Solution Manual For Understanding Economics 9ce Mark Lovewell

Solution Manual For Understanding Economics 9ce Mark Love well Chapter 1-15

Chapter 1 Teaching Tips An Example from Behavioural Economics Behavioural economics is mentioned in a text footnote. Instructors may wish to give an illustration of the types of irrational behaviour highlighted in this emerging field of study. One of the best-known is the endowment effect. This refers to the fact that people value an item they own more highly than the exact same item when they do not own it. In other words, the mere fact of ownership raises one‘s utility from an item, which is a sign of irrationality.

Distinguishing Among Resources The definitions of natural, capital and human resources seem straightforward but can be challenging in practice. The fuzziest boundaries are between natural and capital resources and between labour and entrepreneurship.

Natural and Capital Resources Natural resources are defined as gifts of nature while capital resources are the processed materials, equipment, and buildings used in production. In some realworld cases the distinction between these two definitions is not immediately clear. Consider the case of livestock farming. The animals used in this industry might be viewed as natural resources, given that these animals are part of nature. However, given the intensive tending they require − not least in terms of daily food required to prepare them for market − they are a capital resource. In other words, animal husbandry is a form of production processing.

Labour and Entrepreneurship The distinction between these two types of human resources is hardest for entrepreneurs themselves when trying to categorize the time they put into a business.

These individuals tend to expend large amount of time in human effort (i.e., labour) as well as engaging in initiative and risk-taking. In practice, apportioning the business‘s net revenues into wages from labour and profit from risk-taking is extremely hard.

Extensions of the Production Possibilities Model The production possibilities model can be extended in two main ways.

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Constant-Cost Production Possibilities The text‘s treatment focuses on an economy subject to the law of increasing costs, which causes the production possibilities curve to bow out from the origin. It is also possible to sketch out the case where resources are perfectly transferable between production of the two items and constant costs apply. As shown in Practice Problem 2 at the end of chapter section 1.2 and problem 11 at the end of the chapter, the production possibilities curve in this case is a downward-sloping straight line.

Asymmetric Growth The text‘s treatment of economic growth stresses the case where an economy‘s ability to produce each item on the graph‘s axes increases by the same extent. It is possible this assumption is not met. As shown in problem 10 at the end of the chapter, it may be that there is an increase in the economy‘s ability to produce only one of the items on the axes. In this case the economy‘s production possibilities curve rotates around either the intercept on the horizontal or vertical axis, rather than shifting out in a parallel fashion.

Answers to Thinking about Economics Questions TAE I, Section 1.1: At one time, communist countries, such as China, tried to persuade their citizens to reduce their selfish material wants. However, such attempts to change mass behaviour were not successful, and have now largely ended in these countries.

TAE II, Section 1.2: Charitable organizations use strategies such as public acknowledgement of donors. For example, charitable performance companies often list the names of donors in their show programs.

TAE III, Section 1.2: The information revolution seems to have had some impact on rates of economic growth in industrialized countries. For example, between 1995 and the 2008 credit meltdown, growth rates in countries such as Canada and the United States were higher than in the immediately preceding period. Many economists suggested that the increased use of computer-based technology was one important reason for this improved growth performance.

Answers to Chapter Problems 1.1 Practice Problems 1. a) The smoker is not behaving rationally because of a physical addiction that has led them to continue engaging in an action they wish to stop. b) By providing themselves with small rewards for abstaining from smoking, and penalizing themselves when they do smoke, the smoker is much more likely to be able to quit.

2.

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a) The two variables are (i) the economic welfare of the country‘s citizens, and (ii) the quantity of the country‘s resources. The quantity of the country‘s resources is the independent variable (since it is the cause) and the economic welfare of the country‘s citizens is the dependent variable (since it is the effect). b) The relationship is direct because a movement in the independent variable‘s value leads to a movement of the dependent variable‘s value in the same direction. c) The statement is positive, since it is a description of reality that does not depend on value judgments. d) This statement is an illustration of the economic problem, because it shows how economic welfare is constrained by the quantity of economic resources.

3. Rent is a payment to owners of natural resources, interest is paid to owners of capital resources, and human resources receive wages for their labour and profit for their entrepreneurship. A loan repayment is not a resource income because loans are not an economic resource. (Recall that interest on a loan can be a resource income. But repayment of the principle is not income.)

1.2 Practice Problems 1. a) The opportunity cost of the first fish is 4 coconuts, since coconut production is reduced from 24 to 20 when the first fish is caught. Similarly, the opportunity costs of the second and third fish are 8 (= 20 − 12) and 12 (= 12 − 0) coconuts. b) These results conform with the law of increasing opportunity costs, because as fish production is increased so does the opportunity cost of each newly caught fish. c) The curve bows out to the right, reflecting the law of increasing opportunity costs. d) Besides the assumption that only two goods are produced, we must assume that the quantity of the castaway‘s resources and the technology they use are fixed, and that their resources are employed to their full capacity. e) With 12 instead of eight hours of labour devoted each day to acquiring coconuts and fish, the castaway‘s production possibilities curve shifts outwards, with both its vertical and horizontal intercepts increasing. If there are six instead of eight hours devoted each day by the castaway, the production possibilities curve shifts inwards. f) With a new capital asset that can be used to acquire fish (a fishing rod), the castaway‘s production possibilities curve shifts outwards, with its horizontal or fish intercept (but not its vertical coconut intercept) increasing.

2. a) Hot dog production falls from 300 to 250 hotdogs as the first smartphone is produced while moving from point a to b. The opportunity cost of this first smartphone is therefore 50 (= 300 − 250) hot dogs. Similarly, the opportunity costs of the second and third smartphones are 100 (= 250 − 150) and 150 (= 150 − 0) hot dogs.

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b) These results illustrate the law of increasing opportunity costs, because each new smartphone that is produced has a higher opportunity cost than the one before.

3. In the case of constant costs, the production possibilities curve will be a downward-sloping straight line. Because the slope of the production possibilities curve is based on the two products‘ opportunity costs, if both these opportunity costs are constant then the slope of the production possibilities curve will be constant as well.

1.3 Practice Problems 1. a) Beta is likely to have more economic freedom, given the greater importance of Beta‘s private sector and the consumer sovereignty it promotes. b) Alpha is likely to have more economic stability, because of the relative importance of its traditional and public sectors. Both of these sectors tend to reduce economic instability. c) In Alpha, traditional culture and national planners are more likely to conflict, given its relatively large traditional and public sectors. d) In terms of this triangle, Alpha will be southeast of Beta because it has stronger elements of both a traditional economy and a command economy.

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2. As expanding employment tends to push up economic growth at the same time as it stimulates inflation, government policies that promote economic growth will tend to lessen price stability. That means economic growth and price stability tend to be conflicting goals.

End of Chapter Problems 1. a) Paying $10 per visit is most logical. Given your past behaviour of ―not always following through with your plans,‖ there is a good chance that you will not increase your visits to the gym. Therefore, the cost of the $60 monthly contract is likely to be more than the cost of visiting the club two or three times a month at $10 per visit − $60 per month is greater than $20 or $30. b) Your past behaviour is an important factor. If you could be sure that you would follow through with your plans, the $60 per month might be less than the monthly cost of $10 per visit.

2. a) The main indication that your friend is not behaving rationally is that by making impulse purchases that exhaust their monthly paycheque they are unable to meet a goal they have already set for themselves. b) By setting up a separate savings plan with automatic withdrawal as soon as their paycheque is deposited in their account, they are less likely to engage in impulse purchases that would otherwise use up these funds.

3. a) The two variables are the price of digitally streamed music and the quantity of CDs purchased. The price of digitally streamed music is the independent variable, since it is the cause, and the quantity of CDs purchased is the dependent variable, since it is the effect. b) The two variables are Canadian household incomes and transfer payments to households.

Canadian household incomes is the independent variable, since it is the cause, and transfer payments to households is the dependent variable, since it is the effect. c) The two variables are the average salary of computer programmers and the number of people seeking a career in computer programming. The average salary of computer programmers is the independent variable, since it is the cause, and the number of people seeking a career in computer programming is the dependent variable, since it is the effect. d) The two variables are the price of wheat fertilizer and the amount of wheat planted by farmers. The price of wheat fertilizer is the independent variable, since it is the cause, and the amount of wheat planted by farmers is the dependent variable, since it is the effect.

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e) The two variables are output per worker in the Canadian economy and Canada‘s rate of economic growth. Output per worker in the Canadian economy is the independent variable, since it is the cause, and Canada‘s rate of economic growth is the dependent variable, since it is the effect. f) The two variables are the number of cases of an infectious disease in Canada and Canada‘s economic output. The number of cases of the infectious disease in Canada is the independent variable, since it is the cause, and Canada‘s economic output is the dependent variable, since it is the effect.

4. a) The relationship is inverse because the changes in the two variables are in the opposite direction. b) The relationship is direct because the changes in the two variables are in the same direction. c) The relationship is direct because the changes in the two variables are in the same direction. d) The relationship is direct because the changes in the two variables are in the same direction. e) The relationship is inverse because the changes in the two variables are in the opposite direction. f) The relationship is direct because the changes in the two variables are in the same direction.

5. a) The statement deals with a topic in microeconomics because it focuses on a particular market − in this case the one associated with collectibles. b) The statement deals with a topic in microeconomics because it focuses on a particular market − in this case the one associated with high fashion clothing. c) The statement deals with a topic in macroeconomics because it focuses on an entire economic sector and the economy as a whole. d) The statement deals with a topic in microeconomics because it focuses on a particular market − in this case the one associated with painkillers. e) The statement deals with a topic in macroeconomics because it focuses on an entire economic sector and the economy as a whole. f) The statement deals with a topic in microeconomics because it focuses on a particular market – in this case the one associated with a city‘s mass transit system.

6. a) The statement is normative, since it is a statement of how the world ought to be. b) The statement is positive, since it is a description of reality that does not depend on value judgments.

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c) The statement is positive, since it is a description of reality that does not depend on value judgments. d) The statement is normative, since it is a statement of how the world ought to be. e) The statement is normative, since it is a statement of how the world ought to be. f) The statement is normative, since it is a statement of how the world ought to be.

7. a) The two variables are average income and the number of homeless people. Average income is the independent variable, since it is the cause, and the number of homeless people is the dependent variable, since it is the effect. The relationship is inverse because the two variables move in the opposite direction. b) The two variables are the number of cars sold and the price of gasoline. The price of gasoline is the independent variable, since it is the cause, and the number of cars sold is the dependent variable, since it is the effect. The relationship is inverse because the two variables move in the opposite direction. c) The two variables are the supply of available farming land and the annual level of precipitation. The annual level of precipitation is the independent variable, since it is the cause, and the supply of available farming land number is the dependent variable, since it is the effect. The relationship is direct because the two variables move in the same direction. d) The two variables are the rate of economic growth and the amount of subsidies the government provides to businesses. The rate of economic growth is the independent variable, since it is the cause, and the amount of subsidies provided to businesses is the dependent variable, since it is the effect. The relationship is inverse because the two variables move in the opposite direction. e) The two variables are the number of smokers and the amount of taxes imposed on cigarettes.

The amount of taxes imposed on cigarettes is the independent variable, since it is the cause, and the number of smokers is the dependent variable, since it is the effect. The relationship is inverse because the two variables move in the opposite direction. f) The two variables are the number of immigrants who choose to come to Canada and the Canadian standard of living. The Canadian standard of living is the independent variable, since it is the cause, and the number of immigrants who choose to come to Canada is the dependent variable, since it is the effect. The relationship is direct because the two variables move in the same direction.

8. a) The consumer will choose the video game console because its utility is higher than the utility associated with the flat screen TV. b) Yes, utility does relate to the concept of opportunity cost. The opportunity cost of either item is the utility sacrificed by not consuming the other item. Because the utility derived by this

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consumer from the flat-screen TV is lower than for the video game console, the opportunity cost of the console is less than for the TV.

9. a) In moving from points b to c, Dynamia’s output of bicycles increases by 1 (= 2 − 1) while skateboard production decreases by 6 (= 32 − 38). Therefore, a new bicycle has an opportunity cost of 6 skateboards.

In moving from points c to d, bicycle production continues to rise by 1 (= 3 − 2) while skateboard output declines by 12 (= 20 − 32). Therefore, a new bicycle now has an opportunity cost of 12 skateboards.

These answers illustrate the law of increasing opportunity costs, because as more bicycles are produced there is a rise in the opportunity cost of this product. b) An output of 38 skateboards and 2 bicycles cannot be produced, since it lies beyond the production possibilities curve. c) An output of 32 skateboards and 1 bicycle is within the production possibilities curve. It represents a situation where resources are not being used effectively, either because they are unemployed or used at less than their full capacity. d) The technological improvement in the assembly of bicycles would cause the production possibilities curve to rotate rightward, with the horizontal intercept shifting outward but the vertical intercept staying constant. This shows that the economy‘s potential output of bicycles has increased while the potential output of skateboards has stayed the same. e) An increase in Dynamia‘s supply of labour would cause the production possibilities curve to shift to the right, with both the vertical and horizontal intercepts increasing. This shows that the economy‘s potential output of both bicycles and skateboards has increased.

10. a) In moving from points a to b, the output of lithium-ion batteries increases by 1 (=1 − 0) while solar panel production decreases by 8 (= 50 − 42). Therefore, the first lithium-ion battery has an opportunity cost of 8 solar panels.

In moving from points b to c, lithium-ion battery production continues to rise by 1 (= 2 − 1) while solar panel output declines by 18 (= 42 − 24). Therefore, an additional lithium-ion battery has an opportunity cost of 18 solar panels.

In moving from points c to d, lithium-ion battery production continues to rise by 1 (= 3 − 2) while solar panel output declines by 24 (= 24 − 0). Therefore, an additional lithium-ion battery has an opportunity cost of 24 solar panels.

These answers illustrate the law of increasing opportunity costs, because as more lithium-ion batteries are produced there is a rise in the opportunity cost of this product.

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b) In moving from points e to f, the output of lithium-ion batteries increases by 1 (= 1 − 0) while solar panel production decreases by 12 (= 70 − 58). Therefore, a new lithium-ion battery has an opportunity cost of 12 solar panels.

In moving from points f to g, the output of lithium-ion batteries increases by 1 (= 2 − 1) while solar panel production decreases by 24 (= 58 − 34). Therefore, an additional lithiumion battery has an opportunity cost of 24 solar panels.

In moving from points g to d, the output of lithium-ion batteries increases by 1 (= 3 − 2) while solar panel production decreases by 34 (= 34 − 0). Therefore, an additional lithium-ion battery has an opportunity cost of 34 solar panels.

These opportunity costs are higher than those in part a. (i.e., 12, 24, 34 vs. 8, 18, 24). c) The figure depicts a technological improvement in the production of solar panels. As such, the production possibilities curve rotates rightward, with the vertical intercept shifting outward but the horizontal intercept staying constant. Meridian is now better at producing solar panels. Now when resources are moved away from making solar panels, the opportunity cost of making batteries is higher. This simply reflects the fact that Meridian is now better at making solar panels so when resources are allocated into the other sector, they must give up more solar panels.

11. a)

b) In moving from scenarios A to B, the output of gold increases by 1 (= 1 − 0) kg while silver production decreases by 10 (= 20 − 30) kgs. Therefore, a new kg of gold has an opportunity cost of 10 kgs of silver.

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When moving from scenarios B to C, gold production continues to rise by 1 (= 2 − 1) kg while silver production declines by another 10 (= 10 − 20) kgs. Therefore, a new kg of gold still has an opportunity cost of 10 kgs of silver.

From scenarios C to D, gold production keeps rising by 1 (= 3 − 2) kg while silver output decreases by 24 (= 0 − 24) kgs. This means a new kg of gold still has an opportunity cost of 10 kgs of silver. c) The answers in part b do not illustrate the law of increasing opportunity costs. Because the production possibilities curve is a straight line rather than a curve bowed away from the origin, the opportunity cost of gold is constant at 10 kgs of silver. d) When plotted on the graph, scenario E is within the production possibilities curve.

Therefore, Mercantia‘s resources are sufficient to attain it, and this output combination is feasible. e) When plotted on the graph, scenario F is outside the production possibilities curve.

Mercantia‘s resources are therefore insufficient to reach it and this output combination is unattainable.

12. a) The most stable culture is likely to be found in the country with the largest traditional sector (Country B), since a traditional sector tends to promote stability.

The most equal distribution of income is likely to be found in the country with the largest public sector (Country C), since one of the main functions of government is to redistribute income.

The greatest economic freedom is likely to be found in the country with the largest private sector (Country A), since private markets provide individuals with the liberty to pursue their own self-interest. b) With a larger private sector, Country B will move up and to the left as it becomes more like a pure market economy. With a larger public sector, Country C will move up and to the right as it becomes more like a pure command economy.

13. a) In moving from points a to b, the output of industrial robots increases by 2 (= 2 − 0) while ice-cream soda production decreases by 5,000 (= 45,000 − 50,000). Therefore, the two new industrial robots each have an opportunity cost of 2,500 (= 5,000 / 2) ice-cream sodas.

In moving from points b to c, the production of industrial robots continues to rise by 2 (= 4 − 2) while ice-cream soda output declines by 10,000 (= 35,000 − 45,000) sodas.

Therefore, the two new industrial robots each have an opportunity cost of 5,000 (= 10,000 / 2) sodas.

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In moving from points e to d, the output of ice-cream sodas increases by 20,000 (= 20,000 − 0) while industrial robot production decreases by 2 (= 6 − 8). Therefore, the 20,000 new sodas each have an opportunity cost of 0.0001 = 2 / 20,000 industrial robots.

In moving from points d to c, the output of ice-cream sodas increases by 15,000 (= 35,000 − 20,000) while industrial robot production decreases by 2 (= 4 − 6). Therefore, the 15,000 new sodas each have an opportunity cost of 0.00013 = 2 / 15,000 industrial robots.

Yes, these answers illustrate the law of increasing opportunity costs.

As the production of industrial robots increases (from a to b and from b to c) so does the opportunity cost of the new robots produced, and when the production of ice-cream sodas increases (from points e to d and from points d to c) so does the opportunity cost of the new sodas produced. b) The technological improvement in the assembly of industrial robots would cause the production possibilities curve to rotate rightward, with the horizontal intercept shifting outward but the vertical intercept staying constant. This shows that the economy‘s potential output of robots has increased while the potential output of sodas has stayed the same. c) If this economy produces more industrial robots, which are capital goods, then the economy will increase its amount of available resources and therefore shift out its future production possibilities curve, with both the vertical and horizontal intercepts increasing.

This shows that the economy‘s future potential output of both sodas and industrial robots will increase.

14. Because households cannot keep any income above $60,000, those that could earn more by supplying their resources are unlikely to do so, reducing the overall amount of resources available to the economy.

15. a) Year

Inflation Unemployment (%) (%)

Misery Index

Above, below, or at the average?

Year

Inflation (%)

Above, Unemployment Misery below or (%) Index at the average?

2002

2.2

7.7

[9.9]

[above]

2012

1.5

7.3

[8.8]

[below]

2003

2.8

7.6

[10.4]

[above]

2013

0.9

7.1

[8.0]

[below]

2004

1.8

7.2

[9.0]

[above]

2014

2.0

6.9

[8.9]

[equal]

2005

2.2

6.8

[9.0]

[above]

2015

1.1

6.9

[8.0]

[below]

2006

2.0

6.3

[8.3]

[below]

2016

1.4

7.0

[8.4]

[below]

2007

2.2

6.0

[8.2]

[below]

2017

1.6

6.3

[7.9]

[below]

2008

2.3

6.1

[8.4]

[below]

2018

2.3

5.8

[8.1]

[below]

2009

0.3

8.3

[8.6]

[below]

2019

1.9

5.7

[7.6]

[below]

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2010

1.8

8.1

[9.9]

[above]

2020

0.7

9.5

[10.2]

[above]

2011

2.9

7.5

[10.4]

[above]

2021

3.4

7.5

[10.9]

[above]

b) The average value during the years from 2002 to 2021 was 8.9%. The misery index was above the average from 2002 to 2005 and then again from 2010 to 2011 and from 2020 to 2021. It was below the average from 2006 to 2009 and then again from 2012 to 2013 and from 2015 to 2019. It was the same as the average in 2014. c) The misery index is an indicator of the distress to Canadians caused by both inflation and unemployment. In this index, the inflation rate and the unemployment rate are each given the same weighting. Not everyone would agree with this weighting. For example, it could be argued that a percentage point of unemployment causes more hardship and distress that a percentage point of inflation.

Advancing Economic Thought Problems 1. As workers become more specialized, repetition helps them perform tasks more efficiently and without a break from one task to another. Hence, the same number of workers in a pin-making factory will be able to produce a greater output if they perform separate rather than similar tasks.

2. a) The exorbitant profits made in the production of Good W cause the invisible hand of competition to operate by enticing new entrepreneurs to enter the market. As they do, they push up the amount of Good W offered to consumers and push down the price. Price keeps falling until all suppliers in the market make only a moderate profit. In this case, the selfish actions of entrepreneurs hoping to make excess profits ensures that, over time, excess profits are eradicated. b) By taking advantage of the cost-savings associated with the new innovation, businesses that produce Good X now make higher-than-normal profits. This causes the invisible hand of competition to operate, through the appearance of new entrepreneurs in the market for Good X. The result is a rise in the amount supplied for this good, pushing down its price until all businesses producing this good are earning moderate profits. The selfishness of entrepreneurs seeking out excess profits causes price to fall to match the reduction in business costs. c) With the free flow of goods between countries A and B, some businesses in each country now find they can underprice competitors in the other country‘s market. As trade occurs between the two countries, prices of affected goods fall. Due to the self-interested behaviour of profit-seeking business-owners, consumers in both countries can buy certain goods more cheaply than they could before.

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3. a) It is because hungry stadium-goers have no choice but to purchase food from the catering company that the company can charge prices greater than those charged on comparable food outside the stadium. b) The corporations may try to cooperate with one another to set Good Y‘s price above what it would be in a fully competitive market. The absence of full competition in this market could therefore lead to the self-interested actions of the corporations‘ managers harming the interests of the consumer. c) It is impossible for Good Z to be made by workers who are not members of the union. As a result, of the new union contract, wage costs for all firms producing the good rise, which pushes up Good Z‘s price. The lack of competition between unionized and nonunionized workers in this labour market means that the self-interested actions of union members harm the interests of the consumer.

In-class Activities 1. Introductory Information Time: a minimum of 30 minutes to complete all the parts of the simulation. Parts A, B, and C each have a 3-minute time limit.

Materials: toothpicks, several packages of small marshmallows, several packages of large marshmallows.

Division of Students: Divide the class evenly into three teams (A, B, C). Push the desks together creating three long tables. Have each team sit at their respective table. You can have as many students participate as you like.

Key Concepts Covered: circular flow diagram division of labour economic efficiency economic problem economics law of increasing opportunity costs opportunity cost product markets production possibilities curve resource markets

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Learning Objectives: Part A: - Analyze and apply the concepts of economic efficiency and the division of labour.

- Participate in and examine a simulated mini-economy, while gaining insights into how this economy can incorporate product markets, resource markets and the circular flow diagram.

Part B: - Identify and evaluate specific examples of opportunity cost.

- Understand and apply the economic problem and the definition of economics to concrete examples.

Part C: - Explain and evaluate the effects of technology on the production possibilities curve as depicted by an outward shift in the curve.

- Create and evaluate a production possibilities curve based on hands-on experience.

- Apply the law of increasing opportunity costs.

2. Part A Exercise Recall that the class has been divided evenly into three teams (A, B, and C), and that each team is sitting at their respective tables.

Team A: makes only houses out of toothpicks and small marshmallows using the pattern shown below.

Team B: makes only cars out of toothpicks, small marshmallows, and large marshmallows using the pattern shown below.

Team C: observes the other two teams to count, and keep track of, the number of each product that is made by each team.

Timekeeper: the students will be given three minutes to make as many units of their product as they can.

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Were more houses or cars produced?

The number of houses made by team A was [fill in appropriate value], and the number of cars made by team B was [fill in appropriate value].

Were some students faster than the other students at putting the models together? How could production have been more efficient?

Explanation: Count the number of units of each product that were made during the allotted time. More houses than cars should have been produced because houses are easier to build, using the given patterns.

Some students will have been faster at putting the models together than others. Because not all people are created equal some will be more efficient at this task than others.

Some ways the teams could have been more efficient is by having the fastest students assigned to build models, or by breaking the model building process down into smaller tasks like a production line.

Follow-up areas of learning: - Discuss the division of labour and its role in production.

- Introduce product markets and resource markets.

- Refer to the circular flow diagram by looking at what would be needed to make this a complete mini-economy including both households and businesses.

3. Part B Exercise 1-15 Copyright © 2023 by McGraw Hill

Teams A and B merge as one company, called AB, that serves a town. This town has 50% more families than there are students in the room. Each family must have at least one house and one car produced by the company AB. Coincidentally the total number of cars and houses demanded by this town is approximately double the number produced in Part A. Team A and Team B, now company AB: All members of AB will make houses or cars out of toothpicks and marshmallows using the patterns below (same patterns as in Part A). Teams A and B will decide together which of their members will make cars, houses, or some of both products. The goal is to make approximately double the number of houses and cars that were produced in Part A. Company AB must find the best way to reach that goal.

Team C: observes the other two teams to count, and keep track of, the number of each product that is made.

Timekeeper: the students will be given three minutes to make as many units of their product as they can.

Were more houses or cars produced than in Part A? The number of houses made by team A was [fill in appropriate value], and the number of cars made by team B was [fill in appropriate value].

Were more students producing houses or cars?

More students were producing [cars*; houses] because cars take longer to make than houses.* houses take longer to make than cars. more families want a car.

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more families want a house.

Explanation: It should have already been discovered from Part A that it takes longer to make cars than houses. Teams A and B, or company AB, should assign their fastest workers to produce cars. They should also assign more workers to produce cars than houses, or eventually some students will have to switch to making cars in order to obtain an identical number of units of both products.

Follow-up areas of learning: - Reiterate the concepts of division of labour and economic efficiency.

- Discuss the scarcity of economic resources, the unlimited nature of wants and needs, and the way these two concepts merge to create the economic problem.

4. Part C Exercise Teams A and B continue as one company, called AB, that serves a town with 50% more families as there are students in the room. And, as in Part B, the total number of cars and houses demanded by this town is approximately double the number produced in Part A. Team A and Team B, now company AB: Like in Part B, all members of AB will make houses or cars out of toothpicks and marshmallows using the patterns below (same patterns as in Part A). The goal is to make approximately double the number of houses and cars that were produced in Part A. Team C: becomes Team Technology. Team Technology builds L-shaped pieces as shown below. These pieces can, and should, then be used by company AB to build cars and houses using the same patterns as in Part A. Timekeeper: the students will be given three minutes to make as many units of their product as they can.

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Were more houses and cars produced than were produced in Parts A and B? The number of houses made by team A was [fill in appropriate number] and the number of cars made by team B was [fill in appropriate number].

How does Part C provide evidence of an outward shift in the economy‘s production possibilities curve?

AB was able to produce more houses.

AB was able to produce more cars.

There was an increase in the production of both houses and cars after the addition of technology.* There was a decrease in the production of both houses and cars after the addition of technology.

Explanation: The production of both houses and cars should be greater in Part C than in Parts A or B. The simulation in Part C provides evidence for an outward shift in the economy‘s production possibilities curve as shown by the increase in the production of both cars and houses with the addition of technology.

Follow-up areas of learning: - Discuss points of less than full production inside the production possibilities curve and the unattainable points outside the curve.

5. Discussion Questions 1. a. Based on the pair of total output combinations achieved in Parts A and B, identify the points on the production possibilities curve for cars and houses shown below.

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Point a shows the number of houses and cars produced in Part A.* the number of houses and cars produced in Part B. the number of houses and cars produced in Part C. none of the results shown in Parts A, B or C. the number of houses produced in part A and the number of cars produced in Part B. Point b shows the number of houses and cars produced in Part A. the number of houses and cars produced in Part B.* the number of houses and cars produced in Part C. none of the results shown in Parts A, B or C. the number of houses produced in Part A and the number of cars produced in Part C. Point c shows the number of houses and cars produced in Part A. the number of houses and cars produced in Part B. the number of houses and cars produced in Part C.* none of the results shown in Parts A, B or C. the number of houses produced in Part B and the number of cars produced in Part C. 1-19 Copyright © 2023 by McGraw Hill

b. Explain how the shape of the curve in the graph above is affected by the law of increasing opportunity cost in terms of cars given up to achieve greater production of houses.

Houses do not have to be given up to obtain more cars.

More and more cars must be given up to obtain more houses.* Fewer and fewer cars must be given up to obtain more houses.

Cars do not have to be given up to obtain more houses.

2. a. Using the production possibilities curve above, a point of less than full production is [a; b; c; d*] and an unattainable point is [a; b; c*; d]. b. Referring to the production possibilities curve above, the opportunity cost of cars in terms of houses given up can be described as: the decrease in the production of houses on the horizontal axis when producing one more house. the decrease in the production of cars on the vertical axis when producing one more house. the decrease in the production of houses on the horizontal axis when producing one more car.* the decrease in the production of cars on the vertical axis when producing one more car. c. What caused your production possibilities curve to shift outwards in the simulation in Part C. An increase in supply.

The addition of a new product.

A reduction in demand.

The addition of technology.

3. What was the impact of technology on the production of cars and houses?

There was no change in production.

There was greater production of houses but not cars.

There was greater production of both cars and houses.* There was greater production of cars but not houses.

4. Referring to the simulation in Part B, explain the key role of scarcity in the economic

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problem.

There were sufficient labour resources, but not other resources to produce houses and cars.

Wants of the town‘s inhabitants were scarce, but resources to produce houses and cars were unlimited.

Both the wants of the town‘s inhabitants and resources to produce houses and cars were scarce.

Resources to produce houses and cars were scarce but wants were unlimited.* Explanation: 1a. The production possibilities curve passes through points a and b. At point a, more houses are produced as shown by the point‘s horizontal intercept than cars as shown by the point‘s vertical intercept. It therefore corresponds to the result in Part A. At point b, an identical number of houses and cars are produced, corresponding to Part B. At point c, more houses and cars are produced than at point b, corresponding to Part C. b. The production possibilities curve in the graph, which bows out to the right, reflects the increasing opportunity cost of houses as more of them of produced. The further to the up one moves to the right along the horizontal axis, the decrease on the vertical axis needed to move a given length on the horizontal axis continues to rise, showing that more cars must be given up to produce each extra house.

2a. The point d represents less than full production because given the initial technology and supply of resources because one could produce more of both houses and cars, thereby moving upwards and to the right towards the production possibilities curve. The point c is unattainable given the initial technology and supply of resources because it lies outside the production possibilities curve. b. The opportunity cost of houses in terms of cars is represented on the graph by the decrease in the production of houses (i.e., leftward movement on the horizontal axis) when producing one more car (i.e., the upward movement along the vertical axis). c. In Part C, the addition of technology increased the production of both cars and houses, shifting the production possibilities curve out to the right.

3. The impact of technology in Part C was to allow for an increase in the production of both houses and cars, as shown by the movement from points a to c.

4. In Part B, it was necessary to employ scarce resources − in particular scarce labour − as efficiently as possible to meet the wants of the town‘s inhabitants.

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6. Multiple Choice Questions 1. The possible output combinations of houses and cars expressed as a graph is called a(n) a) opportunity cost curve. b) decreasing opportunity cost curve. c) full production curve. d) productions possibilities curve.* e) increasing opportunity cost curve.

2. If several cars are being given up to produce an extra house, then the opportunity cost of this extra house is: a) impossible to determine. b) the number of houses given up to produce an extra car. c) the fraction found by dividing 1 by the number of houses sacrificed to produce an extra car. d) the fraction found by dividing 1 by the number of cars sacrificed to produce the extra house. e) the number of cars given up to produce the house.*

3. The fact that the production possibilities curve for cars and houses bows out to the right illustrates a) the point of economic growth. b) the point of economic efficiency. c) the law of demand. d) the law of increasing opportunity costs.* e) the law of decreasing opportunity costs.

4. In the circular flow diagram, the markets for cars and houses would be considered a) resource markets. b) business markets. c) traditional markets. d) household markets. e) product markets.* 5. The economic system represented in this set of simulations is best described as a a) traditional mixed economy. b) traditional economy. c) market economy.* d) command economy.

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e) modern mixed economy.

Explanation: 1. This graph of possible output combinations of the two products is called a production possibilities curve.

2. Because the opportunity cost of one product is the number of units of another product that must be sacrificed to gain an extra unit of this product, the opportunity cost of this extra house is the number of cars given up to produce the house.

3. This bowed shape illustrates the law of increasing opportunity costs because it depends on the fact that resources are not perfectly transferable between cars and houses.

4. In the circular flow diagram, the markets for cars and houses would be considered product markets.

5. The economic system represented in this set of simulations is best described as a market economy.

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Chapter 2 Teaching Tips The Graphical Properties of Demand and Supply Students‘ comfort in using demand and supply may be aided by having them review the mathematical properties of straight lines outlined in the Connect resource‘s Graphing Module.

Through a review of the algebraic notions of slope and axis intercepts, the module helps students appreciate the differences between negatively sloped demand curves and positively sloped supply curves so essential in understanding the graphical explanations outlined in this chapter.

These topics are also covered in the Connect resource‘s Skills Resource.

Demand and Supply Shifts Changes in demand are easier to visualize than changes in supply. This is because of the graphical properties of demand curves. An increase in demand, for example, is graphed as a rightward (when seen horizontally) or upward (when seen vertically) shift. Similarly, a decrease in demand is graphed as a leftward or downward shift. Shifts in demand therefore look the same whether viewed horizontally or vertically. Still, it is best to refer to an increase in demand as a rightward shift, rather than an upward shift. Similarly, refer to a decrease in demand as a leftward shift. Doing so helps circumvent confusion when students come to supply. For in this case a rightward shift of the curve appears downward when viewed vertically. Meanwhile a leftward shift appears to be vertically upward. As with demand, always refer to supply changes in horizontal terms, so that a supply increase is described as a rightward not downward shift, while a decrease is described as a leftward not upward shift.

Demand Factors In presenting this material, you may find students perplexed over the workings of two factors − prices of other products and consumer expectations. If so, extend your treatment with the following points.

Prices of Other Products The easiest way to recall the negative relationship between quantity demanded and price of a complement is by remembering that this relationship parallels that between quantity demanded and the product‘s own price. If two products are complements, the direction of the movement in quantity demanded is the same regardless of which product‘s price changes − the product‘s own price or the price of its complement. In contrast, with a change in a substitute‘s price, the direction of the movement in quantity demanded is opposite to the impact of a change in the product‘s own price.

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Consumer Expectations Consumer expectations about future prices on the one hand and incomes on the other are best covered separately. For expected changes in price, the effect on quantity demanded is opposite to what would happen if it were the current price that were changing. That‘s because, if consumers are affected by expected price changes, they view future purchases and current purchases of the same item as substitute options. For example, an expected rise in price causes current quantity demanded to increase, since consumers are choosing to purchase now rather than in the future. Now let‘s consider the impact of consumer expectations about future income. Here the key point is whether the product in question is normal or inferior.

In either case, the effect of an expected change in income is in the same direction as the effect if it were current income that were changing. For example, an expected rise in future income raises quantity demanded for normal products, just as a rise in current income does. That‘s because expected changes in income, just like current income changes, tend to affect how well-off consumers feel at the present moment.

Supply Factors As in the case of demand factors, two supply factors may prove particularly challenging to students: prices of related products and producer expectations. If necessary, supplement your explanations with the following points.

Prices of Related Products It is crucial to be clear on whether the price of another product that is changing is affecting consumers or producers. (Note the difference in the names of the two factors: prices of other products for the demand factor, prices of related products for the supply factor.) In the case of supply, the effect of a change in the price of a related product depends on whether the two products in questions are produced as replacements to one another (by far the most common case) or whether they are produced jointly (rare, but still possible). In the case of products that are produced as replacements to one another, quantity moves in the opposite direction to the change in the price of a related product. That‘s because producers are choosing to substitute the supply of one product for another. On the other hand, in the case of products that are produced jointly, quantity moves in the same direction as the change in the price of the related product. That‘s because producers choose to produce both goods together.

Producer Expectations The impact on quantity of producer expectations concerning future prices is always in an opposite direction to the way the price is expected to move. That‘s because producers are viewing current sales and future sales of their product as substitute options. For example, an expected rise in the price of an item causes its producers to decrease current quantity 1-25 Copyright © 2023 by McGraw Hill

supplied so they can gain the extra revenue from selling it after the expected price rise.

Effects of Demand and Supply Shifts on Equilibrium There are several shorthand methods for quickly ascertaining the impact of demand and supply shifts on equilibrium price and quantity. If only demand is shifting, the results on price and quantity are straightforward since both values move in the same direction as the demand change.

For example, if demand increases then so do equilibrium price and quantity. If only supply is shifting, then the change in equilibrium quantity is in the same direction as the supply change, while the change in equilibrium price is in the opposite direction. For example, if supply increases then so does equilibrium quantity, while equilibrium price decreases. If both curves shift simultaneously, then the most straightforward cases are if both curves increase or decrease simultaneously. Then quantity moves in the same direction as demand and supply while the change in price is indeterminate. On the other hand, if demand is shifting one way and supply the other, then it is the direction of the price change that can be ascertained, while the change in quantity is indeterminate. In these cases, it is the vertical movements in demand and supply that determine the direction of the price change. If both shift vertically upwards, price rises; in the case of simultaneous downward shifts, price falls.

Answers to Thinking about Economics Questions TAE I, Section 2.1: Rolex watches are a specific example of such a product, since their high price is one of this product‘s attractive features to those consumers who can afford to buy them.

TAE II, Section 2.3: The appearance of the surge multiplier that accompanies the increase in demand represents an increase in price which causes a reduction in quantity demanded by riders and an increase in quantity supplied by drivers. Because it takes time for drivers longer to reach areas where surge pricing is relevant their reaction will tend to be slower than the reaction of riders.

Answers to Chapter Problems 2.1 Practice Problems 1. a) D1 and D2 both satisfy the law of demand since both illustrate an inverse relationship between price and quantity demanded. As the price of milkshakes falls, as from $2 to $1.80, for example, the quantity demanded for Student 1 rises from 4 to 5 milkshakes, and the quantity demanded for Student 2 rises from 5 to 7 milkshakes.

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b) The market demand curve is found by adding together the quantities demanded by Student 1 and Student 2 at each possible price. c) At a price of $2, quantity demanded in the market is 9 (= 5 + 4) milkshakes; at a price $1.80 it is 12 (= 7 + 5) milkshakes, at $1.60 it is 15 (= 9 + 6) milkshakes, and at $1.40 it is 18 (= 11 + 7) milkshakes. d)

In this graph the quantities demanded by Student 1 and Student 2 and in the market are highlighted at a price of $1.60.

2. a) Because ebooks are a normal product, demand increases due to higher incomes. b) Ebooks and ebook readers are complementary products, so a drop in the price of readers increases not just the quantity demanded of readers but also the demand for ebooks. c) A sudden expectation by consumers of a fall in ebook prices means they will delay ebook purchases, decreasing current demand. d) Because ebooks and print books are substitute products, a rise in the price of print books increases the demand for ebooks.

3. a) A decrease in the price of coffee, which raises the quantity demanded of coffee, is associated with a movement along the demand curve for coffee and is categorized as an increase in quantity demanded.

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b) Because coffee and tea are substitute products, a drop in the price of coffee decreases the entire demand curve for tea. This occurs because the quantity of tea is reduced at every possible price of tea. This is therefore categorized as a decrease in demand.

2.2 Practice Problems 1. a) The law of supply is satisfied, since a rise in the price of tomatoes (from $1 to $2, and then from $2 to $3) increases quantity supplied (from 5 to 7 million kgs, and then from 7 to 9 million kgs). b)

In this graph the quantities supplied before and after the shift in supply are highlighted at a price of $2. c) In each of the cases the following occurs: - As wages rise, the supply of tomatoes decreases, shifting the curve to the left.

- Because tomatoes and corn are supply-related products, a drop in the price of corn will increase the supply of tomatoes, shifting the curve to the right.

- An early frost decreases the supply of tomatoes, shifting the curve to the left.

- Technological progress in tomato cultivation increases the supply of tomatoes, shifting the curve to the right.

- An expected fall in the price of tomatoes increases the current supply, as producers try to get today‘s high price, shifting the curve to the right. d) A doubling of quantity supplied at each price means that quantity supplied is now 10 million (= 2 × 5 million) kgs at a price of $1, 14 million (= 2 × 7 million) kgs at $2 and

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18 million (= 2 × 9 million) kgs at $3. The new market supply curve S1 shifts out to the right. Because of the curve‘s rightward shift this is known as an increase in supply.

2. a) A drop in the price of corn, which reduces the quantity supplied of corn, is associated with a movement along the supply curve for corn and is classified as a decrease in quantity supplied. b) Because corn and tomatoes are supply-related products, a drop in the price of corn causes a rightward shift in the entire supply curve for tomatoes. This happens because some farmers will respond by moving from corn to tomato production. The result is classified as an increase in supply.

2.3 Practice Problems 1.

a) Supply has decreased, which is shown as a leftward shift in the curve in the graph shown above. b) With a decrease in supply, equilibrium quantity decreases. c) The rise in equilibrium price and fall in equilibrium quantity are accompanied by a temporary shortage that occurs immediately after the decrease in supply, as illustrated in the graph, where after the shift in supply from S0 to S1, there is a shortage (as seen by the points labelled a in the graph), which pushes price upwards to its equilibrium value (point b in the graph).

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2.

a) Demand has increased, which is associated with rightward shift of the curve in the graph shown above. b) With an increase in demand, equilibrium quantity increases. c) The rise in equilibrium price and quantity are accompanied by a temporary shortage that occurs immediately after the increase in demand, as illustrated in the graph, where after the shift in demand from D0 to D1, there is a shortage (points a in the graph), which pushes price upwards to its equilibrium value (point b in the graph).

End of Chapter Problems 1. a) The three points are 8 (= 3 + 5) chocolate bars at a price of $1.25, 13 (= 5 + 8) chocolate bars at a price of $1, and 18 (= 7 + 11) at a price of 75 cents. b) The law of demand is satisfied, because a fall in the price of chocolate bars (from $1.25 to $1, or from $1 to 75 cents) increases quantity demanded (from 8 to 13 chocolate bars, or again from 13 to 18 chocolate bars).

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c)

In this graph the quantities demanded by Kate and Carlo, and in the market before and after the change in market demand, are highlighted at a price of $1. d) Kate now buys 6 and Carlo 10 chocolate bars at a price of $1.25; Kate buys 10 and Carlo 16 chocolate bars at a price of $1; and Kate buys 14 and Carlo 22 at a price of 75 cents.

Therefore, the three points are 16 (= 6 + 10) at $1.25, 26 (= 10 + 16) at $1, and 36 (= 14 + 22) at 75 cents. Because the entire market demand curve shifts rightward this is an increase in demand.

2. a) Shanice‘s

Nick‘s

Priya‘s

Quantity Demanded (books per month)

Quantity Demanded (books per month)

Quantity Demanded (books per month)

$15.00

2

3

4

9

$10.00

3

4

5

12

5.00

4

5

6

15

Price ($ per book)

Quantity Demanded in Market (books per month)

The three quantities demanded in the market are 9 (= 2 + 3 + 4) books at a price of $15, 12 (= 3 + 4 + 5) books at a price of $10, and 15 (= 4 + 5 + 6) at a price of $5.

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b)

c) The law of demand is met for Dm0. This is because price and quantity demand move in opposite directions. For example, a fall in the price of books from $15 to $10 increases quantity demanded on the curve from 9 to 12 books. d) At a price of $15 Shanice now buys 1 book, Nick buys 2 and Priya 3. At a price of $10 Shanice now buys 2 books, Nick buys 3 and Priya 4. At a price of $5 Shanice now buys 3, Nick buys 4 and Priya buys 5. Therefore, the three points on the new market demand curve Dm1 are 6 (= 1 + 2 + 3) at $15, 9 (= 2 + 3 + 4) at $10, and 12 (= 3 + 4 + 5) at $5.

This is a decrease in demand. See part b for the graph of Dm0.

3. a) S0 satisfies the law of supply since it has an upward slope, showing that as the price of apples rises, as from $2 to $3, so does the quantity supplied of apples, as from 70,000 to 150,000 apples. b) With an increase in the amount of apples offered for sale at each price, the supply curve shifts to the right, which illustrates an increase in supply. c) At a price of $2, the new quantity supplied is 130,000 (= 70,000 + 50,000) kg, at $3 it is 200,000 (= 150,000 + 50,000) kg and at $4 it is 280,000 (= 230,000 + 50,000) kg. d) In this graph the quantities supplied for both of the supply curves are highlighted at a price of $3.

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4. a)

D0 is negatively sloped, because from left to right, the curve falls. S0 is positively sloped, because from left to right, the curve rises. D0 satisfies the law of demand since as the price of avocados rises, as from $1 to $1.50, the quantity demanded of avocados moves in the opposite direction, from 4 million to 3.5 million. S0 satisfies the law of supply since as the price of avocados rises, as from $1 to $1.50, so does the quantity supplied of avocados, from 2 million to 3.5 million. The equilibrium price and quantity of avocados are $1.50 an 3.5 million, found at the intersection of D0 and S0 (point a in the graph). b) At $2.50 the new quantity supplied is 4.5 million (= 6.5 million − 2 million), at $2 it is 3 million (= 5 million − 2 million), at $1.50 it is 1.5 million (= 3.5 million − 2 million), and at $1 it is 0 (= 2 million − 2 million). c) There is a decrease in supply, since at each price of the product quantity supplied falls.

The new equilibrium price is $2 and the new equilibrium quantity is 3 million, found at the intersection of D0 and S1 (point b in the graph). Compared with their initial equilibrium values, quantity has decreased and price has increased. This is what we would expect with a decrease in supply.

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5.

Demand Factors

Supply Factors

number of buyers income price of another product consumer preferences consumer expectations

number of producers resource price state of technology change in nature price of related product producer expectations

a) Demand increases, since this discovery changes consumer perceptions of the medical benefits of blueberries, making them more likely to prefer this product at each possible price. The demand factor, consumer preferences, is changing. This causes the demand curve for blueberries to shift to the right. b) Supply increases, because the new automated equipment increases how much tea growers can produce at each possible price. The supply factor, state of technology, is changing.

This causes the supply curve for tea to shift to the right. c) Demand decreases, since game consoles and video games are complementary goods and a rise in the price of consoles makes games less attractive to consumers at each possible price for games. The demand factor, price of another product, is changing. This causes the demand curve for video games to shift to the left. d) Supply decreases, because a rise in the price of grazing land reduces how much wool suppliers can produce at each possible price of wool. The supply factor, resource price, is changing. This causes the supply curve for wool to shift to the left. e) Supply decreases, because a fall in the price of beef and the resulting drop in the raising of cattle reduces how much leather that suppliers can produce at each possible price of leather. The supply factor, price of a related product, is changing. This causes the supply curve for leather to shift to the left.

6. a) As the streaming service‘s subscription rate falls, there will be an increase in quantity demanded, shown by a movement down and to the right along the demand curve. b) With the drop in consumer incomes, there will be an increase in demand for an inferior product such as canned milk, associated with a rightward shift in the demand curve. c) The rise in the price of this brand of perfume causes a decrease in quantity demanded for this item, shown by a movement up and to the left along the demand curve.

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d) The increased popularity of online games will cause a decrease in demand for video games, since these two products are substitutes. This is associated with a leftward shift in the demand curve for video games. e) The reduced price of headsets causes an increase in quantity demanded for this item, shown by a movement down and to the right along the demand curve.

7. a) With a higher price of tomatoes, there will be an increase in quantity supplied for this product, shown by a movement up and to the right along the supply curve. b) Due to the oil spill, there is a decrease in supply of salmon, accompanied by a leftward shift in the supply curve. c) As the price of cranberries falls, there will be a decrease in quantity supplied, shown by a movement down and to the left along the supply curve. d) With the introduction of more sophisticated mining equipment, there is an increase in supply for iron, shown by a rightward shift in the supply curve. e) With a rise in the price of avocados and the resulting increase in avocado production by farmers, there will be a decrease in supply of quinoa, coupled with a leftward shift in the supply curve.

8.

(1) Price ($ per cap)

(2) (3) (4) Quantity Quantity Surplus (+) or Demanded Supplied Shortage (-) (caps per week) (caps per week)

(5) Effect on Price

(6) (7) (8) New Quantity New Surplus New Effect Demanded (+) or on Price (caps per week) Shortage (-)

$25.00

8,000

14,000

[6,000]

down

11,000

[3,000]

down

20.00

9,000

12,000

[3,000]

down

12,000

[0]

stay the same

15.00

10,000

10,000

[0]

stay the same

13,000

[-3,000]

up

10.00

11,000

8,000

[-3,000]

up

14,000

[-6,000]

up

5.00

12,000

6,000

[-6,000]

up

15,000

[-9,000]

up

a) The values in column (4) are found by subtracting the relevant quantity demanded in column (2) from the associated quantity supplied in column (3). For example, there is a surplus of 6,000 (= 14,000 − 8,000) at a price of $25. The descriptions in column (5) follow from whether or not there is a surplus or shortage. With a surplus, price is pushed down; with a shortage, price is pushed up; and when there is no discrepancy between quantities demanded and supplied there is no change in price.

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b)

c) Equilibrium price is $15, associated with a quantity of 10,000 caps per week. At any other price besides $15, there is a discrepancy between the quantities demanded and supplied. At prices above $15, there is a surplus which causes price to fall (in the graph above, the points labelled a at a price of $25 and the points labelled b at a price of $20), while at prices below $15 there is a shortage which causes price to rise fall (in the graph above, the points labelled c at a price of $10 and the points labelled d at a price of $5).

