paid by consumers is P2 (including the tax paid to the government), and the price received by producers is P2 – 50 cents.

Figure 6

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Chapter 6: Supply, Demand, and Government Policies • 87 b.

The more elastic is the demand curve, the more effective this tax will be in reducing the quantity of gasoline consumed. Greater elasticity of demand means that quantity falls more in response to the rise in the price of gasoline. Figure 7 illustrates this result.

Demand curve D1 represents an elastic demand curve, while demand curve D2 is more inelastic. To get the same tax wedge between demand and supply requires a greater reduction in quantity with demand curve D1 than for demand curve D2.

Figure 7

8.

c.

The consumers of gasoline are hurt by the tax because they get less gasoline at a higher price.

d.

Workers in the oil industry are hurt by the tax as well. With a lower quantity of gasoline being produced, some workers may lose their jobs. With a lower price received by producers, wages of workers might decline.

A case study in this chapter discusses the minimum-wage law. a. Suppose the minimum wage is above the equilibrium wage in the market for unskilled labour. Using a supply-and-demand diagram of the market for unskilled labour, show the market wage, the number of workers who are employed, and the number of workers who are unemployed. Also show the total wage payments to unskilled workers. b. Now suppose the provincial government proposes an increase in the minimum wage.

What effect would this increase have on employment? Does the change in employment depend on the elasticity of demand, the elasticity of supply, both elasticities, or neither? c. What effect would this increase in the minimum wage have on unemployment? Does the change in unemployment depend on the elasticity of demand, the elasticity of supply, both elasticities, or neither? d. If the demand for unskilled labour were inelastic, would the proposed increase in the minimum wage raise or lower total wage payments to unskilled workers? Would your answer change if the demand for unskilled labour were elastic?

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88 • Chapter 6: Supply, Demand, and Government Policies a.

Figure 8 shows the effects of the minimum wage. In the absence of the minimum wage, the market wage would be w1 and Q1 workers would be employed. With the minimum wage (wm) imposed above w1, the market wage is wm, the number of employed workers is Q2, the labour force becomes Q3, and the number of unemployed is Q3 – Q2. Total wage payments to workers are shown as the area of rectangle ABCD, which equals wm times Q2.

Figure 8

9.

b.

An increase in the minimum wage would decrease employment. The size of the effect on employment depends only on the elasticity of demand. The elasticity of supply does not matter, because there is a surplus of labour.

c.

The increase in the minimum wage would increase unemployment. The size of the rise in unemployment depends on the elasticities of both supply and demand. The elasticity of demand determines the quantity of labour demanded, the elasticity of supply determines the quantity of labour supplied, and the difference between the quantity supplied and the quantity demanded of labour is the amount of unemployment.

d.

If the demand for unskilled labour were inelastic, the rise in the minimum wage would increase total wage payments to unskilled labour. With inelastic demand, the percentage decline in employment would be less than the percentage increase in the wage, so total wage payments increase. However, if the demand for unskilled labour were elastic, total wage payments would decline, since then the percentage decline in employment would exceed the percentage increase in the wage.

The Canadian government administers two programs that affect the market for cigarettes. Health Canada media campaigns and labelling requirements are aimed at making the public aware of the dangers of cigarette smoking. At the same time, Agriculture and Agri-Food Canada imposes production quotas on tobacco farmers, which raise the price of tobacco above the equilibrium price. a. How do these two programs affect cigarette consumption? Use a graph of the cigarette market in your answer. b. What is the combined effect of these two programs on the price of cigarettes? c. Cigarettes are also heavily taxed. What effect does this tax have on cigarette consumption?

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Chapter 6: Supply, Demand, and Government Policies • 89 a.

Programs aimed at making the public aware of the dangers of smoking reduce the demand for cigarettes, shown in Figure 9 as a shift from demand curve D1 to D2. The production quota increases the price of tobacco, which is the main ingredient in cigarettes. As a result, the supply of cigarettes shifts to the left, from S1 to S2. The effect of both programs is to reduce the quantity of cigarette consumption from Q1 to Q2.

Figure 9

10.

b.

The combined effect of the two programs on the price of cigarettes is ambiguous. The education campaign reduces demand for cigarettes, which tends to reduce the price. The tobacco production quotas raise the cost of production of cigarettes, which tends to increase the price.

c.

The taxation of cigarettes further reduces cigarette consumption, since it increases the price to consumers. As shown in Figure 9, the quantity falls to Q3.

A subsidy is the opposite of a tax. With a $0.50 tax on the buyers of ice-cream cones, the government collects $0.50 for each cone purchased; with a $0.50 subsidy for the buyers of icecream cones, the government pays buyers $0.50 for each cone purchased. a. Show the effect of a $0.50 per cone subsidy on the demand curve for ice-cream cones, the effective price paid by consumers, the effective price received by sellers, and the quantity of cones sold. b. Do consumers gain or lose from this policy? Do producers gain or lose? Does the government gain or lose? a.

The effect of a $0.50 per cone subsidy is to shift the demand curve up by $0.50 at each quantity, since at each quantity a consumer’s willingness to pay is $0.50 higher. The effects of such a subsidy are shown in Figure 10. Before the subsidy, the price is P1. After the subsidy, the price received by sellers is PS and the effective price paid by consumers is PD, which equals PS minus 50 cents. Before the subsidy, the quantity of cones sold is Q1; after the subsidy, the quantity increases to Q2.

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90 • Chapter 6: Supply, Demand, and Government Policies

Figure 10 b.

11.

Because of the subsidy, consumers are better off, since they consume more at a lower price. Producers are also better off, since they sell more at a higher price. The government loses, since it has to pay for the subsidy.

At the Scotiabank Arena, home of the Raptors and the Maple Leafs, seating is limited to about 19 000. Hence, the number of tickets issued is fixed at that figure. (Assume that all seats are equally desirable and are sold at the same price.) Seeing a golden opportunity to raise revenue, the City of Toronto levies a per-ticket tax of $5 to be paid by the ticket buyer. Toronto sports fans, a famously civic-minded lot, dutifully send in the $5 per ticket. Draw a well-labelled graph showing the impact of the tax. On whom does the tax burden fall—the team’s owners, the fans, or both? Why? The supply of tickets is inelastic. The demand for tickets shifts downward by $5 because of the tax. Suppose the initial equilibrium price was $75. As Figure 11 shows, the price buyers pay does not change, but the team owners lower the price by exactly $5. If the team owners did not lower the price, then the number of tickets sold would decrease, say to 15 000, and the team owners’ revenue would drop by $75 × 2000 = $150 000; when they lower the price by $5, they sell all 17 000 seats and the revenue loss is “only” $5 × 17 000 = $85 000. With inelastic supply, the sellers bear the entire tax burden.

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Chapter 6: Supply, Demand, and Government Policies • 91

Figure 11 Appendix Problems and Applications A1.

The demand and supply functions for hockey sticks are given by QD = 286 – 20P QS = 88 + 40P In order to raise revenue to finance minor hockey so that Canada can continue its gold medal streak at the Olympics, the federal government decides to impose a tax of $2 per hockey stick sold, to be paid by the buyers of hockey sticks. a. Determine the equilibrium price and quantity of hockey sticks both before and after the tax. How is the burden of the tax shared between buyers and sellers? b. How many hockey sticks would be sold before the tax is imposed? After the tax? c. Graph the supply and the demand curves for hockey sticks both before and after the tax, clearly showing the intercepts and equilibrium outcomes. d. What would happen if the tax were paid by the sellers of hockey sticks instead of the buyers? a.

In equilibrium, Q D = Q S. Replacing the expressions of demand and supply, 286 – 20P = 88 + 40P, with the solutions P = $3.30 and Q D = Q S = 220. We are told that the tax is paid by consumers (if the seller is to pay the tax, the solution is the same). Thus, 286 – 20(P + 2) = 88 + 40P, or 286 – 20 × 2 – 20P = 88 + 40P, or 246 – 20P = 88 + 40P, for which the solution is P = $2.63 and Q = 193. The tax burden on the seller is $3.30 – $2.63 = $0.67; the tax burden on the buyer is ($2.63 + $2) – $3.30 = $1.33.

b.

Before the tax, 220 sticks would be sold. After the tax, only 193 would be sold.

c.

Figure 12 shows the effect of the tax of $2 on prices and quantities. If consumers pay the tax, the demand curve shifts downward by a vertical distance equal to the tax.

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92 • Chapter 6: Supply, Demand, and Government Policies

Figure 12 d.

A2.

If the tax were paid by the sellers, the outcome should be the same. The demand equation, however, would not change, but the supply would add the tax to the price. The solution follows the same steps as shown in the case of tax paid by consumers.

Say the demand schedule for ice-cream cones can be represented by the equation QD = 160 – 3P, where QD is the quantity demanded and P is the price. The supply schedule can be represented by QS = 140 + 7P, where QS is the quantity supplied. a. Calculate the equilibrium price and quantity in the market for ice-cream cones. b. Say the Canadian Association of Ice-Cream Eaters complains that the equilibrium price calculated in part (a) is too high, and their members cannot eat enough ice-cream cones at this price. They lobby the government to impose a price ceiling on ice-cream cones of $1. What is the quantity demanded at this price? The quantity supplied? Is there a shortage or surplus of ice cream? How big is it? What if a $2.50 price ceiling were imposed instead? c. Say instead that the Canadian Association of Ice-Cream Makers lobbies the government, arguing that the equilibrium price is too low for their members to make a decent living. They want a price floor of $3 per cone. What is the quantity demanded at this price? The quantity supplied? Is there a shortage or a surplus of ice cream?

What is it? What if a price floor of $1.50 were imposed instead? a.

In equilibrium, Q D = Q S. Replacing the expressions of demand and supply, 160 – 3P = 140 + 7P. The solution to this equation is the equilibrium price, P = $2. The equilibrium quantity can be determined by replacing the price P = $2 in either the demand or the supply equation. If we use the demand equation, we get Q = 160 – 3 × 2 = 154. (Using the supply equation must give the same result.)

b.

With the price ceiling of $1, the quantity demanded is Q D = 160 – 3 × 1 = 157, and quantity supplied is Q S = 140 + 7 × $1 = 147. There is a shortage of 157 – 147 = 10. A price ceiling of $2.50 is not binding, since the equilibrium price of $2 is lower.

c.

With a price floor of $3, the quantity demanded is Q D = 160 – 3 × 3 = 151, and the quantity supplied is 140 + 7 × $3 = 161. There is a surplus of 161 – 151 = 10. A price floor of $1.50 is not binding.

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Chapter 7 Consumers, Producers, and the Efficiency of Markets SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Draw a demand curve for turkey. In your diagram, show a price of turkey and the consumer surplus that results from that price. Explain in words what this consumer surplus measures.

Figure 1 shows the demand curve for turkey. The price of turkey is P1 and the consumer surplus that results from that price is denoted CS. Consumer surplus measures buyers’ willingness to pay (measured by the demand curve) minus the amount the buyers actually pay.

Figure 1 2.

Draw a supply curve for turkey. In your diagram, show a price of turkey and the producer surplus that results from that price. Explain in words what this producer surplus measures.

Figure 2 shows the supply curve for turkey. The price of turkey is P1 and the producer surplus that results from that price is denoted PS. Producer surplus measures the amount sellers are paid for a good minus the sellers’ cost (measured by the supply curve).

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94 • Chapter 7: Consumers, Producers, and the Efficiency of Markets

Figure 2 3.

Draw the supply and demand for turkey. In the equilibrium, show producer and consumer surplus. Explain why producing more turkey would lower total surplus.

Figure 3 shows the supply and demand for turkey. The price of turkey is P1, consumer surplus is CS, and producer surplus is PS. Producing more turkey would lower total surplus because the value to buyers would be less than the cost to sellers.

Figure 3

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Chapter 7: Consumers, Producers, and the Efficiency of Markets • 95 Questions for Review 1.

Explain how buyers’ willingness to pay, consumer surplus, and the demand curve are related.

Buyers’ willingness to pay, consumer surplus, and the demand curve are all closely related. The height of the demand curve represents the buyers’ willingness to pay. Consumer surplus is the area below the demand curve and above the price, which equals each buyer’s willingness to pay, less the price of the good.

2.

Explain how sellers’ costs, producer surplus, and the supply curve are related.

Sellers’ costs, producer surplus, and the supply curve are all closely related. The height of the supply curve represents the costs of the sellers. Producer surplus is the area below the price and above the supply curve, which equals the price minus each seller’s costs.

3.

In a supply-and-demand diagram, show producer and consumer surplus in the market equilibrium.

Figure 4 shows producer and consumer surplus in a supply-and-demand diagram.

Figure 4 4.

What is efficiency? Is it the only goal of economic policymakers?

An allocation of resources is efficient if it maximizes total surplus—the sum of consumer surplus and producer surplus. But efficiency may not be the only goal of economic policymakers; they may also be concerned about equitythe fairness of the distribution of well-being.

5.

Name two types of market failure. Explain why each may cause market outcomes to be inefficient.

Two types of market failure are market power and externalities. Market power may cause market outcomes to be inefficient because when firms influence prices, they cause price and quantity to differ from the levels they would be under perfect competition, which keeps total surplus from being maximized. Externalities are side effects that are not taken into account by buyers and sellers. As a result, the free market does not maximize total surplus.

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96 • Chapter 7: Consumers, Producers, and the Efficiency of Markets Quick Check Multiple Choice

1. Jen values her time at $60 an hour. She spends 2 hours giving Colleen a massage. Colleen was willing to pay as much as $300 for the massage, but they negotiate a price of $200. Which of the following is true regarding this transaction? a. consumer surplus is $20 larger than producer surplus b. consumer surplus is $40 larger than producer surplus c. producer surplus is $20 larger than consumer surplus d. producer surplus is $40 larger than consumer surplus 2. The demand curve for cookies is downward sloping. When the price of cookies is $2, the quantity demanded is 100. If the price rises to $3, what happens to consumer surplus? a. It falls by less than $100. b. It falls by more than $100. c. It rises by less than $100. d. It rises by more than $100.

3. John has been working as a tutor for $300 a semester. When the university raises the price it pays tutors to $400, Emily enters the market and begins tutoring as well. How much does producer surplus rise as a result of this price increase? a. by less than $100 b. between $100 and $200 c. between $200 and $300 d. by more than $300 4. Which of the following is maximized by an efficient allocation of resources? a. consumer surplus b. producer surplus c. consumer surplus plus producer surplus d. consumer surplus minus producer surplus 5. When a market is in equilibrium, the buyers are those with the ___ willingness to pay and the sellers are those with the ___ costs. a. highest, highest b. highest, lowest c. lowest, highest d. lowest, lowest 6. Producing a quantity larger than the equilibrium of supply and demand is inefficient when the marginal buyer’s willingness to pay can be described as which of the following? a. negative b. zero c. positive but less than the marginal seller’s cost d. positive and greater than the marginal seller’s cost 1. a 2. a 3. b 4. c 5. b 6. c

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Chapter 7: Consumers, Producers, and the Efficiency of Markets • 97 Problems and Applications 1.

A drought in Nova Scotia reduces the apple harvest. Explain what happens to consumer surplus in the market for apples. What happens to consumer surplus in the market for apple juice?

Illustrate your answers with diagrams.

If a drought in Nova Scotia reduces the apple harvest, the supply curve for apples shifts to the left, as shown in Figure 5. The result is a rise in the price of apples and a decline in consumer surplus from A + B + C to just A. So consumer surplus declines by the amount B + C.

Figure 5 In the market for apple juice, the higher cost of apples reduces the supply of apple juice, as shown in Figure 6. The result is a rise in the price of apple juice and a decline in consumer surplus from D + E + F to just D, a loss of E + F. Note that an event that affects consumer surplus in one market often has effects on consumer surplus in related markets.

Figure 6

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98 • Chapter 7: Consumers, Producers, and the Efficiency of Markets 2.

Suppose the demand for French bread rises. What happens to producer surplus in the market for French bread? What happens to producer surplus in the market for flour? Illustrate your answer with diagrams.

A rise in the demand for French bread leads to an increase in producer surplus in the market for French bread, as shown in Figure 7. The shift of the demand curve leads to an increased price, which increases producer surplus from area A to area A + B + C.

Figure 7 The increased quantity of French bread being sold increases the demand for flour, as shown in Figure 8. As a result, the price of flour increases and the producer surplus increases from area D to D + E + F. Note that an event that affects producer surplus in one market may lead to effects on producer surplus in related markets.

Figure 8

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Chapter 7: Consumers, Producers, and the Efficiency of Markets • 99 3.

It is a hot day, and Bert is thirsty. Here is the value he places on a bottle of water: Value of first bottle $7 Value of second bottle 5 Value of third bottle 3 Value of fourth bottle 1 a. From this information, derive Bert’s demand schedule. Graph his demand curve for bottled water. b. If the price of a bottle of water is $4, how many bottles does Bert buy? How much consumer surplus does Bert get from his purchases? Show Bert’s consumer surplus in your graph. c. If the price falls to $2, how does quantity demanded change? How does Bert’s consumer surplus change? Show these changes in your graph. a.

Bert’s demand schedule is: Price More than $7 $5 to $7 $3 to $5 $1 to $3 $1 or less

Quantity Demanded 0 1 2 3 4

Bert’s demand curve is shown in Figure 9.

Figure 9 b.

When the price of a bottle of water is $4, Bert buys two bottles of water. His consumer surplus is shown as area A in Figure 9. He values his first bottle of water at $7, but pays only $4 for it, so has consumer surplus of $3. He values his second bottle of water at $5, but pays only $4 for it, so has consumer surplus of $1. Thus, Bert’s total consumer surplus is $3 + $1 = $4, which is the area of A in the figure.

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100 • Chapter 7: Consumers, Producers, and the Efficiency of Markets c.

4.

When the price of a bottle of water falls from $4 to $2, Bert buys three bottles of water, an increase of one. His consumer surplus consists of both areas A and B in the figure, an increase in the amount of area B. He gets consumer surplus of $5 from the first bottle ($7 value minus $2 price), $3 from the second bottle ($5 value minus $2 price), and $1 from the third bottle ($3 value minus $2 price), for a total consumer surplus of $9. Thus, consumer surplus rises by $5 (which is the size of area B) when the price of a bottle of water falls from $4 to $2.

Ernie owns a water pump. Because pumping large amounts of water is harder than pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost he incurs to produce each bottle of water: Cost of first bottle Cost of second bottle Cost of third bottle Cost of fourth bottle

$1 3 5 7

a. From this information, derive Ernie’s supply schedule. Graph his supply curve for bottled water. b. If the price of a bottle of water is $4, how many bottles does Ernie produce and sell?

How much producer surplus does Ernie get from these sales? Show Ernie’s producer surplus in your graph. c. If the price rises to $6, how does quantity supplied change? How does Ernie’s producer surplus change? Show these changes in your graph. a.

Ernie’s supply schedule for water is: Price More than $7 $5 to $7 $3 to $5 $1 to $3 Less than $1

Quantity Supplied 4 3 2 1 0

Ernie’s supply curve is shown in Figure 10.

Figure 10

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Chapter 7: Consumers, Producers, and the Efficiency of Markets • 101

5.

b.

When the price of a bottle of water is $4, Ernie sells two bottles of water. His producer surplus is shown as area A in the figure. He receives $4 for his first bottle of water, but it costs only $1 to produce, so Ernie has producer surplus of $3. He also receives $4 for his second bottle of water, which costs $3 to produce, so he has producer surplus of $1.

Thus, Ernie’s total producer surplus is $3 + $1 = $4, which is the area of A in the figure.

c.

When the price of a bottle of water rises from $4 to $6, Ernie sells three bottles of water, an increase of one. His producer surplus consists of both areas A and B in the figure, an increase by the amount of area B. He gets producer surplus of $5 from the first bottle ($6 price minus $1 cost), $3 from the second bottle ($6 price minus $3 cost), and $1 from the third bottle ($6 price minus $5 price), for a total producer surplus of $9. Thus, producer surplus rises by $5 (which is the size of area B) when the price of a bottle of water rises from $4 to $6.

Consider a market in which Bert from problem 3 is the buyer and Ernie from problem 4 is the seller. a. Use Ernie’s supply schedule and Bert’s demand schedule to find the quantity supplied and quantity demanded at prices of $2, $4, and $6. Which of these prices brings supply and demand into equilibrium? b. What are consumer surplus, producer surplus, and total surplus in this equilibrium? c. If Ernie produced and Bert consumed one fewer bottle of water, what would happen to total surplus? d. If Ernie produced and Bert consumed one additional bottle of water, what would happen to total surplus? a.

From Ernie’s supply schedule and Bert’s demand schedule, the quantity demanded and the quantity supplied are: Price $2 4 6

Quantity Supplied 1 2 3

Quantity Demanded 3 2 1

Only a price of $4 brings supply and demand into equilibrium, with an equilibrium quantity of 2. b.

At a price of $4, consumer surplus is $4 and producer surplus is $4, as shown in problems 3 and 4. Total surplus is $4 + $4 = $8.

c.

If Ernie produced one fewer bottle, his producer surplus would decline to $3, as shown in problem 4. If Bert consumed one fewer bottle, his consumer surplus would decline to $3, as shown in problem 3. So total surplus would decline to $3 + $3 = $6.

d.

If Ernie produced one additional bottle of water, his cost would be $5, but the price is only $4, so his producer surplus would decline by $1. If Bert consumed one additional bottle of water, his value would be $3, but the price is $4, so his consumer surplus would decline by $1. So total surplus declines by $1 + $1 = $2 (from $8 to $6).

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102 • Chapter 7: Consumers, Producers, and the Efficiency of Markets 6.

The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider some implications of this fact. a. Use a supply-and-demand diagram to show the effect of falling production costs on the price and quantity of flat-screen TVs sold. b. In your diagram, show what happens to consumer surplus and producer surplus. c. Suppose the supply of flat-screen TVs is very elastic. Who benefits most from falling production costs—consumers or producers of these TVs? a.

The effect of falling production costs in the market for flat-screen TVs results in a shift to the right in the supply curve, as shown in Figure 11. As a result, the equilibrium price of these TVs declines and the equilibrium quantity increases.

Figure 11 b.

The decline in the price of TVs increases consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D. Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price). After the shift in supply, producer surplus is area E + F + G. So producer surplus changes by the amount F + G – B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Since consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total surplus rises by C + D + F + G.

c.

If the supply of TVs is very elastic, then the shift of the supply curve benefits consumers most. In the extreme case of perfectly elastic supply, there is no producer surplus at all, either before or after the fall in the cost of production. Consumers capture all the benefits of falling production costs, with consumer surplus rising from area A to area A + B + D (see Figure 12).

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Chapter 7: Consumers, Producers, and the Efficiency of Markets • 103

Figure 12 7.

There are four consumers willing to pay the following amounts for haircuts: Gloria: $35

Jay: $10

Claire: $40

Phil: $25

There are four haircutting businesses with the following costs: Firm A: $15

Firm B: $30

Firm C: $20

Firm D: $10

Each firm has the capacity to produce only one haircut. For efficiency, how many haircuts should be given? Which businesses should cut hair, and which consumers should have their hair cut?

How large is the maximum possible total surplus?

Figure 13 shows supply and demand curves for haircuts. Supply equals demand at a quantity of three haircuts and a price between $20 and $25. Firms A, C, and D should cut the hair of Gloria, Claire, and Phil. Jay’s willingness to pay is too low and firm B’s costs are too high, so they do not participate. The maximum total surplus is the area between the demand and supply curves, which totals $55 ($40 value minus $10 cost for the first haircut, plus $35 value minus $15 cost for the second, plus $25 value minus $20 cost for the third).

Figure 13

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104 • Chapter 7: Consumers, Producers, and the Efficiency of Markets 8. One of the largest changes in the economy over the past several decades is that technological

advances have reduced the cost of making computers. a. Draw a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for computers. b. Several decades ago, students used typewriters to prepare papers for their classes; today they use computers. Does that make computers and typewriters complements or substitutes? Use a supply-and-demand diagram to show what happens to price, quantity, consumer surplus, and producer surplus in the market for typewriters.

Describe what has happened to producer surplus in the typewriter market over the last several decades. c. Are computers and software complements or substitutes? Draw a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for software. Describe what has happened to producer surplus for software producers. d. Does this analysis help explain why software producer Bill Gates is one of the world’s richest men? a.

The effect of falling production costs in the market for computers resulted in a shift to the right in the supply curve, as shown in Figure 14. As a result, the equilibrium price of computers declined and the equilibrium quantity increased. The decline in the price of computers increased consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D.

Figure 14 Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price). After the shift in supply, producer surplus is areas E + F + G. So producer surplus changes by the amount F + G – B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Because consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total surplus rises by C + D + F + G.

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Chapter 7: Consumers, Producers, and the Efficiency of Markets • 105 b.

Typewriters and computers are substitutes. The decline in the price of computers means that people substituted computers for typewriters, shifting the demand for typewriters to the left, as shown in Figure 15. The result is a decline in both the equilibrium price and equilibrium quantity of typewriters. Consumer surplus in the typewriter market changes from area A + B to A + C, a net change of C – B. Producer surplus changes from area C + D + E to area E, a net loss of C + D. Producer surplus has declined.

Figure 15 c.

Software and computers are complements. When the price of computers decreases, the demand for software increases. The demand for software shifts to the right, as shown in Figure 16. The result is an increase in both the price and quantity of software. Consumer surplus in the software market changes from B + C to A + B, a net change of A – C. Producer surplus changes from E to C + D + E, an increase of C + D, so producer surplus has increased.

Figure 16

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106 • Chapter 7: Consumers, Producers, and the Efficiency of Markets d.

9.

Yes, this analysis helps explain why Bill Gates is one the world’s richest people. His company produces a lot of software and the producer surplus in the software market increased with the technological advance in computers.

Melissa buys an iPhone for $240 and gets consumer surplus of $160. a. What is her willingness to pay? b. If she had bought the iPhone on sale for $180, what would her consumer surplus have been? c. If the price of an iPhone was $500, what would her consumer surplus have been? a.

Melissa’s willingness to pay is equal to $240 + 160 = $400.

b.

If the iPhone was on sale for $180, Melissa’s consumer surplus would have been $400 – 180 = $220.

c.

If the price of the iPhone was $500, Melissa’s consumer surplus would have been zero, because she would not have bought the iPhone.

Appendix Problems and Applications A1.

The supply and demand for broccoli are described by the following equations: Supply: QS = 4 P – 80 Demand: QD = 100 – 2 P Q is in tonnes, and P is in dollars per bushel.

a. Graph the supply curve and the demand curve. What is the equilibrium price and quantity? b. Calculate consumer surplus, producer surplus, and total surplus at the equilibrium. c. If a dictator who hated broccoli were to ban the vegetable, who would bear the larger burden—the buyers or sellers of broccoli?

a.

The equilibrium price is given by the equation 4P – 80 = 100 – 2P. The solution is P = $30, with the corresponding quantity Q = 100 – 2 × 30 = 40. Figure 17 shows approximately the two curves.

Price of Broccoli

$50 Supply $30 $20

Demand 40

Quantity of Broccoli

Figure 17

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Chapter 7: Consumers, Producers, and the Efficiency of Markets • 107

A2.

b.

Consumer surplus = (1/2)(50 – 30) × 40 = 400. Producer surplus = (1/2)(30 – 20) × 40 = 200. Total surplus = 400 + 200 = 600.

c.

The buyers would bear the higher burden because they lose $400 in consumer surplus, while the sellers lose $200.

A friend of yours is considering two providers of cellphone services. Provider A charges $120 per month for the service, regardless of the number of phone calls made. Provider B does not have a fixed service fee but instead charges $1 per minute for calls. Your friend’s monthly demand for minutes of calling is given by the equation QD = 150 – 50 P , where P is the price of a minute. a. With each provider, what is the cost to your friend of an extra minute on the phone? b. In light of your answer to (a), how many minutes would your friend spend on the phone with each provider? c. How much would he end up paying each provider every month? d. How much consumer surplus would he obtain with each provider? (Hint: Graph the demand curve and recall the formula for the area of a triangle.) e. Which provider would you recommend that your friend choose? Why? a.

With the first provider, the cost of an extra minute is 0; with the second, the cost is $1.

b.

My friend spends 150 – 50 × 0 = 150 minutes on the phone with the first provider; with the second, my friend spends 150 – 50 × 1 = 100 minutes.

c.

Total costs with the two providers are $120 and $100, respectively.

d.

Figure 18 shows my friend’s demand. My friend’s consumer surplus with Provider A is 3 × 150/2 – 120 = 105; with Provider B, my friend’s consumer surplus is (3 – 1) × 100/2 = 100.

Figure 18 e.

I would recommend Provider A, because my friend’s consumer surplus is larger.

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108 • Chapter 7: Consumers, Producers, and the Efficiency of Markets A3.

The demand for broccoli in the Kingdom of Vegan is described by a linear demand curve: QD = 100 – 2 P.

Say the price of broccoli is set by the ruler of the kingdom, Mr. Potato Head. Say initially that the price is $5 per bunch of broccoli. a. What is the equilibrium quantity demanded at this price and the consumer surplus? b. Now say that in order to encourage people to consume more broccoli, Mr. Potato Head decrees that the price of broccoli will decline to $4. What is the new equilibrium quantity? The change in consumer surplus? a.

The quantity demanded when P = $5 is Q = 100 – 2 × 5 = 90; consumer surplus = (50 – 5) × 90/2 = 2025 (see Figure 19).

Figure 19 b.

If the price decreases to $4, the quantity demanded increases to 100 – 2 × 4 = 92, and the consumer surplus increases to (50 – 4) × 92/2 = 2116.

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Chapter 8 Application: The Costs of Taxation SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Draw the supply and demand curves for cookies. If the government imposes a tax on cookies, show what happens to the quantity sold, the price paid by buyers, and the price paid by sellers.

In your diagram, show the deadweight loss from the tax. Explain the meaning of the deadweight loss.

Figure 1 shows the supply and demand curves for cookies, with equilibrium quantity Q1 and equilibrium price P1. When the government imposes a tax on cookies, the price to buyers rises to PB, the price received by sellers declines to PS, and the equilibrium quantity falls to Q2. The deadweight loss is the triangular area below the demand curve and above the supply curve between quantities Q1 and Q2. The deadweight loss shows the fall in total surplus that results from the tax.

Figure 1 2.

The demand for beer is more elastic than the demand for milk. Would a tax on beer or a tax on milk have a larger deadweight loss? Why? A tax on beer would have a larger deadweight loss than a tax on milk, since the demand for beer is more elastic than the demand for milk, and the deadweight loss of a tax is larger the greater is the elasticity of demand.

3.

If the government doubles the tax on gasoline, can you be sure that revenue from the gasoline tax will rise? Can you be sure that the deadweight loss from the gasoline tax will rise? Explain.

If the government doubles the tax on gasoline, the revenue from the gasoline tax could rise or fall, depending on where the tax falls on the Laffer curve. However, if the government doubles the tax on gasoline, you can be sure that the deadweight loss of the tax rises, since deadweight loss always rises as the tax rate rises.

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110 • Chapter 8: Application: The Costs of Taxation Questions for Review 1.

What happens to consumer and producer surplus when the sale of a good is taxed? How does the change in consumer and producer surplus compare to the tax revenue? Explain.

When the sale of a good is taxed, both consumer surplus and producer surplus decline. The decline in consumer surplus and producer surplus exceeds the amount of government revenue that is raised, so society’s total surplus declines. The tax distorts the incentives of both buyers and sellers, so resources are allocated inefficiently.

2.

Draw a supply-and-demand diagram with a tax on the sale of the good. Show the deadweight loss. Show the tax revenue.

Figure 2 illustrates the deadweight loss and tax revenue from a tax on the sale of a good.

Without a tax, the equilibrium quantity would be Q1, the equilibrium price would be P1, consumer surplus would be A + B + C, and producer surplus would be D + E + F. The imposition of a tax places a wedge between the price buyers pay, PB, and the price sellers receive, PS, where PB = PS + tax. The quantity sold declines to Q2. Now consumer surplus is A, producer surplus is F, and government revenue is B + D. The deadweight loss of the tax is C + E, since that area is lost because of the decline in quantity from Q1 to Q2.

Figure 2 3.

How do the elasticities of supply and demand affect the deadweight loss of a tax? Why do they have this effect?

The greater the elasticities of demand and supply, the greater the deadweight loss of a tax. Since elasticity measures the response of quantity to a change in price, higher elasticity means the tax induces a greater reduction in quantity, hence a greater distortion to the market.

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Chapter 8: Application: The Costs of Taxation • 111 4.

Why do experts disagree about whether labour taxes have small or large deadweight losses?

Experts disagree about whether labour taxes have small or large deadweight losses because they have different views about the elasticity of labour supply. Some believe that labour supply is inelastic, so a tax on labour has a small deadweight loss. But others think that workers can adjust their hours worked in various ways, so labour supply is elastic and, thus, a tax on labour has a large deadweight loss.

5.

What happens to the deadweight loss and tax revenue when a tax is increased?

The deadweight loss of a tax rises more than proportionally as the tax rises. Tax revenue, however, may increase initially as the tax rises, but as the tax rises further, revenue eventually declines.

Quick Check Multiple Choice

1. In which of the following circumstances does a tax on a good have a deadweight loss? a. the reduction in consumer and producer surplus is greater than the tax revenue b. the tax revenue is greater than the reduction in consumer and producer surplus c. the reduction in consumer surplus is greater than the reduction in producer surplus d. the reduction in producer surplus is greater than the reduction in consumer surplus 2. Jane pays Chuck $50 to mow her lawn every week. When the government levies a mowing tax of $10 on Chuck, he raises his price to $60. Jane continues to hire him at the higher price. What is the change in producer surplus, change in consumer surplus, and deadweight loss? a. $0, $0, $10 b. $0, –$10, $0 c. +$10, –$10, $10 d. +$10, –$10, $0 3. Eggs have a supply curve that is linear and upward sloping and a demand curve that is linear and downward sloping. If a tax of 2 cents per egg is increased to 3 cents, what happens to the deadweight loss of the tax? a. it increases by less than 50 percent and may even decline b. it increases by exactly 50 percent c. it increases by more than 50 percent d. The answer depends on whether supply or demand is more elastic.

4. Peanut butter has an upward-sloping supply curve and a downward-sloping demand curve. If a tax of 10 cents per kilogram is increased to 15 cents, what happens to the government’s tax revenue? a. it increases by less than 50 percent and may even decline b. it increases by exactly 50 percent c. it increases by more than 50 percent d. The answer depends on whether supply or demand is more elastic.

5. The Laffer curve illustrates that, in some circumstances, the government can reduce a tax on a good and increase which of the following? a. deadweight loss b. government’s tax revenue c. equilibrium quantity d. price paid by consumers

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112 • Chapter 8: Application: The Costs of Taxation

6. If a policymaker wants to raise revenue by taxing goods while minimizing the deadweight losses, he should look for goods with ___ elasticities of demand and ___ elasticities of supply. a. small, small b. small, large c. large, small d. large, large 1. a 2. b 3. c 4. a 5. b 6. a Problems and Applications 1.

The market for pizza is characterized by a downward-sloping demand curve and an upwardsloping supply curve. a. Draw the competitive market equilibrium. Label the price, quantity, consumer surplus, and producer surplus. Is there any deadweight loss? Explain. b. Suppose that the government forces each pizzeria to pay a $1 tax on each pizza sold.

Illustrate the effect of this tax on the pizza market, being sure to label the consumer surplus, producer surplus, government revenue, and deadweight loss. How does each area compare to the pre-tax case? c. If the tax were removed, pizza eaters and sellers would be better off but the government would lose tax revenue. Suppose that consumers and producers voluntarily transferred some of their gains to the government. Could all parties (including the government) be better off than they were with a tax? Explain using the labelled areas in your graph. a.

Figure 3 illustrates the market for pizza. The equilibrium price is P1, the equilibrium quantity is Q1, consumer surplus is area A + B + C, and producer surplus is area D + E + F. There is no deadweight loss, as all the potential gains from trade are realized; total surplus is the entire area between the demand and supply curves: A + B + C + D + E + F.

Figure 3

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Chapter 8: Application: The Costs of Taxation • 113

2.

3.

b.

With a $1 tax on each pizza sold, the price paid by buyers, PB, is now higher than the price received by sellers, PS, where PB = PS + $1. The quantity declines to Q2, consumer surplus is area A, producer surplus is area F, government revenue is area B + D, and deadweight loss is area C + E. Consumer surplus declines by B + C, producer surplus declines by D + E, government revenue increases by B + D, and deadweight loss increases by C + E.

c.

If the tax were removed and consumers and producers voluntarily transferred B + D to the government to make up for the lost tax revenue, then everyone would be better off than with the tax. The equilibrium quantity would be Q1, as in the case without the tax, and the equilibrium price would be P1. Consumer surplus would be A + C, because consumers get surplus of A + B + C, and then voluntarily transfer B to the government.

Producer surplus would be E + F, since producers get surplus of D + E + F, and then voluntarily transfer D to the government. Both consumers and producers are better off than the case when the tax was imposed. If consumers and producers gave a little bit more than B + D to the government, then all three parties, including the government, would be better off. This illustrates the inefficiency of taxation.

Evaluate the following two statements. Do you agree? Why or why not? a. “A tax that has no deadweight loss cannot raise any revenue for the government.” b. “A tax that raises no revenue for the government cannot have any deadweight loss.” a.

The statement “A tax that has no deadweight loss cannot raise any revenue for the government” is incorrect. An example is the case of a tax when either supply or demand is perfectly inelastic. The tax has neither an effect on quantity nor any deadweight loss, but it does raise revenue.

b.

The statement “A tax that raises no revenue for the government cannot have any deadweight loss” is incorrect. An example is the case of a 100-percent tax imposed on sellers. With a 100-percent tax on their sales of the good, sellers will not supply any of the good, so the tax will raise no revenue. Yet the tax has a large deadweight loss, since it reduces the quantity sold to zero.

Consider the market for rubber bands. a. If this market has very elastic supply and very inelastic demand, how would the burden of a tax on rubber bands be shared between consumers and producers? Use the tools of consumer surplus and producer surplus in your answer. b. If this market has very inelastic supply and very elastic demand, how would the burden of a tax on rubber bands be shared between consumers and producers?

Contrast your answer with your answer to part (a).

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114 • Chapter 8: Application: The Costs of Taxation a.

With very elastic supply and very inelastic demand, the burden of the tax on rubber bands will be borne largely by buyers. As Figure 4 shows, consumer surplus declines considerably, by area A + B, but producer surplus does not fall much at all, just by area C + D.

Figure 4 b.

With very inelastic supply and very elastic demand, the burden of the tax on rubber bands will be borne largely by sellers. As Figure 5 shows, consumer surplus does not decline much, just by area A + B, while producer surplus falls substantially, by area C + D. Compared to part (a), producers bear much more of the burden of the tax, and consumers bear much less.

Figure 5

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Chapter 8: Application: The Costs of Taxation • 115 4.

5.

Suppose that the government imposes a tax on heating oil. a. Would the deadweight loss from this tax likely be greater in the first year after it is imposed or in the fifth year? Explain. b. Would the revenue collected from this tax likely be greater in the first year after it is imposed or in the fifth year? Explain. a.

The deadweight loss from a tax on heating oil is likely to be greater in the fifth year after it is imposed rather than the first year. In the first year, the elasticity of demand is fairly low, as people who own oil heaters are not likely to get rid of them right away. But over time, they may switch to other energy sources, and people buying new heaters for their homes will more likely choose gas or electric, so the tax will have a greater impact on quantity.

b.

The tax revenue is likely to be higher in the first year after it is imposed than in the fifth year. In the first year, demand is more inelastic, so the quantity does not decline as much and tax revenue is relatively high. As time passes and more people substitute away from oil, the equilibrium quantity declines, as does tax revenue.

After economics class one day, your friend suggests that taxing food would be a good way to raise revenue because the demand for food is quite inelastic. In what sense is taxing food a “good” way to raise revenue? In what sense is it not a “good” way to raise revenue?

Since the demand for food is inelastic, a tax on food is a good way to raise revenue because it does not lead to much of a deadweight loss; thus, taxing food is less inefficient than taxing other things. But it is not a good way to raise revenue from an equity point of view, since poorer people spend a higher proportion of their income on food, so the tax would hit them harder than it would hit wealthier people.

6.

7.

U.S. Senator Daniel Patrick Moynihan once introduced a bill that would levy a 10 000-percent tax on certain hollow-tipped bullets. a. Do you expect that this tax would raise much revenue? Why or why not? b. Even if the tax would raise no revenue, what might be Senator Moynihan’s reason for proposing it? a.

This tax has such a high rate that it is not likely to raise much revenue. Because of the high tax rate, the equilibrium quantity in the market is likely to be at or near zero.

b.

Senator Moynihan’s goal was probably to ban the use of hollow-tipped bullets. In this case, a tax is as effective as an outright ban.

The government places a tax on the purchase of socks. a. Illustrate the effect of this tax on equilibrium price and quantity in the sock market.

Identify the following areas both before and after the imposition of the tax: total spending by consumers, total revenue for producers, and government tax revenue. b. Does the price received by producers rise or fall? Can you tell whether total receipts for producers rise or fall? Explain. c. Does the price paid by consumers rise or fall? Can you tell whether total spending by consumers rises or falls? Explain carefully. (Hint: Think about elasticity.) If total consumer spending falls, does consumer surplus rise? Explain.

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116 • Chapter 8: Application: The Costs of Taxation a.