Only at $15 are quantities demanded and supplied identical at 10,000 caps. d) This represents an increase in demand, since buyers raise the amounts of baseball caps they purchase at every price. It would be shown by a rightward shift in the demand curve. e) The new values in columns (7) and (8) are found using the same methods used in part a − the surplus or shortage in column (7) is derived by subtracting quantity demanded from quantity supplied and the description of the change in price in column (8) follows from whether there is a surplus, in which case price is pushed down, or a shortage, in which case price is pushed up. As before, when there is no discrepancy between quantities demanded and supplied there is no change in price.

9.

(1)

(2)

(3)

(4)

Price ($ per cap)

Quantity Demanded (pumpkins

Quantity Supplied (pumpkins

Surplus (+)

per month)

per month)

$10.00

20,000

[50,000]

30,000

35,000

[15,000]

8.00

30,000

[45,000]

15,000

30,000

[0]

6.00

40,000

[40,000]

0

25,000

[-15,000]

(6)

New Quantity New Surplus Supplied (+) or or (pumpkins per Shortage (-) Shortage (-) month)

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(5)

4.00

50,000

[35,000]

-15,000

20,000

[-30,000]

2.00

60,000

[30,000]

-30,000

15,000

[-45,000]

a) The values in column (3) are found by adding the relevant surplus or subtracting the relevant shortage in column (4) from the associated quantity demanded in column (1).

For example, at a price of $10 quantity supplied is 50,000 (= 20,000 + 30,000). b)

c) Equilibrium price is $6, associated with a quantity of 40,000 pumpkins per month. At any other price besides $6, there is a discrepancy between the quantities demanded and supplied. At prices above $6, there is a surplus which causes price to fall (in the graph above, the points labelled a at a price of $10 and the points labelled b at a price of $8), while at prices below $6 a shortage which causes price to rise (in the graph above, the points labelled c at a price of $4 and the points labelled d at a price of $2). Only at $6 are quantities demanded and supplied identical at 40,000 pumpkins. d) This represents a decrease in supply, since buyers reduce the amounts of pumpkins they offer for sale at every price. It would be shown by a leftward shift in the supply curve. e) The new equilibrium price and quantity are $8 and 30,000 pumpkins per month. These are found as the point at the intersection of D0 and S1.

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10. a)

b) The initial equilibrium price and quantity are found at the intersection of D0 and S0 (the point labelled a in the graph). c) This new equilibrium price and quantity are found at the intersection of curves D1 and S0 (point b in the graph). When compared with the initial equilibrium point, the values for both price and quantity have fallen. d) Equilibrium price and quantity are now at the intersection of D1 and S1 (point c in the graph). When compared with the equilibrium point in part c, equilibrium price has risen and equilibrium quantity has fallen.

11. a)

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b) The initial equilibrium price and quantity are $2 and 6 million, found at the intersection of D0 and S0 (the point labelled a in the graph). c) This new equilibrium price and quantity are $4 and 6 million, found at the intersection of curves D1 and S1 (point b in the graph). When compared with their initial equilibrium values, equilibrium price has risen from $2 to $4 and equilibrium quantity has stayed the same at 6 million. d) Because only price has increased and equilibrium quantity has stayed the same, the shifts in the demand and supply curves have been of equal size though in opposite direction.

12. a) Equilibrium price and quantity both fall. Because dry cleaning is a normal product, a drop in consumer incomes shifts the demand curve to the left, which causes the equilibrium point to move down and to the left along the supply curve. b) Equilibrium price rises and equilibrium quantity falls. A decline in the number of law school graduates shifts the supply curve of legal services to the left, which causes the equilibrium point to move up and to the left along the demand curve. c) Equilibrium price and quantity both rise. With consumer expectations that turkey prices will soon rise, the demand curve for turkeys shifts to the right, which causes the equilibrium point to move up and to the right along the supply curve. d) Equilibrium price falls and equilibrium quantity rises. A cost-saving technological innovation shifts the supply curve of rice to the right, which causes the equilibrium point to move down and to the right along a stationary demand curve. e) Equilibrium price rises and equilibrium quantity falls. With the fall in the population of cod caused by the shift in ocean currents, the supply curve for cod shifts to the left, which causes the equilibrium point to move up and to the left along the demand curve.

13. a) As consumer incomes fall, there is a decrease in demand for a normal product such as wheat. Meanwhile the drop in the price of combine harvesters leads to an increase in supply for wheat. With a leftward shift in demand and a rightward shift in supply, equilibrium price falls while equilibrium quantity may rise, fall or stay the same. b) With a particularly severe flu season there is an increase in demand for this herbal remedy. Meanwhile the rise in the price of ingredients causes a decrease in supply. With a rightward shift in demand and a leftward shift in supply, equilibrium price rises while equilibrium quantity may rise, fall or stay the same. c) Due to the rise in consumer preferences for spicy food, there is an increase in demand for jalapeno peppers. Meanwhile, the fall in wages paid to farmworkers leads to an increase 1-39 Copyright © 2023 by McGraw Hill

in supply. With a rightward shift in both demand and supply, equilibrium price may rise, fall or stay the same while equilibrium quantity rises. d) Given consumer expectations that the price of tuna will rise, there is an increase in the current demand for tuna. Meanwhile, as the number of tuna fishers drops there is a decrease in supply. With a rightward shift in demand and a leftward shift in supply, equilibrium price increases while equilibrium quantity may rise, fall or stay the same. e) As a result of the fall in the price of margarine, there is a decrease in the demand for butter. Meanwhile, the expectation by dairy farmers that the price of butter will soon rise causes a decrease in current supply. With a leftward shift in both demand and supply, equilibrium price may rise, fall or stay the same while equilibrium quantity falls.

14. a) Public education causes demand for the product to fall reducing equilibrium quantity while equilibrium price as seen by consumers drops. Legal restrictions or taxes shift the supply vertically upwards (i.e., cause a drop in supply) reducing equilibrium quantity while equilibrium price as seen by consumers rises. b) Public education that reduces demand is likely to have more long-term success than legal restrictions or taxes that affect supply. This is because the impact of public education on consumption is much more likely to be permanent, whereas the reduced consumption caused by restrictions or taxes lasts only as long as the policy remains in effect.

Advancing Economic Thought Problems 1.

Consumption of A (price = $2)

Units of A

Consumption of B (price = $4)

Total Utility Marginal Utility Marginal Utility Total Utility Marginal Units of B (utils) (utils) per $ (utils per $) (utils) Utility (utils)

0

0

1

22

[22]

2

40

3

Marginal Utility per $ (utils per $)

0

0

[11] per $

1

20

[20]

[5] per $

[18]

[9] per $

2

36

[16]

[4] per $

54

[14]

[7] per $

3

48

[12]

[3] per $

4

64

[10]

[5] per $

4

56

[8]

[2] per $

5

70

[6]

[3] per $

5

60

[4]

[1] per $

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a) The marginal utility for each new unit of A or B is found by subtracting the total utility associated with the initial consumption of A or B from the total utility that results from adding the new unit. For good A, the marginal utility of the first unit is 22 (= 22 − 0) utils, the second unit 18 (= 40 − 22), the third unit 14 (= 54 − 40), the fourth unit 10 (= 64 − 54) and the fifth unit 6 (= 70 − 64). The marginal utility per dollar for each unit of A is then found by dividing each of these marginal utilities by A‘s price of $2: 11 (= 22 / 2), 9 (= 18 / 2), 7 (= 14 / 2), 5 (= 10 / 2), 3 (= 6 / 2). For good B the marginal utility of the first unit is 20 (= 20 − 0) utils, the second unit 16 (= 36 − 20), the third unit 12 (= 48 − 36), the fourth unit 8 (= 56 − 48) and the fifth unit 4 (= 60 − 56). The marginal utility per dollar for each unit of B is then found by dividing each of these marginal utilities by B‘s price of $4: 5 (= 20 / 4), 4 (= 16 / 4), 3 (= 12 / 4), 2 (= 8 / 4), 1 (= 4 / 4). b) Consumer X first purchases 3 units of A (with MUs per $ of 11, 9, and 7), the 4th unit of A and the 1st unit of B (each with an MU per $ of 5), the 2nd unit of B (with an MU per $ of 4), and the 5th unit of A and the 3rd unit of B (each with an MU per $ of 3). Their $22 income is then exhausted at a consumption level where the marginal utilities per dollar spent on A and B are both equal, at a value of 3. c) Consumer X first purchases 3 units of A (with MUs per $ of 11, 9, and 7), then the 4th unit of A and the 1st unit of B (each with an MU per $ of 5). Their $12 income is then exhausted at a consumption level where the marginal utilities per dollar spent on A and B are both equal, at a value of 5.

2. Given the utility-maximizing rule, the ratio of marginal utility to price will be the same for rootbeer consumed at the party and rootbeer consumed at home. Because the effective price of rootbeer at the party is close to zero, you will try to reach a lower marginal utility on the last unit consumed than you would if you were consuming rootbeer at home. Given the law of diminishing marginal utility, a lower than usual marginal utility for the last unit of rootbeer can only be reached by consuming a higher than usual number of units. To reach this lower level of marginal utility, you therefore consume more rootbeer at the party than you would at home.

In-class Activities I. Introductory Information Time: Approximately an hour for Parts A and B. Parts A and B each have a 25-minute time limit.

Materials: 1-41 Copyright © 2023 by McGraw Hill

1) An identical number of red and blue cars (in the form of images, toys or coloured labels) that add up to the total number of students in the class less two.

2) Six motorcycles (again in the form of images, toys or coloured labels).

3) A sum of play money for each buyer in small denominations. Perhaps $20 in one dollar Monopoly money bills, or slips of paper, for each student acting as a buyer. Do not tell the sellers how much money each buyer has.

4) A note for each buyer with an instruction regarding which car to buy, blue or red. Notes to purchase blue cars should be created for half the number of buyers plus 5, and notes with instructions for red cars to be purchased should be created for the remaining buyers – i.e., if there are 22 students, 2 will be sellers and the remaining 20 will be buyers, then create 15 notes instructing buyers to purchase a blue car and 5 to purchase a red car.

(Note: Purchases of the other colour car, which they are not instructed to buy, are allowed but only as a last resort.)

Set-up: 1) If there are a large number of students have them work in pairs, with only one student in each pair assigned to do the negotiations (they should switch for Part B).

2) Select two students to be sellers, all other students will be buyers. The goal of each car seller is to amass the largest amount of money at the end of the simulation while the goal of each buyer is to purchase their car at the lowest price.

3) Place two large tables at the front of the room. All other desks should be separate and facing the front two tables.

4) Blue cars will be sold at one table and red cars at the other table. Place the blue cars (i.e., images, toys, or whatever is representing blue cars) on one table at the front of the room and red cars on the other table such that the number of cars available are visible to the students buying the cars.

Key Concepts Covered: change in demand change in quantity demanded change in quantity supplied change in supply demand demand curve demand factors market equilibrium substitute product supply 1-42 Copyright © 2023 by McGraw Hill

supply curve shortage surplus Learning Objectives: Part A: - Analyze and evaluate the role of demand, supply, and market equilibrium in a competitive setting, while demonstrating an ability to act as participants in a simulated marketplace.

- Become proficient at graphing demand curves and supply curves while evaluating how price changes can be caused by a change in demand or a change in supply.

- Explain how a change in price can cause a change in quantity demanded or a change in quantity supplied, as shown by movements along demand and supply curves.

- Analyze the impact of a product shortage or surplus in a simulated market.

Part B: - Assess the effect of a substitute product on the price of an existing product.

- Extend this analysis to the entire range of demand factors.

Part A Exercise Recall that the class has been divided into sellers and buyers, sellers do not know how much money each buyer has, and both buyers and sellers are trying to get the best deal for themselves.

Student A: sells blue cars. The goal of the car sellers is to make as much money as possible.

Student B: sells red cars. The goal of the car sellers is to make as much money as possible.

Other Students: all other students are car buyers. The goal of each buyer is to pay the lowest price possible for the car they purchase. Each buyer is given one of the notes stating which color car they need to purchase. Purchases of the other type of car is allowed, but only as a last resort.

Timekeeper: students will be given 20 minutes to negotiate for their car purchases (if needed increase the time limit for negotiations). If sellers are in teams allow each team 5 minutes to decide on a strategy prior to negotiation.

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Procedure: If not already done, students are given one of the two notes telling them to buy either a blue or red car. Once time begins the students negotiating the purchase of a car (i.e., the car buyers) will rush to the front of the room to the tables with the cars and car sellers. Sellers will negotiate their purchase, and its price, at the sellers‘ tables. It will eventually look like a small auction in front of each table with the sellers of red and blue cars.

Were blue cars or red cars more expensive? Why? The average price of blue cars was $[fill in appropriate value] and the average price of a red car was $[fill in appropriate value]. The average price of blue cars does not equal the average price of red cars because There was more demand for blue cars.* There was more demand for red cars.

There was equal demand for both types of cars.

Each buyer of one type of car had more money than each buyer for the other type of car.

In the graph below draw the demand curve for blue cars as compared to the demand curve for red cars assuming there were more buyers of blue cars (i.e., assume that more students were instructed to buy a blue car than were instructed to buy a red car).

Given the identical supply curves for each car the price of [blue*; red] cars will be higher.

Explanation: Unlike a classic competitive market, red cars and blue cars will each be sold at a range of prices.

The average price of blue cars will be higher than the average price of red cars because of the 1-44 Copyright © 2023 by McGraw Hill

greater demand for blue cars. There will not be enough blue cars for everyone who wishes to purchase one. Those students told to buy blue cars who are not able to do so will either choose not to make a purchase or will purchase a red car. Those in this situation who buy a red car will be dissatisfied because they have not been able to make their preferred purchase. Students told to purchase red cars will, on average, pay a lower price than buyers of blue cars, and will get the type of car they want.

After the simulation is ended, if the students are not already aware, the instructor should inform the students about the discrepancy in the number of notes handed out to buyers. The average prices for blue cars will be higher than for red cars. This is because demand is higher for blue cars (i.e., there were more notes telling buyers they wanted a blue car) than for red cars. With a stationary supply curve this implies the price of blue cars will be higher.

Follow-up areas of learning: - Discuss the different positions of the demand curves for blue cars and red cars, and how these different positions affect the average prices of each type of car, given the identical (vertical) supply curves for both.

2. Part B Exercise Choose another two students to be the new sellers of red and blue cars, as well as motorcycles.

The sellers from Part A become buyers. Return all the cars purchased in Part A back to their tables at the front of the class. Add the 6 motorcycles to the table of blue cars.

Student A: sells blue cars and motorcycles. The goal of the sellers is to make as much money as possible.

Student B: sells red cars. The goal of the car sellers is to make as much money as possible.

Other Students: all other students are car, or motorcycle, buyers. The goal of each buyer is to pay the lowest price possible for the vehicle they purchase. Each buyer is given one of the notes stating which color car they need to purchase. Purchases of the other type of car is allowed, but only as a last resort. Now, students with notes to buy blue cars may choose, instead, to buy a motorcycle (consider making a third set of notes that state the student may buy a blue car or a motorcycle to use for this part).

Timekeeper: students will be given 20 minutes to negotiate for their purchases (if needed increase the time limit for negotiations). If sellers are in teams allow each team 5 minutes to decide on a strategy prior to negotiation.

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Procedure: If not already done students are given one of the two notes telling them to buy either a red car, or a blue car or motorcycle. Once time begins the students negotiating their purchases (i.e., the buyers) will rush to the front of the room to the tables with the cars and sellers. Sellers will negotiate their purchase, and its price, at the sellers‘ tables. It will eventually look like a small auction in front of each table with the sellers of red and blue cars.

Were blue cars or red cars more expensive? Why? The average price of blue cars was $[fill in appropriate value], and the average price of a red car was $[fill in appropriate value]. The average price of blue cars changed from Part A because buyers who could not obtain a red car could get a motorcycle. all buyers have more choice in Part B. some buyers of blue cars chose to buy a motorcycle instead.* motorcycles and cars are complements.

In the graph below move the appropriate curve to show the outcome if buyers have less income on average. For example, how would the curves below change if there was a mass lay-off that affected buyers in the simulation.

If there was less money in the economy the price of cars would be [higher; lower*].

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Explanation: In this simulation motorcycles and blue cars are substitute products. Some motorcycles will be purchased instead of blue cars. The price of blue cars will be reduced because of the availability of the substitute product. Meanwhile, the price of red cars may also drop because fewer unsuccessful buyers of blue cars will end up shifting their demand to red cars.

Cars and motorcycles are normal products. In the case where income drops, the demand for both all three products will therefore decrease, pushing down the price of cars.

Follow-up areas of learning: - Extend this discussion to all demand factors: number of buyers, income (not just normal products but also inferior products), prices of other products (not just substitute products but also complementary products), consumer preferences and consumer expectations. This can be done by suggesting different scenarios that could take place.

- Explore what would happen if there was a recall on the red cars or the motorcycles were known to be defective.

3. Discussion Questions 1. a) In Part A, what would have happened to the prices of both red and blue cars if more notes had been handed out to buy blue cars and fewer notes had been handed out to buy red cars?

The average price of red cars would have risen and the average price of blue cars would have fallen The average price of blue cars would have risen and the average price of red cars would have fallen.* The average price of both blue and red cars would have fallen.

The average price of both red and blue cars would have risen. b) How can your answer be shown using demand and supply graphs for both the market for blue cars and the market for red cars?

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The demand curve for both blue and red cars would have shifted rightward.

The demand curve for blue cars would have shifted rightward and the demand curve for red cars would have shifted leftward.* The demand curve for blue cars would have shifted leftward and the demand curve for red cars would have shifted rightward.

The demand curve for both red and blue cars would have shifted leftward.

2. In Part B, blue cars and motorcycles are substitute products. Referring to a demand and supply graph, explain how the introduction of this new product affected the average price for blue cars.

The availability of a new substitute product leads to a leftward shift in the demand for blue cars and a rise in their price.

The availability of a new substitute product leads to a rightward shift in the demand for blue cars and a fall in their price.

The availability of a new substitute product leads to a leftward shift in the demand for blue cars and a fall in their price.* The availability of a new substitute product leads to a rightward shift in the demand for blue cars and a rise in their price.

3. Think of a product that would be a complementary product for motorcycles and explain why sales of this product would increase if the demand for motorcycles increased. leather chaps; the demand for such a product would increase as the demand for motorcycles expanded since it is required by law. helmet; the demand for such a product would increase as the demand for motorcycles expanded since it is required by law.* handlebars; the demand for such a product would increase as the demand for motorcycles expanded since it is part of the motorcycle. leather coat; the demand for such a product would increase as the demand for motorcycles expanded since it is a classic pairing.

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Explanation: 1. a) Because this represents an increase in the demand for blue cars and a decrease in the demand for red cars the average price of blue cars would have risen and the average price of red cars would have fallen. b) In terms of demand and supply graphs, the demand curve for blue cars would have shifted rightward and the demand curve for red cars would have shifted leftward. These demand shifts would cause a rise in the price of blue cars and a fall in the price of red cars.

2. The availability of this new substitute product leads to a leftward shift in the demand for blue cars and a fall in their price.

3. The demand for a complementary product such as helmets would increase or shift to the right as the demand for motorcycles expanded.

4. Multiple Choice Questions 1. In Part A, there were more buyers demanding blue cars than there were blue cars for sale.

This situation created a(n) a) immediate equilibrium. b) temporary shortage of blue cars.* c) temporary surplus of blue cars. d) scenario in which the prices of blue and red cars were unable to change. e) temporary shortage of red cars.

2. In Part B, the introduction of motorcycles as a possible substitute for blue cars caused the following change: a) Equilibrium price in this market was unaffected. b) The demand of blue cars increased. c) The quantity demanded of blue cars increased. d) The quantity demanded of blue cars decreased. e) The demand of blue cars decreased.* 3. If the quantity of red cars bought and sold suddenly decreased, what would be the impact in the market for blue cars? a) The supply of blue cars would shift leftward.

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b) Equilibrium price in this market would be unaffected. c) The demand of blue cars would shift leftward. d) The supply of blue cars would shift rightward. e) The demand of blue cars would shift rightward.* 4. If the price of blue cars was expected to drop in the near future, what would be the impact on the market for blue cars right now? a) Equilibrium price in this market would be unaffected. b) The demand of blue cars would shift rightward. c) The supply of blue cars would shift rightward. d) The demand of blue cars would shift leftward.* e) The supply of blue cars would shift leftward 5. If the price of motorcycles suddenly increased, what would be the impact in the market for blue cars? a) The quantity demanded of blue cars would decrease. b) The supply of blue cars would increase. c) The demand of blue cars would increase.* d) The quantity supplied of blue cars would decrease. e) The demand of blue cars would decrease.

Explanation: 1. Because the quantity demanded of blue cars exceeds the quantity supplied this represented a temporary shortage of blue cars.

2. With some of the demand for blue cars being replaced by the demand for motorcycles the demand of blue cars decreased.

3. With a drop in the demand for red cars some buyers would switch to blue cars so that the demand of blue cars would shift rightward.

4. With the expectation of a lower price of blue cars in the near future some buyers would put off purchases of this product so that the demand of blue cars would shift leftward.

5. Because motorcycles and blue cars are substitutes a sudden rise in the price of motorcycles would cause some buyers to switch to blue cars which so the demand of blue cars would increase.

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Chapter 3 Teaching Tips Elastic and Inelastic Demand The concept of elasticity is a challenging one for many students to master. In introducing it, start by focusing on the relative sizes of the numerator and denominator in the fraction for the price elasticity of demand. This boils down to just two simple ideas: (1) the numerator of the elasticity fraction outweighs the denominator for elastic demand curves, and (2) the denominator outweighs the numerator for inelastic demand curves. The analysis can then be extended to the special cases of perfectly elastic and perfectly inelastic demand. The first occurs when the fraction‘s denominator is zero; the second applies when the numerator is zero. Because both perfectly elastic and perfectly inelastic demand curves have easily identifiable slopes, this is the place as well to introduce the relation of elasticity to the concept of slope.

Price Elasticity of Demand and Total Revenue Once the two main demand elasticity categories are defined, the best way to cement their significance is by linking them with changes in total revenue. When covering Figures 3.3 and 3.4, questions are bound to arise concerning the slopes of the two demand curves. It is at this point when the association between slope and elasticity can be fully developed, by pointing out that the notions of slope and elasticity are distinct but linked. In particular, for two demand curves on the same set of axes, the steeper curve will be less elastic than the flatter one. But because slope is a ratio of absolute changes while elasticity is a ratio of relative changes, this one-to-one correspondence does not necessarily apply except in this special case. It is also in this section that the case of unit-elastic demand is best presented as the balancing case where the changes in price and quantity demanded are equal.

Calculating Price Elasticity of Demand Students need to feel comfortable with the definition of price elasticity of demand, especially as it relates to the possible links between changes in price and total revenue, before moving on to calculate numerical coefficients. In covering ed it is important to distinguish between the conceptual formula that relies on percentage changes in price and quantity and the computational formula that features the average values of quantity demanded and price. Problem 1 at the end of the chapter, which asks students to calculate price and quantity changes using both the conceptual formula and the computational formula, may prove useful in helping to solidify their understanding of this distinction.

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Elasticity and Linear Demand Curves It is often a surprise to students that the numerical value of elasticity differs at every point on a linear demand curve. Yet this follows logically from the fact that slope and elasticity are conceptually separate. The numerical value of elasticity rises when moving vertically upwards on any linear demand curve. The value nears infinity as it reaches the curve‘s vertical intercept and zero as it approaches the curve‘s horizontal intercept. To remember this, notice that the value of elasticity approaches that of a perfectly elastic curve at the point where the curve crosses the vertical axis, just as perfectly elastic demand curves do. Similarly, the value approaches that of a perfectly inelastic curve at the point where the curve crosses the horizontal axis in the same way as perfectly inelastic demand curves do.

Income and Cross-Price Elasticities Once the mechanics of the price elasticity of demand are mastered, understanding income and cross-price elasticities is relatively easy. The main difference involves the relevance of negative and positive signs. In the case of price elasticity of demand, the negative sign that appears in the numerical answer is usually ignored. For both income and cross-price elasticities, the convention differs. Now the sign of the coefficient is included in the numerical answer, as it provides important information. In the case of income elasticity, the sign indicates whether the product is normal or inferior. In the case of cross-price elasticity, the sign tells us whether the two products are substitutes or complements.

Price Elasticity of Supply As with income and cross-price elasticities, the extension of elasticity to the case of supply should be straightforward. While the link between elasticity and changes in total revenue no longer applies, supply curves can be categorized in the same way as are demand curves, with the slope of a supply curve and its elasticity loosely associated but not exactly parallel. Similarly, it is necessary to distinguish between the conceptual formula with percentages and the computational formula that uses average values. The most important distinctive feature of the price elasticity of supply is the way in which this elasticity is affected in the long run by whether an industry is constant-cost or increasing-cost. In distinguishing between these two cases, you might want to mention that the height of the long-supply curve for either industry is simply the average cost (including normal profit) of producing any given output. Seen in this way, the reason why the long-run supply curve for an increasing-cost industry has an upward slope is because average costs gradually increase along with the price of at least one resource used in the industry.

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Answers to Thinking About Economics Questions TAE I, Section 3.1: Yes there is. Because a perfectly elastic demand curve is horizontal, it has a zero slope. Similarly, a perfectly inelastic demand curve is vertical, so it has an infinite slope.

TAE II, Section 3.1: Club memberships are viewed as being akin to a necessity for most consumers who purchase them, while they tend to make up a relatively small portion of consumer incomes. On the other hand, restaurant meals are viewed as being a relative luxury for most consumers who purchase them. If consumed regularly, they may also make up a relatively large portion of consumers‘ incomes.

TAE III, Section 3.1: Yes, the signs of all six estimated coefficients are what one would expect.

Ground beef and lottery tickets are both inferior products with a negative income elasticity, given that the higher one‘s income the less likely one is to buy them; eggs are normal products with a positive income elasticity given that the higher one‘s income the more likely one is to buy them; Alcohol and food are complementary products with a negative cross-price elasticity, given that they tend to be consumed together. Electricity and natural gas are substitute products with a positive cross-price elasticity, since these two products tend to be consumed in replacement for one another. Similarly, beef and pork are substitute products with a positive cross-price elasticity, since they tend to be consumed in replacement for one another.

TAE IV, Section 3.2: Negative. This is because a long run expansion in production would lead to a lower per-unit cost, allowing a fall in price at higher quantity levels. However, as some businesses get larger, they gain a competitive advantage over smaller rivals, which makes a perfectly competitive market structure very unlikely.

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Answers to Chapter Problems 3.1 Practice Problems

1. a)

b) At a price of $3,000 (point a in the graph), total revenue is $30 million (= $3,000 × 10,000), at a price of $2,000 (point b) it is $40 million (= $2,000 × 20,000), and at a price of $1,000 (point c) it is $30 million (= $1,000 × 30,000). c) The market demand curve is elastic in the price range $3,000 to $2,000, since total revenue and price move in opposite directions. Total revenue rises as price falls. In contrast, the demand curve is inelastic in the range $2,000 to $1,000, because total revenue and price are moving in the same direction, with both falling. d) Recall the formula for elasticity:

Between prices $3,000 and $2,000, the coefficient of the price elasticity of demand has a value of -1.67 {= [(20,000 − 10,000) / (15,000)] / [($2,000 − $3,000) / ($2,500)]}, and between $2,000 and $1,000 it has a value of -0.60 {= [(30,000 − 20,000) / (25,000)]/[($1,000 − $2,000) / ($1,500)]}. e) Yes, the answers are consistent. The absolute value of the price elasticity of demand between prices $3,000 and $2,000 is greater than one. This is consistent with part c where demand in this price range was found to be elastic. Similarly, the absolute value of the price elasticity of 1-54 Copyright © 2023 by McGraw Hill

demand between $2,000 and $1,000 is less than one, which is consistent with part c, where demand in this range was found to be inelastic. Recall that price elasticity of demand always has a negative sign because the numerator and denominator necessarily have different signs but that it is customary to use the absolute value of this calculation in further analysis.

2. a) The cross-price elasticity’s value of +1.29 is found using the formula:

b) exy = [(750,000 − 1 million) / 875,000] / [($20,000 − $25,000) / $22,500] = 1.29. The sign of the coefficient of cross-price elasticity is positive because the two goods are substitutes.

The price elasticity of demand’s value of -0.69 is found using the formula:

ed = [(17,500 − 15,000) / 16,250] / [($400 − $500) / $450] = -0.69. The sign of the coefficient of demand elasticity is negative because the demand curve is downward sloping. With a downward sloping demand curve the formula’s numerator and denominator will always have different signs. c) This income elasticity’s value of -0.87 is found using the formula:

ei = [(3,000 − 2,000) / 2,500] / [($50,000 − $80,000) / $65,000] = -0.87. The sign of the coefficient of income elasticity is negative because the product is an inferior product.

3.2 Practice Problem

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1. Recall the formula for the elasticity of supply:

a) The coefficient of the price elasticity of supply, es, is found by employing the formula whose numerator is the change in quantity supplied divided by average quantity supplied and whose denominator is the change in price divided by average price: 0.75 = [(500 − 300) / (400)] / [($20 − $10) / ($15)]. b) This price elasticity of supply applies in the short run. This is because, in the case of a ride-hailing provider such as Uber, the immediate run applies only over the duration of mere minutes. Over the course of an entire night, the quantity of rides that Uber can supply undergoes a significant change as drivers respond to the signals provided by the variation in fares.

2. Recall the formula for the elasticity of supply:

c) es is 0 = [(80,000 − 80,000) / (80,000)] / [($1.20 − $1) / ($1.10)]. d) es is 1 = [(1.2 million − 1 million) / (1.1 million)] / [($1.20 − $1) / ($1.10)]. e) es is undefined = [(final quantity − initial quantity) / (average quantity)] / [($1 − $1) / ($1)] = [quantity / 0] because division by zero is always undefined. f)

This is a constant-cost industry, since its long-run supply curve is perfectly elastic. This means the industry is not a major user of any single resource, so price is always driven back to its original level in the long run after a change in production.

g)

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End of Chapter Problems 1. a) Total revenue is $0 million (= $900 × 0) at a price of $900 (point a in the graph), it is $60 million (= $600 × 100,000) at a price of $600 (point b), it is $60 million (= $300 × 200,000 at a price of $300 (point c), and it is $0 (= $0 × 300,000) at a price of $0 (point d). b) The market demand curve is elastic in the price range $900 to $600, since total revenue rises as price falls. This means total revenue and price move in opposite directions. In contrast, the demand curve is unit-elastic in the price range $600 to $300, since total revenue is constant as price falls. This is shown by the fact that the areas of rectangles A and C are equal, so that the shaded areas A+B and B+C are equal. Finally, the demand curve is inelastic in the price range $300 to $0, since both total revenue and price are falling. This means both are moving in the same direction.

c) Recall the formula for elasticity: 1-57 Copyright © 2023 by McGraw Hill

Between prices $900 and $600, the coefficient of the price elasticity of demand has a value of 5.00 {= [(100,000 − 0) / (50,000)] / [($600 − $900) / ($750)]}; between prices $600 and $300, it has a value of -1.00 = [(200,000 − 100,000) / (150,000)]/[($300 − $600) / ($450)]}; and between $300 and $0 it has a value of -0.20 {= [(300,000 − 200,000) / (250,000)]/[($0 − $300) / ($150)]}. d) Yes, the answers are consistent. The absolute value of the price elasticity of demand between prices $900 and $600 is greater than one. This is consistent with part c where demand in this price range was found to be elastic. Similarly, the absolute value of the price elasticity of demand between $600 and $300 is one, which is consistent with part c, where demand in this range was found to be unit-elastic. Finally, the absolute value of the price elasticity between $300 and $0 is less than one, which is consistent with part c, where demand in this range was found to be inelastic. Recall that price elasticity of demand always has a negative sign because the numerator and denominator necessarily have different signs but that it is customary to use the absolute value of this calculation in further analysis.

2. The absolute value of the first percentage change is found by subtracting the variable‘s initial value from its final value, and dividing by the initial value or: %Δ = (final value − initial value) / initial value.

The absolute value of the second change is found by using the same formula, but reversing the initial and final values or: %Δ = (initial value − final value) / final value.

The absolute value of the final change is found by using the average of the two values, [average value − (initial value + final value) / 2], and then dividing the change in the two variables by the average value or %Δ = (final value − initial value) / [(initial value + final value) / 2]. a) The absolute value of the first percentage change is: 100% = ($6 − $3) / $3. The second is 50% − ($3 − $6) / $6. The third is found first by calculating the average of the two values, $4.50 = ($3 + $6)/2, and then dividing the change in the two variables by this average value: 67% = ($3 − $6) / $4.50 = ($6 − $3) /$4.50. b) The absolute value of the first percentage change is: 40% = (150 − 250) / 250. The second is 67% = (250 − 150) / 150. The average is 200 = (250 + 150) / 2 and the absolute value of the third percentage change is 50% = (250 − 150) / 200 = (150 − 250) / 200.

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c) The absolute value of the first percentage change is: 67% = ($4 − $12) / $12. The second is 200% = ($12 − $4) / 4. The average is $8 = ($12 + $4) / 2 and the absolute value of the third percentage change is 100% = ($12 − $4) / $8 = ($4 − $12) / $8. d) The absolute value of the first percentage change is: 33% = (2,000 – 1,500) / 1,500. The second is 25% = (1,500 – 2,000) / 2,000. The average is 1,750 = (1,500 + 2,000) / 2 and the absolute value of the third percentage change is 29% = (1,500 – 2,000) / 1,750 = (2,000 – 1,500) / 1,750.

3. a) Because consumers can live without luxuries and it is easier to respond to price changes when an item has many close substitutes, demand for this product is likely to be elastic. b) Because buyers pay more attention to price when an item makes up a large portion of their incomes and it is easier to respond to price changes when an item has many close substitute, demand for this product is likely to be elastic. c) Because consumers find it difficult without necessities and a short-run time frame does not give consumers time to change their habits and needs, demand for this product is likely to be inelastic. For example, suppose your car breaks down and you have no other way to get to work. Your demand for the required car part and/or repairs needed to fix your car would be relatively inelastic. d) Because consumers can live without luxuries and buyers pay more attention to price when an item makes up a large portion of their incomes, demand for this product is likely to be elastic.

4. The initial and final values for sellers‘ total revenue are found by multiplying the relevant price and quantity demanded for both the initial value of total revenue and for the final value of total revenue. If the change in total revenue is in the same direction as the change in price then demand is inelastic. If the change in total revenue is in the opposite direction to the change in price then demand is elastic. Should total revenue not change when price changes then demand is unit-elastic. a) The initial value of total revenue is $80,000 = ($4 × 20,000). The final value for total revenue is $75,000 = ($5 × 15,000). Because the change in total revenue from $80,000 to $75,000 is in the opposite direction to the change in price from $4 to $5, demand is elastic. b) Initial total revenue is $80,000 = ($4 × 20,000). The final value of total revenue is $75,000 1-59 Copyright © 2023 by McGraw Hill

= ($3 × 25,000). Because the change in total revenue from $80,000 to $75,000 is in the same direction as the change in price from $4 to $3, demand is inelastic. c) The initial value of total revenue is $350,000 = ($10 × 35,000). The final value of total revenue is $360,000 = ($9 × 40,000). Because the change in total revenue from $350,000 to $360,000 is in the opposite direction to the change in price from $10 to $9, demand is elastic. d) The initial value of total revenue is $300,000 = ($60 × 5,000). The final value for total revenue is $300,000 = ($50 × 6,000). Because the change in total revenue from $300,000 to $300,000 is constant, demand is unit-elastic. e) The initial value of total revenue is $120,000 = ($4 × 30,000). The final value for total revenue is $150,000 = ($6 × 25,000). Because the change in total revenue from $120,000 to $150,000 is in the same direction as the change in price from $4 to $6, demand is inelastic.

5. a)

b) The equilibrium price and quantity are at $250 and 80,000 jackets (point a in the graph), since at a price of $250 the quantities demanded and supplied are identical. c) Because of the supply increase, quantity supplied becomes 160,000 jackets at a $300 price, 140,000 at $250, 120,000 at $200, 100,000 at $150 and 80,000 at $100. The new equilibrium price and quantity are $150 and 100,000 jackets (point b in the graph) 1-60 Copyright © 2023 by McGraw Hill

because at this new price the quantities demanded and supplied are again identical. d) See graph above. e) The initial total revenue of producers is $20 million (= $250 × 80,000), as shown by area A + B in the graph, while the new total revenue is $15 million (= $150 × 100,000), as shown by area B + C in the graph. Price and total revenue move in the same direction, so that demand is inelastic between the two equilibrium points.

6. a) The equilibrium price and quantity are $125 and 500,000 pairs of jeans, while sellers‘ total revenue is $62.5 million ((= $125 × 500,000). b) Because of the supply decrease, quantity supplied becomes 400,000 million pairs at a $175 price, 300,000 million at $150, 125,000 at $125 and 100,000 at $100. The new equilibrium price and quantity are $150 and 300,000 pairs (point b in the graph) because at this new price the quantities demanded and supplied are again identical.

c) Compared with the total revenue of $62.5 million associated with the initial equilibrium (point a) as shown by area A + B in the graph, the total revenue associated with the new equilibrium point (point b) is $45 million (= $150 × 300,000), as shown by area B + C in the graph. Demand between the two equilibrium points is elastic because price and total revenue move in opposite directions.

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7. a)

b) Total revenue is $320,000 (= $800 × 400) at a price of $800 (the rectangle found using point a on the graph), $480,000 (= $600 × 800) at a price of $600 (point b), $480,000 (= $400 × 1200) at a price of $400 (point c), and $320,000 (= $200 × 1600) at a price of $200 (point d). c) When price drops from $800 to $600, total revenue moves in the opposite direction, from $320,000 to $480,000. Thus, demand is elastic in this price range. When price drops further from $600 to $400, total revenue stays constant at $480,000, which means that demand is unit-elastic in this price range. When price falls even further from $400 to $200, total revenue moves in the same direction, from $480,000 to $320,000. Demand is therefore inelastic in this price range. d) (-)2.33 = [(800 − 400) / 600] / [($600 − $800) / $700] from prices $800 to $600; (-)1 = [(1200 − 800) / 1,000] / [($400 − $600) / $500] from prices $600 to $400; (-)0.43 = [(1600 − 1200) / 1400] / [($200 − $400) / $300] from prices $400 to $200. e) Yes. When price drops from $800 to $600, the absolute value of the elasticity coefficient (2.33) is greater than 1, so that demand is elastic, as suggested by the rise in total revenue in this price range. From prices $600 to $400, the absolute value of the elasticity coefficient equals 1 so that demand is unit-elastic, which corresponds to the constant total revenue in this price range. When price falls from $400 to $200, the absolute value of the elasticity coefficient (0.43) is less than 1, so that demand is inelastic, as suggested by the decrease in total revenue in this price range.

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f) The slope of D has a constant value of -0.50. For example, between $800 and $600 the slope is found by dividing the vertical change of -$200 (= $600 − $800) by the horizontal change of 400 (= 800 − 400). A constant slope does not necessarily mean a constant demand elasticity, as shown by D, whose elasticity changes, though its slope stays constant. This is because slope reflects absolute changes in quantity demanded and price, while elasticity reflects percentage changes in quantity demanded and price.

8. a) Total revenue is $6 million (= $60 × 100,000) at a price of $60 (the rectangle found using point a on the graph), $10 million (= $50 × 200,000) at a price of $50 (point b), $12 million (= $40 × 300,000) at a price of $40 (point c), $12 million (= $30 × 400,000) at a price of 320 (point d), $10 million (= $20 × 500,000) at a price of $20 (point e), and $6 million (= $10 × 600,000) at a price of $10 (point f). b) When price drops from $60 to $50 and from $50 to $40, total revenue moves in the opposite direction, from $6 million to $10 million and from $10 million to $12 million.

Thus, demand is elastic in this price range. When price drops further from $40 to $30, total revenue remains constant at $12 million. Thus, demand is unit-elastic. When price drops even further from $30 to $20 and from $20 million to $10 million, total revenue moves in the same direction, from $12 million to $10 million and from $10 million to $6 million. Demand is therefore inelastic in this price range. c) (-)3.67 = [(200,000 – 100,000) / 150,000] / [($50 − $60) / $55] from prices $60 to $50; ()1.80 = [(300,000 − 200,000) / 250,000] / [($40 − $50) / $45] from prices $50 to $40; ()1.00 = [(400,000 − 300,000) / 350,000] / [($30 − $40) / $35] from prices $40 to $30; (-) 0.56 = [(500,000 − 400,000) / 450,000] / [($20 − $30) / $25] from prices $30 to $20; and (-)0.27 = [(600,000 – 500,00) / 550,000] / [($20 − $10) / $15] from prices $20 to $10. d) Yes. When price drops from $60 to $50 and from $50 to $40, the absolute value of the two elasticity coefficients (3.67 and 1.80) are greater than 1, so that demand is elastic, as suggested by the rise in total revenue in these price ranges. From prices $40 to $30, the absolute value of the elasticity coefficient is 1.00, which means that demand is unitelastic. From prices $30 to $20 and from $20 to $10, the absolute value of the two elasticity coefficients (0.56 and 0.27) are less than 1, so that demand is inelastic, as suggested by the decrease in total revenue in these price ranges.

9. Recall the price elasticity of demand is found using the formula whose numerator is the change in quantity demanded divided by average quantity demanded and whose denominator is the change in price divided by average price:

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a) Given the change in price from $10 to $12 and the change in quantity demanded from 4 to 3, average price is $11 = ($10 + $12) / 2 and average quantity demanded is 3.5 = (4 + 3) / 2. The coefficient of the price elasticity of demand, ed, is: (-)1.57 = [(3 − 4) / 3.5] / [($12 − $10) / $11]. b) Given the change in price from $1 to $0.80 and the change in quantity demanded from 1.2 million to 1.3 million, average price is $0.90 = ($1 + $0.80) / 2 and average quantity demanded is 1.25 million = (1.2 million + 1.3 million) / 2. The coefficient of the price elasticity of demand, ed, is: (-)0.36 = [(1.3 million − 1.2 million) / 1.25 million] / [($0.80 − $1) / $0.90]. c) Given the change in price from $25 to $30 and the change in quantity demanded from 85,000 to 80,000, average price is $27.50 = ($25 + $30) / 2 and average quantity demanded is 82 500 = (80,000 + 85,000) / 2. The coefficient of the price elasticity of demand, ed, is: (-)0.33 = [(80,000 – 85,000) / 82,500] / [($30 − $25) / $27.50]. d) Given the change in price from $700 to $600 and the change in quantity demanded from 200,000 to 300,000, average price is $650 = ($700 + $600) / 2 and average quantity demanded is 250,000 = (200,000 + 300,000) / 2. The coefficient of the price elasticity of demand, ed, is: (-)2.60 = [(300,000 – 200,000) / 250,000] / [($600 − $700) / $650]. e) Given the change in price from $150 to $250 and the change in quantity demanded from 5,000 to 3,000, average price is $200 = ($150 + $250) / 2 and average quantity demanded is 4,000 = (5,000 + 3,000) / 2. The coefficient of the price elasticity of demand, ed, is: (-)1.00 = [(3,000 – 5,000) / 4,000] / [($250 − $150) / $200].

10. Recall that the coefficient of the cross-price elasticity, exy, is found using the formula whose numerator is the change in the quantity demanded of one product divided by that product‘s average quantity demanded and whose denominator is the change in price of the other product divided by that product‘s average price:

a) Given the change in price of access to the internet from $80 to $40 and the change in quantity demanded of e-magazines from 3 to 5, average price is $60 = ($80 + $40) / 2 and average quantity demanded is 4 = (3 + 5) / 2. The coefficient of the cross-price elasticity, exy, is then found using the formula whose numerator is the change in the quantity demanded of emagazines divided by average quantity demanded and whose denominator is the change in price of access to the internet divided by average price: (-)0.75 = [(5 − 3) / 4)] / [($40 − $80) / $60]. Because the cross-price elasticity is negative, the two products are complementary.

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b) Given the change in price of a hairstylist‘s cut from $40 to $60 and the change in quantity demanded of do-it-yourself haircutting sets from 5,000 to 10,000, average price is $50 = ($40 + $60) / 2 and average quantity demanded is 7500 = (5,000 + 10,000) / 2. The coefficient of the cross-price elasticity, exy, is then found using the formula whose numerator is the change in the quantity demanded of do-it-yourself haircutting sets divided by average quantity demanded and whose denominator is the change in price of a hairstylist‘s cut divided by average price: (+)1.67 = [(10,000 − 5,000) / 7,500] / [($60 − $40) / $50]. Because the crossprice elasticity is positive, the two products are substitutes. c) Given the change in price of smartphones from $600 to $400 and the change in quantity demanded of smartphone apps from 1 million to 3 million, average price is $500 = ($600 + $400) / 2 and average quantity demanded is 2 million = (1 million + 3 million) / 2. The coefficient of the cross-price elasticity, exy, is then found using the formula whose numerator is the change in the quantity demanded of smartphone apps divided by average quantity demanded and whose denominator is the change in price of smartphones divided by average price: (-)2.50 = [(3 million − 1 million) / 2 million] / [($400 − $600) / $500]. Because the cross-price elasticity is negative, the two products are complements. d) Given the change in price of a can of tuna from $3.50 to $4.50 and the change in quantity demanded of cans of luncheon meat from 90,000 to 110,000, average price is $4 = ($3.50 + $4.50) / 2 and average quantity demanded is 100,000 = (90,000 + 110,000) / 2. The coefficient of the cross-price elasticity, exy, is then found using the formula whose numerator is the change in the quantity demanded of luncheon meat divided by average quantity demanded and whose denominator is the change in price of tuna divided by average price: (+)0.80 = [(110,000 – 90,000) / 100,000] / [($4.50 − $3.50) / $4]. Because the cross-price elasticity is positive, the two products are substitutes. e) Given the change in price of electricity from $1.75 to $1.25 and the change in quantity demanded of electric cars from 500,000 to 1 million, average price is $1.50 = ($1.75 + $1.25) / 2 and average quantity demanded is 750,000 = (500,000 + 1 million) / 2. The coefficient of the cross-price elasticity, exy, is then found using the formula whose numerator is the change in the quantity demanded of electric cars divided by average quantity demanded and whose denominator is the change in price of electricity divided by average price: (-)2.00 = [(1 million – 500,000) / 750,000] / [($1.25 − $1.75) / $1.50]. Because the cross-price elasticity is negative, the two products are complements.

11. Recall that income elasticity is found using the formula whose numerator is the change in quantity demanded divided by average quantity demanded and whose denominator is the change in income divided by average income: 1-65 Copyright © 2023 by McGraw Hill

a) Given the change in income from $50,000 to $70,000 and the change in quantity demanded from 2 million to 3 million, average income is $60,000 = ($50,000 + $70,000) / 2 and average quantity demanded is 2.5 million = (2 million + 3 million) / 2. The coefficient of income elasticity, ei, is found employing the formula whose numerator is the change in quantity demanded divided by average quantity demanded and whose denominator is the change in income divided by average income: (+)1.20 = [(3 million − 2 million) / 2.5 million] / [($70,000 − $50,000) / $60,000]. Because the income elasticity is positive the product is normal. b) Given the change in income from $30,000 to $40,000 and the change in quantity demanded from 100,000 to 50,000, average income is $35,000 = ($30,000 + $40,000) / 2 and average quantity demanded is 75,000 = (100,000 + 50,000) / 2. The coefficient of income elasticity, ei, is found employing the formula whose numerator is the change in quantity demanded divided by average quantity demanded and whose denominator is the change in income divided by average income: (-)2.33 = [(50,000 − 100,000) / 75,000] / [($40,000 − $30,000) / $35,000].

Because the income elasticity is negative the product is inferior. c) Given the change in income from $3,000 to $2,800 and the change in quantity demanded from 120,000 to 100,000, average income is $2900 = ($3,000 + $2,800) / 2 and average quantity demanded is 110,000 = (120,000 + 100,000) / 2. The coefficient of income elasticity, ei, is found employing the formula whose numerator is the change in quantity demanded divided by average quantity demanded and whose denominator is the change in income divided by average income: (+)2.64 = [(100,000 – 120,000) / 110,000] / [($2,800 − $3,000) / $2,900].

Because the income elasticity is positive the product is normal. d) Given the change in income from $4,000 to $6,000 and the change in quantity demanded from 50,000 to 30,000, average income is $5,000 = ($4,000 + $6,000) / 2 and average quantity demanded is 40 000 = (50 000 + 30 000) / 2. The coefficient of income elasticity, ei, is found employing the formula whose numerator is the change in quantity demanded divided by average quantity demanded and whose denominator is the change in income divided by average income: (-)1.25 = [(30,000 – 50,000) / 40,000] / [($6,000 − $4,000) / $5,000]. Because the income elasticity is negative the product is inferior. e) Given the change in income from $50,000 to $70,000 and the change in quantity demanded from 25,000 to 35,000, average income is $60,000 = ($50,000 + $70,000) / 2 and average quantity demanded is 30,000 = (25,000 + 35,000) / 2. The coefficient of income elasticity, ei, is found employing the formula whose numerator is the change in quantity demanded divided by average quantity demanded and whose denominator is the change in income divided by average income: (+)1.00 = [(35,000 – 25,000) / 30,000] / [($70,000 − $50,000) / $60,000].

Because the income elasticity is positive the product is normal.

12. Recall that the price elasticity of supply is found using the formula whose numerator is the change in quantity supplied divided by average quantity supplied and whose denominator is the change in price divided by average price: 1-66 Copyright © 2023 by McGraw Hill

a) With a price change from $300 to $350 and the change in quantity supplied from 8 million to 9 million, average price is $325 = ($300 + $350) / 2 and average quantity supplied is 8.5 million = (8 million + 9 million) / 2. The coefficient of the price elasticity of supply, es, is found employing the formula whose numerator is the change in quantity supplied divided by average quantity supplied and whose denominator is the change in price divided by average price: 0.76 = [(9 million − 8 million) / 8.5 million] / [($350 − $300) / $325]. b) With a price change from $8 to $7.50 and the change in quantity supplied from 2 million to 1 million, average price is $7.75 = ($8 + $7.50) / 2 and average quantity supplied is 1.5 million = (2 million + 1 million) / 2. The coefficient of the price elasticity of supply, es, is found employing the formula whose numerator is the change in quantity supplied divided by average quantity supplied and whose denominator is the change in price divided by average price: 10.33 = [(1 million − 2 million) / 1.5 million] / [($7.50 − $8) / $7.75]. c) With a price change from $2 to $3 and the change in quantity supplied from 2 million to 4 million, average price is $2.50 = ($2 + $3) / 2 and average quantity supplied is 3 million = (2 million + 4 million) / 2. The coefficient of the price elasticity of supply, es, is found employing the formula whose numerator is the change in quantity supplied divided by average quantity supplied and whose denominator is the change in price divided by average price: 1.67 = [(4 million − 2 million) / 3 million] / [($3 − $2) / $2.50]. d) With a price change from $6 to $4 and the change in quantity supplied from 1 million to 600,000, average price is $5 = ($6 + $4) / 2 and average quantity supplied is 800,000 = (1 million + 600,000) / 2. The coefficient of the price elasticity of supply, es, is found employing the formula whose numerator is the change in quantity supplied divided by average quantity supplied and whose denominator is the change in price divided by average price: 1.25 = [(600,000 – 1 million) / 800,000] / [($4 − $6) / $5]. e) With a price change from $5 to $7 and the change in quantity supplied from 8 million to 12 million, average price is $6 = ($5 + $7) / 2 and average quantity supplied is 10 million = (8 million + 12 million) / 2. The coefficient of the price elasticity of supply, es, is found employing the formula whose numerator is the change in quantity supplied divided by average quantity supplied and whose denominator is the change in price divided by average price: 1.20 = [(12 million – 8 million) / 10 million] / [($7 1-67 Copyright © 2023 by McGraw Hill

− $5) / $6].

13. a) In the immediate run, quantity supplied is still 1 million ounces at the new $8 price, since silver producers are unable to vary the amount they produce. This is shown by the immediate-run supply curve, a vertical line, whose horizontal intercept is 1 million. b) In the short run, silver producers respond to the new $8 price by raising quantity supplied above what it would be at $6. This means that the short-run supply curve is upward-sloping. c) If the industry exhibits constant costs, the high revenues available at an $8 price attract new silver producers in the long run, which pushes down price until it returns to its initial level of $6.

The industry’s long-run supply curve is therefore a horizontal line (with a vertical intercept of $6). If the industry exhibits increasing costs, the high revenues available at the $8 price again attract new silver producers, pushing down price. Price stops falling at a value between $8 and $6 because an increasing-cost industry is a significant user of a certain resource such as mining machinery, whose price rises when the quantity supplied of silver increases. Higher quantities supplied therefore push up each producer’s per-unit costs, forcing price to remain above $6.

This means the long-run supply curve is a gently upward-sloping line.

14.

a) The value for the slope of this curve is constant at 0.125 [= ($2 − $1.50) / (9 − 5)) = ($2.50 − $2) / (13 − 9)]. b) The formula for the price elasticity of supply is:

The values for price elasticity of supply are 2.00 [= ((9 − 5) / 7) / (($2.00 − $1.50) / $1.75)] from prices $1.50 to $2 and 1.64 [= ((13 − 9) / 11) / (($2.50 − $2.00) / $2.25)] from prices $2 to $2.50. c) Corresponding to the case of demand, a constant slope does not necessarily mean a constant supply elasticity, as shown by this supply curve whose numerical elasticity changes though its slope stays constant.

15.

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a)

. b) This demand curve is unit-elastic, since total revenue is unaffected by price changes.

Advancing Economic Thought Problems

1. a) Total value = daily wage + materials and machine depreciation + surplus value therefore: surplus value = total value − (daily wage + materials and machine depreciation). Then surplus value is $40 [= $120 − ($50 + $30)]. b) Surplus value becomes $30 [= $120 − ($60 + $30)]. c) As the daily wage rises from $50 to $60, surplus value per worker falls from $40 to $30. The exploitation rate is surplus value as a proportion of the daily wage (or surplus value divided by the daily wage), and has decreased from $40 / $50 = 0.80 to $30 / $60 = 0.50.

2. a) If in 8 hours workers can produce $120 of value then in 12 hours workers can produce $180 in value. The daily wear and tear on machines per worker would be $30 for a 12-hour day.

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That‘s because with wear and tear being $20 for 8 hours the wear and tear for 12 hours is $30 [= ($20 / 8hrs) × 12hrs]. Total value = daily wage + materials and machine depreciation + surplus value therefore: surplus value = total value − (daily wage + materials and machine depreciation). Then surplus value is $100 [= $180 − ($50 + $30)]. b) Recall that the exploitation rate is surplus value divided by the daily wage. Prior to the lengthening of the workday the surplus value was $50 [=$120 − ($50 + $20)] and so the exploitation rate was $50 / $50 or 1. With the longer workday the surplus value becomes $100 [=$180 − ($50 + $30)] and the exploitation rate has increased to $100 / $50 or 2.

In-class Activities

There are no in-class activities accompanying Chapter 3.

Chapter 4 Teaching Tips

Labour-Intensive and Capital-Intensive Processes Labour-intensive and capital-intensive processes are defined in relation to one another. When saying a process is labour-intensive because it employs more labour and less capital, the comparison is with a more capital-intensive process. Similarly, when saying a process is capitalintensive because it employs more capital and less labour, the comparator is a more labourintensive process. Without such a comparison, a single process cannot be identified as either labour-intensive or capital-intensive. As a result, it is wrong to suggest that a process using more units of capital than units of labour is capital-intensive., or vice versa for a labour-intensive process, because the units for measuring labour and capital are always arbitrary.

Depreciation The distinction between explicit and implicit costs should be relatively easy for students, though those with an accounting background may wish to explore the distinction further. In particular, they may raise the case of depreciation of machinery and equipment. Is this an explicit or implicit cost? It is an explicit cost because it appears in the accounting statements of a business.

Yet it is a unique type of explicit cost, because it is imputed in a way not dissimilar to the method used with implicit costs. However, unlike the case of implicit costs, there are rules governing exactly how depreciation is imputed. As noted in the text, in conceptual terms, the imputation process is a way of distributing the explicit cost of purchasing a piece of capital 1-70 Copyright © 2023 by McGraw Hill

equipment over multiple years.

Graphing Average and Marginal Values One of the trickiest features of showing marginal and average values, especially when both appear in the same table or graph, is ensuring they are positioned correctly. As noted in the text, average values are specified relative to a certain number of units of output or labour, with the relevant output or labour unit expressed as a whole number. So, for example, the average product of one worker applies to an employment level of exactly 1 worker, the average product of two workers to the employment level of 2 workers, and so forth.

However, because a marginal value is defined in relation to a change in output or labour, it is associated with the midpoint between the starting and ending units of output or labour. For example, the marginal product of the first worker applies to an employment level of 0.5 workers, while the marginal product of the second worker applies to an employment level of 1.5 workers.

In a table, these values appear in separate rows halfway between the rows for the relevant beginning and ending units of output or labour. So, when entering the marginal product of the first worker in a table, this value is placed in a row halfway between 0 workers and 1 worker. In a graph, the marginal value is found halfway between the two relevant points on the horizontal axis. So, when plotting the marginal product of the first worker on a graph, it is placed halfway between the origin and the horizontal coordinate for 1 worker. In the case of marginal product values, this positioning is straightforward: it is immediately obvious what the midpoint between 1 and 2 workers must be. However, in the case of marginal cost, when the points being plotted are relative to multiple units of quantity, as in Figure 4.6, a separate calculation is necessary for each plotted point on the curve.

While the graphing convention for marginal values might seem trivial, it has significant implications. Most importantly, it makes it far easier to ensure that, when drawing the family of short-run cost curves on one pair of axes, the relationships between the marginal cost, average cost and average variable cost curves outlined in the chapter are satisfied. In particular, it helps guarantee that the marginal cost curve crosses both the average variable cost and average cost curves at their respective minima. If marginal values are not positioned correctly, this becomes virtually impossible.

Graphing Total, Variable and Fixed Costs

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Some instructors may wish to cover the graphing of total, variable and fixed cost curves, and how these curves compare with per-unit and marginal cost curves over the same output range.

While not present in the body of the text, these curves do appear in Problem 10 at the end of the chapter, which gives students the chance to derive the relationships discussed above themselves.

These relationships are then fully covered in the feedback accompanying the problem.

Answers to Thinking about Economics Questions TAE I, Section 4.1: Yes. Though currently a small part of the new economy, biotechnology could be a major industry in the near future, thanks to continuing technological breakthroughs.

TAE II, Section 4.3: Once a consumer has bought hardware such as an iPod or iPad at a relatively low price, they are less likely to purchase a competitor‘s online entertainment products, allowing Apple to charge a price for these products on iTunes that is far above the extremely low marginal cost of each extra sale.

TAE III, Section 4.4: No. Because customized methods reduce the importance of increasing returns to scale, businesses do not need to be as large to gain the competitive advantage that comes with low long-run average costs.

Answers to Chapter Problems 4.1 Practice Problems 1. a) With Process A, total daily costs of employing labour and capital are $400 [= ($80 × 2 workers) + ($40 × 6 machines)]. With Process B, these costs are $360 [= ($80 × 3 workers) + ($40 × 3 machines)]. Because Process B minimizes daily costs and maximizes productive efficiency, it will be chosen by the owner. b) Explicit costs are $400 [= ($80 × 3) + ($40 × 3) + $30 + $10]. This is the sum of worker‘s wages, the rental of photocopy machines, building rent, and business taxes. c) Accounting profit is $200 [= ($0.06 × 10,000) − $400]. This is found by subtracting explicit costs from the total revenue associated with making 10,000 copies at a price of 6 cents each. d) Implicit costs are $180 (= $150 + $30). This is the sum of the owner‘s estimate of how much she could earn if she managed another shop instead of her own and her estimate of

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what she could earn if she put the funds she invested in her shop into her friend‘s business venture. Economic costs are $580 (= $400 + $180). e) Economic profit is $20 (= $600 − $580). This is found by deducting economic costs from total revenue. f) The owner should not consider closing, since the shop is making a positive economic profit.

2. a) Ready Solutions’ Total Revenue and Costs For the year 2024 Total Revenue Explicit Costs Wages Business Supplies Depreciation Interest Total explicit costs

$45 400 $20 600 2 300 1 000 800 $24 700

Accounting Profit

$20 700

Readyware Solutions‘ annual accounting profit of $20 700 is found by deducting the business‘s total explicit costs of $24 700 from total revenue of $45 400. b) The business‘s annual economic profit of $3400 is found by deducting total implicit costs of $17 300 (the normal profit of $2000 plus the wages to yourself of $15 300) from the accounting profit of $20 700.

4.2 Practice Problems 1. By drafting new players whose height (the relevant marginal value) exceeds the team‘s current average height, in your role as the manager you can be assured that the team‘s average height will increase with each new draft.

2. a) Number of workers 0

Total product (bouquets per day) 0

Marginal product Average product (bouquets per (bouquets per day) day)

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[50] 1

50

2

200

[50] [150] [100] [70]

3

270

[90] [30]

4

300

[75] [-60]

5

240

[48]

Marginal product is 50 (= 50 − 0) bouquets for the first worker, 150 (= 200 − 50) bouquets for the second worker, 70 (= 270 − 200) bouquets for the third worker, 30 (= 300 − 270) bouquets for the fourth worker, and -60 (= 240 − 300) bouquets for the fifth worker. b) Marginal product rises when the first and second workers are hired, falls and is positive when the third and fourth workers are hired, and is negative when the fifth worker is hired. c) Average product is 50 (= 50 / 1) bouquets with 1 worker, 100 (= 200 / 2) bouquets with 2 workers, 90 (= 270 / 3) bouquets with 3 workers, 75 (= 300 / 4) bouquets with 4 workers, and 48 (= 240 / 5) bouquets with 5 workers. d) Marginal and average product are the same (50 bouquets) when the first worker is hired.

Marginal product is greater than average product when the second worker is hired (150 bouquets versus 100 bouquets). Marginal product is less than average product when the last three workers are hired (70 bouquets versus 90 bouquets for the third worker, 30 bouquets versus 75 bouquets for the fourth worker, -60 bouquets versus 48 bouquets when the fifth worker is hired). e) As each additional worker is hired if marginal product is above the previous average product then average product rises. This occurs when the second worker is hired. If marginal product is below the previous average product then average product falls. This occurs when the last three workers are hired.

4.3 Practice Problems 1. a) (1) Labour (workers

(2) Total Product

(3) Fixed Costs

(4) (5) (6) Variable Total Cost Marginal Costs ($) Cost

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(7) Average Fixed

(8) Average Variable

(9) Average Cost

per day)

(pots per day)

($)

($)

0

0

100

0

($)

Cost ($)

Cost ($)

($)

[2.00]

[2.00]

[4.00]

[0.63]

[1.25]

[1.88]

[0.43]

[1.30]

[1.74]

[0.36]

[1.43]

[1.79]

[100.00] [2.00]

1

50

[100.00]

100

[200.00] [0.91]

2

160

[100.00]

200

[300.00] [1.43]

3

230

[100.00]

300

[400.00] [2.00]

4

280

[100.00]

400

[500.00]

Total cost is $100 (= $100 + $0) with 0 pots, $200 (= $100 + $100) with 50 pots, $300 (= $100 + $200) with 160 pots, $400 (= $100 + $300) with 230 pots, and $500 (= $100 + $400) with 280 pots. Marginal cost is $2.00 [= ($100 − $0) / (50 − 0)] when moving from 0 to 50 pots, $0.91 [= ($200 − $100) / (160 − 50)] from 50 to 160 pots, $1.43 [= ($300 − $200) / (230 − 160)] from 160 to 230 pots, $2.00 [= ($400 − $300) / (280 − 230)] from 230 to 280 pots. Average fixed cost is $2.00 (= $100 / 50) with 50 pots, $0.63 (= $100 / 160) with 160 pots, $0.43 (= $100 / 230) with 230 pots, and $0.36 (= $100 / 280) with 280 pots. Average variable cost is $2.00 (= $100 / 50) with 50 pots, $1.25 (= $200 / 160) with 160 pots, $1.30 (= $300 / 230) with 230 pots, and $1.43 (= $400 / 280) with 280 pots. Average cost is $4.00 (= $200 / 50) with 50 pots, $1.88 (= $300 / 160) with 160 pots, $1.74 (= $400 / 230) with 230 pots, and $1.79 (= $500 / 280) with 280 pots. b) A marginal value such as marginal cost is defined as a change that occurs from one point to another − in the case of marginal cost, between two output levels. When graphed the marginal value is plotted halfway between the beginning and the ending point on the horizontal axis. In the case of marginal cost, this means halfway between the beginning and ending output levels. The reason for this is that the marginal value applies not to a single value of the variable on the horizontal axis but rather over a range of values. c) The average fixed cost curve falls throughout the range of output. The average variable cost curve falls until, at its minimum value, it crosses the marginal cost curve and then begins to rise again. The average cost curve similarly falls until, at its minimum value, it crosses marginal cost curve and then begins to rise again. d) In drawing the graph remember that points on the marginal cost curve are graphed halfway between the relevant outputs on the horizontal axis. For example, the first 1-75 Copyright © 2023 by McGraw Hill

point on the marginal cost curve is plotted at a horizontal coordinate of 25 pots, halfway between 0 and 50 pots [= (0 + 50) / 2], while the second point on the curve is plotted at a horizontal coordinate of 105 pots, halfway between 50 and 160 pots [= (50 + 160) / 2].

4.4 Practice Problems 1. a) The percentage increase in the labour input is 50% {= [(9 − 6) / 6] × 100%} and the percentage increase in the capital input is also 50% {= [(3 − 2) / 2] × 100%}, while the percentage increase in output is 100% [= (240 − 120) / 120]. Because the relative increase in output exceeds the relative increase in each of the inputs, the business is experiencing increasing returns to scale. Long-run average cost falls from $5.33 {= [(6 × $100) + (2 × $20)] / 120} to $4.00 {= [(9 × $100) + (3 × $20)] / 240}. b) The percentage increase in output is 50% [= (180 − 120) / 120]. Because the relative increase in output equals the relative increase in each of the inputs, the business is experiencing constant returns to scale. Long-run average cost at 120 units is $5.33 {= [(6 × $100) + (2 × $20)] / 120} and at 180 units is also $5.33 {= [(9 × $100) + (3 × $20)] / 180}. c) The percentage increase in output is 33% [= (160 − 120) / 120]. Because the relative increase in output is less than the relative increase in each of the inputs, the business is experiencing decreasing returns to scale. Long-run average cost rises from $5.33 {= [(6 × $100) + (2 × $20)] / 120} to $6.00 {= [(9 × $100) + (3 × $20)] / 160}.

End of Chapter Problems 1.

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a) The daily cost of Process A is $130 [= ($20 × 4 workers) + ($25 × 2 machines)] and the daily cost of Process B is $135 [= ($20 × 3 workers) + ($25 × 3 machines)]. Because Process A is cheaper than Process B, it maximizes productive efficiency. b) The daily cost of Process A is $700 [= ($100 × 4 workers) + ($150 × 2 machines)] and the daily cost of Process B is $750 [= ($100 × 3 workers) + ($150 × 3 machines)].

Because Process A is cheaper than Process B, it maximizes productive efficiency.

2. a) The owner‘s total explicit costs, which include rent, taxes and inventory costs, are $390,000 (= $25,000 + $15,000 + $350,000). The owner‘s total implicit costs, which include normal profit and implicit wages, are $106,000 [= (0.20 × $80,000) + $90,000]. b) The store‘s accounting profit, which is found by subtracting explicit costs from total revenue, is $90,000 (= $480,000 − $390,000). The store‘s economic profit, which is found by subtracting both explicit costs and implicit costs from total revenue, is ()$16,000 (= $480,000 − $390,000 − $106,000). c) Because the variety store is making an economic loss, the owner should consider closing down this business.

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3. a) Your business‘s total explicit costs are $4,300 (= $2,500 + $1,000 + $800). This is the sum of material, rent, and tax costs. The business‘s total implicit costs are $5,200 [= (0.01 × $20,000) + $5,000]. This is the sum of normal profit and implicit wages. Normal profit is your estimate of how much you would earn if you invested your $20 000 in your relative‘s house painting business. Implicit wages are what you estimate you would earn if you worked for your relative‘s business. b) The business‘s monthly accounting profit is $5,700 (= $10,000 − $4,300). This is found by subtracting explicit costs from total revenue. The business‘s economic profit is $500 (= $10,000 − $4,300 − $5,200). This is found by subtracting economic costs from total revenue. Economic costs are $9,500 (= $4,300 + $5,200). c) You should stay in business because you are making an economic profit.

4. a) Depreciation is a fixed cost because it is limited to the business‘s fixed inputs such as machinery and buildings. b) Employee health benefits are a variable cost because these benefits vary with the number of workers employed by the business. c) Lumber is a variable cost because it is a material input that varies with the business‘s output. d) Property insurance is a fixed cost because is related to the restaurant‘s fixed inputs such as furniture and equipment. e) Gasoline is a variable cost because it is a material input that varies with the business‘s output. f) Vaccine testing is a fixed cost because this testing must be carried out regardless of how many vaccines the pharmaceutical company makes and sells. g) Wage costs are a variable cost because they are tied to the employment of labour, which varies with the business‘s output.

5. a) (1) Labour (workers per day) 0

(2) Total Product (pastries per day) 0

1

100

(3) Marginal Product (pastries per day)

(4) Average Product (pastries per day)

[100] [100] [180] 2

280

[140] [230]

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3

510

[170] [50]

4

560

[140] [-10]

5

550

[110]

The marginal products in column 3 are found by subtracting the total product with the previous number of workers from the total product with the new number of workers. For example, when moving from 0 to 1 workers, marginal product is 100 (= 100 − 0) pastries.

The average products in column 4 are found by dividing the relevant total product by the relevant number of workers. For example, at 1 worker, average product is 100 (= 100 / 1) pastries. b) Marginal product rises when the first, second, and third workers are hired, since the marginal product of the second worker (180 pastries) exceeds that of the first worker (100 pastries), and the marginal product of the third worker (230 pastries) exceeds that of the second worker. Marginal product falls and is positive when the fourth worker is hired, since marginal product is declining (from 230 to 50 pastries). Marginal product is negative (-10 pastries) when the fifth worker is hired. Meanwhile, total product in this employment range is falling. c) In the total product graph the 6 total product values are plotted at the employment levels of 0, 1, 2, 3, 4, and 5. In the right graph the 5 points of the marginal product curve are plotted halfway between the relevant employment levels on the horizontal axis, which means the marginal product for the first worker is positioned at a horizontal coordinate of 0.5 [= (1 + 0) / 2] workers, for the second worker at a horizontal coordinate of 1.5 [= (2 + 1) / 2] workers and so on. The 5 average product values are plotted at the employment levels of 1, 2, 3, 4, and 5 workers. The marginal product curve crosses the average product curve where the average product curve reaches a maximum.

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6. a) (1) Labour (workers per week) 0

(2) Total Product (radios per week) 0

(3) Marginal Product (radios per week)

(4) Average Product (radios per week)

[40] 1

40

[40] [60]

2

100

[50] [70]

3

170

[57] [30]

4

200

[50] [-20]

5

180

[36]

The marginal products in column 3 are found by subtracting the total product with the previous number of workers from the total product with the new number of workers. For example, when moving from 0 to 1 workers, marginal product is 40 (= 40 − 0) radios. The average products in column 4 are found by dividing the relevant total product by the relevant number of workers. For example, at a 1 worker, average product is 40 (= 40 / 1) radios. b) Diminishing marginal returns set in when the fourth worker is hired, since marginal product begins to decline (from 70 to 30 radios). c) In the total product graph the 6 total product values are plotted at the employment levels of 0, 1, 2, 3, 4, and 5. In the right graph the 5 points of the marginal product curve are plotted halfway between the relevant employment levels on the horizontal axis, which means the marginal product for the first worker is positioned at a horizontal coordinate of 0.5 [= (1 + 0) / 2] workers, for the second worker at a horizontal coordinate of 1.5 [= (2 + 1) / 2] workers and so on. The 5 average product values are plotted at the employment levels of 1, 2, 3, 4, and 5 workers. The marginal product curve crosses the average product curve where the average product curve reaches a maximum at 2.5 workers.

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7. a) (2) (3) (1) Total Marginal Labour Product Product (workers (cars (cars per hour) parked per parked per hour) hour) 0

0

(4) Fixed Costs ($)

25

(9) (5) (7) (8) (6) Average Variable Marginal Average Total Cost Variable Costs Cost Fixed Cost ($) Cost ($) ($) ($) ($) 0

[25.00]

[40] 1

40

[0.50] 25

20

[45.00]

[52] 2

92

25

132

40

[65.00]

25

160

60

[85.00]

25

180

[1.13]

[0.27]

[0.43]

[0.71]

[0.19]

[0.45]

[0.64]

[0.16]

[0.50]

[0.66]

[0.14]

[0.56]

[0.69]

[0.71] 80

[105.00]

[20] 5

[0.50]

[0.50]

[28] 4

[0.63] [0.38]

[40] 3

(10) Average Cost ($)

[1.00] 25

100

[125.00]

The marginal products in column 3 are found by subtracting the total product with the previous number of workers from the total product with the new number of workers. For 1-81 Copyright © 2023 by McGraw Hill

example, when moving from 0 to 1 workers, marginal product is 40 (= 40 − 0) cars. The total costs in column 6 are found adding together fixed and variable costs at each quantity of output. For example, at 40 cars parked the total cost is $45 (= $25 + $20). The marginal costs in column 7 are found by subtracting total cost with the previous quantity from total cost with the new quantity and then dividing the result by the associated change in quantity. For example, when moving from 0 to 40 cars parked, the difference in total cost is $20 (= $45 − $25) which is then divided by the change in quantity of 40 cars, giving $0.50 [= ($20 / 40)]. The average fixed costs in column 8 are found by dividing the relevant fixed cost by the relevant quantity. For example, at a quantity of 40 cars parked average fixed cost is $0.63 [= ($25 / 40)]. The average variable costs in column 9 are found by dividing the relevant variable cost by the relevant quantity. For example, at a quantity of 40 cars parked average variable cost is $0.50 [= ($20 / 40)]. The average costs in column 10 are found by dividing the relevant total cost by the relevant quantity.

For example, at a quantity of 40 cars parked average cost is $1.13 [= ($45 / 40)]. b) Because each of the 5 marginal cost values is plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 20 [= (40 + 0) / 2] cars parked, 66 [= (92 + 40) / 2] cars parked, 112 [= (132 + 92) / 2] cars parked, 146 [= (160 + 132) / 2] cars parked, and 170 [= (180 + 160) / 2] cars parked. The 5 average variable cost and 5 average cost values are plotted at the relevant quantity levels: 40, 92, 132, 160 and 180 cars parked. c) Marginal product begins to fall when the third worker is hired, since marginal product decreases from 52 to 40 cars per hour. This is related to the point at which marginal cost begins to rise from its minimum of $0.38 to $0.50, when moving from 66 to 112 cars parked. Once each new worker adds less to total product, the extra cost of this new output begins to rise. d) Average variable cost and marginal cost pass through the same set of values at a quantity of 92 cars, while average cost and marginal cost pass through the same set of values at a quantity of 132 cars.

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8. a) (1) Labour (workers per day)

(2) Total Product (burgers per day)

(3) (5) Marginal (4) Variable Product Fixed Costs Costs (burgers ($) ($) per day)

0

0

400

0

(9) (7) (8) (6) Average Marginal Average Total Cost Variable Cost Fixed Cost ($) Cost ($) ($) ($) [400.00]

[100] 1

100

[2.50] [400.00]

250

[650.00]

[300] 2

400

[400.00]

550

500

[900.00]

[400.00]

646

750

[1,150.00]

[400.00]

680

[6.50]

[1.00]

[1.25]

[2.25]

[0.73]

[1.36]

[2.09]

[0.62]

[1.55]

[2.17]

[0.59]

[1.84]

[2.43]

[2.60] 1000

[1,400.00]

[34] 5

[2.50]

[1.67]

[96] 4

[4.00] [0.83]

[150] 3

(10) Average Cost ($)

[7.35] [400.00]

1250

[1650.00]

The marginal products in column 3 are found by subtracting the total product with the previous number of workers from the total product with the new number of workers. For example, when moving from 0 to 1 workers, marginal product is 100 (= 100 − 0) burgers.

The fixed costs in column 4 are all $400, given that fixed cost is $400 at a quantity of 0 burgers. The total costs in column 6 are found adding together fixed and variable costs at each quantity of output. For example, at 100 burgers the total cost is $650 (= $400 + $250).

The marginal costs in column 7 are found by subtracting total cost with the previous quantity from total cost with the new quantity and then dividing the result by the associated change in quantity. For example, when moving from 0 to 100 burgers, the difference in total cost is $250 (= $650 − $400) which is then divided by the change in quantity of 100 burgers, giving $2.50 [= ($250 / 100)]. The average fixed costs in column 8 are found by dividing the relevant fixed cost by the relevant quantity. For example, at a quantity of 100 burgers average fixed cost is $4.00 [= ($400 / 100)]. The average variable costs in column 9 are found by dividing the relevant variable cost by the relevant quantity. For example, at a quantity of 100 burgers average variable cost is $2.50 [= ($250 / 100)]. The average costs in column 10 are found by dividing the relevant total cost by the relevant quantity. For example, at a quantity of 100 burgers average cost is $6.50 [= ($650 / 100)].

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b) Because each of the 5 marginal cost values is plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 50 [= (100 + 0) / 2] burgers, 250 [= (400 + 100) / 2] burgers, 475 [= (550 + 400) / 2] burgers, 598 [= (646 + 550) / 2] burgers, and 663 [= (680 + 646) / 2] burgers. The 5 average variable cost and 5 average cost values are plotted at the relevant quantity levels: 100, 400, 550, 646 and 680 burgers.

c) The average fixed cost curve is a downsloping curve that becomes flatter at higher quantity levels. This differs from the shape of the average variable cost and average cost curves, both of which are U-shaped. d) Average variable cost and marginal cost pass through the same set of values at a quantity of 400 burgers, while average cost and marginal cost pass through the same set of values at a quantity of 550 burgers.

9. a) A craft such as handmade pottery has a long-run average cost curve with an extended horizontal range and a zero slope. This reflects constant returns to scale because an expansion of output requires an exact repetition of production methods, so that inputs and output vary by the same percentage. b) A sophisticated manufacturing process such as the production of smartphones has a longrun average cost curve with an extended downward sloping range and a negative slope.

This is because an expansion of output allows for added specialization of labour and capital, so that output rises more quickly than inputs. c) The growing of an exotic coffee variety has a long-run average cost curve with an extended upward sloping range and a positive slope. This reflects diseconomies of scale, since limited resource supplies mean that an increase in inputs does not lead to as large a percentage increase in output.

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d) E-book publishing is an industry in which most of the inputs in the production process, such as those needed for distribution and marketing, are needed at the outset, with few new inputs being required to produce more units. Therefore, this industry has a long-run average cost curve with an extended downward sloping range and a negative slope. This reflects economies of scale, since output can expand more rapidly than inputs. e) At-home childcare is a service that has a long-run average cost curve with an extended horizontal range and a zero slope. This reflects constant returns to scale because an expansion of output requires an exact repetition of production methods, so that inputs and output vary by the same percentage.

10. a) As output increases, total cost and variable cost both rise in ways identical to one another.

In the first output range total cost and variable cost both rise more slowly. Then they start rising more rapidly. Fixed costs stay constant at $500 at every quantity. b) Marginal cost has its usual ‗J‘-shape, first falling and then rising. Once marginal cost begins to rise, total cost and variable cost both start to rise at an increasing rate. c) In the first output range (up to the minimum point on the marginal cost curve, shown by point a in the graph on the right), increasing marginal returns apply to this business.

Because each new worker produces more extra output than the one before, both total cost and variable cost rise more slowly while marginal cost falls. After point a, diminishing marginal returns mean that each new worker produces less additional output than the one before, so that total cost and variable cost rise more quickly while marginal cost rises.

11. See Figure 4.8 in the text. The first point has a horizontal coordinate of 40, which is the midpoint of the two associated output levels, 0 and 80 T-shirts [40 = (80 + 0) / 2]. The second point has a coordinate of 140 [= (200 + 80) / 2], the third a coordinate of 225 [= (250 + 200) / 2], the fourth a coordinate of 260 [= (270 + 250) / 2], and the fifth a coordinate of 275 [= (280 + 270) / 2].

12. Governments can help reduce the price of knowledge (for example, by funding research and development, or by subsidizing knowledge-producing industries). This helps reduce one of the main fixed costs of knowledge-based industries, thereby raising profits and spurring expansion in these industries.

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Advancing Economic Thought Problems 1. Gladu would argue that any loss of efficiency created by the federal government‘s Indigenous procurement strategy requirement would be more than made up by the long run benefits flowing from the enhanced role of Indigenous businesses in the Canadian economy.

2. Gladu would argue that the benefits of fostering additional economic opportunities among Indigenous peoples will expand, rather than diminish, the political role that Indigenous peoples are able to play in Canada.

In-class Activities

1. Introductory Information Time: Approximately 40 minutes.

Materials: a stopwatch, plus each team requires − one Styrofoam cup, − four popsicle sticks, − six pipe cleaners, − five paper clips and − four elastic bands.

Set-up: Form teams of five. This simulation can be done with as few as two students per team.

Key Concepts Covered: average cost average fixed cost average variable cost fixed costs law of diminishing marginal returns marginal cost 1-86 Copyright © 2023 by McGraw Hill

marginal product total cost total product variable costs Learning Objectives: − Illustrate and discuss the law of diminishing marginal returns in the context of running a production company in a manufacturing or craft industry. − Explain and evaluate the short-run production conditions for this business and create a table showing total product and marginal product. − Explain and evaluate the short-run costs that affect this business by creating a table showing fixed costs, variable costs, total cost, marginal cost, average fixed cost, average variable cost and average cost and a graph showing the marginal cost, average variable and average cost curves.

2. Exercise Note: this question must be manually graded by your instructor.

Recall that the class has been divided into groups of 5. This exercise can be completed with groups as small as 2.

Timekeeper: Each team has ten minutes to design a consumer product. One member of each team will act as a worker and be timed as they assemble the product as quickly as possible, using the materials provided. The team will record the time it took the worker to produce the product, rounding up to the nearest full minute.

Stage 1: Each team has to design a consumer product by drawing it on a piece of paper. The design must include the materials that were provided for each team (i.e., the cup, pipe cleaners, popsicle sticks, etc.). Students are not allowed to touch the materials, until told to do so. At first teams are allowed only to draw the design. Teams will build the design in the second stage. If stuck for product ideas, consider anything from a flower basket, to a radio, kite, bicycle, or sailboat. Teams must use at least 15 of the 20 pieces of material they were given to create their design and eventually their prototype. It is permitted to break or modify the pieces in any way the team would like.

Teams may also create a company name.

Stage 2: Once the teams have created their designs, they must select one student to be their first 1-87 Copyright © 2023 by McGraw Hill

worker. Another student from each team will time their worker as they assemble the product as quickly as possible, using the materials provided. The team will record the time it took the worker to produce the product, rounding up to the nearest full minute.

Calculate the number of units of output that can be produced per day by one worker. Assume the working day is 8 hours, with 1 hour for lunch and two 30-minute breaks. Record this number in the table below.

Either use the assumptions below to find the number of units of output that can be produced per day with up to five workers or do the following. Time two team members assembling the product at the same time, count the number of units of product two workers can simultaneously make in five minutes, then calculate the number of units of output that 2 workers can produce in a day.

Repeat the assembly timing process with three workers, then four workers and finally five workers. Using which ever method is preferred (i.e., using the assumptions below or timing production), determine the number of units of output that can be produced per day by varying numbers of workers. Enter that information in the table in the next question.

Production assumptions: − Two workers can produce 150 more units of output per day than one worker. − Three workers can produce 130 more units of output per day than two workers. − Four workers can produce 100 more units of output per day then three workers − Five workers can produce 30 more units of output per day then four workers.

Stage 3: Finally, create a short-run production and cost table for the team‘s company using the information given below (or fill in the already created table in the next question).

Pricing information: The supplier of your product materials has told you that the cost will decrease if you buy in bulk. The following information outlines the deal you set. − Styrofoam cups cost $3 each. − Popsicle sticks cost 75 cents each. − Pipe cleaners cost 50 cents each. − Paper clips cost $1 each. − Elastic bands cost 25 cents each.

Assumptions: − You may have up to five workers working on your product. − You must pay each worker a daily wage of $100.

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− Your monthly factory rental fee is $900.

Explanation: The short answer questions that require the teams to create a table of short-run production and costs and to draw the business‘s cost curves will be the basis of each team‘s analysis of their company. Each team will then select two members to present their findings in front of the class – preferably during the following period, since a significant amount of calculation may be required. The instructor may want to select one team to present, and ask the other teams to contribute. Each team will have different results.

Follow-up areas of learning: − Students will gain an understanding of the short-run costs associated with their business.

3. Discussion Questions 1. a. The fixed inputs used by your company in this simulation include factory space. product materials. factory space.* labour and product materials. labour. b. The variable inputs used by your company in this simulation are: product materials. labour and product materials.* labour. factory space.

2. Fill in the table below. Note: the table, graph, and related solutions must be manually graded.

Labour

Total Product

Marginal Variable Fixed Costs Product Costs

Total Cost

0

[___]

[___]

[___]

[___]

[___] 1

[___]

[___]

[___]

Average Variable Cost

Average Cost

[___]

[___]

[___]

[___]

[___]

[___]

[___]

[___]

[___] [___]

[___]

[___]

[___]

[___]

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Average Fixed Cost

[___]

[___] 2

Marginal Cost

3

[___]

[___]

[___]

[___]

[___] 4

[___]

[___]

[___]

[___]

[___]

[___]

[___]

[___]

[___]

[___]

[___]

[___] [___]

[___]

[___] 5

[___]

[___] [___]

[___]

[___]

This company should hire [fill in appropriate value] workers.

3. Based on your table in the answer to question 2, marginal product begins to fall when the [first; second*; third; fourth; fifth] worker is hired.

4. a) In the graph of this short-run production and cost schedule, the marginal cost curve should i)

be horizontal.

ii) be vertical. iii) rise then fall. iv) fall then rise.*

the average variable cost curve should i) rise until it crosses the MC curve at the minimum MC then fall ii) fall until it crosses the MC curve at the minimum MC then rise iii) fall until it crosses the MC curve at the minimum AVC then rise* iv) rise until it crosses the MC curve at the minimum AVC then fall and the average cost curve should i) rise until it crosses the MC curve at the minimum MC then fall. ii) fall until it crosses the MC curve at the minimum AC then rise.* iii) rise until it crosses the MC curve at the minimum AC then fall. iv) fall until it crosses the MC curve at the minimum MC then rise.

b) Graph the Marginal Cost, Average Variable Cost, and Average Cost curves using the tools given below. To manually plot values first click on the line segment between two points in a plotted curve or line in the graphing area then click on the icon of a widget to bring up the manual data entry box. If necessary scale axis values. Remember to plot the marginal cost values halfway between the relevant output values on the horizontal axis.

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Explanation: 1) Of the inputs specified in the simulation, factory space is a fixed input while product materials and labour are variable inputs.

2) Numerical results will differ depending on the design specifications the students use. For example, if a team finds that one unit of their product can be produced in three minutes, then 120 (= 360/3) can be produced in the 360 minutes [= (6 × 60)] of an eight-hour workday minus one hour for lunch and two 30-minute breaks.

In this case: as the number of workers per day rises from 0 to 5 (i.e. 0, 1, 2, 3, 4, 5), total product is 0, 120, 270 (= 120 + 150), 400 (= 270 + 130), 500 (= 400 + 100), 530 (= 500 + 30); marginal product is 120 (= 120 – 0), 150 (= 270 – 120), 130 (= 400 – 270), 100 (= 500 – 400), 30 (= 530 – 500); and fixed costs are $900, $900, $900, $900, $900, $900, $900.

The remainder of the cost concepts in the production and cost table will depend also on the variable costs associated with each possible total output of the team‘s prototype. For example, if a team‘s prototype fully uses all 20 of the pieces of material the team was given, then each unit of output costs $15 (= $3 + (4 × $0.75) + (6 × $0.50) + (5 × $1) + (4 × $0.25)].

The variable cost (VC) of zero units of output is $0. Meanwhile, the VC of the 120 units of output associated with one worker is $1900 [= ($15 × 120) + $100], the VC of the 270 units associated with two workers is $4250 [= $15 × 270) + $200], the VC of the 400 units associated with three workers is $6300 [= ($15 × 400) + $300], the VC of the 500 units associated with four workers is $7900 [= $15 × 500) + $400], and the VC of the 530 units associated with five workers is $8450 [= $15 × 530) + $500].

Total cost is first $900, then $2800 (= $900 + $1900), $5150 (= $900 + $4250), $7200 (= $900 + $6300), $8800 (= $900 + $7900) and $9350 (= $900 + $8450); marginal cost is $15.83 [= ($2800 – $900)/(120 – 0)], $15.67 [= ($5150 − $2800)/(270 – 120)], $15.77 [= ($7200 – $5150)/(400 – 270)], $16.00 [= ($8800 – $7200)/(500 – 400)] and $18.33 [= ($9350 – $8800)/(530 – 500)]; average fixed cost is undefined for zero units of output, then $7.50 (= $900/120), $3.33 (= $900/270), $2.25 (= $900/400), $1.80 (= $900/500) and $1.70 (= $900/530); average variable cost is undefined for zero units of output, then $15.83 (= $1900/120), $15.74 (= $4250/270), $15.75 (= $6300/400), $15.80(= $7900/500) and $15.94 (= 1-91 Copyright © 2023 by McGraw Hill

$8450/530); and average cost is undefined for zero units of output, then $23.33 (= $2800/120), $19.07 (= $5150/270), $18.00 (= $7200/400), $17.60(= $8800/500), $17.64 (= $9350/530).

3) In the illustrative case used in the previous answer, diminishing returns set in with the second worker, since after this work every new worker produces a lower marginal product than the one before.

4) Regardless of each team‘s particular numerical results, their graph of these three curves should approximate that found Figure 4.7 in the text. For example, the table and graph of the illustrative numbers outlined above are the following.

Labour

Total Marginal Product Product

0

[0]

Fixed Costs

Variable Costs

Total Cost

[900]

[0]

[900]

Marginal Cost

[120] 1

[120]

[15.83] [900]

[1900]

[2800]

[150] 2

[270]

[900]

[400]

[4250]

[5150]

[900]

[500]

[6300]

[7200]

[900]

[530]

[23.33]

[3.33]

[15.74]

[19.07]

[2.25]

[15.75]

[18.00]

[1.80]

[15.80]

[17.60]

[1.70]

[15.94]

[17.64]

[16.00] [7900]

[8800]

[30] 5

[15.83]

[15.77]

[100] 4

[7.50] [15.67]

[130] 3

Average Average Average Fixed Variable Cost Cost Cost

[18.33] [900]

[8450]

[9350]

19.5 18.5

b

$ per unit

MC AC

17.5 16.5

AVC a

15.5 14.5 0

100

200

300

400

Units per allotted time period

1-92 Copyright © 2023 by McGraw Hill

500

600

4. Multiple Choice Questions 1. The process of transforming your labour and material into a product in your simulated company is called: a) production.* b) marginal returns. c) productive efficiency. d) economic cost. e) explicit cost 2. The rent that your company pays is: a) a fixed cost.* b) an implicit cost. c) a variable cost. d) not an economic cost. e) none of the above.

3. The labour and materials used in the simulated company are examples of a(n): a) economic cost.

b) implicit cost. c) opportunity cost. d) fixed input e) variable input.* 4. As you added more labour and materials to your company after some point the additional number of units produced started to decrease. This is called: a) the law of demand. b) the law of supply. c) the law of decreasing marginal costs. d) the law of diminishing marginal returns.* e) none of the above.

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5. What could be considered an implicit cost of being involved with the simulated business today? a) The cost of your travel to the campus. b) The value of wages you could have earned from working during this time.* c) The cost of the materials used in the company. d) The time you devoted to your team. e) The cost of the labour used in the company.

Explanation: 1. Production is defined as the process of transforming your labour and material into a product – in this case in your simulated company.

2. Because the rent that your company pays does not vary with the business‘s output, it is a fixed cost.

3. The labour and materials used in the simulated company both vary with the business‘s output they are examples of a variable input.

4. The law of diminishing marginal returns states that as you add more labour and materials to your company at some point the additional number of units produced start to decrease.

5. The value of wages you could have earned from working during this time represents an estimate of what you give up by being involved in the simulated business today. Therefore, it is an implicit cost.

Chapter 5 Teaching Tips

Applying the Profit-Maximizing Output Rule A careful positioning of marginal values is especially important when using a table to find profitmaximizing output. Let‘s first review the rules governing this positioning using the table of Figure 5.4 as an example. In column 3 the marginal revenue associated with moving from 0 to 80 T-shirts is vertically positioned halfway between the two relevant rows, as is the marginal cost associated with moving from 0 to 80 T-shirts in column 4. This placement applies to the remaining values of marginal cost and marginal revenue in the table as well.

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We can examine columns 3 and 4 in the table of Figure 5.4 to determine this firm‘s profitmaximizing quantity. To do so, we need to compare each consecutive pair of marginal cost values with the constant $6 marginal revenue. For example, between 0 and 80 T-shirts and then between 80 and 200 T-shirts, marginal cost falls from $1.75 to $1.33, with both values below the marginal revenue of $6. The next pair of marginal costs, $1.33 (between 80 and 200 T-shirts) and $2.50 (between 200 and 250), still fall short of the $6 marginal revenue, as so do the pair $2.50 (between 200 and 250 T-shirts) and $5.50 (between 250 and 270). It is only with the last pair of values, $5.50 (between 250 and 270 T-shirts) and $10.50 (between 270 and 280), that the profit-maximizing output rule is met. This is because marginal cost now moves from below to above $6. Hence, the profit-maximizing quantity must be at the common boundary of these last two output ranges, or at 270 T-shirts.

The Breakeven and Shutdown Points As noted in the chapter, a business‘s breakeven point is defined to be where profits are maximized and where price equals average cost. Because of these two conditions − that the point be the profit-maximizing one at the relevant price, and that it reflects the equality of price and average cost − there is only one such point for the business at any price. This definition of the breakeven point differs from the definition found in accounting. Accountants use the term to refer to any point where a business‘s price and average cost are equal, regardless of whether or not profit is maximized. Both definitions are equally legitimate. It is simply a matter of making it clear which definition is being employed.

Similar reasoning applies to the concept of the shutdown point. In economics, this point is defined as the situation where profit is being maximized when price equals average variable cost.

Again, it is necessary that two conditions be met – profit needs to be maximized at the relevant price and the price needs to equal average variable cost. As in the case of the definition of the breakeven point in economics, there is only one shutdown point for the business at any price.

Long-Run Equilibrium Figure 5.7 shows the operation of long-run competitive forces in a perfectly competitive constant-cost industry whose businesses are not major users of any resource. As a result, the long-run market supply curve is perfectly elastic. Students may ask about the other possible case discussed in Chapter 3. This is an increasing cost industry where businesses are major users of at least one resource. Now the long-run market supply curve is upward-sloping. Is it possible to 1-95 Copyright © 2023 by McGraw Hill

draw this case using graphs similar to those in Figure 5.7? Yes, but with added complexity. Not only does the MR line in the left-hand graph for the business shift due to the long-run competitive forces that follow from an initial price rise, so do the MC and AC curves, as changes in the relevant resource price(s) affect each business‘s marginal and average costs at every output level. The result of this more complicated graphical analysis is a gradually upward-sloping longrun market supply curve in the right-hand graph.

Answers to Thinking about Economics Questions TAE I Section 5.1: The continuing dominance of Microsoft in the markets for word-processing, spreadsheet, and other office software is a good example. First-time buyers are often swayed to purchase Microsoft products because so many other consumers already use them. And those consumers who have spent time learning these programs are often reluctant to switch to competing software products.

TAE II Section 5.2: The output level providing -$100 in negative profit will be chosen, since this output has a lower loss than the -$300 negative profit associated with the other possible output level.

Answers to Chapter Problems 5.1 Practice Problems 1. a) The cafe is part of a monopolistically competitive market, since there are many cafés in the area, each providing a slightly different product. b) The company operates in a monopoly since the company is the sole provider of public transit in this area. c) The corporation is in an oligopoly, since a relatively small number of businesses make popular brands of breakfast cereal. d) This shareowner is operating in a perfectly competitive market, since there are many buyers and sellers of RBC shares.

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e) Because there are relatively few chartered banks in Canada, this firm operates in an oligopoly in Canada. f) Because there are many app creators, each producing different apps, this is a monopolistically competitive market.

2. a) This is a case of restricted ownership of resources, given that the company controls the global supply of this mineral. b) This is a case of R&D expenditures being used as a potential entry barrier, given that the internet services giant believes it can use this spending to help stay ahead of potential rivals in its main business in future years. c) This is a case of brand proliferation because any new rival in this market would be forced to undertake this same costly replication of brands. d) This is a case of the lock-in effect, since the points program increases the costs of customers switching to a new airline. e) This is a case of the network effect. The widespread use of the suite around the world increases the value of the product to current and future users.

3. Razor manufacturers are making use of the lock-in effect. Once a consumer has bought a razor handle at a relatively low price, they are less likely to purchase a competitor‘s razor blades, allowing the company to charge a relatively high price for blades.

5.2 Practice Problems

1. a) Total revenue is $0 (= $5 × 0) at 0 kilograms and $25,000 (= $5 × 5,000) at 5,000 kilograms. Dividing this difference by the change in output gives the marginal revenue of $5 [= ($25,000 − $0) / (5,000 − 0)]. b) Since the fisher is a perfect competitor, the fisher faces a constant price (equal to average revenue). In this situation, marginal revenue and price are always the same. c)

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2. a) This is the fisher‘s profit-maximizing point. Marginal cost, which is rising from $4.95 to $5.05 at the output of 4,000 kilograms, equals the fisher‘s marginal revenue of $5 at, or close to, 4,000 kilograms. b) Because average cost exceeds price, the fisher is making a loss. The fisher‘s total loss is $800 [= ($5 × 4,000) − ($5.20 × 4,000) = ($20,000 − $20,800) = (-$800)]. c) Yes. Even though the fisher is making a loss, the $20,000 in total revenue covers variable costs of $19,200 (= $4.80 × 4,000), with an amount left over to pay some fixed costs. d) Because each marginal cost value is plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 3,900 [= (4,000 + 3,800) / 2] kilograms and 4,100 [= (4,200 + 4,000) / 2] kilograms. The average cost and average variable cost values are both plotted at 4,000 kilograms.

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The profit-maximizing output is at point a on the graph where marginal revenue and marginal cost intersect. The height of the shaded rectangle is $0.20 (= $5.20 − 5.00) and its width is 4,000 (= 4,000 − 0) kilograms. Its area therefore equals the business‘s loss of $800 (= $0.20 × 4,000).