Figure 6 illustrates the market for socks and the effects of the tax. Without a tax, the equilibrium quantity would be Q1, the equilibrium price would be P1, total spending by consumers equals total revenue for producers, which is P1 × Q1, which equals area B + C + D + E + F; and government revenue is zero. The imposition of a tax places a wedge between the price buyers pay, PB, and the price sellers receive, PS, where PB = PS + tax. The quantity sold declines to Q2. Now total spending by consumers is PB × Q2, which equals area A + B + C + D, total revenue for producers is PS × Q2, which is area C + D, and government tax revenue is Q2 × tax, which is area A + B.

Figure 6

8.

b.

Unless supply is perfectly elastic, the price received by producers falls because of the tax.

Total receipts for producers fall, since producers lose revenue equal to area B + E + F.

c.

The price paid by consumers rises, unless demand is perfectly elastic. Whether total spending by consumers rises or falls depends on the price elasticity of demand. If demand is elastic, the percentage decline in quantity exceeds the percentage increase in price, so total spending declines. If demand is inelastic, the percentage decline in quantity is less than the percentage increase in price, so total spending rises. Whether total consumer spending falls or rises, consumer surplus declines because of the increase in price and reduction in quantity.

Suppose the government currently raises $100 million through a $0.01 tax on widgets, and another $100 million through a $0.10 tax on gadgets. If the government doubled the tax rate on widgets and eliminated the tax on gadgets, would it raise more tax revenue than it does today, less tax revenue, or the same amount? Explain.

Since the tax on gadgets was eliminated, all tax revenue must come from the tax on widgets.

The tax revenue from the tax on widgets equals the tax per unit times the quantity produced.

Assuming that neither the supply nor the demand curves for widgets are perfectly elastic or inelastic, and since the increased tax causes a smaller quantity of widgets to be produced, then it is impossible for tax revenue to double: multiplying the tax per unit (which doubles) times the quantity (which declines) gives a number that is less than double the original tax revenue from widgets. So the government’s tax change will yield less money than before.

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Chapter 8: Application: The Costs of Taxation • 117 9.

10.

Suppose the Canadian government decides that it needs to raise an additional $100 million in tax revenues. One Cabinet minister argues for a tax on all soft drinks. A second Cabinet minister argues for a tax on cola only, since this would give consumers a choice of paying the tax (by drinking cola) or avoiding it (by switching to another soft drink). a. Which market has the more elastic supply and demand curves: the market for cola, or the market for all soft drinks? b. To raise the same $100 million in revenue, which would require a higher rate: a tax on cola, or a tax on all soft drinks? c. Which would cause a larger deadweight loss: a tax on cola, or a tax on all soft drinks? d. Which would be the better tax? Explain. a.

The market for cola would have a more elastic demand curve because consumers will have access to alternative substitutes if the price of cola changes.

b.

The tax rate would have to be higher for those goods that have elastic supply and demand curves, such as cola. A marginal increase in the tax rate on all soft drinks will yield a higher amount of tax revenue for the government, as consumers and producers are less responsive to price changes.

c.

The deadweight loss of a tax would be greater the greater the elasticities of supply and demand, in this case, a tax on cola.

d.

From a government’s point of view, the better tax would be the one placed on the market for all soft drinks if this market faces inelastic demand and supply curves.

However, it is uncertain if consumers will dramatically change their consumption of soft drinks and go to alternative substitutes, such as water, coffee, tea, etc.

Hotel rooms in Smalltown go for $100, and 1000 rooms are rented on a typical day. a. To raise revenue, the mayor decides to charge hotels a tax of $10 per rented room.

After the tax is imposed, the going rate for hotel rooms rises to $108, and the number of rooms rented falls to 900. Calculate the amount of revenue this tax raises for Smalltown and the deadweight loss of the tax. (Hint: The area of a triangle is ½ x base x height.) b. The mayor now doubles the tax to $20. The price rises to $116, and the number of rooms rented falls to 800. Calculate tax revenue and deadweight loss with this larger tax. Do they double, more than double, or less than double? Explain. a.

Tax revenue = $10 × 900 = $9000. The deadweight loss arises from the difference in the number of rooms rented: deadweight loss = (1/2) × $10 × (1000 – 900) = $500.

b.

Tax revenue = $20 × 800 = $16 000. Deadweight loss = (1/2) × $20 × (1000 – 800) = $2000. Although the tax has doubled, tax revenue has increased by less than double.

The deadweight loss has more than doubled. The increase in taxes was partially offset by the decrease in the equilibrium quantity. This result shows that the market is on the downward side of the Laffer curve.

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118 • Chapter 8: Application: The Costs of Taxation 11.

This chapter analyzed the welfare effects of a tax on a good. Consider now the opposite policy.

Suppose that the government subsidizes a good: For each unit of the good sold, the government pays $2 to the buyer. How does the subsidy affect consumer surplus, producer surplus, tax revenue, and total surplus? Does a subsidy lead to a deadweight loss? Explain.

Figure 7 illustrates the effects of the $2 subsidy on a good. Without the subsidy, the equilibrium price is P1 and the equilibrium quantity is Q1. With the subsidy, buyers pay price PB, producers receive price PS (where PS = PB + $2), and the quantity sold is Q2. The following table illustrates the effect of the subsidy on consumer surplus, producer surplus, government revenue, and total surplus. Since total surplus declines by area D + H, the subsidy leads to a deadweight loss in that amount.

Consumer surplus Producer surplus Government revenue Total surplus

Old A+B E+I 0 A+B+E+I

New A+B+E+F+G B+C+E+I –(B+C+D+E+F+G+H) A+B–D+E–H+I

Change +(E+F+G) +(B+C) –(B+C+D+E+F+G+H) –(D+H)

Figure 7

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Chapter 8: Application: The Costs of Taxation • 119 Appendix Problems and Applications A1.

Suppose that a market is described by the following supply and demand equations: QS = 2 P

Q = 300 – P D

a. Solve for the equilibrium price and the equilibrium quantity. b. Suppose that a tax of T is placed on buyers, so the new demand equation is QD = 300 – (P + T) Solve for the new equilibrium. What happens to the price received by sellers, the price paid by buyers, and the quantity sold? c. Tax revenue is T x Q. Use your answer to part (b) to solve for tax revenue as a function of T. Graph this relationship for T between 0 and 300. d. The deadweight loss of a tax is the area of the triangle between the supply and demand curves. Recalling that the area of a triangle is ½ x base x height, solve for deadweight loss as a function of T. Graph this relationship for T between 0 and 300.

(Hint: Looking sideways, the base of the deadweight loss triangle is T, and the height is the difference between the quantity sold with the tax and the quantity sold without the tax.) e. The government now levies a tax on this good of $200 per unit. Is this a good policy?

Why or why not? Can you propose a better policy? a.

Setting quantity supplied equal to quantity demanded gives 2P = 300 – P. Adding P to both sides of the equation gives 3P = 300. Dividing both sides by 3 gives P = 100.

Plugging P = 100 back into either equation for quantity demanded or supplied gives Q = 200.

b.

Now P is the price received by sellers, and P + T is the price paid by buyers. Equating quantity demanded to quantity supplied gives 2P = 300 – (P + T). Adding P to both sides of the equation gives 3P = 300 – T. Dividing both sides by 3 gives P = 100 – T /3. This is the price received by sellers. The buyers pay a price equal to the price received by sellers plus the tax (P + T = 100 + 2T /3). The quantity sold is now Q = 2P = 200 – 2T /3.

c.

Since tax revenue is equal to T × Q, and Q = 200 – 2T /3, tax revenue equals 200T – 2T 2/3. Figure 8 shows a graph of this relationship. Tax revenue is zero at T = 0 and at T = 300.

Figure 8

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120 • Chapter 8: Application: The Costs of Taxation d.

As Figure 9 shows, the area of the triangle (laid on its side) that represents the deadweight loss is 1/2 × base × height, where the base is the change in the price, which is the size of the tax (T ), and the height is the amount of the decline in quantity (2T /3).

So the deadweight loss equals 1/2 × T × 2T /3 = T 2/3. This rises exponentially from $0 (when T = 0) to $30 000 when T = 300, as shown in Figure 10.

Figure 9

Figure 10 e.

A tax of $200 per unit is a bad idea because it is in a region in which tax revenue is declining. The government could reduce the tax to $150 per unit, get more tax revenue ($15 000 when the tax is $150 versus $13 333 when the tax is $200), and reduce the deadweight loss ($7500 when the tax is $150 compared to $13 333 when the tax is $200).

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Chapter 9 Application: International Trade SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

The country Autarka does not allow international trade. In Autarka, you can buy a wool suit for 100 grams of gold. Meanwhile, in neighbouring countries, you can buy the same suit for 60 grams of gold. If Autarka were to allow free trade, would it import or export suits? Why? Since wool suits are cheaper in neighbouring countries, Autarka would import suits if it were to allow free trade.

2.

Draw the supply and demand curves for wool suits in the country of Autarka. When trade is allowed, the price of a suit falls from 100 to 60 grams of gold. In your diagram, what is the change in consumer surplus, the change in producer surplus, and the change in total surplus?

How would a tariff on suit imports alter these effects?

Price of Wool Suits

Figure 1 shows the supply and demand for wool suits in Autarka. With no trade, the price of suits is 100 grams of gold, consumer surplus is area A, producer surplus is area B + C, and total surplus is area A + B + C. When trade is allowed, the price falls to 60 grams of gold, consumer surplus rises to A + B + D (an increase of B + D), and producer surplus falls to C (a decline of B), so total surplus rises to A + B + C + D (an increase of D). A tariff on suit imports would reduce the increase in consumer surplus, reduce the decline in producer surplus, and reduce the gain in total surplus.

100 60

Figure 1

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122 • Chapter 9: Application: International Trade 3.

The textile industry of Autarka advocates a ban on the import of wool suits. Describe five arguments its lobbyists might make. Give a response to each of these arguments.

Lobbyists for the textile industry might make five arguments in favour of a ban on the import of wool suits: (1) Imports of wool suits destroy domestic jobs; (2) The wool-suit industry is vital for national security; (3) The wool-suit industry is just starting and needs protection from foreign competition until it is established; (4) Other countries are unfairly subsidizing their wool-suit industries; and (5) The ban on wool suits can be used as a bargaining chip in international negotiations.

In defending free trade in wool suits, you could argue that: (1) Free trade creates jobs in some industries, even as it destroys jobs in the wool-suit industry, and allows Autarka to enjoy a higher standard of living; (2) The role of wool suits for the military is probably exaggerated; (3) Government protection is not needed for an industry to grow on its own; (4) It would be good for Autarka to buy wool suits at a subsidized price; and (5) Threats against free trade may backfire, leading to lower levels of trade and lower economic welfare for everyone.

Questions for Review 1.

What does the domestic price that prevails without international trade tell us about a nation’s comparative advantage?

If the domestic price that prevails without international trade is above the world price, the country does not have a comparative advantage in producing the good. If the domestic price is below the world price, the country has a comparative advantage in producing the good.

2.

When does a country become an exporter of a good? An importer?

A country will export a good for which its domestic price is lower than the prevailing world price.

Thus, if a country has a comparative advantage in producing a good, it will become an exporter when trade is allowed. A country will import a product for which its domestic price is greater than the prevailing world price. Thus, if a country does not have a comparative advantage in producing a good, it will become an importer when trade is allowed.

3.

Draw the supply-and-demand diagram for an importing country. What is consumer surplus and producer surplus before trade is allowed? What is consumer surplus and producer surplus with free trade? What is the change in total surplus?

Figure 2 illustrates supply and demand for an importing country. Before trade is allowed, consumer surplus is area A and producer surplus is area B + C. After trade is allowed, consumer surplus is area A + B + D and producer surplus is area C. The change in total surplus is an increase of area D.

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Chapter 9: Application: International Trade • 123

Figure 2 4.

Describe what a tariff is, and describe its economic effects.

A tariff is a tax on goods produced abroad and sold domestically. If a country is an importer of a good, a tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade, increasing the price of the good, reducing consumer surplus and total surplus, while raising producer surplus and government revenue.

5.

List five arguments often given to support trade restrictions. How do economists respond to these arguments?

The arguments given to support trade restrictions are: (1) Trade destroys jobs; (2) Industries threatened with competition may be vital for national security; (3) New industries need trade restrictions to help them get started; (4) Some countries unfairly subsidize their firms, so competition is not fair; and (5) Trade restrictions can be useful bargaining chips. Economists disagree with these arguments: (1) Trade may destroy some jobs, but it creates other jobs; (2) Arguments about national security tend to be exaggerated; (3) The government cannot easily identify new industries that are worth protecting; (4) If countries subsidize their exports, doing so simply benefits consumers in importing countries; and (5) Bargaining over trade is a risky business, since it may backfire, making the country worse off without trade.

6.

What is the difference between the unilateral and multilateral approaches to achieving free trade? Give an example of each.

A unilateral approach to achieving free trade occurs when a country removes trade restrictions on its own. Under a multilateral approach, a country reduces its trade restrictions while other countries do the same, based on an agreement reached through bargaining. The unilateral approach was taken by Great Britain in the 1800s and by Chile and South Korea in recent years.

Examples of the multilateral approach include NAFTA in 1993 and the GATT negotiations since World War II.

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124 • Chapter 9: Application: International Trade Quick Check Multiple Choice

1. What would be the result if a nation that does not allow international trade in steel has a domestic price of steel lower than the world price? a. The nation has a comparative advantage in producing steel and would become a steel exporter if it opened up trade. b. The nation has a comparative advantage in producing steel and would become a steel importer if it opened up trade. c. The nation does not have a comparative advantage in producing steel and would become a steel exporter if it opened up trade. d. The nation does not have a comparative advantage in producing steel and would become a steel importer if it opened up trade.

2. When the nation of Ectenia opens itself to world trade in coffee beans, the domestic price of coffee beans falls. Which of the following describes the situation? a. Domestic production of coffee rises, and Ectenia becomes a coffee importer. b. Domestic production of coffee rises, and Ectenia becomes a coffee exporter. c. Domestic production of coffee falls, and Ectenia becomes a coffee importer. d. Domestic production of coffee falls, and Ectenia becomes a coffee exporter.

3. What is the result when a nation opens itself to trade in a good and becomes an importer? a. producer surplus decreases, but consumer surplus and total surplus both increase b. producer surplus decreases, consumer surplus increases, and so the impact on total surplus is ambiguous c. producer surplus and total surplus increase, but consumer surplus decreases d. producer surplus, consumer surplus, and total surplus all increase 4. If a nation that imports a good imposes a tariff, it will increase which of the following? a. the domestic quantity demanded b. the domestic quantity supplied c. the quantity imported from abroad d. the quantity exported abroad 5. Which of the following trade policies would benefit producers, hurt consumers, and increase the amount of trade? a. the increase of a tariff in an importing country b. the reduction of a tariff in an importing country c. starting to allow trade when the world price is greater than the domestic price d. starting to allow trade when the world price is less than the domestic price 6. The main difference between imposing a tariff and handing out licences under an import quota is that a tariff increases which of the following? a. consumer surplus b. producer surplus c. international trade d. government revenue 1. a 2. c 3. a 4. b 5. c 6. d Copyright © 2020 Nelson Education Ltd.

Chapter 9: Application: International Trade • 125 Problems and Applications 1.

When China’s clothing industry expands, the increase in world supply lowers the world price of clothing. a. Draw an appropriate diagram to analyze how this change in price affects consumer surplus, producer surplus, and total surplus in a nation that imports clothing, such as the United States. b. Now draw an appropriate diagram to show how this change in price affects consumer surplus, producer surplus, and total surplus in a nation that exports clothing, such as the Dominican Republic. c. Compare your answers to parts (a) and (b). What are the similarities and what are the differences? Which country should be concerned about the expansion of the Chinese textile industry? Which country should be applauding it? Explain. a.

For a country that imports clothing, the effects of a decline in the world price are shown in Figure 3. The initial price is Pw1 and the initial level of imports is Q D1 – Q s1. The new world price is PW2 and the new level of imports is Q D2 – Q s2. The table below shows the changes in consumer surplus, producer surplus, and total surplus. Domestic consumers are made better off, while domestic producers are made worse off. Total surplus rises by areas D + E + F.

Figure 3

Consumer surplus Producer surplus Total surplus

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Figure 4

Pw1

Pw2

A+B C+G A+C+G

A+B+C+D+E+F G A+B+C+D+E+F+G

CHANGE C+D+E+F –C D+E+F

126 • Chapter 9: Application: International Trade b.

For a country that exports clothing, the effects of a decline in the world price are shown in Figure 4. The initial price is Pw1 and the initial level of exports is Q s1 – Q d1. The new world price is Pw2 and the new level of exports is Q s2 – Q d2. The table below shows the changes in consumer surplus, producer surplus, and total surplus. Domestic consumers are made better off, while domestic producers are made worse off. Total surplus falls by area D.

Consumer surplus Producer surplus Total surplus c.

2.

Pw1

Pw2

A B+C+D+E+F+G+H A+B+C+D+E+F+G+H

A+B+C E+F+G+H A+B+C+E+F+G+H

CHANGE B+C –B–C–D –D

Overall, importing countries benefit from the fall in the world price of clothing, while exporting countries are harmed. In both cases, consumers are better off and producers are worse off, regardless of whether the country is an exporter or an importer. Total surplus increases in the case where the country is an importer and decreases when the country is an exporter.

The world price of wine is below the price that would prevail in Canada in the absence of trade. a. Assuming that Canadian imports of wine are a small part of total world wine production, draw a graph for the Canadian market for wine under free trade. Identify consumer surplus, producer surplus, and total surplus in an appropriate table. b. Now suppose that an unusual shift of the Gulf Stream leads to an unseasonably cold summer in Europe, destroying much of the grape harvest there. What effect does this shock have on the world price of wine? Using your graph and table from part (a), show the effect on consumer surplus, producer surplus, and total surplus in Canada.

Who are the winners and losers? Is Canada as a whole better off or worse off? a.

Figure 5 illustrates the Canadian market for wine, where the world price of wine is P1.

The following table illustrates the results under the heading “P1.”

Consumer surplus Producer surplus Total surplus

P1

P2

A+B+D+E C A+B+C+D+E

A+D B+C A+B+C+D

Change –(B+E) +B –E

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Chapter 9: Application: International Trade • 127

Figure 5 b.

3.

The shift in the Gulf Stream destroys some of the grape harvest, raising the world price of wine to P2. The table shows the effects on consumer, producer, and total surplus under the heading “P2,” and the change in the surplus measures under the heading “Change.” Consumers lose, producers win, and Canada as a whole is worse off.

Suppose that Parliament imposes a tariff on imported clothes to protect the Canadian clothing industry from foreign competition. Assuming that Canada is a price taker in the world clothing market, show the following on a diagram: (a) the change in the quantity of imports, (b) the loss to Canadian consumers, (c) the gain to Canadian manufacturers, (d) government revenue, and (e) the deadweight loss associated with the tariff. The loss to consumers can be decomposed into three pieces: a transfer to domestic producers, a transfer to the government, and a deadweight loss. Use your diagram to identify these three pieces.

Figure 6 shows the market for clothes in Canada. a.

The change in the quantity of imports is the difference H – I.

b.

The loss to Canadian consumers is equal to C + D + E + F.

c.

The gain to Canadian manufacturers is C.

d.

Government revenue is E.

e.

The deadweight loss is D + F.

The three pieces of the loss to consumers are: C = transfer to domestic producers, E = transfer to the government, and D + F = the deadweight loss.

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128 • Chapter 9: Application: International Trade

Price of clothing

Domestic Supply

A B

P2 C P1

G

D

E

F Domestic Demand

I

Quantity of clothing

H Figure 6 4.

5.

Most Canadian dairy farmers oppose free trade, and most Canadian lumber producers support it.

For simplicity, assume that Canada is a small country in the markets for both milk and lumber, and that without free trade Canada would not trade these goods internationally. (Both of these assumptions are false, but they do not affect the qualitative responses to the following questions.) a. Based on who opposes and who supports free trade, do you think the world milk price is above or below the Canadian no-trade milk price? Do you think the world lumber price is above or below the Canadian no-trade lumber price? Now analyze the welfare consequences of free trade for both markets. b. Considering both markets together, would free trade make Canadian producers as a group better off or worse off? Would it make Canadian consumers as a group better off or worse off? Does it make Canada as a whole better off or worse off? a.

The world milk price must be below the Canadian no-trade price, because dairy farmers oppose free trade. They oppose it because they know that when trade is allowed, the Canadian price of milk will decline to the world price, and their producer surplus will fall.

The world lumber price must be above the Canadian no-trade price, since lumber producers support free trade. They know that when trade is allowed, the Canadian price of lumber will rise to the world price, and their producer surplus will rise.

b.

Considering both markets together, free trade makes dairy farmers worse off and lumber producers better off, so it is not clear whether producers as a whole gain or lose.

Similarly, consumers of milk gain (since the price of milk will decline) and consumers of lumber lose (since the price of lumber will rise), so consumers as a whole may either gain or lose. However, we know that the total gains from trade are positive, so Canada as a whole is better off.

Imagine that winemakers in British Columbia petitioned the provincial government to tax wines imported from Ontario. They argue that this tax would both raise tax revenue for the provincial government and raise employment in the British Columbia wine industry. Do you agree with these claims? Is it a good policy?

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Chapter 9: Application: International Trade • 129 The tax on wine from Ontario is just like a tariff imposed by one country on imports from Ontario. British Columbia producers would be better off and British Columbia consumers would be worse off. The higher price of wine in British Columbia means producers would produce more wine, so they would hire more workers. Tax revenue would go to the government of British Columbia. So both claims are true, but it is a bad policy because the losses to British Columbia consumers exceed the gains to producers and the government.

6.

The nation of Textilia does not allow imports of clothing. In its equilibrium without trade, a T-shirt costs $20 and the equilibrium quantity is 3 million T-shirts. One day, after reading Adam Smith’s The Wealth of Nations while on vacation, the president decides to open the Textilian market to international trade. The market price of a T-shirt falls to the world price of $16. The number of T-shirts consumed in Textilia rises to 4 million, while the number of T-shirts produced declines to 1 million. a. Illustrate in a graph the situation just described. Your graph should show all of the numbers. b. Calculate the change in consumer surplus, producer surplus, and total surplus that results from opening up trade. (Hint: Recall that the area of a triangle is ½ x base x height.) a.

Figure 7 shows the changes in consumer, producer, and total surpluses.

Price of T-shirts Domestic Supply

A $20

B

D

$16

World Price

C Domestic Demand 1

3

4

Quantity of T-shirts (in Millions)

Figure 7 b.

The increase in consumer surplus (B + D) = $14 million. (An easy way to calculate the area B + D is the following: B + D = (20 – 16) × 3 + (1/2) × (20 – 16) × (4 – 3) = $14 million.) The change in producer surplus is –B = –[(20 – 16) × 3 – (1/2) × (20 – 16) × (3 – 1)] = –$8 million, and the change in total surplus, D = 14 – 8 = $6 million.

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130 • Chapter 9: Application: International Trade 7.

Consider a small country that exports steel. Suppose that a “pro-trade” government decides to subsidize the export of steel by paying a certain amount for each tonne sold abroad. How does this export subsidy affect the domestic price of steel, the quantity of steel produced, the quantity of steel consumed, and the quantity of steel exported? How does it affect consumer surplus, producer surplus, government revenue, and total surplus? (Hint: The analysis of an export subsidy is similar to the analysis of a tariff.)

An export subsidy increases the price of steel exports received by producers by the amount of the subsidy, s, as shown in Figure 8. The figure shows the world price, PW, before the subsidy is put in place. At that price, domestic consumers buy quantity Q1D of steel, producers supply Q1S units, and the country exports the quantity Q1S – Q1D. With the subsidy put in place, suppliers get a total price per unit of PW + s since they receive the world price for their exports PW, and the government pays them the subsidy of s. However, note that domestic consumers can still buy steel at the world price PW by importing it. Domestic firms do not want to sell steel to domestic customers, since they do not get the subsidy for doing so. So domestic companies will sell all the steel they produce abroad, in total quantity Q2S. Domestic consumers continue to buy quantity Q1D. The country imports steel in quantity Q1D and exports the quantity Q2S, so net exports of steel are the quantity Q2S – Q1D. The end result is that the domestic price of steel is unchanged, the quantity of steel produced increases, the quantity of steel consumed is unchanged, and the quantity of steel exported increases. As the following table shows, consumer surplus is unaffected, producer surplus rises, government revenue declines, and total surplus declines.

Figure 8

Consumer surplus Producer surplus Government revenue Total surplus

Without Subsidy A+B E+F+G 0 A+B+E+F+G

With Subsidy A+B B+C+E+F+G –(B+C+D) A+B–D+E+F+G

Change 0 +(B+C) –(B+C+D) –D

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Chapter 9: Application: International Trade • 131 8.

Consider the arguments for restricting trade. a. Assume you are a lobbyist for timber, an established industry suffering from lowpriced foreign competition. Which two or three of the five arguments do you think would be most persuasive to the average member of Parliament as to why he or she should support trade restrictions? Explain your reasoning. b. Now assume you are an astute student of economics (hopefully not a hard assumption). Although all the arguments for restricting trade have their shortcomings, name the two or three arguments that seem to make the most economic sense to you.

For each, describe the economic rationale for and against these arguments for trade restrictions.

9.

a.

Since the timber industry is already established, the infant-industry argument is not applicable. The national security argument is not applicable either, because timber will always exist in the country. The most plausible arguments would refer to job losses and unfair competition from abroad. To some extent, the production-as-a-bargaining-chip may also work.

b.

Several answers are possible.

China is a major producer of grains, such as wheat, corn, and rice. In 2008, the Chinese government, concerned that grain exports were driving up food prices for domestic consumers, imposed a tax on grain exports. Draw the graph that describes the market for grain in an exporting country. Use this graph as the starting point to answer the following questions. a. How does an export tax affect domestic grain prices? b. How does it affect the welfare of domestic consumers, the welfare of domestic producers, and government revenue? c. What happens to total welfare in China, as measured by the sum of consumer surplus, producer surplus, and tax revenue? a.

Figure 9 illustrates the effects of an export tax in the Chinese market for grains. Before the tax, the domestic price is equal to the world price. After the imposition of the tax, domestic grain prices are lowered by the amount of the tax: It cannot be lower because any producer can export at that price; it cannot be higher either because part of the quantity that would be exported in the absence of the tax is now sold domestically, pushing prices down.

b.

Consumer surplus increases by the amount A (see Figure 9), producer surplus decreases by the amount A + B + C + D, and government revenue is equal to area C.

c.

Total welfare decreases by the deadweight loss of the export tax, which is equal to B + D.

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132 • Chapter 9: Application: International Trade

Price of grains

B

D

Domestic Supply

World Price C

A

World Price Minus Tax

Export Tax

Domestic Demand

Quantity of grains

Figure 9 10.

Consider a country that imports a good from abroad. For each of the following statements, say whether it is true or false. Explain your answer. a. “The greater the elasticity of demand, the greater the gains from trade.” b. “If demand is perfectly inelastic, there are no gains from trade.” c. “If demand is perfectly inelastic, consumers do not benefit from trade.” a.

True. As Figure 10 shows, the increase in consumer surplus is greater when demand is elastic than with inelastic demand for the same difference between the domestic equilibrium price and the lower international price. The gain from trade is B + C with elastic demand, but only B with inelastic demand.

Price Inelastic Demand Domestic Supply

A

C B World Price Elastic Demand

Quantity Figure 10

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Chapter 9: Application: International Trade • 133

11.

b.

False. Area B in Figure 10 is still greater than zero even if demand is vertical (perfectly inelastic).

c.

False. In fact, all gains from trade go to consumers when we only consider one market at a time.

Having rejected a tariff on textiles (a tax on imports), the president of Isoland is now considering the same-sized tax on textile consumption (including both imported and domestically produced textiles). a. Using Figure 9.6, identify the quantity consumed and the quantity produced in Isoland under a textile consumption tax. b. Construct a table similar to that in Figure 9.6 for the textile consumption tax. c. Which raises more revenue for the government—the consumption tax or the tariff?

Which has a smaller deadweight loss? Explain. a.

Using Figure 9.6 from the text, the quantity demanded will fall to Q2D, the same quantity demanded under the tariff. However, quantity supplied will not change because the price that sellers receive will be the world price. Thus, quantity supplied will remain at Q1S.

b.

The effects of the consumption tax can be seen in the table below:

Consumer surplus Producer surplus Government revenue Total surplus c.

World price

World price + tax

A+B+C+D+E+F G None A+B+C+D+E+F+G

A+B G C+D+E A+B+C+D+E+G

CHANGE –C – D – E – F None C+D+E –F

The consumption tax raises more government revenue because the tax is on all units (not just the imported units). Thus, the deadweight loss is smaller with the consumption tax than with a tariff.

Appendix Problems and Applications A1.

Assume that Canada is an importer of televisions and that there are no trade restrictions.

Canadian consumers buy 1 million televisions per year, of which 400 000 are produced domestically and 600 000 are imported. a. Suppose that a technological advance among Japanese television manufacturers causes the world price of televisions to fall by $100. Draw a graph to show how this change affects the welfare of Canadian consumers and Canadian producers and how it affects total surplus in Canada. b. After the fall in price, consumers buy 1.2 million televisions, of which 200 000 are produced domestically and 1 million are imported. Calculate the change in consumer surplus, producer surplus, and total surplus from the price reduction. c. If the government responded by putting a $100 tariff on imported televisions, what would this do? Calculate the revenue that would be raised and the deadweight loss.

Would it be a good policy from the standpoint of Canadian welfare? Who might support the policy? Who might oppose it? d. Suppose that the fall in price is attributable not to technological advance but to a $100 per television subsidy from the Japanese government to Japanese industry. How would this affect your analysis?

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134 • Chapter 9: Application: International Trade When a technological advance lowers the world price of televisions, the effect on Canada, an importer of televisions, is shown in Figure 11. At the initial (higher) price, consumer surplus is A + B, domestic producer surplus is C + E, and total surplus is A + B + C + E. After the improvement in technology, the world price of televisions declines by $100, consumer surplus increases by C + D to A + B + C + D, producer surplus declines by C to E, and total surplus rises by D to A + B + C + D + E.

Price of Television

a.

Domestic supply

A B

$100

D

C E

Domestic demand 2

4

10 12

Quantity of Televisions (in 100 000s)

Figure 11 b.

The change in consumer surplus (C + D) = $100 × 10 + 1/2 × $100 × (12 – 10) = $1100 ($110 million). The change in producer surplus (–C) = –[$100 × 2 + 1/2 × $100 × (4 – 2)] = –$300 (–$30 million). The change in total surplus (+D) = $110 million – $30 million = $80 million.

c.

(See Figure 11.) If Canada sets a tariff of $100 on imported televisions, the price in Canada increases back by $100, sending the domestic quantities demanded and supplied back to 1 million and 400 000 televisions, respectively. Thus, consumer and producer surplus go back to what they were before the technological improvement. However, the government would receive a tariff of $60 million (600 000 units of $100 each). The deadweight loss would be [1/2 × $100 × (4 – 2)] + [1/2 × $100 × (12 – 10)] = $100 + $100 = $20 million. The policy induces an inefficiency measured by the deadweight loss we have just calculated. Domestic producers of televisions would support this policy as their producer surplus increases. Consumers, on the other hand, will oppose it.

d.

The analysis remains the same, since the particular reason for which the foreign producers face lower costs of production is irrelevant for Canada.

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Chapter 9: Application: International Trade • 135 A2.

Kawmin is a small country that produces and consumes jelly beans. The world price of jelly beans is $1 per bag, and Kawmin’s domestic demand and supply for jelly beans are governed by the following equations: Demand: QD = 8 – P Supply: QS = P where P is in dollars per bag and Q is in bags of jelly beans. a. Draw a well-labelled graph of the situation in Kawmin if the nation does not allow trade. Calculate the following (recalling that the area of a triangle is ½ x base x height): the equilibrium price and quantity, consumer surplus, producer surplus, and total surplus. b. Kawmin then opens the market to trade. Draw another graph to describe the new situation in the jelly bean market. Calculate the equilibrium price, quantities of consumption and production, imports, consumer surplus, producer surplus, and total surplus. c. After a while, the czar of Kawmin responds to the pleas of jelly bean producers by placing a $1 per bag tariff on jelly bean imports. On a graph, show the effects of this tariff. Calculate the equilibrium price, quantities of consumption and production, imports, consumer surplus, producer surplus, government revenue, and total surplus. d. What are the gains from opening up trade? What are the deadweight losses from restricting trade with the tariff? Give numerical answers. a.

The equilibrium price in the absence of trade is given by the equation 8 – P = P, with the solution P = $4. The equilibrium quantity is equal to 8 – 4 = 4. Figure 12 shows the demand and supply model corresponding to the given equations. Consumer and producer surplus are each equal to $8. Total surplus is $16.

Price Domestic Supply

$8

$4

Domestic Demand Quantity

4 Figure 12 b.

Figure 13 shows the effects of opening the market for trade. The new price is now $1, equal to the international price. The quantity consumed is 7 and the quantity produced domestically is equal to 1. Consumer surplus increases to (1/2) × (8 – 1) × 7 = 24.5.

Producer surplus decreases to (1/2) × 1 × 1 = 0.5. Total surplus is 25; imports are equal to 7 – 1 = 6.

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136 • Chapter 9: Application: International Trade

Price Domestic Supply

$8

$4

$1

World Price Domestic Demand Quantity 7

4

1

Figure 13 c.

Figure 14 shows the situation with a tariff of $1. Price = $2; quantity consumed = 6; quantity produced domestically = 2; imports = 6 – 2 = 4; consumer surplus = (1/2) × (8 – 2) × 6 = 18; producer surplus = (1/2) × 2 × 2 = 2; government revenue = $1 × (6 – 2) = $4; total surplus = 18 + 2 + 4 = 24.

Price Domestic Supply

$8

$4 $2

World Price +Tariff

$1

World Price Domestic Demand Quantity 1

2

4

6

7

Figure 14 d.

When the markets open for trade, consumers gain 24.5 – 8 = 16.5, and producers lose 8 – 0.5 = 7.5. The total gains from opening up trade are equal to 25 – 16 = 9. The deadweight losses from restricting trade with the tariff are each equal to $0.5. Thus, the total deadweight loss is $1.

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Chapter 10 Externalities SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Give an example of a negative externality and a positive externality. • Explain why market outcomes are inefficient in the presence of externalities.

Examples of negative externalities include pollution, barking dogs, and consumption of alcoholic beverages (many others are possible). Examples of positive externalities include restoring historical buildings, research into new technologies, and education (many others are possible).

Market outcomes are inefficient in the presence of externalities because markets produce a larger quantity than is socially desirable when there is a negative externality and a smaller quantity than is socially desirable when there is a positive externality.

2.

A glue factory and a steel mill emit smoke containing a chemical that is harmful if inhaled in large amounts. Describe three ways the town government might respond to this externality. What are the pros and cons of each of your solutions?

The town government might respond to the externality from the smoke in three ways: (1) regulation, (2) corrective taxes, or (3) tradable pollution permits.

Regulation prohibiting pollution beyond some level is good because it is often effective at reducing pollution. But doing so successfully requires the government to have a lot of information about the industries and about the alternative technologies that those industries could adopt.

Corrective taxes are a useful way to reduce pollution because the tax can be increased to get pollution to a lower level and because the taxes raise revenue for the government. The tax is more efficient than regulation because it gives factories economic incentives to reduce pollution and to adopt new technologies that pollute less. The disadvantage of corrective taxes is that the government needs to know a lot of information to pick the right amount to tax.

Tradable pollution permits are similar to corrective taxes but allow the firms to trade the right to pollute with each other. As a result, the government does not need as much information about the firms’ technology. The government can simply set a limit on the total amount of pollution, issue permits for that amount, and allow the firms to trade the permits, thus reducing pollution while allowing economic efficiency. The disadvantage of pollution permits is that the government may not set the right overall level of pollution.

3.

Give an example of a private solution to an externality. • What is the Coase theorem? • Why are private economic actors sometimes unable to solve the problems caused by an externality?

Examples of private solutions to externalities include moral codes and social sanctions, charities, relying on the self-interest of the relevant parties, and entering into contracts. The Coase theorem is the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Private economic actors are sometimes unable to solve the problems caused by an externality because of transaction costs, because bargaining breaks down, or when the number of interested parties is large so that coordinating everyone is costly.

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138 • Chapter 10: Externalities Questions for Review 1.

Give an example of a negative externality and an example of a positive externality.

Examples of negative externalities include pollution, barking dogs, and consumption of alcoholic beverages (many others are possible). Examples of positive externalities include restoring historical buildings, research into new technologies, and education (many others are possible).

2.

Draw a supply-and-demand diagram to explain the effect of a negative externality in production.

Figure 1 illustrates the effect of a negative externality. The equilibrium quantity provided by the market is Qmarket. Because of the externality, the social cost of production is greater than the private cost of production, so the social-cost curve is above the supply curve. The optimal quantity for society is Qoptimum. The private market produces too much of the good, as Qmarket is greater than Qoptimum.

Figure 1 3.

In what way does the patent system help society solve an externality problem?

The patent system helps society solve the externality problem from technology spillovers. By giving inventors exclusive use of their inventions for a period of time, the inventor can capture much of the economic benefit of the invention. In doing so, the patent system encourages research and technological advance, which benefits society through spillover effects.

4.

List some of the ways that the problems caused by externalities can be solved without government intervention.

Externalities can be solved without government intervention through moral codes and social sanctions (which tell us to internalize externalities, such as not to litter), charities (donations to organizations like Greenpeace to protect the environment or to universities to support education), merging firms whose externalities affect each other (for example, the apple grower and the beekeeper), or by contract.

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Chapter 10: Externalities • 139 5.

Imagine that you are a nonsmoker sharing a room with a smoker. According to the Coase theorem, what determines whether your roommate smokes in the room? Is this outcome efficient? How do you and your roommate reach this solution?

According to the Coase theorem, you and your roommate will bargain over whether your roommate will smoke in the room. If you value clean air more than your roommate values smoking, the bargaining process will lead to your roommate not smoking. But if your roommate values smoking more than you value clean air, the bargaining process will lead to your roommate smoking. The outcome is efficient as long as transaction costs do not prevent an agreement from taking place. The solution may be reached by one of you paying off the other either not to smoke or for the right to smoke.

6.

Even if the externality issue is resolved using a private solution (Coase), can you think of other issues or problems that would stem from the situation? (For example, how do you determine to whom to give rights?)

While the Coase theorem says that if transaction costs are low, an efficient outcome can emerge, it does not say anything about how the underlying property rights should be allocated. In fact, an efficient outcome will emerge regardless of who the property rights are assigned to. However, it is better to have the property rights than not. Another issue that might arise that can affect who is relatively better off includes which of you are better at bargaining (sometimes referred to as bargaining power). It may also be difficult to reach a bargain if you are not certain what value your roommate places on smoking (and vice versa).

7.

What are corrective taxes? Why do economists prefer them over regulations as a way to protect the environment from pollution?

Corrective taxes are taxes enacted to correct the effects of a negative externality. Economists prefer corrective taxes over regulations as a way to protect the environment from pollution because they can reduce pollution at a lower cost to society. A tax can be set to reduce pollution to the same level as a regulation. The tax has the advantage of letting the market determine the least expensive way to reduce pollution. The tax gives firms the incentive to develop cleaner technologies to reduce the taxes they have to pay.

Quick Check Multiple Choice

1. Which of the following is an example of a positive externality? a. Dev mows Hillary’s lawn and is paid $100 for performing the service. b. While mowing the lawn, Dev’s lawnmower spews out smoke that Hillary’s neighbour Kristen has to breathe. c. Hillary’s newly cut lawn makes her neighbourhood more attractive. d. Hillary’s neighbours pay her if she promises to get her lawn cut on a regular basis.

2. If the production of a good yields a negative externality, then the social-cost curve lies ___ the supply curve, and the socially optimal quantity is ___ than the equilibrium quantity. a. above, greater b. above, less c. below, greater d. below, less

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140 • Chapter 10: Externalities

3. When the government levies a tax on a good equal to the external cost associated with the good’s production, it ___ the price paid by consumers and makes the market outcome ___ efficient. a. increases, more b. increases, less c. decreases, more d. decreases, less 4. Which of the following statements about corrective taxes is NOT true? a. Economists prefer them to command-and-control regulation. b. They raise government revenue. c. They cause deadweight losses. d. They reduce the quantity sold in a market.

5. The government auctions off 500 units of pollution rights. They sell for $50 per unit, raising total revenue of $25 000. This policy is equivalent to a corrective tax of what amount per unit of pollution? a. b. c. d.

$10 $50 $450 $500

6. The Coase theorem does NOT apply in which of the following scenarios? a. a significant externality exists between two parties b. the court system vigorously enforces all contracts c. transaction costs make negotiating difficult d. both parties understand the externality fully 1. c 2. b 3. a 4. c 5. b 6. c Problems and Applications 1.

Consider two ways to protect your car from theft. The Club (a car steering wheel lock) makes it difficult for a car thief to take your car. LoJack (a car tracking and recovery system) makes it easier for the police to catch a car thief. Which of these types of protection conveys a negative externality on other car owners? Which conveys a positive externality? Do you think there are any policy implications of your analysis?

The Club conveys a negative externality on other car owners because car thieves will not attempt to steal a car with The Club visibly in place. This means that they will move on to another car.

The LoJack system conveys a positive externality because thieves do not know which cars have this technology. Therefore, they are less likely to steal any car. Policy implications include a subsidy for car owners that use the LoJack technology and a tax on those who use The Club.

2.