5.3 Practice Problem 1. a) Price exceeds average cost and businesses in this market are making a positive profit.

New businesses therefore enter the market, which causes the market supply curve to shift to the right. This puts downward pressure on equilibrium price. This process continues until price and average cost are equal. b) No, the minimum-cost pricing rule is not being met at the $50 price. Only once price has reached the lowest possible average cost, and the influx of new businesses ends, will the rule be satisfied. c) Yes, the marginal-cost pricing rule is being met at the $50 price. In any perfectly competitive market, individual businesses face a constant price and average revenue (because they are price takers), which means that average revenue and marginal revenue are the same. Because businesses in this market maximize profits at the point where marginal cost and marginal revenue are equal, they will also be ensuring that price equals marginal cost.

End of Chapter Problems 1. a) The farmer is a perfect competitor since there are numerous farmers in this market, easy entry and exit, and a standardized product (once beef has been graded and cut) whose price is determined by the interaction of demand and supply in the market. b) The retailer is an oligopolist because it operates in a market dominated by only a few firms. c) The shop is a monopolistic competitor given that there are many shops of this type in a large metropolitan area, relatively easy entry and exit, and differences (relating to location and/or quality) in the products sold by each shop.

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d) The seller is a perfect competitor since there are numerous sellers in this market, easy entry and exit, and a standardized product whose price (for example, expressed in US$) is determined by the interaction of demand and supply in the market. e) The influencer is a monopolistic competitor given that there are many social influencers on Instagram, relatively easy entry and exit, and differences (relating to each influencer‘s distinctive brand) in the services provided by each. f) This country is a monopolist, since it is the sole provider of this particular rare earth metal in the world. g) This company is an oligopolist because it operates in a market dominated by only a few firms.

2. a) (5) (6) (7) (1) (2) (3) (4) Marginal Marginal Average Price Quantity Total Total Cost Revenue Cost Cost ($ per (kilograms Revenue ($) ($ per ($ per ($ per kilogram) per month) ($) kilogram) kilogram) kilogram) [0.49] 0 0 18 [0.49] [0.23] [0.49] 100 49 41 [0.41] [0.49] [0.16] [0.49] 200 98 57 [0.29] [0.49] [0.19] [0.49] 300 147 76 [0.25] [0.49] [0.36] [0.49] 400 196 112 [0.28] [0.49] [0.63] [0.49] 500 245 175 [0.35] [0.49] [1.55] [0.49] 600 294 330 [0.55]

(8) Profit ($) [-18.00] [8.00] [41.00] [71.00] [84.00] [70.00] [-36.00]

The prices in column 1 are found by dividing total revenue by quantity. For example, price at a quantity of 100 kilograms is $0.49 (= $49 / 100). The marginal revenues in column 5 are found by subtracting total revenue with the previous quantity from total revenue with the new quantity and then dividing the result by the associated change in quantity. For example, when moving from 0 to 100 kilograms, the difference in total revenue is $49 (= $49 − $0) which is then divided by the change in quantity of 100 kilograms, giving $0.49 (= $49 / 100). The marginal costs in column 6 are found by subtracting total cost with the previous quantity from total cost with the new quantity and then dividing the result by the associated change in quantity. For example, when moving 1-100 Copyright © 2023 by McGraw Hill

from 0 to 100 kilograms, the difference in total cost is $23 (= $41 − $18) which is then divided by the change in quantity of 100 kilograms, giving $0.23 (= $23 / 100). The average costs in column 7 are found by dividing the relevant total cost by the relevant total quantity. For example, at a quantity of 100 kilograms average cost is $0.41 (= $41 / 100). The profits in column 8 are found by subtracting the relevant total cost from total revenue. For example, profit at a quantity of 100 kilograms is $8 (= $49 − $41). b) This gardener operates in a perfectly competitive market, since price is constant at 49 cents per kilogram, no matter how much this gardener decides to sell. c)

d) At a quantity of 400 kilograms, profit in column (8) of the table reaches its highest positive value of $84. This value can be derived using the profit-maximizing output rule, since 400 kilograms is the quantity at which marginal costs in column (6) are closest to the business‘s marginal revenue of 49 cents per kilogram. The profit-maximizing point is at point a on the graph. The gardener‘s $84 profit is shown by the area of the shaded rectangle ($0.21 × 400), whose height ($0.21) is the difference between price ($0.49 at point a) and average cost ($0.28 at point b), and whose width is quantity of output (400). e) The breakeven point occurs at a price of 25 cents and a quantity of 300 kilograms (point c on the graph), which is the minimum point on the AC curve.

3. a) (1) Price ($ per

(2) Quantity (kilograms

(3) Total Revenue

(4) Fixed Cost

(5) (6) (7) Variable Total Cost Average Cost ($) ($) Fixed Cost

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(8) Average Variable

(9) Average Cost

(10) Marginal Cost

kilogram)

per day)

($)

($)

($ per kilogram)

Cost ($ per kilogram)

($ per kilogram)

0.70

0

[0.00]

254

0

[254.00]

0.70

90

[63.00]

254

50

[304.00]

[2.82]

[0.56]

[3.38]

0.70

170

[119.00]

254

70

[324.00]

[1.49]

[0.41]

[1.91]

0.70

260

[182.00]

254

117

[371.00]

[0.98]

[0.45]

[1.43]

0.70

300

[210.00]

254

149

[403.00]

[0.85]

[0.50]

[1.34]

0.70

340

[238.00]

254

238

[492.00]

[0.75]

[0.70]

[1.45]

($ per kilogram)

[0.56] [0.25] [0.52] [0.80] [2.23]

b) The total revenues in column 3 are found by multiplying the relevant price and quantity.

For example, total revenue at a quantity of 90 kilograms is $63 (= $0.70 × 90). The total costs in column 6 are found by adding the relevant fixed and variable costs. For example, at a quantity of 90 kilograms total cost is $304 (= $254 + $50). The average fixed costs in column 7 are found by dividing fixed cost by quantity. For example, average fixed cost at a quantity of 90 kilograms is $2.82 (= $254 / 90). The average variable costs in column 8 are found by dividing the relevant variable cost by quantity. For example, average variable cost at a quantity of 90 kilograms is $0.56 (= $50 / 90). The average costs in column 9 are found by dividing the relevant total cost by quantity. For example, average cost at a quantity of 90 kilograms is $3.38 (= $304 / 90). The marginal costs in column 10 are found by subtracting total cost with the previous quantity from total cost with the new quantity and then dividing the result by the associated change in quantity. For example, when moving from 0 to 90 kilograms, the difference in total cost is $50 (= $304 − $254) which is then divided by the change in quantity of 90 kilograms, giving $0.56 (= $50 / 90).

The constant marginal revenue value of 70 cents is plotted twice at 0 and 340 kilograms.

Because each of the 5 marginal cost values are plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 45 [= (90 + 0) / 2] kilograms, 130 [= (170 + 90) / 2] kilograms, 215 [= (260 + 170) / 2] kilograms, 280 [= (300 + 260) / 2] kilograms, and 320 [= (340 + 300) / 2] kilograms. The 5 average variable cost and 5 average cost values are plotted at the relevant quantity levels: 90, 170, 260, 300 and 340 kilograms. The marginal cost and average variable cost curves intersect at the quantity of 170 kilograms, the marginal cost and average cost curves intersect at a quantity of 300 kilograms, and marginal revenue and marginal cost intersect at a quantity of 260 kilograms.

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c) This value can be derived using the profit-maximizing rule, since 260 kilograms is the quantity at which marginal costs in column (10) are closest to the fisher‘s marginal revenue of $0.70 per kilogram. This is because marginal cost has a value lower than marginal revenue between 170 and 260 kilograms ($0.56), and a value higher than marginal revenue between 260 and 300 kilograms ($0.80). The fisher is making a loss of $189 (= 182 − 371). Based on the graph drawn in answer to part b above, the profitmaximizing point (point a) occurs where the horizontal marginal revenue curve intersects the marginal cost curve. The loss is shown by the area of the shaded rectangle ($0.73 × 260), whose height ($0.73) is the difference between price ($0.70 at point a) and average cost ($1.43 at point b), and whose width is quantity of output (260). d) The breakeven point occurs at a price of $1.34 and a quantity of 300 kilograms (point c on the graph), at the minimum point on the AC curve. The shutdown point occurs at a price of $0.41 and a quantity of 170 kilograms (point d on the graph), at the minimum point on the AVC curve. e) The business‘s supply curve is the marginal cost curve above the shutdown point. f) Because the fisher continues to make a loss, the fisher will leave the industry in the long run.

4. a) (1) Price ($ per kg)

(2) Quantity (kgs per day)

[4]

0

(3) (4) (5) Total Fixed Cost Variable Revenue ($) Cost ($) ($) [0.00]

100

0

(8) (7) (9) (6) Average Average Average Total Cost Variable Fixed Cost Cost ($) Cost ($ per kg) ($ per kg) ($ per kg) [100.00]

(10) Marginal Cost ($ per kg) [4.40]

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[4]

25

[100.00]

[100.00]

110

[210.00]

[4.00]

[4.40]

[8.40]

[4]

62

[248.00]

[100.00]

162

[262.00]

[1.61]

[2.61]

[4.23]

[4]

80

[320.00]

[100.00]

220

[320.00]

[1.25]

[2.75]

[4.00]

[4]

110

[440.00]

[100.00]

380

[480.00]

[0.91]

[3.45]

[4.36]

[4]

140

[560.00]

[100.00]

700

[800.00]

[0.71]

[5.00]

[5.71]

[1.41] [3.22] [5.33] [10.67]

The total revenues in column 3 are found by multiplying the relevant price and quantity.

For example, total revenue at a quantity of 25 kilograms is $100 (= $4 × 25). The fixed costs in column 4 are all $100, given that fixed cost is $100 at a quantity of 25 kilograms.

The total costs in column 6 are found by adding the relevant fixed and variable costs. For example, at a quantity of 25 kilograms total cost is $210 (= $100 + $110). The average fixed costs in column 7 are found by dividing fixed cost by quantity. For example, average fixed cost at a quantity of 25 kilograms is $4.00 (= $100 / 25). The average variable costs in column 8 are found by dividing the relevant variable cost by quantity.

For example, average variable cost at a quantity of 25 kilograms is $4.40 (= $110 / 25).

The average costs in column 9 are found by dividing the relevant total cost by quantity.

For example, average cost at a quantity of 25 kilograms is $8.40 (= $210 / 25). The marginal costs in column 10 are found by subtracting total cost with the previous quantity from total cost with the new quantity and then dividing the result by the associated change in quantity. For example, when moving from 0 to 25 kilograms, the difference in total cost is $110 (= $210 − $100) which is then divided by the change in quantity of 25 kilograms, giving $4.40 (= $1.10 / 25). b) The constant marginal revenue value of $4 is plotted twice at 0 and 140 kilograms.

Because each of the 5 marginal cost values are plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 12.5 [= (25 + 0) / 2] kilograms, 43.5 [= (62 + 25) / 2] kilograms, 71 [= (80 + 62) / 2] kilograms, 95 [= (110 + 80) / 2] kilograms, and 125 [= (140 + 110) / 2] kilograms. The 5 average variable cost values are plotted at the relevant quantity levels: 25, 62, 80, 110 and 140 kilograms. The marginal cost and average cost curves intersect at a quantity of 80 kilograms (point a).

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c) The profit-maximizing quantity of output is where marginal revenue and marginal cost intersect at a quantity of 80 kilograms. This value can be derived using the profitmaximizing rule, since 80 kilograms is the quantity at which marginal costs in column (10) are closest to the farmer‘s marginal revenue of $4 per kilogram. This is because marginal cost has a value lower than marginal revenue between 62 and 80 kilograms ($3.22), and a value higher than marginal revenue between 80 and 110 kilograms ($5.33).

The farmer is making a profit of $0 (= 320 − 320). Based on the graph drawn in answer to part b above, the profit-maximizing point (point a) occurs where the horizontal marginal revenue curve intersects the marginal cost curve. Because the height of the demand curve (i.e., price) and the height of the average cost curve are both equal, with a value of $4.00, at this quantity, the profit rectangle has an area of 0. Thus, the farmer is breaking even. d) Because profit is zero, with all costs both implicit and explicit being covered, the farmer will stay in business in the long run.

5. a) (1) Price ($ per kg)

(2) (3) (4) Quantity Total Fixed Cost (kgs per Revenue ($) ($) day)

(5) Variable Cost ($)

(7) (6) Average Total Cost Fixed Cost ($) ($ per kg)

(8) Average Variable Cost ($ per kg)

(9) Average Cost ($ per kg)

15

0

[0.00]

[1,500.00]

[0.00]

1,500

15

200

[3,000.00]

[1,500.00]

[1,700.00]

3,200

[7.50]

[8.50]

[16.00]

15

400

[6,000.00]

[1,500.00]

[3,000.00]

4,500

[3.75]

[7.50]

[11.25]

15

600

[9,000.00]

[1,500.00]

[4,700.00]

6,200

[2.50]

[7.83]

[10.33]

15

800

[12,000.00] [1,500.00]

[7,100.00]

8,600

[1.88]

[8.88]

[10.75]

15

1000

[15,000.00] [1,500.00] [10,700.00]

12,200

[1.50]

[10.70]

[12.20]

(10) Marginal Cost ($ per kg) [8.50] [6.50] [8.50] [12.00] [18.00]

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The total revenues in column 3 are found by multiplying the relevant price and quantity.

For example, total revenue at a quantity of 200 kilograms is $3,000 (= $15 × 200). The fixed costs in column 4 are found by noting that fixed cost is identical to total cost at a quantity of 0 kilograms, or $1,500. The variable costs in column 5 are found by subtracting the relevant fixed cost and total cost. For example, at a quantity of 200 kilograms variable cost is $1,700 (= $3,200 − $1,500). The average fixed costs in column 7 are found by dividing fixed cost by quantity. For example, average fixed cost at a quantity of 200 kilograms is $7.50 (= $1,500 / 100). The average variable costs in column 8 are found by dividing the relevant variable cost by quantity. For example, average variable cost at a quantity of 200 kilograms is $8.50 (= $1,700 / 200). The average costs in column 9 are found by dividing the relevant total cost by quantity. For example, average cost at a quantity of 200 kilograms is $16.00 (= $3,200 / 200). The marginal costs in column 10 are found by subtracting total cost with the previous quantity from total cost with the new quantity and then dividing the result by the associated change in quantity. For example, when moving from 0 to 200 kilograms, the difference in total cost is $1,700 (= $3,200 − $1,500) which is then divided by the change in quantity of 200 kilograms, giving $8.50 (= $1,700 / 200).

b) The constant marginal revenue value of $15 is plotted twice at 0 and 1000 kilograms.

Because each of the 5 marginal cost values are plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 100 [= (200 + 0) / 2] kilograms, 300 [= (400 + 200) / 2] kilograms, 500 [= (600 + 400) / 2] kilograms, 700 [= (800 + 600) / 2] kilograms, and 900 [= (1000 + 800) / 2] kilograms. The 5 average cost values are plotted at the relevant quantity levels: 200, 400, 600, 800 and 1000 kilograms. The marginal cost and average cost curves intersect at a quantity of 600 kilograms at point c.

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c) The fisher‘s profit-maximizing quantity of output is where marginal revenue and marginal cost intersect at a quantity of 800 kilograms. This value can be derived using the profit-maximizing rule, since 800 kilograms is the quantity at which marginal costs in column (10) are closest to the fisher‘s marginal revenue of $15 per kilogram. This is because marginal cost has a value lower than marginal revenue between 600 and 800 kilograms ($12.00), and a value higher than marginal revenue between 800 and 1000 kilograms ($18.00). The fisher is making a profit of $3,400 (= 12,000 – 8,600). Based on the graph drawn in answer to part b above, the profit-maximizing point (point a) occurs where the horizontal marginal revenue curve intersects the marginal cost curve. The profit is shown by the area of the shaded rectangle ($4.25 × 800), whose height ($4.25) is the difference between price ($15.00 at point a) and average cost ($10.75 at point b), and whose width is quantity of output (800). d) Because profit is positive, the fisher will stay in business in the long run.

6. a) The initial equilibrium price and quantity are $2 and 60 thousand cartons at point a in the graph. Because this initial point is a long-run equilibrium, egg farmers are making an economic profit of zero. In other words, they are making only a normal profit

b) The values in D1 column of the table are 20, 30, 40, 50 and 60 thousand cartons. These values are each 20 thousand cartons less than the values in the D0 column, which means that the demand curve has shifted 20 thousand cartons to the left. The new equilibrium price and quantity are $1.50 and 50 thousand cartons. Because this market is a constantcost industry and egg farmers were breaking even at the initial price or $2, they are now making an economic loss. c) The new supply curve S1 must intersect the new demand curve D1 at the initial equilibrium price of $2. For this to occur, the curve must shift to the left by 20 thousand 1-107 Copyright © 2023 by McGraw Hill

cartons. This gives values in the S1 column of the table of 60, 50, 40, 30 and 20 thousand cartons, which are each 20 thousand cartons less than the values in the S0 column. The new equilibrium price and quantity are $2 and 40 thousand cartons. Because the price is again at its break-even level egg farmers are again making zero economic profits.

(1) Price ($ per carton) 3.00 2.50 2.00 1.50 1.00

(2) Quantity Demanded (thousands of cartons per month)

(3) Quantity Supplied (thousands of cartons per month)

D0

D1

S0

S1

40 50 60 70 80

[20] [30] [40] [50] [60]

80 70 60 50 40

[60] [50] [40] [30] [20]

7. These conditions support Adam Smith‘s contention that the profit-maximizing behaviour of business owners provides products to consumers at the lowest possible price while maximizing consumer benefits. When minimum-cost pricing is met, price equals minimum average cost, so that businesses take advantage of all possible cost savings and pass them on to consumers. When marginal-cost pricing is met, price equals marginal cost, so that every unit of a product for which extra benefits to the consumer exceed the extra costs to the producer is produced. These conditions show that the invisible hand of competition works completely only when markets are perfectly competitive and in long-run equilibrium. There is no guarantee that real-world markets, which rarely are perfectly competitive and rarely reach long-run equilibrium, fully satisfy these conditions.

Advancing Economic Thought Problems 1. In the case where potential benefits of development are being explored, one can defend treating different test sites differently, since in all likelihood the worst possible outcome is that experienced by the ‗control‘ sites, where no change is made. However, if this same approach were to be used to study potential costs, then the conditions for some participants in the experiment might be worse than before.

2. Random selection ensures that researchers‘ subjective opinions—either explicit or implicit— do not taint the results. For example, without the random selection of villages in Seva Mandir‘s immunization experiment, researchers might unwittingly choose villages more likely to be open to change as those subject to the scheme being tested.

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In-class Activities

1. Introductory Information Time: Approximately 20 minutes.

Materials: Coloured pencils or markers and paper. (optional) Five identical masks (usually available at dollar stores). These could also be made out of paper bags with cut outs for eyes and mouth.

Set-up: Students should divide into five teams.

Each team will select one student to be the acting seller.

Place five chairs at the front of the room facing the audience.

Key Concepts Covered: average revenue business‘s demand curve entry barriers marginal revenue perfect competition profit-maximizing output rule Learning Objectives: Illustrate and discuss the requirements for perfect competition, including the absence of entry barriers, in the context of a market for lobsters.

Explain and evaluate the operation of perfect competition in the short run, including the concepts of average revenue, marginal revenue, business‘s demand curve and profit-maximizing output rule.

2. Exercise (essay) Recall that the class has divided into 5 groups and one student from each group is acting as a seller.

Timekeeper: Each team has 5 minutes to design a marketing campaign.

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Stage 1: Each team will be told that they work on a lobster fishing boat that has just returned from sea. Each team has caught several hundred lobsters. The government does not regulate the price of lobsters and there are no large retailers that buy or sell lobster. Each team must ensure that their seller can sell their boat‘s lobster catch in the best way possible. Each team will be given paper and markers and then will have five minutes to design a marketing campaign to sell their lobster catch. [Note: save these materials for re-use in the chapter 6 simulation] After the five minutes are up, the sellers from each group will take their places at the front of the room. All other students will return to their seats facing the sellers.

Stage 2: Each of the sellers will be at the front of the room. They will all have different pricing strategies and marketing signs. Students who are not sellers will be buyers or bidders. One-byone each seller will present their marketing campaign and loosely sell their catch to the buyers, by auction, for a particular price. [Proper buying and selling will occur in the chapter 6 simulation.]

Did all the sellers get the same price for their lobster catches?

Yes, all the sellers got the same price.

No, the sellers got different prices.*

Is this perfect competition?

Yes, this is perfect competition.

No, this is not perfect competition.

Make a list on the board, or in the response box below, of all the things that would need to change about the sellers and buyers to ensure this market is perfectly competitive. As each thing that would need to change is added to the list sellers should make the changes visually for the class. i.e., if the list stated that all perfectly competitive sellers are the same height then the taller sellers should physically shrink themselves down to be the same height as the shortest seller.

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Stage 3: The students should return to their original teams to discuss and respond to the questions below.

1. Assuming a perfectly competitive market, where the market supply and demand curves meet is at $10. Determine the equilibrium price for lobsters, and describe how to draw the business‘s demand curve for your lobster company.

2. Your company sold 800 lobsters in the month of June. Calculate your total revenue and average revenue. If your company increased its sales to 900 units in June, what is the marginal revenue for the last $100 units sold?

3. How would each of the lobster companies be able to maximize their profit? Discuss the relevance of the profit maximizing output rule in this decision.

Explanation: The prices will likely vary between sellers.

No, this is not perfect competition.

As the students come up with the list on the board the sellers should make the changes visually.

The list should include the following: - the product and the price at which it is sold are the same for all sellers; - marketing (such as the use of signs) is absent; - timing, storage, availability and location are identical; - sellers are completely interchangeable from the buyer‘s perspective. (At this point the instructor can give each seller a mask while discussing the impact of a seller‘s personal connections and personality in markets that do not meet the conditions of perfect competition.); - sellers need to be able to enter or leave the market in the long run, which means no entry barriers; - there needs to be many buyers and sellers, many more sellers and buyers than present in this simulated market.

The students should return to their original teams for the debriefing portion of this simulation.

Follow-up areas of learning: The instructor will be able to extend this experience to discuss average revenue, marginal revenue and the profit-maximization strategies for perfect competition.

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3. Discussion Questions 1. Recalling the simulation list identify the factors that must exist for perfect competition in the market for lobsters. Click to place a checkmark next to the true solutions and click twice to place blanks next to wrong reasons. Boxes containing a question mark will score as wrong. a) company marketing b) individually identifiable sellers c) easy entry and exit* d) standard product* e) many buyers and sellers* 2. a) Describe a product that is bought and sold in a perfectly competitive market. Why is this? i) Cereal, because it is a product with many buyers and sellers. ii) Wheat, because it is a standardized product with many buyers and sellers.* iii) Cheese, because it can only be made in small batches. iv) Frozen dinners, because all frozen dinners are very similar. b) Does perfect competition really exist? Why or why not? i) Yes, but it is very rare because most things in our world are unique in some way.* ii) No, because virtually everything in our world is unique in some way. iii) Yes, and it is very common because many things in our world are similar to one another. iv) No, perfect competition is an illusion perpetrated by economists.

3. a) Who benefits from perfect competition? i) No one benefits from perfect competition. ii) Consumers benefit from perfect competition.* iii) Shareholders benefit from perfect competition. iv) Producers benefit from perfect competition. b) Why and how? i. Because perfect competition ensures that product price reflect the costs of sellers, and that seller profits are maximized. ii. Because perfect competition ensures that product price reflect the sellers‘ minimum average variable costs. iii. Because perfect competition ensures that product price reflect the sellers‘ minimum average fixed costs. iv.

Because perfect competition ensures that product price reflect the costs of sellers, and that seller profits are minimized.* 1-112 Copyright © 2023 by McGraw Hill

Explanation: 1. Many buyers and sellers, standard product, easy entry and exit.

2. Possible answers include unprocessed food items such as wheat or milk and financial products such as corporate shares. For any product that a student chooses, they should describe how it meets the criteria described in the first discussion question.

3. Consumers benefit because perfect competition ensures that product price reflect the costs of sellers, and that seller profits are minimized.

4. Multiple Choice Questions:

1. Originally the lobster companies in this simulation did not represent perfect competition because: a) there were too many buyers. b) there were too many sellers. c) they each had different marketing strategies.* d) they could exit or enter the market at any time. e) they were all selling lobsters.

2. For each of the lobster companies in this exercise, at which point would profit be maximized? a) Where marginal revenue equals average cost. b) Where marginal cost equals marginal revenue.* c) Where average revenue equals marginal revenue. d) Where average cost equals marginal cost. e) When total revenue equals variable cost.

3. In a perfectly competitive market for lobsters, the equilibrium price is derived by finding the point where: a) total revenue equals total cost for each lobster company. b) quantity supplied is greater than quantity demanded in the entire market. c) the market demand for lobsters meets the market supply for lobsters.* d) quantity demanded is greater than quantity supplied in the entire market. e) each lobster company‘s demand curve meets the company‘s own supply curve.

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4. For each lobster company in a perfectly competitive market a) marginal revenue is always greater than average revenue. b) marginal cost and marginal revenue are always identical. c) average revenue and average cost are identical. d) average revenue and marginal revenue are identical.* e) average revenue is always greater than marginal revenue.

5. A lobster company sells 400 lobsters for $5 each. The company‘s marginal revenue for each

of the last 100 lobsters is therefore: a) $500. b) $50. c) $5.* d) $2,000. e) $2,500.

Explanation: 1. Originally the lobster companies in this simulation did not represent perfect competition because they each had different marketing strategies.

2. For each of the lobster companies in this exercise, profit would be maximized where marginal cost equals marginal revenue.

3. In a perfectly competitive market for lobsters, the equilibrium price is derived by finding the point where the market demand for lobsters meets the market supply for lobsters.

4. For each lobster company in a perfectly competitive market average revenue and marginal revenue are identical.

5. A lobster company sells 400 lobsters for $5 each. The company‘s marginal revenue for each of the last 100 lobsters is therefore $5.

Chapter 6 Teaching Tips Applying the Profit-Maximizing Output Rule As in Chapter 5, applying the profit-maximizing output rule to the relevant tables of this chapter requires careful placement and assessment of the values for marginal revenue and marginal cost.

In Chapter 5, marginal revenue for a perfectly competitive business was constant, which simplified the reading of profit-maximization tables such as the one in Figure 5.4. For 1-114 Copyright © 2023 by McGraw Hill

businesses in monopolistic or imperfectly competitive markets, marginal revenue for each business is no longer constant. When determining profit-maximizing quantities using tables in this chapter, students must therefore pay attention not just to marginal cost but to marginal revenue as well.

Profit Maximization for a Monopolist In the table of Figure 6.6, the values for marginal revenue (MR) and marginal cost (MC) in columns 4 and 5 are vertically positioned halfway between the other rows, as we saw for the table of Figure 5.4, our illustration in the last chapter. But now, when using Figure 6.6‘s table to determine the monopolist‘s profit-maximizing quantity, we need to compare each successive pair of marginal revenue values along with the corresponding pair of marginal costs. In the case of the first two output ranges, between 0 and 1 computer and then between 1 and 2 computers, marginal revenue falls from $160 to $80 while marginal cost falls from $60 to $40. Because the values for marginal cost values fall short of those for marginal revenue, this is not the profitmaximizing quantity. The next two pairs of values are $80 and $0 for marginal revenue and $40 and $70 for marginal cost. In this case, marginal cost moves from below marginal revenue ($40 compared with $80) to above marginal revenue ($70 compared with $0). This means this is the profit-maximizing quantity. We can look at the last two pairs of values to ensure that they do not meet the same condition. Now marginal revenue is falling from $0 to -$80 while marginal cost is rising from $70 to $150, so that marginal cost is always above marginal revenue, which means that profits are not maximized in this range. Now let‘s go back to our profit-maximizing case.

With marginal cost below marginal revenue between 1 and 2 computers and the reverse true between 2 and 3 computers, the profit-maximizing quantity must sit at the common boundary of these two output ranges, or 2 computers.

Profit Maximization for a Monopolistic Competitor Profit maximization for a monopolistic competitor with the aid of a table employs the very same procedure as used for a monopolist. With marginal revenue and marginal cost both changing, students should examine each successive pair of marginal revenue values along with the corresponding pair of marginal cost values to see at which point marginal revenue and marginal cost pass through the same range of values, with profit-maximizing quantity found at the common boundary of these two output ranges.

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Profit-Maximization for an Oligopolist The case of an oligopolist in a market characterized by rivalry is similar to the above two cases with one main difference: marginal revenue no longer falls at a constant rate as output is increased. In the table of Figure 6.10, we again compare each successive pair of marginal revenue values along with the corresponding pair of marginal costs. In the case of the first two output ranges, between 0 and 10,000 cars and then between 10,000 and 20,000 cars, marginal revenue falls from $35,000 to $25,000 while marginal cost falls from $15,000 to $10,000.

Because the marginal cost values are lower than the values for marginal revenue, this is not the profit-maximizing quantity. The next two pairs of marginal revenue and marginal cost values are $25,000 and -$20,000 for marginal revenue and $10,000 and $15,000 for marginal cost. In this case, marginal cost moves from below marginal revenue ($10,000 compared with $25,000) to being above marginal revenue ($15,000 compared with -$20,000). Therefore, this is the profitmaximizing quantity. As a check, we can look at the last two pairs of values. Now marginal revenue is falling from -$20,000 to -$40,000 while marginal cost is rising from $15,000 to $25,000, so that marginal cost is always above marginal revenue. That means profits are not maximized in this range. Returning to our profit-maximizing case, with marginal cost below marginal revenue between 10,000 and 20,000 cars and the reverse true between 20,000 and 25,000 cars, the profit-maximizing quantity must sit at the boundary of these two output ranges, or 20,000 cars.

Answers to Thinking about Economics Questions TAE I, Section 6.2: Cost estimates require estimating explicit and implicit costs at each possible output level. While revenue estimation is easy for perfect competitors, cost estimation is as difficult as it is for other businesses.

TAE II: Section 6.3: As in the case of businesses in imperfectly competitive markets, a monopolist chooses one level of output and then finds the highest possible price at that quantity.

So, it is impossible for the monopolist to devise a supply curve independent of the demand conditions it faces.

TAE III, Section 6.3: Facebook‘s purchase of the messaging service WhatsApp is a good example.

Answers to Chapter Problems

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6.1 Practice Problem 1. a) The perfect competitor‘s demand curve is perfectly elastic because the business is a price taker. This means that the business‘s demand curve is a horizontal line with a vertical intercept equal to the price set in the market. b) A relatively elastic curve applies to a monopolistic competitor. Because each business is selling output with many close substitutes, due to product differentiation within the market, even small changes in price will lead to relatively large changes in quantity demanded. c) Because it is the sole seller of a product with no close substitutes, the monopolist has a demand curve that is less elastic than for businesses in other markets. d) A kinked demand curve applies to an oligopolist in a market where rivalry prevails. This is because of the differing reactions of the business‘s rivals to an increase or decrease in price.

6.2 Practice Problems 1. a) Recall the definition of marginal revenue as the change in total revenue divided by the change in quantity. The change in total revenue between the two output levels is $8 million (= $20 × 400,000) at 400,000 prescriptions and $7.5 million (= $15 × 500,000) at 500,000 prescriptions. The change in output is 100,000 prescriptions. Therefore, marginal revenue is calculated as ($8 million – $7.5 million) / (400,000 – 500,000) = - ($500,000 / 100,000) = -$5. This gives a marginal revenue of -$5. b) Since demand (which equals average revenue) is downsloping for a monopolist, marginal revenue is below the demand curve and therefore less than price. This ensures that price falls as output expands, as shown in the graph below.

c)

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Note that the single point on the MR curve that can be identified using the data provided is a marginal revenue of -$5 at a quantity of 450,000 prescriptions, which is the value on the quantity axis half-way between 400,000 and 500,000 prescriptions.

2. a) Yes, profit is maximized at this output and price, because this is where marginal cost (MC) and marginal revenue (MR) are equal. b) If this monopolist is turned into a perfectly competitive market, output will exceed 100,000 units and price will be less than $6. Perfectly competitive businesses operate at the intersection of the market demand (D) and supply (S) curves. While D is the same as in the case of monopoly, S is a portion of the monopolist‘s MC curve. Because D and S cross at a point to the right of the intersection of the monopolist‘s MC and MR curves, perfectly competitive output is higher. Moreover, the perfectly competitive price is found further along the downsloping D curve, so it is lower.

6.3 Practice Problems 1. a) Total revenue is $400 (= $0.04 × 10,000) at 10,000 copies and $450 (= $0.03 × 15,000) at 15,000 copies. Dividing this difference by the change in output gives the marginal revenue of 1 cent [= ($450 – $400) / (15,000 – 10,000)]. b) As in the case of monopoly, demand (which equals average revenue) is downsloping for a monopolistic competitor. To ensure that price falls as output expands, marginal revenue must be below the demand curve and therefore less than price.

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c)

4.5 4

Cents per Copy

3.5 3

D = AR

2.5 2 1.5 1

MR

0.5 0 0

2

4

6

8

10

12

14

16

Quantity (thousands of copies per day)

Note that the single point on the MR curve that can be identified using the data provided is a marginal revenue of 1 cent at a quantity of 12,500 copies (the value on the quantity axis half-way between 10,000 and 15,000 copies).

2. a) The business makes a short-run loss, with its $5 price below the $6 average cost. In the long run, as some of its competitors leave the market, this business will see an outward shift in its demand curve. The curve will also become less elastic, with fewer close substitutes for the business‘s output. The short-run loss gradually disappears as the business moves towards its long-run equilibrium point. b) The business now makes a profit, with its $5 price greater than the $4 average cost. In the long run, new businesses enter the market. This business will see a leftward shift in its demand curve, and the curve will become more elastic, because there are more close substitutes for the business‘s output. This time, the business‘s profit gradually disappears as it approaches its long-run equilibrium point.

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3. a) At the output associated with the kink in the demand curve, the business‘s marginal revenue (MR) curve is a vertical segment. This is because the MR curve has two downsloping segments – each associated with one part of the kinked demand curve – and the vertical segment running between these two downsloping MR segments. b) As long as the marginal cost curve continues to intersect marginal revenue along the MR curve‘s vertical segment, there will be no change in the business‘s profit-maximizing output or price.

4. a) By both agreeing to stay silent, each prisoner receives 2 years jail time, which is better than the other possibility that they might both agree on, which is 8 years jail time for each prisoner, if they both confess. b) If the two prisoners cannot communicate with one another, then each has an incentive to choose the least harmful worst-case scenario for themselves, which is the option of confessing (where the worst-case scenario for each is 8 years of jail time) as opposed to not confessing (where the worst-case scenario for each is 15 years of jail time).

6.4 Practice Problems a) a) Total industry sales are $24 million (= 12 × $2 million), while sales of four of the firms are $8 million (= 4 × $2 million). Given that one cannot distinguish among the firms that are all exactly the same size, the four-firm concentration ratio is 33% [= ($8 million / $24 million) × 100]. b) Because the four-firm concentration ratio is below 50%, this industry can be classified as monopolistically competitive. c) A business in this market may choose to engage in non-price competition to distinguish its product from that of rivals. If so, the business‘s motive would be to increase its demand and make demand less elastic, allowing the business to raise its price. d) It would be a horizontal merger, since both businesses are in the same industry.

b) If big businesses pass on cost-savings of large outputs under conditions of economies of scale to consumers, this represents a potential advantage of industrial concentration to consumers.

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End of Chapter Problems 1. a) (1) Price ($ per ticket) 10

(2) Quantity (tickets per week) 0

(3) Total Revenue ($) [0.00]

8

200

[1600.00]

6

400

[2400.00]

4

600

[2400.00]

2

800

[1600.00]

0

1000

[0.00]

(4) Marginal Revenue ($ per ticket) [8.00] [4.00] [0.00] [-4.00] [-8.00]

The total revenues in column (3) are found by multiplying the relevant quantity and price.

For example, at a quantity of 200 tickets, total revenue is $1600 (= $8 × 200). The marginal revenues in column (4) are found by subtracting total revenue at the previous quantity from total revenue at the new quantity and dividing the result by the change in quantity. For example, when moving from 0 to 200 tickets, the difference in total revenue is $1600 (= $1600 – $0) which is then divided by the change in quantity of 200 tickets, giving $8 (= $1600 / 200). b) Silver Screen‘s status as a monopoly means it faces the downward-sloping market demand curve. Average revenue (price) is falling as output increases, so marginal revenue is below price beyond the very first point where both meet on the vertical axis.

Given that the marginal revenue values are plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 100 [= (200 + 0) / 2] tickets, 300 [= (400 + 200) / 2] tickets, 500 [= (600 + 400) / 2] tickets, 700 [= (800 + 600) / 2] tickets and 900 [= (1000 + 800) / 2] tickets.

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c) Marginal revenue moves from being positive to negative at a quantity of 500 tickets, where Silver Screen Cinema‘s marginal revenue curve intersects the quantity axis.

2. a) (1) Price ($ per copy)

(2) Quantity (copies per month)

(3) Total Revenue ($)

500

0

[0]

(4) Marginal Revenue ($ per copy)

[400] 400

[60]

[24,000] [200]

300

[120]

[36,000] [0]

200

[180]

[36,000] [-200]

100

[240]

[24,000] [-400]

0

[300]

[0]

1-122 Copyright © 2023 by McGraw Hill

The total revenues in column (3) are found by multiplying the relevant quantity and price. For example, at a quantity of 60 copies of the program, total revenue is $24,000 (= $400 × 60). The marginal revenues in column (4) are found by subtracting total revenue at the previous quantity from total revenue at the new quantity and dividing the result by the change in quantity. For example, when moving from 0 to 60 copies of the program, the difference in total revenue is $24,000 (= $24,000 – $0) which is then divided by the change in quantity of 60 copies, giving $400 (= $24,000 / 60). b) Biodata Software‘s monopoly status means that it faces the downward-sloping market demand curve. Because average revenue (price) falls as output increases, marginal revenue is below price beyond the very first point where both meet on the vertical axis.

Because each of the marginal revenue values is plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 30 [= (60 + 0) / 2] copies, 90 [= (120 + 60) / 2] copies, 150 [= (180 + 120) / 2] copies, and 210 [= (240 + 180) / 2] copies.

c) Marginal revenue moves from being positive to negative at a quantity of 150 copies, where Biodata Software‘s marginal revenue curve intersects the quantity axis.

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3. a) (1) Price ($ per cup) 1

(2) Quantity (cups per day) 0

(3) Total Revenue ($) [0]

0.95

[100]

[95]

0.90

[200]

[180]

0.85

[300]

[255]

0.80

[400]

[320]

(4) Marginal Revenue ($ per cup) [0.95] [0.85] [0.75] [0.65]

The total revenues in column 3 are found by multiplying the relevant quantity and price.

For example, at a quantity of 100 cups of coffee, total revenue is $95 (= $0.95 × 100).

The marginal revenues in column 4 are found by subtracting total revenue at the previous quantity from total revenue at the new quantity and dividing the result by the change in quantity. For example, when moving from 0 to 100 cups of coffee, the difference in total revenue is $95 (= $95 – $0), which is then divided by the change in quantity of 100 cups, giving $0.95 or 95 cents (= $95 / 100). b) As a seller in a monopolistically competitive market, Stan‘s Coffee Shop faces an elastic downward-sloping demand curve. The fall in average revenue (price) as output increases causes marginal revenue to be below price beyond the very first point where both meet on the vertical axis. Because each of the marginal revenue values is plotted halfway between the relevant quantities on the horizontal axis, they are positioned at 50 [= (100 + 0) / 2] cups, 150 [= (200 + 100) / 2] cups, 250 [= (300 + 200) / 2] cups, and 350 [= (400 + 300) / 2] cups.

1-124 Copyright © 2023 by McGraw Hill

4. a) (1) Price ($ per treatment) 200

(2) Quantity (treatments per day) 0

(3) Total Revenue ($) [0.00]

(4) Marginal Revenue ($ per cup) [190.00]

190

[5]

[950.00]

180

[10]

[1800.00]

170

[15]

[2550.00]

160

[20]

[3200.00]

[170.00] [150.00] [130.00]

Oasis Spa‘s total revenues in column 3 are found by multiplying the relevant quantity and price. For example, at a quantity of 5 treatments, total revenue is $950 (= $190 × 5). The marginal revenues in column 4 are found by subtracting total revenue at the previous quantity from total revenue at the new quantity and dividing the result by the change in quantity. For example, when moving from 0 to 5 treatments, the difference in total revenue is $950 (= $950 – $0), which is then divided by the change in quantity of 5 treatments, giving $190 (= $950 / 5).

1-125 Copyright © 2023 by McGraw Hill

b) The total revenue at each price is $0 at a price of $200, $950 at $190, $1800 at $180, $2250 at $170 and $3200 at $160. The marginal revenues values are found by subtracting total revenue at the previous quantity from total revenue at the new quantity and dividing the result by the change in quantity. When moving from 0 to 5 treatments, the difference in total revenue is $950 (= $950 – $0), which is then divided by the change in quantity of 5 treatments, giving $190 (= $950 / 5). When moving from 5 to 10 treatments, the difference in total revenue is $850 (= $1800 – $950), which is then divided by the change in quantity of 5 treatments, giving $170 (= $850 / 5). When moving from 10 to 15 treatments, the difference in total revenue is $750 (= $2550 – $1800), which is then divided by the change in quantity of 5 treatments, giving $150 (= $750 / 5). When moving from 15 to 20 treatments, the difference in total revenue is $650 (= $3200 – $2550), which is then divided by the change in quantity of 5 treatments, giving $130 (= $650 / 5).

5. a) (1) Price ($ per bottle) 3.50

(2) Quantity (bottles per day) 0

(3) Total Revenue ($) [0]

3.00

[2,000]

[6,000]

2.50

[4,000]

[10,000]

2.00

[5,000]

[10,000]

1.50

[6,000]

[9,000]

(4) Marginal Revenue ($ per bottle) [3] [2] [0] [-1]

The total revenues in column 3 are found by multiplying the relevant quantity and price.

For example, at a quantity of 2,000 bottles, total revenue is $6,000 (= $3 × 2,000). The marginal revenues in column 4 are found by subtracting total revenue at the previous quantity from total revenue at the new quantity and dividing the result by the change in quantity. For example, when moving from 0 to 2,000 bottles, the difference in total revenue is $6,000 (= $6,000 – $0) which is then divided by the change in quantity of 2,000 bottles, or $3 (= $6,000 / 2,000). b) Given its participation in an oligopoly characterized by rivalry, the Big Hair Company faces a kinked demand curve. Therefore, its marginal revenue curve is composed of two linear segments joined by a vertical line.

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c) The kink in the demand curve occurs at 4,000 bottles, since at this quantity the curve‘s slope changes. In the ranges 0 to 2,000 bottles and 2,000 to 4,000 bottles price falls by 50 cents each time quantity on the demand curve increases by 2,000 bottles. In the ranges 4,000 to 5,000 bottles and 5,000 to 6,000 bottles price falls by 50 cents each time quantity increases by 1,000 bottles. d) The four marginal revenue values from the table are plotted halfway between the relevant quantities on the axis, 1,000 [= (2,000 + 0) / 2] bottles, 3,000 [= (4,000 + 2,000) / 2] bottles, 4,500 [= (5,000 + 4,000) / 2] bottles, and 5,500 [= (6,000 + 5,000) / 2] bottles.

The leftmost point of the curve is plotted where the demand curve intercepts the vertical axis at $3.50. Then come the first two points from the table at the quantities described in the sentence above. Because the demand curve‘s kink occurs at a quantity of 4,000 bottles the fourth MR point is at this quantity level, and has a value of $1.50. The second downsloping section of the curve incorporates the third and fourth MR values in the table. Extending this downsloping section up and leftward to a quantity 4,000 bottles gives the last MR point which has a value of $0.50. This point, along with the point with a value of $1.50, represent the two endpoints of the vertical section of the curve. Then plot the two final points from the table described in the first sentence of this paragraph.

6. a) (1) Price ($ per room) 200

(2) Quantity (rooms per night) [0]

(3) Total Revenue ($) [0.00]

175

[30]

[5250.00]

(4) Marginal Revenue ($ per room) [175.00]

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[125.00] 150

[60]

[9000.00]

125

[75]

[9375.00]

100

[90]

[9000.00]

[25.00] [-25.00]

The total revenues in column 3 are found by multiplying the relevant quantity and price.

For example, at a quantity of 30 rooms per night, total revenue is $5,250 (= $175 × 30).

The marginal revenues in column 4 are found by subtracting total revenue at the previous quantity from total revenue at the new quantity and dividing the result by the change in quantity. For example, when moving from 0 to 30 rooms per night, the difference in total revenue is $5,250 (= $5,250 – $0) which is then divided by the change in quantity of 30 rooms per night, or $175 (= $5,250 / 30). b) The kink in Nirvana Resort‘s demand curve at 60 rooms per night reflects the fact that at this quantity the curve‘s slope changes. In the ranges 0 to 30 rooms and 30 to 60 rooms, price falls by $25 each time quantity on the demand curve increases by 30 rooms. In the ranges 60 to 75 rooms and 75 to 90 rooms, price falls by $25 each time quantity increases by 15 rooms. c) The MR curve has a vertical segment because the MR segments associated with each segment of the demand curve do not intersect at the quantity of 60 rooms per night. The MR segment associated with the upper portion of the demand curve has a higher value at 60 rooms than does the MR segment associated with the lower portion of the demand curve.

7. a)

5.00

(2) Quantity (shirts per month) 0

4.50

1,000

[4,500.00]

5,000

4.00

2,000

[8,000.00]

6,250

3.50

3,000

[10,500.00]

8,000

3.00

4,000

[12,000.00]

10,300

2.50

5,000

[12,500.00]

15,000

(1) Price ($ per shirt)

(3) Total Revenue ($)

(4) Total Cost ($)

[0.00]

3,000

1-128 Copyright © 2023 by McGraw Hill

(5) (6) Marginal Marginal Cost Revenue ($ per shirt) ($ per shirt) [4.50]

[2.00]

[3.50]

[1.25]

[2.50]

[1.75]

[1.50]

[2.30]

[0.50]

[4.70]

The total revenues in column 3 are found by multiplying the relevant quantity and price.

For example, at a quantity of 1,000 shirts cleaned, total revenue is $4,500 (= $4.50 × 1,000). The marginal revenues in column 5 are found by subtracting total revenue at previous quantity from total revenue at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 1,000 shirts, the difference in total revenue is $4,500 [= $4,500 – $0] which is then divided by the change in quantity of 1,000 shirts, giving $4.50 (= $4,500 / 1,000). The marginal costs in column 6 are found by subtracting the total cost at the previous quantity from total cost at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 1,000 shirts, the difference in total cost is $2,000 = [$5,000 – $3,000] which is then divided by the change in quantity of 1,000 shirts, giving $2.00 (= $2,000 / 1,000). b) Using the values in the table, 3,000 shirts is the profit-maximizing quantity because it is the quantity where marginal revenue (which is falling from $2.50 to $1.50) and marginal cost (which is rising from $1.50 to $1.75) pass through a range of common values. c) This profit can be found by deducting total cost ($8,000) from total revenue ($10,500) at the profit-maximizing quantity. d) Because Presto is making a positive short run economic profit, in the long run new entrants can be expected in this market, pushing Presto‘s demand curve to the left (due to lost customers) and making it more elastic (due to more close substitutes). This process will continue until Presto is breaking even in long run equilibrium.

8. a) (1) (2) (3) (4) Price Quantity Total Revenue Total Cost ($ per (memberships ($) ($) membership) per month) 25.00

22.50

20.00

17.50

0

200

400

600

[0]

[4,500.00]

[8,000.00]

[10,500.00]

(6) (7) Marginal Marginal Cost Revenue ($ per ($ per membership) membership)

9,300

12,900

14,200

15,200

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(5) Average Cost ($ per membership)

[22.50]

[18.00]

[17.50]

[6.50]

[12.50]

[5.00]

[7.50]

[21.00]

[64.50]

[35.50]

[25.33]

15.00

800

[12,000.00]

19,400

[24.25] [2.50]

12.50

1000

[12,500.00]

30,500

[55.50]

[30.50]

The total revenues in column 3 are found by multiplying the relevant quantity and price.

For example, at a quantity of 200 memberships, total revenue is $4,500 (= $22.50 × 200).

The average costs in column 5 are found by dividing total cost by the relevant quantity.

For example, at a quantity of 200 memberships, average cost is $64.50 (= $12,900 / 200).

The marginal revenues in column 6 are found by subtracting total revenue at previous quantity from total revenue at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 200 memberships, the difference in total revenue is $4,500 [= $4,500 – $0] which is then divided by the change in quantity of 200 memberships, giving $17.50 (= $4,500 / 200). The marginal costs in column 7 are found by subtracting the total cost at the previous quantity from total cost at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 200 memberships, the difference in total cost is $3,600 = [$12,900 – $9,300] which is then divided by the change in quantity of 200 memberships, giving $18.00 (= $3,600 / 200). b) Using the table, 600 memberships is the profit-maximizing quantity because it is the quantity where marginal revenue (which is falling from $12.50 to $7.50) and marginal cost (which is rising from $5 to $21) pass through a range of common values. The price associated with this quantity is $17.50. Using the graph, a vertical line can be drawn between horizontal axis and the demand curve at the point where the MR and MC curves intersect (point a in the graph below). This line is at a quantity of 600 memberships. If the line is then extended horizontally from the relevant point on demand curve (point b in the graph below) to the vertical axis, the relevant price is found to be $17.50. c) Fit for Life is making a loss of $4,700. Using the table, this loss is found by deducting total cost ($15,200) from total revenue ($10,500) at the profit-maximizing quantity.

Using the graph, this loss can be found by drawing a horizontal line from the point where the vertical line through 600 memberships intersects the AC curve (point c in the graph below). The loss is then the area of the shaded rectangle in the graph below.

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d) Because gyms like Fit for Life are making a short run economic loss, in the long run new businesses can be expected to leave this market, pushing Fit for Life‘s demand curve to the right (due to new customers) and making it more inelastic (due to fewer close substitutes). This process will continue until Fit for Life is breaking even in long run equilibrium.

9. a) (1) (2) Price Quantity ($ per carton) (cartons per day) 2.20

2.10

2.00

1.90

1.70

1.50

0

30,000

60,000

90,000

100,000

110,000

(3) Total Revenue ($)

(4) Total Cost ($)

[0.00]

50,000

[63,000.00]

(6) Marginal Cost ($ per carton)

[2.10]

[1.33]

[1.90]

[0.67]

[1.70]

[0.53]

[-0.10]

[1.70]

[0.50]

[3.70]

90,000

[120,000.00]

[171,000.00]

[170.000.00]

[165,000.00]

110,000

126,000

143,000

180,000

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(5) Marginal Revenue ($ per carton)

The total revenues in column 3 are found by multiplying the relevant quantity and price.

For example, at a quantity of 30,000 cartons, total revenue is $63,000 (= $2.10 × 30,000).

The marginal revenues in column 5 are found by subtracting the total revenue at the previous quantity from the total revenue at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 30,000 cartons, the difference in total revenue is $63,000 (= $63,000 – $0) which is then divided by the change in quantity of 30,000 cartons, giving $2.10 (= $63,000 / 30,000). The marginal costs in column 6 are found by subtracting the total cost at the previous quantity from total cost at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 30,000 cartons, the difference in total cost is $40,000 (= $90,000 – $50,000) which is then divided by the change in quantity of 30,000 cartons, giving $1.33 (= $40,000 / 30,000). b) Using the values in the table, 90,000 cartons is the profit-maximizing quantity because it is the quantity where marginal revenue (which is falling from $2.50 to $1.50) and marginal cost (which is rising from $0.53 to $1.70) pass through a range of common values. Meanwhile the profit-maximizing price of $1.90 is the price at the profitmaximizing quantity as listed in the table. c) The kink in the demand curve occurs at 90,000 cartons, since at this quantity the curve‘s slope changes. In the ranges 0 to 30,000 cartons, 30,000 to 60,000 cartons, and 60,000 and 90,000 cartons price falls by 10 cents each time quantity on the demand curve increases by 30,000 cartons. In the ranges 90,000 to 100,000 cartons, 100,000 to 110,000 cartons, and 110,000 to 120,000 cartons price falls by 20 cents each time quantity increases by 10,000 cartons. d) The $45,000 profit can be found by subtracting the total cost of $126,000 from the total revenue of $171,000 at the profit-maximizing quantity. e) Because of barriers to entry in this market, Citrus Delight can continue making positive profits in the long run.

10. a) (1) Price ($ per bottle $20

(2) (3) (4) Quantity Total Revenue Total Cost (bottles per ($) ($) day) 0 [0.00] 215

(5) Average Cost ($ per bottle)

18

50

[900.00]

971

[19.42]

16

100

[1,600.00]

1,370

[13.70]

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(6) (7) Marginal Marginal Cost Revenue ($ per bottle) ($ per bottle) [18.00]

[15.12]

[14.00]

[7.98]

14

120

[1,680.00]

1,530

[12.75]

12

140

[1,680.00]

1,923

[13.74]

10

160

[1,600.00]

2,715

[16.97]

[4.00]

[8.00]

[0.00]

[19.65]

[-4.00]

[39.60]

The total revenues in column 3 are found by multiplying the relevant quantity and price.

For example, at a quantity of 50 bottles, total revenue is $900 (= $18 × 50). The average costs in column 5 are found by dividing total cost by the relevant quantity. For example, at a quantity of 50 bottles, average cost is $19.42 (= $971 / 50). The marginal revenues in column 6 are found by subtracting the total revenue at the previous quantity from the total revenue at the new quantity and then dividing the result by the change in quantity.

For example, when moving from 0 to 50 bottles, the difference in total revenue is $900 (= $900 – $0) which is then divided by the change in quantity of 50 bottles, giving $18 (= $900 / 50). The marginal costs in column 7 are found by subtracting the total cost at the previous quantity from total cost at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 50 bottles, the difference in total cost is $756 (= $971 – $215) which is then divided by the change in quantity of 50 cartons, giving $15.12 (= $756 / 50). b) Using the table, 100 bottles is the profit-maximizing quantity because it is the quantity where marginal revenue (which is falling from $14 to $4) and marginal cost (which is rising from $7.98 to $8) pass through a common range of values. Using the graph, a vertical line can be drawn between horizontal axis and the demand curve at the point where the MR and MC curves intersect (point a in the graph below). This line is at a quantity of 100 bottles. If the line is then extended horizontally from the relevant point on demand curve (point b in the graph below) to the vertical axis, the relevant price is found to be $16. c) Lifelong Health is making a $230 profit. Using the table, this profit is found by deducting total cost ($1,370) from total revenue ($1,600) at the profit-maximizing quantity. Using the graph, this profit can be found by drawing a horizontal line from the point where the vertical line through 100 bottles intersects the AC curve at $13.70 (point c in the graph below). The profit is then the area of the shaded rectangle in the graph below.

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d) The kink in the demand curve occurs at 100 bottles (point b in the graph above), since at this quantity the curve‘s slope changes. In the ranges 0 to 50 bottles and 50 and 100 bottles, price falls by $2 each time quantity on the demand curve increases by 50 bottles.

In the ranges 100 to 120 bottles, 120 to 140 cartons, and 140 to 160 bottles, price falls by $2 cents each time quantity increases by 20 bottles. The vertical segment in the marginal revenue curve occurs at 100 bottles as well.

11. a) (1) Price ($ per passenger) 420

(2) (3) Quantity Total Revenue (passengers per ($) day) 0

(4) Total Cost ($)

[0.00]

50

[17,500.00]

26,750

280

100

[28,000.00]

27,750

140 70 0

150 200 250 300

(6) Marginal Cost ($ per passenger)

[350.00]

[40.00]

[210.00]

[20.00]

[70.00]

[3.00]

[-70.00]

[2.00]

[-210.00]

[20.00]

[-350.00]

[110.00]

24,750

350

210

(5) Marginal Revenue ($ per passenger)

[31,500.00]

27,900

[28,000.00]

28,000

[17,500.00]

29,000

[0.00]

34,500

True North‘s total revenues in column 3 are found by multiplying the relevant quantity and price. For example, at a quantity of 50 passengers, total revenue is $17,500 [= $350 × 1-134 Copyright © 2023 by McGraw Hill

50)]. The marginal revenues in column 5 are found by subtracting the total revenue at the previous quantity from the total revenue at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 50 passengers, the difference in total revenue is $17,500 [= $17,500 – $0] which is then divided by the change in quantity of 50 passengers, giving $350 [= ($17,500/50)]. The marginal costs in column 6 are found by subtracting the total cost at the previous quantity from total cost at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 50 passengers, the difference in total cost is $2,000 = [$26,750 – $24,750] which is then divided by the change in quantity of 50 passengers, giving $40 [= ($2,000/50)]. b) Using the values in the table, 150 passengers is the profit-maximizing quantity because it is the quantity where marginal revenue (which is falling from $70 to -$70) and marginal cost (which is falling from $3 to $2) pass through a common range of values. The profitmaximizing price of $210 is the price at the profit-maximizing quantity as listed in the table. c) True North‘s $3,600 profit is found by subtracting the total cost of $27,900 from the total revenue of $31,500 at the profit-maximizing quantity.

12. a) (1) Price ($ per kilowatt hour)

(2) Quantity (kilowatt hours per week)

(3) Total Revenue ($)

(4) Total Cost ($)

0.20

0

[0.00]

8,700,000

(5) Average Cost ($ per kilowatt hour)

0.16

100,000,000

[16,000,000.00]

15,500,000

[0.16]

0.12

200,000,000

[24,000,000.00]

20,300,000

[0.10]

0.08

300,000,000

[24,000,000.00]

23,700,000

400,000,000

[16,000,000.00]

28,400,000

[0.07]

$0

500,000,000

[0.00]

38,100,000

[0.08]

1-135

(7) Marginal Cost ($ per kilowatt hour)

[0.16]

[0.07]

[0.08]

[0.05]

[0.00]

[0.03]

[-0.08]

[0.05]

[-0.16]

[0.10]

[0.08]

0.04

Copyright © 2023 by McGraw Hill

(6) Marginal Revenue ($ per kilowatt hour)

Power Up‘s total revenues in column 3 are found by multiplying the relevant quantity and price. For example, at a quantity of 100 million kilowatt hours, total revenue is $16 million [= $0.16 × 100 million]. The average costs in column 5 are found by dividing total cost by the relevant quantity. For example, at a quantity of 100 million kilowatt hours, average cost is $0.16 (= $16 million / 100). The marginal revenues in column 6 are found by subtracting the total revenue at the previous quantity from the total revenue at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 100 million kilowatt hours, the difference in total revenue is $16 million [= $16 million – $0] which is then divided by the change in quantity of 100 million kilowatt hours, giving $0.16 [= ($16 million/$100 million]. The marginal costs in column 7 are found by subtracting the total cost at the previous quantity from total cost at the new quantity and then dividing the result by the change in quantity. For example, when moving from 0 to 100 million kilowatt hours, the difference in total cost is $7 million = [$15 million – $8 million] which is then divided by the change in quantity of $100 million kilowatt hours, giving $0.07 [= ($7 million/100 million)]. b) Using the table, 200 million kilowatt hours is the profit-maximizing quantity because it is the quantity where marginal revenue (which is falling from 5 cents to 0 cents) and marginal cost (which is falling from 5 cents to 3 cents) pass through a common range of values. Using the graph, a vertical line can be drawn between horizontal axis and the demand curve at the point where the MR and MC curves intersect (point a in the graph below). This line is at a quantity of 200 million kilowatt hours. If the line is then extended horizontally from the relevant point on demand curve (point b in the graph) to the vertical axis, the relevant price is found to be 12 cents. c) Power Up is making a $3.7 million profit. Using the table, this profit is found by deducting total cost ($20.3 million) from total revenue ($24.0 million) at the profitmaximizing quantity. Using the graph, this profit can be found by drawing a horizontal line from the point where the vertical line through 200 million kilowatt hours intersects the AC curve at 10 cents (point c in the graph below). The profit is then the area of the shaded rectangle in the graph below.

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13. a) If Harvey and Marv can communicate, they will agree not to confess, since then they can both be assured of serving only a half year in jail. This option is preferable to the other cooperative outcome where both confess and receive 3 years in jail. b) If Harvey and Marv cannot communicate, they will each choose the option with the least harmful worst-case scenario. For each, this is the option of confessing. This option‘s worst-case scenario is 3 years of jail time, as opposed to 5 years of jail time, which is the worst-case scenario of not confessing.

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14. a)

b) If cheating is easily discovered, then both businesses have an incentive not to cheat, since the profit to each if they don‘t cheat is higher than the profit to each if they both cheat.

This means that each makes an annual profit of $400,000 rather than the $300,000 each would make if they both cheat. c) If cheating is not easily discovered, then each business will focus on choosing the option with the least harmful worst-case scenario. This means that both will tend to cheat, since the worst-case-scenario profit associated with cheating ($300,000) is preferable to the worst-case-scenario profit associated with not cheating ($200,000). Each will therefore make a profit of $300,000.

15. a) If cheating is easily discovered, then both businesses have an incentive not to cheat, since the profit to each if they don‘t cheat is higher than the profit to each if they both cheat.

For example, if Sexton is sure that Blake won‘t cheat, Sexton is better off not cheating, since this strategy provides Sexton a profit of $10 million in contrast to a profit of $4 million if Sexton does cheat. Similarly, if Blake is sure that Sexton won‘t cheat, Blake is better off not cheating, since this strategy provides Blake with a profit of $10 million in contrast to the profit of $4 million if Blake does cheat. Because both businesses choose not to cheat they each makes an annual profit of $10 million. b) If cheating is not easily discovered, then each business has an incentive to cheat. This is because each business will focus on choosing the option with the least harmful worstcase scenario. For example, if Sexton is not sure whether or not Blake will cheat, Sexton 1-138 Copyright © 2023 by McGraw Hill

has the option of not cheating, in which case the worst-case scenario for Sexton is a profit of $4 million, or the option of cheating, in which case the worst-case scenario is a profit of $5 million. Similarly, Blake has the option of not cheating, in which case the worstcase scenario for Blake is a profit of $4 million, or the option of cheating, in which case the worst-case scenario is a profit of $5 million. Each will therefore make an annual profit of $5 million.

16. a) The ratio‘s value is 79% [= ($300 million / $380 million) × 100%], since combined sales for the largest four firms are $300 (= $100 + $80 + $65 + $55) million, while total sales in the industry are $380 million. b) This industry is an oligopoly, since the concentration ratio exceeds 50%.

17. a) The official concentration ratio will tend to underestimate the level of competition, since imported books are not included in this industry‘s national concentration ratio. b) The official concentration ratio will tend to overestimate the level of competition, since the concentration ratio is a national statistic that does not account for the regional dominance of certain construction companies. c) The official concentration ratio will tend to underestimate the level of competition, since competition from non-hotel rivals such as Airbnb are not included in this industry‘s concentration ratio.

18. a) This case of product differentiation involves entry into a new market. (i) The company‘s profits rise as long as the extra sales revenue exceeds the costs of entry. (ii) Presuming the company remains in the new market, it may be able to use entry barriers to keep out potential rivals. (iii) Despite the company‘s market power, consumers likely gain, since they can buy a previously unavailable product. b) This is a case of an anti-competitive advertising strategy. (i) There is an increase in the corporation‘s profits if the extra sales created by increased demand and lower demand elasticity outweigh the extra costs. (ii) Because of the possible negative effect on sales, other businesses in the market will likely be forced to raise their advertising budgets as well, raising the industry‘s per-unit costs while also strengthening entry barriers against new rivals. (iii) Given the added market power gained by established producers,

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consumers are likely to be harmed, because of higher prices as well as the reduced chance of added competition in the market. c) This is a case of product differentiation that involves selling an existing product in a new way. (i) The firm can use this strategy to increase profits as long as the benefits of increased demand and lower demand elasticity are greater than the costs of changing the brand name. (ii) If the company‘s strategy to raise its market power is successful, other cosmetics firms will lose sales unless they engage in similar initiatives. (iii) Consumers, on average, are likely to lose. Though some perfume buyers may gain satisfaction from the new strategies used by sellers, a larger number will be forced to pay a higher price due to firms‘ added costs. d) This is a case of advertising that enhances competition. (i) The lawyer who advertises her prices will increase her income if her revenues rise more than the advertising costs. (ii) Because of pressure from clients and a potential drop in sales, other lawyers may be forced to advertise their prices as well. (iii) Consumers will find it easier to choose a lawyer on the basis of price. Consequently, lawyers have less market power than they did when they did not advertise their prices. It is therefore possible that, despite lawyers‘ added costs, consumers benefit by paying a lower price than before.

Advancing Economic Thought Problems

1. Often cost-reducing changes apply in more than one sector. If various sectors are clustered in a local area, it is more likely innovations will spread from one sector to another. A wide variety of examples could be used to show such a link. To take an historical illustration, the introduction of railways in British cities during the latter part of the Industrial Revolution reduced transportation costs in a raft of these cities' industries, from steel to textiles.

2. One example is the antitrust case launched by the European Union against Amazon in 2020.

This argued that Amazon exploited the data it collected to gain an unfair advantage over the companies which traded on its online marketplace.

In-class Activities 1. Introductory Information

Time: Approximately 20 minutes.

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Materials: Red poker chips to represent lobsters Sufficient Monopoly money or play money so that about $20 in small denominations can be distributed to each member of half the class.

Keep the advertising paraphernalia created for the Chapter 5 simulation.

Set-up: Students should rejoin the same groups they were in for the chapter 5 simulation (i.e., divide the class into five teams).

Each team will select one student to be the acting seller.

Each team will select two students from each group to become consumers. Consumers from all the groups should gather together at the back of the room.

Place five tables and chairs at the front of the room facing the audience. The seller from each team should take a seat at one of the tables and chairs at the front of the room.

Divide up the red poker chips representing lobsters and give them to the sellers.

Give each of the consumers the $20 of Monopoly or play money.

Key Concepts Covered: collusion monopoly mutual interdependence oligopoly price leadership profit maximization

Learning Objectives: Illustrate and discuss oligopoly and monopoly in the context of operating in a market for lobsters.

Explain and evaluate the impact on consumers of the profit maximization strategies by oligopolists and monopolists, including the effects of collusion, price leadership and mutual interdependence in the case of oligopoly.

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2. Exercise

This exercise picks up where the Chapter 5 simulation involving the selling of lobsters left off. Students will rejoin the same groups they were in for the Chapter 5 simulation. Two students from each group will become consumers and gather at the back of the room. One student from each group is acting as a seller and will take a seat at a table at the front of the room.

Timekeeper: Students are given five minutes for each strategy development session and subsequent negotiation.

Stage 1: Each lobster company will be given a set of instructions (below) and five minutes to develop a pricing strategy. At this point the sellers may choose to work together or act alone, although they are still competing on an individual basis. The market will then open.

Give the lobster companies (i.e., the sellers) the following information (and then five minutes to develop a pricing strategy): - The average cost of catching a lobster is $8.

- Your lobster company can collude with other lobster companies, though companies do not have to work together.

- All companies will be selling lobsters to the consumers on the other side of the room.

- Each consumer will have a certain amount of money that they are able to spend on lobster; however, you are not given this information.

- Your goal is to make as much money as you can for your individual company.

Give each of the consumers the following information: - Your goal is to buy as many lobsters as you can.

- You may buy it from any company you want.

- You may not work together with other consumers.

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The consumers will have five minutes to negotiate with the sellers, at the front of the room, to buy as many lobsters as they can purchase with the money they are allotted. Keep track of the prices paid and quantity of lobsters sold at each price.

Stage 2: Reset the game, i.e., return the poker chips and Monopoly money to the sellers and buyers as it was before stage 1, and have the consumers return to the back of the room.

Make an announcement that a large corporation called Seawater Lobster has bought all the lobster companies. Seawater Lobster is able to take advantage of economies of scale in production, reducing the average cost of lobsters to $6. This means that all the sellers now work for the same company, Seawater Lobster.

Now the sellers will get together for five minutes to form a pricing strategy as a single company, Seawater Lobster. The sellers should find a private area to formulate their strategy as a group (perhaps sellers can leave the room to discuss as a group). Select one person to do the negotiations on behalf of their new company.

Consumers are now allowed to work together. The consumers will also be given five minutes to develop their strategy, in a private area where the sellers cannot overhear them. The consumers should consider whether they will all get a better lobster price if they form an alliance and have only one person negotiate for the whole group. If they choose to, the customers should select one person to do the negotiations on behalf of the group of consumers.

After the five minutes of group strategizing, the sellers and consumers will return to the front of the room where the final negotiations will take place. The negotiators from each group, sellers and consumers, will be given five minutes to negotiate for the lobsters in front of the class. Keep track of the prices paid and quantity of lobsters sold at each price.

The results of this exercise will vary depending on how the students approach each portion of the exercise.

Stage 3: For a fuller but more time-consuming simulation: in Stage 2 have the consumers remain independent against the single seller. Then reset the game again for stage 3 and have the 1-143 Copyright © 2023 by McGraw Hill

consumers come together as a single group against the single seller (i.e., form a monopsony to negotiate with the monopoly).

Which segment of this exercise represented an oligopoly? What impact did it have on consumers?

The sellers in stage 1 represented an oligopoly. As a result consumers paid higher prices.* The sellers in stage 1 represented an oligopoly. As a result consumers paid lower prices.

The sellers in stage 2 represented an oligopoly. As a result consumers paid higher prices.

The consumers in stage 2 represented an oligopoly. As a result consumers paid lower prices.

Was there a monopoly in this exercise? If so, how did it affect negotiations between buyers and sellers?

Yes, the customers in stage 2 formed a monopoly. The consumers gained market power.

No, there was not a monopoly.

Yes, Seawater Lobster is a monopoly but there was no impact on the customers.

Yes, Seawater Lobster is a monopoly. The consumers lost market power.*

How did the consumers gain more power in the negotiations?

By negotiating individually against the seller.

By coming together to form a single negotiation team against the sellers.* By forming better individual negotiating tactics.

By forming a monopoly to compete with the sellers.

Explanation: The results of this exercise will vary depending on how the students approach each portion of the exercise.

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The sellers in Stage 1 may have represented an oligopoly because there were few of them.

Presumably consumers paid higher prices than they would have if it was a perfectly competitive industry.

Yes, Seawater Lobster is a monopoly. The sellers had more market power than the consumers.

Consumers gained more power by coming together to form a single negotiation team, a monopsony to negotiate against the monopoly.

Follow-up areas of learning: Discuss why imperfect competition and monopoly exist and why regulation is sometimes necessary to maintain a balance.

3. Discussion Questions (essay)

1. Describe a case in your community where consumers were effectively able to gain more negotiating power when they were facing a monopoly or oligopoly. Describe the situation and what actions were taken.

2. Describe a situation where the government has stepped in to reduce the power of a monopoly or oligopoly.

3. Based on the second segment of this simulation, what possible benefits could lobster companies derive by working together?

4. Describe mutual interdependence and whether it was present in this exercise.

Explanation: 1. Examples could include either formal or informal groupings of buyers.

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2. Examples cited by students could include markets for such products as electrical power, cable TV services and postal mail.

3. Student should discuss the fact that oligopolies and monopolies have increased power over consumers, allowing them to charge higher prices and make higher profits than is typically the case in other types of markets.

4. After providing the definition of mutual interdependence as the relationship among oligopolists in which the actions of one affects the others, they may give an illustration involving how their team planned and set their pricing strategy based on the actions they predicted other teams would take.

4. Multiple Choice Questions

1. If in the first segment of this simulation several lobster sellers worked together to set a price, they would be engaging in: a) a vertical merger. b) nonprice competition. c) collusion.* d) a prisoner‘s dilemma. e) price leadership.

2. When Seawater Lobster purchased the other lobster companies this market became a(n): a) conglomerate merger. b) monopoly.* c) monopolistically competitive industry. d) oligopoly. e) perfectly competitive industry.

3. If one of the lobster companies agreed to set a higher price for the lobster knowing that the other companies agreed to follow suit, this would be considered: a) a horizontal merger. b) government regulation.

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c) price leadership.* d) collusion. e) a cartel.

Explanation: 1. Collusion occurs whenever sellers in a market agree to work together to set price.

2. When Seawater Lobster purchased the other lobster companies this market became a monopoly with only one company now selling the product.

3. If other companies in the market have agreed to follow the price decisions of one of the lobster companies this is considered price leadership.

Chapter 7 Teaching Tips

Excess Benefit and Deadweight Loss Note that the concepts of excess benefit and deadweight loss are closely linked. As the total difference between marginal benefit and marginal cost for all units that are produced or consumed in a market, the concept of excess benefit has the most general application. It can be applied whenever comparisons are being made between marginal benefit and marginal cost in order to see how particular market changes are either add or subtract from the net difference between total benefits and total cost. In the chapter, this concept is used in analyzing the impact of subsidies and taxes geared to reducing spillover benefits and costs.

Deadweight loss is a measure of the reduction in excess benefit that results from policies – such as the creation of government-sanctioned cartels, agricultural price supports, rent controls or the imposition of an excise tax in a market with no pre-existing spillover costs or benefits – where the overall effect is a reduction excess benefit. In these cases, the deadweight loss is a measure of the size of this decrease in excess benefit.

Product Taxes and their Uses A connected issue is the double view of product taxes found in this chapter. In the discussion of spillover effects, product taxes are being used as a means to deal with spillover costs, with the 1-147 Copyright © 2023 by McGraw Hill

aim of augmenting the excess benefit associated with a particular market. In the discussion of excise taxes, on the other hand, the purpose of imposing a product tax is distinct. Now the intent of government policy makers is to generate revenue for government operations. With no spillover costs to correct for, the impact of this form of taxation is to reduce rather than raise excess benefit in the relevant market, as shown by the deadweight loss that is created by such taxes. What the analysis of welfare effects allows policy makers to do is minimize this deadweight loss.

Answers to Thinking about Economics Questions

TAE I, Section 7.1: No. Some consumers can buy a product more cheaply as a result of price discrimination than would be the case if price-discriminating businesses instead charged all their customers the same price.

TAE II, Section 7.2: They do so by charging those who wish to acquire addresses on the Internet.

TAE III, Section 7.4: The market for unskilled labour is the one in which a set minimum wage is mostly likely to exceed the equilibrium wage rate, because wage rates in this market tend to be low.

TAE IV, Section 7.5: Using lifetime incomes rather than annual incomes would make the distribution of income appear more equal, since this would cancel out the wide fluctuations in annual income experienced by individuals over their lifetime.

TAE V, Section 7.5: None of these economic choices is more rational than the others. Each option merely represents different preferences concerning the acquisition of knowledge, and the timing of income flows.

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TAE VI, Section 7.5: An extremely unequal distribution of income may dampen incentives to undertake such income-enhancing strategies as education or saving, since social and economic divisions make individual mobility difficult if not impossible.

Answers to Chapter Problems 7.1 Practice Problem

1. a)

b) The equilibrium price and quantity of $3 and 6 million litres are found at the intersection of D and S0 (point a on the graph). c) The initial consumer and producer surpluses can each be calculated as the areas of triangles (A + B + C) and D shown in the graph. Triangle (A + B + C)‘s height is $2 (= $5−$3), and its base is 6 million litres so the initial consumer surplus is $6 million [= ($2 1-149 Copyright © 2023 by McGraw Hill

× 6 million) / 2]. Triangle D has the same height of $2 (= $3 − $1) and its base is 6 million litres so the initial producer surplus also equals $6 million. d) With the supply curve S1 the new equilibrium price is $4 and the new equilibrium quantity is 3 million litres (point b on the graph). e) The new consumer and producer surpluses are triangles A and B in the graph. Triangle A‘s height is $1 (= $4 − $3) and its base is 3 million litres so the consumer surplus is $1.5 million [= ($1 × 3 million) / 2]. Triangle B has the same height of $1 (= $5 − $4) and its base is 3 million litres so the producer surplus also equals $1.5 million [= ($1 × 3 million) / 2]. f) Due to the reduction in both the consumer surplus and producer surplus both consumers and producers have become worse off.

7.2 Practice Problems

1. a) The disturbance created by the club for nearby residents is a spillover cost. b) The subway‘s reduction of traffic congestion is a spillover benefit. c) Because the existence of the species is a public good poaching that leads to its extinction is a tragedy of the commons. d) The addition to soil pollution caused by throw-away batteries is a spillover cost. e) The reduction in electricity use and carbon emissions stemming from use of the new bulb is a spillover benefit. f) The higher energy use and carbon emissions associated with the new jet is a spillover cost. g) Given that email is a public good its declining usefulness as a result of proliferating spam messages is a tragedy of the commons. h) The spur which opioid prescriptions give to drug abuse is a spillover cost.

2. a) Price ($ per vaccine)

Quantity Demanded (millions of vaccinations per year)

Quantity Demanded (millions of vaccinations per year)

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Quantity Supplied (millions of vaccinations per year)

D0

D1

S

14

-

[0]

8

12

0

[2]

6

10

2

[4]

4

8

4

[6]

2

6

6

[8]

0

b) The equilibrium price of $9 per vaccination and equilibrium quantity of 3 million vaccinations per year are found at the intersection of D0 and S (point d on the graph). c) With a $2 spillover benefit for each vaccination the demand curve incorporating spillover benefits (D1) is vertically higher than the initial demand curve (D0) by $2 at every possible quantity. For example, at the initial quantity of 3 million vaccinations the new price is $2 above the original $9 level at $11 (point a on the graph). The preferred quantity is at the intersection of the new demand curve (D1) and the supply curve (S) with 4 million vaccinations (point b in the graph).

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d) The excess benefit before government intervention is the difference between the demand curve D1 that incorporates the spillover benefits and the supply curve S up to the initial equilibrium quantity of 3 million vaccinations. This is the area (A + B + D) in the graph.

Triangle A‘s height is $3 (= $14 − $11) and its base is 3 million vaccinations so its area is $4.5 million [= ($3 × 3 million) / 2]. Triangle D has the same height of $3 (= $9−$6) and its base is 3 million vaccinations so it also has an area of $4.5 million. Rectangle B has a height of $2 (= $11 − $9) and a width of 3 million vaccinations so its area is $6 million (= $2 × 3 million). The excess benefit is the sum of all three areas. This is $15 million (= $4.5 million + $6 million + $4.5 million). e) A government-imposed $2 subsidy per vaccination shifts demand from D0 to D1 and raises the quantity of vaccinations to the preferred quantity. The price as seen by producers is $10 (point b in the graph) and as seen by consumers is $8 (point c on the graph). f) The total amount spent on the subsidy is found by multiplying the new quantity of 4 million vaccinations by the per unit subsidy of $2. This gives $8 million. g) After the subsidy is in place, quantity rises from 3 to 4 million vaccinations. This rise captures the increase in net benefit shown by triangle C in the graph. C‘s area can be found by dividing it into two triangles. The upper of these triangles has a height of $1 (= $11−$10) and a base of 1 million vaccinations so its area is $500,000 [= ($1 × 1 million) / 2]. The lower of these triangles has the same height of $1 (= $10−$9) and a base of 1 million vaccinations so its area also equals $500,000. The area of C is the sum of these two triangles. This equals $1 million. The new excess benefit is the area (A + B + C + D).

This is the sum of the $15 million area of (A + B + D) found in part f and the $1 million area of C. So, the new excess benefit is $16 million. h) Given the appearance of a new related virus, the spillover benefit of the vaccine is bound to increase. This shifts the demand curve D1 that incorporates spillover benefits outwards and therefore increases the preferred quantity of the vaccine as well.

7.3 Practice Problem 1. a) Price ($ per kg)

Quantity Demanded (millions of kg per year)

Quantity Supplied0 (millions of kg per year)

Quantity Supplied1 (millions of kg per year)

D

S0

S1

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12

-

10

[6]

11

0

8

[4]

10

2

6

[2]

9

4

4

[0]

8

6

2

[0]

7

8

0

[0]

b) The initial equilibrium price and quantity of $9 and 4 million kilograms are found at the intersection of D and S0 (point c on the graph). c) With the $2 excise tax, the after-tax supply curve S1 is vertically higher than the initial supply curve S0 by $2 at every possible quantity. For example, at the initial quantity of 4 million kilograms, the new price is $2 above the original $9 level at $11 (point b on the graph). This means that quantity supplied is 0 kilograms at several possible prices – $7, $8 and $9. d) The new equilibrium price as seen by consumers and equilibrium quantity are $10 and 2 million kilograms (point a in the graph). The price as seen by producers is $8 (point d on the graph).

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e) The total tax payment is the area of the rectangle (B + D) in the graph, or $4 million (= $2 × 2 million). The portion that falls on consumers (area B in the graph) is $2 million (= $1 × 2 million), while the portion that falls on producers (area D in the graph) is also $2 million (= $1 × 2 million). f) The consumer surplus and producer surplus before the tax are the areas of the triangles (A + B + C) and (D + E + F) in the graph. Triangle (A + B + C)‘s height is $2 (= $11 − $9) and its base is 4 million kilograms. So, the initial consumer surplus is $4 million [= ($2 × 4 million) / 2]. Triangle (D + E + F) has the same height of $2 (= $9−$7) and base of 4 million kilograms so the initial producer surplus is also $4 million. g) The consumer surplus and producer surplus after the tax are the areas of triangles A and F in the graph. Triangle A‘s height is $1 (= $11 − $10) and its base is 2 million kilograms so the consumer surplus is $1 million [= ($1 × 2 million) / 2]. Triangle F has the same height of $1 (= $8 − $7) and base of 2 million kilograms so the producer surplus is also $1 million. h) Due to the tax, both the consumer surplus and producer surplus fall from $4 million to $1 million so that the loss of welfare is the same for consumers and producers. i) The deadweight loss of the tax is (C + E). Triangle C‘s height is $1 (= $10 − $9) and its base is 2 million kilograms so its area is $1 million [= ($1 × 2 million) / 2]. Triangle E has the same height of $1 (= ($9−$8) and base is 2 million kilograms so its area is also $1 million. The deadweight loss is the sum of these two amounts combined, or $2 million.

7.4 Practice Problems 1. a)

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b) The initial equilibrium price and quantity of $0.80 and 60 million kilograms are found at the intersection of D and S (point a in the graph). Consumers‘ total expenditure and producers‘ total revenue are both equal to the area of the rectangle (C + D) in the graph whose height is $0.80 and width is 60 million litres. This amount is $48 million (= $0.80 × 60 million). c) The $0.90 price support creates an annual surplus of 20 million (= 70 million − 50 million) litres. This is the distance between points b and c in the graph. d) Consumers are made worse off by the program because they buy less of the product at a higher price. Their total expenditure is the area of the rectangle (A + C) in the graph. This rectangle‘s height is $0.90 and its width is 50 million litres so the new consumer expenditure is $45 million (= $0.90 × 50 million). Producers benefit through selling a higher quantity at a higher price. Their total revenue becomes the area of the rectangle (A + B + C + D + E). This rectangle‘s height is $0.90 and its width is 70 million litres so the new total revenue for producers is $63 million (= $0.90 × 70 million). e) The cost of the program to taxpayers is the government‘s total expenditure to purchase the surplus. This is the area of the rectangle (B + D + E) in the graph. This rectangle‘s height is $0.90 and its width is 20 million (= 70 million − 50 million) litres so the total cost to taxpayers is $18 million (= $0.90 × 20 million).

2. a)

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b) The initial equilibrium rent and quantity of $1,200 and 40,000 units are found at the intersection of D and S (point a in the graph). c) The $800 price ceiling creates a shortage of 20,000 (= 30,000 − 50,000) units, as shown by the distance between points b and c in the graph. Tenants who are able to find units at the ceiling price are made better off because they pay less than the original $1,200 price.

Landlords are made worse off because of this reduction in rent. d) Total revenue before controls is $48 million. It is found by multiplying the initial rent of $1,200 by the initial quantity of 40,000 units. Total revenue after controls are imposed becomes $24 million. This is found by multiplying the new rent of $800 by the new quantity of 30,000 units.

7.5 Practice Problems 1. a) 1

2

3

4

5

Annual Income ($)

5,000

10,000

15,000

30,000

40,000

Share of income (%)

[5]

[10]

[15]

[30]

[40]

Cumulative share of income (%)

[5]

[15]

[30]

[60]

[100]

Household

Total income earned in Libra is $100,000 (= $5,000 + $10,000 + $15,000 + $30,000 + $40,000). The shares of income earned by the five households are 5% [= ($5,000 / $100 000) 1-156 Copyright © 2023 by McGraw Hill

× 100%], 10% [= ($10,000 / $100,000) × 100%], 15% [= ($15,000 / $100,000) × 100%], 30% [= ($30,000 / $100,000) × 100%], and 40% [= ($40,000 / $100,000) × 100%]. b) The cumulative shares of income earned by each household are 5%, 15% (= 5 + 10), 30% (= 5 + 10 + 15), 60% (= 5 + 10 + 15 + 30) and 100% (= 5 + 10 + 15 + 30 + 40). c)

2. a) The Saskatchewan carpenter probably earns more. This is primarily due to regional disparities. b) The truck driver probably earns more. This is primarily due to more unpleasant job conditions. c) The postal worker probably earns more. This is primarily due to the fact that the postal worker is unionized while the courier company employee is probably not unionized. d) The warehouse clerk probably earns more. This is primarily due to discrimination on the basis of gender. While restaurant jobs are dominated by low-paid female labour, warehouse clerks are usually men. e) The lawyer probably earns more. This is primarily due to the greater amount of education required to be a lawyer. f) The clerk who works on commission probably earns more. This is due to the higher income needed to remunerate the risks associated with commission income. g) The landlord probably earns more. This is primarily due to their greater ownership of wealth. h) The programmer who has won the coding competition probably earns more. This is primarily due to ability.

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End of Chapter Problems 1. a)

b) The equilibrium price and quantity of $1.50 and 2 million kilograms are found at the intersection of D and S (point a in the graph). c) The initial consumer surplus and producer surplus are the areas of the triangles (A + B + C) and (D + E) in the graph. Triangle (A + B + C)‘s height is $1 (= $2.50 − $1.50), and its base is 2 million kilograms so the initial consumer surplus is $1 million [= ($1 × 2 million) / 2]. Triangle (D + E) has the same height of $1 and its base is 2 million kilograms so the initial producer surplus also equals $1 million. d) The equilibrium price at the restricted quantity of 1 million kilograms is $2 (point b in the graph). e) The transfer of consumer surplus to producer surplus is the area of rectangle B in the graph. This rectangle‘s height is $0.50 (= $2−$1.50) and its width is 1 million kilograms so the transfer of consumer surplus to producer surplus equals $500,000 [= ($0.50 × 1 million)]. The deadweight loss is the area of triangle (C + E) in the graph. Triangle C‘s height is $0.50 (= $2 − $1.50) and base is 1 million kilograms so its area is $250,000 [= ($0.50 × 1 million) / 2]. Triangle E has the same height of $0.50 (= $1.50 − $1) and base of 1 million kilograms so its area also equals $250,000. The sum of these two triangles is $500,000.

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f) The transfer of consumer surplus to producer surplus means that consumers are worse off and producers still operating in the market are better off due to the output restriction. g) The deadweight loss is a dollar estimate of how much society as a whole is made worse off by the output restriction. The area C + D represents the loss in surplus due to mutually beneficial trades that will not occur as a result of the output restriction.

2. a)

Quantity Demanded (kg per day)

Quantity Demanded (millions of kg per day)

Quantity Supplied (millions of kg per day)

D0

D1

S

-

[0]

12,000

8

0

[4,000]

8,000

6

4,000

[8,000]

4,000

4

8,000

[12,000]

0

2

12,000

[16,000]

-

Price ($ per kg)

10

b) The equilibrium price of $6 per kilogram and equilibrium quantity of 4,000 kilograms per day are found at the intersection of D0 and S (point d on the graph). c) With a $2 spillover benefit for each kilogram, the demand curve incorporating spillover benefits (D1) is vertically higher than the initial demand curve (D0) by $2 at every possible quantity. For example, at the initial quantity of 4,000 kilograms the new price is $2 above the original $6 level at $8 (point a on the graph). The preferred quantity is at the intersection of the new demand curve (D1) and the supply curve (S) with 6,000 kilograms (point b in the graph). d) The excess benefit before government intervention is the difference between the demand curve D1 that incorporates the spillover benefits and the supply curve S up to the initial equilibrium quantity of 4,000 kilograms. This is the area (A + B + D) in the graph.

Triangle A‘s height is $2 (= $10 − $8) and its base is 4,000 kilograms so its area is 1-159 Copyright © 2023 by McGraw Hill

$4,000 [= ($2 × 4,000) / 2]. Triangle D has the same height of $2 (= $6 − $4) and its base is 4,000 kilograms so it also has an area of $4,000. Rectangle B has a height of $2 (= $8−$6) and a width of 4,000 kilograms so its area is $8,000 (= $2 × 4,000). The excess benefit is the sum of all three areas. This is $16,000 (= $4,000 + $8,000 + $4,000). e) A government-imposed $2 subsidy per kilogram shifts demand from D0 to D1 and raises the quantity of honey to the preferred quantity. The price as seen by producers is $7 (point b in the graph) and as seen by consumers is $5 (point c on the graph). f) The total amount spent on the subsidy is found by multiplying the new quantity of 6,000 kilograms by the per unit subsidy of $2. This gives $12,000. g) After the subsidy is in place, quantity rises from 4,000 to 6,000 kilograms. This rise captures the increase in net benefit shown by triangle C in the graph. C‘s area can be found by dividing it into two triangles. The upper of these triangles has a height of $1 (= $8 − $7) and a base of 2,000 kilograms so its area is $1,000 [= ($1 × 2,000) / 2]. The lower of these triangles has the same height of $1 (= $7 − $6) and a base of 2,000 kilograms so its area also equals $1,000. The area of C is the sum of these two triangles.

This equals $2,000. The new excess benefit is the area (A + B + C + D). This is the sum of the $16,000 area of (A + B + D) found in part f and the $2,000 area of C. Thus, the new excess benefit is $18,000.

3. a) Price Quantity Demanded Quantity Supplied0 Quantity Supplied1 ($ per kg) (millions of kg per year) (millions of kg per year) (millions of kg per year) D

S0

S1

12

0

20

[16]

10

4

16

[12]

8

8

12

[8]

6

12

8

[4]

4

16

4

[0]

2

20

0

[0]

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b) The initial equilibrium price and quantity of $7 and 10 million packs are found at the intersection of D and S0 (point a on the graph). c) With the $2 excise tax the after-tax supply curve S1 is vertically higher than the initial supply curve S0 by $2 at every possible quantity. For example, at the initial equilibrium quantity of 10 million packs, the new price is $2 above the original $7 level at $9 (point b on the graph). This means that quantity supplied on S1 is 0 packs at two possible prices – $4 and $2. The preferred quantity is now 8 million units. d) The excess benefit before the tax is the difference between D and the supply curve S1 that incorporates the spillover costs. This includes all the area of triangle A in the graph.

Because S1 is above D between the quantities 8 million and 10 million the triangle B represents a negative excess benefit whose area must be deducted from the area of triangle A. Triangle A can be treated as two identical triangles. The first has a height of $4 (= $12 − $8) and a base of 8 million packs so its area is $16 million [= ($4 × 8 million) / 2]. The second triangle has the same height of $4 (= $8 − $4) and a base of 8 million packs so also has an area of $16 million. So, triangle A has a total area of $32 million.

Triangle B can be treated as two identical triangles. The first triangle has a height of $1 (= $9 − $8) and a base of 2 million packs so has an area of $1 million [= ($1 × 2 million) / 2]. The second triangle has the same height of $1 [= ($8 − $7) / 2] and a base of 2 million packs so its area is also $1 million. This means triangle B has a total area of $2 million. Total excess benefit is the difference between triangles A and B and is therefore $30 million (= $32 million − $2 million).

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e) A $2 tax shifts supply from S0 to S1 and reduces the quantity of cigarettes to the preferred quantity. The price as seen by consumers is $8 (point d in the graph) and as seen by producers is $6 (point c on the graph). f) The total revenue from the tax is found by multiplying the new quantity of 8 million packs by the $2 tax, or $16 million. g) After the tax is in place, quantity falls from 10 to 8 million. This drop extinguishes the negative excess benefit shown by the area of triangle B. This means the excess benefit in this market is now the full area of triangle A which is $32 million.

4. a) The initial equilibrium price and quantity of $1.80 and 12 million shakes are found at the intersection of D and S0 (point c in the graph). b) The amount of the excise tax is shown by the vertical distance between S0 and S1. The after-tax supply curve S1 is $0.30 higher than S0 at every possible quantity. For example, at the initial quantity of 12 million shakes price rises from $1.80 to $2.10 (point b on the graph). So, the tax is 30 cents per shake. c) The new equilibrium price as seen by consumers and quantity are $1.90 and 8 million shakes (point a in the graph). The price as seen by producers is $1.60 (point d on the graph). d) The total tax payment is area (B + D) in the graph, or $2.4 million (= $0.30 × 8 million).

The portion that falls on consumers (area B in the graph) is $800,000 (= $0.10 × 8 million) while the portion that falls on producers (area D in the graph) is $1.6 million (= $0.20 × 8 million). e) The consumer surplus and producer surplus before the tax are the areas of triangles (A + B + C) and (D + E + F) in the graph. Triangle (A + B + C)‘s height is $0.30 (= $2.10 − $1.80) and its base is 12 million shakes so the initial consumer surplus is $1.8 million [= ($0.30 × 12 million) / 2]. Triangle (D + E + F)‘s height is $0.60 (= $1.80 − $1.20) and its base is 12 million so the initial producer surplus is $3.6 million [= ($0.60 × 12 million) / 2]. f) The consumer surplus and producer surplus after the tax are the areas of triangles A and F in the graph. Triangle A‘s height is $0.20 (= $2.10 − $1.90) and its base is 8 million so the new consumer surplus is $800,000 [= ($0.20 × 8 million) / 2]. Triangle F‘s height is $0.40 (= $1.80 − $1.20) and its base is 8 million so the new producer surplus is $1.6 million [= ($0.40 × 8 million) / 2]. g) The loss of consumer surplus is $1 million (= $1.8 million − $800,000) and the loss of producer surplus is $ 2 million (= $3.6 million − $1.6 million) so that the loss of welfare is greater for producers than for consumers.

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h) The deadweight loss of the tax is (C + E). Triangle C‘s height is $0.10 (= $1.90 − $1.80) and its base is 4 million shakes so its area is $200,000 [= ($0.10 × 4 million) / 2].

Triangle E‘s height is $0.20 (= $1.80 − $1.60) and base is 4 million kilograms so its area is $400,000 [= ($0.20 × 4 million) / 2]. The deadweight loss is the sum of these two amounts, or $600,000.

5. a) Quantity Demanded (thousands of kg per year)

Quantity Supplied (thousands of kg per year)

Quantity Supplied (thousands of kg per year)

D

S0

S1

20

-

500

[300]

18

0

400

[200]

16

100

300

[100]

14

200

200

[0]

12

300

100

[0]

10

400

0

[0]

Price ($ per kg)

b) The initial equilibrium price and quantity of $14 and 200,000 kilograms are found at the intersection of D and S0 (point c on the graph). c) With the $4 excise tax, the after-tax supply curve S1 is vertically higher than the initial supply curve S0 by $4 at every possible quantity. For example, at the initial quantity of 200,000 kilograms, the new price is $4 above the current $14 level at $18 (point b on the 1-163 Copyright © 2023 by McGraw Hill

graph). This means that quantity supplied is 0 kilograms at several possible prices – $10, $12 and $14. d) The new equilibrium price as seen by consumers and equilibrium quantity are $16 and 100,000 kilograms (point a in the graph). The price as seen by producers is $12 (point d on the graph). e) The total tax payment is the area of the rectangle (B + D) in the graph, or $400,000 (= $4 × 100,000). The portion that falls on consumers (area B in the graph) is $200,000 (= $2 × 100,000), while the portion that falls on producers (area D in the graph) is also $200,000 (= $2 × 100,000). f) The consumer surplus and producer surplus before the tax are the areas of the triangles (A + B + C) and (D + E + F) in the graph. Triangle (A + B + C)‘s height is $4 (= $18 − $14) and its base is 200,000 kilograms. So, the initial consumer surplus is $400,000 [= ($4 × 200,000) / 2]. Triangle (D + E + F) has the same height of $4 (= $14 − $10) and base of 200,000 kilograms so the initial producer surplus is also $400,000. g) The consumer surplus and producer surplus after the tax are the areas of triangles A and F in the graph. Triangle A‘s height is $2 (= $18 − $16) and its base is 100,000 kilograms so the consumer surplus is $100,000 [= ($2 × 100,000) / 2]. Triangle F has the same height of $2 (= $12 − $10) and base of 100,000 kilograms so the producer surplus is also $100,000. h) Due to the tax, both the consumer surplus and producer surplus fall from $400,000 to $100,000 so that the loss of welfare is the same for consumers and producers. i) The deadweight loss of the tax is (C + E). Triangle C‘s height is $2 (= $16 − $14) and its base is 100,000 kilograms so its area is $100,000 [= ($2 × 100,000) / 2]. Triangle E has the same height of $2 (= ($14 − $12) and base is 100,000 kilograms so its area is also $100,000. The deadweight loss is the sum of these two amounts combined, or $200,000.

6. a)

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b) The initial equilibrium price and quantity of $6 and 2 million kilograms are found at the intersection of D and S0 (point a in the graph). c) After the $8 minimum price is imposed, the new quantity demanded is 1 million kilograms and the new quantity supplied is 3 million kilograms. Unless the government imposes additional policies there is a potential surplus of 2 million (= 3 million − 1 million) kilograms as shown by the horizontal distance between points b and c in the graph. d) The consumer surplus and producer surplus before controls are the areas of triangles (A + B + C) and (D + E + F) in the graph. Triangle (A + B + C)‘s height is $4 (= $10 − $6) and its base is 2 million kilograms so the initial consumer surplus is $4 million [= ($4 × 2 million) / 2]. Triangle (D + E + F) has the same height of $4 (= $6 − $2) and its base is 2 million kilograms so the initial producer surplus is also $4 million. e) The consumer surplus and producer surplus after controls are the areas A and (B + D + F) in the graph. Triangle A‘s height is $2 (= $10−$8) and its base is 1 million units so the new consumer surplus is $1 million [= ($2 × 1 million) / 2]. Area (B + D + F) can be treated as the sum of areas (B + D) and F. Rectangle (B + D)‘s height is $4 (= $8 − $4) and its width is 1 million kilograms so its area is $4 million (= $4 × 1 million). Triangle F‘s height is $2 (= $4 − $2) and its base is 1 million kilograms so its area is $1 million [= ($2 × 1 million) / 2]. The new producer surplus is the sum of these two amounts. This equals $5 million. f) Due to the combined polices, the consumer surplus falls from $4 million to $1 million and the producer surplus rises from $4 million to $5 million. Therefore, consumers are made worse off and producers are made better off.

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g) The deadweight loss created by these combined policies is the area of triangle (C + E) in the graph, which can be treated as the sum of the two triangles C and E. Triangle C‘s height is $2 (= $8 − $6) and its base is 1 million kilograms so its area is $1 million [= ($2 × 1 million) / 2]. Triangle E has the same height of $2 and base of 1 million kilograms so its area is also $1 million. The deadweight loss is the sum of these two amounts. This equals $2 million. h) With S1 the surplus created by the policy increases to 3 million (= 4 million − 1 million) kilograms. This is shown by the distance between points b and d in the graph.