Do you agree with the following statements? Why or why not? a. “The benefits of corrective taxes as a way to reduce pollution have to be weighed against the deadweight losses that these taxes cause.”

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Chapter 10: Externalities • 141

b. “When deciding whether to levy a corrective tax on consumers or producers, the government should be careful to levy the tax on the side of the market generating the externality.”

3.

a.

The statement “The benefits of corrective taxes as a way to reduce pollution have to be weighed against the deadweight losses that these taxes cause” is false. In fact, corrective taxes reduce the inefficiency of pollution by reducing the quantity of the good being produced that has pollution as a by-product. So, corrective taxes reduce deadweight loss, they do not increase it.

b.

The statement “When deciding whether to levy a corrective tax on consumers or producers, the government should be careful to levy the tax on the side of the market generating the externality” is inaccurate. It does not matter on whom the tax is imposed—the incidence of the tax will be identical. So whether the externality is caused by the seller or by the buyer of a good, a tax on either producers or consumers will lead to the same reduction of quantity and change in the prices producers receive or consumers pay.

Consider the market for fire extinguishers. a. Why might fire extinguishers exhibit positive externalities? b. Draw a graph of the market for fire extinguishers, labelling the demand curve, the social-value curve, the supply curve, and the social-cost curve. c. Indicate the market equilibrium level of output and the efficient level of output. Give an intuitive explanation for why these quantities differ. d. If the external benefit is $10 per extinguisher, describe a government policy that would result in the efficient outcome. a.

Fire extinguishers exhibit positive externalities because even though people buy them for their own use, they help limit the spreading of fires and can prevent a fire from damaging the property of others.

b.

Figure 2 illustrates the positive externality from fire extinguishers. Notice that the social value curve is above the demand curve, and the social cost curve is the same as the supply curve.

Figure 2

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142 • Chapter 10: Externalities

4.

5.

c.

The market equilibrium level of output is denoted Qmarket and the efficient level of output is denoted Qoptimum. The quantities differ because in deciding to buy fire extinguishers, people do not account for the benefits they provide to other people.

d.

A government policy that would result in the efficient outcome would be to subsidize people $10 for every fire extinguisher they buy. This would shift the demand curve up to the social value curve, and the market quantity would increase to the optimum quantity.

Ringo loves playing rock-and-roll music at high volume. Luciano loves opera and hates rock and roll. Unfortunately, they are next-door neighbours in an apartment building with paper-thin walls. a. What is the externality here? b. What command-and-control policy might the landlord impose? Could such a policy lead to an inefficient outcome? c. Suppose the landlord lets the tenants do whatever they want. According to the Coase theorem, how might Ringo and Luciano reach an efficient outcome on their own? What might prevent them from reaching an efficient outcome? a.

The externality is noise pollution. Ringo’s consumption of rock-and-roll music affects Luciano, but Ringo does not take that into account in deciding how loud he plays his music.

b.

The landlord could impose a rule that music could not be played above a certain decibel level. This could be inefficient because there would be no harm done by Ringo playing his music loud if Luciano is not home.

c.

Ringo and Luciano could negotiate an agreement that might, for example, allow Ringo to play his music loud at certain times of the day. They might not be able to reach an agreement if the transaction costs are high or if bargaining fails because each holds out for a better deal.

Greater consumption of alcohol leads to more motor vehicle accidents and, thus, imposes costs on people who do not drink and drive. a. Illustrate the market for alcohol, labelling the demand curve, the social-value curve, the supply curve, the social-cost curve, the market equilibrium level of output, and the efficient level of output. b. On your graph, shade the area corresponding to the deadweight loss of the market equilibrium. (Hint: The deadweight loss occurs because some units of alcohol are consumed for which the social cost exceeds the social value.) Explain. a.

The market for alcohol is shown in Figure 3. The social value curve is below the demand curve because of the negative externality from increased motor vehicle accidents caused by those who drink and drive. The free-market equilibrium level of output is QMARKET and the efficient level of output is QOPTIMUM.

b.

The shaded area shows the amount by which social costs exceed social value for the quantity of alcohol consumption beyond the efficient level.

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Chapter 10: Externalities • 143

Figure 3 6.

Many observers believe that the levels of pollution in our society are too high. a. If society wishes to reduce overall pollution by a certain amount, why is it efficient to have different amounts of reduction at different firms? b. Command-and-control approaches often rely on uniform reductions among firms. Why are these approaches generally unable to target the firms that should undertake larger reductions? c. Economists argue that appropriate corrective taxes or tradable pollution rights will result in efficient pollution reduction. How do these approaches target the firms that should undertake larger reductions? a.

It is efficient to have different amounts of pollution reduction at different firms because the costs of reducing pollution differ across firms. If they were all made to reduce pollution by the same amount, the costs would be low at some firms and prohibitive at others, imposing a greater burden overall.

b.

Command-and-control approaches that rely on uniform pollution reduction among firms give the firms no incentive to reduce pollution beyond the mandated amount. Instead, every firm will reduce pollution by just the amount required and no more.

c.

Corrective taxes or tradable pollution rights give firms greater incentives to reduce pollution. Firms are rewarded by paying lower taxes or spending less on permits if they find methods to reduce pollution, so they have the incentive to engage in research on pollution control. The government does not have to figure out which firms can reduce pollution the most; it lets the market give firms the incentive to reduce pollution on their own.

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144 • Chapter 10: Externalities 7.

The many identical residents of Whoville love drinking Zlurp. Each resident has the following willingness to pay for the tasty refreshment: First bottle Second bottle Third bottle

$5 4 3

Fourth bottle Fifth bottle Further bottles

2 1 0

a. The cost of producing Zlurp is $1.50, and the competitive suppliers sell it at this price.

(The supply curve is horizontal.) How many bottles will each Whovillian consume?

What is each person’s consumer surplus? b. Producing Zlurp creates pollution. Each bottle has an external cost of $1. Taking this additional cost into account, what is total surplus per person in the allocation you described in part (a)? c. Cindy Lou Who, one of the residents of Whoville, decides on her own to reduce her consumption of Zlurp by one bottle. What happens to Cindy’s welfare (her consumer surplus minus the cost of pollution she experiences)? How does Cindy’s decision affect total surplus in Whoville? d. Mayor Grinch imposes a $1 tax on Zlurp. What is consumption per person now?

Calculate consumer surplus, the external cost, government revenue, and total surplus per person. e. Based on your calculations, would you support the mayor’s policy? Why or why not? a.

When the price is $1.50, there are four bottles demanded since the fourth is the last to correspond to a willingness to pay higher than $1.50. Consumer surpluses for each of the four bottles are: ($5 – $1.50) = $3.50 for the first, and $2.50, $1.50, and $0.50 respectively for the next three. The total consumer surplus for the typical person is $8.

b.

With the social cost of $1 per bottle, each bottle’s true consumer surplus decreases by $1, such that the total consumer’s surplus per person is only $4.

c.

When Cindy reduces her consumption by one bottle, the change in her consumer’s surplus has two components: first, it decreases by $0.50 because she gives up her fourth bottle; second, it increases by $1/N, where N is the number of persons in Whoville who benefit from the $1 worth of pollution that is avoided by Cindy’s unilateral decision.

Therefore, Cindy’s decision reduces her welfare as long as Whoville has more than two inhabitants. Since there are many residents in Whoville, Cindy’s decision has a negligible effect on the total surplus of the community.

d.

With a $1 tax, the consumer price increases by $1 since the supply is competitive, and the quantity demanded falls to three bottles per person. Now the total consumer’s surplus per person is $2.50 + $1.50 + $0.50 = $4.50, which is greater than in the absence of the tax. The external cost is now zero because each person pays the full cost (the cost of production plus the social cost of $1 for pollution). Government revenue is $1 × 3 = $3 per consumer. Total surplus is equal to consumer surplus plus government revenue: $4.50 + $3 = $7.50, up from the $4 that was in the absence of the tax.

e.

Yes, because the tax policy increases total surplus from $4 to $7.50. Initiatives such as Cindy’s are not effective because they are too costly for the individual, with almost no results for the community.

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Chapter 10: Externalities • 145 8.

Figure 10.5 shows that for any given demand curve for the right to pollute, the government can achieve the same outcome either by setting a price with a corrective tax or by setting a quantity with pollution permits. Suppose there is a sharp improvement in the technology for controlling pollution. a. Using graphs similar to those in Figure 10.5, illustrate the effect of this development on the demand for pollution rights. b. What is the effect on the price and quantity of pollution under each regulatory system? Explain. a.

An improvement in the technology for controlling pollution would reduce the demand for pollution rights, shifting the demand curve to the left. Figure 4 illustrates what would happen if there were a corrective tax, while Figure 5 shows the impact if there were a fixed supply of pollution permits. In both figures, the curve labelled D1 is the original demand for pollution rights, and the curve labelled D2 is the new demand for pollution rights after the improvement in technology.

Figure 4

Figure 5

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146 • Chapter 10: Externalities b.

9.

10.

With a corrective tax, the price of pollution remains unchanged and the quantity of pollution declines, as Figure 4 shows. With pollution permits, the price of pollution declines and the quantity of pollution is unchanged, as Figure 5 illustrates.

Suppose that the government decides to issue tradable permits for a certain form of pollution. a. Does it matter for economic efficiency whether the government distributes or auctions the permits? Why or why not? b. If the government chooses to distribute the permits, does the allocation of permits among firms matter for efficiency? Explain. a.

In terms of economic efficiency in the market for pollution, it does not matter if the government distributes the permits or auctions them off, as long as firms can sell the permits to each other. The only difference would be that the government could make money if it auctioned the permits off, thus allowing it to reduce taxes, which would help reduce the deadweight loss from taxation. There could also be some deadweight loss occurring if firms use resources to lobby for additional permits.

b.

If the government allocated the permits to firms that did not value them as highly as other firms, the firms could sell the permits to each other so they would end up in the hands of the firms that value them most highly. Thus, the allocation of permits among firms would not matter for efficiency, but it would affect the distribution of wealth, since those who got the permits and sold them would be better off.

A local drama company proposes a new neighbourhood theatre in Vancouver. Before approving the building permit, the city planner completes a study of the theatre’s impact on the surrounding community. a. One finding of the study is that theatres attract traffic, which adversely affects the community. The city planner estimates that the cost to the community from the extra traffic is $5 per ticket. What kind of an externality is this? Why? b. Graph the market for theatre tickets, labelling the demand curve, the social-value curve, the supply curve, the social-cost curve, the market equilibrium level of output, and the efficient level of output. Also show the per-unit amount of the externality. c. On further review, the city planner uncovers a second externality. Rehearsals for the plays tend to run until late at night, with actors, stagehands, and other theatre members coming and going at various hours. The planner has found that the increased foot traffic improves the safety of the surrounding streets, an estimated benefit to the community of $2 per ticket. What kind of externality is this? Why? d. On a new graph, illustrate the market for theatre tickets in the case of these two externalities. Again, label the demand curve, the social-value curve, the supply curve, the social-cost curve, the market equilibrium level of output, the efficient level of output, and the per-unit amount of both externalities. e. Describe a government policy that would result in an efficient outcome. a.

This is a negative externality because it imposes an extra cost on the people who live in the neighbourhood.

b.

Figure 6 shows the market for theatre tickets, where the social cost curve is higher than the private supply curve by $5. Figure 6 assumes that there are no significant positive externalities from having a theatre in the neighbourhood.

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Chapter 10: Externalities • 147 Price of Tickets

External cost=$5 per ticket

Social cost (private plus external) Supply (private cost)

Demand (private value) QMARKET

QOPTIMUM

Quantity of Tickets

Figure 6 c.

This is a positive externality because it reflects a benefit to people who do not pay for it.

d.

Figure 7 shows the effects of the two externalities. Q’OPTIMUM is greater than QOPTIMUM shown in Figure 6 because of the positive externality.

Price of tickets

External benefit=$2 per ticket

Social cost (private plus external) Supply (private cost)

Social benefit (private benefit +external benefit) Demand (private value) Q’OPTIMUM QMARKET

Quantity of tickets

Figure 7 e.

A possible policy to induce the optimum number of tickets is to tax the theatre company about $3 per ticket.

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148 • Chapter 10: Externalities 11.

There are three industrial firms in Happy Valley.

Firm A B C

Initial Pollution Level 70 units 80 50

Cost of Reducing Pollution by 1 Unit $20 25 10

The government wants to reduce pollution to 120 units, so it gives each firm 40 tradable pollution permits. a. Who sells permits and how many do they sell? Who buys permits and how many do they buy? Briefly explain why the sellers and buyers are each willing to do so. What is the total cost of pollution reduction in this situation? b. How much higher would the costs of pollution reduction be if the permits could not be traded?

12.

a.

A permit is worth $25 to Firm B, $20 to Firm A, and $10 to Firm C, since that is the cost of reducing pollution by one unit. Since Firm B faces the highest costs of reducing pollution, it will keep its own 40 permits and buy 40 permits from the other firms, so that it can still pollute by 80 units. That leaves 40 permits for Firms A and C. Since Firm A values them most highly, it will keep its own 40 permits. So it must be that Firm C sells its 40 permits to Firm B. Thus Firm B does not reduce its pollution at all, Firm A reduces its pollution by 30 units at a cost of $20 × 30 = $600, and Firm C reduces its pollution by 50 units at a cost of $10 × 50 = $500. The total cost of pollution reduction is $1100.

b.

If the permits could not be traded, then Firm A would have to reduce its pollution by 30 units at a cost of $20 × 30 = $600, Firm B would reduce its pollution by 40 units at a cost of $25 × 40 = $1000, and Firm C would reduce its pollution by 10 units at a cost of $10 × 10 = $100. The total cost of pollution reduction would be $1700. That is $600 higher than in the case in which the permits could be traded.

The market for a particular chemical, called Negext, is described by the following equations.

Demand is given by QD = 100 – 5P

Supply is given by QS = 5P

where Q is measured as units of Negext and P is price in dollars per unit. a. Find the equilibrium price and quantity. Compute consumer surplus, producer surplus, and total surplus in the market equilibrium. b. For each unit of Negext produced, 4 units of pollution are emitted, and each unit of pollution imposes a cost on society of $1. Compute the total cost of pollution when the market for Negext is in equilibrium. What is total surplus from this market after taking into account the cost of pollution? c. Would banning Negext increase or decrease welfare? Why? d. Suppose that the government restricts emissions to 100 units of pollution. Graph the Negext market under this constraint. Find the new equilibrium price and quantity and show them on your graph. Compute how this policy affects consumer surplus, producer surplus, and the cost of pollution. Would you recommend this policy? Why?

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Chapter 10: Externalities • 149

e. Suppose that instead of restricting pollution, the government imposes a tax on producers equal to $4 for each unit of chemical produced. Calculate the new equilibrium price and quantity, as well as consumer surplus, producer surplus, tax revenue, and the cost of pollution. What is total surplus now? Would you recommend this policy? Why? f. New research finds the social cost of pollution is actually higher than $1. How would that change the optimal policy response? Is there some cost of pollution that would make it sensible to ban Negext? If so, what is it? a.

The equilibrium price is given by the equation 100 – 5P = 5P. The solution is P = $10.

The equilibrium quantity is the quantity demanded and supplied at the equilibrium price, Q = 100 – 5 × 10 = 50. Figure 8 shows approximately the demand and supply curves in the market for Negext. Consumer surplus = (1/2) × (20 – 10) × 50 = $250; producer surplus is also equal to $250; total surplus is $500.

Price of Negext Supply

$20

$10

Demand 50

Quantity of Negext

Figure 8 b.

The total cost of pollution when the market is in equilibrium is 50 × 4 × $1 = $200. The total surplus decreases by that amount. Thus, total surplus when pollution is accounted for is equal to $500 – $200 = $300.

c.

Banning Negext would decrease welfare by the value of total surplus with pollution, which is $300. Society’s benefit from producing and consuming Negext is higher than the social cost of producing it.

d.

Figure 9 shows the market for Negext under the 100 units of pollution restriction. To produce 100 units of pollution, the level of production must be 25 units of Negext.

Consumer surplus decreases from $250 to (1/2) × ($20 – $15) × 25 = $62.50; producer surplus decreases from $250 to (1/2) × $5 × 25 = $62.50; total surplus without accounting for pollution is equal to 2 × $62.50 = $125, down from $500. The cost of pollution is $100. The net social surplus is now $125 – $100 = $25, which is still positive, but less than in the absence of the restriction. Restricting pollution to 100 units is not recommendable.

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150 • Chapter 10: Externalities

Price of Negext $20

Restricted supply Unrestricted Supply

$15

$5 Demand Quantity of Negext

25

Figure 9 e.

The tax of $4 increases the producer’s per-unit cost by the same amount. Figure 10 shows this situation. The new equilibrium price is the solution to the equation 100 – 5P = 5(P – 4); the result is P = $12. The new equilibrium quantity is equal to 100 – 5 × 12 = 40 units of Negext. Consumer surplus is now (1/2) × $8 × 40 = $160, producer surplus = (1/2) × $8 × 40 = $160, government revenue = $4 × 40 = $160, and total surplus excluding the social cost of pollution is $160 + $160 + $160 = $480. The cost of pollution is 40 × 4 × $1 = $160. The net social benefit is equal to total surplus minus cost of pollution, $480 – $160 = $320. Since this is greater than the total surplus in the absence of the tax (which was equal to $300), this policy is recommendable.

Price of Negext Supply with the tax of $4

$20

Supply without tax $12

$4 Demand 40

Quantity of Negext

Figure 10 f.

One should notice that government revenue is equal to the cost of pollution if the tax is set equal to 4 × the per-unit cost of pollution. Thus, the total social surplus (accounting for the cost of pollution) is always equal to the area between the demand curve and the social cost curve. Figure 10 shows that this area becomes zero for a tax equal to $20 per unit of Negext produced, or a $20/4 = $5 per unit cost of pollution. In conclusion, if the cost of pollution is greater than $5 per unit, the production of Negext should be banned.

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Chapter 11 Public Goods and Common Resources SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Define public goods and common resources, and give an example of each.

Public goods are goods that are neither excludable nor rival in consumption. Examples include a tornado siren, national defence, and uncongested nontoll roads. Common resources are goods that are rival in consumption but not excludable. Examples include fish in the ocean, the environment, and congested nontoll roads.

2.

What is the free-rider problem? • Why does the free-rider problem induce the government to provide public goods? • How should the government decide whether to provide a public good?

The free-rider problem occurs when people receive the benefits of a good but avoid paying for it.

The free-rider problem induces the government to provide public goods because if the government uses tax revenue to provide the good, everyone pays for it and everyone enjoys its benefits. The government should decide whether to provide a public good by comparing the good’s costs to its benefits; if the benefits exceed the costs, society is better off.

3.

Why do governments try to limit the use of common resources?

Governments try to limit the use of common resources because one person’s use of the resource diminishes others’ use of it, so there is a negative externality that leads people to use common resources excessively.

Questions for Review 1.

Explain what is meant by a good being “excludable.” Explain what is meant by a good being “rival in consumption.” Is a slice of pizza excludable? Is it rival in consumption?

An excludable good is one that people can be prevented from using. A good that is rival in consumption is one for which one person’s use diminishes other people’s use of the same good.

A slice of pizza is excludable, because a pizza producer can prevent someone who does not pay for the slice of pizza from eating it. A slice of pizza is also rival in consumption, because when one person eats it, no one else can eat it.

2.

Define and give an example of a public good. Can the private market provide this good on its own? Explain.

A public good is a good that is neither excludable nor rival in consumption. An example is national defence, which protects the entire nation. No one can be prevented from enjoying the benefits of it, so it is not excludable, and an additional person who benefits from it does not diminish the value of it to others, so it is not rival in consumption. The private market will not supply the good, since no one would pay for it because they cannot be excluded from enjoying it if they do not pay for it.

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152 • Chapter 11: Public Goods and Common Resources 3.

What is cost–benefit analysis of public goods? Why is it important? Why is it hard?

Cost–benefit analysis of public goods is a study that compares the costs and benefits to society of providing a public good. It is important because the government needs to know which public goods people value most highly and which have benefits that exceed the costs of supplying them. It is hard to do because quantifying the benefits is difficult to do from a questionnaire and because respondents have little incentive to tell the truth.

4.

Define and give an example of a common resource. Without government intervention, will people use this good too much or too little? Why? A common resource is a good that is rival in consumption but not excludable. An example is fish in the ocean. If someone catches a fish, that leaves fewer fish for everyone else, so it is a rival in consumption good. But the ocean is so vast, you cannot charge people for the right to fish, or prevent them from fishing, so it is not excludable. Thus, without government intervention, people will use the good too much, since they do not account for the costs they impose on others when they use the good.

Quick Check Multiple Choice

1. Which categories of goods are excludable? a. private goods and club goods b. private goods and common resources c. public goods and club goods d. public goods and common resources 2. Which categories of goods are rival in consumption? a. private goods and club goods b. private goods and common resources c. public goods and club goods d. public goods and common resources 3. Which of the following is an example of a public good? a. residential housing b. national defence c. restaurant meals d. fish in the ocean 4. Which of the following is an example of a common resource? a. residential housing b. national defence c. restaurant meals d. fish in the ocean 5. Which of the following describes public goods? a. efficiently provided by market forces b. underprovided in the absence of government c. overused in the absence of government d. a type of natural monopoly

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Chapter 11: Public Goods and Common Resources • 153

6. Which of the following describes common resources? a. efficiently provided by market forces b. underprovided in the absence of government c. overused in the absence of government d. a type of natural monopoly 1. a 2. b 3. b 4. d 5. b 6. c Problems and Applications 1.

2.

Both public goods and common resources involve externalities. a. Are the externalities associated with public goods generally positive or negative? Use examples in your answer. Is the free-market quantity of public goods generally greater or less than the efficient quantity? b. Are the externalities associated with common resources generally positive or negative?

Use examples in your answer. Is the free-market use of common resources generally greater or less than the efficient use? a.

The externalities associated with public goods are positive. Since the benefits from the public good received by one person do not reduce the benefits received by anyone else, the social value of public goods is substantially greater than the private value. Examples include a tornado siren, national defence, uncongested nontoll roads, and uncongested parks. Since public goods are not excludable, the free-market quantity is zero, so it is less than the efficient quantity.

b.

The externalities associated with common resources are generally negative. Since common resources are rival in consumption but not excludable (so not priced), the use of those common resources by one person reduces the amount available for others. Since common resources are not priced, people tend to overuse them—their private cost of using the resources is less than the social cost, which leads to a use that is greater than required by efficiency. Examples include fish in the ocean, the environment, congested nontoll roads, the town commons, and congested parks.

Think about the goods and services provided by your local government. a. Using the classification in Figure 11.1, explain into which category each of the following goods falls:  police protection  snowplowing  education  rural roads  city streets b. Why do you think the government provides items that are not public goods?

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154 • Chapter 11: Public Goods and Common Resources a.

(1) Police protection is a club good since it is excludable (the police may ignore some neighbourhoods) and not rival in consumption (unless the police force is overworked, they are available whenever a crime arises). You could make an argument that police protection is rival, if the police are too busy to respond to all crimes, so that one person’s use of the police reduces the amount available for others; in that case, police protection is a private good.

(2) Snowplowing is most likely a common resource. Once a street is plowed, it is not excludable. But it is rival in consumption, especially right after a big snowfall, since plowing one street means not plowing another street.

(3) Education is a private good (with a positive externality). It is excludable since someone who does not pay can be prevented from taking classes. It is rival in consumption since the presence of an additional student in a class reduces the benefits to others.

(4) Rural roads are public goods. They are not excludable and they are not rival in consumption since they are uncongested.

(5) City streets are common resources when congested. They are not excludable since anyone can drive on them. But they are rival in consumption since congestion means every additional driver slows down the progress of other drivers. When they are not congested, city streets are public goods since they are no longer rival in consumption.

b.

3.

The government may provide goods that are not public goods, such as education, because of the externalities associated with them.

Charlie loves watching Downton Abbey on his local public TV station, but he never sends any money to support the station during its fundraising drives. a. What name do economists have for people like Charlie? b. How can the government solve the problem caused by people like Charlie? c. Can you think of ways the private market can solve this problem? How does the existence of cable TV alter the situation? a.

Charlie is a free rider.

b.

The government could solve the problem by sponsoring the show and paying for it with tax revenue collected from everyone.

c.

The private market could also solve the problem by making people watch commercials that are incorporated into the program. The existence of cable TV makes the good excludable, so it would no longer be a public good.

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Chapter 11: Public Goods and Common Resources • 155 4.

5.

Some economists argue that private firms will not undertake the efficient amount of basic scientific research. a. Explain why this is so. In your answer, classify basic research in one of the categories shown in Figure 11.1. b. What sort of policy has Canada adopted in response to this problem? c. It is often argued that this policy increases the technological capability of Canadian producers relative to that of foreign firms. Is this argument consistent with your classification of basic research in part (a)?

(Hint: Can excludability apply to some potential beneficiaries of a public good and not others?) a.

Since knowledge is a public good, the benefits of basic scientific research are available to many people. The private firm does not take this into account when choosing how much research to undertake; it takes into account only what it will earn.

b.

Canada has tried to give private firms incentives to provide basic research by subsidizing it through organizations like the National Sciences and Engineering Research Council of Canada (NSERCC) and the Social Sciences and Humanities Research Council of Canada (SSHRCC).

c.

If it is basic research that adds to knowledge, it is not excludable at all, unless people in other countries can be prevented somehow from sharing that knowledge. So perhaps Canadian firms get a slight advantage because they hear about technological advances first, but knowledge tends to diffuse rapidly.

Why is there often litter along most highways but rarely in people’s yards?

When a person litters along a highway, others bear the negative externality, so the private costs are low. Littering in your own yard imposes costs on you, so it has a higher private cost and is thus rare.

6.

High-income people are willing to pay more than lower-income people to avoid the risk of death.

For example, they are more likely to pay for safety features on cars. Do you think cost–benefit analysts should take this fact into account when evaluating public projects? Consider, for instance, a rich town and a poor town, both of which are considering the installation of a traffic light. Should the rich town use a higher dollar value for a human life in making this decision?

Why or why not?

Recognizing that there are opportunity costs that are relevant for cost–benefit analysis is the key to answering this question. A richer community can afford to place a higher value on life and safety. So the richer community is willing to pay more for a traffic light, and that should be considered in cost–benefit analysis.

7.

Four roommates are planning to spend the weekend in their dorm room watching old movies, and they are debating how many to watch. The following table shows their willingness to pay for each film.

First film Second film Third film Fourth film Fifth film

Orson $7 6 5 4 3

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Alfred $5 4 3 2 1

Woody $3 2 1 0 0

Ingmar $2 1 0 0 0

156 • Chapter 11: Public Goods and Common Resources

a. Within the dorm room, is the showing of a movie a public good? Why or why not? b. If it costs $8 to rent a movie, how many movies should the roommates rent to maximize total surplus? c. If they choose the optimal number from part (b) and then split the cost of renting the movies equally, how much surplus does each person obtain from watching the movies? d. Is there any way to split the cost to ensure that everyone benefits? What practical problems does this solution raise? e. Suppose they agree in advance to choose the efficient number and to split the cost of the movies equally. When Orson is asked his willingness to pay, will he have an incentive to tell the truth? If so, why? If not, what will he be tempted to say? f. What does this example teach you about the optimal provision of public goods?

This problem concerns the determination of the optimal quantity of a public good.

8.

a.

Yes, showing a movie in the dorm room is a public good since nobody living there can be excluded from watching, and watching by one does not prevent another from doing the same.

b.

The roommates should buy an additional movie if the price is less than the sum of their willingness to pay, because otherwise the additional movie would decrease the total surplus. Total willingness to pay exceeds $8 for each of the three movies, but not for the fourth. Hence, they should buy three movies.

c.

The cost of renting 3 movies is $24. If they split the cost equally, each has to pay $6.

Orson’s surplus is ($7 + $6 + $5) – $6 = $12, Alfred’s is $12 – $6 = $6, Woody’s is zero, and Ingmar’s is –$3.

d.

There are several ways to split the cost such that everyone benefits. The problem is that all have an incentive to misreport their willingness to pay.

e.

If they agree in advance to split the cost equally, Orson will have an incentive to exaggerate his willingness to pay because, for each additional movie, his extra benefit exceeds his share of the extra cost, which is equal to $2.

f.

The optimal amount of a public good is determined by equating the sum of marginal benefits to the marginal cost of the public good. In practice, it is difficult to know people’s marginal benefits because they have an incentive to misrepresent their true preferences.

Wireless, high-speed Internet is provided for free in the airport of the city of Communityville. a. At first, only a few people use the service. What type of a good is this and why? b. Eventually, as more people find out about the service and start using it, the speed of the connection begins to fall. Now what type of a good is the wireless Internet service? c. What problem might result and why? What is one possible way to correct this problem? a.

Free Internet is a public good as long as it is not congested because anyone can use it and one more user has negligible effect on the others.

b.

When the connection becomes congested, free Internet is a common resource: nobody can be excluded but one more user significantly lowers the speed for the others.

c.

The problem with a common resource is that it cannot be allocated to its most efficient use. In other words, people who really need fast connection get the same speed as those who may not need it that much. One solution is to introduce a fee per use.

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Chapter 11: Public Goods and Common Resources • 157 9.

Two towns, each with three members, are deciding whether to put on a fireworks display to celebrate the New Year. Fireworks cost $360. In each town, some people enjoy fireworks more than others.

In the town of Bayport, each of the residents values the public good as follows: a.

Frank Joe Callie b.

c.

Would fireworks pass a cost–benefit analysis? Explain.

The mayor of Bayport proposes to decide by majority rule and, if the fireworks referendum passes, to split the cost equally among all residents. Who would vote in favour, and who would vote against? Would the vote yield the same answer as the cost–benefit analysis?

In the town of River Heights, each of the residents values the public good as follows: Nancy Bess Ned

d.

e.

$ 50 $100 $300

$ 20 $140 $160

Would fireworks pass a cost–benefit analysis? Explain.

The mayor of River Heights also proposes to decide by majority rule and, if the fireworks referendum passes, to split the cost equally among all residents. Who would vote in favour, and who would vote against? Would the vote yield the same answer as the cost–benefit analysis?

What do you think these examples say about the optimal provision of public goods?

a. The sum of the benefits of the fireworks in this case is $450 ($50 + $100 + $300), which is greater than the cost of $360. So the fireworks do pass a cost–benefit analysis and should be put on. b. Evenly splitting the cost of the fireworks would result in each resident paying $120 each ($360 divided by 3). This is less than the private benefit for Callie, who votes in favour of the fireworks, but more than the private benefit for Joe and Frank, who vote against. So the vote will not pass and the fireworks will not proceed. The vote will not yield the same result as the cost–benefit analysis in this case. c. In this case, the sum of the benefits of the fireworks is $320 ($20 + $140 + $160), which is less than the cost of $360. So the fireworks do not pass a cost–benefit analysis and should not be put on. d. In this case, the cost of $120 each is lower than the private benefit for Bess and Ned, who will vote in favour, but more than the private benefit for Nancy, who will vote against. So the vote will pass and the fireworks will proceed. The vote will not yield the same result as the cost–benefit analysis in this case. e. These examples show that using majority voting to determine the provision of public goods may not yield the appropriate outcome from a cost–benefit analysis perspective; public goods may be either over- or under-provided when put to a vote. The reason for this is that in a majority, voting does not reflect the intensity of preferences for a public good— each voter gets just one vote regardless of how much they may value the public good.

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158 • Chapter 11: Public Goods and Common Resources 10. The nation of Wiknam has 5 million residents, whose only activity is producing and consuming fish.

They produce fish in two ways. Each person who works on a fish farm raises 2 fish per day. Each person who goes fishing in one of the nation’s many lakes catches X fish per day. X depends on N, the number of residents (in millions) fishing in the lakes. In particular, if N million people fish in the lakes, each catches X = 6 – N fish. Each resident is attracted to the job that pays more fish, so in equilibrium the two jobs must offer equal pay. a. Why do you suppose that X, the productivity of each fisherman, falls as N, the number of fishermen, rises? What economic term would you use to describe the fish in the country’s lakes? Would the same description apply to the fish from the farms? Explain. b. The country’s Freedom Party thinks every individual should have the right to choose between fishing in the lakes and farming without government interference. Under its policy, how many of the residents would fish in the lakes and how many would work on fish farms? How many fish are produced? c. The country’s Efficiency Party thinks Wiknam should produce as many fish as it can. To achieve this goal, how many of the residents should fish in the lakes and how many should work on the farms? (Hint: Create a table that shows the number of fish produced—on farms, from the lakes, and in total—for each N from 0 to 5.) d. The Efficiency Party proposes achieving its goal by taxing each person fishing in the lakes by an amount equal to T fish per day. It will then distribute the proceeds equally among all Wiknam residents. (Fish are assumed to be divisible, so these rebates need not be whole numbers.) Calculate the value of T that would yield the outcome you derived in part (c). Compared with the Freedom Party’s hands-off policy, who benefits and who loses from the imposition of the Efficiency Party’s fishing tax? a.

The productivity of each fisherman declines as N rises because the fish in the town lakes are a common resource. The fish are not excludable but rival in consumption. The fish on the farm are private goods because they are excludable and rival in consumption.

b.

Four million residents would fish in the lakes and 1 million would fish on the farm. Each fisherman would catch 2 fish, so 10 million fish would be produced.

c.

The table below shows how total fish production varies with N:

# Fishermen at lakes (in millions) 5 4 3 2 1 0

Fish per fisherman at lakes 1 2 3 4 5 0

Total fish at lakes (in millions) 5 8 9 8 5 0

# Fishermen at farm (in millions) 0 1 2 3 4 5

Total fish at farm (in millions) 0 2 4 6 8 10

Total fish caught (in millions) 5 10 13 14 13 10

The greatest number of fish is produced when 2 million fishermen fish at the lakes while the other 3 million fish at the farm. A total of 14 million fish would be produced.

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Chapter 11: Public Goods and Common Resources • 159 d.

The tax would have to be slightly larger than 1 (such as 1.01). Then only 2 million fishermen would want to fish in the lake. Number of fishermen (in millions) N = 2 must satisfy the equation X ’ = 2, which gives 6 – 2 –T = 2, or T = 2. Each fisherman catches 6 – 2 = 4 fish, of which 2 go to the local government in taxes and 2 is each fisherman’s net earnings. Government revenue = 2 × 2 million fish = 4 million fish. There are now 3 million residents working on the farm, each earning 2 fish. The government redistributes 4 million fish to 5 million residents, 4/5 = 0.8 fish per resident, such that each resident ends up at the end of the day with 2.8 fish. This is an improvement for everyone with respect to the no-regulation situation where each earned 2 fish from either the farm or the lakes. However, the 2 million fishermen catching fish in the lakes may perceive it as unfair because they have to share half of their catch with the farm workers.

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Chapter 12 The Design of the Tax System SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

What are the two most important sources of tax revenue for the federal government? • What are the two most important sources of tax revenue for provincial and territorial governments?

The two most important sources of tax revenue for the federal government are personal and corporate income taxes. The two most important sources of tax revenue for provincial/territorial are personal income taxes and corporate income taxes.

2.

What is meant by the efficiency of a tax system? • What can make a tax system inefficient?

The efficiency of a tax system refers to how low the costs are of collecting a given amount of tax revenue. One tax system is more efficient than another if the same amount of tax revenue can be raised at a lower cost.

A tax system can be inefficient because of the deadweight losses that result when taxes distort the decisions that people make and because of the administrative burdens that taxpayers bear as they comply with the tax laws. An efficient tax system has low deadweight losses and small administrative burdens.

3.

Explain the benefits principle and the ability-to-pay principle. • What are vertical equity and horizontal equity? • Why is studying tax incidence important for determining the equity of a tax system?

The benefits principle is the idea that people should pay taxes based on the benefits they receive from government services. It tries to make public goods similar to private goods by making those who benefit more from the public good pay more for it. The ability-to-pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden. It tries to equalize the sacrifice each person makes toward paying taxes.

Vertical equity is the idea that taxpayers with greater ability to pay taxes should pay larger amounts. Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should pay the same amount.

Studying tax incidence is important for determining the equity of a tax system because understanding how equitable the tax system is requires understanding the indirect effects of taxes. In many cases, the burden of the tax is borne by people other than those who actually pay the tax.

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162 • Chapter 12: The Design of the Tax System Questions for Review 1.

2.

Over the past several decades, has government grown more or less slowly than the rest of the economy?

Over the past several decades, government has grown more rapidly than the rest of the economy. The ratio of government revenue to GDP has increased over time.

What are the two most important sources of revenue for the federal government?

The two most important sources of revenue for the Canadian federal government are personal income taxes (about 48 percent of total revenue) and corporate income taxes (about 14 percent).

3.

Why is the burden of a tax to taxpayers greater than the revenue received by the government?

The burden of a tax to taxpayers is greater than the revenue received by the government because (1) taxes impose deadweight losses by reducing the quantity of goods produced and purchased below their efficient level, and (2) taxes entail a costly administrative burden on taxpayers.

4.

Why do some economists advocate taxing consumption rather than income?

Some economists advocate taxing consumption rather than income because taxing income discourages saving. A consumption tax would not distort people’s saving decisions.

5.

Give two arguments why wealthy taxpayers should pay more taxes than poor taxpayers.

Wealthy taxpayers should pay more taxes than poor taxpayers because (1) they benefit more from public services, and (2) they have a greater ability to pay.

6.

What is the concept of horizontal equity, and why is it hard to apply?

Horizontal equity refers to the idea that families in the same economic situation should be taxed equally. The concept of horizontal equity is hard to apply because families differ in many ways, so it is not obvious how to tax them equitably. For example, two families with the same income may have different numbers of children and different levels of medical expenses.

Quick Check Multiple Choice

1. What are the two largest sources of tax revenue for the Canadian federal government? a. individual and corporate income taxes b. individual income taxes and payroll taxes for social insurance c. corporate income taxes and payroll taxes for social insurance d. payroll taxes for social insurance and property taxes 2. Andy gives piano lessons. He has an opportunity cost of $50 per lesson and charges $60. He has two students: Bob, who has a willingness to pay of $70, and Carl, who has a willingness to pay of $90.

When the government puts a $20 tax on piano lessons and Andy raises his price to $80, the deadweight loss is ___ and the tax revenue is ___. a. $10, $20 b. $10, $40 c. $20, $20 d. $20, $40 Copyright © 2020 Nelson Education Ltd.

Chapter 12: The Design of the Tax System • 163

3. If the tax code exempts the first $20 000 of income from taxation and then taxes 25 percent of all income above that level, then a person who earns $50 000 has an average tax rate of ___ percent and a marginal tax rate of ___ percent. a. 15, 25 b. 25, 15 c. 25, 30 d. 30, 25 4. A toll is a tax on those citizens who use toll roads. This policy can be viewed as an application of which of the following? a. the benefits principle b. horizontal equity c. vertical equity d. tax progressivity 5. If the corporate income tax induces businesses to reduce their capital investment, then which of the following is true? a. the tax does not have any deadweight loss b. corporate shareholders benefit from the tax c. workers bear some of the burden of the tax d. the tax achieves the goal of vertical equity

1. a 2. c 3. a 4. a 5. c

Problems and Applications 1.

Government spending in Canada has grown as a share of national income over time. What changes in our economy and our society might explain this trend? Do you expect the trend to continue?

Government spending has grown over time as our society has come to rely on the government to provide a social safety net, including medical care for everyone. The trend is likely to continue as the average age of the population increases.

2.

In a published source or on the Internet, find out whether the Canadian federal government had a budget deficit or surplus last year. What do policymakers expect to happen over the next few years?

According to Table 10-10-0147-01 (formerly CANSIM 385-0042), the consolidated net operating balance for 2018 was a surplus of $1.58 billion.

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164 • Chapter 12: The Design of the Tax System 3.

4.

Explain how individuals’ behaviour is affected by the following features of the federal tax laws. a. Contributions to charity are tax deductible. b. Sales of beer are taxed. c. Realized capital gains are taxed, but accrued gains are not. (When someone owns a share of stock that rises in value, she has an “accrued” capital gain. If she sells the share, she has a “realized” gain.) a.

Because contributions to charity are tax deductible, people donate more to charity than they otherwise would.

b.

Because sales of beer are taxed, people buy less beer than they otherwise would.

c.

Because realized capital gains are taxed but accrued gains are not people sell assets that have fallen in value, but they do not sell assets that have appreciated so that they can avoid paying taxes on their gains.

Suppose that your province raises its sales tax from 5 percent to 6 percent. The government forecasts a 20 percent increase in sales tax revenue. Is this plausible? Explain.

If the province raises its sales tax from 5 percent to 6 percent, it is not plausible that sales tax revenue will increase 20 percent. The increase in the tax rate is 20 percent, so the only way tax revenue could increase 20 percent would be if total spending did not fall in response to the tax increase, which is unlikely. Instead, the higher tax would raise the price of goods, so people would spend less. Thus tax revenue might go up, because the tax rate is higher, but by less than 20 percent. There is even some possibility that tax revenues will fall.

5.

6.

Categorize each of the following funding schemes as examples of the benefits principle or the ability-to-pay principle. a. Visitors to many national parks pay an entrance fee. b. Local property taxes support elementary and secondary schools. c. An airport trust fund collects a tax on each plane ticket sold and uses the money to improve airports and the air traffic control system. a.

The fact that visitors to many national parks pay an entrance fee is an example of the benefits principle, since people are paying for the benefits they receive.

b.

The fact that local property taxes support elementary and secondary schools is an example of the ability-to-pay principle, since if you own more expensive property you must pay more tax.

c.