7. a)

b) The initial equilibrium price and quantity of $600 and 4,000 units are found at the intersection of D0 and S (point a in the graph). c) The $400 price ceiling means a new quantity of 2,000 units and a shortage of 4,000 (= 2,000 − 6,000) units. This is shown by the difference in the horizontal distance between points b and c in the graph. d) The initial consumer surplus and producer surplus are the areas (A + B + C) and (D + E + F) in the graph. Triangle (A + B + C)‘s height is $400 (= $1,000 − $600) and its base is 4,000 units so the initial consumer surplus is $800,000 [= ($400 × 4,000) / 2]. Triangle (D + E + F) has the same height of $400 (= $600 − $200) and its base is 4,000 units so the initial producer surplus is also $800,000. e) The new consumer surplus and producer surplus are the areas (A + B + D) and F in the graph. The first area can be treated as the sum of triangle A and rectangle (B + D).

Triangle A‘s height is $200 (= $1,000 − $800) and its width is 2,000 units so its area is $200,000 [= ($200 × 2,000) / 2]. Rectangle (B + D)‘s height is $400 (= $800 − $400) and 1-166 Copyright © 2023 by McGraw Hill

its width is 2,000 units so its area is $800,000 (= $400 × $2,000). The new consumer surplus is the sum of these two amounts, equaling $1,000,000. Triangle F‘s height is $200 (= $400 − $200) and its base is 2,000 units so the new producer surplus is $200,000 [= ($200 × 2,000) / 2]. f) Due to the controls the consumer surplus rises from $800,000 to $1,000,000 and the producer surplus falls from $800,000 to $200,000. Therefore, tenants who are able to find units at the ceiling price are made better off and landlords are made worse off. g) The deadweight loss is the area of the triangle (C + E) in the graph. This can be treated as the sum of the triangles C and E. Triangle C‘s height is $200 (= $800 − $600) and its base is 2,000 units so its area is $200,000 [= ($200 × 2,000) / 2]. Triangle E has the same height of $200 and its base is 2,000 so its area is also $200,000. The deadweight loss is these two amounts combined. That equals $400,000. h) With D1, the shortage created by the policy increases to 6,000 (= 2,000 − 8,000), which is shown by the distance between points a and d in the graph.

8. a) 1

2

3

4

(lowest)

5 (highest)

Country 1

[7]

[11]

[17]

[24]

[41]

Country 2

[5]

[10]

[15]

[25]

[45]

Country 3

[9]

[14]

[18]

[23]

[36]

For Country 1 the cumulative shares received by each group are 7%, 18% (= 7 + 11), 35% (= 18 + 17), 59% (= 35 + 24), and 100% (= 59 + 41). For Country 2 the shares are 5%, 15% (= 5 + 10), 30% (= 15 + 15), 55% (= 30 + 25), and 100% (= 55 + 45). For Country 3 they are 9%, 23% (= 9 + 14), 41% (= 23 + 18), 64% (= 41 + 23), and 100% (= 64 + 36). b)

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c) Country 3 has the most equal distribution of income because its Lorenz curve is closer to the 45-degree line in the graph than the curves for the other two countries. Country 2 has the most unequal distribution of income because its Lorenz curve is farther from the 45degree line in the graph than the curves for the other two countries. The Lorenz curve for Country 1 is between those for the other two countries.

9. a) 1

2

3

4

5

Total Income in Group ($)

[300]

[700]

[1,100]

[1,500]

[1,900]

Share of Total Income (%)

[5]

[13]

[20]

[27]

[35]

Cumulative share of income (%)

[5]

[18]

[38]

[65]

[100]

Income Group

The total incomes in each group are $300 (= $100 + $200) for the lowest, followed by $700 (= $300 + $400), $1,100 (= $500 + $600), $1,500 (= $700 + $800) and $1,900 (= $900 + $1,000). Total income earned in Harmonia is $5,500 (= $300 + $700 + $1,100 + $1,500 + $1,900). The shares of income earned by the five groups are 5% [= ($300 / $5,500) × 100%], 13% [= ($700 / $5,500) × 100%], 20% [= ($1,100 / $5,500) × 100%], 27% [= ($1,500 / $5,500) × 100%], and 35% [= ($1,900 / $5,500) × 100%]. b) The cumulative shares of income earned by each household are 5%, 18% (= 5 + 13), 38% (= 5 + 13 + 20), 65% (= 5 + 13 + 20 + 27) and 100% (= 5 + 313 + 20 + 27 + 35). c)

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10. a) For income before transfer payments and personal income taxes the cumulative shares received by each group are 1%, 8% (= 1 + 7), 22% (= 8 + 14), 47% (= 22 + 25), and 100% (= 47 + 53).

For income after transfer payments and personal income taxes the shares are 5%, 16% (= 5 + 11), 33% (= 16 + 17), 57% (= 33 + 24), and 100% (= 57 + 43).

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b) The Lorenz curve for income after transfer payments and taxes is significantly closer to the line of perfect equality (the straight diagonal in the graph), which shows that government intervention in the form of transfer payments and taxes has made the distribution of income more equal.

11. a) Because the Gini coefficient has risen, the distribution of Canadian pre-tax income has become more unequal. b)

Country

Gini Coefficient

Order from:

Germany

0.289

1. most equal

France

0.301

2

Canada

0.303

3

Italy

0.330

4

Japan

0.334

5

United Kingdom

0.366

6

United States

0.393

7. least equal

Given that the country ranking is from most equal to least equal, the first-ranked country is the one with the lowest Gini coefficient (Germany) and the last-ranked country is the one with the highest coefficient (the United States).

12. a) Governments would apply subsidies to products such as speed-limiting devices on cars, or certain types of building insulation, that lead to net reductions in emissions. b) If the introduction of carbon taxes were made revenue-neutral, for example through a decrease in income tax rates, then residents of large urban centres who bike or take rapid transit rather than owning a car would probably end up paying less tax than before.

Similarly, those individuals able to work from home would probably pay less tax. On the other hand, most rural inhabitants, who tend to depend on cars for mobility, would likely pay. So would individuals whose careers involve a great deal of travel either by car or airplane.

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Advancing Economic Thought Problems 1.

a) The most desirable point is at d, with 10 tonnes of carbon emissions reduced (distance a to b) and 20 tonnes still produced (distance c to b). At this point, Company A is no longer emitting tonnes of carbon for which the marginal benefit of carbon reduction, MBCR, exceeds the marginal cost of carbon reduction MCCR. b) The excess benefit of carbon reduction is found by calculating the area of triangle A, or $200 million [= ($40 × 10 million)/2]. This is the amount by which the total benefit of carbon reduction, or the area of rectangle (A + B), is greater than the total cost of carbon reduction, the area of triangle B. c) Point d is attained with a carbon tax of $40, so that the tax line showing the impact of the tax exactly matches the MBCR line. At this dollar amount the emissions between points a and b are all subject to reduction, since it is more expensive to pay the $40 tax than it is to incur the marginal cost of carbon reduction as shown by the height of the MCCR curve. d) Point d is attained when the cap is set at 10 million tonnes. With this cap the company will choose to emit 20 million tonnes and cut back on the other 10 million.

In-class Activities

Activity 1

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1. Introductory Information

Time: Approximately 20 minutes.

Materials: Photocopies of the three cases found below.

Case A (enough copies for half the class): −You are a landlord. −You have been in business for 25 years. −Rent controls have been imposed in your city. −You cannot rent your apartments for any monthly price higher than $500, but you know that, because of the shortage of apartments, you can find many other prospective tenants willing to pay the controlled rent of $500. −You do not have to disclose this information during your negotiations.

Case B (enough copies for one quarter of the class): −You are a student looking for a new apartment. −You have a part-time job and some student loans. −This is not your favorite apartment or the best location. −You estimate that the maximum monthly rent you can afford is $600, but that at any amount above $400 your budget is becoming stretched. −You realize you are living in a city with rent controls. −If you do not reach a deal for an apartment, you will be forced to move in with a high school friend, who, while eager to have you as a roommate, is untidy, financially undependable, and loves playing music at full volume at 2 am. −You do not have to disclose this information during your negotiations.

Case C (enough copies for one quarter of the class):

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−You are a student looking for a new apartment. −You have a part-time job and some student loans. −You estimate you can afford up to $800 per month in rent. −You realize you are living in a city with rent controls. −While your goal is to rent an apartment at a reasonable price, it is acceptable if you do not reach a deal with a landlord. Your parents live down the street and have offered you the option of living at home at a cost of $200 per month to help them cover expenses. −You do not have to disclose this information during your negotiations.

Set-up: 1) Place all students in pairs facing each other. One student will be a landlord and the other a tenant.

2) The landlords will be given Case A. 3) Half the tenants will be given Case B and the other half Case C. The students must not share the information provided in the cases with their partner they are negotiating with.

4) Each pair will be given five minutes to reach a deal on the apartment rental. If they reach a deal, the landlord and tenant write a statement (the rental contract) of the agreed-upon monthly rent.

Key Concepts Covered: price ceiling price elasticity of demand shortage

Learning Objectives: −Draw and discuss the market demand and market supply curves for apartments. −Evaluate the effects of the shortage created by rent controls as an example of a price ceiling, based on hands-on experience with negotiations for apartments. −Explain some of the factors that affect price elasticity of demand.

2. Exercise

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Recall that the class has been divided evenly into pairs. In each pair, one student will be a landlord and the other a tenant.

Students as landlords: The landlords will be given Case A.

Students as tenants: Half the tenants will be given Case B and the other half Case C. The students must not share the information provided in the cases with their partner they are negotiating with.

Timekeeper: students will be given 5 minutes to negotiate. Sit facing your partner and begin negotiations by making an opening offer.

Procedure: If not already done, students acting as landlords will be given Case A. Half the tenants will be given Case B and the other half Case C. Sit facing your partner and once time starts, begin negotiations by making an opening offer. You are not allowed to share the information with your partner during the case. If they reach a deal, the landlord and tenant write a statement (the rental contract) of the agreed-upon monthly rent.

A student with Case B may choose not to sign a rental agreement with the landlord because of budget constraints.

And a student with Case C may choose not to reach a deal with the landlord because of available substitutes.

Assuming the rent controls cause an apartment shortage, students with Case B are made worse off by the controls.

Explanation: Many of the students with Case B, and some with Case C, will have not reached a deal with their landlords. Those with Case B can cite the budget constraints they face. Those with Case C can cite the option to stay with their parents at a low monthly cost. Many of the tenants with less 1-174 Copyright © 2023 by McGraw Hill

attractive options (i.e., with Case B) were the ones most harmed by the apartment shortage (landlords with many potential tenants may choose not to enter agreements with renters with situations like case B).

Follow-up areas of learning: −Discuss the impact of the access to substitutes and the status of an apartment as a luxury as opposed to a necessity, in the case of students with Case C, on the price elasticity of demand. −Discuss the potential inequities of the shortage that results from a price ceiling such as rent controls. While some of the students who have not reached a deal with their landlords will be able to reach an agreement with other landlords, others will not.

3. Discussion Questions (essay) Note that this question will be manually graded by your instructor.

1. a. Show a shortage of apartments in a market with rent controls in the demand and supply graph below. Use the double headed arrow tool to show a shortage. [instructor-marked graph] b. Refer to the simulation to explain how the effects of the shortage created by this price ceiling can be inequitable for tenants.

Only the tenants with more attractive options (i.e., with Case C) were harmed by the apartment shortage.

Only the tenants with less attractive options (i.e., with Case B) were harmed by the apartment shortage.

Many of the tenants with less attractive options (i.e., with Case B) were the ones most harmed by the apartment shortage.* Many of the tenants with more attractive options (i.e., with Case C) were the ones most harmed by the apartment shortage 2. a. How would you classify a product such as a rented apartment?

An apartment is always a necessity.

An apartment is a luxury for those with no other options but a necessity for those with alternatives.

For a student, a private apartment is always a luxury.

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An apartment is a necessity for those with no other options but a luxury for those with alternatives.* b. What impact does this have on the price elasticity of demand? Use an example from the exercise.

The price elasticity of demand is less for those students who have alternative options The price elasticity of demand is greater for those students who have alternative options.*

3. What is the current situation regarding rent controls in your city? What is the vacancy rate?

Describe the real market for apartments in your city.

[instructor-marked answer box] Explanation: 1. a. See solution graph above. A shortage is shown with a price below equilibrium where the demand curve lies to the right of the supply curve. Because the controlled price is below equilibrium, the size of the gap between demand and supply is the value of the shortage at that price.

b. Many of the tenants with less attractive options (i.e., with Case B) were the ones most harmed by the apartment shortage. But those tenants, with Case B, who can obtain a rentcontrolled apartment are made better off by rent controls.

2. a. An apartment is a necessity for those students with no other options and a luxury for those who could live with their parents.

b. The price elasticity of demand is greater for those students who have the option of living with their parents.

3. The answer will depend on your city. British Columbia has rent controls. Ontario has more complicated rent control rules that depend on a number of factors like the age of the property.

Students from other countries may share their knowledge of the situation in other national contexts.

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And many of those who do not manage to rent an apartment will be those with less attractive options (i.e., those with Case B).

4. Multiple Choice Questions

1. When the government imposes rent controls, it creates a shortage. a) surplus. b) shortage.* c) rightward shift in supply d) rightward shift in demand e) leftward shift in demand

2. The following factor(s) have an effect on a product‘s price elasticity of demand:

a) access to substitutes for the product. b) the amount of time households have to change their buying habits. c) the portion of income represented by expenditure on the product. d) whether the product is a necessity or a luxury. e) all of the above.*

3. If you have the option to live at a low monthly cost in your parents‘ house, then as a prospective tenant you:

a) have access to a complementary product. b) consider renting an apartment to be a necessity. c) would have a more inelastic demand curve than someone who did not have this option d) have access to a substitute product.* e) gain more utility from renting an apartment than would someone without this option

4. In the long run, the greater ability of landlords to adjust their quantity supplied of apartments would cause the supply curve to

a) be more elastic.* b) be more inelastic.

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c) shift to the right. d) shift to the left. e) remain unchanged.

5. In the long run, the greater ability of tenants to adjust their quantity demanded of apartments would cause the demand curve to

a) be more elastic.* b) be more inelastic. c) shift to the right. d) shift to the left. e) remain unchanged.

Explanation: 1) When the government imposes rent controls these are set below what would otherwise be the equilibrium rent. With this lower price the quantity demanded is higher and the quantity supplied is lower than it would be at equilibrium. Therefore, it creates a shortage.

2) The following factor(s) have an effect on a product‘s price elasticity of demand. All of the options: the portion of income represented by expenditure on the product; access to substitutes for the product; whether the product is a necessity or a luxury; the amount of time households have to change their buying habits.

3) If you are a prospective tenant the option of living at a low monthly cost in your parents‘ house represents access to a substitute product.

4) In the long run, the greater ability of landlords to adjust their quantity supplied of apartments would cause the supply curve to be more elastic, with a given change in price leading to a larger change in quantity supplied.

5) In the long run, the greater ability of tenants to adjust their quantity demanded of apartments would cause the demand curve to be more elastic, with a given change in price leading to a larger change in quantity demanded.

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Activity 2

1. Introductory Information

Time: Approximately 30 minutes.

Materials: No Materials are necessary.

Set-up: Divide the class into groups of four students.

In each group two students will represent ―Further Education‖ and the other two will represent ―Working Immediately.‖ The students should be seated in pairs facing each other.

Following the debate, the instructor will bring all of the ideas together for a full class discussion of the arguments presented in the debate.

Key Concepts Covered: human capital job discrimination labour productivity seniority rights wealth

Learning Objectives: Illustrate and discuss the reasons for income inequality in society and the impact it has on the career decisions we make in our lives.

Explain and evaluate the decision to pursue postsecondary education based on the concept of human capital.

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Demonstrate an understanding of the impact on income distribution of such factors as labour productivity, job discrimination, seniority rights and wealth.

2. Exercise (essay)

Recall that students are in groups of four, seated in pairs facing each other. From each group, two students will represent “Further Education” and the other two students will represent “Working Immediately.”

Timekeeper: Each pair will be given ten minutes to prepare their arguments and, following that, ten minutes to debate the topic.

Stage 1: Each pair of students will be given ten minutes to find their own space, away from the rest of their group, in order to prepare their case. After the ten minutes, the students will return to their positions.

The students will be given ten minutes to debate the topic, ―It is economically beneficial to pursue a postsecondary education?‖ in their groups of four. During the debate the students should be keeping notes of the arguments

Stage 2: Following the debates the instructor will create a list of the pros and cons for postsecondary education on the board. This will give each pair an opportunity to share their arguments with the rest of the class.

Students should address issues such as opportunity cost, income distribution and the number of people with postsecondary education. The instructor can also encourage students to analyze the independent roles played by such factors as ability, experience, seniority rights, job conditions, discrimination, risk-taking, regional disparities, trade unions, and wealth.

Write a short essay that outlines the specific reasons that were most important to you when you made the decision to pursue a postsecondary education.

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Select a country for which you can find education statistics. Summarize the statistics below.

Briefly discuss the connection between average household income and education.

Explanation: Reasons may include desire for knowledge, family pressure, future earning potential, etc.

Depends on the country chosen.

Income and education are generally positively or directly related.

Follow-up areas of learning: Analyze the independent roles played by such factors as ability, experience, seniority rights, job conditions, discrimination, risk-taking, regional disparities, trade unions, and wealth as they relate to education and employment.

3. Discussion Questions (essay)

1. Describe the impact that education has had on your career path so far. How has it affected the type of job you are in? What impact has it had on wages?

2. Describe a time when your attitude towards risk taking has affected your earnings.

Explanation: 1. & 2. Answers will vary depending on the student‘s own participation in the labour market.

4. Multiple Choice Questions

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1. One of the main advantages of pursuing a postsecondary education is that it: a) has an opportunity cost in terms of the direct and indirect costs of pursuing an education. b) is an investment in human capital which can lead to higher incomes in the future.* c) makes it easier to claim seniority rights later in one‘s career. d) makes one likelier to take on jobs that have unstable incomes. e) all of the above 2. Typically with more education your income will a) rise.* b) fall. c) stay the same. d) fall unless you are below the poverty line, in which case it will rise. e) rise unless you are below the poverty line, in which case it will stay the same.

3. All of the following are reasons for income inequality, except: a) job conditions. b) labour productivity. c) experience. d) family size.* e) education.

4. Workers in the same occupation can earn a different amount of money because of: a) discrimination. b) their seniority. c) the region they work in. d) whether or not they are part of a union that represents at least some workers in the occupation. e) all of the above.*

Explanation: 1. One of the main advantages of pursuing a postsecondary education is that it is an investment in human capital, which can lead to higher incomes in the future.

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2. Typically with more education your income will rise.

3. Family size is not a reason for income inequality.

4. Workers in the same occupation can earn a different amount of money because of: their

seniority, the region they work in, whether or not they are part of a union that represents at least some workers in the occupation, and discrimination.

Chapter 8 Teaching Tips

Measuring GDP In recent years, Statistics Canada has adjusted its method for calculating GDP using the income approach. No longer is there a separate account for interest income. The flows formerly found there have been distributed to the corporate income account and proprietors‘ incomes and rents account. The procedure used for applying the expenditure approach has also been adjusted, with spending by non-profit institutions such as trade unions, religious societies and consumer associations now all included in a separate account. This latter adjustment does not fundamentally change the expenditure equation, given that this spending can still be lumped with spending by households as part of consumption.

Purchasing Power Parity Given their abstract nature, the mechanics of purchasing power parity adjustment are not touched on in the chapter. Instructors wishing to cover the topic can do so by focusing on how the price for a single commodity differs when bought directly in the country‘s domestic currency, converted into US dollar, versus how much when bought in US dollars in the United States. The best-known application of this single-commodity idea is the Big Mac index, a tongue-in-cheek PPP adjustment that focuses solely on the prices of the Big Mac in countries where it is sold.

Developed by The Economist magazine, its most recent values are accessible online at the magazine‘s website www.economist.com. For example, if a Big Mac bought in Canada by exchanging US dollars for Canadian dollars is priced at US$3 while it has a price of US$4 in the United States, the Canadian dollar is undervalued by 25 percent [= [($3 − $4)/$4] × $100] relative to the US dollar based on purchasing power parity. In practice, the calculation of PPPadjusted exchange rates is more intricate than this simple example suggests, but this index has the advantage of highlighting the key issue of cost-of-living differences across countries with 1-183 Copyright © 2023 by McGraw Hill

minimum mathematical complexity.

Gross National Income and Gross National Product Statistics Canada recently terminated its publication of updates for Gross National Product (GNP). This statistic has been replaced with Gross National Income (GNI), the statistic featured in the chapter. The difference between GNI and GNP is that the transactions subtracted from GDP to derive it have been expanded. For GNP, it was net investment income to the rest of the world which was deducted from GDP; in the case of GNI it is the more broadly defined term net international income to the rest of the world which is deducted. These transactions include not just flows of investment income in and out of Canada, but other forms of cross-border income as well.

Answers to Thinking about Economics Questions TAE I, Section 8.1: No, if a used car were sold directly by its owner then there would be valued added in the formal economy only if the owner paid for a sale advertisement.

TAE II, Section 8.1: If spending on education were included as investment, then Canada‘s total capital stock would have to be redefined to include the income-earning potential of education, known as human capital.

TAE III, Section 8.2: Product prices in China in its own currency are less than the prices for the same products in the US, so that when PPP-adjustment takes place the GDP value is pushed higher than it would otherwise be.

Answers to Chapter Problems 8.1 Practice Problems 1. a) A purchase of used goods is excluded from GDP since it has already been counted when it was first sold, and so is part of none of the components of GDP. b) An addition to inventories is included in GDP and appears as part of the expenditure component investment. c) A household purchase of a durable item is included in GDP and appears as part of the expenditure component consumption.

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d) Interest on a private corporation‘s debt is included in GDP and appears as part of the income component corporate income, which incorporates all corporations‘ payments of interest. e) Spending on goods and services by a provincial government is included in GDP and appears as part of the expenditure component government purchases. f) A financial transaction is excluded from GDP because it merely shifts purchasing power from one economic participant to another and so is part of none of the components of GDP. g) A government transfer payment is excluded from GDP because it represents merely a shift of purchasing power from taxpayers to the transfer payment recipient, and so is part of none of the components of GDP. h) A foreigner‘s purchase of a Canadian-made good is included in GDP and appears as part of the expenditure component net exports.

2. a) Use the expenditure equation: GDP = C + I + G + (X − M). The expenditure-based estimate of GDP is $162 billion [= $85 billion + $35 billion + $43 billion + ($14 billion − $15 billion)]. b) Using the income approach GDP is calculated as the sum of: GDP = Wages and salaries + Corporate income + Proprietors‘ incomes and rents + Indirect taxes + Depreciation.

Note that depreciation can be calculated as the difference between gross and net investment: Depreciation = Gross investment − Net investment. The income-based estimate of GDP is $194 billion [= $76 billion + $55 billion + $29 billion + $25 billion + ($35 billion − $26 billion)]. c) The statistical discrepancy is $16 billion, found by taking the difference between the two GDP estimates ($32 billion = $194 billion − $162 billion) and then dividing by two (= $32 billion / 2). d) Macronia‘s GDP is halfway between the two estimates, or $178 billion (= $162 billion + $16 billion = $194 billion − $16 billion). e) Macronia‘s depreciation is $9 billion, found by deducting net investment ($26 billion) from gross investment ($35 billion).

8.2 Practice Problems 1. a) Recall that GDP per capita equals GDP divided by the population. Per capita GDP in terms of the country‘s own dollars is $39,167 (= $235 billion / 6 million).

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b) Per capita GDP in terms of US dollars is $21,933 [= ($235 billion / 6 million) × 0.56]. c) Per capita GDP in terms of PPP-adjusted US dollars is $23,500 [= ($235 billion / 6 million) × 0.60]. d) Because the PPP-adjusted US-dollar value of the country‘s currency is higher than the unadjusted US dollar value, prices in this country are lower than in the United States.

Once this difference in the price levels in the two countries is taken into account, the purchasing power of this country‘s income, as shown by per capita GDP in PPP-adjusted US dollars, is higher than is shown by the unadjusted per capita GDP in US dollars.

2. a) In this case because incomes received by residents for their contributions to production elsewhere, which are added to GDP to derive GNI, are greater than the incomes of nonresidents for their contributions to production in the country, which are subtracted from GDP to derive GNI, the country‘s GNI is higher than GDP and there is a net inflow of income into the country. b) The country‘s residents benefit because their incomes exceed the production that takes place in the country.

End of Chapter Problems 1. a) Recall that GDP per capita equals GDP divided by the population. Per capita GDP in terms of Algoma‘s own dollars is $33,692 (= $1314 billion / 39 million). b) Algoma‘s GNI is found by deducting its net international income to the rest of the world (-$58 billion) from GDP ($1314 billion), giving a GNI of $1372 [= $1314 – (-$58)] billion. Because GNI is greater than GDP there is a net inflow of investment income from the country, so that income earned by residents of other countries for their involvement in production in Algoma is less than income earned by residents of Algoma for their involvement in production in the rest of the world. c) Algoma‘s GDP in terms of US dollars is $1785 billion (= $1314 billion × 1.47) d) Algoma‘s GDP in terms of PPP-adjusted US dollars is $1695 billion (= ($1314 billion × 1.29). e) Because the PPP-adjusted US-dollar value of the country‘s currency is lower than the unadjusted US dollar value, prices in this country are higher than in the United States.

Once this difference in the price levels in the two countries is taken into account, the purchasing power of Algoma‘s income, as shown by GDP in PPP-adjusted US dollars, is lower than is shown by the unadjusted per capita GDP in US dollars.

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2. a) The income-based estimate of GDP = wages and salaries ($546 billion) + corporate income ($98 billion) + proprietors‘ incomes and rents ($56 billion) + indirect taxes ($75 billion) + depreciation ($79 billion) = $854 billion. b) The expenditure-based estimate of GDP = personal consumption ($490 billion) + gross investment ($157 billion) + government purchases (184 billion) + net exports [exports ($68 billion) − imports ($27 billion)] = $872 billion. c) Given the $18 (= $872 − $854) billion difference between the income-based and expenditure-based GDP estimates in part a, half this amount ($9 billion) is added to the lower income-based estimate ($854 billion) and half this amount is subtracted from the higher expenditure-based estimate ($872 billion). The GDP value of $863 billion is found either be deducting the $9 billion statistical discrepancy from the income-based estimate of $872 billion or adding $9 billion to the expenditure-based estimate of $854 billion. d) Because net investment is $78 (= $157 − $79) billion, Metrica‘s capital stock is expanding by this amount in 2015. e) Metrica‘s GNI is found by deducting its net international income to the rest of the world ($8 billion) from GDP ($863 billion), giving a GNI of $855 (= $863 − $8) billion.

Because GNI is less than GDP there is a net outflow of investment income from the country, so that income earned by residents of other countries for their involvement in production in Metrica is greater than income earned by residents of Metrica for their involvement in production in the rest of the world.

3. a) Because net investment is $467 billion and depreciation is $75 billion, Cascadia‘s gross investment is $542 (= $467 + $75) billion. b) The expenditure-based estimate of GDP = personal consumption ($1225 billion) + gross investment ($542 billion) + government purchases ($643 billion) + net exports [exports ($94 billion) − imports ($195 billion)] = $2309 billion. c) The income-based estimate of GDP = wages and salaries ($1386 billion) + corporate income ($342 billion) + proprietors‘ incomes and rents ($232 billion) + indirect taxes ($258 billion) + depreciation ($75 billion) = $2293 billion. d) Given the $16 (= $2309 − $2293) billion difference between the expenditure-based and income-based GDP estimates in part a, half this amount ($8 billion) is added to the lower expenditure-based estimate ($2293 billion) and half this amount is subtracted from the higher income-based estimate ($2309 billion). The GDP value of $2301 billion is found 1-187 Copyright © 2023 by McGraw Hill

either by deducting the $8 billion statistical discrepancy from the expenditure-based estimate of $2309 billion or adding $8 billion to the income-based estimate of $2293 billion. e) Because Cascadia‘s GDP per capita is found by dividing GDP by its population, per capita GDP in terms of Cascadia‘s dollars is $37,721 (= $2301 billion / 61 million). f) Per capita GDP in terms of US dollars is $49,792 [= ($2301 billion / 61 million) × 1.32].

4. a) So that final and intermediate products are not double counted (which would lead to a total value of $6.35), only the extra worth of the salmon at each stage of production is included in GDP. This extra worth is calculated by subtracting the cost of materials from the value of the business‘s output. In the first stage of production, the value added by the fisherman is the value of the salmon sold to the food processor ($1.40). In the second stage, the value added by the food processor is $0.80, and in the third stage, the value added by the retailer is $0.55. b) The total value added in all three production stages ($2.75) therefore equals the value of the final product. c) If final and intermediate products were double counted, the salmon‘s total value incorporated in GDP would be the sum of the value of the fish when sold to the food processor by the fisher, its value when sold to the retailer by the food processor to the retailer, and then its value when sold by the retailer to the consumer, or $6.35 (= $1.40 + $2.20 + $2.75).

5. a) A movie-theatre ticket is always a final product and never an intermediate product because it is never resold for further processing. b) A roll of newsprint is never a final product and always an intermediate product because it must be processed further. c) Electrical power is sometimes a final product and sometimes an intermediate product. It is a final product if used by a household and an intermediate product if used by a business. d) A TV is always a final product and never an intermediate product because it is never resold for further processing. e) An ingot of steel is never a final product and always an intermediate product because it must be processed further.

6.

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a) A household purchase of a service is included in GDP and appears as part of the expenditure component consumption. b) Interest on government debt is excluded from GDP because it represents merely a shift of purchasing power from taxpayers to the bondholder and so is part of none of the components of GDP. c) A business‘s purchase of capital equipment is included in GDP and appears as part of the expenditure component investment. d) A nonmarket activity is excluded from GDP because its value is not captured by official statistics and so is part of none of the components of GDP. e) A government transfer payment is excluded from GDP because it represents merely a shift of purchasing power from taxpayers to the transfer payment recipient and so is part of none of the components of GDP. f) A government‘s expenditure on goods and services is included in GDP and appears as part of the expenditure component government purchases. g) An increase in business inventories is included in GDP and appears as part of the expenditure component investment. h) A purchase of used goods is excluded from GDP since it has already been counted when it was first sold, and so is part of none of the components of GDP. i) A government subsidy is excluded from GDP because it represents merely a shift of purchasing power from taxpayers to the subsidy recipient and so is part of none of the components of GDP. j) A foreigner‘s purchase of a Canadian-made good is included in GDP and appears as part of the expenditure component net exports. k) A financial transaction is excluded from GDP because it represents merely a change in ownership and so is not part of any components of GDP. l) A nonmarket activity is excluded from GDP because its value is not captured by official statistics and so is not part of any components of GDP. m) A government agency‘s expenditure on an income-producing asset is included in GDP and appears as part of gross investment.

7. a) Since the decline in living standards caused by less leisure does not appear in GDP, the change in living standards is overstated. b) Because the rise in living standards associated with the growth of this sector is left out of GDP, the change in living standards is understated. c) The growth in living standards associated with increasing environmental sustainability is missing from GDP, which means that the change in living standards is understated

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d) The drop in living standards that occurs because of the less equitable distribution of income is not captured in GDP, so the change in living standards is overstated.

8. (Advanced Problem) A is Resource Markets; B is Government; C is Businesses; D is Financial Markets; E is Households; F is Rest of the World; G is Product Markets.

Advancing Economic Thought Problems 1.

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a) The answer will depend on the latest SPI report available at the website. Based on the 2021 rankings, the world SPI score has risen from 60.42 in 2011 to 65.05 in 2021—a 4.63 point increase. b) The answer will depend on the latest SPI report available at the website. Based on the 2021 rankings, the chart is as follows:

c) As of 2021, the value of the world SPI has undergone a consistent rise since 2011, showing that overall social policies around the world are becoming more effective.

In-class Activities

1. Introductory Information

Time: Approximately 30 minutes.

Materials: Four packages of popsicle sticks Glue Coloured markers Paper and scissors About $10,000 in Monopoly or play money

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Set-up: Divide the class into seven groups Seat each group at a separate table Each group (except Group 1) should be given $1,000 of Monopoly or play money Key Concepts Covered: double-counting expenditure approach final products GDP intermediate products value added

Learning Objectives: - Illustrate and discuss the reasons and the process for calculating GDP using the expenditure approach.

- Demonstrate an understanding of final products and intermediate products and how they are dealt with in the calculation of GDP. - Show an appreciation of why double-counting occurs in the calculation of GDP, and how the concept value added deals with the issue.

2. Exercise

Recall that students have been split into 7 groups, each seated at separate tables.

Timekeeper: Allow ten minutes for everyone to complete the market cycle.

Stage 1: Become familiar with your group‘s place in the market cycle using the information below.

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Group 1 is a lumber company that cuts down trees and processes and paints the wood. This group sells blue lumber to Group 2 and yellow lumber to Group 3 at $5 for each piece. Group 1 members are responsible for colouring the popsicle sticks blue and yellow to match the needs of their two sets of buyers.

Group 2 are the core boat manufacturers. They create the main body of the sailboat with blue popsicle sticks as shown in the image below and with glue that they already own. They buy the sticks from Group 1 and sell the cores to Group 5. They charge $50 to make each core, plus the cost of the sticks they buy from Group 1.

Group 3 is the boat framing company that creates sail frames with yellow popsicle sticks and with glue they already own as shown in the image below. They buy the sticks from Group 1 and sell the frames to Group 5. They charge $40 to make the sail frames, plus the cost of the sticks they buy from Group 1.

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Group 4 is the sail manufacturer and installer. To make the sails, Group 4 cuts and colours the red paper then installs the paper onto the sail supports, as shown in the image below. The paper they use is purchased for $3 a piece from an outside company (money that goes to the instructor as payment), while they sell their services to Group 5. They charge $20 to put in the sails, plus the cost of the paper they purchase.

Group 5 is the sailboat retail company which pays Groups 2, 3, and 4 for their products and services. The group then sells each final sailboat to Group 6 for $250.

Group 6 are the buyers of sailboats. They purchase the boats from Group 5 then sell their used sailboats to Group 7 for $150.

Group 7 are buyers of used sailboats. They make their purchases from Group 6.

Stage 2: Give the students the necessary materials and ten minutes to complete the full market cycle.

Which portion of the process should be included in the expenditure calculation of GDP?

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Purchases of every good used in the production of new sailboats, as well as the sailboats themselves, would be included in the GDP calculation.

Purchases of every good used in the production of new sailboats, new sailboats, and used sailboats would be included in the GDP calculation.

Only the purchases of new sailboats would be included in the GDP calculation.* Purchases of new and used sailboats would be included in the GDP calculation.

Explanation: Only the $250 purchases of new sailboats would be included in the GDP calculation.

Follow-up areas of learning: - Discussion of value added activities - Additional discussions could include the secondary market in which Group 6 sells used sailboats to Group 7.

3. Discussion Questions (essay)

1. Fill in the table below, of value added in making one sailboat based on the monetary amounts at which exchanges were made at each stage of production starting with Group 1 and ending with Group 5. Note: the table below must be manually graded. Answers will depend on the exact way Groups 2, 3 and 4 chose to use popsicle sticks and paper to construct their various sailboat components. The answers provided below are for illustrative purposes.

Production Stage Blue and yellow lumber is made Main body of the boat is built Sail frames are built Sails are manufactured and installed Sailboat is sold

Total Value Paid/Received [30] [80] [120]

[30] [50] [40]

Business That Adds Value [Group 1] [Group 2] [Group 3]

[143]

[23]

[Group 4]

[250]

[107]

[Group 5]

Value Added

2. Select a product or service in your city or town. Describe the value-added activities that went into creating that product. Describe what parts of the process would be included in the calculation of GDP. Explanation: 1-195 Copyright © 2023 by McGraw Hill

1. Numerical results will differ depending on the exact way Groups 2, 3 and 4 chose to use popsicle sticks and paper to construct their various sailboat components.

For example, if one sailboat uses 6 popsicle sticks, then at the first stage (Group 1), the total value paid/received is $30 (= $5 × 6) and the value added is also $30 (= $30 − $0).

At the second stage (Group 2), the total value paid/received is $80 (= $30 + $50) and the value added is $50 (= $80 − $30).

At the third stage (Group 3), the total value paid/received is $120 (= $30 + $50 + $40) and the value added is $40 (= $120 − $80).

At the fourth stage (Group 4), if one sailboat uses one sheet of paper, then the total value paid/received is $143 (= $120 + $20 + $3) and the value added is $23 (= $143 − $120).

At the fifth stage (Group 5), the total value paid/received is $250 (ie. the retail price of a sailboat), while the value added is $107 (= $250 − $143).

2. Answers will vary depending on the illustration chosen by the student.

4 Multiple Choice Questions

1. If Group 2 uses 10 blue popsicle sticks bought from Group 1 to make 2 boat cores, then the total amount they charge to Group 5 for each of these cores will be: a) $50. b) $60. c) $70. d) $75.* e) $80.

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2. If Group 3 uses 4 yellow popsicle sticks bought from Group 1 to make 2 sail frames, then the total amount they charge to Group 5 for each of these frames will be: a) $40. b) $50.* c) $60. d) $70. e) $80.

3. If Group 5 pays Groups 2, 3 and 4 a total of $150 per sailboat for the materials they buy from these groups, then the value added by Group 5 after they sell each boat is: a) $100.* b) $150. c) $250. d) $400. e) none of the above

4. Which of the following would be considered value added activity in the sailboat market? a) the installation of sails* b) the selling of a used boat c) the repainting of a boat by a buyer after the boat‘s purchase d) all of the above e) none of the above

5. In this exercise, which part of the market process was not present? a) value added activities b) the sale of used products in a secondary market c) final disposal of used products* d) all of the above e) none of the above

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6. Which of the following is not a value-added activity in the production of sailboats? a) painting b) construction c) sailing* d) lumber cutting Explanation: 1. If Group 2 uses 10 blue popsicle sticks bought from Group 1 to make 2 boat cores, then the total amount they charge to Group 5 for each of these cores will be $75. Each popsicle stick costs $5, 5 popsicle sticks are used to made 1 boat core, and the process of making each core costs $50. Therefore, the total amount charged for each core is $75 [= (5 × $5) + $50].

2. If Group 3 uses 4 yellow popsicle sticks bought from Group 1 to make 2 sail frames, then the total amount they charge to Group 5 for each of these frames will be $50. Each popsicle stick costs $5, 2 popsicle sticks are used to make 1 sail frame, and the process of making each frame costs $40. Therefore, the total amount charged for each sail frame is $50[= (2 × $5) + $40].

3. If Group 5 pays Groups 2, 3 and 4 a total of $150 per sailboat for the materials they buy from these groups, then the value added by Group 5 after they sell each boat is $100. The value added after selling each boat is found by subtracting Group 5‘s total outlay per boat of $150 from the $250 retail price.

4. The installation of sails would be considered value added activity in the sailboat market.

Selling a used boat or repainting a boat after purchase are not included in the GDP calculation.

5. In this exercise, the final disposal of used products part of the market process was not present.

6. Sailing is not a value-added activity in the production of sailboats. Instead, it is the activity associated with consumption of the boat.

Chapter 9 Teaching Tips

The GDP Deflator In the past decade, Statistics Canada has refined its method for calculating real GDP. Its former method, explained in Figure 9.3 of the text, stresses reference-year prices in weighting the 1-198 Copyright © 2023 by McGraw Hill

outputs of various products. The reason for Statistics Canada‘s switch is that this method creates the potential for bias over time, especially when there is a range of price changes, with some prices rising much more than others. Recall that, based on Figure 9.3, quantities of individual products appearing in GDP are valued both at current-year and reference-year prices. The total valuation in current-year prices is divided by the total valuation in reference-year prices to give the relevant value of the GDP deflator. For example, if 2019 is the reference year, the GDP deflator in 2019 equals 100. For 2020, the calculation results in a ratio, with individual quantities for 2020 appearing in both the numerator and denominator. In the numerator, these quantities are valued at 2020 prices, and in the denominator at 2019 prices. Once the GDP deflator is derived, real GDP is found through the basic formula:

Real GDP = nominal GDP / GDP deflator (in hundredths)

Note the role played by prices from the reference year in these calculations. As long as relative prices in the economy stay approximately the same, using reference-year prices to weight quantities in the denominators of each of the GDP deflator ratios is not a significant problem.

But if some prices change far more rapidly than others, or if some prices are even falling, then the weighting based on reference-year prices diverges considerably from the way quantities would be weighted using current-year prices.

Statistics Canada‘s new method minimizes this potential divergence. The method employs a concept known as a chain volume index, which refers to the way a series of price calculations, each involving volumes of output from two consecutive years, are linked together to form a continuous chain. To understand this approach, let‘s look at an economy‘s GDP in the same two years as before, 2019 and 2020. Calculating the change in real GDP using a chain volume index involves four basic steps. In the first step, the individual quantities that appear in GDP in each of the two years are both valued at 2014 prices to give two aggregate dollar amounts – one for total output in 2019 and one for total output in 2020. The first step is completed by the calculation of the percentage increase in total value, expressed in terms of 2019 prices, between these two years. In the second step, the calculations of the two aggregate dollar amounts are repeated, but now with 2020 rather than 2019 prices. The results of steps one and two are a pair of estimates of the percentage change in total value between the two years, one using 2019 prices and the other using 2020 prices. The third step involves taking the average of these two percentage changes, which gives a final estimate of the change in real GDP. In the fourth step, the 2020 estimate of real GDP is employed to derive the GDP deflator for 2020. This is done by rearranging the equation for the GDP deflator: 1-199 Copyright © 2023 by McGraw Hill

GDP deflator (in hundredths) = nominal GDP / real GDP

The set of calculations outlined above is repeated for each pair of consecutive years, with the real GDP found for 2020 representing the starting point for the calculations involving 2020 and 2021.

The result is a series of real GDP values much more closely tied to the underlying price changes taking place in the economy than the estimates found using Statistics Canada‘s former calculation method, even if it is a more involved and complicated procedure. Instructors may wish to suggest the way that derivation of the deflator has been updated in general terms, even if the particulars of this derivation are not covered in this course.

Okun’s Law It‘s useful to stress to students that this law is simply a statistical estimate of an economic relationship, with the size of that estimate subject to change. When Arthur Okun first introduced the concept in 1962, he presumed that a one percent in the unemployment rate would lead to a reduction in real output of 3 percent. Later estimates for Canada and the US have shown a lower number. For example, one long-run study suggests the figure is about 2.5 percent for Canada (the figure used in the chapter), and about 2 percent for the United States.1 If recent data is correct, then this number may have fallen even further, especially in the aftermath of the 2008-09 recession to a figure around or below 2 percent. But it is too early to tell whether this is a permanent or temporary shift.

Answers to Thinking about Economics Questions TAE I, Section 9.1: Deflation helps those whose incomes are fixed (or whose incomes do not fall) in nominal terms. For these people, real incomes increase, because nominal incomes stay the same while prices fall. Deflation that is unexpected also helps lenders. This is because actual real interest rates end up being higher than expected real interest rates. Others are hurt by deflation. Because deflation reduces business prospects, not only are entrepreneurs hurt, but also those who lose their jobs as a result of the self-feeding effects of deflation. Borrowers, too, are hurt by unexpected deflation.

1

Kimberly Beaton, ‗Time Variations in Okun‘s Law: A Canada and US Comparison‘ Bank of Canada Working Paper, 2010, p.

4.

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TAE I, Section 9.2: The rapid pace of retirements during the 2018-2028 period should means an unusually high replacement demand for workers. In combination with the relatively low share of the population entering the labour force for the first time, this will put downward pressure on structural employment.

Answers to Chapter Problems 9.1 Practice Problems 1. a) Using 2022 prices the 2022 shopping basket has a value of $25 [= ($2.50 × 5) + ($1.25 × 10)].

Using 2023 prices the 2022 shopping basket has a value of $26.75 [= ($2.75 × 5) + ($1.30 × 10)]. b) With 2022 as the base year, the 2022 value of the index is 100 [= ($25 / $25) × 100]. The 2023 value of the index is 107 [= ($26.75 / $25) × 100]. c) The inflation rate between these two years is 7% [= ((107 − 100) / 100) × 100].

2.

Year

Nominal GDP (current $ billions)

GDP Deflator

Real GDP (2018 $ billions)

2021

[205.3]

97.458

210.7

2022

234.3

[100.000]

[234.3]

2023

245.9

101.340

[242.6]

2024

258.7

[102.945]

251.3

2025

[275.6]

105.438

261.4

Nominal GDP is found by multiplying real GDP by the GDP deflator expressed as a decimal. For 2021 it is $205.3 billion (= $210.7 billion × 0.97458). For 2025 it is $275.6 billion (= $261.4 billion × 1.05438). Because 2022 is the reference year the GDP deflator in 2022 is 100.000. The GDP deflator’s 2024 value is found by dividing nominal GDP by real GDP then multiplying by 100 or 102.945 [= ($258.7 billion / $251.3 billion) × 100]. Because 2022 is the reference year real GDP in 2022 has the same value as nominal GDP ($234.3 billion). Real GDP in 2023 is $242.6 billion (= $245.9 billion / 1.01340). This is found by dividing the year’s nominal GDP by the value of the GDP deflator expressed as a decimal.

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9.2 Practice Problem 1. a) The labour force is the sum of the number of unemployed members of the labour force, workers with full-time jobs, part-time workers who wish to have full-time jobs, and part-time workers who do not wish to have full-time jobs or 31.4 million (= 2.3 million + 21.4 million + 3.5 million + 4.2 million). b) The labour force population is found by rearranging the formula used to derive the participation rate. This means dividing the labour force by the participation rate expressed as a decimal or 49.1 million (= 31.4 million / 0.64). c) The official unemployment rate is found by dividing the total number of unemployed members of the labour force by the labour force, then multiplying by 100 or 7.3% [= (2.3 million / 31.4 million) × 100]. d) An unemployment rate that includes underemployment is found by summing the number of unemployed members of the labour force and the number of part-time workers who wish to have full-time jobs, dividing this amount by the labour force, then multiplying by 100 or 18.5% {= [(2.3 million + 3.5 million) / 31.4 million] × 100}.

End of Chapter Problems 1. a) In 2022, Student A spends $4.50 (= 3 × $1.50) on hot dogs, $12 (= 16 × $0.75) on cola, $7 (= 7 × $1) on chocolate bars, $10.50 (= 3 × $3.50) on magazines, and $6 (= 2 × $3) on movies, giving a shopping basket with a value of $40 (= $4.50 + $12 + $7 + $10.50 + $6). Item weights are 0.11 (= $4.50 / $40) for hot dogs, 0.30 (= $12 / $40) for cola, 0.18 (= $7 / $40) for chocolate bars, 0.26 (= $10.50 / $40) for magazines, and 0.15 (= $6 / $40) for movies. b) The value of Student A’s 2022 shopping basket using 2023 prices would be $42.00 [= (3 × $1.60) + (16 × $0.70) + (7 × $1) + (3 × $4.50) + (2 × $2.75)]. The 2023 value of Student A’s price index, using 2022 as the base year, is 105 [= ($42 / $40) × 100]. Given that 2022 is the base year, the 2022 value of the index is 100. The index has therefore changed by 5.0% {= [(105 − 100) / 100)] × 100} between 2022 and 2023.

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2. a) Using 2022 prices, Consumer Y’s 2022 shopping basket has a value of $60 [= ($4 × 5) + ($10 × 4)].

Using 2023 prices the 2022 shopping basket has a value of $66 [= ($4.80 × 5) + ($10.50 × 4)].

Using 2024 prices, the 2022 shopping basket has a value of $66 [= ($5 × 5) + ($10.25 × 4)]. b) With 2022 as the base year, the 2022 value of the index is 100 [= ($60 / $60) × 100]. The 2023 value of the index is 110 [= ($66 / $60) × 100]. The 2024 value of the index is 110 [= ($66 / $60) × 100]. c) The inflation rate between 2022 and 2023 is 10% [= ((110 − 100) / 100) × 100]. The inflation rate between 2023 and 2024 is 0% [= ((110 – 110) / 110) × 100].

3. a) $178.00 [= (4 × $22.00) + (50 × $1.80)] b) $139.00 [= (4 × $16.00) + (50 × $1.50)] c) 128 [= ($178.00 / $139.00) × 100] d) The GDP deflator includes the quantities and prices of all of the products produced in the economy, whereas the consumer price index includes only a small subset of products commonly bought by consumers. In calculating the GDP deflator, prices in both the current year and reference year are weighted in terms of current-year quantities. In contrast, when calculating the consumer price index, prices in both the current year and base year are weighted in terms of base-year quantities.

4.

Year

Nominal GDP (current $ billions)

GDP Deflator

Real GDP (2019 $ billions)

2020

[837.5]

91.691

913.4

2021

982.4

98.923

[993.1]

2022

1,152.9

[100.000]

[1,152.9]

2023

1,373.8

110.187

[1,246.8]

2024

1,589.6

[120.598]

1,318.1

Nebula’s nominal GDP is found by multiplying real GDP by the GDP deflator expressed as a decimal. For 2020 it is $837.5 billion (= $913.4 billion × 0.91691). Because 2022 is the reference year the GDP deflator is 100.000. The GDP deflator’s 2024 value is found by dividing nominal GDP by real GDP then multiplying by 100, or 120.598 [= ($1,589.6 billion / $1,318.1 billion) × 100]. Real GDP in 2021 is $993.1 billion (= $982.4 billion / 0.98923) and in 2023 is $1,246.8 (= $1,373.8 billion / 1.10187). These values are found by dividing the year’s nominal GDP by the 1-203 Copyright © 2023 by McGraw Hill

value of the GDP deflator expressed as a decimal. Because 2022 is the reference year real GDP has the same value as nominal GDP ($1,152.9 billion).

5. a) Year

Nominal GDP (current $ billion)

GDP Deflator

Real GDP (2019 $ billions)

2019

2,742.1

95.203

[2,880.3]

2020

[2,948.3]

97.623

3,020.1

2021

[3,136.5]

[100,000]

3,136.5

2022

3,332.7

[103.345]

3,224.8

2023

3,651.9

106.829

[3,418.5]

Aurora‘s nominal GDP is found by multiplying real GDP by the GDP deflator expressed as a decimal. For 2020 it is $2,948.3 billion (= $3020.1 billion × 0.97623). Because 2021 is the reference year the GDP deflator is 100.000. The GDP deflator‘s 2022 value is found by dividing nominal GDP by real GDP then multiplying by 100, or 103.345 [= ($3,332.7 billion / $3,224.8 billion) × 100]. Real GDP in 2019 is $2880.3 billion (= $2,742.1 billion / 0.95203) and in 2023 is $3,418.5 (= $3,651.9 billion / 1.06829). These values are found by dividing the year‘s nominal GDP by the value of the GDP deflator expressed as a decimal. Because 2021 is the reference year real GDP has the same value as nominal GDP ($3,135.3 billion).

6. a) The lawyer is unaffected by inflation. With costs and revenues both rising by the inflation rate, the lawyer’s net income will also increase by the same rate, leaving her real income constant. b) Because his restaurant is heavily in debt, this individual will probably benefit from unexpected inflation. The real interest rate paid on his outstanding debt is less than it would be in the absence of inflation. c) With a COLA clause in her contract, this worker is unaffected by inflation, since her nominal wage automatically rises by the inflation rate. d) This individual’s income is only partially indexed, meaning that his nominal income does not rise as quickly as the inflation rate. Therefore, this individual is harmed by inflation, due to the decline in his real income. e) The landlord should be unaffected by inflation. Their costs and revenues will both tend to both rise by the inflation rate, leaving their real income constant.

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f)

This individual is harmed by inflation since their nominal income will not change as inflation occurs.

7. a) The real interest rate is 5% (= 9 − 4), and the desired real interest rate is 6% (= 9 − 3). Because the actual real interest rate is 1% less than was anticipated, borrowers are better off and lenders are worse off. b) The real interest rate is 8% (= 10 − 2), and the desired real interest rate is 6% (= 10 − 4). The actual real interest rate is therefore 2% more than was anticipated, which means that borrowers are worse off and lenders are better off. c) The real interest rate is 6% (= 8 − 2), and the desired real interest rate is 6% (= 8 − 2). There is no difference between the actual and desired real interest rates, so that both borrowers and lenders are unaffected. d) The real interest rate is 6% (= 7 − 1), and the desired real interest rate is 4% (= 7 − 3). The actual real interest rate is therefore 2% more than was anticipated, which means that borrowers are worse off and lenders are better off. e) The real interest rate is 2% (= 6 − 4), and the desired real interest rate is 4% (= 6 − 2). Because the actual real interest rate is 2% less than was anticipated, borrowers are better off and lenders are worse off.

8. a) In 2022, Assiniboia’s labour force population is 17.50 million (= 20.70 million − 3.20 million), the labour force is 12.50 million (= 10.30 million + 1.75 million + 450,000), the participation rate is 71.4% [= (12.50 million / 17.50 million) × 100], and the official unemployment rate is 3.6% [= (450,000 / 12.50 million) × 100]. In 2023, Assiniboia’s labour force population is 17.80 million (= 21.10 million − 3.30 million), the labour force is 12.70 million (= 10.4 million + 1.80 million + 500,000), the participation rate is 70.8% [= (12.60 million / 17.80 million) × 100], and the official unemployment rate is 4.0% [= (500,000 / 12.60 million) × 100]. b) Assiniboia’s official unemployment rate has risen between 2022 and 2023 from 3.6 percent to 4.0 percent. The number of unemployed members of the labour force has also risen from 450,000 to 500,000.

9. a) In 2021, Selkirk’s labour force population is 2.80 million (= 4.20 million − 1.40 million), the labour force is 1.75 million (= 1.20 million + 100,000 + 300,000 + 150,000), the participation rate is 62.5% [= (1.75 million / 2.80 million) × 100], and the official unemployment rate is 8.6% [= (150,000 / 1.75 million) × 100]. In 2022, Selkirk’s labour force population is again 2.80 million, the labour force is 1.96 million (= 1.30 million + 125,000 + 375,000 + 160,000), the participation 1-205 Copyright © 2023 by McGraw Hill

rate is 70% [= (1.96 million / 2.80 million) × 100], and the official unemployment rate is 8.2% [= (160,000 / 1.96 million) × 100]. b) Selkirk’s official unemployment rate has fallen between 2021 and 2022 from 8.6% to 8.2%, even though the number of unemployed members of the labour force has increased from 150,000 to 160,000. The rise in the participation rate from 62.5% to 70% has meant that the increase in the size of the entire labour force has outweighed the increase in unemployment. c) In 2021, if we include Selkirk’s 400,000 discouraged workers in the unemployment rate, they must be added to both the numerator and denominator of the formula. With the incorporation of the 100,000 underemployed workers and the 400,000 discouraged workers in the numerator, the unemployment rate becomes 30.2% {= [(150,000 + 100,000 + 400,000) / (1.75 million + 400,000)] × 100}. In 2022, if we include the 500,000 discouraged workers in the unemployment rate, they must be added to both the numerator and denominator of the formula. With the incorporation of the 125,000 underemployed workers and the 500,000 discouraged workers in the numerator, Selkirk’s unemployment rate becomes 31.9% {= [(160,000 + 125,000 + 500,000) / (1.96 million + 500,000)] × 100}.

10. a) Because there is a mismatch between their skills and available jobs this person is structurally unemployed. They are included in the official unemployment rate. b) This person has given up looking for work so is classified as a discouraged worker. They are not included in the official unemployment rate. c) This person is seasonally unemployed. Because the official unemployment rate referred to is the rate before seasonal adjustment they are included in this rate. d) This person is cyclically unemployed. They are included in the official unemployment rate. e) This person is underemployed. Given their current part-time job they are not included in the official unemployment rate. f)

This person is frictionally unemployed and as long as he actively seeks employment is included in the official unemployment rate.

11. a) In 2022, the unemployment rate was 0.7 = (6.2 – 5.5) above the assumed natural rate. According to Okun’s Law, real output could have been 1.75% (= 0.7 × 2.5) higher if unemployment equalled the natural rate. Thus, GDP in 2022 dollars could have been $27.0 billion (= $1,543.2 billion × 0.0175) higher. b) In 2023, the unemployment rate was 1.8% (= 7.3 − 5.5) above the assumed natural rate.

According to Okun’s Law, real output could have been 4.5% (= 1.8 × 2.5) higher if unemployment equalled the natural rate. GDP in 2022 dollars could therefore have been $72.6 billion (= $1,612.8 billion × 0.045) higher.

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12. a) The value of Student A’s 2023 shopping basket using 2023 prices is $40.05 [= (2 × $1.60) + (18 × $0.70) + (7 × $1) + (2 × $4.50) + (3 × $2.75)]. Item weights are 0.08 (= $3.20 / $40.05) for hotdogs, 0.31 (= $12.60 / $40.05) for cola, 0.17 (= $7.00 / $40.05) for chocolate bars, 0.22 (= $9.00 / $40.05) for magazines, and 0.21 (= $8.25 / $40.05) for movies (numbers do not add to 1 because of rounding). b) The value of this same basket in 2022 would be $39.50 [= (2 × $1.50) + (18 × $0.75) + (7 × $1) + (2 × $3.50) + (3 × $3)]. The 2022 value of Student A’s price index, using 2023 as the base year, is 98.6 [= ($39.50 / $40.05) × 100]. Given that 2023 is the base year, the 2023 value of the index is 100.0. The index has therefore changed by 1.4% {= [(100 − 98.6) / 98.6] × 100} between 2022 and 2023.

13. a) The value of Consumer Y’s 2023 shopping basket using 2023 prices is $66.90 [= (3 × $4.80) + (5 × $10.50)]. b) The value of this same basket in 2022 would be $62 [= (3 × $4) + (5 × $10)]. The 2022 value of Consumer Y’s price index, using 2023 as the base year, is 92.7 [= ($62 / $66.90) × 100]. Given that 2023 is the base year, the 2023 value of the index is 100.0. The 2024 value of Consumer Y’s price index, using 2023 as the base year, is 99.0 [= ($66.25 / $66.90) × 100]. The index has therefore changed by 7.9% {= [(100 − 92.7) / 92.7] × 100} between 2022 and 2023 and by -1.0% {= [(99 − 100) / 99] × 100} between 2023 and 2024.

Advancing Economic Thought Problem 1. According to Cowen’s analysis, as demand in these professions decreases employment levels in these professions will decrease as well. This will cause some individuals who would otherwise have entered these professions into low-skilled occupations instead. If this happens wages in these lowskilled occupations will be pushed down.

2. With a higher premium paid to those individuals who are able to take full advantage of the incomeearning potential of the computer revolution, and lower wages to those who cannot, as the supply of workers in low-income occupations increases, it is quite possible that the proportion of pre-tax incomes received by the highest 1 percent of earners will continue to expand.

In-class Activities

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1. Introductory Information

Time: Approximately 20 minutes.

Materials: A package of multicolored construction paper.

Print the appropriate information, from below, on each coloured card.

There should be one card made for each student.

Card Information: Yellow Card: You are over 18 years of age and are employed in a full-time job.

Red Card: You are 14 years of age and make pocket money by mowing lawns.

Blue Card: You are over 18 years of age. You are having trouble finding a job, but currently looking.

Green Card: Though you have a college diploma, you have been employed in a succession of unskilled jobs for the past four years because you could not find a job that uses your education.

Orange Card: You are over 18 years of age. You spent a long time looking for a job, but you have given up trying to find one.

Pink Card: You worked for a company that upholstered furniture until recently, when the employer closed its Canadian plant and moved its operations overseas. You are looking for a new position that uses your current skills.

Purple Card: You have just received a university degree and you haven’t yet been able to find a job yet.

You are submitting your resume everywhere.

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White Card: You used to work the cash register at a popular Italian restaurant, but you were laid off when the economy slumped and consumers began eating out less often. You are looking widely for a new job, though your previous boss has told you that she will hire you back if business picks up again.

Black Card: You work on a lobster boat, but you are not currently working because it is not lobster season in your area, and the government will allow your employer to fish only three months per year.

You are receiving employment insurance benefits, which requires you to look for work during times when there is no lobster fishing.

Set-up: Give each student one, and only one, card.

All of the different colours of cards should be used.

Key Concepts Covered: cyclical unemployment discouraged workers frictional unemployment labour force population labour force seasonal unemployment structural unemployment underemployment unemployment rate

Learning Objectives: - Explain and evaluate how the unemployment rate is calculated and gain an understanding of who makes up the labour force and labour force population.

- Illustrate and discuss the various types of unemployment and related situations -- including cyclical unemployment, frictional unemployment, seasonal unemployment and structural unemployment as well as discouraged workers and underemployment -- and the impact they have on individuals and society.

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2. Exercise

Recall that students have each been given one card.

Timekeeper: N/A

Stage 1: Each student has been given a different coloured card describing some key personal and employment characteristic.

Once every student has a card they should all line up on one side of the room with their cards.

The instructor will call out different employment criteria (shown below Stage 2). The students who feel they meet the criteria, according to description on their card, will move to the other side of the room.

Once the students have organized themselves on the other side of the room, they will read out what is written on their cards one by one. The rest of the class will determine if the student is correct in his/her assessment.

Stage 2: After one criterion is completed, reset and repeat the game with the next criterion on the list below. Repeat the process for several different criteria, as many as desired. The criteria are as follows: 1) a member of the labour force population 2) a member of the labour force 3) officially employed 4) officially unemployed 5) frictionally unemployed 6) structurally unemployed 7) cyclically unemployed 8) seasonally unemployed 9) a discouraged worker 10) underemployed

Students with which coloured cards should move to the other side of the room in each case from above.

1) everyone except those with red cards 1-210 Copyright © 2023 by McGraw Hill

2) everyone except those with red and orange cards 3) those with yellow and green cards 4) those with purple, pink, white and black cards 5) those with purple cards 6) those with pink cards 7) those with white cards 8) those with black cards 9) those with orange cards 10) those with green cards

Explanation: 1) a member of the labour force population (everyone except those with red cards) 2) a member of the labour force (everyone except those with red and orange cards) 3) officially employed (those with yellow and green cards) 4) officially unemployed (those with purple, pink, white and black cards) 5) frictionally unemployed (those with purple cards) 6) structurally unemployed (those with pink cards) 7) cyclically unemployed (those with white cards) 8) seasonally unemployed (those with black cards) 9) a discouraged worker (those with orange cards) 10) underemployed (those with green cards) 3. Discussion Questions (essay)

1. Describe a situation where someone would be considered underemployed. What are some factors that could cause this to happen?

2. Describe a job where someone would experience seasonal unemployment Why is this job seasonal?

Explain.

Explanation: 1. Answers will vary. Students may reference personal reasons or economic reasons in explaining the situation of the person whose work conditions they are highlighting. One frequent example is the underemployment of immigrants. An immigrant may have been trained to be an engineer, doctor, or other profession but in a country where the qualifications or standards are not considered 1-211 Copyright © 2023 by McGraw Hill

equivalent to Canadian standards. Another example is someone who has a bachelor’s degree from a Canadian university but works at a fast-food outlet in order to support themselves and their families because they graduated at a time of high unemployment and low economic growth, such as in the early 1990s or after 2008, and were unable to find a higher-level job.

2. Answers will vary. Possible examples include jobs in construction, forestry, and fishing. Work is seasonal in Canada because of winter. Many jobs cannot be done when the ambient temperature falls below freezing.

4. Multiple Choice Questions

1. A 13-year-old who occasionally babysits for cash is considered: a) seasonally unemployed. b) not part of the labour force.* c) part of the labour force. d) officially unemployed. e) officially employed.

2. A person who is over 18 years old and who has given up looking for work would be considered: a) a discouraged worker.* b) employed. c) frictionally unemployed. d) seasonally unemployed. e) none of the above

3. A construction worker who is unemployed during winter months would be considered: a) cyclically unemployed. b) frictionally unemployed. c) seasonally unemployed.* d) structurally unemployed. e) all of the above

4. A janitor with an engineering degree would be considered: a) a discouraged worker b) frictionally unemployed 1-212 Copyright © 2023 by McGraw Hill

c) fully employed d) underemployed.* e) none of the above

5. A student who has just graduated and is looking for a job would be considered: a) cyclically unemployed. b) frictionally unemployed.* c) seasonally unemployed. d) structurally unemployed. e) all of the above

Explanation: 1. A 13-year-old who occasionally babysits for cash is considered not part of the labour force as the labour force only includes those 15 years of age and older.

2. A person who is over 18 years old and who has given up looking for work would be considered a discouraged worker because they are no longer actively seeking employment.

3. A construction worker who is unemployed during winter months would be considered seasonally unemployed since they can expect to be employed in their occupation during the summer months.

4. A janitor with an engineering degree is not using their skills to their full potential so would be considered underemployed.

5. A student who has just graduated and is looking for a job would be considered frictionally unemployed since they are looking for their first job.

Chapter 10 Teaching Tips

The Wealth and Foreign Trade Effects When introduced to aggregate demand, students sometimes find it hard to distinguish how the wealth and foreign trade effects explain the aggregate demand curve‘s downward slope in contrast to aggregate demand factors, which explain shifts in the curve.

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With both the wealth and foreign trade effects, the focus is on the impact of a change the price level. Both sets of movements help give the aggregate demand curve its downward slope, showing the inverse relationship between the price level and real expenditures. That is because both effects cause movements along the aggregate demand curve rather than shifts in the curve.

In the case of the wealth effect, a price change affects real expenditures through its impact on the real value of households‘ financial assets. A rise in prices causes a decrease in the real value of these assets, making households feel poorer and causing real expenditures to fall. In contrast, a drop in prices raises the real value of households‘ financial assets. As households feel richer, they raise real expenditures. In contrast, when any trend other than a change in the price level causes an adjustment in household wealth, the impact is a shift in aggregate demand curve, rather than a movement along it.

The reasoning in the case of the foreign trade effect is similar, but now we must account for two sets of movements, one involving exports and the other imports. For example, an increase in prices means that exports from Canada to the rest of the world are more expensive to foreign purchasers. This causes the dollar value of exports to fall. At the same time, the increase in the prices of domestically produced items reduces import prices relative to prices of domestic products, which causes the dollar value of imports to rise. The overall impact is a decrease in the dollar value of net exports (X − M) and therefore a drop in real expenditures. Because a rise in the price level causes a decline in real expenditures, and vice versa, this effect contributes to the downward slope of the aggregate demand curve in the same way as the wealth effect does.

Increases and Decreases in Aggregate Supply Students usually find it straightforward to link shifts in the aggregate demand curve as depicted in Figure 10.2 to increases and decreases in aggregate demand, and the various possible causes, as shown in Figure 10.4. But as with shifts in demand and supply in individual markets, they sometimes have more difficulty when it comes to linking the aggregate supply shifts portrayed in Figures 10.6 and 10.7 with the movements highlighted in Figure 10.8. Such difficulties arise most often when students view upward and downward movements of aggregate supply in vertical terms. Remind them that changes in aggregate supply, just as with supply changes in an

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individual market, need to be viewed in horizontal terms, with an increase in aggregate supply, whether in the short run or long run, linked with a rightward shift in the curve, and a decrease linked with a leftward shift.

Rule of 72 As an approximation, the Rule of 72 works very well when applied to cases with relatively low percentage growth rates. At higher growth rates, however, its accuracy is lessened. Instructors may wish to supplement their discussion of this rule by linking it explicitly with the mathematical concept of logarithmic functions, and in particular the natural logarithmic function ln(x). If so, the formula used to derive the exact number of years it takes any variable to double is:

Number of years = ln (2)/ ln (1 + (percentage growth rate expressed as a decimal))

For students who are comfortable with logarithms and their mathematical application, this version of the formula has the advantage that it is possible to adjust it easily to account for some other total increase than doubling. For example, the number of years for a variable to triple would be shown by substituting 3 for 2 in the term ln (2).

Answers to Thinking about Economics Questions TAE I, Section 10.1: Of all of the aggregate demand components, consumption is the most stable. While investment is highly unstable, government purchases can vary due to decisions by government policy-makers. Net exports, meanwhile, are affected not just by income changes in the domestic economy (imports) and in the rest of the world (exports), but also by variations in the exchange rate.

TAE II, Section 10.2: As various IT innovations are adopted throughout the economy, the efficiency of old-economy businesses is being improved. The gradual spread of computer technology, new communications methods and now robots and AI are particularly important aspects of these trends.

TAE III, Section 10.4: Because of an increase in economic activity, economic growth will tend to increase employment. At the same time, it will lead to a higher depletion of natural resources.

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TAE IV, Section 10.5: Sectors producing nondurable consumer goods and services are least affected by a downturn, since households tend to purchase these items regardless of changes in the business cycle.

Answers to Chapter Problems 10.1 Practice Problem 1. a) A reduction in household tax rates increases consumption, shifting aggregate demand to the right. b) A slump in share prices reduces household wealth, which decreases consumption and shifts aggregate demand to the left. c) A rise in the price level does not cause a shift in the aggregate demand curve. Instead, it causes a movement leftwards and upwards along the curve, due to the wealth and foreign trade effects. d) A fall in Canadian interest rates increases investment and the consumption of durable items. Both these trends cause aggregate demand to shift to the right. e) A rise in the US-dollar value of the Canadian dollar makes Canadian exports more expensive for Americans and imports from the US cheaper for Canadians. The result is a decrease in net exports, shifting aggregate demand to the left. f) A fall in business confidence decreases investment, shifting aggregate demand to the left. g) The sudden spread of a global pandemic that causes households to expect a rise in the prices of many essential goods and services increases consumption now, shifting aggregate demand to the right.

10.2 Practice Problem 1. a) A rise in the economy‘s capital stock causes a long-run increase in aggregate supply. b) A strengthening of government regulations results in a long-run decrease in aggregate supply. c) A decrease in the price of electricity causes a short-run increase in aggregate supply. d) A reduction in wage rates leads to a short-run increase in aggregate supply.

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e) A contraction in the amount of available land results in a long-run decrease in aggregate supply. f) A decline in the size of the labour force causes a long-run decrease in aggregate supply. g) Technological progress causes a long-run increase in aggregate supply. h) An increase in the prices of a range of natural resources causes a short-run decrease in aggregate supply.

10.3 Practice Problem 1. a) Investment is related to saving, as both are connected with financial markets.

Government purchases are related to taxes, as both are associated with government. Exports are related to imports, as both represent ties with the rest of the world. b) No. Investment need not equal saving, government purchases need not equal taxes, and exports need not equal imports. Only total injections and total withdrawals need to be in balance when the economy is in equilibrium.

10.4 Practice Problem 1. Recall the rule of 72 as: the number of years for a variable to double equals 72 divided by the annual percentage growth rate (i.e., # years to double = 72 / annual % growth rate). a) It will take 144 (= 72 / 0.5) years. b) The average annual growth in per capita real GDP is 2.67% (= 72 / 27). c) The capital stock doubles every 12 (= 72 / 6) years so in 24 years will double twice.

10.5 Practice Problem 1. a) Since the consumption of durable goods depends on households‘ disposable income it moves down during contractions and up during expansions. b) Recall that planned investment depends on business expectations which tend to be optimistic when output is rising and pessimistic when real output is falling. Therefore, planned investment tends to fall during contractions and rise during expansions.

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c) Exports depend on foreign incomes. Given that business cycles in various countries tend to move together, exports usually fall during contractions and rise during expansions. d) The demand for labour tends to move in the same direction as real output. Therefore, wage rates tend to be pushed down during contractions and pushed up during expansions. e) Equilibrium output tends to move down during contractions, which is associated with positive unplanned investment, and up during expansions, which is associated with negative unplanned investment.

End of Chapter Problems 1. a)

b) At a 4% real interest rate investment is $200 million because there are 200 projects of $1 million each that have a real rate of return equal to or greater than 4%. c) At a 6% real interest rate investment is $150 million because now only 150 projects of $1 million have a real rate of return equal to or greater than 6%.

2. a) A rise in consumer confidence raises personal consumption which causes an increase in aggregate demand and a rightward shift. The overall result is a higher equilibrium price level and a higher equilibrium real output. b) A rise in Canadian interest rates reduces investment as well as the consumption of durable goods which causes a decrease in aggregate demand and a leftward shift. The overall result is a lower equilibrium price level and a lower equilibrium real output.

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c) An increase in tax rates on high-income households reduces disposable incomes and therefore personal consumption which causes a decrease in aggregate demand and a leftward shift. The result is a lower equilibrium price level and a lower equilibrium real output. d) A rise in government purchases causes an increase in aggregate demand and a rightward shift. The result is a higher equilibrium price level and a higher equilibrium real output. e) A boom in the Chinese economy raises Canadian exports which causes an increase in aggregate demand and a rightward shift. The result is a higher equilibrium price level and a higher equilibrium real output. f) A fall in the value of the Canadian dollar against the US dollar makes Canadian exports less expensive in the rest of the world and makes imports into Canada more expensive.

Net exports rise which causes an increase in aggregate demand and a rightward shift. The overall result is a higher equilibrium price level and a higher equilibrium real output. g) A tumble in the economies of Canada‘s trading partners causes a decrease in net exports, which causes a decrease in aggregate demand and a leftward shift. The overall result is a lower equilibrium price level and a lower equilibrium real output. h) Innovations in artificial intelligence raise investment which causes an increase in aggregate demand and a rightward shift. The overall result is a higher price level and a higher equilibrium real output.

3. a) A rise in wages for Canadian workers pushes up production costs which causes a shortrun decrease in aggregate supply and a leftward shift with a constant potential output.

The result is a higher equilibrium price level and a lower equilibrium real output. b) Higher labour productivity means that Canadian economic resources can produce more at every price level. This causes a long-run increase in aggregate supply and a rightward shift with a higher potential output. The overall result is a lower equilibrium price level and a higher equilibrium real output. c) Lower corporate income taxes increase incentives to work and save, which means that households provide more economic resources than before. This causes a long-run increase in aggregate supply and a rightward shift with a higher potential output. The overall result is a lower equilibrium price level and a higher equilibrium real output. d) A reduced amount of land decreases resource supplies, pushing down real output at every price level. This causes a long-run decrease in aggregate supply and a leftward shift with a lower potential output. The overall result is a higher equilibrium price level and a lower equilibrium real output.

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e) A lower oil price pushes down production costs which causes a short-run increase in aggregate supply and a rightward shift with a constant potential output. The overall result is a lower equilibrium price level and a higher equilibrium real output. f) A higher value of the Canadian dollar in terms of the U.S. dollar reduces input prices and production costs. This causes a short-run increase in aggregate supply and a rightward shift with a constant potential output. The overall result is a lower equilibrium price level and a higher equilibrium real output. g) Higher immigration increases resource supplies, pushing up real output at every price level. This causes a long-run increase in aggregate supply and a rightward shift with a higher potential output. The overall result is a lower equilibrium price level and a higher equilibrium output,

4. a)

b) Acadia‘s equilibrium levels of 120 and $230 billion are found at the intersection of the AD0 and AS0 (point a in the graph). At a price level of 140, the economy‘s real output of $270 billion exceeds real expenditures of $190 billion. This means that more is produced than is purchased in Acadia, causing an unintended increase in inventories. The result is a reduction in prices until real output and real expenditures are equal at a price level of 120.

If the price level is 110, Acadia‘s real expenditures of $250 billion exceed the real output of $200 billion. Because more is purchased than is produced in Acadia, there is an 1-220 Copyright © 2023 by McGraw Hill

unintended decrease in inventories. This leads to an increase in prices until real output and real expenditures are again equal at a price level of 120. c) Because aggregate demand expands by $50 billion at every price level, this is an increase in aggregate demand. The equilibrium price level rises to 130 and the equilibrium real output to $260 billion (point b in the graph). d) Because real output expands by a lower amount at higher price levels, this is a short-run increase in aggregate supply. The equilibrium price level falls to 110 and the equilibrium real output rises to $250 billion (point c in the graph).

5. a)

b) Avalon‘s equilibrium levels of 120 and $175 billion are found at the intersection of AD0 and AS0 (point a in the graph). c) Because aggregate demand is reduced by $50 billion at every price level, this is a decrease in aggregate demand. The equilibrium price level falls to 110 and the equilibrium real output to $150 billion (point b in the graph). d) Because real output falls by a lower amount at higher price levels, this is a short-run increase in aggregate supply. The equilibrium price level rises to 120 and the equilibrium real output falls to $125 billion (point c in the graph).

6. Recall the rule of 72 as: the number of years for a variable to double equals 72, divided by the annual percentage growth rate (i.e., # years to double = 72 / annual % growth rate).

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a) It will take 48 (= 72 / 1.5) years. b) The average annual rate of inflation is 2.7% (= 72 / 27). c) Because population doubles every 24 (= 72 / 3) years, it will double 4 times in 96 years.

7. a) In 2021, Ergonia‘s labour productivity was $62,500 (= $500 billion / 8 million workers).

In 2022, it was $67,500 (= $540 billion / 8 million workers). b) Ergonia‘s rate of productivity growth between 2021 and 2022 was 8.0% {= [($67,500 − $62,500) / $62,500] × 100}.

8. a) The economy expanded when the change in real GDP was positive, from 1994 to 2008, from 2010 to 2019, and in 2021. b) The economy contracted when the change in real GDP was negative, in 2009, and 2020. c) Peaks occurred just before the change in real GDP moved from being positive to negative: in 2008, and 2019. d) Troughs occurred once the change in real GDP moved from being negative to positive: in 2010, and 2021.

9. a) Sales of romance novels tend to move in the opposite direction. Sales rise during economic downturns when many individuals have more free time on their hands. b) Registrations with online dating services tend to move in the opposite direction. Interest in online dating tends to rise during economic downturns when many individuals have more free time on their hands. c) Cosmetic surgery bookings tend to move in the same direction. Bookings decline during economic downturns when individuals are more likely to postpone major purchases and are less likely to book extended times off work when job security is less assured. d) Google searches using the keyword ―jobs‖ tend to move in the opposite direction. Jobseeking on the internet tends to rise during economic downturns given the rise in unemployment.

10. a) Higher personal and corporate tax rates decrease household incomes, either directly through changes in disposable income or indirectly by reducing corporate profits. In either case, a rise in tax rates causes a fall in aggregate demand, which reduces an 1-222 Copyright © 2023 by McGraw Hill

inflationary gap. Meanwhile a fall in personal and corporate tax rates leads to an increase in aggregate demand and a reduction in a recessionary gap. b) A fall in government purchases causes a decrease in aggregate demand which reduces an inflationary gap. Meanwhile a rise in government purchases increases aggregate demand which reduces a recessionary gap. c) A rise in interest rates leads to lower planned investment and the consumption of durables. Aggregate demand therefore decreases, reducing an inflationary gap.

Meanwhile, a fall in interest rates raises planned investment and the consumption of durables, which leads to an increase in aggregate demand and reduces a recessionary gap. d) With a higher value of the Canadian dollar in terms of the US dollar, Canadian exports are more expensive in other countries and foreign imports are cheaper in Canada. Net exports therefore fall, which decreases aggregate demand and reduces an inflationary gap. Meanwhile, a lower value of the Canadian dollar raises net exports and results in an increase in aggregate demand, which reduces a recessionary gap.

11. a)

b) As computer production rises from 1 to 2, the quantity of milkshakes produced falls from 350 to 225. This is represented by a movement to the right and down Binomia‘s production possibilities curve from point e to f on the graph. Because Binomia is devoting a larger proportion of its economic resources to the production of capital goods, this increases its future endowment of economic resources. As these additional economic resources become available Binomia‘s production possibilities curve shifts to the right, as illustrated by the shift from PPC0 to PPC1 on the graph c) With a technological innovation in the production of computers, Binomia‘s production possibilities curve rotates so that the vertical intercept stays constant while the horizontal 1-223 Copyright © 2023 by McGraw Hill

intercept increases as illustrated by the move from PPC0 to PPC2 on the graph. Unlike the shift from PPC0 to PPC1, this trend involves only a rightward movement in the curve, rather than an upward and rightward shift, since only the potential production of computers is affected.

12. When an economy is below its potential output, the aggregate supply curve has a flattened slope. A $100 million decrease in aggregate demand therefore causes a relatively large reduction in real output and a relatively small reduction in the price level. In contrast, the AS curve has a steep slope when the economy is above its potential output. In this case, the same $100 million decrease in aggregate demand has a smaller impact on real output and a larger impact on the price level.

Advancing Economic Thought Problems 2. e) Based on the Piketty‘s first fundamental law, if s is 0.09 and g is 0.015 then β is 4 (= s/g = 0.09/0.015). Based on Piketty‘s second fundamental law, if r is 0.05 and β is 4 then α is 20 percent or 0.20 (= r × β = 0.05 × 4). f) If g falls to 1 percent, then the value of β rises from 4 to 9 (= s/g = 0.09/0.01) and the value of α rises from 20 percent to 45 percent or 0.45 (= r × β = 0.05 × 9). If g remains at 1.5 percent while r falls to 2.5 percent then the value of β stays at 4 (= s/g = 0.09/0.015) while the value of α drops from 20 percent to 10 percent or 0.10 (= r × β = 0.025 × 4).

3. An increase in β tends to put upward pressure on α, the share of income from capital in national income. This follows from Piketty‘s second fundamental law, α = r × β, as well as the fact that changes in the rate of return on capital, r, tend to be outweighed by changes in β.

Wealth and capital income tend to be very unequally distributed. Therefore, a rise in the values of α and β tends to put upward pressure on income inequality.

In-class Activities

1. Introductory Information

Time: Approximately 30 minutes.

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Materials: Markers and white boards (or chalk and chalk boards, or an easel / flip chart) that students can write on.

Set-up: Divide the class into two teams.

Each team should sit together.

Key Concepts Covered: aggregate demand aggregate supply decrease in aggregate demand increase in aggregate demand long-run decrease in aggregate supply long-run increase in aggregate supply short-run decrease in aggregate supply short-run increase in aggregate supply

Learning Objectives: - Identify the factors that cause shifts in aggregate demand and aggregate supply.

- Illustrate and discuss the effect on equilibrium of shifts in aggregate demand and either shortrun or long-run shifts in aggregate supply.

2. Exercise

Recall that students have been split into two groups and are sitting together as teams.

Scorekeeper: If the correct answer is shown, that team will be awarded 2 points. If the answer is incorrect, the student‘s team is penalized 1 point.

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Stage 1: The two teams will be competing against each other in a game show.

Each team will send one contestant to the board, or their flip chart, to represent the team. The instructor will call out a scenario (scenarios are listed below Stage 2). Based on the scenario the students at the board must draw aggregate demand and aggregate supply curves that illustrate the appropriate changes. The remaining students on each team are allowed to call out answers to their teammate at the board.

When the person at the board feels that they have the correct answer, they must put their marker or chalk down and yell ―economics.‖ If the student fails to say ―economics‖ the contest will continue.

Once a student yells ―economics‖ the instructor will then judge whether the illustration on the board is correct or incorrect. If the correct answer is shown, that team will be awarded 2 points.

If the answer is incorrect, the student‘s team is penalized 1 point, and both teams must keep racing to illustrate the proper answer until someone yells ―economics‖ again.

Stage 2: The same process continues for each scenario. A new student should be selected from each team to illustrate each new scenario. The scenarios – all relating to the Canadian economy – are as follows:

1) Households choose to spend more on consumption items.

2) Businesses anticipate that profits will decrease.

3) The price of oil increases.

4) Households choose to deposit more funds in their personal savings accounts.

5) Interest rates in Canada drop by a significant percentage.

6) Due to a major technological breakthrough in the way electricity is generated, Canadian workers become more productive.

7) A temporary tax rebate of $1,000 is given to every household.

8) Trade unions force Canadian employers to pay higher wages which leads to higher incomes in Canada, 9) Income levels in the United States fall, affecting Canadian exports.

10) The federal government pays out a large sum to purchase new military equipment.

11) Canadian households suddenly fear that global share prices are going to tumble.

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12) Canadians become less entrepreneurially minded and start up fewer new businesses than before.

13) The demand by manufacturers in China for Canadian commodity exports increases.

14) There is a significant influx of immigrants into Canada which increases Canadian employment and incomes.

15) The Canadian dollar rises relative to the US dollar.

16) The federal government reduces taxes on both households and businesses.

Bonus or tie breaker question: 17) Draw an inflationary gap.

Describe the solutions for each scenario listed above:

1) The aggregate demand curve [shifts left; shifts right*; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

2) The aggregate demand curve [shifts left*; shifts right; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

3) The aggregate demand curve [shifts left; shifts right; does not shift*], and the aggregate supply curve [shifts left*; shifts right; does not shift].

4) The aggregate demand curve [shifts left*; shifts right; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

5) The aggregate demand curve [shifts left: shifts right*; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

6) The aggregate demand curve [shifts left; shifts right; does not shift*], and the aggregate supply curve [shifts left; shifts right*; does not shift].

7) The aggregate demand curve [shifts left; shifts right*; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

8) The aggregate demand curve [shifts left; shifts right*; does not shift], and the aggregate supply curve [shifts left*; shifts right; does not shift].

9) The aggregate demand curve [shifts left*; shifts right; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

10) The aggregate demand curve [shifts left; shifts right*; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

11) The aggregate demand curve [shifts left*; shifts right; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

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12) The aggregate demand curve [shifts left; shifts right; does not shift*], and the aggregate supply curve [shifts left*; shifts right; does not shift].

13) The aggregate demand curve [shifts left; shifts right*; does not shift], and the aggregate supply curve [shifts left; shifts right; does not shift*].

14) The aggregate demand curve [shifts left; shifts right*; does not shift], and the aggregate supply curve [shifts left; shifts right*; does not shift].

15) The aggregate demand curve [shifts left*; shifts right; does not shift], and the aggregate supply curve [shifts left; shifts right*; does not shift].

16) The aggregate demand curve [shifts left; shifts right*; does not shift], and the aggregate supply curve [shifts left; shifts right*; does not shift].

Explanation: 1) Households choose to spend more on consumption items. This raises consumption, causing an increase in aggregate demand, which pushes up both the economy‘s equilibrium price and output levels.

2) Businesses anticipate that profits will decrease. This reduces investment, causing a decrease in aggregate demand, which pushes down both the economy‘s equilibrium price and output levels.

3) The price of oil increases. This causes a short-run decrease in aggregate supply, which pushes up the economy‘s equilibrium price level, pushes down the equilibrium output level, and keeps the potential output level the same.

4) Households choose to deposit more funds in their personal savings accounts. This reduces consumption, causing a decrease in aggregate demand, which pushes down both the economy‘s equilibrium price and output levels.

5) Interest rates in Canada drop by a significant percentage. This raises consumption and investment, causing an increase in aggregate demand, which pushes up both the economy‘s equilibrium price and output levels.

6) Due to a major technological breakthrough in the way electricity is generated, Canadian workers become more productive. This causes a long-run increase in aggregate supply, which pushes down the economy‘s equilibrium price level, pushes up the equilibrium output level, and raises the potential output level.

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7) A temporary tax rebate of $1000 is given to every household. This raises consumption, causing an increase in aggregate demand, which pushes up both the economy‘s equilibrium price and output levels.

8) Trade unions force Canadian employers to pay higher wages. On the demand side, this causes an increase in aggregate demand due to the growth in total incomes and therefore consumption. On the supply side, this causes a short-run decrease in aggregate supply, which pushes up the economy‘s equilibrium price level, pushes down the equilibrium output level, and keeps the potential output level the same. Overall, the equilibrium price level rises, while the effect on the equilibrium output level is indeterminate.

9) Income levels in the United States fall, affecting Canadian exports. This reduces net exports, causing a decrease in aggregate demand, which pushes down both the economy‘s equilibrium price and output levels.

10) The federal government pays out a large sum to purchase new military equipment. This raises government purchases, causing an increase in aggregate demand, which pushes up both the economy‘s equilibrium price and output levels.

11) Canadian households suddenly fear that global share prices are going to tumble. This reduces consumption, causing a decrease in aggregate demand, which pushes down both the economy‘s equilibrium price and output levels.

12) Canadians become less entrepreneurially minded and start up fewer new businesses than before. This causes a long-run decrease in aggregate supply, which pushes up the economy‘s equilibrium price level, pushes down the equilibrium output level, and reduces the potential output level.

13) The demand by manufacturers in China for Canadian commodity exports increases. This raises net exports, causing an increase in aggregate demand, which pushes up both the economy‘s equilibrium price and output levels.

14) There is a significant influx of immigrants into Canada. On the demand side this causes an increase in aggregate demand due to the growth in total incomes and therefore consumption.

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On the supply side, this causes a long-run increase in aggregate supply, which pushes down the economy‘s equilibrium price level, pushes up the equilibrium output level, and raises the potential output level. Overall, the equilibrium output level rises, while the effect on the equilibrium price level is indeterminate.

15) The Canadian dollar rises relative to the US dollar. On the demand side, this reduces net exports and causes a decrease in aggregate demand, which pushes down both the economy‘s equilibrium price and output levels. On the supply side, this causes a short-run increase in aggregate supply (to the extent that the higher dollar reduces prices of imported raw materials), which pushes down the economy‘s equilibrium price level, pushes up the equilibrium output level, and raises the potential output level. Overall, the equilibrium price level necessarily falls, while the effect on the equilibrium output level is indeterminate.

16) The federal government reduces taxes on both households and businesses. On the demand side, this causes an increase in aggregate demand, which pushes up both the economy‘s equilibrium price and output levels. On the supply side, this causes a short-run increase in aggregate supply, which pushes down the economy‘s equilibrium price level, pushes up the equilibrium output level, and raises the potential output level. Overall, the effect on the equilibrium price level is indeterminate, while the equilibrium output level necessarily rises along with the potential output level.

17) Draw an inflationary gap. See the illustrative graph below.

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Recessionary Gap

Inflationary Gap

160

160

AS

Rec. Gap

120 100

Price Level (2007 = 100)

Price Level (2007 = 100)

140

AD

80 Potential Output

60 40 20

Inf. Gap

140

AS

120 100

AD

80 Potential Output

60 40 20

0

0 0

100

200

300

400

500

600

0

Real GDP (2007 $ billions)

100

200

300

400

500

600

Real GDP (2007 $ billions)

Follow-up areas of learning: Ask the students to explain why the curves shifted in each case. The instructor can also form a class discussion around some of the scenarios.

3. Discussion Questions (essay)

1. Find an article in the news that describes something that will cause a shift in the demand curve for the Canadian economy? Describe and explain.

2. Find an article in the news that describes something that will cause a shift in the supply curve for the Canadian economy? Describe and explain.

3. List the factors that cause shifts in the aggregate demand curve.

4. List the factors that cause shifts in the aggregate supply curve.

Explanation: 1-231 Copyright © 2023 by McGraw Hill

1. While answers will vary, the news article chosen by the student should concentrate on aggregate demand factors that affect consumption, investment, government purchases and/or net exports.

2. While answers will vary, the news article chosen by the student should concentrate on aggregate supply factors that cause either a short-run or long-run shift in aggregate supply.

3. consumption: disposable income, wealth, consumer expectations, interest rates. (2) investment: interest rates, business expectations. (3) government purchases. (4) net exports: foreign incomes, exchange rates.

4. input prices, (2) resource supplies, (3) productivity, (4) government policies.

4. Multiple Choice Questions

1. When net exports go up: a) the aggregate demand curve shifts left. b) the aggregate demand curve shifts right.* c) the aggregate supply curve shifts left with potential output falling. d) the aggregate supply curve shifts right with potential output staying the same. e) none of the above

2. When the value of consumers‘ homes decreases: a) the aggregate demand curve shifts left.* b) the aggregate demand curve shifts right. c) the aggregate supply curve shifts left with potential output falling. d) the aggregate supply curve shifts right with potential output staying the same. e) none of the above

3. When the amount of available land in the economy increases: a) the aggregate demand curve shifts left. b) the aggregate demand curve shifts right. c) the aggregate supply curve shifts left with potential output falling.

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d) the aggregate supply curve shifts right with potential output rising.* e) none of the above

4. When labour productivity drops: a) the aggregate demand curve shifts left. b) the aggregate demand curve shifts right. c) the aggregate supply curve shifts left with potential output falling.* d) the aggregate supply curve shifts right with potential output staying the same. e) none of the above

When the prices of raw materials rise: a) the aggregate demand curve shifts left. b) the aggregate demand curve shifts right. c) the aggregate supply curve shifts left with potential output staying the same.* d) the aggregate supply curve shifts right with potential output rising. e) none of the above

Explanation: 1. When net exports go up the aggregate demand curve increases. This means the curve shifts right.

2. When the value of consumers‘ homes falls the aggregate demand decreases. This means the curve shifts left.

3. When wages in the economy fall the aggregate supply curve undergoes a short-run increase. This means the curve shifts right with potential output staying the same.

4. When labour productivity drops the aggregate supply curve undergoes a long-run decrease. This means the curve shifts left with potential output falling.

5. When the prices of raw materials rise the aggregate supply curve undergoes a short-run decrease. This means the curve shifts left with potential output staying the same.

Chapter 11 1-233 Copyright © 2023 by McGraw Hill

Teaching Tips

Automatic Stabilizers Students may find the double-sided nature of automatic stabilizers hard to grasp. The net tax revenues that drive this stabilization process are defined as taxes minus transfer and subsidies, with the word ‗net‘ appearing in the name referring to the fact that transfers and subsides can be viewed as negative taxes. Both elements – taxes on the one hand and transfers and subsidies on the other – are part of the explanation of how automatic stabilizers operate. During periods of economic expansion, for example, two things take place. First, rising household incomes and business profits cause the dollar value of revenues from taxes on households, businesses and sales to increase. Second, with rising incomes and employment, the dollar amount that governments spend on transfer payments to households and subsidies to businesses decreases.

Both trends have the same effect – to raise net tax revenues. Because taxes are a withdrawal from the income-spending flow, this increase in net tax revenues dampens the economy‘s expansion.

During periods of contraction the logic is reversed. Now the decline in household incomes and business profits causes the dollar value of revenues from taxes on households, businesses and sales to decrease. At the same time, transfer payments to households and subsidies to businesses grow. Thanks to both trends, net tax revenues fall, and, because taxes are a withdrawal, this dampens the economy‘s contraction.

The Multiplier Effect and Injections and Withdrawals One reason for including the injections and withdrawals approach in the treatment of equilibrium in Chapter 10 was so that this approach can be employed here in Chapter 11 to explain the workings of the multiplier effect. In this chapter we look at the additions to real output from each new spending round spurred by an increase in injections. This approach is conceptually straightforward, but not that revealing for students wishing to understand the numerical size of the multiplier effect. For this, the injections and withdrawals approach is better suited, given that it is the marginal propensity to withdraw, or MPW, that is closely tied to the multiplier formula.

With a $1,000 increase in government purchases, for example, the overall impact on equilibrium real output can be thought of as the accumulated increase in withdrawals needed to match the $1,000 in added injections. Because each dollar in extra income creates $1 × MPW in withdrawals, the overall increase in income needed to accomplish this is 1/MPW, which is the formula used to calculate the multiplier effect.

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Instructors may want to emphasize the potentially problematic nature of the term public debt, which in virtually every circumstance that students will see it – for example in government publications or in the media – is limited to federal government debt, explicitly excluding debts of provincial, territorial and local governments. When the debts of these lower levels of government are incorporated, the result is referred to a government debt, not public debt. It is important to keep these two terms distinct.

Answers to Thinking about Economics Questions TAE I, Section 11.1: With lower tax rates in the economy, the impact of automatic stabilizers will be somewhat reduced.

TAE II, Section 11.2: With the increase in the proportion of income withdrawn by governments due to higher tax rates, there has been a rise in the Canadian economy‘s MPW and therefore a fall in the value of the spending multiplier.

TAE III, Section 11.3: Examples of relevant factors include the expanding proportion of elderly Canadians in the nation‘s population and the growth in the sophistication of techniques used in modern-day health care, which have helped increase Canadians‘ average life expectancy but also added costs to the health care system.

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Answers to Chapter Problems 11.1 Practice Problem

1. a) Because real output falls short of its potential level, an expansionary fiscal policy is called for, which means government purchases should be increased and/or taxes decreased. b) With unemployment below its natural rate, a contractionary fiscal policy should be used.

This means government purchases should be decreased and/or taxes increased. c) With the economy already at potential output and the corresponding natural rate of unemployment, there is no need for fiscal policy.

2. a) As incomes and spending drop, tax revenues fall. Meanwhile government transfer payments and subsidies rise. The result is a reduction in net tax revenues, which has a stabilizing expansionary effect on the economy. b) As incomes and spending expand, tax revenues rise. Government transfer payments and subsidies, meanwhile, fall. This leads to a rise in net tax revenues, which has a stabilizing contractionary impact on the economy.

11.2 Practice Problem 1. a) Withdrawals will have to rise by the same amount of $1 million so that injections and withdrawals are again equal. b) With an MPW of 0.67, then incomes and output must rise by $1.5 million, since each $1.50 in extra income will create $1 (= 0.67 × $1.50) in additional withdrawals.

2. a) With a $10 billion fall in government purchases, the AD curve shifts to the left by ()$16.7 billion [= -$10 billion × (1 / 0.60)]. b) The initial $25 billion rise in spending due to the tax cut causes the AD curve to shift to the right by $31.3 billion [= $25 billion × (1 / 0.80)].

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c) An MPC of 0.25 means that the economy‘s MPW is 0.75 (= 1 − 0.25). Therefore, with a $15 billion rise in government purchases, the AD curve shifts to the right by $20 billion [= $15 billion × (1 / 0.75)]. d) An MPC of 0.4 means the economy‘s MPW is 0.6 (= 1 − 0.4). With a $30 billion tax rise, the AD curve shifts to the left by (-)$20 billion [= − (0.4 × $30 billion) × (1 / 0.6)].

11.3 Practice Problem 1. a) With expenditures of $10 billion and tax revenues of $15 billion, there is a budget surplus of $5 billion (= $15 billion − $10 billion), and the government‘s debt falls to $95 billion (= $100 billion − $5 billion). b) If expenditures are $12.5 billion and tax revenues are $10 billion, there is a budget deficit of (-)$2.5 billion (= $10 billion − $12.5 billion). The government‘s debt therefore rises instead to $102.5 billion (= $100 billion + $2.5 billion).

2. a) With a 6% interest rate and $500 billion public debt, the budget deficit in Caledonia is $10 billion [= $180 billion + (0.06 × $500 billion) − $200 billion]. In contrast, a $600 billion public debt means the budget deficit is $16 billion [= $180 billion + (0.06 × $600 billion) − $200 billion]. Therefore, budget deficits and the size of the public debt are directly related, because a higher public debt means greater public debt charges, which cause a higher budget deficit. b) With a 5% interest rate and $500 billion public debt, the budget deficit in Caledonia is $5 billion [= $180 billion + (0.05 × $500 billion) − $200 billion], and with a 6% interest rate and $500 billion public debt, the budget deficit is $10 billion [= $180 billion + (0.06 × $500 billion) − $200 billion]. Therefore budget deficits and interest rates are directly related, since lower interest rates mean smaller public debt charges, which cause a lower budget deficit.

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End of Chapter Problems

1. a) Unemployment is below its natural rate and inflation is an increasing problem, so that real output must be above its potential level, and the economy faces an inflationary gap.

To diminish this gap, the government can reduce its purchases, raise taxes, or pursue both actions simultaneously. Any of these actions results in a leftward shift in the AD curve. b) Because unemployment is at or close to its natural rate, equilibrium real output approximates its potential level. Therefore, no fiscal policy is required. c) With declining output and unemployment above its natural rate, real output falls short of its potential level and the economy is experiencing a recessionary gap. This gap can be lessened by increasing government purchases, cutting taxes, or combining these two actions. Each of these actions results in a rightward shift in the AD curve.

2.