The setup of airport trust funds is an example of the benefits principle, since use of the airport generates a tax that pays for upkeep of the airport.

Any income tax schedule embodies two types of tax rates—average tax rates and marginal tax rates. a. The average tax rate is defined as total taxes paid divided by income. For the proportional tax system presented in Table 12.8, what are the average tax rates for people earning $50 000, $100 000, and $200 000? What are the corresponding average tax rates in the regressive and progressive tax systems? b. The marginal tax rate is defined as the extra taxes paid on additional income divided by the increase in income. Calculate the marginal tax rate for the proportional tax system as income rises from $50 000 to $100 000. Calculate the marginal tax rate as income rises from $100 000 to $200 000. Calculate the corresponding marginal tax rates for the regressive and progressive tax systems.

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Chapter 12: The Design of the Tax System • 165

c. Describe the relationship between average tax rates and marginal tax rates for each of these three systems. In general, which rate is relevant for someone deciding whether to accept a job that pays slightly more than her current job? Which rate is relevant for judging the vertical equity of a tax system? a.

For the proportional tax system, the average tax rate is 25 percent, whether a person earns income of $50 000, $100 000, or $200 000.

For the regressive tax system, the average tax rate is 30 percent for someone earning $50 000, 25 percent for someone earning $100 000, and 20 percent for someone earning $200 000.

For the progressive tax system, the average tax rate is 20 percent for someone earning $50 000, 25 percent for someone earning $100 000, and 30 percent for someone earning $200 000.

b.

For the proportional tax system, the marginal tax rate as income rises from $50 000 to $100 000 is the increase in taxes ($12 500) divided by the increase in income ($50 000) = 25 percent. The marginal tax rate as income rises from $100 000 to $200 000 is the increase in taxes ($25 000) divided by the increase in income ($100 000) = 25 percent.

For the regressive tax system, the marginal tax rate as income rises from $50 000 to $100 000 is the increase in taxes ($10 000) divided by the increase in income ($50 000) = 20 percent. The marginal tax rate as income rises from $100 000 to $200 000 is the increase in taxes ($15 000) divided by the increase in income ($100 000) = 15 percent.

For the progressive tax system, the marginal tax rate as income rises from $50 000 to $100 000 is the increase in taxes ($15 000) divided by the increase in income ($50 000) = 30 percent. The marginal tax rate as income rises from $100 000 to $200 000 is the increase in taxes ($35 000) divided by the increase in income ($100 000) = 35 percent.

c.

7.

In the proportional tax system, the average tax rate equals the marginal tax rate. In the regressive tax system, the marginal tax rate is less than the average tax rate, and both tax rates decline as income rises. In the progressive tax system, the marginal tax rate is greater than the average tax rate, and both tax rates rise as income rises. The marginal tax rate is relevant to someone deciding whether to accept a job that pays slightly more than her current job, since it tells her how much of the extra income she will be able to keep after taxes. For judging the vertical equity of a tax system, the average tax rate is relevant, since vertical equity suggests that people with a greater ability to pay should pay a larger amount.

If a salesperson takes a client to lunch, part of the cost of the lunch is a deductible business expense for his/her company. Some MPs have argued that this feature of the tax laws benefits relatively wealthy businesspeople and should be eliminated. Yet their arguments have been met with greater opposition from eating and drinking establishments than from companies themselves. Explain.

Eliminating the tax deduction for meals would reduce the amount of lunches to which corporate executives take clients. However, the incidence would not be borne entirely by corporations, but instead by eating and drinking establishments that would lose a substantial portion of their business.

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166 • Chapter 12: The Design of the Tax System 8.

Provincial/territorial welfare programs have very high “clawback” rates. For example, when a person receiving welfare earns money from employment, that person’s welfare payments decline by as much as 75 cents for each dollar earned. What do you think is the effect of this feature of welfare programs on the labour supply of low-income individuals? Explain.

There would be a disincentive to seek employment that earns considerable income as welfare payments would be reduced significantly. As a result, the labour supply of low-income individuals falls as people stop working.

9.

10.

Federal payroll taxes to fund the EI program are levied at a combined rate of 3.89 percent up to an income ceiling of $53 100. a. If there was no limit on the income level at which these taxes apply, would they be proportional, progressive, or regressive? With the limit, are the taxes proportional, progressive, or regressive? b. The amount of EI benefits that people receive depends on the amount of payroll taxes they paid. Relative to people who had low earnings, people who had higher earnings and paid more in taxes receive more benefits, but not proportionally more. Does this feature of the EI system make EI a progressive or a regressive payroll tax? a.

One could consider such a tax as being proportional as taxpayers would be paying the same fraction of income.

b.

EI would be a regressive tax as employees earning under the $53 100 ceiling are paying a rate of 3.89 percent of wages on their entire income, while earnings in excess of $53 100 are not subject to tax. However, for the 0 through $53 100 range the system is progressive, because on net (benefits – contributions), richer people pay more than poorer people as a percent of their income.

What is the efficiency justification for taxing consumption rather than income? Suppose that Ottawa reduced personal tax rates and, to raise the same amount of revenue, increased the GST rate. Would this make the Canadian tax system more or less progressive? Explain.

The efficiency justification for taxing consumption rather than income is that taxing income discourages saving. If Canada were to adopt a consumption tax, the Canadian tax system would become less progressive because the poor spend a greater proportion of their income than the rich. However, tax rates could be modified or deductions increased to make the tax more progressive.

11.

Payroll taxes to fund the EI system are paid by both employees and employers. Does this legal division of responsibility indicate the true incidence of these taxes? Explain.

No. The true incidence of taxes does not depend on who has the legal responsibility of paying the taxes, but on the relative elasticities of the demand and supply of labour. Less relative elasticity of demand (or supply) implies more tax burden.

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Chapter 13 The Costs of Production SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Farmer McDonald gives banjo lessons for $20 an hour. One day, he spends 10 hours planting $100 worth of seeds on his farm. What opportunity cost has he incurred? What cost would his accountant measure? If these seeds will yield $200 worth of crops, does McDonald earn an accounting profit? Does he earn an economic profit?

Farmer McDonald’s opportunity cost is $300, consisting of 10 hours of lessons at $20 an hour that he could have been earning plus $100 in seeds. His accountant would not count the lost banjo lesson money, only the seeds worth $100. If McDonald earns $200 from selling the crops, then McDonald earns a $100 accounting profit ($200 sales minus $100 cost of seeds) but makes an economic loss of $100 ($200 sales minus $300 opportunity cost).

2.

If Farmer Jones plants no seeds on his farm, he gets no harvest. If he plants 1 bag of seeds, he gets 3 bushels of wheat. If he plants 2 bags, he gets 5 bushels. If he plants 3 bags, he gets 6 bushels. A bag of seeds costs $100, and seeds are his only cost. Use these data to graph the farmer’s production function and total-cost curve. Explain their shapes.

Farmer Jones’s production function is shown in Figure 1 and his total-cost curve is shown in Figure 2. The production function is concave because of diminishing marginal product. As the number of bags of seeds increases, the marginal product declines, and the production function becomes flatter. The total-cost curve is convex, as the curve gets steeper as the amount of production increases. That is also a feature that arises because of diminishing marginal product, since each additional bag of seeds has lower marginal product, and thus the cost of producing additional bushels of wheat goes up.

Figure 1

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Figure 2

168 • Chapter 13: The Costs of Production 3.

Suppose Honda’s total cost of producing 4 cars is $225 000 and its total cost of producing 5 cars is $250 000. What is the average total cost of producing 5 cars? What is the marginal cost of the fifth car? • Draw the marginal-cost curve and the average-total-cost curve for a typical firm, and explain why these curves cross where they do.

The average total cost of producing five cars is $250 000/5 = $50 000. Since total cost rose from $225 000 to $250 000 when output increased from four to five, the marginal cost of the fifth car is $25 000.

The marginal-cost curve and the average-total-cost curve for a typical firm are shown in Figure 3. They cross at the efficient scale because at low levels of output marginal cost is below average total cost, so average total cost is falling. But after the two curves cross, marginal cost rises above average total cost, and average total cost starts to rise. So the point of intersection must be the minimum of average total cost.

Figure 3 4.

If Bombardier produces 9 jets per month, its long-run total cost is $9.0 million per month. If it produces 10 jets per month, its long-run total cost is $9.5 million per month. Does Bombardier exhibit economies or diseconomies of scale?

The long-run average total cost of producing 9 planes is $9 million/9 = $1 million. The longrun average total cost of producing 10 planes is $9.5 million/10 = $0.95 million. Since the long-run average total cost declines as the number of planes increases, Bombardier exhibits economies of scale.

Questions for Review 1.

What is the relationship between a firm’s total revenue, profit, and total cost?

The relationship between a firm’s total revenue, profit, and total cost is profit equals total revenue minus total costs.

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Chapter 13: The Costs of Production • 169 2.

Give an example of an opportunity cost that an accountant might not count as a cost. Why would the accountant ignore this cost?

An accountant would not count the owner’s opportunity cost of alternative employment as an accounting cost. An example is given in the text in which Caroline runs a cookie business, but she could instead work as a computer programmer. Because she’s working in her cookie factory, she gives up the opportunity to earn $100 per hour as a computer programmer. The accountant ignores this opportunity cost because no money flow occurs. But the cost is relevant to Caroline’s decision to run the cookie factory.

3.

What is marginal product, and what does it mean if it is diminishing?

Marginal product is the increase in output that arises from an additional unit of input.

Diminishing marginal product means that the marginal product of an input declines as the quantity of the input increases.

4.

Draw a production function that exhibits diminishing marginal product of labour. Draw the associated total-cost curve. (In both cases, be sure to label the axes.) Explain the shapes of the two curves you have drawn.

Quantity of Output

Figure 4 shows a production function that exhibits diminishing marginal product of labour.

Figure 5 shows the associated total-cost curve. The production function is concave because of diminishing marginal product, while the total-cost curve is convex for the same reason.

Quantity of Labour

Figure 4 5.

Figure 5

Define total cost, average total cost, and marginal cost. How are they related?

Total cost consists of the costs of all inputs needed to produce a given quantity of output. It includes fixed costs and variable costs. Average total cost is the cost of a typical unit of output and is equal to total cost divided by the quantity produced. Marginal cost is the cost of producing an additional unit of output and is equal to the change in total cost divided by the change in quantity. An additional relation between average total cost and marginal cost is that whenever marginal cost is less than average total cost, average total cost is declining; whenever marginal cost is greater than average total cost, average total cost is rising.

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170 • Chapter 13: The Costs of Production 6.

Draw the marginal-cost and average-total-cost curves for a typical firm. Explain why the curves have the shapes that they do and why they cross where they do.

Figure 6 shows the marginal-cost curve and the average-total-cost curve for a typical firm. It has three main features: (1) marginal cost is initially rising; (2) average total cost is U-shaped; and (3) whenever marginal cost is less than average total cost, average total cost is declining and whenever marginal cost is greater than average total cost, average total cost is rising. Marginal cost is rising for output greater than a certain quantity because, in the short run, the firm must hire additional labour to produce more output without being able to buy additional equipment. The average-total-cost curve is U-shaped because the firm initially is able to spread out fixed costs over additional units, but as quantity increases, it costs more to increase quantity further because some important input is limited. Marginal cost and average total cost have the relationship they do because marginal cost pulls average total cost in the same direction. The marginal-cost and average-total-cost curves intersect at the minimum of average total cost; that quantity is the efficient scale.

Figure 6 7.

How and why does a firm’s average-total-cost curve differ in the short run compared with the long run?

In the long run, a firm can adjust the factors of production that are fixed in the short run; for example, it can increase the size of its factory. As a result, the long-run average-total-cost curve has a much flatter U-shape than the short-run average-total-cost curve. In addition, the long-run curve lies along the lower envelope of the short-run curves.

8.

Define economies of scale and explain why they might arise. Define diseconomies of scale and explain why they might arise.

Economies of scale exist when long-run average total cost falls as the quantity of output increases, which occurs because of specialization among workers. Diseconomies of scale exist when long-run average total cost rises as the quantity of output increases, which occurs because of coordination problems inherent in a large organization.

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Chapter 13: The Costs of Production • 171 Quick Check Multiple Choice

1. Raj opens up a lemonade stand for two hours. He spends $10 for ingredients and sells $60 worth of lemonade. In the same two hours, he could have mowed his neighbour’s lawn for $40. Raj has an accounting profit of ___ and an economic profit of ___. a. $50, $10 b. $90, $50 c. $10, $50 d. $50, $90 2. Diminishing marginal product explains why, as a firm’s output increases, which of the following is likely to occur? a. the production function and total-cost curve both get steeper b. the production function and total-cost curve both get flatter c. the production function gets steeper, while the total-cost curve gets flatter d. the production function gets flatter, while the total-cost curve gets steeper 3. A firm is producing 1000 units at a total cost of $5000. If it were to increase production to 1001 units, its total cost would rise to $5008. What does this information tell you about the firm? a. Marginal cost is $5, and average variable cost is $8. b. Marginal cost is $8, and average variable cost is $5. c. Marginal cost is $5, and average total cost is $8. d. Marginal cost is $8, and average total cost is $5.

4. A firm is producing 20 units with an average total cost of $25 and marginal cost of $15. If it were to increase production to 21 units, which of the following must occur? a. Marginal cost would decrease. b. Marginal cost would increase. c. Average total cost would decrease. d. Average total cost would increase.

5. The government imposes a $1000-per-year licence fee on all pizza restaurants. Which cost curves shift as a result? a. average total cost and marginal cost b. average total cost and average fixed cost c. average variable cost and marginal cost d. average variable cost and average fixed cost 6. If a higher level of production allows workers to specialize in particular tasks, a firm will likely exhibit ___ of scale and ___ average total cost. a. economies, falling b. economies, rising c. diseconomies, falling d. diseconomies, rising 1. a 2. d 3. d 4. c 5. b 6. a

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172 • Chapter 13: The Costs of Production Problems and Applications 1.

This chapter discusses many types of costs: opportunity cost, total cost, fixed cost, variable cost, average total cost, and marginal cost. Fill in the type of cost that best completes each phrase below: a. The true cost of taking some action is its ___. b. ___ is falling when marginal cost is below it, and rising when marginal cost is above it. c. A cost that does not depend on the quantity produced is a(n) ___. d. In the ice-cream industry in the short run, ___ includes the cost of cream and sugar, but not the cost of the factory. e. Profits equal total revenue less ___. f. The cost of producing an extra unit of output is the ___. a. opportunity cost b. Average total cost c. fixed cost d. variable cost e. total cost f. marginal cost

2.

3.

Your aunt is thinking about opening a hardware store. She estimates that it would cost $500 000 per year to rent the location and buy the stock. In addition, she would have to quit her $50 000 per year job as an accountant. a. Define opportunity cost. b. What is your aunt’s opportunity cost of running a hardware store for a year? If your aunt thought she could sell $510 000 worth of merchandise in a year, should she open the store? Explain. a.

The opportunity cost of something is what must be forgone to acquire it.

b.

The opportunity cost of running the hardware store is $550 000, consisting of $500 000 to rent the store and buy the stock and a $50 000 opportunity cost, since your aunt would quit her job as an accountant to run the store. Since the total opportunity cost of $550 000 exceeds revenue of $510 000, your aunt should not open the store, as her economic profit would be negative—she would be worse off.

The city government is considering two tax proposals: • a lump-sum tax of $300 on each producer of hamburgers • a tax of $1 per burger, paid by producers of hamburgers a. Which of the following curves—average fixed cost, average variable cost, average total cost, and marginal cost—would shift as a result of the lump-sum tax? Why? Show this in a graph. Label the graph as precisely as possible. b. Which of these same four curves would shift as a result of the per-burger tax?

Why? Show this in a new graph. Label the graph as precisely as possible.

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Chapter 13: The Costs of Production • 173 a.

The lump-sum tax is a fixed cost for any producer who chooses to remain in business for the year. The average-fixed-cost and average-total-cost curves shift. Figure 7 shows these changes.

Costs

ATC2 ATC1

AFC2 AFC1 Quantity of Hamburgers Figure 7 b.

The per-unit tax increases marginal, average variable, and average total costs.

Figure 8 shows the shifts in the three curves. (The ATC curves are represented in thin lines and are not labelled to keep the graph readable.)

Costs

MC2 AVC2 MC1 AVC1 $1

Quantity of Hamburgers Figure 8

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174 • Chapter 13: The Costs of Production 4.

A commercial fisherman notices the following relationship between hours spent fishing and the quantity of fish caught: Hours 0 1 2 3 4 5

Quantity of Fish (in kilograms) 0 10 18 24 28 30

a. What is the marginal product of each hour spent fishing? b. Use these data to graph the fisherman’s production function. Explain its shape. c. The fisherman has a fixed cost of $10 (his pole). The opportunity cost of his time is $5 per hour. Graph the fisherman’s total-cost curve. Explain its shape. a.

Hours 0 1 2 3 4 5 b.

The following table shows the marginal product of each hour spent fishing: Fish 0 10 18 24 28 30

Fixed Cost $10 10 10 10 10 10

Variable Cost $0 5 10 15 20 25

Total Cost $10 15 20 25 30 35

Marginal Product --10 8 6 4 2

Figure 9 graphs the fisherman’s production function. The production function becomes flatter as the number of hours spent fishing increases, illustrating diminishing marginal product.

Figure 9 c.

The table in part (a) shows the fixed cost, variable cost, and total cost of fishing.

Figure 10 shows the fisherman’s total-cost curve. It slopes up because catching additional fish takes additional time. The curve is convex because there are diminishing returns to fishing time—each additional hour spent fishing yields fewer additional fish.

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Chapter 13: The Costs of Production • 175

Figure 10 5.

Nimbus Ltd. makes brooms and then sells them door to door. Here is the relationship between the number of workers and Nimbus’s output in a given day:

Workers 0 1 2 3 4 5 6 7

Output 0 20 50 90 120 140 150 155

Marginal Product ___ ___ ___ ___ ___ ___ ___ ___

Total Cost -------------------------

Average Total Cost -------------------------

Marginal Cost ____ ____ ____ ____ ____ ____ ____ ____

a. Fill in the column of marginal products. What pattern do you see? How might you explain it? b. A worker costs $100 per day, and the firm has fixed costs of $200. Use this information to fill in the column for total cost. c. Fill in the column for average total cost. (Recall that ATC = TC/Q.) What pattern do you see? d. Now fill in the column for marginal cost. (Recall that MC = ∆TC/∆Q.) What pattern do you see? e. Compare the column for marginal product and the column for marginal cost.

Explain the relationship. f. Compare the column for average total cost and the column for marginal cost.

Explain the relationship.

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176 • Chapter 13: The Costs of Production Here is the table of costs:

Workers 0 1 2 3 4 5 6 7

6.

Output 0 20 50 90 120 140 150 155

Marginal Product --20 30 40 30 20 10 5

Total Cost $200 300 400 500 600 700 800 900

Average Total Cost --$15.00 8.00 5.56 5.00 5.00 5.33 5.81

Marginal Cost --$5.00 3.33 2.50 3.33 5.00 10.00 20.00

a.

See the table for marginal product. Marginal product rises at first, then declines because of diminishing marginal product.

b.

See the table for total cost.

c.

See the table for average total cost. Average total cost is U-shaped. When quantity is low, average total cost declines as quantity rises; when quantity is high, average total cost rises as quantity rises.

d.

See the table for marginal cost. Marginal cost is also U-shaped, but rises steeply as output increases. This is due to diminishing marginal product.

e.

When marginal product is rising, marginal cost is falling, and vice versa.

f.

When marginal cost is less than average total cost, average total cost is falling; the cost of the last unit produced pulls the average down. When marginal cost is greater than average total cost, average total cost is rising; the cost of the last unit produced pushes the average up. Marginal cost equals average total cost at minimum average total cost.

A firm uses two inputs in production: capital and labour. In the short run, the firm cannot adjust the amount of capital it is using, but it can adjust the size of its workforce. What happens to the firm’s average total cost curve, the average variable cost curve, and the marginal cost curve when a. the cost of renting capital increases? b. the cost of hiring labour increases? a.

Cost of capital is fixed in the short run. When the cost of capital increases, the firm’s average-total-cost curve shifts up, while the average variable cost and marginal costs do not change.

b.

Costs of labour are variable. When they increase, the marginal, average-variable, and average-total-cost curves shift upward.

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Chapter 13: The Costs of Production • 177 7.

Consider the following cost information for a pizzeria: Q (dozens) 0 1 2 3 4 5 6

Total Cost $300 350 390 420 450 490 540

Variable Cost $ 0 50 90 120 150 190 240

a. What is the pizzeria’s fixed cost? b. Construct a table in which you calculate the marginal cost per dozen pizzas using the information on total cost. Also calculate the marginal cost per dozen pizzas using the information on variable cost. What is the relationship between these sets of numbers? Comment. a.

The fixed cost is $300, since fixed cost equals total cost minus variable cost.

b.

Quantity 0 1 2 3 4 5 6

Total Cost $300 350 390 420 450 490 540

Variable Cost $0 50 90 120 150 190 240

Marginal Cost (using total cost) --$50 40 30 30 40 50

Marginal Cost (using variable cost) --$50 40 30 30 40 50

Marginal cost equals the change in total cost or the change in variable cost. That is because total cost equals variable cost plus fixed cost, and fixed cost does not change as the quantity changes. So, as quantity increases, the increase in total cost equals the increase in variable cost and both are equal to marginal cost.

8.

You are thinking about setting up a coffee stand. The stand itself costs $200. The ingredients for each cup of coffee cost $0.50. a. What is your fixed cost of doing business? What is your variable cost per cup? b. Construct a table showing your total cost, average total cost, and marginal cost for output levels varying from 0 to 40 L. (Hint: There are 4 cups in a litre.) Draw the three cost curves. a.

The fixed cost of setting up the coffee stand is $200. The variable cost per cup is $0.50.

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178 • Chapter 13: The Costs of Production

(×4L) Quantity of Coffee (x4L)

Figure 11 b.

The following table shows total cost, average total cost, and marginal cost (quantity is in multiples of 4 litres). These are plotted in Figure 11.

Quantity (×4L) 0 1 2 3 4 5 6 7 8 9 10

Total Cost $200 208 216 224 232 240 248 256 264 272 280

Average Total Cost --$208 108 74.7 58 48 41.3 36.6 33 30.2 28

Marginal Cost --$8 8 8 8 8 8 8 8 8 8

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Chapter 13: The Costs of Production • 179 9.

Your cousin Vinnie owns a painting company with fixed costs of $200 and the following schedule for variable costs: Quantity of Houses Painted per Month 1 Variable Costs $10

2 $20

3 $40

4 $80

5 $160

6 $320

7 $640

Calculate average fixed cost, average variable cost, and average total cost for each quantity.

What is the efficient scale of the painting company?

The following table illustrates average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC) for each quantity. The efficient scale is four houses per month, since that minimizes average total cost.

Quantity 0 1 2 3 4 5 6 7 10.

Variable Cost $0 10 20 40 80 160 320 640

Fixed Cost $200 200 200 200 200 200 200 200

Total Cost $200 210 220 240 280 360 520 840

Average Fixed Cost --$200 100 66.7 50 40 33.3 28.6

Average Variable Cost --$10 10 13.3 20 32 53.3 91.4

Average Total Cost --$210 110 80 70 72 86.7 120

Jane’s Juice Bar has the following cost schedules: Q (vats) 0 1 2 3 4 5 6

Variable Cost $ 0 10 25 45 70 100 135

Total Cost $ 30 40 55 75 100 130 165

a. Calculate average variable cost, average total cost, and marginal cost for each quantity. b. Graph all three curves. What is the relationship between the marginal-cost curve and the average-total-cost curve? Between the marginal-cost curve and the average-variable-cost curve? Explain.

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180 • Chapter 13: The Costs of Production a.

The following table shows average variable cost (AVC), average total cost (ATC), and marginal cost (MC) for each quantity.

Quantity 0 1 2 3 4 5 6

b.

Variable Cost $0 10 25 45 70 100 135

Total Cost $30 40 55 75 100 130 165

Average Variable Cost --$10 12.5 15 17.5 20 22.5

Average Total Cost --$40 27.5 25 25 26 27.5

Marginal Cost --$10 15 20 25 30 35

Figure 12 graphs the three curves. The marginal-cost curve is below the averagetotal-cost curve when output is less than 4, as average total cost is declining. The marginal-cost curve is above the average-total-cost curve when output is above 4, as average total cost is rising. The marginal-cost curve lies above the average variable cost curve.

Figure 12 11.

Consider the following table of long-run total cost for three different firms: Quantity

1

2

3

4

5

6

7

Firm A Firm B Firm C

$60 11 21

$70 24 34

$80 39 49

$90 56 66

$100 75 85

$110 96 106

$120 119 129

Does each of these firms experience economies of scale or diseconomies of scale?

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Chapter 13: The Costs of Production • 181 The following table shows quantity (Q ), total cost (TC ), and average total cost (ATC ) for the three firms:

Quantity 1 2 3 4 5 6 7

Firm A TC ATC 60 60 70 35 80 26.7 90 22.5 100 20 110 18.3 120 17.1

Firm B TC ATC 11 11 24 12 39 13 56 14 75 15 96 16 119 17

Firm C TC ATC 21 21 34 17 49 16.3 66 16.5 85 17 106 17.7 129 18.4

Firm A has economies of scale since average total cost declines as output increases. Firm B has diseconomies of scale since average total cost rises as output rises. Firm C has economies of scale for output from 1 to 3, then diseconomies of scale for greater levels of output.

12.

You are the chief financial officer for a firm that sells digital music players. Your firm has the following average total cost schedule: Quantity 600 players 601 players

Average Total Cost $300 301

Your current level of production is 600 devices, all of which have been sold. Someone calls, desperate to buy one of your music players. The caller offers you $550 for it. Should you accept the offer? Why or why not?

The total cost of producing 600 players is 600 × $300 = $180 000; the total cost of producing 601 players is 601 × $301 = $180 901. Hence, the marginal cost of producing one more player is $901, which is greater than what the client offers. The offer should not be accepted because it reduces total profit.

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Chapter 14 Firms in Competitive Markets SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

When a competitive firm doubles the amount it sells, what happens to the price of its output and its total revenue?

When a competitive firm doubles the amount it sells, the price remains the same, so its total revenue doubles.

2.

How does the price faced by a profit-maximizing competitive firm compare to its marginal cost?

Explain. • When does a profit-maximizing competitive firm decide to shut down? When does a profit-maximizing competitive firm decide to exit a market?

The price faced by a profit-maximizing firm is equal to its marginal cost because if price were above marginal cost, the firm could increase profits by increasing output, while if price were below marginal cost, the firm could increase profits by decreasing output.

A profit-maximizing firm decides to shut down in the short run when price is less than average variable cost. In the long run, a firm will exit a market when price is less than average total cost.

3.

In the long run with free entry and exit, is the price in a market equal to marginal cost, average total cost, both, or neither? Explain with a diagram.

In the long run with free entry and exit, the price in the market is equal to both a firm’s marginal cost and its average total cost, as Figure 1 shows. The firm chooses its quantity so that marginal cost equals price; doing so ensures that the firm is maximizing its profit. In the long run, entry into and exit from the industry drive the price of the good to the minimum point on the averagetotal-cost curve. In the long run equilibrium, the firm’s economic profits are therefore zero.

Figure 1

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184 • Chapter 14: Firms in Competitive Markets Questions for Review 1.

What are the main characteristics of a competitive firm?

A competitive firm is a firm in a market in which (1) there are many buyers and many sellers in the market; (2) the goods offered by the various sellers are largely the same; and (3) usually, firms can freely enter or exit the market.

2.

Explain the difference between a firm’s revenue and its profit. Which do firms maximize?

Revenue is the price of a good times the quantity sold, and is equal to the dollar value of total sales. Profit is equal to revenue minus the cost of producing the goods. Profit is thus a measure of the net benefit (revenue minus cost) to the firm of producing the good. Firms maximize profits, not revenue.

3.

Draw the cost curves for a typical firm. For a given price, explain how the firm chooses the level of output that maximizes profit. At that level of output, show on your graph the firm’s total revenue and total costs.

Figure 2 shows the cost curves for a typical firm. For a given price (such as P ), the level of output that maximizes profit is the output where marginal cost equals price (Q*), as long as price is greater than average variable cost at that point (in the short run), or greater than average total cost (in the long run). The darker (upper) rectangle measures profit; the lighter (lower) one measures total cost, and their sum is total revenue.

Figure 2 4.

Under what conditions will a firm shut down temporarily? Explain.

A firm will shut down temporarily if the revenue it would get from producing is less than the variable costs of production. This occurs if price is less than average variable cost.

5.

Under what conditions will a firm exit a market? Explain.

A firm will exit a market if the revenue it would get if it stayed in business is less than its total cost. This occurs if price is less than average total cost.

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Chapter 14: Firms in Competitive Markets • 185 6.

Does a firm’s price equal marginal cost in the short run, in the long run, or both? Explain.

A firm’s price equals marginal cost in both the short run and the long run. In both the short run and the long run, price equals marginal revenue. The firm should increase output as long as marginal revenue exceeds marginal cost, and reduce output if marginal revenue is less than marginal cost. Profits are maximized when marginal revenue equals marginal cost.

7.

Does a firm’s price equal the minimum of average total cost in the short run, in the long run, or both? Explain.

The firm’s price equals the minimum of average total cost only in the long run. In the short run, price may be greater than average total cost, in which case the firm is making profits, or price may be less than average total cost, in which case the firm is making losses. But the situation is different in the long run. If firms are making profits, other firms will enter the industry, which will lower the price of the good. If firms are making losses, they will exit the industry, which will raise the price of the good. Entry or exit continues until firms are making neither profits nor losses. At that point, price equals minimum average total cost.

8.

Are market supply curves typically more elastic in the short run or in the long run? Explain.

Market supply curves are typically more elastic in the long run than in the short run. In a competitive market, since entry or exit occurs until price equals the minimum of average total cost, the supply curve is perfectly elastic in the long run.

Quick Check Multiple Choice

1. Which of the following occurs in the case of a perfectly competitive firm? a. chooses its price to maximize profits b. sets its price to undercut other firms selling similar products c. takes its price as given by market conditions d. picks the price that yields the largest market share 2. A competitive firm maximizes profit by choosing the quantity where which condition occurs? a. average total cost is at its minimum b. marginal cost equals the price c. average total cost equals the price d. marginal cost equals average total cost 3. A competitive firm’s short-run supply curve is its ___ cost curve above its ___ cost curve. a. average total, marginal b. average variable, marginal c. marginal, average total d. marginal, average variable 4. If a profit-maximizing, competitive firm is producing a quantity at which marginal cost is between average variable cost and average total cost, it will do which of the following? a. keep producing in the short run but exit the market in the long run b. shut down in the short run but return to production in the long run c. shut down in the short run and exit the market in the long run d. keep producing both in the short run and in the long run

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186 • Chapter 14: Firms in Competitive Markets

5. In the long-run equilibrium of a competitive market with identical firms, what is the relationship between price P, marginal cost MC, and average total cost ATC? a. P > MC and P > ATC b. P > MC and P = ATC c. P = MC and P > ATC d. P = MC and P = ATC 6. Pretzel stands in Ottawa are a perfectly competitive industry in long-run equilibrium. One day, the city starts imposing a $100 per month tax on each stand. How does this policy affect the number of pretzels consumed in the short run and in the long run? a. down in the short run, no change in the long run b. up in the short run, no change in the long run c. no change in the short run, down in the long run d. no change in the short run, up in the long run 1. c 2. b 3. d 4. a 5. d 6. c Problems and Applications 1.

You go out to the best restaurant in town and order a lobster dinner for $40. After eating half of the lobster, you realize that you are quite full. Your date wants you to finish your dinner, because you can’t take it home and because “you’ve already paid for it.” What should you do? Relate your answer to the material in this chapter.

Once you have ordered the dinner, its cost is sunk, so it does not represent an opportunity cost.

As a result, the cost of the dinner should not influence your decision about stuffing yourself.

2.

When going to the supermarket, check out how many different companies produce toilet paper/ eggs/ cereals/ milk. Which of these goods are more likely to exhibit the characteristics of competitive market?

The products which are produced by a large number of companies are more likely to exhibit the characteristics of a competitive market. This is the case for eggs and milk, which are produced by many farmers.

3.

Bob’s lawn-mowing service is a profit-maximizing, competitive firm. Bob mows lawns for $27 each. His total cost each day is $280, of which $30 is a fixed cost. He mows 10 lawns a day.

What can you say about Bob’s short-run decision regarding shutdown and his long-run decision regarding exit?

Since Bob’s average total cost is $280/10 = $28, which is greater than the price, he will exit the industry in the long run. Since fixed cost is $30, average variable cost is ($280 – $30)/10 = $25, which is less than price, so Bob will not shut down in the short run.

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Chapter 14: Firms in Competitive Markets • 187 4.

Consider total cost and total revenue given in the table below: Quantity 0 Total Cost $8 Total Revenue 0

1 $9 8

2 $10 16

3 $11 24

4 $13 32

5 $19 40

6 $27 48

7 $37 56

a. Calculate profit for each quantity. How much should the firm produce to maximize profit? b. Calculate marginal revenue and marginal cost for each quantity. Graph them. (Hint: Put the points between whole numbers. For example, the marginal cost between 2 and 3 should be graphed at 2.5.) At what quantity do these curves cross? How does this relate to your answer to part (a)? c. Can you tell whether this firm is in a competitive industry? If so, can you tell whether the industry is in a long-run equilibrium?

Here is the table showing costs, revenues, and profits:

Quantity 0 1 2 3 4 5 6 7

Total Cost $8 9 10 11 13 19 27 37

Marginal Cost --$1 1 1 2 6 8 10

Total Revenue $0 8 16 24 32 40 48 56

Marginal Revenue --$8 8 8 8 8 8 8

Profit $ –8 –1 6 13 19 21 21 19

a.

The firm should produce 5 or 6 units to maximize profit.

b.

Marginal revenue and marginal cost are graphed in Figure 3. The curves cross at a quantity between 5 and 6 units, yielding the same answer as in part (a).

c.

This industry is competitive since marginal revenue is the same for each quantity. The industry is not in long-run equilibrium since profit is positive.

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188 • Chapter 14: Firms in Competitive Markets 5.

In 2003, a single case in Alberta of bovine spongiform encephalopathy, also known as mad cow disease, temporarily shut down export markets for Canadian beef. a. Using firm and industry diagrams, show the short-run effect of declining demand for Canadian beef due to the shutdown of its export markets. Label the diagram carefully and write out in words all of the changes that you can identify. b. Although export markets eventually began to open up later that same year, the demand for Canadian beef remained low. On a new diagram, show the long-run effect of the declining demand. Explain in words. a.

Figure 4 shows the short-run effect of declining demand for beef. The shift of the industry demand curve from D1 to D2 reduces the quantity from Q1 to Q2 and reduces the price from P1 to P2. This affects the firm, reducing its quantity from q1 to q2. Before the decline in the price, the firm was making zero profits; afterward, profits are negative, as average total cost exceeds price.

Figure 4 b.

Figure 5 shows the long-run effect of declining demand for beef. Since firms are losing money in the short run, some firms leave the industry. This shifts the supply curve from S1 to S3. The shift of the supply curve is just enough to increase the price back to its original level, P1. As a result, industry output falls still further, to Q3. For firms that remain in the industry, the rise in the price to P1 returns them to their original situation, producing quantity q1 and earning zero profits.

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Chapter 14: Firms in Competitive Markets • 189

Figure 5 6.

Suppose the book-printing industry is competitive and begins in a long-run equilibrium. a. Draw a diagram describing the typical firm in the industry. b. Hi-Tech Printing Company invents a new process that sharply reduces the cost of printing books. What happens to Hi-Tech’s profits and the price of books in the short run when Hi-Tech’s patent prevents other firms from using the new technology? c. What happens in the long run when the patent expires and other firms are free to use the technology? a.

Figure 6 shows the typical firm in the industry, with average total cost ATC1, marginal cost MC1, and price P1.

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190 • Chapter 14: Firms in Competitive Markets b.

The new process reduces Hi-Tech’s marginal cost to MC2 and its average total cost to ATC2, but the price remains at P1 since other firms cannot use the new process. Thus Hi-Tech earns positive profits.

c.

7.

When the patent expires and other firms are free to use the technology, all firms’ average-total-cost curves decline to ATC2, so the market price falls to P3 and firms earn no profits.

Many small boats are made of fibreglass, which is derived from crude oil. Suppose that the price of oil rises. a. Using diagrams, show what happens to the cost curves of an individual boat-making firm and to the market supply curve. b. What happens to the profits of boat makers in the short run? What happens to the number of boat makers in the long run? a.

The rise in the price of oil increases production costs for individual firms and thus shifts the industry supply curve up, as shown in Figure 7. The typical firm’s initial marginal-cost curve is MC1 and its average-total-cost curve is ATC1. In the initial equilibrium, the industry supply curve, S1, intersects the demand curve at price P1, which is equal to the minimum average total cost of the typical firm. Thus the typical firm earns no economic profit. The increase in the price of oil shifts the typical firm’s cost curves up to MC2 and ATC2, and shifts the industry supply curve up to S2. The equilibrium price rises from P1 to P2, but the price does not increase by as much as the increase in marginal cost for the firm. As a result, price is less than average total cost for the firm, so profits are negative.

b.

In the long run, the negative profits lead some firms to exit the industry. As they do so, the industry supply curve shifts to the left. This continues until the price rises to equal the minimum point on the firm’s average-total-cost curve. The long-run equilibrium occurs with supply curve S3, equilibrium price P3, industry output Q3, and the firm’s output q3. Thus, in the long run, profits are zero again and there are fewer firms in the industry.

Figure 7

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Chapter 14: Firms in Competitive Markets • 191 8.

Suppose that the Canadian textile industry is competitive, and there is no international trade in textiles. In long-run equilibrium, the price per unit of cloth is $30. a. Describe the equilibrium using graphs for the entire market and for an individual producer. b. Now suppose that textile producers in other countries are willing to sell large quantities of cloth in Canada for only $25 per unit. Assuming that Canadian textile producers have large fixed costs, what is the short-run effect of these imports on the quantity produced by an individual producer? What is the short-run effect on profits?

Illustrate your answer with a graph. c. What is the long-run effect on the number of Canadian firms in the industry? a.

Figure 8 illustrates the situation in the Canadian textile industry. With no international trade, the market is in long-run equilibrium. Supply intersects demand at quantity Q1 and price $30, with a typical firm producing output q1.

Figure 8 b.

The effect of imports at $25 is that the market supply curve follows the old supply curve up to a price of $25, then becomes horizontal at that price. As a result, demand exceeds domestic supply, so the country imports textiles from other countries. The typical domestic firm now reduces its output from q1 to q2, incurring losses, since the large fixed costs imply that average total cost will be much higher than the price.

c.

In the long run, domestic firms will be unable to compete with foreign firms because their costs are too high. All the domestic firms will exit the industry and other countries will supply enough to satisfy the entire domestic demand.

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192 • Chapter 14: Firms in Competitive Markets 9.

Suppose there are 1000 hot-pretzel stands operating in Toronto. Each stand has the usual U-shaped average-total-cost curve. The market demand curve for pretzels slopes downward, and the market for pretzels is in long-run competitive equilibrium. a. Draw the current equilibrium, using graphs for the entire market and for an individual pretzel stand. b. Now the city decides to restrict the number of pretzel-stand licences, reducing the number of stands to only 800. What effect will this action have on the market and on an individual stand that is still operating? Use graphs to illustrate your answer. c. Suppose that the city decides to charge a licence fee for the 800 licences. How will this affect the number of pretzels sold by an individual stand, and the stand’s profit? The city wants to raise as much revenue as possible and also wants to ensure that 800 pretzel stands remain in the city. By how much should the city increase the licence fee? Show the answer on your graph. a.

Figure 9 shows the current equilibrium in the market for pretzels. The supply curve, S1, intersects the demand curve at price P1. Each stand produces quantity q1 of pretzels, so the total number of pretzels produced is 1000 × q1. Stands earn zero profit, since price equals average total cost.

Figure 9 b.

If the city government restricts the number of pretzel stands to 800, the industry supply curve shifts to S2. The market price rises to P2, and individual firms produce output q2.

Industry output is now 800 × q2. Now the price exceeds average total cost, so each firm is making a positive profit. Without restrictions on the market, this would induce other firms to enter the market, but they cannot, since the government has limited the number of licences.

c.

The city could charge a licence fee for the licences. Since it is a lump-sum fee for the licence, not based on the quantity of sales, such a tax has no effect on marginal cost, so it will not affect the firm’s output. It will, however, reduce the firm’s profits. As long as the firm is left with a zero or positive profit, it will continue to operate. So the licence fee that brings the most money to the city is one that charges each firm the amount (P2 – ATC2)q2, the amount of the firm’s profit.

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Chapter 14: Firms in Competitive Markets • 193 10.

The market for apple pies in the city of Ectenia is competitive and has the following demand schedule: Price Quantity Demanded $1 1200 pies 2 1100 3 1000 4 900 5 800 6 700 7 600 8 500 9 400 10 300 11 200 12 100 13 0 Each producer in the market has fixed costs of $9 and the following marginal cost: Quantity 1 pie 2 3 4 5 6

Marginal Cost $ 2 4 6 8 10 12

a. Compute each producer’s total cost and average total cost for 1 to 6 pies. b. The price of a pie is now $11. How many pies are sold? How many pies does each producer make? How many producers are there? How much profit does each producer earn? c. Is the situation described in part (b) a long-run equilibrium? Why or why not? d. Suppose that in the long run, there is free entry and exit. How much profit does each producer earn in the long-run equilibrium? What is the market price and number of pies each producer makes? How many pies are sold? How many pie producers are operating? a.

b.

The following table shows a firm’s costs.

Q

FC=$9

MC

VC

TC=FC+VC

ATC=TC/Q

1 2 3 4 5 6

9 9 9 9 9 9

2 4 6 8 10 12

2 6 12 20 30 42

11 15 21 29 39 51

11 7.5 7 7.25 7.8 8.5

The demand schedule shows 200 pies demanded at P = $11. The quantity of pies produced by a firm when the price is $11 is found where price equals marginal cost, which gives us Q* = 5 (for pie #5, the marginal cost is $10, but if the firm would produce one more pie, it would lose $1). The profit to each firm is equal to P × Q – TC = 11 × 5 – 39 = $16. With 200 total pies produced and 5 by each producer, there are 40 producers.

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194 • Chapter 14: Firms in Competitive Markets

11.

c.

This is not a long-run equilibrium; since entry is free and there are positive profits, more firms will enter, driving the price down.

d.

Each firm makes zero profit in the long run. The price that maximizes profit and makes it zero is equal to the lowest value of ATC, P = Lowest ATC = $7. At this price, the quantity demanded is 600 pies and each firm produces 3 pies. Thus, the number of firms in the market is 600/3 = 200.

Ball Bearings Inc. faces costs of production as follows: Quantity 0 1 2 3 4 5 6

Total Fixed Costs $100 100 100 100 100 100 100

Total Variable Costs $ 0 50 70 90 140 200 360

a. Calculate the company’s average fixed costs, average variable costs, average total costs, and marginal costs. b. The price of a case of ball bearings is $50. Seeing that she can’t make a profit, the chief executive officer (CEO) decides to shut down operations. What are the firm’s profits/losses? Was this a wise decision? Explain. c. Vaguely remembering his introductory economics course, the chief financial officer tells the CEO it is better to produce 1 case of ball bearings because marginal revenue equals marginal cost at that quantity. What are the firm’s profits/losses at that level of production? Was this the best decision? Explain.

Ball Bearings Inc. a.

The following table shows the company’s costs:

Quantity 0 1 2 3 4 5 6

Total Fixed Costs $100 100 100 100 100 100 100

Total Variable Costs $0 50 70 90 140 200 360

Average Fixed Costs െ $100 50 33.33 25 20 16.67

Average Variable Costs – $50 35 30 35 40 60

Average Total Costs – $150 85 63.33 60 60 76.67

Marginal Costs – $50 20 20 50 60 160

b.

The firm must produce 4 units to maximize profit, because marginal cost is equal to the price at that production level. Profit is equal to 4 × $50 – 4 × $60 = –$40, which is a loss of $40. However, the firm should not shut down because if it does, it loses the fixed costs, which are equal to $100. By operating, the firm minimizes losses.

c.

If the firm produces 1 unit of output, the loss is $50 – $150 = –$100, which is greater than the one corresponding to the loss-minimizing level of production of 4. However, it is still better to produce 1 unit than to produce nothing.

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Chapter 14: Firms in Competitive Markets • 195 12.

An industry currently has 100 firms, each of which has fixed costs of $16 and average variable costs as follows: Quantity 1 2 3 4 5 6

Average Variable Cost $1 2 3 4 5 6

a. Compute a firm’s marginal cost and average total cost for each quantity from 1 to 6. b. The equilibrium price is currently $10. How much does each firm produce? What is the total quantity supplied in the market? c. In the long run, firms can enter and exit the market, and all entrants have the same costs as above. As this market makes the transition to its long-run equilibrium, will the price rise or fall? Will the quantity demanded rise or fall? Will the quantity supplied by each firm rise or fall? Explain your answers. d. Graph the long-run supply curve for this market, with specific numbers on the axes as relevant. a. The firms’ variable cost (VC), total cost (TC), marginal cost (MC), and average total cost (ATC) are shown in the table below: Quantity 1 2 3 4 5 6

VC 1 4 9 16 25 36

TC 17 20 25 32 41 52

MC 1 3 5 7 9 11

ATC 17 10 8.33 8 8.20 8.67

b. If the price is $10, each firm will produce 5 units. There are 100 firms in the industry, so there will be 5  100 = 500 units supplied in the market. c.

At a price of $10 and a quantity supplied of 5, each firm is earning a positive profit because price is greater than average total cost. Thus, entry will occur and the price will fall. As price falls, quantity demanded will rise in accordance with the law of demand.

This entry will continue until price is equal to minimum average total cost, $8, and each firm is producing the quantity at which marginal revenue ($8) is equal to marginal cost (4 units if we assume units are not divisible). Therefore, the quantity supplied by each firm decreases.

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196 • Chapter 14: Firms in Competitive Markets d. Figure 10 shows the long-run market supply curve, which will be horizontal at minimum average total cost, $8. Each firm produces 4 units.

Price and Costs

Market

Firm MC

ATC P=$8

P=$8

S

q=4

Figure 10 13.

A profit-maximizing firm in a competitive market is currently producing 100 units of output. It has average revenue of $10, average total cost of $8, and fixed costs of $200. a. What is profit? b. What is marginal cost? c. What is average variable cost? d. Is the efficient scale of the firm more than, less than, or exactly 100 units?

The market price is $10, thus total revenue is $1000. Total cost is 100 × $8 = $800.

14.

a.

Profit = $1000 – $800 = $200

b.

Marginal cost = price = $10.

c.

Average variable cost = average total cost – average fixed cost = $8 – ($200/100) = $6.

d.

At a level of production of 100 units, marginal cost is greater than average total cost.

Therefore, the efficient level of production (where average total cost is minimum) is less than 100 units.

The market for fertilizer is perfectly competitive. Firms in the market are producing output, but are currently experiencing economic losses. a. How does the price of fertilizer compare to the average total cost, the average variable cost, and the marginal cost of producing fertilizer? b. Draw two graphs, side by side, illustrating the present situation for the typical firm and in the market. c. Assuming there is no change in demand or in the firms’ cost curves, explain what will happen in the long run to the price of fertilizer, marginal cost, average total cost, the quantity supplied by each firm, and the total quantity supplied to the market. a.

(See Figure 11.) Since the firms keep producing while making losses, price must be less than the average total cost but greater than the average variable cost. Assuming that the firms maximize profit, marginal cost must be equal to price.

b.

The price is determined in the market, and the firm is a price taker.

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Chapter 14: Firms in Competitive Markets • 197

Price of fertilizer

Price of fertilizer

The Typical Firm

The Market

Supply

MC ATC AVC

Price

Demand Quantity of Fertilizer

Quantity of Fertilizer

Figure 11 c.

15.

16.

Some firms will leave the market, thus the supply shifts to the left and the market price will increase until it becomes equal to the average total cost and firms make zero profits.

Marginal cost will decline, the quantity supplied by each firm will fall, as will the total quantity supplied to the market.

Analyze the two following scenarios for firms in competitive markets: a. Suppose that TC = 100 + 15Q, where TC is total cost and Q is the quantity produced.

What is the minimum price necessary for this firm to produce any output in the short run? b. Suppose that MC = 4Q, where MC is marginal cost. The perfectly competitive firm maximizes profits by producing 10 units of output. At what price does it sell these units? a.

The minimum price necessary for a firm to produce in the short run is equal to the lowest possible average variable cost. Our firm’s total variable cost is VC = 15Q, and AVC = 15Q/Q = 15 (constant). The minimum price is thus $15.

b.

The firm produces a quantity that makes marginal cost equal to price. If MC = 4Q and Q = 10, then price must be 4 × 10 = $40.

There is a single production technology available to firms that might choose to operate in the market for hammers. Suppose all firms have access to a technology that gives the following total cost (TC) for producing a quantity (Q) of hammers: TC = 3 + 3Q2, for any Q > 0, but the costs of production are equal to zero if Q = 0. The marginal cost of producing hammers is MC = 6Q. a. What is the equation for the average variable cost (AVC) and the average total cost (ATC)? b. If the price of hammers is P, find the supply curve of a single firm, for all possible prices P > 0. For the following two parts, suppose that there is free entry into the hammer market, and the cost functions of firms don’t change. c. The market demand for hammers is given by QD = 600 – 50P. What is the long-run equilibrium price in the market and how much does each firm produce at this price? d. How many firms in total are in the market?

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198 • Chapter 14: Firms in Competitive Markets a.

ATC = TC /Q = 3/Q + 3Q if Q > 0; AVC = 3Q2/Q = 3Q.

b.

The quantity supplied, Q, is zero for all prices less than the lowest ATC. The quantity that minimizes ATC must satisfy the equation ATC = MC, or 3/Q + 3Q = 6Q, for which the positive solution is Q = 1. The corresponding value of ATC is ATC = 3/1 + 3 × 1 = 6.

Thus, the quantity supplied is zero for all prices less than $6 and P = 6Q, or Q = P/6 for P > 6.

c.

The long-run equilibrium price is equal to the lowest ATC of each firm, which we have found to be P = $6. Using the market demand function Q D = 600 – 50P, we find the equilibrium quantity demanded Q D = 600 – 50 × 6 = 300 hammers. Each firm produces 1 hammer at this price.

d.

The number of firms in the market is 300.

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Chapter 15 Monopoly SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

What are the three reasons why a market might have a monopoly? • Give two examples of monopolies, and explain the reason for each.

A market might have a monopoly because (1) a key resource is owned by a single firm, (2) the government gives a single firm the exclusive right to produce some good or service, and (3) the costs of production make a single producer more efficient than a large number of producers.

Examples of monopolies include (1) the water producer in a small town, which owns a key resource, the one well in town; (2) pharmaceutical companies that are given a patent on a new drug by the government; and (3) a bridge, which is a natural monopoly because (if the bridge is uncongested) having just one bridge is efficient. Many other examples are possible.

2.

Explain how a monopolist chooses the quantity of output to produce and the price to charge.

A monopolist chooses the amount of output to produce by finding the quantity at which marginal revenue equals marginal cost. It finds the price to charge by finding the point on the demand curve at that quantity.

3.

How does a monopolist’s quantity of output compare to the quantity of output that maximizes total surplus?

A monopolist produces a quantity of output that is less than the quantity of output that maximizes total surplus because it produces the quantity at which marginal cost equals marginal revenue, rather than the quantity at which marginal cost equals price.

4.

Give two examples of price discrimination. • How does perfect price discrimination affect consumer surplus, producer surplus, and total surplus?

Examples of price discrimination include (1) movie tickets, for which children and senior citizens get lower prices; (2) airline prices, which are different for business and leisure travellers; (3) discount coupons, which lead to different prices for people who value their time in different ways; (4) financial aid, which offers college or university tuition at lower prices to poorer students and higher prices to wealthier students; and (5) quantity discounts, which offer lower prices for higher quantities, capturing more of a buyer’s willingness to pay. Many other examples are possible.

Perfect price discrimination reduces consumer surplus, increases producer surplus by the same amount, and has no effect on total surplus, compared to a competitive market. Compared to a monopoly that charges a single price, perfect price discrimination reduces consumer surplus, increases producer surplus, and increases total surplus, since there is no deadweight loss.

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200 • Chapter 15: Monopoly 5.

Describe the ways policymakers can respond to the inefficiencies caused by monopolies. List a potential problem with each of these policy responses.

Policymakers can respond to the inefficiencies caused by monopolies in one of four ways: (1) by trying to make monopolized industries more competitive; (2) by regulating the behaviour of the monopolies; (3) by turning some private monopolies into public enterprises; and (4) by doing nothing at all. Competition laws prohibit mergers of large companies and prevent them from coordinating their activities in ways that make markets less competitive, but such laws may keep companies from merging to gain from synergies. Some monopolies, especially natural monopolies, are regulated by the government, but it is hard to keep a monopoly in business, achieve marginal-cost pricing, and give the monopolist incentive to reduce costs. Private monopolies can be taken over by the government, but the companies are not likely to be well run. Sometimes doing nothing at all may seem to be the best solution, but there are clearly deadweight losses from monopoly that society will have to bear.

Questions for Review 1.

Give an example of a government-created monopoly. Is creating this monopoly necessarily bad public policy? Explain.

An example of a government-created monopoly comes from the existence of patent and copyright laws. Both allow firms or individuals to be monopolies for extended periods of time— 20 years for patents, forever for copyrights. But this monopoly power is good, because without it, less people would write books (because anyone could print copies of the books, so authors might not be adequately compensated), and firms might severely limit their investment in research and development and may not invent as many new products or drugs (since any other company could produce or sell them, and the firm would have difficulty recouping investment costs).

2.

Define natural monopoly. What does the size of a market have to do with whether an industry is a natural monopoly?

An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. As a market grows, it may evolve from a natural monopoly to a competitive market.

3.

Why is a monopolist’s marginal revenue less than the price of its good? Can marginal revenue ever be negative? Explain.

A monopolist’s marginal revenue is less than the price of its product because (1) its demand curve is the market demand curve, so (2) to increase the amount sold, the monopolist must lower the price of its good for every unit it sells. (3) This cut in prices reduces revenue on the units it was already selling.

A monopolist’s marginal revenue can be negative because, to get purchasers to buy an additional unit of the good, the firm must reduce its price on all units of the good. The fact that it sells a greater quantity increases revenue, but the decline in price decreases revenue. The overall effect depends on the elasticity of the demand curve. If the demand curve is inelastic, marginal revenue may be negative.

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Chapter 15: Monopoly • 201 4.

Draw the demand, marginal-revenue, and marginal-cost curves for a monopolist. Show the profit-maximizing level of output. Show the profit-maximizing price.

Figure 1 shows the demand, marginal-revenue, and marginal-cost curves for a monopolist. The intersection of the marginal-revenue and marginal-cost curves determines the profit-maximizing level of output, Qm. The demand curve then shows the profit-maximizing price, Pm.

Figure 1 5.

In your diagram from the previous question, show the level of output that maximizes total surplus. Show the deadweight loss from the monopoly. Explain your answer.

The level of output that maximizes total surplus in Figure 1 is where the demand curve intersects the marginal-cost curve, Qc. The deadweight loss from monopoly is the triangular area between Qc and Qm that is above the marginal-cost curve and below the demand curve. It represents deadweight loss, since society loses total surplus because of monopoly, equal to the value of the good (measured by the height of the demand curve) less the cost of production (given by the height of the marginal-cost curve) for the quantities between Qm and Qc.

6.

What gives the government the power to regulate mergers between firms? From the standpoint of the welfare of society, give a good reason and a bad reason why two firms might want to merge.

The government has the power to regulate mergers between firms because of competition laws.

Firms might want to merge to increase operating efficiency and reduce costs, something that is good for society, or to gain monopoly power, which is bad for society.

7.

Describe the two problems that arise when regulators tell a natural monopoly that it must set a price equal to marginal cost.

When regulators tell a natural monopoly that it must set price equal to marginal cost, two problems arise. The first is that, because a natural monopoly has a constant marginal cost that is less than average total cost, setting price equal to marginal cost means that the price is less than average total cost, so the firm will lose money. The firm would then exit the industry unless the government subsidized it. However, getting revenue for such a subsidy would cause the government to raise other taxes, increasing the deadweight loss. The second problem of using marginal costs to set price is that it gives the monopoly no incentive to reduce costs.

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202 • Chapter 15: Monopoly 8.

Give two examples of price discrimination. In each case, explain why the monopolist chooses to follow this business strategy.

One example of price discrimination is in publishing books. Publishers charge a much higher price for hardback books than for paperback books—far higher than the difference in production costs.

Publishers do this because die-hard fans will pay more for a hardback book when the book is first released. Those who do not value the book as highly will wait for the paperback version to come out. The publisher makes greater profit this way than if it charged just one price.

A second example is the pricing of movie tickets. Theatres give discounts to children and senior citizens because they have a lower willingness to pay for a ticket. Charging different prices helps the theatre increase its profit above what it would be if it charged just one price.

Quick Check Multiple Choice

1. A firm is a natural monopoly if it exhibits which of the following as its output increases? a. decreasing marginal revenue b. increasing marginal cost c. decreasing average revenue d. decreasing average total cost 2. For a profit-maximizing monopoly that charges the same price to all consumers, what is the relationship between price P, marginal revenue MR, and marginal cost MC? a. P = MR and MR = MC b. P > MR and MR = MC c. P = MR and MR > MC d. P > MR and MR > MC 3. If a monopoly’s fixed costs increase, its price will ___ and its profit will ___. a. increase, decrease b. decrease, increase c. increase, stay the same d. stay the same, decrease 4. Compared to the social optimum, a monopoly firm chooses which of the following? a. a quantity that is too low and a price that is too high b. a quantity that is too high and a price that is too low c. a quantity and a price that are both too high d. a quantity and a price that are both too low 5. Why does the deadweight loss from monopoly arise? a. the monopoly firm makes higher profits than a competitive firm would b. some potential consumers who forgo buying the good value it more than its marginal cost c. consumers who buy the good have to pay more than marginal cost, reducing their consumer surplus d. the monopoly firm chooses a quantity that fails to equate price and average revenue

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Chapter 15: Monopoly • 203

6. What is reduced when a monopolist switches from charging a single price to perfect price discrimination? a. the quantity produced b. the firm’s profit c. consumer surplus d. total surplus 1. d 2. b 3. d 4. a 5. b 6. c Problems and Applications 1.

A publisher faces the following demand schedule for the next novel of one of its popular authors: Price $100 90 80 70 60 50 40 30 20 10 0

Quantity Demanded 0 100 000 200 000 300 000 400 000 500 000 600 000 700 000 800 000 900 000 1 000 000

The author is paid $2 million to write the book, and the marginal cost of publishing the book is a constant $10 per book. a. Compute total revenue, total cost, and profit at each quantity. What quantity would a profit-maximizing publisher choose? What price would it charge? b. Compute marginal revenue. (Recall that MR = ∆TR/∆Q.) How does marginal revenue compare to the price? Explain. c. Graph the marginal-revenue, marginal-cost, and demand curves. At what quantity do the marginal-revenue and marginal-cost curves cross? What does this signify? d. In your graph, shade in the deadweight loss. Explain in words what this means. e. If the author was paid $3 million instead of $2 million to write the book, how would this affect the publisher’s decision regarding the price to charge? Explain. f. Suppose the publisher was not profit-maximizing but was concerned with maximizing economic efficiency. What price would it charge for the book? How much profit would it make at this price?

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204 • Chapter 15: Monopoly The following table shows revenue, costs, and profits, where quantities are in thousands, and total revenue, marginal revenue, total cost, and profit, which are in millions of dollars: Price $ 100 90 80 70 60 50 40 30 20 10 0

Quantity 0 100 200 300 400 500 600 700 800 900 1000

Total Revenue $0 9 16 21 24 25 24 21 16 9 0

Marginal Revenue ---$ 9 7 5 3 1 –1 –3 –5 –7 –9

Total Cost $2 3 4 5 6 7 8 9 10 11 12

Profit $ –2 6 12 16 18 18 16 12 6 –2 –12

a.

A profit-maximizing publisher would choose a quantity of 400 000 at a price of $60, or a quantity of 500 000 at a price of $50; both combinations would lead to profits of $18 million.

b.

Marginal revenue is always less than price. Price falls when quantity rises because the demand curve slopes downward, but marginal revenue falls even more than price because the firm loses revenue on all the units of the good sold when it lowers the price.

c.

Figure 2 shows the marginal-revenue, marginal-cost, and demand curves. The marginalrevenue and marginal-cost curves cross between quantities of 400 000 and 500 000. This signifies that the firm maximizes profits in that region.

Figure 2

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Chapter 15: Monopoly • 205

2.

d.

The area of deadweight loss is marked “DWL” in the figure. Deadweight loss means that the total surplus in the economy is less than it would be if the market were competitive, since the monopolist produces less than the socially efficient level of output.

e.

If the author were paid $3 million instead of $2 million, the publisher would not change the price, since there would be no change in marginal cost or marginal revenue. The only thing that would be affected would be the firm’s profit, which would fall.

f.

To maximize economic efficiency, the publisher would set the price at $10 per book, since that is the marginal cost of the book. At that price, the publisher would have negative profits equal to the amount paid to the author.

A small town is served by many competing supermarkets, which have constant marginal cost. a. Using a diagram of the market for groceries, show the consumer surplus, producer surplus, and total surplus. b. Now suppose that the independent supermarkets combine into one chain. Using a new diagram, show the new consumer surplus, producer surplus, and total surplus. Relative to the competitive market, what is the transfer from consumers to producers? What is the deadweight loss? a.

Figure 3 illustrates the market for groceries when there are many competing supermarkets with constant marginal cost. Output is QC, price is PC, consumer surplus is area A, producer surplus is zero, and total surplus is area A.

Figure 3 b.

If the supermarkets merge, Figure 4 illustrates the new situation. Quantity declines from QC to QM and price rises to PM. Area A in Figure 3 is equal to area B + C + D + E + F in Figure 4. Consumer surplus is now area B + C, producer surplus is area D + E, and total surplus is area B + C + D + E. Consumers transfer the amount of area D + E to producers, and the deadweight loss is area F.

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206 • Chapter 15: Monopoly

Figure 4 3.

Johnny Rockabilly has just finished recording his latest CD. His record company’s marketing department determines that the demand for the CD is as follows: Price $24 22 20 18 16 14

Number of CDs 10 000 20 000 30 000 40 000 50 000 60 000

The company can produce the CD with no fixed cost and a variable cost of $5 per CD. a. Find total revenue for quantity equal to 10 000, 20 000, and so on. What is the marginal revenue for each 10 000 increase in the quantity sold? b. What quantity of CDs would maximize profit? What would be the price? What would be the profit? c. If you were Johnny’s agent, what recording fee would you advise Johnny to demand from the record company? Why? a.

The following table shows total revenue and marginal revenue for each price and quantity sold:

Price 24 22 20 18 16 14

Quantity 10 000 20 000 30 000 40 000 50 000 60 000

Total Revenue $ 240 000 440 000 600 000 720 000 800 000 840 000

Marginal Revenue ---$ 200 000 160 000 120 000 80 000 40 000

Total Cost $ 50 000 100 000 150 000 200 000 250 000 300 000

Profit $ 190 000 340 000 450 000 520 000 550 000 540 000

b.

Profits are maximized at a price of $16 and quantity of 50 000. At that point, profit is $550 000.

c.

As Johnny’s agent, you should recommend that he demand $550 000 from them, so he instead of the record company receives all of the profit.

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Chapter 15: Monopoly • 207 4.

A company is considering building a bridge across a river. The bridge would cost $2 million to build and nothing to maintain. The following table shows the company’s anticipated demand over the lifetime of the bridge.

Price per Crossing $8 7 6 5 4 3 2 1 0

Number of Crossings (in thousands) 0 100 200 300 400 500 600 700 800

a. If the company were to build the bridge, what would be its profit-maximizing price?

Would that be the efficient level of output? Why or why not? b. If the company is interested in maximizing profit, should it build the bridge? What would be its profit or loss? c. If the government were to build the bridge, what price should it charge? d. Should the government build the bridge? Explain. a.

The table below shows total revenue and marginal revenue for the bridge (quantities, total revenue, and marginal revenue are all in thousands). The profit-maximizing price would be where revenue is maximized, which will occur where marginal revenue equals zero, since marginal cost equals zero. This occurs at a price of $4 and quantity of 400.

The efficient level of output is 800, since that is where price equals marginal cost equals zero. The profit-maximizing quantity is lower than the efficient quantity because the firm is a monopolist.

Price $8 7 6 5 4 3 2 1 0 b.

Quantity 0 100 200 300 400 500 600 700 800

Total Revenue $0 700 1200 1500 1600 1500 1200 700 0

Marginal Revenue ---$700 500 300 100 –100 –300 –500 –700

The company should not build the bridge because its profits are negative. The most revenue it can earn is $1 600 000 and the cost is $2 000 000, so it would lose $400 000.

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208 • Chapter 15: Monopoly

Figure 5

5.

c.

If the government were to build the bridge, it should set price equal to marginal cost to be efficient. But marginal cost is zero, so the government should not charge people to use the bridge.

d.

Yes, the government should build the bridge, because it would increase society’s total surplus. As shown in Figure 5, total surplus has area 1/2 × $8 × 800 000 = $3 200 000, which exceeds the cost of building the bridge.

Larry, Curly, and Moe run the only saloon in town. Larry wants to sell as many drinks as possible without losing money. Curly wants the saloon to bring in as much revenue as possible. Moe wants to make the largest possible profits. Using a single diagram of the saloon’s demand curve and its cost curves, show the price and quantity combinations favoured by each of the three partners. Explain.

Larry wants to sell as many drinks as possible without losing money, so he wants to set quantity where price (demand) equals average total cost, which occurs at quantity QL and price PL in Figure 6. Curly wants to bring in as much revenue as possible, which occurs where marginal revenue equals zero, at quantity QC and price PC. Moe wants to maximize profits, which occurs where marginal cost equals marginal revenue, at quantity QM and price PM.

Figure 6

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Chapter 15: Monopoly • 209 6.

7.

For many years, both local and long-distance phone services have been provided by provincially owned or regulated monopolies. a. Explain why long-distance phone service was originally a natural monopoly. b. Over the past several decades, technological developments have allowed companies to launch communications satellites that can transmit a limited number of calls. How did the growing role of satellites change the cost structure of long-distance phone service? c. In response to these technological developments, some provinces/territories have deregulated the long-distance market in Canada. Local phone service has remained regulated. Why might it be efficient to have competition in long-distance phone service and regulated monopolies in local phone service? a.

Long-distance phone service was originally a natural monopoly because installation of phone lines across the country meant that one firm’s costs were much lower than if two or more firms did the same thing.

b.

With communications satellites, the cost is no different if one firm supplies them or if many firms do so. So the industry evolved from a natural monopoly to a competitive market.

c.

It is efficient to have competition in long-distance phone service and regulated monopolies in local phone service because local phone service remains a natural monopoly (being based on land lines), while long-distance service is a competitive market (being based on satellites).

Many schemes for price-discriminating involve some cost. For example, discount coupons take up the time and resources of both the buyer and the seller. This question considers the implications of costly price discrimination. To keep things simple, let’s assume that our monopolist’s production costs are simply proportional to output, so that average total cost and marginal cost are constant and equal to each other. a. Draw the cost, demand, and marginal-revenue curves for the monopolist. Show the price the monopolist would charge without price discrimination. b. In your diagram, mark the area equal to the monopolist’s profit and call it X. Mark the area equal to consumer surplus and call it Y. Mark the area equal to the deadweight loss and call it Z. c. Now suppose that the monopolist can perfectly price-discriminate. What is the monopolist’s profit? (Give your answer in terms of X, Y, and Z.) d. What is the change in the monopolist’s profit from price discrimination? What is the change in total surplus from price discrimination? Which change is larger? Explain.

(Give your answers in terms of X, Y, and Z.) e. Now suppose that there is some cost of price discrimination. To model this cost, let’s assume that the monopolist has to pay a fixed cost C in order to price-discriminate.

How would a monopolist make the decision whether to pay this fixed cost? (Give your answer in terms of X, Y, Z, and C.) f. How would a benevolent social planner, who cares about total surplus, decide whether the monopolist should price-discriminate? (Give your answer in terms of X, Y, Z, and C.) g. Compare your answers to parts (e) and (f). How does the monopolist’s incentive to price-discriminate differ from the social planner’s? Is it possible that the monopolist will price-discriminate even though it is not socially desirable?

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210 • Chapter 15: Monopoly a.

Figure 7 shows the cost, demand, and marginal-revenue curves for the monopolist.

Without price discrimination, the monopolist would charge price PM and produce quantity QM.

Figure 7

8.

b.

The monopolist’s profit consists of the two areas labelled X, consumer surplus is the two areas labelled Y, and the deadweight loss is the area labelled Z.

c.

If the monopolist can perfectly price discriminate, it produces quantity QC, and has profit equal to X + Y + Z.

d.

The monopolist’s profit increases from X to X + Y + Z, an increase in the amount Y + Z. The change in total surplus is area Z. The rise in the monopolist’s profit is greater than the change in total surplus, since the monopolist’s profit increases both by the amount of deadweight loss (Z) and by the transfer from consumers to the monopolist (Y).

e.

A monopolist would pay the fixed cost that allows it to discriminate as long as Y + Z (the increase in profits) exceeds C (the fixed cost).

f.

A benevolent social planner who cared about maximizing total surplus would want the monopolist to price discriminate only if Z (the deadweight loss from monopoly) exceeded C (the fixed cost) since total surplus rises by Z – C.

g.

The monopolist has a greater incentive to price discriminate (it will do so if Y + Z > C) than the social planner would allow (she would allow it only if Z > C). Thus if Z < C but Y + Z > C, the monopolist will price discriminate even though it is not in society’s best interest.

Consider the relationship between monopoly pricing and price elasticity of demand. a. Explain why a monopolist will never produce a quantity at which the demand curve is inelastic. (Hint: If demand is inelastic and the firm raises its price, what happens to total revenue and total costs?)

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Chapter 15: Monopoly • 211

b. Draw a diagram for a monopolist, precisely labelling the portion of the demand curve that is inelastic. (Hint: The answer is related to the marginal-revenue curve.) c. On your diagram, show the quantity and price that maximizes total revenue.

This question concerns the relationship between monopoly pricing and price elasticity of demand. a.

When demand is inelastic, an increase in price increases revenue and decreases the quantity; in turn, lower quantity reduces the costs. Both higher revenue and lower costs act in the same direction of increasing profit. Thus, the monopoly would have already exploited the inelasticity of demand when maximizing profit, such that at the profitmaximizing level of production, demand must be already elastic.

b.

The point on the demand curve that separates the inelastic from the elastic region corresponds to the quantity at which marginal revenue is zero. (See Figure 8.)

Price

Elastic demand

PR Inelastic Demand

Quantity

QR Marginal revenue Figure 8 c.

9.

In Figure 8, the quantity and price that maximize total revenue are labelled Q R and P R.

If the government wanted to encourage a monopoly to produce the socially efficient quantity, should it use a per-unit tax or a per-unit subsidy? Explain how this tax or subsidy would achieve the socially efficient level of output. Among the various interested parties—the monopoly firm, the monopoly’s consumers, and other taxpayers—who would support the policy and who would oppose it?

A tax is not appropriate because it increases the monopoly’s marginal cost, which in turn increases price and reduces quantity even more. A subsidy equal to the monopoly’s loss in profit from increasing quantity to the efficient level would achieve the government’s goal. If the subsidy just compensates for lost profit, the monopoly would be indifferent between producing the efficient or the profit-maximizing quantity. Consumers benefit, because price is lower. Other taxpayers would oppose such a policy.

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212 • Chapter 15: Monopoly 10.

You live in a town with 300 adults and 200 children, and you are thinking about putting on a play to entertain your neighbours and make some money. This type of play has a fixed cost of $2000, but selling an extra ticket has zero marginal cost. Here are the demand schedules for your two types of customer: Price $10 9 8 7 6 5 4 3 2 1 0

Adults 0 100 200 300 300 300 300 300 300 300 300

Children 0 0 0 0 0 100 200 200 200 200 200

a. To maximize profit, what price would you charge for an adult ticket? For a child’s ticket? How much profit do you make? b. The town council passes a law prohibiting you from charging different prices to different customers. What price do you set for a ticket now? How much profit do you make? c. Who is worse off because of the law prohibiting price discrimination? Who is better off? (If you can, quantify the changes in welfare.) d. If the fixed cost of the play was $3000 rather than $2000, how would your answers to parts (a), (b), and (c) change?

The following table shows the total demand schedule and revenues.

Price

Adults

Children

Revenue from Adults

$10 9 8 7 6 5 4 3 2 1 0

0 100 200 300 300 300 300 300 300 300 300

0 0 0 0 0 100 200 200 200 200 200

0 900 1600 2100 1800 1500 1200 900 600 300 0

Revenue from Children

Total Revenue

0 0 0 0 0 500 800 600 400 200 0

0 900 1600 2100 1800 2000 2000 1500 1000 500 0

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Chapter 15: Monopoly • 213

11.

a.

Since marginal cost is zero, the profit-maximizing quantities are also revenue-maximizing.

A price-discriminating monopolist would set price at $7 for adults and $4 for children.

Profit is equal to $2100 + $800 – $2000 = $900.

b.

The price of a ticket is $7 when price discrimination is not possible. No child buys a ticket at this price. Profit is $2100 – $2000 = $100.

c.

Children are worse off. They lose 200 × ($4 – $0) = $800 in consumer surplus. The monopoly is also worse off; they lose $800 in profit.

d.

If the fixed cost was $3000, no profit is possible, so the play is not provided.

The residents of the town Ectenia all love economics, and the mayor proposes building an economics museum. The museum has a fixed cost of $2 400 000 and no variable costs. There are 100 000 town residents, and each has the same demand for museum visits: QD = 10 – P, where P is the price of admission. a. Graph the museum’s average-total-cost curve and its marginal-cost curve. What kind of market would describe the museum? b. The mayor proposes financing the museum with a lump-sum tax of $24 and then opening the museum free to the public. How many times would each person visit?

Calculate the benefit each person would get from the museum, measured as consumer surplus minus the new tax. c. The mayor’s anti-tax opponent says the museum should finance itself by charging an admission fee. What is the lowest price the museum can charge without incurring losses? (Hint: Find the number of visits and museum profits for prices of $2, $3, $4, and $5.) d. For the break-even price you found in part (c), calculate each resident’s consumer surplus. Compared with the mayor’s plan, who is better off with this admission fee, and who is worse off? Explain. e. What real-world considerations absent in the above problem might argue in favour of an admission fee? a.

Figure 9 shows the average-total-cost and marginal-cost curves. Since the marginal cost is zero for all visitors, the MC curve is horizontal, coinciding with the horizontal axis. This ATC cost curve is specific to a natural monopoly.

Figure 9 b.

If P = 0, each person visits the museum 10 times. Each person gets consumer’s surplus equal to 10 × 10/2 = $50 and has to pay $24, so that the net benefit is $50 – $24 = $26.

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214 • Chapter 15: Monopoly c.

12.

Profit = Total revenue – Total cost. The following table shows revenues and profits for a few prices. It shows that the lowest price for which profit is zero is $4.

P

Q=10–P

$2 $3 $4 $5

8 7 6 5

TR=P×Q×0.1 (millions) $1.6 $2.1 $2.4 $2.5

TC=2.4 (millions) $2.4 $2.4 $2.4 $2.4

Profit=TR–TC (millions) –$0.8 –$0.3 $0.0 $0.1

d.

A resident’s consumer surplus when the price is $4 is equal to (10 – 4) × (10 – 4)/2 = $18. Consumers are worse off because their consumer surplus is less than in the case of a flat tax. Nobody is better off; therefore, the “fee-per-visit” alternative is inferior to the flat-tax one.

e.

If some people have lower demand for visits to the museum, or if the marginal costs are not zero (the museum needs cleaning, security, and management), then the analysis may yield significantly different results.

Only one firm produces and sells soccer balls in the country of Wiknam, and as the story begins, international trade in soccer balls is prohibited. The following equations describe the monopolist’s demand, marginal revenue, total cost, and marginal cost: Demand: Marginal Revenue: Total Cost: Marginal Cost:

P = 10 – Q MR = 10 – 2Q TC = 3 + Q + 0.5Q2 MC = 1 + Q

where Q is quantity and P is the price measured in Wiknamian dollars. a. How many soccer balls does the monopolist produce? At what price are they sold?

What is the monopolist’s profit? b. One day, the king of Wiknam decrees that henceforth there will be free trade—either imports or exports—of soccer balls at the world price of $6. The firm is now a price taker in a competitive market. What happens to domestic production of soccer balls?

To domestic consumption? Does Wiknam export or import soccer balls? c. In our analysis of international trade in Chapter 9, a country becomes an exporter when the price without trade is below the world price and an importer when the price without trade is above the world price. Does that conclusion hold in your answers to parts (a) and (b)? Explain. d. Suppose that the world price was not $6 but, instead, happened to be exactly the same as the domestic price without trade as determined in part (a). Would allowing trade have changed anything in the Wiknamian economy? Explain. How does the result here compare with the analysis in Chapter 9? a.

In the absence of trade, the monopoly produces a quantity Q M, determined by the equation MR = MC, or 10 – 2Q = 1 + Q, with the solution Q M = 3; the corresponding monopoly price and profit are P M = 10 – 3 = $7, and profit = P × Q – TC = 7 × 3 – (3 + 3 + 0.5 × 32) = $10.50.

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Chapter 15: Monopoly • 215

13.

b.

With the competitive international price being P * = $6, the company that used to be a domestic monopoly produces a quantity QC determined by the equation MC = P *, or 1 + Q = $6, with the solution QC = 5. However, at this price, domestic demand is Q = 10 – 6 = 4. Thus, the company produces for the whole domestic market and exports 5 – 4 = 1 unit of the product.

c.

Our conclusion in Chapter 9 that a country becomes an exporter when the international price is greater than the domestic price without trade does not hold, because the domestic no-trade price is a monopoly price. However, the conclusion still holds if we relate to the “efficient” domestic price, the one determined by the equation P = MC, or 10 – Q = 1 + Q. (This equation gives Q E = 4.5 and the corresponding price P E = 10 – 4.5 = $5.5.)

d.

If the international price happened to be exactly equal to the domestic monopoly price, the domestic quantities demanded and supplied would not change; therefore, consumers would neither gain nor lose from trade. The monopoly, however, would produce a greater quantity, given by the equation P * = MC, or $7 = 1 + Q, with the solution Q = 6. The difference 6 – 3 = 3 would be exported. Our conclusion in Chapter 9 holds above the monopoly price.

Based on market research, a film production company obtains the following information about the demand and production costs of its new DVD: Price Total Revenue Marginal Revenue Marginal Cost

= 1000 – 10Q = 1000Q – 10Q2 = 1000 – 20Q = 100 + 10Q

where Q indicates the number of copies sold and P is the price in cents. a. Find the price and quantity that maximizes the company’s profit. b. Find the price and quantity that would maximize social welfare. c. Calculate the deadweight loss from monopoly. d. Suppose, in addition to the costs above, the director of the film has to be paid. The company is considering four options: i. A flat fee of 2000 cents ii. 50 percent of the profits iii. 150 cents per unit sold iv. 50 percent of the revenue For each option, calculate the profit-maximizing price and quantity. Which, if any, of these compensation schemes would alter the deadweight loss from monopoly? Explain.

The company faces a downward sloping demand curve; therefore, it has monopoly power in the market for its DVD. a. The profit-maximizing quantity is given by the equation 1000 – 20Q = 100 + 10Q. The solution is Q = 30 units. The corresponding price is given by the demand curve for Q = 30: P = 1000 – 10 × 30 = 700. b. Social welfare is maximized when P = MC; that is, 1000 – 10Q = 100 + 10Q. The result is Q = 45 units, and P = 1000 – 10 × 45 = 550.

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216 • Chapter 15: Monopoly c.

Deadweight loss is (1/2)(700 – 550)(45 – 30) = 1125.

d. The flat fee is a fixed cost, which does not alter the profit-maximizing quantity or price; deadweight loss is the same as before. The second option does not alter the quantity decision either. The third option, 150 cents per unit sold, changes marginal cost to MC = 250 + 10Q. The new profit maximizing quantity is given by 1000 – 20Q = 250 + 10Q, with the solution Q = 25 and P = 1000 – 10 × 25 = 750. The fourth option reduces total revenue and marginal revenue by half. The profit-maximizing quantity is now given by the equation 500 – 10Q = 100 + 10Q; the solution is Q = 20 units, and price is P = 1000 – 10 × 20 = 800. The last two options reduce quantity and increase price; thus they alter deadweight loss.

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Chapter 16 Monopolistic Competition SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Define oligopoly and monopolistic competition and give an example of each.

Oligopoly is a market structure with few sellers and similar or identical products. Such examples are aircraft manufacturing, breakfast cereal, and cigarettes. Monopolistic competition markets include many firms producing slightly differentiated products. Examples are fiction literature, restaurants, movies, and CDs.

2.

List the three key attributes of monopolistic competition. • Draw a diagram and explain the longrun equilibrium in a monopolistically competitive market. How does this equilibrium differ from that in a perfectly competitive market?

The three key attributes of monopolistic competition are (1) there are many sellers, (2) each firm produces a slightly different product, and (3) firms can enter or exit the market freely.

Figure 1 shows the long-run equilibrium in a monopolistically competitive market. This equilibrium differs from that in a perfectly competitive market because price exceeds marginal cost and the firm does not produce at the minimum point of average total cost.

Figure 1

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218 • Chapter 16: Monopolistic Competition 3.

How might advertising make markets less competitive? How might it make markets more competitive? • Give the arguments for and against brand names.

Advertising may make markets less competitive because it manipulates people’s tastes rather than being informative. Advertising gives consumers the perception that there is a greater difference between two products than really exists. That makes the demand curve for a product more inelastic, so the firms then charge greater markups over marginal cost. However, some advertising could make markets more competitive, since advertising is just one more method of competition between products, and since it sometimes provides useful information to consumers, allowing them to more easily take advantage of price differences. In addition, expensive advertising can be a signal of quality. Advertising also allows entry, since advertising can be used to inform consumers about a new product.

Brand names may be beneficial because they provide information to consumers about the quality of goods. They also give firms an incentive to maintain high quality, since their reputations are important. But brand names may be criticized because they may simply differentiate products that are not really different, as in the case of drugs that are identical but the brand-name drug sells at a much higher price than the generic drug.

Questions for Review 1.

Describe the three attributes of monopolistic competition. How is monopolistic competition like monopoly? How is it like perfect competition?

The three attributes of monopolistic competition are (1) there are many sellers, (2) each seller produces a slightly different product, and (3) firms can enter or exit the market without restriction. Monopolistic competition is like monopoly because firms face a downward-sloping demand curve, so price exceeds marginal cost. Monopolistic competition is like perfect competition because, in the long run, price equals average total cost, as free entry and exit drive economic profit to zero.

2.

Draw a diagram depicting a firm in a monopolistically competitive market that is making profits.

Now show what happens to this firm as new firms enter the industry.

In Figure 2, a firm has demand curve D1 and marginal-revenue curve MR1. The firm is making profits because, at quantity Q1, price (P1) is above average total cost (ATC ). Those profits induce other firms to enter the industry, causing the demand curve to shift to D2 and the marginalrevenue curve to shift to MR2. The result is a decline in quantity to Q2, at which point the price (P2) equals average total cost (ATC ), so profits are now zero.

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Chapter 16: Monopolistic Competition • 219

Figure 2 3.

Draw a diagram of the long-run equilibrium in a monopolistically competitive market. How is price related to average total cost? How is price related to marginal cost?

Figure 3 shows the long-run equilibrium in a monopolistically competitive market. Price equals average total cost. Price is above marginal cost.

Figure 3

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220 • Chapter 16: Monopolistic Competition 4.

Does a monopolistic competitor produce too much or too little output compared to the most efficient level? What practical considerations make it difficult for policymakers to solve this problem?

Since, in equilibrium, price is above marginal cost, a monopolistic competitor produces too little output. But this is a hard problem to solve because (1) the administrative burden of regulating the large number of monopolistically competitive firms would be high, and (2) the firms are earning zero economic profits, so forcing them to price at marginal cost means that firms would lose money unless the government subsidized them.

5.

How might advertising reduce economic well-being? How might advertising increase economic well-being?

Advertising might reduce economic well-being because it is costly, manipulates people’s tastes, and impedes competition by making products appear more different than they really are. But advertising might increase economic well-being by providing useful information to consumers and fostering competition.

6.

How might advertising with no apparent informational content in fact convey information to consumers?

Advertising with no apparent informational content might convey information to consumers if it provides a signal of quality. A firm will not be willing to spend much money advertising a lowquality good, but will be willing to spend significantly more advertising a high-quality good.

7.

Explain two benefits that might arise from the existence of brand names.

The two benefits that might arise from the existence of brand names are (1) brand names provide consumers with information about quality when quality cannot be easily judged in advance, and (2) brand names give firms an incentive to maintain high quality to maintain the reputation of their brand names.

Quick Check Multiple Choice

1. Which of the following conditions does NOT describe a firm in a monopolistically competitive market? a. It makes a product different from its competitors. b. It takes its price as given by market conditions. c. It maximizes profit both in the short run and in the long run. d. It has the freedom to enter or exit in the long run.

2. Which of the following goods best fits the definition of monopolistic competition? a. wheat b. tap water c. crude oil d. restaurants 3. A monopolistically competitive firm will increase its production in which of the following circumstances? a. marginal revenue is greater than marginal cost b. marginal revenue is greater than average total cost c. price is greater than marginal cost d. price is greater than average total cost

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Chapter 16: Monopolistic Competition • 221

4. New firms will enter a monopolistically competitive market in which of the following circumstances? a. marginal revenue is greater than marginal cost b. marginal revenue is greater than average total cost c. price is greater than marginal cost d. price is greater than average total cost 5. Which of the following is true of a monopolistically competitive market in long-run equilibrium? a. Price is greater than marginal cost. b. Price is equal to marginal revenue. c. Firms make positive economic profits. d. Firms produce at the minimum of average total cost.

6. If advertising makes consumers more loyal to particular brands, it could ___ the elasticity of demand and ___ the markup of price over marginal cost. a. increase, increase b. increase, decrease c. decrease, increase d. decrease, decrease 1. b 2. d 3. a 4. d 5. a 6. c Problems and Applications 1.

Classify the following markets as perfectly competitive, monopolistic, or monopolistically competitive, and explain your answers. a. wooden #2 pencils b. bottled water c. copper d. local telephone service e. peanut butter f. lipstick g. cola h. beer a.

The market for #2 pencils is perfectly competitive, since pencils by any manufacturer are identical and there are a large number of manufacturers.

b.

The market for bottled water is monopolistically competitive because of consumers’ concerns about quality. As a result, each producer has a slightly different product.

c.

The market for copper is perfectly competitive, since all copper is identical and there are a large number of producers.

d.

The market for local telephone service is monopolistic because it is a natural monopoly— it is cheaper for one firm to supply all the output.

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222 • Chapter 16: Monopolistic Competition

2.

3.

e.

The market for peanut butter is monopolistically competitive because different brand names exist with different quality characteristics.

f.

The market for lipstick is monopolistically competitive because lipstick from different firms differs slightly, but there are a large number of firms who can enter or exit without restriction.

g.

The market for cola is monopolistically competitive because cola from different firms differs slightly but there are a large number of firms who can enter or exit without restriction.

h.

The market for beer is monopolistically competitive because beer from different firms differs slightly but there are a large number of firms who can enter or exit without restriction.

For each of the following characteristics, say whether it describes a perfectly competitive firm, a monopolistically competitive firm, both, or neither. a. sells a differentiated product from its competitors b. has marginal revenue less than price c. earns economic profit in the long run d. produces at minimum of average total cost in the long run e. equates marginal revenue and marginal cost f. charges a price above marginal cost a.

Monopolistically competitive firm.

b.

Monopolistically competitive firm.

c.

Neither.

d.

Perfectly competitive firm.

e.

Both.

f.

Monopolistically competitive firm.

For each of the following characteristics, say whether it describes a monopoly firm, a monopolistically competitive firm, both, or neither. a. faces a downward-sloping demand curve b. has marginal revenue less than price c. faces the entry of new firms selling similar products d. earns economic profit in the long run e. equates marginal revenue and marginal cost f. produces the socially efficient quantity of output a.

Both.

b.

Both.

c.

Monopolistically competitive firm.

d.

Monopoly.

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Chapter 16: Monopolistic Competition • 223

4.

e.

Both.

f.

Neither.

Sparkle is one firm of many in the market for toothpaste, which is in long-run equilibrium. a. Draw a diagram showing Sparkle’s demand curve, marginal-revenue curve, average total-cost curve, and marginal-cost curve. Label Sparkle’s profit-maximizing output and price. b. What is Sparkle’s profit? Explain. c. On your diagram, show the consumer surplus derived from the purchase of Sparkle toothpaste. Also show the deadweight loss relative to the efficient level of output. d. If the government forced Sparkle to produce the efficient level of output, what would happen to the firm? What would happen to Sparkle’s customers? a.

Figure 4 illustrates the market for Sparkle toothpaste in long-run equilibrium. The profitmaximizing level of output is QM and the price is PM.

Figure 4 b.

Sparkle’s profit is zero, since at quantity QM, price equals average total cost.

c.

The consumer surplus from the purchase of Sparkle toothpaste is area A + B. The efficient level of output occurs where the demand curve intersects the marginal-cost curve, at QC. So the deadweight loss is area C, the area above marginal cost and below demand, from QM to QC.

d.

If the government forced Sparkle to produce the efficient level of output, the firm would lose money because average total cost would exceed price, so the firm would shut down.

If that happened, Sparkle’s customers would earn no consumer surplus from this firm.

They would likely switch to another firm (reduced product variety may result).

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224 • Chapter 16: Monopolistic Competition 5.

6.

You are hired as the consultant to a monopolistically competitive firm. The firm reports the following information about its price, marginal cost, and average total cost. Can the firm possibly be maximizing profit? If not, what should it do to increase profit? If the firm is profit-maximizing, is the firm in a long-run equilibrium? If not, what will happen to restore long-run equilibrium? a. P < MC, P < ATC b. P > MC, P < ATC c. P = MC, P > ATC d. P > MC, P = ATC a.

No, the firm is making losses; the firm may want to find a higher price on the demand curve it faces. In the long run, if the firm cannot set a higher price, then it will exit the market.

b.

No, the firm is making losses; the firm may want to lower its own costs. In the long run, the firm will exit.

c.

Yes, the firm is making a profit but not maximizing its profit; it may want to find a higher price on the demand curve it faces. To restore long-run equilibrium, the entry of new firms will occur, and the demand curve faced by this firm will shift to the left.

d.

Yes, the firm is maximizing profit and it is in a long-run equilibrium.

For each of the following pairs of firms, explain which firm would be more likely to engage in advertising: a. a family-owned farm or a family-owned restaurant b. a manufacturer of forklifts or a manufacturer of cars c. a company that invented a very reliable watch or a company that invented a less reliable watch that costs the same amount to make a.

A family-owned restaurant would be more likely to advertise than a family-owned farm because the output of the farm is sold in a perfectly competitive market, in which there is no reason to advertise, while the output of the restaurant is sold in a monopolistically competitive market.

b.

A manufacturer of cars is more likely to advertise than a manufacturer of forklifts because there is little difference between different brands of industrial products such as forklifts, while there are greater perceived differences between consumer products such as cars. The possible return to advertising is greater in the case of cars than in the case of forklifts.

c.

A company that invented a reliable watch is likely to advertise more than a company that invented a less reliable watch that costs the same amount to make, because the company with the reliable watch will get many repeat sales over time to cover the cost of the advertising, while the company with the less reliable watch will not.

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Chapter 16: Monopolistic Competition • 225 7.

The makers of Tylenol pain reliever do a lot of advertising and have very loyal customers. In contrast, the makers of generic acetaminophen do no advertising, and their customers shop only for the lowest price. Assume that the marginal costs of Tylenol and generic acetaminophen are the same and constant. a. Draw a diagram showing Tylenol’s demand, marginal-revenue, and marginal-cost curves. Label Tylenol’s price and markup over marginal cost. b. Repeat part (a) for a producer of generic acetaminophen. How do the diagrams differ?

Which company has the bigger markup? Explain. c. Which company has the greater incentive for careful quality control? Why? a.

Figure 5 shows Tylenol’s demand, marginal-revenue, and marginal-cost curves. Tylenol’s price is PT, its marginal cost is MCT, and its markup over marginal cost is PT – MCT.

Figure 5 b.

Figure 6 shows the demand, marginal-revenue, and marginal-cost curves for a maker of acetaminophen. The diagrams differ in that the acetaminophen maker faces a horizontal demand curve, while the maker of Tylenol faces a downward-sloping demand curve. The acetaminophen maker has no markup of price over marginal cost, while the maker of Tylenol has a positive markup, because it has some market power.

Figure 6 c.

The maker of Tylenol has a bigger incentive for careful quality control because if quality were poor, the value of its brand name would deteriorate, sales would decline, and its advertising would be worth less.

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226 • Chapter 16: Monopolistic Competition 8.

Sleek Sneakers Co. is one of many firms in the market for shoes. a. Assume that Sleek is currently earning short-run economic profits. On a correctly labelled diagram, show Sleek’s profit maximizing output and price, as well as the area representing profit. b. What happens to Sleek’s price, output, and profit in the long run? Explain this change in words, and show it on a new diagram. c. Suppose that over time, consumers become more focused on stylistic differences among shoe brands. How would this change in attitude affect each firm’s price elasticity of demand? In the long run, how will this change in demand affect Sleek’s price, output, and profits? d. At the profit-maximizing price you identified in part (c), is Sleek’s demand curve elastic or inelastic? Explain. a. Figure 7 shows Sleek’s short-run profit.

Price, Costs MC

Pric e ATC

ATC Profit Demand Marginal Revenue Quantity Figure 7

b. More firms enter the market in the long run, reducing the demand for Sleek’s product.

Sleek’s price decreases and profits reduce to zero. Quantity may decrease or not, depending on how the elasticity of demand changes; most likely, demand becomes more elastic because of the diversification in substitutes, in which case the quantity produced increases. Figure 8 shows the long-run situation with zero profits.

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Chapter 16: Monopolistic Competition • 227

Price, Costs

MC ATC

Price=ATC Demand Marginal revenue Quantity Figure 8 c.

If Sleek’s and other firms’ customers become more loyal to the brand, price elasticity of demand is reduced; each firm can decrease production and increase prices. They make profit in the short run, but in the long run, profits remain at zero.

d. Demand must be inelastic at the profit-maximizing level of production for any firm facing a downward-sloping demand curve because, otherwise, the firm could increase the price and profit.

9.

The market for peanut butter in Nutville is monopolistically competitive and in long-run equilibrium. One day, consumer advocate Skippy Jif discovers that all brands of peanut butter in Nutville are identical. Thereafter, the market becomes perfectly competitive and again reaches its long-run equilibrium. Using an appropriate diagram, explain whether each of the following variables increases, decreases, or stays the same for the typical firm in the market:  price  quantity  average total cost  marginal cost  profit

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228 • Chapter 16: Monopolistic Competition Compared to perfect competition, the monopolistic competitive firm produces less output and sells at a higher price; its average total cost is higher and marginal cost lower. Profits are zero in the long run for both types of firms. (See Figure 9, where P ’ and Q’ represent the monopolistic competitive firm, while P ” and Q ” represent the competitive firm.)

Figure 9 10.

Consider a monopolistically competitive market with N firms. Each firm’s business opportunities are described by the following equations: Demand: Marginal Revenue: Total Cost: Marginal Cost:

Q = 100/N – P MR = 100/N – 2Q TC = 50 + Q2 MC = 2Q

a. How does N, the number of firms in the market, affect each firm’s demand curve?

Why? b. How many units does each firm produce? (The answer to this question and the next two depend on N.) c. What price does each firm charge? d. How much profit does each firm make? e. In the long run, how many firms will exist in this market? a.

Each firm’s demand falls when the number of firms increases because the products are to some extent substitutes. A new brand will divert some customers from the other existing brands.

b.

Each firm will produce a quantity determined by the equation MR = MC, or 100/N – 2Q = 2Q. The solution is Q = 25/N.

c.

The corresponding price is given by the demand function: P = 100/N – 100/(4N) = 75/N.

d.

Profit = PQ – TC = ((75/N) × (25/N)) – (50 + 625/N2) = (1875/N2) – (625/N2) – 50 = 1250/N2 – 50.

e.

The number of firms is given by the condition that Profit = 0. The equation 1250/N2 – 50 = 0 has the solution N = 5 firms in the market.

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Chapter 17 Oligopoly SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

If the members of an oligopoly could agree on a total quantity to produce, what quantity would they choose? • If the oligopolists do not act together but instead make production decisions individually, do they produce a total quantity more or less than in your answer to the previous question? Why? If the members of an oligopoly could agree on a total quantity to produce, they would choose to produce the monopoly quantity, acting in collusion as if they were a monopoly.

If the members of the oligopoly make production decisions individually, they produce a greater quantity than the monopoly quantity because self-interest leads them to produce more than the monopoly quantity.

2.

Tell the story of the prisoners’ dilemma. Prepare a table showing the prisoners’ choices and explain what outcome is likely. • What does the prisoners’ dilemma teach us about oligopolies?

The prisoners’ dilemma is the story of two criminals suspected of committing a crime, in which the sentence that each receives depends both on his or her decision whether to confess or remain silent and on the decision made by the other. The following table shows the prisoners’ choices: Bonnie’s Decision

Clyde’s Decision

Confess

Remain Silent

Confess

Bonnie gets 8 years Clyde gets 8 years

Bonnie gets 20 years Clyde goes free

Remain Silent

Bonnie goes free Clyde gets 20 years

Bonnie gets 1 year Clyde gets 1 year

The likely outcome is that both will confess, since that is a dominant strategy for both.

The prisoners’ dilemma teaches us that oligopolies have trouble maintaining monopoly profits because each oligopolist has an incentive to cheat.

3.

What kind of agreement is illegal for businesses to make? • Why are the competition laws controversial?

It is illegal for businesses to make an agreement about reducing quantities or raising prices.

Competition laws are controversial because it is not always clear which kinds of behaviour these laws should prohibit, such as resale price maintenance, predatory pricing, and tying.

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230 • Chapter 17: Oligopoly Questions for Review 1.

If a group of sellers could form a cartel, what quantity and price would they try to set?

If a group of sellers could form a cartel, they would try to set quantity and price like a monopolist. They would set quantity at the point where marginal revenue equals marginal cost, and set price at the corresponding point on the demand curve.

2.

Compare the quantity and price of an oligopoly to those of a monopoly.

Firms in an oligopoly produce a quantity of output greater than the level produced by monopoly at a price lower than the monopoly price.

3.

Compare the quantity and price of an oligopoly to those of a competitive market.

Firms in an oligopoly produce a quantity of output less than the level produced by a competitive market at a price greater than the competitive price.

4.

How does the number of firms in an oligopoly affect the outcome in its market?

As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

5.

What is the prisoners’ dilemma, and what does it have to do with oligopoly?

The prisoners’ dilemma is a game between two people or firms that illustrates why it is difficult for opponents to cooperate even when cooperation would make them all better off. Each person or firm has a great incentive to cheat on any cooperative agreement to make themselves or itself better off. Thus oligopoly outcomes will be less profitable than a cooperative (or monopoly) outcome.

6.

Give two examples other than oligopoly that show how the prisoners’ dilemma helps to explain behaviour.

Advertising and common resources are two examples of how the prisoners’ dilemma helps explain behaviour. In advertising, two companies would be better off if neither advertised, but each is fearful that if it does not advertise, the other company will. When two companies share a common resource, they would be better off sharing it conscientiously. But, fearful that the other company will use more of the common resource, each company ends up overusing it.

7.

What kinds of behaviour do the competition laws prohibit?

Competition laws prohibit firms from trying to monopolize a market. They are used to prevent mergers that would lead to excessive market power in any firm and to keep oligopolists from acting together in ways that would make the market less competitive.

8.

What is resale price maintenance, and why is it controversial?

Resale price maintenance occurs when a wholesaler sets a minimum price that retailers can charge. This might seem to be anticompetitive because it prevents retailers from competing on price. But that is doubtful because (1) if the wholesaler has market power, it can exercise such power through the wholesale price; (2) wholesalers have no incentive to discourage competition among retailers since doing so reduces the quantity sold; and (3) maintaining a minimum price may be valuable, so retailers will provide customers with good service.

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Chapter 17: Oligopoly • 231 Quick Check Multiple Choice

1. What is the key feature of an oligopolistic market? a. each firm produces a different product from other firms b. a single firm chooses a point on the market demand curve c. each firm takes the market price as given d. a small number of firms are acting strategically 2. If an oligopolistic industry organizes itself as a cooperative cartel, it will produce a quantity of output that is ___ the competitive level and ___ the monopoly level. a. less than, more than b. more than, less than c. less than, equal to d. equal to, more than 3. If an oligopoly does not cooperate and each firm chooses its own quantity, the industry will produce a quantity of output that is ___ the competitive level and ___ the monopoly level. a. less than, more than b. more than, less than c. less than, equal to d. equal to, more than 4. As the number of firms in an oligopoly grows large, the industry approaches a level of output that is ___ the competitive level and ___ the monopoly level. a. less than, more than b. more than, less than c. less than, equal to d. equal to, more than 5. The prisoners’ dilemma is a two-person game that illustrates which of the following? a. the cooperative outcome could be worse for both people than the Nash equilibrium b. even if the cooperative outcome is better than the Nash equilibrium for one person, it might be worse for the other c. even if cooperation is better than the Nash equilibrium, each person might have an incentive not to cooperate d. rational, self-interested individuals will naturally avoid the Nash equilibrium because it is worse for both of them 6. What does competition policy aim to do? a. facilitate cooperation among firms in oligopolistic industries b. encourage mergers to take advantage of economies of scale c. discourage firms from moving production facilities overseas d. prevent firms from acting in ways that reduce competition 1. d 2. c 3. a 4. d 5. c 6. d

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232 • Chapter 17: Oligopoly Problems and Applications 1.

2.

Some years ago, the New York Times reported that “the inability of OPEC to agree last week to cut production has sent the oil market into turmoil . . . [leading to] the lowest price for domestic crude oil since June 1990.” a. Why were the members of OPEC trying to agree to cut production? b. Why do you suppose OPEC was unable to agree on cutting production? Why did the oil market go into “turmoil” as a result? c. The newspaper also noted OPEC’s view “that producing nations outside the organization, like Norway and Britain, should do their share and cut production.” What does the phrase “do their share” suggest about OPEC’s desired relationship with Norway and Britain? a.

OPEC members were trying to reach an agreement to cut production so they could raise the price.

b.

They were unable to agree on cutting production because each country has an incentive to cheat on any agreement. The turmoil is a decline in the price of oil because of increased production.

c.

OPEC would like Norway and Britain to join their cartel so they could act like a monopoly.

A large share of the world supply of diamonds comes from Russia and South Africa. Suppose that the marginal cost of mining diamonds is constant at $1000 per diamond, and the demand for diamonds is described by the following schedule: Price $8000 7000 6000 5000 4000 3000 2000 1000

Quantity 5000 6000 7000 8000 9000 10 000 11 000 12 000

a. If there were many suppliers of diamonds, what would be the price and quantity? b. If there was only one supplier of diamonds, what would be the price and quantity? c. If Russia and South Africa formed a cartel, what would be the price and quantity? If the countries split the market evenly, what would be South Africa’s production and profit? What would happen to South Africa’s profit if it increased its production by 1000 while Russia stuck to the cartel agreement? d. Use your answer to part (c) to explain why cartel agreements are often not successful. a.

If there were many suppliers of diamonds, price would equal marginal cost ($1000), so the quantity would be 12 000.

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Chapter 17: Oligopoly • 233 b.

With only one supplier of diamonds, quantity would be set where marginal cost equals marginal revenue. The following table derives marginal revenue:

Price (thousands of dollars) 8 7 6 5 4 3 2 1

Quantity (thousands) 5 6 7 8 9 10 11 12

Total Revenue (millions of dollars) 40 42 42 40 36 30 22 12

Marginal Revenue (millions of dollars) ---2 0 –2 –4 –6 –8 –10

With marginal cost of $1000 per diamond, or $1 million per thousand diamonds, the monopoly will maximize profits at a price of $7000 and a quantity of 6000. Additional production beyond this point would lead to a situation where marginal revenue is lower than marginal cost.

3.

c.

If Russia and South Africa formed a cartel, they would set price and quantity like a monopolist, so the price would be $7000 and the quantity would be 6000. If they split the market evenly, they would share total revenue of $42 million and costs of $6 million, for a total profit of $36 million. So each would produce 3000 diamonds and get a profit of $18 million. If Russia produced 3000 diamonds and South Africa produced 4000, the price would decline to $6000. South Africa’s revenue would rise to $24 million, costs would be $4 million, so profits would be $20 million, which is an increase of $2 million.

d.

Cartel agreements are often not successful because one party has a strong incentive to cheat to make more profit. In this case, each could increase profit by $2 million by producing an extra thousand diamonds. However, if both countries did this, profits would decline for both of them.

This chapter discusses companies that are oligopolists in the market for the goods they sell.

Many of the same ideas apply to companies that are oligopolists in the market for the inputs they buy. a. If sellers who are oligopolists try to increase the price of goods they sell, what is the goal of buyers who are oligopolists? b. National Hockey League team owners have an oligopoly in the market for hockey players. What is the owners’ goal regarding players’ salaries? Why is this goal difficult to achieve? c. Hockey players went on strike in 2004 because they would not accept the salary cap that the owners wanted to impose. If the owners were already colluding over salaries, why did the owners feel the need for a salary cap? a.

Buyers who are oligopolists try to decrease the prices of goods they buy.

b.

The owners of hockey teams would like to keep players’ salaries low. This goal is difficult to achieve because each team has an incentive to cheat on any agreement, since they will be able to attract better players by offering higher salaries.

c.

The salary cap would have formalized the collusion on salaries and helped to prevent any team from cheating.

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234 • Chapter 17: Oligopoly 4.

Consider trade relations between Canada and Mexico. Assume that the leaders of the two countries believe the payoffs to alternative trade policies are as follows:

a. What is the dominant strategy for Canada? For Mexico? Explain. b. Define Nash equilibrium. What is the Nash equilibrium for trade policy? c. In 1993, Parliament ratified the North American Free Trade Agreement (NAFTA), in which Canada, the United States, and Mexico agreed to reduce trade barriers simultaneously. Do the perceived payoffs shown here justify this approach to trade policy? d. Based on your understanding of the gains from trade (discussed in Chapters 3 and 9), do you think that these payoffs actually reflect a nation’s welfare under the four possible outcomes? a.

If Mexico imposes low tariffs, then Canada is better off with high tariffs, since it gets $30 billion with high tariffs and only $25 billion with low tariffs. If Mexico imposes high tariffs, then Canada is better off with high tariffs, since it gets $20 billion with high tariffs and only $10 billion with low tariffs. So, Canada has a dominant strategy of high tariffs.

If Canada imposes low tariffs, then Mexico is better off with high tariffs, since it gets $30 billion with high tariffs and only $25 billion with low tariffs. If Canada imposes high tariffs, then Mexico is better off with high tariffs, since it gets $20 billion with high tariffs and only $10 billion with low tariffs. So, Mexico has a dominant strategy of high tariffs.

b.

A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies others have chosen. The Nash equilibrium in this case is for each country to have high tariffs.

c.

NAFTA represents cooperation among the three countries. Each country reduces tariffs and all are better off as a result.

d.

The payoffs in the upper left and lower right parts of the box do reflect a nation’s welfare. Trade is beneficial and tariffs are a barrier to trade. However, the payoffs in the upper right and lower left parts of the box are not valid. A tariff hurts domestic consumers and helps domestic producers, but total surplus declines, as we saw in Chapter 9. So, it would be more accurate for these two areas of the box to show that both countries’ welfare will decline if they imposed high tariffs, whether or not the other country had high or low tariffs.

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Chapter 17: Oligopoly • 235 5.

You and a classmate are assigned a project on which you will receive one combined grade. You each want to receive a good grade, but you also want to avoid hard work. In particular, here is the situation: • If both of you work hard, you both get an A, which gives each of you 40 units of happiness.

• If only one of you works hard, you both get a B, which gives each of you 30 units of happiness.

• If neither of you works hard, you both get a D, which gives each of you 10 units of happiness.

• Working hard costs 25 units of happiness. a. Fill in the payoffs in the following decision box:

b. What is the likely outcome? Explain your answer. c. If you get this classmate as your partner on a series of projects throughout the year, rather than only once, how might that change the outcome you predicted in part (b)? d. Another classmate cares more about good grades: She gets 50 units of happiness for a B and 80 units of happiness for an A. If this classmate were your partner (but your preferences were unchanged), how would your answers to parts (a) and (b) change?

Which of the two classmates would you prefer as a partner? Would she also want you as a partner? a. To fill in the payoff matrix, you need to determine the net payoff, which is the units of happiness you get from the resulting outcome minus the cost of working hard in the case where the decision is to work hard. If you both work hard and get A’s, you both get 40 units of happiness, but at a cost of 25 units of happiness due to working hard, for a net payoff for each of you of 15 (40–25). If one of you works hard and the other shirks, you both get a B and the net benefit to the one that works hard is 5 (30–25), and the net benefit to the one that shirks is 30. If you both shirk, you each get a payoff of 10. The payoff matrix looks like this:

15 15

30 5

5 30

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10 10

236 • Chapter 17: Oligopoly b. If your classmate chooses Work, the best thing for you to do is choose Shirk (30 > 15). If your classmate chooses Shirk, the best thing for you to do is to choose Shirk (10 > 5). So, you should Shirk regardless of what your classmate does. You have a dominant strategy of Shirk. The same is true for your classmate. Since you each have a dominant strategy of Shirk, this is likely to be the outcome, and you each receive a payoff of 10. Notice that you would both be better off if you could cooperate and both choose Work, which would give you a payoff of 15 each. c.

If you are together for a series of projects, you could make an initial agreement to cooperate and both work hard, but you can also specify what happens if either of you reneges on this agreement and shirks. You could agree, for instance, that once one of you reneges and shirks, both of you will shirk forever after that. This penalty is easy to enforce because if one of you shirks, the other has every reason to do the same. The threat of this penalty may be all that is needed to maintain cooperation. You each know that shirking while the other works would raise the shirker’s net payoff from 15 to 30. But this benefit would last for only one project. Thereafter, the payoff would fall to 10 and stay there. As long as you and your classmate care enough about future payoffs, you will choose to forgo the one-time gain from defection. Thus, in a repeated game, you may be able to reach the cooperative outcome.

d. In this case, the payoff matrix looks like this:

15 55

30 25

5

50

10

10

In this case, your dominant strategy remains to Shirk regardless of what your classmate does.

Your classmate’s dominant strategy however is to Work regardless of what you do. Thus, the outcome of the game is likely to be that you Shirk while your classmate Works. You would prefer this classmate to the previous classmate because your payoff in this case will be 30 rather than 10. Your classmate would prefer a partner with preferences for high grades similar to hers, and who had a dominant strategy of Work.

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Chapter 17: Oligopoly • 237 6.

7.

The chapter described an advertising game between Molson and Labatt. Suppose the federal government is considering a law prohibiting beer commercials on television. a. Would you expect the beer companies to oppose this law? Why? b. Would you expect beer company profits to rise or fall? Why? a.

The beer companies would not oppose the law, as each firm would not have to bear the cost of advertising.

b.

Beer company profits would rise due to no advertising costs.

Farmer Singh and Farmer Vu graze their cattle in the same field. If there are 20 cows grazing in the field, each cow produces $4000 of milk over its lifetime. If there are more cows in the field, then each cow can eat less grass, and its milk production falls. With 30 cows in the field, each produces $3000 of milk; with 40 cows, each produces $2000 of milk. Cows cost $1000 apiece. a. Assume that Farmer Singh and Farmer Vu can each purchase either 10 or 20 cows, but that neither knows how many the other is buying when she makes her purchase.

Calculate the payoffs of each outcome. b. What is the likely outcome of this game? What would be the best outcome? Explain. c. There used to be more common fields than there are today. Why? (For more discussion of this topic, reread Chapter 11.) a.

If Vu has 10 cows and Singh has 10, for a total of 20 cows, each cow produces $4000 of milk. Since a cow costs $1000, profits would be $3000 per cow, or $30 000 for each farmer.

If one farmer had 10 cows and the other farmer had 20 cows, for a total of 30 cows, each cow produces $3000 of milk. Profits per cow would be $2000, so the farmer with 10 cows makes $20 000; the farmer with 20 cows makes $40 000.

If both farmers have 20 cows, for a total of 40 cows, each cow produces $2000 of milk.

Profit per cow is $1000, so each farmer’s profit is $20 000. The results are shown in the table: Singh’s Decision

Vu’s Decision

b.

10 cows

20 cows

10 cows

$30 000 profit for Singh $30 000 profit for Vu

$40 000 profit for Singh $20 000 profit for Vu

20 cows

$20 000 profit for Singh $40 000 profit for Vu

$20 000 profit for Singh $20 000 profit for Vu

If Singh had 10 cows, Vu would want 20 cows. If Singh had 20 cows, Vu would be indifferent (get the same profit) if she had 10 or 20 cows. So, Vu has a dominant strategy of having 20 cows.

If Vu had 10 cows, Singh would want 20 cows. If Vu had 20 cows, Singh would be indifferent (get the same profit) if she had 10 or 20 cows. So, Singh has a dominant strategy of having 20 cows.

The Nash equilibrium is for each farmer to have 20 cows, since that is the dominant strategy for each. They each make profits of $20 000. But they would both be better off if they cooperated and each had only 10 cows; then profit would be $30 000 each.

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238 • Chapter 17: Oligopoly c.

8.

The problem illustrates how a common field may be overused, reducing the profits of producers. Since people tend to overuse common fields, it is more efficient for people to own their own portion of the field. Thus, over time, common fields have been divided up and owned privately.

Little Kona is a small coffee company that is considering entering a market dominated by Big Brew. Each company’s profit depends on whether Little Kona enters and whether Big Brew sets a high price or a low price:

Big Brew threatens Little Kona by saying, “If you enter, we’re going to set a low price, so you had better stay out.” Do you think Little Kona should believe the threat? Why or why not? What do you think Little Kona should do?

Little Kona should not believe this threat from Big Brew because it is not in Big Brew’s interest to carry out the threat. If Little Kona enters, Big Brew can set a high price, in which case it makes $3 million, or Big Brew can set a low price, in which case it makes $1 million. Thus, the threat is an empty one, which Little Kona should ignore; Little Kona should enter the market.

9.

Jeff and Steve are playing tennis. Every point comes down to whether Steve guesses correctly whether Jeff will hit the ball to Steve’s left or right. The outcomes are:

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Chapter 17: Oligopoly • 239

Does either player have a dominant strategy? If Jeff chooses a particular strategy (Left or Right) and sticks with it, what will Steve do? Can you think of a better strategy for Jeff to follow?

Steve would want to guess left when Jeff hits left, and to guess right when Jeff hits right. Thus, Steve does not have a dominant strategy. Jeff, on the other hand, would want to hit to the opposite side of what Steve guesses. Therefore, Jeff has no dominant strategy either. For Jeff, the best strategy is to try to surprise Steve, making it hard for Steve to guess. If Jeff stuck to a strategy, Steve would soon learn it and start guessing correctly. By choosing randomly a side with equal probability (50 percent), Jeff makes his choice as unpredictable as possible. The same is true for Steve: guessing randomly with 50 percent probability is his best strategy.

10.

11.

Let’s return to the chapter’s discussion of Jack and Jill’s water duopoly (page 375). Suppose that Jack and Jill are at the duopoly’s Nash equilibrium (total production of 80 L) when a third person, John, discovers a water source and joins the market as a third producer. a. Jack and Jill propose that the three of them continue to produce a total of 80 L, splitting the market three ways. If John agrees to this, how much profit will he make? b. After agreeing to the proposed deal, John is considering increasing his production by 10 L. If he does, and Jack and Jill stick to the agreement, how much profit will John make? What does this tell you about the proposed agreement? c. What is the Nash equilibrium for this market with three producers? How does it compare to the Nash equilibrium with two producers? a.

John will have 1/3 of the total profits in the market = $3200/3 = $1067.

b.

John’s profit will increase to $1100 (36.67 × $30). This tells us that John, as well as each of the other two producers, has a strong incentive to secretly sell more water than agreed to. Therefore, the agreement might not last for too long.

c.

The Nash equilibrium in this case is for each individual to produce 30 litres. In this case, the total quantity is 30 × 3 = 90 litres, the price is $30 per litre, and each producer’s profit is 30 L × $30 = $900. If John wanted to increase production by another 10 L, the market price would drop to $20 and he would make 40 L × $20 = $800 profit, which is less than before. Thus, none of the producers would like to increase the quantity further than 30 L, which makes this the Nash equilibrium quantity. With two producers, the Nash equilibrium output will be lower and the profits higher.

Two athletes of equal ability are competing for a prize of $10 000. Each is deciding whether to take a dangerous performance-enhancing drug. If one athlete takes the drug and the other does not, the one who takes the drug wins the prize. If both or neither take the drug, they tie and split the prize. Taking the drug involves health risks that are equivalent to a loss of X dollars. a. Draw a 2 × 2 decision box describing the decisions the athletes face and fill in the payoffs. b. For what X is taking the drug the Nash equilibrium? c. Does making the drug safer (that is, lowering X) make the athletes better or worse off? Explain. a.

The payoffs are as in the following table: Athlete 1 Athlete 2

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Athlete 1 5000 – X, 5000−X 0, 10 000 – X

Athlete 2 10 000 – X, 0 5000, 5000

240 • Chapter 17: Oligopoly

12.

b.

Taking the drug is a Nash equilibrium if 5000 – X > 0, which gives X < 5000.

c.

If initially X < 5000, making the drug safer makes the athletes better off because they would take it anyway, but the health hazard becomes less; if initially X > 5000, taking the drug is not a Nash equilibrium anymore, and not taking the drug becomes the new Nash equilibrium. Making the drug safer when initially X > 5000 makes the athletes worse off only if X becomes lower than 5000.

Synergy and Dynaco are the only two firms in a specific high-tech industry. They face the following payoff matrix as they decide upon the size of their research budget:

a. Does Synergy have a dominant strategy? Explain. b. Does Dynaco have a dominant strategy? Explain. c. Is there a Nash equilibrium for this scenario? Explain. (Hint: Look closely at the definition of Nash equilibrium.) a. No, Synergy does not have a dominant strategy. If Dynaco chooses Large, the best thing for Synergy to do is choose Large ($20m > $0m). If Dynaco chooses Small, the best thing for Synergy to do is choose Small ($40m > $30m). b. Yes, Dynaco has a dominant strategy. If Synergy chooses Large, the best thing for Dynaco to do is choose Large ($10m > $0m). If Synergy chooses Small, the best thing for Dynaco to do is choose Large ($70m > $50m). Thus, Dynaco should choose Large regardless of what Synergy chooses. c.

Yes, there is a Nash equilibrium: both firms choose a Large budget. At the Nash equilibrium, given the choice made by the other firm, neither firm can do better. This is the definition of a Nash equilibrium.

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Chapter 18 The Markets for the Factors of Production SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Define marginal product of labour and value of the marginal product of labour. • Describe how a competitive, profit-maximizing firm decides how many workers to hire.

The marginal product of labour is the increase in the amount of output from an additional unit of labour. The value of the marginal product of labour is the marginal product of labour times the price of the good.

A competitive, profit-maximizing firm decides how many workers to hire by hiring workers up to the point where the value of the marginal product of labour equals the wage.

2.

Who has a greater opportunity cost of enjoying leisure—a janitor or a brain surgeon? Explain.

Can this help explain why doctors work such long hours?

A brain surgeon has a higher opportunity cost of enjoying leisure than a janitor because the surgeon’s wage is so much higher. That’s why doctors work such long hours—because leisure is so expensive for them.

3.

How does an immigration of workers affect labour supply, labour demand, the marginal product of labour, and the equilibrium wage?

An immigration of workers increases labour supply but has no effect on labour demand. The result is an increase in the equilibrium quantity of labour and a decline in the equilibrium wage, as shown in Figure 1. The decline in the equilibrium wage causes the quantity demanded of labour to increase. The increase in the equilibrium quantity of labour and the decline in the equilibrium wage cause the marginal product of labour to decrease.

Figure 1

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242 • Chapter 18: The Markets for the Factors of Production 4.

What determines the income of the owners of land and capital? • How would an increase in the quantity of capital affect the incomes of those who already own capital? How would it affect the incomes of workers?

The income of the owners of land and capital is determined by the value of the marginal contribution of land and the value of the marginal contribution capital to the production process.

An increase in the quantity of capital would reduce the marginal product of capital, thus reducing the incomes of those who already own capital. However, it would increase the incomes of workers because a higher capital stock raises the marginal product of labour.

Questions for Review 1.

Explain how a firm’s production function is related to its marginal product of labour, how a firm’s marginal product of labour is related to the value of its marginal product, and how a firm’s value of marginal product is related to its demand for labour.

A firm’s production function describes the relationship between the quantity of labour used in production and the quantity of output from production. The marginal product of labour is the increase in the amount of output from an additional unit of labour. Thus the marginal product of labour depends directly on the production function.

The value of the marginal product of labour is the marginal product of labour multiplied by the market price of the output.

A competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labour equals the wage. As a result, the value-of-marginal-product curve is the labour-demand curve.

2.

Give two examples of events that could shift the demand for labour and explain why they do so.

Events that could shift the demand for labour include changes in the output price, technological change, and changes in the supply of other factors. If the output price increases, the firm’s labour-demand curve will shift to the right because the value of the marginal product of labour increases. Technological advances typically raise the marginal product of labour, which in turn increases the demand for labour and shifts the labour-demand curve to the right. If the supply of capital increases, the marginal product of labour increases and the labour-demand curve shifts to the right.

3.

Give two examples of events that could shift the supply of labour, and explain why they do so.

Events that could shift the supply of labour include changes in tastes, changes in alternative opportunities, and immigration. If more people choose to work, the supply of labour will increase.

If the wage earned in one labour market rises relative to the wage earned in another labour market, the supply of labour in the higher-wage market will increase. When immigrants enter a country, the supply of labour in that country increases.

4.

Explain how the wage can adjust to balance the supply and demand for labour while simultaneously equalling the value of the marginal product of labour.

The wage can adjust to balance the supply and demand for labour while simultaneously equalling the value of the marginal product of labour. Supply and demand for labour determine the

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Chapter 18: The Markets for the Factors of Production • 243 equilibrium wage. Firms maximize profits by choosing the amount of labour where the wage is equal to the value of the marginal product of labour.

5.

If the population of Canada suddenly grew because of a large immigration, what would happen to wages? What would happen to the rents earned by the owners of land and capital?

A large immigration would increase the supply of labour, thus reducing the wage. With more labour working with capital and land, the marginal product of capital and land is higher, so rents earned by owners of land and capital would increase.

Quick Check Multiple Choice

1. Approximately what percentage of Canadian national income is paid to workers, as opposed to owners of capital and land? a. 30 percent b. 50 percent c. 67 percent d. 90 percent 2. If firms are competitive and profit-maximizing, the demand curve for labour is determined by which of the following? a. the opportunity cost of workers’ time b. the value of the marginal product of labour c. offsetting income and substitution effects d. the value of the marginal product of capital 3. A bakery operating in competitive markets sells its output for $20 per cake and hires labour at $10 per hour. To maximize profit, it should hire labour until the marginal product of labour is how many cakes per hour? a. 1/2 cake per hour b. 2 cakes per hour c. 10 cakes per hour d. 15 cakes per hour 4. A technological advance that increases the marginal product of labour shifts the labour ___ curve to the ___. a. demand, left b. demand, right c. supply, left d. supply, right 5. Around 1976, the Canadian economy experienced a significant ___ in productivity growth, coupled with a(n) ___ in the growth of real wages. a. acceleration, acceleration b. acceleration, slowdown c. slowdown, acceleration d. slowdown, slowdown

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244 • Chapter 18: The Markets for the Factors of Production

6. A storm destroys several factories, thereby reducing the stock of capital. What effect does this event have on factor markets? a. Wages and the rental price of capital both rise. b. Wages and the rental price of capital both fall. c. Wages rise, and the rental price of capital falls. d. Wages fall, and the rental price of capital rises.

1. c 2. b 3. a 4. b 5. d 6. d Problems and Applications 1.

Suppose that the prime minister proposes a new law aimed at reducing heath care costs: All Canadians are to be required to eat one apple daily. a. How would this apple-a-day law affect the demand and equilibrium price of apples? b. How would the law affect the marginal product and the value of the marginal product of apple pickers? c. How would the law affect the demand and equilibrium wage for apple pickers? a. b.

The law requiring people to eat one apple a day increases the demand for apples. As shown in Figure 2, demand shifts from D1 to D2, increasing the price from P1 to P2, and increasing quantity from Q1 to Q2.

Since the price of apples increases, the value of marginal product increases for any given quantity of labour. There is no change in the marginal product of labour for any given quantity of labour. However, firms will choose to hire more workers, and thus the marginal product of labour at the profit-maximizing level of labour will be lower.

Figure 2

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Chapter 18: The Markets for the Factors of Production • 245 c.

As Figure 3 shows, the increase in the value of marginal product of labour shifts the demand curve of labour from D1 to D2. The equilibrium quantity of labour rises from L1 to L2, and the wage rises from w1 to w2.

Figure 3 2.

Show the effect of each of the following events on the market for labour in the computer manufacturing industry. a. The government buys personal computers for all college and university students. b. More postsecondary students major in engineering and computer science. c. Computer firms build new manufacturing plants. a.

If government were to buy personal computers for all college and university students, the demand for computers would increase, raising the price of computers and thus increasing the value of marginal product of workers who produce computers. This is shown in Figure 4 as a shift in the demand curve for labour from D1 to D2. The result is an increase in the wage from w1 to w2 and an increase in the quantity of labour from L1 to L2.

Figure 4

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246 • Chapter 18: The Markets for the Factors of Production b.

If more postsecondary students major in engineering and computer science, the supply of labour in the computer industry rises. This is shown in Figure 5 as a shift in the supply curve from S1 to S2. The result is a decrease in the wage from w1 to w2 and an increase in the quantity of labour from L1 to L2.

Figure 5 c.

If computer firms build new manufacturing plants, this increases the marginal product of labour and the value of the marginal product of labour for any given quantity of labour.

This is shown in Figure 6 as a shift in the demand curve for labour from D1 to D2. The result is an increase in the wage from w1 to w2 and an increase in the quantity of labour from L1 to L2.

Figure 6

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Chapter 18: The Markets for the Factors of Production • 247 3.

Your enterprising uncle opens a sandwich shop that employs 7 people. The employees are paid $15 per hour, and a sandwich sells for $3. If your uncle is maximizing his profit, what is the value of the marginal product of the last worker he hired? What is that worker’s marginal product?

Since your uncle is maximizing his profit, he must be hiring workers such that their wage equals the value of their marginal product. Since the wage is $15 per hour, their value of marginal product must be $15 per hour. Since the value of marginal product equals the marginal product times the price of the good, and since the price of a sandwich is $3, the marginal product of a worker must be 5 sandwiches per hour.

4.

5.

Suppose a freeze in British Columbia destroys part of the apple crop. a. Explain what happens to the price of apples and the marginal product of apple pickers as a result of the freeze. Can you say what happens to the demand for apple pickers?

Why or why not? b. Suppose the price of apples doubles and the marginal product falls by 30 percent.

What happens to the equilibrium wage of apple pickers? c. Suppose the price of apples rises by 30 percent and the marginal product falls by 50 percent. What happens to the equilibrium wage of apple pickers? a.

When a freeze destroys part of the British Columbia apple crop, the supply of apples declines, so the price of apples rises. Since there are fewer apples in a given area of apple trees, the marginal product of apple pickers declines. But since the price of apples rises, the value of the marginal product of apple pickers could rise or fall, depending on whether the marginal product falls more or less than the price rises. Thus, you cannot say whether the demand for apple pickers will rise or fall.

b.

If the price of apples doubles and the marginal product of apple pickers falls by just 30 percent, then the value of marginal product for a particular quantity of apple pickers increases, shifting the demand for apple pickers to the right, and increasing the equilibrium wage of apple pickers.

c.

If the price of apples rises by 30 percent and the marginal product of apple pickers falls by 50 percent, then the value of marginal product for a particular quantity of apple pickers decreases, shifting the demand for apple pickers to the left, and reducing the equilibrium wage of apple pickers.

During the 1980s and 1990s Canada experienced a significant inflow of capital from other countries. a. Using a diagram of the Canadian capital market, show the effect of this inflow on the rental price of capital in Canada and on the quantity of capital in use. b. Using a diagram of the Canadian labour market, show the effect of the capital inflow on the average wage paid to Canadian workers.

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248 • Chapter 18: The Markets for the Factors of Production a.

Figure 7 shows the Canadian capital market when there is an inflow of capital from abroad. The inflow of capital shifts the supply curve to the right, from S1 to S2. The result is a reduction in the rental rate on capital from r1 to r2 and an increase in the quantity of capital from K1 to K2.

Figure 7 b.

The increase in capital increases the marginal product of labour and the value of marginal product of labour for any given quantity of labour. Figure 8 shows this as a shift in the demand for labour from D1 to D2. As a result, the wage rate rises from w1 to w2 and the quantity of labour rises from L1 to L2.

Figure 8

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Chapter 18: The Markets for the Factors of Production • 249 6.

Suppose that labour is the only input used by a perfectly competitive firm that can hire workers for $50 per day. The firm’s production function is as follows: Days of Labour 0 1 2 3 4 5 6

Units of Output 0 7 13 19 25 28 29

Each unit of output sells for $10. Plot the firm’s demand for labour. How many days of labour should the firm hire? Show this point on your graph.

The following table shows the marginal product of labour and the value of the marginal product of labour:

L

Q

MPL

VMPL

0

0

---

---

1

7

7

70

2

13

6

60

3

19

6

60

4

25

6

60

5

28

3

30

6

29

1

10

Figure 9 plots the firm’s demand for labour. Since the wage is $50 per day, the firm should hire four days of labour. For each of the first four days of labour, the value of the marginal product of labour exceeds the wage. But for more than four days of labour, the value of the marginal product is less than the wage. So the firm maximizes profit by hiring four days of labour.

Figure 9

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250 • Chapter 18: The Markets for the Factors of Production 7.

8.

This chapter has assumed that labour is supplied by individual workers acting competitively. In some markets, however, the supply of labour is determined by a union of workers. a. Explain why the situation faced by a labour union may resemble the situation faced by a monopoly firm. b. The goal of a monopoly firm is to maximize profits. Is there an analogous goal for labour unions? c. Now extend the analogy between monopoly firms and unions. How do you suppose that the wage set by a union compares to the wage in a competitive market? How do you suppose employment differs in the two cases? d. What other goals might unions have that make unions different from monopoly firms? a.

A labour union does have some resemblance with a monopoly. For instance, suppose all construction workers in a small town are members of a union. The union negotiates collective contracts with employers on behalf of workers. Contracts stipulate precise wages corresponding to each qualification and years of employment. Like a monopoly, unions set the “price” (which is the wage) of their “product” (which is workers’ time).

Since all workers have to comply by these contracts, the labour market is not competitive anymore. The wage is, in this case, higher than the value of its marginal product.

b.

Like a monopoly, a union is also maximizing some equivalent of profit: It might maximize the total wage bill given a certain level of employment.

c.

The wage with a union is greater than the competitive wage because there is no competition in the labour market. When an extra worker is hired, employment increases, but the total wage bill received by the members of the union may actually decrease because all the other workers must receive the same wage as the last worker employed.

Since wage is greater than in a competitive market, employment must be less because the number of workers demanded by companies is lower.

d.

Unions might serve some social goals, requesting a certain level of employment, which is an important divergence between a monopoly and a union.

Leadbelly Co. sells pencils in a perfectly competitive product market and hires workers in a perfectly competitive labour market. Assume that the market wage rate for workers is $150 per day. a. What rule should Leadbelly follow to hire the profit-maximizing amount of labour? b. At the profit-maximizing level of output, the marginal product of the last worker hired is 30 boxes of pencils per day. Calculate the price of a box of pencils. c. Draw a diagram of the labour market for pencil workers (as in Figure 18.4) next to a diagram of the labour supply and demand for Leadbelly Co. (as in Figure 18.3). Label the equilibrium wage and quantity of labour for both the market and the firm. How are these diagrams related? d. Suppose some pencil workers switch to jobs in the growing computer industry. On the side-by-side diagrams you prepared in part (c), show how this change affects the equilibrium wage and quantity of labour for both the pencil market and for Leadbelly.

How does this change affect the marginal product of labour at Leadbelly? a.

Leadbelly should hire the amount of labour that makes the equality MPL = w/P hold, where P is the price of pencils and w = $150.

b.

The price of a box of pencils satisfies the equation 30 = $150/P; the solution is P = $150/30 = $5.

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Chapter 18: The Markets for the Factors of Production • 251 c.

Figure 10 shows the market for pencil workers and Leadbelly’s demand for workers. The market wage is determined in the larger, competitive labour market. Leadbelly Co. takes the market wage as given (say at $150), and decides how many workers to employ. To summarize, the two diagrams are linked by the market wage rate.

Wage

Pencil Worker Market

Value of Marginal Product

Leadbelly Co.

S2 S1

Equilibrium wage Demand Value of marginal product (labour demand curve)

Equilibrium Employment

Quantity of Labour

Profitmaximizing number of workers

Number of Pencil Workers

Figure 10 d.

9.

The supply curve shifts to the left, which causes the equilibrium wage to increase.

Leadbelly’s demand for labour does not shift as long as technology, price of pencils, and the supply of other factors remain the same. However, the increase in market wage decreases the profit-maximizing number of workers that Leadbelly wants to hire.

Smiling Cow Dairy can sell all the milk it wants for $4 a litre, and it can rent all the robots it wants to milk the cows at a capital rental price of $100 a day. It faces the following production schedule: Number of Robots 0 1 2 3 4 5 6

Total Product 0 litres 50 85 115 140 150 155

a. In what kind of market structure does the firm sell its output? How can you tell? b. In what kind of market structure does the firm rent robots? How can you tell? c. Calculate the marginal product and the value of the marginal product for each additional robot. d. How many robots should the firm rent? Explain. a.

The market for milk is competitive because the price of milk does not depend on the quantity produced by Smiling Cow Dairy.

b.

The market for robots is competitive because the price of a robot does not depend on the number of robots demanded by Smiling Cow Dairy.

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252 • Chapter 18: The Markets for the Factors of Production c.

The table shows marginal products and the values of marginal products of robots.

Number of Robots 0 1 2 3 4 5 6

d.

10.

Total Product 0 50 85 115 140 150 155

Marginal Product

Value of Marginal Product

50 35 30 25 10 5

200 140 120 100 40 20

The firm should hire four robots, because the fourth robot gives the value of the marginal product equal to its rental price.

Policymakers sometimes propose laws requiring firms to give workers certain fringe benefits, such as paid parental leave. Let’s consider the effects of such a policy on the labour market. a. Suppose that a law required firms to give each worker $3 of fringe benefits for every hour that the worker is employed by the firm. How does this law affect the marginal profit that a firm earns from each worker at a given cash wage? How does the law affect the demand curve for labour? Draw your answer on a graph with the cash wage on the vertical axis. b. If there is no change in labour supply, how would this law affect employment and wages? c. Why might the labour-supply curve shift in response to this law? Would this shift in labour supply raise or lower the impact of the law on wages and employment? d. As discussed in Chapter 6, the wages of some workers, particularly the unskilled and inexperienced, are kept above the equilibrium level by minimum-wage laws. What effect would a fringe-benefit mandate have for these workers? a.

Figure 11 The law lowers the marginal profit earned by each worker for a given cash wage. This results in a downward shift of the labour demand curve by the vertical distance $3, from D0 to D1.

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Chapter 18: The Markets for the Factors of Production • 253 b.

The result is a reduction in the cash wage from w0 to w1 and a reduction in employment from L0 to L1. The effective wage inclusive of the benefits rises to w2. Notice that the cash wage does not fall by the full $3, and that the effective wage inclusive of the benefits (w2) is higher than the previous cash-only wage rate (w1).

c.

If parents leave the labour market due to the parental leave law, labour supply will decrease, shifting the labour supply curve up to S1.

Figure 12 The reduction in labour supply due to the benefits law will increase the wage rate relative to part (b) from w1 to w0. However, it will also lower employment from L1 to L2. d.

Figure 13 The minimum wage applies to the cash wage, not the effective wage inclusive of the benefits. Imposing the policy in the presence of a minimum wage prevents the cash wage from declining in response to the benefits policy, thereby reducing employment by a greater amount (L2 versus L1).

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254 • Chapter 18: The Markets for the Factors of Production 11.

Only labour is used to produce mugs, which sell for $5 each. Labour is hired under perfectly competitive conditions and the market wage is $22.50 per hour. The production function for mugs is given by the following table: Number of Workers 0 1 2 3 4 5 6

Mugs per Hour 0 12 22 28 33 37 40

a. Augment the table by calculating the marginal product of labour, total revenue, and marginal revenue product of labour. (Remember to put marginal items in between units.) b. At the market wage, how many workers will the firm hire in order to maximize profit? c. Suppose that a shortage of workers causes the competitive wage for workers who can make coffee mugs to rise to $27.50 per hour. Now how many workers will this firm hire? d. Suppose that schools that teach pottery skills increase the supply of workers that can make coffee mugs, which lowers the competitive wage for coffee mug workers to $17.50 per hour. Now how many workers will the firm hire? Does this represent a shift in the firm’s demand for labour curve or a movement along the firm’s demand for labour curve? e. Suppose instead that the demand for coffee mugs rises, pushing up the price of coffee mugs to $10 per mug. If the competitive wage for coffee mug workers remains at $27.50 per hour, how many workers will this firm hire now? Does this represent a shift in the firm’s demand for labour curve or a movement along the firm’s demand for labour curve? a.

Number of Workers 0 1 2 3 4 5 6

The table is: Mugs per Hour 0 12 22 28 33 37 40

Marginal Product of Labour 12 10 6 5 4 3

Total Revenue 0 60 110 140 165 185 200

Marginal Revenue Product of Labour 60 50 30 25 20 15

b.

The marginal revenue product of the 4th worker is $25, which is greater than the wage rate of $22.50. The marginal revenue product of the 5th worker is $20, which is less than the wage rate of $22.50. So the firm will hire 4 workers.

c.

The marginal revenue product of the 3rd worker is $30. If the wage rate rises to $27.50, the firm will hire 3 workers.

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Chapter 18: The Markets for the Factors of Production • 255 d.

The marginal revenue product of the 5th worker is $20. If the wage rate falls to $17.50, the firm will hire 5 workers. This is a movement along the labour demand curve.

e.

The new table is:

Number of Workers 0 1 2 3 4 5 6

Mugs per Hour 0 12 22 28 33 37 40

Marginal Product of Labour 12 10 6 5 4 3

Total Revenue 0 120 220 280 330 370 400

Marginal Revenue Product of Labour 120 100 60 50 40 30

The marginal revenue product of the 6th worker is $30. If the wage rate is $27.50, the firm will hire 6 workers. This is a shift in the labour demand curve.

12.

The nation of Ectenia has 20 competitive apple orchards, which sell apples at the world price of $2. The following equations describe the production function and the marginal product of labour in each orchard: Q = 100L – L2 MPL = 100 – 2L

where Q is the number of apples produced in a day, L is the number of workers, and MPL is the marginal product of labour. a. What is each orchard’s labour demand as a function of the daily wage W? What is the market’s labour demand? b. Ectenia has 200 workers who supply their labour inelastically. Solve for the wage W. How many workers does each orchard hire? How much profit does each orchard owner make? c. Calculate what happens to the income of workers and orchard owners if the world price of apples doubles to $4. d. Now suppose the price of apples is back at $2, but a hurricane destroys half the orchards. Calculate how the hurricane affects the income of each worker and of each remaining orchard owner. What happens to the income of Ectenia as a whole? a.

An orchard will hire labour up to the point where the market value of the apples picked by the extra worker becomes equal to the worker’s wage (the cost of employing the worker): P × MPL = W, or $2 × (100 – 2L) = W. This equation can be written under the form L = 50 – W/4, which is the equation of the labour demand curve for an orchard.

Twenty orchards will hire 20 times more labour, so that the industry labour demand will be L = 1000 – 5W.

b.

The equilibrium wage is determined by the equality of supply and demand for labour: 200 workers = 1000 – 5W, for which the solution is W = (1000 – 200)/5 = $160. Each farm hires L = 50 – 160/4 = 10 workers, produces Q = 100 × 10 – 102 = 900 apples, earns revenue = 900 × $2 = $1800, pays 10 × $160 = $1600 in wages, and makes profit = $1800 – $1600 = $200. The total income of the country is equal to the market value of the total production; that is, $2 × 900 apples × 20 orchards = $1800 × 20 = $36 000.

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256 • Chapter 18: The Markets for the Factors of Production c.

When the price of apples doubles to $4, the labour-wage equation becomes $4 × (100 – 2L) = W, or 8L = 400 – W, or L = 50 – W/8. Twenty orchards employ L = 1000 – 20W/8. If we set this equal to the supply of labour, we can determine the market wage: 1000 – 20W/8 = 200, with the solution W = $320, twice as much as before. The costs of production are 200 × $320 = $64 000. For a farm, this cost is $3200. The quantity produced by a farm must be the same (900), because the number of workers is the same and each worker produces the same quantity; revenue is now twice ($3600) because the price is twice; profit is now $3600 – $3200 = $400, twice as much as before.

d.

When P = $2 and the number of farms is 10, the labour-demand equation for an orchard is the same as at point (a) above: L = 50 – W/4. The market demand is now L = 500 – 10W/4; the market wage is given by 500 – 10W/4 = 200, with the solution W = $120. Each farm hires 200/10 = 20 workers [or L = 50 – W/4 = 50 – 120/4 = 50 – 30 = 20 workers]; it pays $120 × 20 = $2400 in wages; it produces 100 × 20 – 202 = 1600 apples; it makes $2 × 1600 = $3200 revenue and $3200 – $2400 = $800 profit. The wage is less than before the hurricane, so the workers are worse off; the profit to a remaining orchard is higher, so the remaining farmers are better off; the total value created in the country is equal to the total revenue of the orchards, namely $3200 × 10 = $32 000, which is less than before the hurricane.

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Chapter 19 Earnings and Discrimination SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Define compensating differential and give an example. • Give two reasons why more-educated workers earn more than less-educated workers.

A compensating differential is a difference in wages that arises to offset the nonmonetary characteristics of different jobs. Examples include coal miners who earn extra wages to compensate them for dangerous working conditions, workers on the night shift who get paid more than day-shift workers, and professors who are paid less than lawyers and doctors.

More-educated workers earn more than less-educated workers because they are viewed as more productive due to higher levels of human capital accumulation, so employers are willing to pay them more, and because more education may signal greater ability.

2.

Why is it hard to establish whether a group of workers is being discriminated against? • Explain how profit-maximizing firms tend to eliminate discriminatory wage differentials. • How might a discriminatory wage differential persist?

It is hard to establish whether a group of workers is being discriminated against because there are many reasons other than discrimination for wages to differ across workers, especially differences in human capital and job characteristics.

Profit-maximizing firms tend to eliminate discriminatory wage differentials because, if some set of workers were being discriminated against, it would be in the interest of profit-maximizing firms to hire those workers with lower wages. But that, in turn, would raise the wages of those workers until the wages of all similar workers were equal.

A discriminatory wage differential might persist due to historical precedent, as may have been the case with tensions between English and French Canadians leading to francophone hockey players playing for teams based in English Canada facing salary discrimination. These wage differentials persist in competitive markets only when customers are willing to pay to maintain the discriminatory practice or when the government mandates it.

Questions for Review 1.

Why are coal miners paid more than other workers with similar amounts of education?

Coal miners get paid more than other workers with similar amounts of education because their higher wage compensates them for the dirty and dangerous nature of coal mining, as well as their long-term health problems. As a result, they earn a sizable compensating differential.

2.

In what sense is education a type of capital?

Education is a type of capital because it represents an expenditure of resources at one point in time to raise productivity in the future.

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258 • Chapter 19: Earnings and Discrimination 3.

How might education raise a worker’s wage without raising the worker’s productivity?

Education might raise a worker’s wage without raising the worker’s productivity if education provides a signal that the worker has high ability.

4.

What conditions lead to economic superstars? Would you expect to see superstars in dentistry?

In economics? Explain.

The conditions that lead to economic superstars are (1) every customer wants to enjoy the good supplied by the best producer, and (2) the good is produced with a technology that makes it possible for the best producer to supply every customer at a low cost. Because one dentist could not supply every customer, you would not expect to see superstars in dentistry. But because copies of economics textbooks can be made and brilliant ideas can be widely dispersed (podcasts, YouTube, etc.) at low cost, you would expect to see superstars in economics.

5.

Give three reasons why a worker’s wage might be above the level that balances supply and demand.

A worker’s wage might be above the level that balances supply and demand because (1) minimum-wage laws raise wages above the levels that some workers would earn in an unregulated labour market; (2) unions may have market power to raise wages above their equilibrium level; and (3) a firm may find it profitable to pay an efficiency wage, which exceeds the equilibrium wage, because doing so raises productivity.

6.

What difficulties arise in deciding whether a group of workers has a lower wage because of discrimination?

Deciding whether a group of workers has a lower wage because of discrimination is difficult because people differ in other attributes, such as the amount of education they have, hours worked, the amount of experience they have, and the possibility of compensating differentials.

7.

Do the forces of economic competition tend to exacerbate or ameliorate discrimination on the basis of race?

The forces of economic competition tend to ameliorate discrimination on the basis of race, since business owners who care only about making profit are usually at an advantage when competing against those who also care about discriminating.

8.

Give an example of how discrimination might persist in a competitive market.

Discrimination can persist in a competitive market if customers have a preference for discrimination. For example, if customers prefer blonde waiters to brunettes, restaurants will prefer to hire blonde waiters and they will discriminate against brunettes.

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Chapter 19: Earnings and Discrimination • 259 Quick Check Multiple Choice

1. Ricky leaves his job as a high school math teacher and returns to school to study the latest developments in computer programming, after which he takes a higher-paying job at a software firm.

This is an example of which of the following? a. a compensating differential b. human capital c. signalling d. efficiency wages 2. Lucy and Ethel work at a local department store. Lucy, who greets customers as they arrive, is paid less than Ethel, who cleans the bathrooms. This is an example of which of the following? a. a compensating differential b. human capital c. signalling d. efficiency wages 3. Fred runs a small manufacturing company. He pays his employees about twice what other firms in the area pay, even though he could pay less and still recruit all the workers he wants. He believes that higher wages make his workers more loyal and hard-working. This is an example of which of the following? a. a compensating differential b. human capital c. signalling d. efficiency wages 4. A business consulting firm hires Vivian because she was a math major in college. Her new job does not require any of the mathematics she learned, but the firm believes that anyone who can graduate with a math degree must be very smart. This is an example of which of the following? a. a compensating differential b. human capital c. signalling d. efficiency wages 5. Why is it difficult to measure how much discrimination affects labour market outcomes? a. data on wages are crucial but not readily available b. firms misreport the wages they pay to hide discriminatory practices c. workers differ in their attributes and the types of jobs they have d. the same minimum-wage law applies to workers in all groups 6. The forces of competition in markets with free entry and exit tend to eliminate wage differentials that arise from discrimination by which of the following groups? a. employers b. customers c. government d. employees 1. b 2. a 3. d 4. c 5. c 6. a

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260 • Chapter 19: Earnings and Discrimination Problems and Applications 1.

2.

University and college students sometimes work as summer interns for private firms or the government. Many of these positions pay little or nothing. a. What is the opportunity cost of taking such a job? b. Explain why students are willing to take these jobs. c. If you were to compare the earnings later in life of workers who had worked as interns and those who had taken summer jobs that paid more, what would you expect to find? a.

The opportunity cost of taking a job as a summer intern that pays little or nothing is the wage that the student could earn at an alternative job.

b.

Despite the low wages (or being paid nothing), students are willing to take internships because an internship might help them land a permanent job with the firm or the government later. Also, the internship enhances the student’s resumé. Finally, the student may gain valuable on-the-job training.

c.

You would expect that students who were interns make higher incomes later in life.

As explained in Chapter 6, a minimum-wage law distorts the market for low-wage labour. To reduce this distortion, some economists advocate a two-tiered minimum-wage system, with a regular minimum wage for adult workers and a lower, “sub-minimum” wage for teenaged workers. Give two reasons why a single minimum wage might distort the labour market for teenaged workers more than it would the market for adult workers.

The single minimum wage might distort the labour market for teenage workers more than for adult workers because (1) teenagers have a lower value of marginal product, so it is more likely that the minimum wage will be above their value of marginal product; and (2) the demand for teenage labour is more elastic than for adult labour, so the minimum-wage law distorts the market more. The minimum wage affects those individuals who are least skilled and least experienced, and these characteristics certainly apply to teenagers.

3.

A basic finding of labour economics is that workers who have more experience in the labour force are paid more than workers who have less experience (holding constant the amount of formal education). Why might this be so? Some studies have also found that experience at the same job (called job tenure) has an extra positive influence on wages. Explain why this might occur.

People with more experience usually have had more on-the-job training than others with the same formal education but less experience. Such training increases the value of the marginal product of their labour. Job tenure is also valuable, because people gain job-specific knowledge or a specialization in knowledge that is useful to the firm.

4.

At some colleges and universities, economics professors receive higher salaries than professors in some other fields. a. Why might this be true? b. Some other colleges and universities have a policy of paying equal salaries to professors in all fields. At some of these schools, economics professors have lighter teaching loads than professors in some other fields. What role is played by the differences in teaching loads? a.

Economics professors may receive higher salaries than professors in some other fields because they have better opportunities outside academia. For example, they could find jobs in the private sector or the government.

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Chapter 19: Earnings and Discrimination • 261 b.

5.

Differences in teaching loads can make up for lower pay. If professors in all fields are paid the same, the pay level is probably below what economics professors could earn elsewhere. To attract economics professors, the college or university would have to offer them some other compensation, such as a lower teaching load.

Sara works for Steve, whom she dislikes because of his snobbish attitude. Yet when she looks for other jobs, the best she can do is find a job paying $10 000 less than her current salary. Should she take the job? Analyze Sara’s situation from an economic point of view.

Sara should take the other job if Steve’s attitude problem is worth $10 000 or more to her. She should view the $10 000 difference in salary as a compensating differential for putting up with Steve. The question Sara must answer is this: Is $10 000 enough of a compensating differential?

If so, she will stay in her current job. If not, she will take the new job.

6.

A current debate in education is whether teachers should be paid on a standard pay scale based solely upon their years of training and teaching experience, or whether part of their salary should be based upon their performance (called “merit pay”). a. Why might merit pay be desirable? b. Who might be opposed to a system of merit pay? c. What is a potential challenge of merit pay? d. A related issue: Why might a school district decide to pay teachers significantly more than the salaries offered by surrounding districts? a. Merit pay will give teachers an incentive to improve their teaching. b. Teachers who are not interested in improving their teaching will obviously be opposed.

Teachers with a lot of experience and/or training may also be opposed to merit pay if they feel that this extra experience may not show up in classroom results. c.

One potential challenge in deciding how merit pay is calculated is determining how precisely performance is measured. One common approach is to measure the performance of students on standardized tests. If teacher pay is based on this performance, there may be a concern that teachers will “teach to the test” rather than focusing on other important skills. Also, there is some evidence that teacher merit pay can give rise to teachers “cheating” in terms of grading students.

d. A school district may pay teachers more than surrounding districts in order to attract good teachers.

7.

Imagine that someone offers you a choice: You could spend four years studying at the world’s best university, but you would have to keep your attendance there a secret. Or you could be awarded an official degree from the world’s best university, but you couldn’t actually attend.

Which choice do you think would enhance your future earnings more? What does your answer say about the debate over signalling versus human capital in the role of education?

Under the signalling theory, you would rather have the degree and not attend the university. But under the human-capital theory, you would rather attend, even though doing so would be a secret. The signalling theory, however, breaks down when more and more people are able to “buy” a degree. Therefore, choosing to attend the university and hoping to be able to prove your skills otherwise than showing a certificate may be a more cautious choice.

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262 • Chapter 19: Earnings and Discrimination 8.

When recording devices were first invented almost 100 years ago, musicians could suddenly supply their music to large audiences at low cost. How do you suppose this development affected the income of the best musicians? How do you suppose it affected the income of average musicians?

The development of recording devices led to a superstar phenomenon in which the best musicians were paid significantly more than average musicians. So the incomes of the best musicians rose and the income of the average musician fell.

9.

A case study in this chapter described how customer discrimination in sports seems to have an important effect on players’ earnings. Note that this is possible because sports fans know the players’ characteristics, including their race. Why is this knowledge important for the existence of discrimination? Give some specific examples of industries where customer discrimination is and is not likely to influence wages.

It is pretty difficult to discriminate against people without knowing about some characteristic of theirs that you do not like. It is possible to discriminate against the type of person who serves you a meal in a restaurant because you can see him or her. But it is harder to discriminate against people who make manufactured goods that are sold in retail stores because you cannot observe who has produced the goods.

10.

Suppose that all young women were channelled into careers as secretaries, nurses, and teachers; at the same time, young men were encouraged to consider these three careers and many others as well. a. Draw a diagram showing the combined labour market for secretaries, nurses, and teachers. Draw a diagram showing the combined labour market for all other fields. In which market is the wage higher? Do men or women receive higher wages on average? b. Now suppose that society changed and encouraged both young women and young men to consider a wide range of careers. Over time, what effect would this change have on the wages in the two markets you illustrated in part (a)? What effect would the change have on the average wages of men and women? a.

Figure 1 shows a situation in which young women are channelled into careers as secretaries, nurses, and teachers. The left panel shows the labour market for secretaries, nurses, and teachers, and the right panel shows the labour market for other fields. The large supply of people in the secretarial, nursing, and teaching fields depresses the wage in those fields. On the other hand, the smaller supply of labour in other fields raises the relative wage.

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Chapter 19: Earnings and Discrimination • 263

Quantity of Labour Figure 1 b.

11.

Quantity of Labour

Over time, if both men and women pursue more varied fields of work, the wages across fields should equalize. The supply of labour in the market for secretaries, nurses, and teachers will fall, and the supply of labour in other fields will rise. Thus, the average wages of men should decline relative to the average wages of women.

This chapter considers the economics of discrimination by employers, customers, and governments. Now consider discrimination by workers. Suppose that some brunette workers did not like working with blonde workers. Do you think this worker discrimination could explain lower wages for blonde workers? If such a wage differential existed, what would a profit-maximizing entrepreneur do? If there were many such entrepreneurs, what would happen over time?

If brunette workers do not like working with blonde workers, a blonde worker’s marginal product of labour is likely to be lower, since the firm’s output will not be as high compared to the case if the firm had a brunette worker instead. Thus firms might find that blonde workers are not worth as much and may reduce their wages relative to brunette workers. A profit-maximizing entrepreneur could create a firm using all blonde workers, so there would be no friction between brunette and blonde workers. If there were many such entrepreneurs, the wage differential between brunette and blonde workers would disappear over time.

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Chapter 20 Income Inequality and Poverty SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

What does the poverty rate measure? • Describe three potential problems in interpreting the measured poverty rate.

The poverty rate measures the percentage of the population whose family income falls below an absolute level called the poverty line. It tells you something about the distribution of income at the lower end of the income scale.

Three potential problems in interpreting the measured poverty rate are (1) in-kind transfers are not accounted for in the poverty rate, so the poverty rate overstates the amount of poverty; (2) the economic life cycle means that incomes are less equal in annual terms but more equal over people’s lifetimes; and (3) the poverty rate is affected by temporary changes in income, but inequality would be better measured by looking at permanent income.

2.

Pam earns more than Pauline. Someone proposes taxing Pam in order to supplement Pauline’s income. How would a utilitarian, a liberal, and a libertarian evaluate this proposal?

A utilitarian would want to redistribute income based on the assumption of diminishing marginal utility, so would favour some redistribution from Pam to Pauline. A liberal would want to maximize the utility of the least well-off person in society, so would also favour redistribution. A libertarian would not want to redistribute income as long as the process of earning income was a fair one, so the libertarian would not want to redistribute income from Pam to Pauline.

3.

List three policies aimed at helping the poor, and discuss the pros and cons of each.

Policies aimed at helping the poor include minimum-wage laws, welfare, a basic minimum income, and in-kind transfers. Minimum-wage laws can help the working poor without any cost to the government, but have the disadvantage of causing unemployment among some workers.

Welfare assists the poor with direct aid, but creates incentives for people to become more reliant on welfare. The negative income tax is a good way to implement a program of financial aid for the poor and does not distort incentives like other programs do, but it may support those who prefer not to work and/or are unwilling to work. In-kind transfers provide goods and services directly to the poor, ensuring that the poor get necessities such as food and shelter, but assume that the government knows what the poor need the most.

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266 • Chapter 20: Income Inequality and Poverty Questions for Review 1.

Does the richest fifth of the Canadian population earn 4, 8, 18, or 50 times the income of the poorest fifth?

The richest fifth of the Canadian population earns about 50 times as much income as the poorest fifth.

2.

How does the extent of income inequality in Canada compare to that of other nations around the world?

In comparison with other nations around the world, Canada is roughly in the middle of the pack.

It is behind countries like Norway, Sweden, and Germany, but ahead of the United States.

3.

What groups in the population are most likely to live in poverty?

The most likely groups to live in poverty are minorities, children, and families headed by a female adult without a spouse present.

4.

When gauging the amount of inequality, why do transitory and life cycle variations in income cause difficulties?

Since people may have temporarily high or low income, and since income varies over the life cycle (people’s incomes are lower when young and higher when older), annual income does not represent true inequality in living standards.

5.

How would a utilitarian, a liberal, and a libertarian determine how much income inequality is permissible?

A utilitarian would like everyone to have equal incomes, but would recognize that redistributing income distorts incentives, so would proceed only part way to that goal. A liberal would go further than a utilitarian in equalizing incomes, since a liberal would focus on how well off is the worst-off person in society. A libertarian would not care about equalizing incomes at all, as long as the process of getting income is fair.

6.

What are the pros and cons of in-kind (rather than cash) transfers to the poor?

In-kind transfers are beneficial because they ensure that the poor get what they need most. In particular, they can get things like food, shelter, and daycare instead of possibly using limited resources for non-essential expenditures or for vices. But in-kind transfers are not as beneficial to the recipients as cash because they provide no opportunity for substitution into more highly valued goods. The poor are in the best position to know what they need.

7.

Describe how antipoverty programs can discourage the poor from working. How might you reduce this disincentive? What are the disadvantages with your proposed policy?

Antipoverty programs can discourage the poor from working because they effectively tax away earnings by reducing benefits when a person earns income. This disincentive could be reduced by not reducing the benefits as sharply, but the disadvantage is that the program would be much more expensive.

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Chapter 20: Income Inequality and Poverty • 267 Quick Check Multiple Choice

1. In Canada, the poorest fifth of the population earns about ___ percent of all income, while the richest fifth earns about ___ percent. a. 2, 45 b. 4, 45 c. 10, 35 d. 15, 25 2. When income inequality is compared across countries, what is revealed about Canada? a. Canada is one of the most equal nations in the world. b. Canada is one of the least equal nations in the world. c. Canada has more equality than most advanced nations but less equality than many developing countries. d. Canada has less equality than most advanced nations but more equality than many developing countries.

3. A utilitarian believes that the redistribution of income from the rich to the poor is worthwhile as long as which of the following is true? a. the worst-off members of society benefit from it b. those contributing to the system are in favour of it c. each person’s income, after taxes and transfers, reflects his marginal product d. the distortionary effect on work incentives is not too large 4. Which fact is Rawls’s thought experiment of the “original position” behind the “veil of ignorance” meant to draw attention to? a. most of the poor do not know how to find better jobs and escape poverty b. the station of life each of us was born into is largely a matter of luck c. the rich have so much money that they don’t know how to spend it all d. outcomes are efficient only if everyone begins with equal opportunity 5. Which of the following occurs under a negative income tax policy? a. individuals with low income get transfers from the government b. the government raises tax revenue without distorting incentives c. everyone pays less than under a conventional income tax d. some taxpayers are on the wrong side of the Laffer curve 6. What happens when the benefits from an antipoverty program are phased out as an individual’s income increases? a. The program will encourage greater work effort from the poor. b. The program will lead to an excess supply of labour among unskilled workers. c. The program will increase the effective marginal tax rate that the poor face. d. The program will cost the government more than a program that benefits everyone.

1. a 2. d 3. d 4. b 5. a 6. c

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268 • Chapter 20: Income Inequality and Poverty Problems and Applications 1.

By most measures, over the past 20 years, income inequality in the United States has increased relative to income inequality in Canada. Some factors that may explain this difference were discussed in Chapter 19. What are they?

The factors contributing to the increase in income inequality in the United States during the past 20 years are the breakup of families, making poor families even poorer, and the increase in the number of two-career families, making rich families even richer.

2.

What do you think would happen to wage rates in the construction industry if Canada introduced full experience rating to the EI system? Explain.

Experience-rated EI premiums means that individuals working in industries where there is a high risk of unemployment would have to pay higher EI premiums. Workers would demand higher wages to compensate for the higher premiums, while employers would want to offer lower wages to compensate for the higher cost of the employer’s share of the EI premiums.

3.

Economists often view life cycle variation in income as one form of transitory variation in income around people’s lifetime, or permanent, income. In this sense, how does your current income compare to your permanent income? Do you think your current income accurately reflects your standard of living?

Students’ current incomes are substantially less than their permanent incomes, so current incomes do not reflect their standards of living very well. They may borrow now or be supported by their parents, but their postsecondary education will pay off with higher future income.

4.

The chapter discusses the importance of economic mobility. a. What policies might the government pursue to increase economic mobility within a generation? b. What policies might the government pursue to increase economic mobility across generations? c. Do you think we should reduce spending on current welfare programs in order to increase spending on programs that enhance economic mobility? What are some of the advantages and disadvantages of doing so? a.

To increase economic mobility within a generation, the government could support training programs (to provide skills to unskilled workers) and workfare instead of welfare (to help the poor increase their incomes).

b.

To increase economic mobility across generations, the government might increase its support for education.

c.

The advantage of reducing spending on welfare to increase spending on programs that enhance economic mobility is that it gives people greater incentive to work hard to get ahead. The disadvantages are that such programs are expensive and are hard on those who do not make it.

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Chapter 20: Income Inequality and Poverty • 269 5.

6.

7.

Consider two communities. In one community, ten families have incomes of $100 each and ten families have incomes of $20 each. In the other community, ten families have incomes of $200 each and ten families have incomes of $22 each. a. In which community is the distribution of income more unequal? In which community is the problem of poverty likely to be worse? b. Which distribution of income would Rawls prefer? Explain. c. Which distribution of income do you prefer? Explain. a.

Community 2 has more unequal income than community 1. In community 2, the rich have nearly ten times the income of the poor, while in community 1 the rich have only five times the income of the poor. However, the problem of poverty is likely to be slightly worse in community 1, since the poor have lower income.

b.

Rawls would prefer the distribution of income in community 2, since the worst-off family has more income than in community 1.

c.

Most people will prefer the income distribution of community 2, since both rich and poor families are better off than their counterparts in community 1, even though inequality is greater.

This chapter uses the analogy of a “leaky bucket” to explain one constraint on the redistribution of income. a. What elements of the Canadian system for redistributing income create the leaks in the bucket? Be specific. b. Do you think that the NDP or Conservative political parties generally believe that the bucket used for redistributing income is more leaky? How does that belief affect their views about the amount of income redistribution that the government should undertake? a.

Leaks in the bucket are caused by the administrative costs of redistributing income, people who lie about their income to cheat the system, and the fact that labour supply is elastic, so that redistributive taxes reduce labour supply.

b.

Generally, the Conservative party would believe the redistributive bucket is more leaky than would the NDP. As a result, they think the government should do less redistribution of income than do the NDP.

Suppose there are two possible income distributions in a society of ten people. In the first distribution, nine people would have incomes of $30 000 and one person would have an income of $10 000. In the second distribution, all ten people would have incomes of $28 000. a. If the society had the first income distribution, what would be the utilitarian argument for redistributing income? b. Which income distribution would Rawls consider more equitable? Explain. c. Which income distribution would Nozick consider more equitable? Explain. a.

A utilitarian would argue that the marginal utility of income for the person with an income of $10 000 is higher than the marginal utility of income for someone with an income of $30 000, so income should be redistributed.

b.

Rawls would prefer the second distribution since the worst-off person is better off than in the first distribution.

c.

Nozick would not find either more equitable. He would think the most equitable distribution is the one in which people got what they deserved. If the rules of the game are fair, either distribution is quite acceptable.

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270 • Chapter 20: Income Inequality and Poverty 8.

9.

Most measures of the poverty rate do not include the value of in-kind transfers in family income.

Yet the value of in-kind transfers can be substantial. An example of an in-kind transfer is a housing subsidy. Let’s say that the value of the housing subsidy is $5000 for each recipient family. a. If the government gave each recipient family an amount of cash equal to $5000 instead of the housing subsidy, do you think that most of these families would spend an additional $5000 on housing? Why or why not? b. How does your answer to part (a) affect your view about whether we should determine the poverty rate by valuing in-kind transfers at the price the government pays for them? Explain. c. How does your answer to part (a) affect your view about whether we should provide assistance to the poor in the form of cash transfers or in-kind transfers? Explain. a.

If people received cash instead of the housing subsidy, it is unlikely that they would spend all of it on additional housing. Instead, they would purchase other things they need or desire.

b.

This suggests that we probably should not value in-kind transfers at the price the government pays for them. They may not be worth as much as their cost.

c.

Since the poor would prefer other things to additional housing, it might be better to give them cash transfers instead.

Suppose that a family’s tax liability equalled its income multiplied by one-half, minus $10 000.

Under this system, some families would pay taxes to the government, and some families would receive money from the government through a “negative income tax.” a. Consider families with pre-tax incomes of $0, $10 000, $20 000, $30 000, and $40 000. Make a table showing pre-tax income, taxes paid to the government or money received from the government, and after-tax income for each family. b. What is the marginal tax rate in this system? (See Chapter 12 if you need to review the definition of marginal tax rate.) What is the maximum amount of income at which a family receives money from the government? c. Now suppose that the tax schedule is changed, so that a family’s tax liability equals its income multiplied by one-quarter, minus $10 000. What is the marginal tax rate in this new system? What is the maximum amount of income at which a family receives money from the government? d. What is the main advantage of each of the tax schedules discussed here? a.

The following table shows pre-tax income, taxes paid to the government (a negative amount means money is received from the government), and after-tax income: Pre-Tax Income $ 0 10 000 20 000 30 000 40 000

b.

Taxes $ –10 000 –5 000 0 5 000 10 000

After-Tax Income $10 000 15 000 20 000 25 000 30 000

The marginal tax rate is 50 percent, since an increase in pre-tax income of $10 000 leads to higher taxes of $5000. The maximum income at which a family receives money from the government is $19 999.99.

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Chapter 20: Income Inequality and Poverty • 271

10.

c.

The change in the tax schedule gives a marginal tax rate of 25 percent. The maximum income at which a family receives money from the government is now $39 999.99.

d.

The advantage of the first tax schedule is that the after-tax income distribution would be more equal. The advantage of the second tax schedule is that the marginal tax rate would be lower, so it would not cause as much of a distortion to labour supply.

John and Jeremy are utilitarians. John believes that labour supply is highly elastic, whereas Jeremy believes that labour supply is quite inelastic. How do you suppose their views about income redistribution differ?

Since John believes labour supply is highly elastic, he will want less redistribution of income because elastic labour supply means a greater distortion from redistributive policies.

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Chapter 21 The Theory of Consumer Choice SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

Draw the budget constraint for a person with income of $1000 if the price of Pepsi is $5 per litre and the price of a pizza is $10. What is the slope of this budget constraint?

A person with an income of $1000 could purchase $1000/$5 = 200 litres of Pepsi if she spent all her income on Pepsi, or she could purchase $1000/$10 = 100 pizzas if she spent all her income on pizza. Thus the point representing 200 litres of Pepsi and no pizzas is the vertical intercept, and the point representing 100 pizzas and no Pepsi is the horizontal intercept of the budget constraint, as shown in Figure 1. The slope of the budget constraint is the rise over the run, or –200/100 = –2.

Figure 1 2.

Figure 2

Draw some indifference curves for Pepsi and pizza. Explain the four properties of these indifference curves.

Figure 2 shows indifference curves between Pepsi and pizza. The four properties of these indifference curves are (1) higher indifference curves are preferred to lower ones because consumers prefer more of a good to less of it; (2) indifference curves are downward sloping because, if the quantity of one good is reduced, the quantity of the other good must increase in order for the consumer to be equally happy; (3) indifference curves do not cross because if they did, the assumption that more is preferred to less would be violated; and (4) indifference curves are bowed inward because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little.

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274 • Chapter 21: The Theory of Consumer Choice 3.

Draw a budget constraint and indifference curves for Pepsi and pizza. Show what happens to the budget constraint and the consumer’s optimum when the price of pizza rises. In your diagram, decompose the change into an income effect and a substitution effect.

Figure 3 shows the budget constraint (BC1) and two indifference curves. The consumer is initially at point A, where the budget constraint is tangent to an indifference curve. The increase in the price of pizza shifts the budget constraint to BC2, and the consumer moves to point C, where the new budget constraint is tangent to a lower indifference curve. To break this move down into income and substitution effects requires drawing the dashed budget line shown, which is parallel to the new budget constraint and tangent to the original indifference curve at point B. The movement from A to B represents the substitution effect, while the movement from B to C represents the income effect.

Figure 3 4.

Explain how an increase in the wage can potentially decrease the amount that a person wants to work.

An increase in the wage can potentially decrease the amount that a person wants to work because a higher wage has an income effect that increases both leisure and consumption and a substitution effect that increases consumption and decreases leisure. Since less leisure means more work, a person will work more only if the substitution effect outweighs the income effect.

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Chapter 21: The Theory of Consumer Choice • 275 Questions for Review 1.

A consumer has income of $3000. Wine costs $3 per glass, and cheese costs $6 per kilogram.

Draw the consumer’s budget constraint. What is the slope of this budget constraint?

Figure 4 shows the consumer’s budget constraint. The intercept on the horizontal axis shows how much cheese the consumer could buy if she bought only cheese; with income of $3000 and the price of cheese $6 a kilogram, she could buy 500 kilograms of cheese. The intercept on the vertical axis shows how much wine the consumer could buy if she bought only wine; with income of $3000 and the price of wine $3 a glass, she could buy 1000 glasses of wine. With cheese on the horizontal axis and wine on the vertical axis, the budget constraint has a slope of –1000/500 = –2. Note that if you put wine on the horizontal axis and cheese on the vertical axis, the budget constraint would have a slope of –500/1000 = –1/2.

Figure 4 2.

Figure 5

Draw a consumer’s indifference curves for wine and cheese. Describe and explain four properties of these indifference curves.

Figure 5 shows a consumer’s indifference curves for wine and cheese. Four properties of these indifference curves are (1) higher indifference curves are preferred to lower ones because more is preferred to less; (2) indifference curves are downward sloping because if the quantity of wine is reduced, the quantity of cheese must increase for the consumer to be equally happy; (3) indifference curves do not cross since a consumer prefers more to less; and (4) indifference curves are bowed inward since a consumer is more willing to trade away wine if she has a lot of it and less willing to trade away cheese if she has little of it.

3.

Pick a point on an indifference curve for wine and cheese and show the marginal rate of substitution. What does the marginal rate of substitution tell us?

In Figure 5, the marginal rate of substitution (MRS ) of one point on an indifference curve is shown. The marginal rate of substitution shows the amount of wine the consumer would be willing to give up in exchange for one more kilogram of cheese.

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276 • Chapter 21: The Theory of Consumer Choice 4.

Show a consumer’s budget constraint and indifference curves for wine and cheese. Show the optimal consumption choice. If the price of wine is $3 per glass and the price of cheese is $6 per kilogram, what is the marginal rate of substitution at this optimum?

Figure 6 shows the consumer’s budget constraint and indifference curves for wine and cheese.

The consumer’s optimum consumption choice is shown as w* and c*. Since the marginal rate of substitution equals the relative price of the two goods at the optimum, the marginal rate of substitution is $6/$3 = 2.

Figure 6 5.

A person who consumes wine and cheese gets a raise, so his income increases from $3000 to $4000. Show what happens if both wine and cheese are normal goods. Now show what happens if cheese is an inferior good.

Figure 7 shows the effect of an increase in income. The rise in income shifts the budget constraint out from BC1 to BC2. Consumption of wine and cheese increases if they are both normal goods. If cheese is an inferior good, the increase in income causes the consumption of cheese to decline, as shown in Figure 8.

Figure 7

Figure 8

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Chapter 21: The Theory of Consumer Choice • 277 6.

The price of cheese rises from $6 to $10 per kilogram, while the price of wine remains $3 per glass. For a consumer with a constant income of $3000, show what happens to consumption of wine and cheese. Decompose the change into income and substitution effects.

A rise in the price of cheese from $6 to $10 a kilogram makes the horizontal intercept of the budget line decline from 500 to 300, as shown in Figure 9. The consumer’s budget constraint shifts from BC1 to BC2, and her optimal choice changes from point A (c1 cheese, w1 wine) to point B (c2 cheese, w2 wine). To decompose this change into income and substitution effects, we draw in budget constraint BC3, which is parallel to BC2 but tangent to the consumer’s initial indifference curve at point C. The movement from point A to C represents the substitution effect.

Since cheese became more expensive, the consumer substitutes wine for cheese as she moves from point A to C. The movement from point C to B represents an income effect. The rise in the price of cheese results in an effective decline in income.

Figure 9 7.

Can an increase in the price of cheese possibly induce a consumer to buy more cheese? Explain.

An increase in the price of cheese could induce a consumer to buy more cheese if cheese is a Giffen good. In that case, the income effect of the rise in the price of cheese induces the consumer to buy more cheese if cheese is an inferior good. If the income effect is bigger than the substitution effect (which induces the consumer to buy less cheese), the consumer would buy more cheese.

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278 • Chapter 21: The Theory of Consumer Choice Quick Check Multiple Choice

1. Emilio buys pizza for $10 and soda for $2. He has income of $100. His budget constraint will experience a parallel outward shift if which of the following events occur? a. The price of pizza falls to $5, the price of soda falls to $1, and his income falls to $50. b. The price of pizza rises to $20, the price of soda rises to $4, and his income remains the same. c. The price of pizza falls to $8, the price of soda falls to $1, and his income rises to $120. d. The price of pizza rises to $20, the price of soda rises to $4, and his income rises to $400.

2. At any point on an indifference curve, the slope of the curve measures the consumer’s level of which of the following? a. income b. willingness to trade one good for the other c. perception of the two goods as substitutes or complements d. elasticity of demand 3. Matthew and Susan are both optimizing consumers in the markets for shirts and hats, where they pay $100 for a shirt and $50 for hat. Matthew buys 4 shirts and 16 hats, while Susan buys 6 shirts and 12 hats. From this information, we can infer that Matthew’s marginal rate of substitution is ___ hats per shirt, while Susan’s is ___. a. 2, 1 b. 2, 2 c. 4, 1 d. 4, 2 4. Charlie buys only milk and cereal. Milk is a normal good, while cereal is an inferior good. What does Charlie do when the price of milk rises? a. buys less of both goods b. buys more milk and less cereal c. buys less milk and more cereal d. buys less milk, but the impact on cereal is ambiguous 5. If the price of pasta increases and a consumer buys more pasta, what can we infer? a. Pasta is a normal good, and the income effect is greater than the substitution effect. b. Pasta is a normal good, and the substitution effect is greater than the income effect. c. Pasta is an inferior good, and the income effect is greater than the substitution effect. d. Pasta is an inferior good, and the substitution effect is greater than the income effect.

6. Under which of the following conditions does the labour-supply curve slope upward? a. when leisure is a normal good b. when consumption is a normal good c. when the income effect on leisure is greater than the substitution effect d. when the substitution effect on leisure is greater than the income effect 1. d 2. b 3. b 4. c 5. c 6. d

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Chapter 21: The Theory of Consumer Choice • 279 Problems and Applications 1.

Jennifer divides her income between coffee and croissants (both of which are normal goods). An early frost in Brazil causes a large increase in the price of coffee in Canada. a. Show the effect of the frost on Jennifer’s budget constraint. b. Show the effect of the frost on Jennifer’s optimal consumption bundle, assuming that the substitution effect outweighs the income effect for croissants. c. Show the effect of the frost on Jennifer’s optimal consumption bundle, assuming that the income effect outweighs the substitution effect for croissants. a.

Figure 10 shows the effect of the frost on Jennifer’s budget constraint. Since the price of coffee rises, her budget constraint swivels from BC1 to BC2.

b.

If the substitution effect outweighs the income effect for croissants, Jennifer buys more croissants and less coffee, as shown in Figure 10. She moves from point A to point B.

Figure 10 c.

If the income effect outweighs the substitution effect for croissants, Jennifer buys fewer croissants and less coffee, moving from point A to point B in Figure 11.

Figure 11

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280 • Chapter 21: The Theory of Consumer Choice 2.

Compare the following two pairs of goods: • Coke and Pepsi • Skis and ski bindings a. In which case are the two goods complements? In which case are they substitutes? b. In which case do you expect the indifference curves to be fairly straight? In which case do you expect the indifference curves to be very bowed? c. In which case will the consumer respond more to a change in the relative price of the two goods? a. Coke and Pepsi are very similar to each other in their attributes so we would expect them to be close substitutes. Skis and ski bindings are consumed together and are therefore complements. b. Indifference curves between Coke and Pepsi are fairly straight, since there is little to distinguish them, so they are nearly perfect substitutes. Indifference curves between skis and ski bindings are very bowed, since they are complements. c.

3.

4.

A consumer will respond more to a change in the relative price of Coke and Pepsi, possibly switching completely from one to the other if the price changes.

Mario consumes only cheese and crackers. a. Could cheese and crackers both be inferior goods for Mario? Explain. b. Suppose that cheese is a normal good for Mario while crackers are an inferior good. If the price of cheese falls, what happens to Mario’s consumption of crackers? What happens to his consumption of cheese? Explain. a.

Cheese and crackers cannot both be inferior goods, since if Mario’s income rises he must consume more of something.

b.

If the price of cheese falls, the substitution effect means Mario will consume more cheese and fewer crackers. The income effect means Mario will consume more cheese (since cheese is a normal good) and fewer crackers (since crackers are an inferior good). So, both effects lead Mario to consume more cheese and fewer crackers.

Jim buys only milk and cookies. a. In 2019, Jim earns $100, milk costs $2 per litre, and cookies cost $4 per dozen. Draw Jim’s budget constraint. b. Now suppose that all prices increase by 10 percent in 2020 and that Jim’s salary increases by 10 percent as well. Draw Jim’s new budget constraint. How would Jim’s optimal combination of milk and cookies in 2020 compare to his optimal combination in 2019?

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Chapter 21: The Theory of Consumer Choice • 281 a.

Figure 12 shows Jim’s budget constraint. The vertical intercept is 50 litres of milk, since if Jim spent all his money on milk, he would buy $100/$2 = 50 litres of it. The horizontal intercept is 25 dozen cookies, since if Jim spent all his money on cookies, he would buy $100/$4 = 25 dozen cookies.

Figure 12 b.

5.

If Jim’s salary rises by 10 percent to $110 and the prices of milk and cookies rise by 10 percent to $2.20 and $4.40, Jim’s budget constraint would be unchanged. Note that $110/$2.20 = 50 and $110/$4.40 = 25, so the intercepts of the new budget constraint would be the same as the old budget constraint. Since the budget constraint is unchanged, Jim’s optimal consumption is unchanged.

Consider your decision about how many hours to work. a. Draw your budget constraint assuming that you pay no taxes on your income. On the same diagram, draw another budget constraint assuming that you pay a 15 percent income tax. b. Show how the tax might lead to more hours of work, fewer hours, or the same number of hours. Explain. a.

Budget constraint BC1 in Figure 13 shows the budget constraint if you pay no taxes.

Budget constraint BC2 shows the budget constraint with a 15 percent income tax.

Figure 13

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282 • Chapter 21: The Theory of Consumer Choice b. Figure 14 shows indifference curves for which a person will work more as a result of the tax because the income effect (less leisure) outweighs the substitution effect (more leisure), so there is less leisure overall. Figure 15 shows indifference curves for which a person will work fewer hours as a result of the tax because the income effect (less leisure) is smaller than the substitution effect (more leisure), so there is more leisure overall. Figure 16 shows indifference curves for which a person will work the same number of hours after the tax because the income effect (less leisure) equals the substitution effect (more leisure), so there is the same amount of leisure overall.

Figure 14

Figure 15

Figure 16

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Chapter 21: The Theory of Consumer Choice • 283 6.

Draw the indifference curve for someone deciding how much to work. Suppose the wage increases. Is it possible that the person’s consumption would fall? Is this plausible? Discuss.

(Hint: Think about income and substitution effects.)

Figure 17 shows the indifference curve between leisure and consumption that determines how much a person works. An increase in the wage leads to both an income effect and a substitution effect. The higher wage makes the budget constraint steeper, so the substitution effect increases consumption and reduces leisure. But the higher wage has an income effect that increases both consumption and leisure if both are normal goods. The only way that consumption could decrease when the wage increased would be if consumption is an inferior good and if the negative income effect outweighs the positive substitution effect. This could happen for a person who really placed an exceptionally high value on leisure.

Figure 17 7.

Anya is awake for 100 hours per week. Using one diagram, show Anya’s budget constraints if she earns $12 per hour, $16 per hour, and $20 per hour. Now draw indifference curves such that Anya’s labour-supply curve is upward-sloping when the wage is between $12 and $16 per hour, and backward-sloping when the wage is between $16 and $20 per hour.

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284 • Chapter 21: The Theory of Consumer Choice 8.

The welfare system provides income to some needy families. Typically, the maximum payment goes to families that earn no income; then, as families begin to earn income, the welfare payment declines gradually and eventually disappears. Let’s consider the possible effects of this program on a family’s labour supply. a. Draw a budget constraint for a family assuming that the welfare system did not exist.

On the same diagram, draw a budget constraint that reflects the existence of the welfare system. b. Adding indifference curves to your diagram, show how the welfare system could reduce the number of hours worked by the family. Explain, with reference to both the income and substitution effects. c. Using your diagram from part (b), show the effect of the welfare system on the wellbeing of the family. a.

Figure 19 shows the effects of the welfare system. Without the system, the budget constraint would begin on the horizontal axis at point Lmax when the family earns no labour income, and would have a slope equal to the wage rate. The system provides income of a certain amount if the family earns no labour income, shown as point A on the figure. Then, if income is earned, the welfare payment is reduced, so the slope of the budget line is less than the slope of the budget line without welfare. At the point where the two budget lines meet, the welfare system provides no further support.

Figure 19 b.

The figure shows how indifference curves could be shaped, indicating a reduction in the number of hours worked by the family because of the welfare system. Since the welfare budget constraint is flatter, there is a substitution effect away from consumption and toward leisure. Since the welfare budget constraint is farther from the origin, there is an income effect that increases both consumption and leisure, if both are normal goods. The overall effect is that the change in consumption is ambiguous and the family will want to have more leisure; hence, it will reduce its labour supply.

c.

There is no doubt that the family’s well-being is increased, since the welfare system gives them consumption and leisure opportunities that were not available before, and they end up on a higher indifference curve.

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Chapter 21: The Theory of Consumer Choice • 285 9.

Economist George Stigler once wrote that, according to consumer theory, “if consumers do not buy less of a commodity when their incomes rise, they will surely buy less when the price of the commodity rises.” Explain this statement.

If consumers do not buy less of a good when their incomes rise, the good in question must be a normal good. For a normal good, the income and substitution effects both imply that the consumer will buy less if the price rises.

10.

A college student has two options for meals: eating at the dining hall for $6 per meal, or eating a Cup O’ Soup for $1.50 per meal. His weekly food budget is $60. a. Draw the budget constraint showing the tradeoff between dining hall meals and Cups O’ Soup. Assuming that he spends equal amounts on both goods, draw an indifference curve showing the optimum choice. Label the optimum as point A. b. Suppose the price of a Cup O’ Soup now rises to $2. Using your diagram from part (a), show the consequences of this change in price. Assume that our student now spends only 30 percent of his income on dining hall meals. Label the new optimum as point B. c. What happened to the quantity of Cups O’ Soup consumed as a result of this price change? What does this result say about the income and substitution effects? Explain. d. Use points A and B to draw a demand curve for Cup O’ Soup. What is this type of good called? a. The budget constraint shows the consumption bundles that the consumer can afford. If a college student spends his entire income on meals at the dining hall, he can buy 10 meals, and if he spends his entire income on packages of Cup O’ Soup, he can buy 40 meals. Since he could spend all his food money on dining hall meals, spend all his food money on Cup O’ Soup, or split his food money between the two goods, his budget constraint extends from the point (10, 0) to the point (0, 40).

If a college student spends half his income on dining hall meals and the other half on Cup O’ Soup, he will consume 5 dining hall meals and 20 packages of Cup O’ Soup.

Figure 20

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286 • Chapter 21: The Theory of Consumer Choice b. When the price of Cup O’ Soup increases to $2, and our student now spends only 30 percent of his income on dining hall meals as shown in Figure 20, he can still buy 10 meals, but if he spends his entire income on packages of Cup O’ Soup, he can now buy only 30 meals. Since he could spend all his food money on dining hall meals, spend all his food money on Cup O’ Soup, or split his food money between the two goods, his new budget constraint extends from the point (10, 0) to the point (0, 30). If the student spends 30 percent of his income on dining hall meals, this means he will have $18 of income to spend on dining hall meals and $42 to spend on Cup O’ Soup. c.

As a result of this price change, the quantity of Cup O’ Soup packages consumed increased. This means that Cup O’ Soup must be an inferior good, and the income effect outweighed the substitution effect.

d. You can derive the demand curve for Cup O’ Soup by examining the optimum at points A and B. Two points that make up the demand curve are (20, 1.5) and (21, 2) in this case. Because the demand curve is upward sloping, Cup O’ Soup is a Giffen good.

Figure 21 11.

Consider a couple’s decision about how many children to have. Assume that over a lifetime, a couple has 200 000 hours of time to either work or raise children. The wage is $10 per hour.

Raising a child takes 20 000 hours of time. a. Draw the budget constraint showing the tradeoff between lifetime consumption and number of children. (Ignore the fact that children come only in whole numbers!) Show indifference curves and an optimum choice. b. Suppose the wage increases to $12 per hour. Show how the budget constraint shifts.

Using income and substitution effects, discuss the impact of the change on number of children and lifetime consumption. c. We observe that, as societies get richer and wages rise, people typically have fewer children. Is this fact consistent with this model? Explain.

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Chapter 21: The Theory of Consumer Choice • 287 a.

Let K be the number of children and C lifetime consumption. If the couple has no children, the couple can consume 200 000 × $10 = $2 million. If they consume nothing (of course an unrealistic assumption), they can have 200 000/20 000 = 10 children. The couple has to give up $200 000 in consumption for each additional child. Figure 22 shows this budget line.

C (Consumption) 2.4 mil

2 mil B A K (number of children)

10 Figure 22

12.

b.

If the wage increases to $12, the maximum possible number of children does not change because it is limited by time, but the maximum consumption for zero children increases to 200 000 × $12 = $2.4 million. The new budget line becomes steeper, which shows that the opportunity cost of raising children has increased. The choice point moves toward higher consumption, from A to B. Whether the couple chooses to have more or fewer children depends on their preferences. If the substitution effect is stronger than the income effect, then the couple will have fewer children, and the other way around.

c.

The observation is consistent with our model and shows that people perceive children as a normal “good.”

Five consumers have the following marginal utility of apples and pears: Marginal Utility of Apples Jerry George Elaine Kramer Newman

12 6 6 3 12

Marginal Utility of Pears 6 6 3 6 3

The price of an apple is $2, and the price of a pear is $1. Which, if any, of these consumers are optimizing over their choice of fruit? For those who are not, how should they change their spending?

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288 • Chapter 21: The Theory of Consumer Choice The market values apples twice as much as pears. Jerry values apples twice as much as pears, too; thus, he does not want to change his choice. George is willing to give up an apple for a pear, but in the market, he can get two pears for that apple. Thus, George is better off if he gives up some apples in exchange for pears. Elaine is in the same situation as Jerry, so she is at optimum. Kramer values pears even more than George, so Kramer should give up apples for pears. Newman’s valuation of apples is more than the market, so he should give up pears in exchange for apples.

You consume only soda and pizza. One day, the price of soda goes up, the price of pizza goes down, and you are just as happy as you were before the price changes. a. Illustrate this situation on a graph. b. How does your consumption of the two goods change? How does your response depend on income and substitution effects? c. Can you afford the bundle of soda and pizza you consumed before the price changes? a.

My choice of pizza and soda remains on the same indifference curve after the change in price. Point A in Figure 23 is my choice before the change, and Point B is my choice after the change.

b.

I now consume more pizza and less soda. If I had “perfect-complement” preferences, for which the substitution effect was zero, I would consume less of both pizza and soda. The greater the substitution effect, the more my consumption of pizza will increase. The impact of the effect depends on whether the goods are normal or inferior.

c.

No, I cannot afford the old bundle because it is now beyond my budget line.

Soda

13.

A B

Pizza Figure 23 14.

State whether each of the following statements is true or false. Explain your answers. a. “All Giffen goods are inferior goods.” b. “All inferior goods are Giffen goods.” a.

True. The Giffen good is consumed less when its price decreases because of the income effect: Higher available income makes the consumer purchase less of the Giffen good.

The income effect exceeds the substitution effect for a Giffen good.

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Chapter 21: The Theory of Consumer Choice • 289 b.

15.

False. For some inferior goods, the substitution effect exceeds the income effect, such that the consumption of an inferior good may increase when its price decreases.

Daniel is a diligent student who loves getting As, but he also loves watching movies. Daniel is awake for 100 hours each week, and studying and watching movies are his only two activities.

Daniel must study for 20 hours per week for each A he earns. Each movie is 2 hours long. a. Draw Daniel’s budget constraint that shows the tradeoff between the number of As he can receive and the number of movies he can watch. Assuming that he is happiest when he earns three As, draw an indifference curve that marks his optimal choice of studying and movie watching. How many movies does he watch each week? With a new semester beginning, Daniel decides to get his difficult requirements out of the way. Each class now requires him to study for 25 hours per week to get an A. b. Draw the new budget constraint on your graph. Show one possible outcome on your diagram. How will the relative strengths of the income and substitution effects determine whether Daniel makes better or worse grades and whether he watches more or fewer movies? a.

Figure 24 shows Daniel’s budget line, his indifference curve, and his choice. When he wants three As, he has to study 3 × 20 = 60 hours; the remaining 100 – 60 = 40 hours allow him to watch 40/2 = 20 movies. (See point A in the figure.)

b.

Figure 24 shows the situation in which Daniel chooses fewer As and fewer movies. In this case, the income effect exceeds the substitution effect for movies: substitution would require more movies, but income would require fewer, and the “less” effect prevails. If the income effect for movies was not so important, the substitution effect would prevail, and Daniel would watch more movies than before.

Movies 50

A

20 B

3

4

Figure 24

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5

‘A’s

Chapter 22 Frontiers of Microeconomics SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1.

A person who buys a life insurance policy pays a certain amount per year and receives for his family a much larger payment in the event of his death. Would you expect buyers of life insurance to have higher or lower death rates than the average person? How might this be an example of moral hazard? Of adverse selection? How might a life insurance company deal with these problems?

Buyers of life insurance will likely have higher than the average death rates. Because those with greater risks of death are more likely to buy life insurance, the price of life insurance will reflect the costs of a riskier-than-average person. Thus, buyers with low risk of death will find the price of life insurance to be too high and will not choose to purchase it.

Moral hazard is the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour. A person with a high risk of death may be aware of his risk but not reveal this information to the insurance company.

Adverse selection is the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party. In this case, the insurance company ends up insuring only those individuals who have high risks of death.

A life insurance company may require that all applicants submit to a medical examination to deal with these problems.

2.

A school board is voting on the school budget and the resulting student–teacher ratio. A poll finds that 35 percent of the voters want a ratio of 9:1, 25 percent want a ratio of 10:1, and 40 percent want a ratio of 12:1. What outcome would you expect the school board to end up with?

According to the median voter theorem, if each voter chooses a point closest to his preferred point, the board vote will reflect the preferences of the median voter. Therefore, the school board will end up with a student–teacher ratio of 10:1.

3.

Describe at least three ways in which human decision making differs from that of the rational individual of conventional economic theory.

Human decision making can differ from the rational individual of conventional economic theory in three important ways: (1) people are not always rational, (2) people care about fairness, and (3) people are inconsistent over time.

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292 • Chapter 22: Frontiers of Microeconomics Questions for Review 1.

What is moral hazard? List three things an employer might do to reduce the severity of this problem.

Moral hazard is the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour. To reduce the severity of this problem, an employer may respond with (1) better monitoring, (2) paying efficiency wages, or (3) delaying part of a worker’s compensation.

2.

What is adverse selection? Give an example of a market in which adverse selection might be a problem.

Adverse selection is the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party. Examples of markets in which adverse selection might be a problem include the market for used cars and the market for insurance.

3.

Define signalling and screening, and give an example of each.

Signalling is an action taken by an informed party to reveal private information to an uninformed party. Job applicants may use a university degree as a signal of ability. Screening is an action taken by an uninformed party to induce an informed party to reveal information. A life insurance company may require applicants to submit to a health examination so that the company will have more information on the person’s risk of death.

4.

What unusual property of voting did Condorcet notice?

Condorcet noticed that the majority rule will fail to produce transitive properties for society.

5.

Explain why majority rule respects the preferences of the median voter rather than the average voter.

The median voter’s preferences will beat out any other proposal in a two-way race because the median voter will have more than half the voters on his side.

6.

Describe the ultimatum game. What outcome from this game would conventional economic theory predict? Do experiments confirm this prediction? Explain.

Two volunteers are chosen and a coin toss determines which volunteer is Player A and which is Player B. Player A proposes a split of a sum of money ($100), and then Player B decides whether to accept or reject the proposal. If Player B accepts, the sum of money ($100) is divided as outlined in the proposal. If Player B rejects the proposal, each player gets nothing.

Conventional economic theory predicts that Player A will offer only $1 to Player B and keep the remainder for himself. This is predicted to occur because Player A knows that Player B will be better off with $1 than with $0. However, in reality, Player B generally rejects small proposals that he considers unfair. If Player A considers this, he will likely offer Player B a more substantial amount.

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Chapter 22: Frontiers of Microeconomics • 293 Quick Check Multiple Choice

1. Because Elaine has a family history of significant medical problems, she buys health insurance, whereas her friend Jerry, who has a healthier family, goes without. This is an example of which of the following? a. moral hazard b. adverse selection c. signalling d. screening 2. George has a life insurance policy that pays his family $1 million if he dies. As a result, he does not hesitate to enjoy his favourite hobby of bungee jumping. This is an example of which of the following? a. moral hazard b. adverse selection c. signalling d. screening 3. Before selling anyone a health insurance policy, the Kramer Insurance Company requires that applicants undergo a medical examination. Those with significant pre-existing medical problems are charged more. This is an example of which of the following? a. moral hazard b. adverse selection c. signalling d. screening 4. The Condorcet paradox illustrates Arrow’s impossibility theorem by showing which characteristic of pairwise majority voting? a. it is inconsistent with the principle of unanimity b. it leads to social preferences that are not transitive c. it violates the independence of irrelevant alternatives d. it makes one person in effect a dictator 5. Two political candidates are running for mayor, and the key issue is how much to spend on the town’s annual Canada Day fireworks. Among the 100 voters, 40 want to spend $30 000, 30 want to spend $10 000, and 30 want to spend nothing at all. What is the winning position on this issue? a. $10 000 b. $15 000 c. $20 000 d. $30 000 6. What is illustrated by the experiment called the “ultimatum game”? a. People are overconfident in their own abilities. b. People play the Nash equilibrium in strategic situations. c. People care about fairness, even to their own detriment. d. People make inconsistent decisions over time.

1. b 2. a 3. d 4. b 5. a 6. c

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294 • Chapter 22: Frontiers of Microeconomics Problems and Applications 1.

2.

Each of the following situations involves moral hazard. In each case, identify the principal and the agent, and explain why there is asymmetric information. How does the action described reduce the problem of moral hazard? a. Landlords require tenants to pay security deposits. b. Firms compensate top executives with options to buy company stock at a given price in the future. c. Car insurance companies offer discounts to customers who install antitheft devices in their cars. a.

The landlord is the principal and the tenant is the agent. There is asymmetric information because the landlord does not know how well the tenant will take care of the property.

Having a tenant pay a security deposit increases the likelihood that the tenant will take care of the property in order to receive his deposit back.

b.

The shareholders of the firm (the owners) are the principals and the top executives are the agents. The firm’s owners do not know in advance how well the top executives will perform their duties. Tying some of the executives’ compensation to the value of the firm provides incentive for the executives to work hard to increase the value of the firm.

c.

The insurance company is the principal and the customer is the agent. Insurance companies do not know whether the car owner is likely to leave the vehicle parked with the keys in it, or park it in a high crime area. Individuals who will go to the trouble of installing antitheft equipment are more likely to ensure that their vehicle is taken care of.

Offering a discount on insurance premiums will induce car owners to install such devices.

Suppose that the Live-Long-and-Prosper Life Insurance Company charges $5000 annually for an insurance policy. The company’s president suggests that the company raise the annual price to $6000 in order to increase its profits. If the firm followed this suggestion, what economic problem might arise? Would the firm’s pool of customers tend to become more or less healthy on average? Would the company’s profits necessarily increase?

Individuals who are relatively healthy may decide to forgo purchasing the policy if the premium rises. Thus, the insurance company is left with only those policyholders who are relatively unhealthy. This means that the firm’s revenues may in fact fall, but its costs could remain the same. Therefore, the firm’s profits could fall.

3.

A case study in this chapter describes how a boyfriend can signal to a girlfriend that he loves her by giving an appropriate gift. Do you think saying “I love you” can also serve as a signal? Why or why not?

Saying “I love you” is likely not a good signal. To be an effective signal, the signal must be costly.

In fact, the signal must be less costly, or more beneficial, to the person with the higher-quality product. Simply professing one’s love does not meet this requirement.

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Chapter 22: Frontiers of Microeconomics • 295 4.

Some AIDS activists believe that life insurance companies should not be allowed to ask applicants if they are infected with HIV, the virus that causes AIDS. Would this rule help or hurt those who are HIV-positive? Would it help or hurt those who are not HIV-positive? Would it exacerbate or mitigate the problem of adverse selection in the market for life insurance? Do you think it would increase or decrease the number of people without life insurance? In your opinion, would this be a good policy?

If insurance companies were not allowed to determine if applicants are HIV-positive, more individuals who are HIV-positive would be able to purchase insurance, but that insurance would be very expensive. Covering these individuals would raise the cost of providing health insurance and the company would have to raise premiums for all. Thus, individuals who are not HIVpositive would be forced to pay more for health insurance and may drop coverage. Insurance companies would be left insuring only those who are ill (including those who are HIV-positive), increasing the adverse selection problem. The number of individuals without health insurance would likely rise as a result.

5.

The government is considering two ways to help the needy: giving them cash, or giving them free meals at soup kitchens. Give an argument for giving cash. Give an argument, based on asymmetric information, for why the soup kitchen may be better than the cash handout.

If the needy are given cash, they can use the cash to purchase whatever they need and/or most desire. This will increase their utility by more than if the government predetermines what they “need.” However, if the government is worried about how these individuals may spend the cash and wants to ensure that the needy receive proper nutrition, they may want to provide free meals at a soup kitchen instead. If there is asymmetric information, and the government does not have full information on how needy individuals are, an in-kind transfer like a soup kitchen may be preferred as non-needy individuals would be less likely to utilize the soup kitchen.

6.

Ken walks into an ice-cream parlour.

WAITER: We have vanilla and chocolate today.

I’ll take vanilla.

KEN: WAITER: I almost forgot. We also have strawberry.

In that case, I’ll take chocolate.

KEN: What standard property of decision making is Ken violating? (Hint: Reread the section on Arrow’s impossibility theorem.)

Ken is violating the property of independence of irrelevant alternatives. Adding a choice of strawberry after he chooses vanilla over chocolate should not induce him to change his mind and prefer chocolate.

7.

Why might a political party in a two-party system choose not to move toward the median voter?

(Hint: Think about abstentions from voting and political contributions.)

It is possible that a minority of voters are willing to contribute large sums of money to a candidate who supports their viewpoint. Running a political campaign is very expensive and a candidate may be able to gain support through expensive advertising. Thus, the candidate may choose to support the views of those individuals who can help finance his campaign. Another possible reason for departing from the median voter is that some politicians assume that abstentions from voting are not neutral, and the median voter is not truly revealed by the actively expressed votes.

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296 • Chapter 22: Frontiers of Microeconomics 8.

Two ice-cream stands are deciding where to locate along a one-kilometre beach. Each person sitting on the beach buys exactly one ice-cream cone per day from the stand nearest to him.

Each ice-cream seller wants the maximum number of customers. Where along the beach will the two stands locate?

More than likely, the two stands will locate at the centre of the beach beside each other. Thus, they will always be closest for at least half of the beach goers.

9.

After a widely reported earthquake in British Columbia, many people call their insurance company to apply for earthquake insurance. Might this reaction reflect some deviation from rationality?

Discuss.

An earthquake occurring in British Columbia does not increase the probability that another will occur. Thus, nothing that affects the benefits from such insurance has really changed. The individuals are simply putting more emphasis than necessary on the event. However, if it were true that the individuals had no idea of the possible risks until the earthquake occurred, then purchasing the insurance would be a rational thing to do.

10.

Three friends are choosing a restaurant for dinner. Here are their preferences: First choice Second choice Third choice Fourth choice

Rachel Italian Chinese Mexican French

Ross Italian Chinese Mexican French

Joey Chinese Mexican French Italian

a. If the three friends use a Borda count to make their decision, where do they go to eat? b. On their way to their chosen restaurant, they see that the Mexican and French restaurants are closed, so they use a Borda count again to decide between the remaining two restaurants. Where do they decide to go now? c. How do your answers to parts (a) and (b) relate to Arrow’s impossibility theorem? a.

The Borda count voting method requires assigning a number from 1 to 4 to each restaurant according to each person’s ranking and summing these numbers for each possible choice. Thus, Italian gets 9, Chinese gets 10, Mexican 7, and French 4. Chinese wins.

b.

When the Mexican and French restaurants are no longer options, Borda count yields 5 for Italian and 4 for Chinese. Italian wins.

c.

Borda count is not a perfect voting system because in this case, the outcome depends on irrelevant alternatives.

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Chapter 22: Frontiers of Microeconomics • 297 11.

Three friends are choosing a TV show to watch. Here are their preferences: Chandler Dexter Glee House

First choice Second choice Third choice

Phoebe Glee House Dexter

Monica House Dexter Glee

a. If the three friends try using a Borda count to make their choice, what would happen? b. Monica suggests a vote by majority rule. She proposes that first they choose between Dexter and Glee, and then they choose between the winner of the first vote and House. If they all vote their preferences honestly, what outcome would occur? c. Should Chandler agree to Monica’s suggestion? What voting system would he prefer? d. Phoebe and Monica convince Chandler to go along with Monica’s proposal. In round one, Chandler dishonestly says he prefers Glee over Dexter. Why might he do this?

12.

a.

Borda count does not work because all three alternatives get equal ranking.

b.

Between Dexter and Glee, Dexter wins; between Dexter and House, House wins.

c.

Chandler should not agree with Monica’s suggestion because House is last in his preferences. Chandler should suggest to vote first between Glee and House and then between the winner of the first vote and Dexter. This way, the winner of the first vote would be Glee and the winner of the second vote would be Dexter, which is Chandler’s first choice.

d.

If Chandler goes along with Monica’s suggestion and dishonestly indicates that he prefers Glee to Dexter, the winner will be Glee instead of House, which better fits Chandler.

Five roommates are planning to spend the weekend in their dorm room watching movies, and they are debating how many movies to watch. Here is their willingness to pay: First film Second film Third film Fourth film Fifth film

Quentin $14 12 10 6 2

Spike $10 8 6 2 0

Ridley $8 4 2 0 0

Martin $4 2 0 0 0

Steven $2 0 0 0 0

Buying a DVD costs $15, which the roommates split equally, so each pays $3 per movie. a. What is the efficient number of movies to watch (that is, the number that maximizes total surplus)? b. From the standpoint of each roommate, what is the preferred number of movies? c. What is the preference of the median roommate? d. If the roommates held a vote on the efficient outcome versus the median voter’s preference, how would each person vote? Which outcome would get a majority? e. If one of the roommates proposed a different number of movies, could his proposal beat the winner from part (d) in a vote? f. Can majority rule be counted on to reach efficient outcomes in the provision of public goods?

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298 • Chapter 22: Frontiers of Microeconomics a.

The efficient number of movies to watch is 3 because the total willingness to pay is 10 + 6 + 2 = 18, the closest to the price of $15 (for the fourth movie, the total willingness to pay is 6 + 2 = 8; if they purchased the fourth movie, their consumer surplus would decrease by 3).

b.

Quentin prefers 4, Spike prefers 3, Ridley 2, Martin 1, and Steven 0.

c.

The preference of the median roommate (Ridley) is 2 movies.

d.

If the roommates held a vote on the efficient outcome (3) versus the median voter’s preference (2), Quentin and Spike vote 3, while Ridley, Martin, and Steven vote 2.

Thus, 2 wins.

e.

Other alternatives are 5, 4, 1, and 0. None can win against the median voter.

f.

No. This example shows that majority rule yields the median voter’s outcome, which is different from the efficient one.

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