Recall the following relationships: MPC = Change in consumption on domestic items / Change in income MPW = Change in total withdrawals / change in income

MPC + MPW = 1 Spending multiplier = 1 / MPW a. MPC is 0.35 (= $350,000 / $1,000,000), MPW is 0.65 (= 1 − 0.35), and the spending multiplier is 1.54 (= 1 / 0.65). b. MPC is 0.25 (= -$1,000,000 / -$4,000,000), MPW is 0.75 (= 1 − 0.25), and the spending multiplier is 1.33 (= 1 / 0.75). c. MPW is 0.60 (= -$3,000,000 / -$5,000,000), MPC is 0.40 (= 1 − 0.60), and the spending multiplier is 1.67 (= 1 / 0.60).

3. a) MPW = 0.40 + (0.30 × 0.60) + (0.05 × 0.60) = 0.40 + 0.18 + 0.03 = 0.61 b) Because MPW is 0.61, MPC is 0.39 (= 1 − 0.61). This means that 39 cents of each new dollar of income is spent on domestic consumption items. c) The spending multiplier is 1.64 (= 1 / 0.61).

4.

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a) Given an MPW of 0.65, the spending multiplier is 1.54 (= 1 / 0.65), so that the AD curve finally shifts to the right by $3.1 billion (= 1.54 × $2 billion). b) With an MPC of 0.45, MPW is 0.55 (= 1 − 0.45). The spending multiplier is therefore 1.82 (= 1 / 0.55), so that the AD curve finally shifts to the left by (-)$9.1 billion (= 1.82 × -$5 billion). c) Given an MPW of 0.7, the MPC is 0.3 (= 1 − 0.7), and the spending multiplier is 1.43 (= 1 / 0.7). The AD curve finally shifts to the left by (-)$1.3 billion [= (-0.3 × $3 billion) × 1.43]. d) If the $4 billion tax cut causes spending to rise initially by $1.5 billion, then the MPC is 0.375 (= $1.5 billion / $4 billion), which means MPW is 0.625 (= 1 − 0.375). The spending multiplier is therefore 1.60 (= 1 / 0.625), so that the AD curve finally shifts to the right by $2.4 billion (= 1.6 × $1.5 billion).

5. a) Recall the relationships: MPW = Change in total withdrawals / Change in income; MPW + MPC = 1; Spending multiplier = 1 / MPW. MPW is 0.55 (= $4.4 billion / $8 billion) and MPC is 0.45 (= 1 − 0.55). The multiplier is therefore 1.82 (= 1 / 0.55). b) The AD curve shifts to the left by $14.5 billion (= 1.82 × $8 billion). (Use the un-rounded solution for the multiplier in part (a) [i.e. 1.81818181...] to find the rounded solution of 14.5 rather than 14.6.) c) Both the equilibrium price level and real output will fall, with the decrease in equilibrium real output being less than the shift in the AD curve.

6. a)

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The initial equilibrium price level and real output of 120 and $450 billion are found at the intersection of AD0 and AS (point a in the graph above). b) With low unemployment and rising inflation the economy faces an inflationary gap.

Therefore, a contractionary fiscal policy should be used and, if government purchases are being changed, they should decrease. With an MPC of 0.67, MPW is 0.33 (= 1 – 0.67) and the multiplier in this economy is 3.03 (= 1 / 0.33). Therefore a decrease in government purchases of $33 billion finally leads to real expenditures decreasing by $100 billion (= $33 billion × 3.03) at every price level. c) The values in the empty column of the table are 300, 350, 400, 450, and 500. The decrease in the real expenditures by $100 billion at every price level is represented by a leftward shift in the AD curve from AD0 to AD1 in the graph. The new price level and real output are 110 and $400 billion (point b in the graph above). The change in equilibrium real output is $50 billion while the shift in the AD curve is $100 billion.

Therefore, the change in output is less than the shift in the AD curve. This is because a decrease in aggregate demand translates not just into a fall in output but also in the price level.

7. a)

The initial equilibrium price level and real output of 100 and $125 billion are found at the intersection of AD0 and AS (point a in the graph above).

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b) With high unemployment and low inflation the economy faces a recessionary gap.

Therefore, an expansionary fiscal policy is required and, if taxes are being changed, they should decrease. With an MPC of 0.33, MPW is 0.67 (= 1 – 0.33) and the multiplier in this economy is 1.5 (= 1 / 0.67). Therefore a decrease in taxes of $60 billion finally leads to real expenditures increasing by $30 billion [= -(0.33 × -$60 billion) × (1 / 0.67) at every price level. c) The values in the empty column of the table are 125, 140, 155, 170, and 185. The increase in the real expenditures by $30 billion at every price level is represented by a rightward shift in the AD curve from AD0 to AD1 in the graph. The new price level and real output are 110 and $140 billion (point b in the graph above). The change in equilibrium real output is $15 billion while the shift in the AD curve is $30 billion.

Therefore, the change in output is less than the shift in the AD curve. This is because an increase in aggregate demand translates not just into a rise in output but also in the price level.

8. a) With public debt charges of $50 billion and public debt of $500 billion, Cambria‘s nominal interest rate is 10% [= $50 billion/$500 billion]. b) Because public debt is $500 billion and nominal GDP is $1 trillion, the public debt ratio at the start of the year is 50% [= $500 billion/$1 trillion]. c) Cambria‘s public debt the end of the year is found by adding public debt charges and the primary budget deficit to the initial public debt, or $575 billion [= $500 billion + $50 billion + $25 billion]. Meanwhile nominal GDP at the end of the year is $1.15 trillion [= $1 trillion × (1 + .15)]. Cambria‘s public debt ratio at the end of the year is therefore 50% [= $575 billion/$1.15 trillion]. Because the nominal interest rate is lower than the growth in nominal GDP, it has been possible for the public debt ratio to stay the same despite the primary budget deficit. This is in line with the interest rate-growth rule. d) Cambria‘s public debt at the end of the year is again $575 billion [= $500 billion + $50 billion + $25 billion] while nominal GDP at the end of the year is $1.05 trillion [= $1 trillion × (1 + .05)]. Cambria‘s public debt ratio at the end of the year is therefore 55% [= $575 billion/$1.05 trillion]. Because the nominal interest rate is higher than the growth in nominal GDP, the primary budget deficit necessarily leads to a rise in the public debt ratio. This is again in line with the interest rate-growth rule.

9. With a regressive tax system, changes in income cause only a small change in tax revenues.

This dampens decreases in net tax revenues during periods of falling incomes and also dampens 1-241 Copyright © 2023 by McGraw Hill

increases in net tax revenues when incomes are rising. Therefore, automatic stabilizers become less effective, which makes the statement true.

Advancing Economic Thought Problems

1. a) According to neoclassical economists, falling wages do not lead to anything other than a very temporary underspending in the economy. This is based on Say‘s Law, which states that supply creates its own demand, and this is the case regardless of whether the demand originates with workers or other resource-providers in the economy. When workers‘ incomes are reduced, then according to neoclassical economists other incomes will rise, so that all of the economy‘s production can be purchased. In contrast, in the Keynesian view, a fall in spending by workers may not be counteracted by spending increases by other economic participants, which means that underspending and an economic downturn are possible

b) According to neoclassical economists, an increase in injections will cause interest rates to change until expenditures and withdrawals are made equal at a single equilibrium level of output. On the other hand, in the Keynesian view, a rise in injections causes an increase in equilibrium output, which is needed to eradicate the discrepancy between injections and withdrawals.

2. a) According to neoclassical economists, periods of low output and high unemployment are self-correcting without government intervention. Given flexible labour markets, high unemployment is eliminated by changes in real wages. Also, a temporary lack of spending causes an adjustment in interest rates. This adjustment balances injections and withdrawals and therefore eradicates the initial underspending. b) Keynes disagreed for two reasons. First, in his view labour markets do not necessarily reach equilibrium through changes in real wages. Second, interest rates do not necessarily adjust to counteract a temporary lack of spending. It is only through government intervention, said Keynes, that the elimination of low output and high unemployment can be assured.

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Simulation

1. Introductory Information Time: Approximately 30 minutes.

Materials: Stopwatches for moderators Set-up: Divide the class into an even number of teams where each team has 5 or fewer members.

Pair the teams, to compete against each other.

In each pair select one team to represent the side of government and the other to represent the opposition.

Select at least one student moderator. One moderator can be used for all the debates or each debate could have a new moderator (in this case select one moderator for each pair of debating teams).

Key Concepts Covered: expansionary fiscal policy contractionary fiscal policy stabilization policy Learning Objectives: - Debate the use of expansionary fiscal policy and contractionary fiscal policy during economic downturns and booms.

2. Exercise Recall that students are in an even number of groups made up of of 5 or fewer students, and there is at least one student moderator.

Timekeeper and Scorekeeper: The moderator will be both the timekeeper and scorekeeper.

Teams will be given 15 minutes to prepare for the debate. During the debate, each member of each team will be given one minute to make their argument or rebuttal.

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The scoring criteria will be chosen by the instructor (who will tell the moderator what the scoring criterion is while the teams are preparing their arguments). The instructor may wish to score based on specific points they have discussed previously in class, for example. Alternatively, score using a simple tally of the number of reasonable arguments provided by each team. The moderator will tally the scores and announce a winner at the end of each debate.

Stage 1: The two teams, one representing the government‘s interests and the other representing the opposition, will debate one of the following two resolutions selected by the instructor: ―An expansionary fiscal policy should be enacted to stabilize the economy during the current economic downturn,‖ or, ―A contractionary fiscal policy should be enacted to stabilize the economy during the current economic boom.‖ Each team will be given 15 minutes to prepare for the debate. The moderators should spend this time becoming well versed with the material, as well as determining the scoring criterion by discussing it with the instructor.

When the teams return after their 15-minute preparation period they will take seats across from each other. The moderator will sit in the middle facing both teams.

The debate will begin with the government team‘s presentation of set of specific fiscal policy actions they have devised. The other team will attempt to refute this set of fiscal policy actions.

The first member of the government team will summarize the recommended set of policy actions in one minute. Once these policy actions have been summarized, the first member of the opposition will be given one minute to rebut the government‘s arguments. Then the second member of the government will be given one minute to respond.

This order will continue until each member on each team has been given one minute to speak. (If there is an uneven number, one member on the larger team will be given the opportunity to speak twice.)

Recall that throughout the debate the moderators will be responsible for timing each one-minute argument and rebuttal.

Stage 2: The moderator will announce a winner.

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The instructor should conduct a class discussion after the debate about the arguments that each group found to be most pertinent.

Explanation: Results will depend on the chosen topic.

3. Discussion Questions (essay) 1. The economy appears to be heading into a significant economic downturn. Outline three fiscal policy actions a government could employ to stabilize the economy in these circumstances.

2. Describe or find and example from the recent news of the government enacting a fiscal policy. What impact is it expect to have? Do you think it was the right decision? Why or why not?

Explanation:

1. Answers will vary, but could include increases in government purchases such as road construction, increases in transfer payments such as employment insurance benefits, or decreases in taxes such as personal income tax.

2. Answers will vary, but students should apply material that they learned from the in-class debates.

4. Multiple Choice Questions 1. When the government policy-makers increase taxes to stabilize the economy, they are using: a) contractionary fiscal policy.* b) expansionary fiscal policy. c) contractionary monetary policy. d) expansionary monetary policy. e) none of the above

2. Transfer payment programs such as employment insurance are examples of: a) automatic stabilizers.* b) discretionary fiscal policy.

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c) discretionary monetary policy. d) fiscal policy that is always contractionary in its effects. e) fiscal policy that is always expansionary in its effects.

3. Expansionary fiscal policy includes: a) only decreases in government purchases. b) only increases in taxes. c) decreases in government purchases and/or increases in taxes. d) increases in government purchases and/or decreases in taxes.* e) none of the above

4. Contractionary fiscal policy includes: a) decreases in both government purchases and taxes. b) increases in both government purchases and taxes. c) decreases in government purchases and/or increases in taxes.* d) increases in government purchases and/or decreases in taxes. e) none of the above

Explanation: 1. When the government policy-makers increase taxes to stabilize the economy, they are using contractionary fiscal policy.

2. Transfer payment programs such as employment insurance are examples of automatic stabilizers.

3. Expansionary fiscal policy includes increases in government purchases and/or decreases in taxes.

4. Contractionary fiscal policy includes decreases in government purchases and/or increases in taxes.

Chapter 12 Teaching Tips

M1 and M1+ In past decades, the Bank of Canada highlighted a narrow definition of the money supply known as M1, which included only two categories: currency outside banks and chartered bank demand 1-246 Copyright © 2023 by McGraw Hill

deposits. This was at a time when demand deposits were heavily used as a means exchange. But the distinction between these deposits and the chequable notice deposits issued by chartered banks and near banks shrank. As a result, this definition lost much of its significance. Indeed, the distinct role that chartered bank demand deposits once played has now disappeared so completely that the Bank of Canada no longer publishes statistics for M1. Instead, M1+ has taken over the role of the most important narrow definition of the Canadian money supply.

Instructors may wish to mention the M1 definition, however, given that it still appears in the money supply statistics published in some other countries.

M1+ versus M2, M3 and M2+ When referring to the various money supply measures in Figure 12.2, it is useful to remind students that while the specification of M1+, M2, M3 and M2+ goes approximately from narrow to broader definitions, the trend is not fully consistent. For example, chequable notice deposits issued by near banks are included in M1+, but not in M2 and M3. Meanwhile, M3 includes chartered bank non-personal term and foreign currency deposits, which are excluded from M2+.

The Price of Bonds In the discussion of the money market, we see that, in the special case of perpetual bonds (also known as consols), the price of the bond can be derived using some hypothetical reasoning. For example, a perpetual bond with an initial value of $1000 that is issued when the nominal interest rate is 10 percent gives an annual interest payment of $100. If the interest rate then falls to 5 percent, the price of the bond rises to $2000, given that newly issued perpetual bonds with an initial value of $1000 will provide only $50 per year. Instructors may wish to refer students to a simple formula for encapsulating this relationship, where the interest rate is expressed as a decimal (e.g. 0.05 for 5 percent):

Current price of perpetual bond = annual interest payment / nominal interest rate For example, where the annual interest payment is $50 and the nominal interest rate is 5%, the current price of the bond is $1000 (= $50 / 0.05). Instructors may also wish to stress, as noted in the text, that the relationship between bond prices and the interest rate for bonds other than this special case is more complicated. But as long as the relevant bond is not short term, the formula is useful in giving a sense of how a bond price will be affected by interest rate fluctuations.

Nominal versus Real Interest Rates 1-247 Copyright © 2023 by McGraw Hill

In Chapter 10 we saw that one of the main factors affecting investment spending was the interest rate. Similarly for the consumption of durable items such as automobiles, the interest rate can play an important role because funds to pay for the item are so often borrowed. The relevant interest rate in both these cases is the real rate rather than the nominal rate. That‘s because businesses and households view the benefits from investment or consumption of durable items (expected extra profit for a business; extra utility for a household) in real rather than nominal terms, so need to compare these benefits with a borrowing cost expressed in real terms as well.

In contrast, the interest rate which determines demand in the money market is the nominal rather than the real rate. Students may need to be reminded to keep this distinction in mind when tracing out changes in the money market to adjustments in the real economy through changes in investment and consumption of durable items. Recall that, while nominal and real rates of interest are closely related, with the expected real rate of interest found by deducted the expected rate of inflation from the nominal interest rate, they are not identical. This becomes particularly important in the next chapter when we look at the impact of monetary policy on the economy.

Answers to Thinking about Economics Questions TAE I, Section 12.1: Stablecoins such as Tether are most likely to be included in the money supply, since their values are fixed against official currencies. The values of most other cryptocoins fluctuate against official currencies – some in extreme ways.

TAE II, Section 12.3: Because banks choose lower reserve ratios than those that were required when these ratios were set by law, the size of the money multiplier has risen.

Answers to Chapter Problems 12.1 Practice Problem

1. a) M1+ is the sum of currency outside chartered banks ($25 billion), publicly-held demand deposits at chartered banks ($12 billion), chequable notice deposits at chartered banks 1-248 Copyright © 2023 by McGraw Hill

($28 billion), and chequable notice deposits at near banks ($17 billion), or $82 billion (= $25 billion + $12 billion + $28 billion + $17 billion). b) M2 is the sum of currency outside chartered banks ($25 billion), publicly-held demand deposits at chartered banks ($12 billion), chequable notice deposits at chartered banks ($28 billion), non-chequable notice deposits at chartered banks ($36 billion) and personal term deposits at chartered banks ($45 billion), or $146 billion (= $25 billion + $12 billion + $28 billion + $36 billion + $45 billion). c) M2+ is the sum of M2 ($146 billion), chequable notice deposits at near banks ($17 billion), non-chequable notice deposits at near banks ($32 billion), personal term deposits at near banks ($18 billion) and other liquid assets included in M2+ ($20 billion), or $233 billion (= $146 billion + $17 billion + $32 billion + $18 billion + $20 billion).

12.2 Practice Problems

1. a) With the nominal interest rate above its equilibrium level, the money market will exhibit a surplus, with the quantity supplied of money exceeding the quantity demanded. This surplus means that wealth holders will try to reduce their holdings of money by buying financial assets such as bonds. As a result, the prices of these financial assets will rise and the nominal interest rate will fall until the money market has moved to its equilibrium. b) Now the nominal interest rate is below its equilibrium level and the money market exhibits a shortage as the quantity demanded of money exceeds the quantity supplied.

This shortage means that wealth holders will attempt to acquire money by selling financial assets such as bonds. As a result, the prices of these financial assets will fall and the nominal interest rate will rise until the money market has moved to its equilibrium.

2. a) The bond‘s annual interest payment is $1,000 (= $20,000 × 0.05). b) Because newly issued $20,000 bonds provide only $400 (= $20,000 × 0.02) per annum, this bond will have a price that is 2.5 (= $1,000 / $400) times as much, or $50,000. c) Newly issued $20,000 bonds now provide $2,000 (= $20,000 × 0.10) per annum. This bond will therefore have a price that is 0.5 (= $1,000 / $2,000) times as much, or $10,000.

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12.3 Practice Problems

1. a) The reserve ratio of 4% [= ($40,000 / $1 million) × 100] is found by dividing desired reserves by deposits and multiplying the result by 100. b) The bank‘s desired reserves increase by $4,000 (= $100,000 × 0.04). This is found by multiplying the increase in deposits by the reserve ratio. The bank‘s excess reserves increase by $96,000 (= $100,000 − $4,000). This is found by subtracting the increase in desired reserves from the total increase in reserves. c) This bank begins the increase in the money supply by lending out its excess reserves of $96,000. The money multiplier equals 1 divided by the reserve ratio or 25 (= 1 / 0.04), meaning that the final increase of the money supply in the banking system will be $2,400,000 (= $96,000 × 25).

2. a) The initial change in excess reserves is found by subtracting the $12 (= $200 × 0.06) increase in desired reserves from the $200 increase in total reserves, or an increase of $188 (= $200 − $12). b) The maximum amount by which the money supply can change is found by multiplying the initial change in excess reserves by the money multiplier, or $3,133.33 [= $188 × (1 / 0.06)].

End of Chapter Problems 1. a) Because money is being used to compare prices it is functioning primarily as a unit of account. b) Because money is being used to pay for food services it is functioning primarily as a means of exchange. c) Because money is being treated as a financial asset it is functioning primarily as a store of purchasing power.

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d) Because money is being used to pay off a debt it is functioning primarily as a means of exchange. e) Because money is being used so that buyers can relay the prices they are willing to pay it is functioning primarily as a unit of account. f) Because money is being used to pay a bank for its services, it is functioning primarily as a means of exchange.

2. a) $222 billion [= currency outside chartered banks ($28 billion) + publicly-held demand deposits at chartered banks ($31 billion) + chequable notice deposits at chartered banks ($88 billion) + chequable notice deposits at near banks ($75 billion)] b) $347 billion [= currency outside chartered banks ($28 billion) + publicly-held demand deposits at chartered banks ($31 billion) + chequable notice deposits at chartered banks ($88 billion) + non-chequable notice deposits at chartered banks ($80 billion) + personal term deposits at chartered banks ($120 billion)] c) $601 billion [= M2 ($347 billion) + nonpersonal term and foreign-currency deposits at chartered banks ($254 billion)] d) $600 billion [= M2 ($347 billion) + chequable notice deposits at near banks ($75 billion) + non-chequable notice deposits at near banks ($60 billion) + personal term deposits at near banks ($100 billion) + other liquid assets included in M2+ ($18 billion)]

3. a)

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b) The equilibrium interest rate is 4% and the equilibrium quantity of money is $150 billion (point a in the graph). c) With an initial interest rate of 2%, the quantity of money demanded ($250 billion) exceeds the quantity supplied ($150 billion). This $100 billion shortage means that wealth holders try to sell bonds to acquire money, pushing down bond prices and raising the interest rate until the shortage of money is eliminated at a 4% interest rate.

With an initial interest rate of 6%, the quantity of money supplied ($150 billion) exceeds the quantity demanded ($100 billion). As wealth holders try to dispense of this $50 billion surplus by purchasing bonds, they push up bond prices, which reduces the interest rate until the surplus of money is eradicated at a 4% interest rate. d) A $50 billion decrease in the money supply at every interest rate means there is a $50 billion shortage of money at the initial equilibrium interest rate of 4%. Wealth holders try to dispense with this shortage by selling bonds, causing a fall in bond prices and raising the interest rate until the shortage of money is eradicated at the new equilibrium interest rate. e) The new equilibrium interest rate is 6 percent (point b in the graph).

4. a) 1-252 Copyright © 2023 by McGraw Hill

b) The equilibrium interest rate is 3% and the equilibrium quantity of money is $10 billion (point a in the graph). c) With an initial interest rate of 4%, the quantity of money supplied ($10 billion) exceeds the quantity demanded ($2.5 billion). As wealth holders try to dispense of this $7.5 billion surplus by purchasing bonds, they push up bond prices, which reduces the interest rate until the surplus of money is eradicated at a 3% interest rate.

With an initial interest rate of 1%, the quantity of money demanded ($40 billion) exceeds the quantity supplied ($10 billion). This $30 billion shortage means that wealth holders try to sell bonds to acquire money, pushing down bond prices and raising the interest rate until the shortage of money is eliminated at a 3% interest rate. d) A $10 billion increase in the money supply at every interest rate means there is a $10 billion surplus of money at the initial equilibrium interest rate of 3%. Wealth holders try to dispense with this surplus to acquire bonds, causing a rise in bond prices and reducing the interest rate until the surplus of money is eradicated at the new 2% equilibrium interest rate (point b in the graph). e) A $10 billion increase in the quantity of money demanded at every interest rate means there is a $10 billion shortage of money at the initial equilibrium interest rate of 2% from part (d). With this shortage, wealth holders try to sell bonds to acquire money, causing a fall in bond prices and raising the interest rate until the shortage of money is eradicated at the new 3% equilibrium interest rate (point c in the graph). f) An increase in real output raises the total value of transactions in the economy, expanding the transactions demand for money and shifting the money demand curve to the right.

This leads to a rise in the equilibrium interest rate. In contrast, a decrease in the price level reduces the total value of transactions in the economy as well as the transactions 1-253 Copyright © 2023 by McGraw Hill

demand for money. This shifts the money demand curve to the left, which causes a decline in the equilibrium interest rate.

5. a) Given that the bond is initially worth $10,000 and has an interest rate of 4%, its annual interest payments must be $400 (= 0.04 × $10,000). A drop in the prevailing interest rate to 2% means that the price of this bond rises to $20,000, so that its $400 interest payment now represents 2% of its price (since 0.02 × $20,000 = $400). b) A rise in the prevailing interest rate to 6% causes the price of this bond to decline to $6,667, so that its $400 interest payment now represents 6% of its price (since 0.06 × $6,667 = $400).

6. a) Hudson Bank‘s $10 million in deposits and 5% reserve ratio mean that the Bank‘s desired reserves are $500,000 (= 0.05 × $10 million). Since the Bank‘s actual reserves are $600,000, it has $100,000 (= $600,000 − $500,000) in excess reserves. b) The money multiplier of 20 [= (1 / 0.05)] is the reciprocal of the reserve ratio expressed as a decimal (0.05). c) When Hudson Bank lends out its $100,000 in excess reserves, the process of money expansion this leads to in the banking system means that the money supply increases by a final amount of $2,000,000 (= $100,000 × 20), found by multiplying the change in excess reserves by the money multiplier of 20.

7. a) With $5 million in deposits and a 4% reserve ratio, Champlain Bank‘s desired reserves are $200,000 (= 0.04 × $5 million). Given the Bank‘s $200,000 in actual reserves, the Bank has zero excess reserves. b) If $15,000 in currency is deposited in the bank, its deposits rise to $5,015,000, so that is desired reserves become $200,600 (= 0.04 × $5,015,000). Since the bank now has $215,000 (= $200,000 + $15,000) in actual reserves, its excess reserves are now $14,400 (= $215,000 − $200,600). c) The money multiplier of 25 [= (1 / 0.04)] is the reciprocal of the reserve ratio expressed as a decimal (0.04). d) Once Champlain Bank lends out its $14,400 in excess reserves, the process of money expansion in the banking system will cause a total increase in the money supply of

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$360,000 (= $14,400 × 25), found by multiplying the change in excess reserves by the money multiplier of 25.

8. a) With $10 million in deposits and a 5% reserve ratio, Riel Bank‘s desired reserves are $500,000 (= 0.05 × $10 million). Given the Bank‘s $500,000 in actual reserves, the Bank has zero excess reserves. b) If $50,000 in currency is withdrawn from the bank, its deposits fall to $9,950,000, so that is desired reserves become $497,500 (= 0.05 × $9,950,000). Since the bank now has $450,000 (= $500,000 − $50,000) in actual reserves, its excess reserves have become −$47,500 (= $450,000 − $497,500). c) The money multiplier of 20 [= (1 / 0.05)] is the reciprocal of the reserve ratio expressed as a decimal (0.05). d) Once Riel Bank calls in loans equal to its -$47,500 in excess reserves, the process of money contraction in the banking system will cause a total change in the money supply of -$950,000 (= -$47,500 × 20), found by multiplying the change in excess reserves by the money multiplier of 20.

9. a) In the first transaction, the wealth-holder is paid the full amount of her $200 withdrawal.

This means the bank‘s cash reserves, as well as its deposits, both decline by $200. In the second transaction, because the bank‘s desired reserves have now decreased by $10 (= 0.05 × $200) while its actual reserves have fallen by $200, its excess reserves have declined by $190 [= (-$200) − (-$10)]. To eliminate this discrepancy, the Bank must reduce its outstanding loans by $190, which causes both its assets and its deposits to decrease by this amount. As its deposits decrease, the money supply is immediately reduced by $190. b) The final change in the money supply is a decrease of $3,800. This is found by multiplying the initial change in excess reserves (-$190) by the money multiplier, which is the reciprocal of the reserve ratio expressed as a decimal [(1 / 0.05) = 20].

Advancing Economic Thought Problems

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1. Darity and Mullen argue that the gap must account for the fact that a small percentage of American whites control such a significant percentage of the overall wealth. Their argument makes sense. Because calculating the mean requires summing all relevant values before dividing by the number of values, this statistic incorporates the very high wealth holdings of this small elite. In contrast, the median, as the middle of all relevant values, does not incorporate this elite‘s wealth holdings in the calculation of the statistic.

2. The logic behind this exclusion is that, because the ancestors of Americans who are Hispanic or from other racial backgrounds did not benefit directly from slavery, they should not be among those who pay for the reparations program. Excluding them makes the program‘s passage harder, since it increases the size of the wealth gap that would need to be accounted for by reparations. It is also likely that some representatives of these groups would argue that the gaps in their average wealth vis a vis whites should also be taken into account.

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Simulation

1. Introductory Information Time: Approximately 15 minutes.

Materials: $1,000 in Monopoly money or play money in various denominations.

Set-up: Divide the class into teams of 6 members each.

Key Concepts Covered: desired reserves money multiplier money supply reserve ratio

Learning Objectives: - Demonstrate an understanding of how the money supply is expanded through bank lending and the operation of the money multiplier.

- Analyze the roles of banks‘ desired reserves and the reserve ratio in the money creation process.

2. Exercise

Recall that students have each been divided into groups of six.

Timekeeper: The students will be given 10 minutes to sort out all of the transactions.

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Stage 1: Each team of 6 students will act as their own separate market. The 6 students will fill the following roles.

Students A and B will play the role of the Maple Leaf Bank. Their goal is to meet the needs of their customers and comply with government regulations.

Student C will play the role of a new schoolteacher who has received her first pay cheque. She wishes to deposit $800 for safe keeping with the Maple Leaf Bank.

Student D has just decided to buy a new motor for his boat. The motor costs $500 and he would like to borrow this amount from the Maple Leaf Bank.

Student E is the seller of motors for boats. He puts all his net earnings into the Maple Leaf Bank.

He earns a net $400 from the sale of each motor.

Student F is a new college student who wishes to buy a new TV for her apartment. She would like to borrow $400 from the Maple Leaf Bank in order to make this purchase.

Stage 2: Student C receives the $1,000 in Monopoly money. Note that the reserve ratio is 0.15, or 15%.

Then students will be given 10 minutes to sort out all of the transactions. Everyone can work together to make sure they all have their preferences met before time runs out.

1. Did the bank meet the reserve ratio? Why or why not?

No, the bank did not meet the reserve ratio. It held less than 4% of all the money it lent out.

No, the bank did not meet the reserve ratio. It held less than 5% of all the money it lent out.

Yes, the bank met the reserve ratio. It held more than 15% of all the money it lent out.* Yes, the bank met the reserve ratio. It held more than 25% of all the money it lent out.

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2. Why was the bank able to take in $400 and lend out $400?

The bank was able to lend out the $400 because it had $100 of excess reserve on hand from the first transaction.

The bank was able to lend out the $400 because it had $180 of excess reserve on hand from the first transaction.* The bank was able to lend out the $400 because it had $200 of excess reserve on hand from the first transaction.

The bank was able to lend out the $400 because it had $280 of excess reserve on hand from the first transaction.

3. How much money was originally in the market? $[800] was originally in the market.

4. How much money was created? $[900] was created.

5. Could the bank have created more money than it did?

Yes, the bank could have lent out an additional $120 because this would leave the bank with the minimum required reserves.* Yes, the bank could have lent out an additional $200 because this would leave the bank with the minimum required reserves.

No, the bank could not have lent out any additional because there was no cash left to lend.

No, the bank could not have lent out any additional money because this would leave the bank with less than the minimum required reserves.

Explanation: 

The result of the exercise will be that everyone is able to make the transactions that they want to make:



The schoolteacher will deposit $800 in her bank account.

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

Maple Leaf Bank will hold on to $300 as reserves – $120 as desired reserves and $180 as excess reserves – against this $800 in new deposits and lend the remaining $500 to the purchaser of the motor, who then gives the $500 to the seller of the motor.



The seller will then deposit their net receipt of $400 in the bank.



Maple Leaf Bank has to turn $60 of their $180 in excess reserves as desired reserves against this $400 in new deposits and while it lends $400 to the student who wishes to buy the TV.

1. Yes, the bank met the reserve ratio. It held more than 15% of all the money it lent out.

2. The bank was able to lend out the $400 because it had $180 of excess reserves on hand from the first transaction.

3. $800 was originally in the market.

4. $900 was created.

5. Yes, the bank could have lent out an additional $120 in its excess reserves because this would leave the bank with the minimum required reserves.

3. Discussion Questions (essay) 1. Describe the process by which money was created in the Chapter 12 simulation?

2. Based on your knowledge of the U.S. market crash in 2008, what impact has that had on the amount of money being created by the banks? Why?

3. Describe a time when you have been part of the money creation process.

Explanation: 1-260 Copyright © 2023 by McGraw Hill

1. Students will describe the process through which money was given to the bank. The bank then kept the required reserves and lent out the additional amount of money. This is how money was created in the market.

2. The market crashed because financial companies were re-structuring mortgage loans and using this to create more money. Essentially the governing rules surrounding the creation of money in this instance were too loose. The impact this has had is that the banks are under more strict rules surrounding lending and are now able to create less money.

3. Answers will vary.

4. Multiple Choice Questions

1. If a person deposits $900 into the bank, how much money can be lent out, if the reserve ratio is 0.10? [$90; $810*; $900; $100; $1,000] can be lent out.

2. The amount of cash that a bank decides hold is called its:. a) bond holdings. b) desired reserves.* c) loans. d) reserve ratio. e) savings.

3. A bank can lend out: a) its desired reserves. b) half its desired reserves. c) all of the funds it receives in deposits less $100. d) all of the funds it receives in deposits. e) all of the funds it receives in deposits less its desired reserves.*

4. The bank has excess reserves when its: 1-261 Copyright © 2023 by McGraw Hill

a) cash reserves are greater than its deposits. b) cash reserves are greater than its desired reserves.* c) loans are greater than its deposits. d) desired reserves are greater than its deposits. e) desired reserves are greater than its cash reserves.

5.

If there is an initial change is excess reserves of $1,500 and the final change in the money supply is $6,000 then the money multiplier is: a) 4.* b) 5. c) 6. d) 8. e) 12.

Explanation: 1. If a person deposits $900 into the bank and the reserve ratio is 10%, $810 can be lent out.

2. The amount of cash that a bank decides hold is called its desired reserves.

3. A bank can lend out all of the funds it receives in deposits less its desired reserves.

4. The bank has excess reserves when its cash reserves are greater than its desired reserves.

5. If there is an initial change is excess reserves of $1,500 and the final change in the money supply is $6,000; the money multiplier is 4.

Chapter 13 Teaching Tips

Quantitative Easing As noted in the chapter, quantitative easing occurs when a central bank such as the Bank of Canada purchases a significant amount of government bonds or other assets to hold for extended periods. Used by many central banks to stimulate economic activity in the aftermath of the global 2008-9 crisis, this policy was previously applied by the Federal Reserve during the early 1930s, then by the Bank of Japan after 2000. Instructors might want to stress that the distinction between regular open market operations and quantitative easing is less conceptual than a matter 1-262 Copyright © 2023 by McGraw Hill

of degree. With quantitative easing, a central bank‘s asset purchases far outweigh what would be bought and sold in the open market during normal periods.

The Phillips Curve Despite its intermittent shifts, the Phillips Curve remains a useful learning tool to highlight the short-run trade-off between inflation and unemployment. This trade-off, reflecting the curve‘s negative slope, plays a key role in the Bank of Canada‘s monetary policy. Though its existence is agreed upon by virtually all economists, there is little consensus over its duration or its size. In the chapter there is a reference to one Bank of Canada estimate of the size of the curve‘s negative slope. This estimate suggests that to bring inflation down by one percentage point requires unemployment to exceed its natural rate by two-thirds of a percentage point for at least a year.

Like the other estimates made by Bank of Canada, this figure is relatively low when compared with estimates made by other economists,2 pointing to various possible slopes for the short-run Phillips Curve.

Answers to Thinking about Economics Questions

TAE I Section 13.1: First, when compared with financial regulation in many other countries, the extent to which Canadian banks were able to invest in risky assets such as subprime mortgages was tightly regulated. Second, management of these banks was relatively conservative, possessing little appetite for what proved to be toxic investment decisions. The market dominance of the ―big six‖ chartered banks also played a role. Each of the six banks is large enough to take full advantage of the lower risk that comes from having well diversified pools of outstanding loans.

TAE II Section 13.2: When quantitative easing is reversed, the Bank of Canada sells back the federal government bonds they bought from financial institutions. Deposit takers‘ cash reserves are then reduced once financial institutions pay for the bonds they have repurchased. The other option, which does not have the same immediate effect on deposit-takers‘ cash reserves, is for the Bank to simply hold onto the bonds they own until they mature..

TAE III Section 13.3: The Phillips curve will move outward, reflecting the worsening trade-off 2

See Pierre Fortin, 'The Bank of Canada and the Inflation-Unemployment Trade-Off, Bank of Canada' in Macroeconomics, Monetary Policy, and Financial Stability, Bank of Canada, 2004, p. 11.

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between inflation and unemployment.

TAE IV Section 13.3: Just as many economists question the relevance of the vertical long-run aggregate supply curve for policy-makers, for the very same reasons these economists are also likely to question the relevance of the vertical long-run Phillips curve.

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Answers to Chapter Problems

13.1 Practice Problems

1. a) With high unemployment and falling inflation the economy faces a recessionary gap.

Therefore, an expansionary monetary policy should be used. b) With an expansionary monetary policy, the Bank of Canada purchases government bonds in order to raise banks‘ excess reserves. This results in a magnified rise in the money supply, thanks to the working of the money multiplier. The increase in the money supply causes the equilibrium nominal interest rate to drop, which raises investment by businesses and consumption spending on durables by households. The spending increase pushes up aggregate demand and raises both equilibrium output and the price level. As the economy expands, the recessionary gap shrinks and the unemployment rate falls. c)

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The initial equilibrium interest rate of 3% is found at the intersection of Dm and Sm0 (point a in the first graph). The initial equilibrium price level and real output of 120 and $300 billion are found at the intersection of AD0 and AS (point c in the second graph). d) Because the monetary policy implemented is an expansionary one, the $10 billion change in the money supply is represented by a rightward shift from Sm0 to Sm1. The new equilibrium interest rate of 2% is found at the intersection of Dm and Sm1 (point b in the graph). e) With the increase in the money supply and drop in the interest rate, the $200 billion change in aggregate demand is represented by a rightward shift from AD0 to AD1. The new price level and real output of 130 and $400 billion are found at the intersection of 1-266 Copyright © 2023 by McGraw Hill

AS and AD1 (point d in the graph).

2. a) The nominal rate of interest on the treasury bill is 2.04% {= [($1,000,000 − $980,000) / $980,000] × 100}, which is found by dividing the increase in the bill‘s value during the year by the initial purchase price, with this ratio then multiplied by 100 to turn it into a percentage. b) To raise the nominal interest rate on one-year treasury bills to 3%, the Bank must increase the supply of these bills in its auction. The result will be a drop in the purchase price of these bills, pushing up their nominal interest rate.

13.2 Practice Problems

1. a) The bond seller‘s deposit increases by $10,000. b) The bank‘s desired reserves rise by $500 (= $10,000 × 0.05). c) The bank‘s excess reserves increase by $9,500 (= $10,000 − $500). d) The maximum increase in the money supply is $200,000, which is found by adding the initial $10,000 rise in the money supply due to the expansion in the bond seller‘s bank deposit to the maximum $190,000 [= $9,500 × (1 / 0.05)] increase in the money supply due to the rise in excess reserves multiplied by the money multiplier.

2. a) The bond buyer‘s deposit decreases by $2,000. b) The bank‘s desired reserves fall by $200 (= $2,000 × 0.10). c) The bank‘s excess reserves decrease by $1,800 (= $2,000 − $200). d) The maximum decrease in the money supply is $20,000, which is found by adding the initial $2,000 fall in the money supply due to the reduction in the bond buyer‘s bank deposit to the maximum $18,000 [= $1,800 × (1 / 0.10)] decrease in the money supply due to the fall in excess reserves multiplied by the money multiplier.

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13.3 Practice Problems

1. a) A bout of cost-push inflation causes an outward shift in the Phillips curve, since this type of inflation is associated with a rise in the unemployment rate. This is the type of inflation that is not directly incorporated into the Phillips curve. b) A bout of demand-pull inflation moves the economy up and to the left along the economy‘s stationary Phillips curve. This is the type of inflation that is directly incorporated into the Phillips curve. c) A contractionary monetary policy moves the economy down and to the right along the economy‘s stationary Phillips curve, since such a policy reduces inflation and increases the rate of unemployment.

2. a) With an initial equilibrium to the right of the long-run aggregate supply curve, real output exceeds its potential level, and the unemployment rate is below its natural rate. In the long run, the low unemployment rate will put upward pressure on wages, shifting the short-run aggregate supply curve to the left. This gradual shift moves equilibrium leftwards towards the vertical long-run aggregate supply curve. b) If initial equilibrium is to the left of the long-run aggregate supply curve, then real output is below its potential level, and the unemployment rate exceeds its natural rate. In the long run, the high unemployment rate will put downward pressure on wages. This shifts the economy‘s short-run aggregate supply curve to the right, which gradually moves equilibrium rightwards towards the vertical long-run aggregate supply curve.

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End of Chapter Problems

1. a) If a one-year treasury bill has a purchase price of $975,000, its nominal rate of interest is 2.6%, which is found by dividing the difference between the face value and the purchase price ($1 million − $975,000 = $25,000) by the purchase price ($975,000), then multiplying by 100. If the purchase price of a one-year treasury bill falls to $960,000, its nominal rate of interest rises to 4.2%, which is found by dividing the difference between the face value and the purchase price ($1 million − $960,000 = $40,000) by the purchase price ($960,000), then multiplying by 100. b) As in any market, a rise in a product‘s supply reduces its price, while a drop in supply leads to a price rise. Because the purchase price and nominal rate of interest of treasury bills vary inversely, their nominal rate of interest can be raised if the Bank of Canada reduces their price through greater supply. c) In any market, a change in a product‘s demand affects its price in the same direction. The inverse relationship between the purchase price and nominal rate of interest of treasury bills means that the nominal rate of interest on treasury bills can be increased through a decline in price caused by the Bank of Canada reducing its own purchases.

2. a)

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b) The initial equilibrium interest rate of 4% is found at the intersection of Dm and Sm0 (point a in the left graph above). The initial equilibrium price level and real output of 130 and $500 billion are found at the intersection of AD0 and AS (point c in the right graph above). c) With low unemployment and rising inflation the economy faces an inflationary gap.

Therefore, a contractionary monetary policy should be used. With a contractionary monetary policy, the Bank of Canada sells government bonds in order to reduce banks‘ excess reserves. This results in a magnified fall in the money supply, due to the working of the money multiplier. The decrease in the money supply causes the equilibrium nominal interest rate to rise, which reduces investment by businesses and consumption spending on durables by households. The spending decrease pushes down aggregate demand and decreases both equilibrium output and the price level. As the economy contracts, the inflationary gap shrinks and the inflation in dampened. d) The values in the empty column of the table are 40, 40, 40, 40, and 40. Because the monetary policy implemented is a contractionary one, the $20 billion change in the money supply is represented by a leftward shift in Sm (from Sm0 to Sm1 in the left graph above). The new equilibrium interest rate of 6% is found at the intersection of Dm and the new money supply curve, Sm1 (point b in the graph). e) The values in the empty column of the table are 300, 350, 400, 450, and 500. With the decrease in the money supply and rise in the interest rate, the $150 billion change in aggregate demand is represented by a leftward shift in the AD curve (from AD0 to AD1 in the right graph above). The new price level and real output are 120 and $400 billion (point d in the graph). f) The change in equilibrium real output is $100 billion while the shift in the AD curve is $150 billion. Therefore, the change in equilibrium real output is less than the shift in the AD curve. This is because a decrease in aggregate demand translates not just into a fall in real output but also in the price level.

3. a) The Bank of Canada‘s holdings of government bonds rise by $1 million, an asset of the Bank of Canada. Meanwhile Frontenac Bank‘s deposit at the Bank of Canada rises by $1 million, a liability of the Bank of Canada. Frontenac Bank‘s deposit at the Bank of Canada rises by $1 million, an asset of Frontenac Bank. Bondholder X‘s deposit rises by $1 million, a liability of Frontenac Bank.

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b) If the reserve ratio is 5%, Frontenac Bank‘s actual reserves increase by $1 million while its desired reserves increase by $50,000. Therefore, the Bank‘s excess reserves increase by $950,000 (= $1 million − $50,000). c) The maximum effect on the money supply is $20 million. This is found by multiplying the initial change in excess reserves ($950,000) by the money multiplier, which is the reciprocal of the reserve ratio expressed as a decimal [(1 / 0.05) = 20], giving $19 million, plus the initial $1 million increase in Bondholder X‘s deposit.

4. a) A $100 million purchase of bonds by the Bank of Canada leads to an immediate $100 million increase in the money supply as sellers of these bonds deposit payments from the Bank of Canada in their accounts with deposit-takers. Given a reserve ratio of 5%, the actual reserves of deposit-takers have been raised by $100 million while their desired reserves have risen by $5 million (= 0.05 × $100 million in new deposits). Therefore, deposit takers‘ excess reserves have risen by $95 million. Through the process of multiple lending, there is an additional potential increase in the money supply of $1.9 billion [= $95 million × (1 / 0.05)]. As a result, the maximum amount by which the money supply can increase is $2 billion (= $100 million + $1.9 billion). b) A $50 million sale of bonds by the Bank of Canada leads to an immediate $50 million decrease in the money supply as the Bank of Canada receives payments from buyers of these bonds and these funds are withdrawn from their accounts with deposit takers. Given a reserve ratio of 7.5%, the actual reserves of deposit takers have declined by $50 million while their desired reserves have fallen by $3.75 million (= 0.075 × $50 million in lost deposits). Therefore, CPA members‘ excess reserves have declined by $46.25 million.

Through the process of multiple lending, there is an additional potential decrease in the money supply of $616.7 million [= -$46.25 million × (1 / 0.075)]. As a result, the maximum amount by which the money supply can decrease is $666.7 million [= (−$50 million − $616.7 million)].

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5. a)

b) Between 2021 and 2022, the inflation rate has fallen and the unemployment rate has risen as shown by the movement from points a to c in the graph above. This could have been caused by contractionary fiscal and/or monetary policies. Between 2022 and 2023, the inflation rate has risen and the unemployment rate has fallen as shown by the movement from points c to b in the graph above. This could have been caused by expansionary fiscal and/or monetary policies. c) Acadia‘s inflation-unemployment pairing for 2024is shown by point d in the graph above. This indicates that the Phillips curve must have shifted to the right. This shift could have been caused by a decrease in the aggregate supply curve with one possible factor being a drop in labour productivity.

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6. a)

b) Between 2021 and 2022, the inflation rate has risen and the unemployment rate has fallen as shown by the movement from points a to b in the graph above. This could have been caused by demand-pull inflation, since this type of inflation moves the economy up and to the left along the economy‘s stationary Phillips curve. c) Gaspé‘s inflation-unemployment pairing for 2024 is shown by point c in the graph above.

Because both the inflation rate and the unemployment rate are lower in 2024 than they were in 2023, the Phillips curve must have shifted to the left. This shift could have been caused by an increase in the aggregate supply curve with one possible factor being a rise in the economy‘s capital stock.

7. This statement is true. For example, in the case of an expansionary monetary policy, the Bank of Canada can reduce the target overnight rate. However, the overnight rate will stay at this new level only if the money supply is increased through the Bank of Canada‘s openmarket purchases of bonds. In the opposite case, the overnight rate will stay at its new target only if the supply of money is decreased with open-market sales of bonds.

8. In this case, any contractionary moves the Bank of Canada makes to deal with the boom in Saskatchewan‘s provincial economy will exacerbate the downturn in spending being experienced in Ontario.

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9. With a vertical long-run aggregate supply curve, changes in aggregate demand (which cause movements along a given Phillips curve) lead to alterations in the price level but not in real output. In this case, the Phillips curve must also be vertical in the long run, since unemployment remains unaffected by variations in aggregate demand.

Advancing Economic Thought Problems

1. The maximum size of the government-employed work force would be the number of individuals who would become unemployed if the job guarantee was not in place. In the case of the economy shown in Figure A, this would equal all those who would become unemployed in moving from a 3 percent unemployment rate at point c to a 6 percent unemployment rate at point b.

2. According to Kelton and other modern monetary theorists, ensuring that a national government has exclusive control over the country‘s currency is an essential requirement for the principles of MMT to operate. When a nation without monetary sovereignty uses government spending to reach full employment, it is liable to face unsustainable debts denominated in the currency over which the nation does not have control.

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Simulation

1. Introductory Information

Time: Approximately 15 minutes.

Materials: $1,000 in Monopoly money or play money in various denominations.

Replica government bonds, i.e., fake or play bonds Replica cheques, i.e., fake or play cheques

Set-up: This exercise is a continuation from Chapter 12. Students will return to the same team they were in for the Chapter 12 simulation. Or divide the class into teams of 6 members each.

Key Concepts Covered: contractionary monetary policy open market operations

Learning Objectives: - Evaluate the basic principles behind open market operations, as used by the Bank of Canada, and illustrate the process by which bonds are bought and sold by the Bank of Canada.

- Demonstrate an understanding of the circular flow and the impact of contractionary monetary policy.

2. Exercise

Recall this is a continuation of the Chapter 12 simulation. Students continue to be divided into groups of six.

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Timekeeper: The students will be given 10 minutes to apply a contractionary monetary policy.

Stage 1: Each team of 6 students will fill the following roles:

Students A and B will play the role of the Maple Leaf Bank.

Students C and D are both now depositors at Maple Leaf Bank.

Students E and F now represent the Bank of Canada.

Stage 2: Note that the reserve ratio is 0.05, or 5%.

The Maple Leaf Bank is in possession of the $1,000 in Monopoly money. The replica cheques should be given to students C and D, while the bonds should be given to the students E and F.

Then students will be given 10 minutes to apply a contractionary monetary policy. Each student must be involved in at least one transaction.

The team members should then create a chart or diagram that illustrates the transactions that took place, or fill in the table below. Remember to enter minus signs when appropriate. Note that this table will need to be manually graded.

Institution or Body

Asset Type

Asset Value

Liability Type

Liability Value

Maple Leaf Bank

[select from the list reproduced below]

[fill in appropriate value]

[select from the list reproduced below]

[fill in appropriate value]

Bank of Canada

[select from the list reproduced below]

[fill in appropriate value]

[select from the list reproduced below]

[fill in appropriate value]

Depositors

[select from the list reproduced below]

[fill in appropriate value]

[select from the list reproduced below]

[fill in appropriate value]

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*bonds; cash; Maple Leaf Bank‘s deposit at the Bank of Canada; reserves at the Bank of Canada; Student C‘s deposit at Maple Leaf Bank; Student D‘s deposit at Maple Leaf Bank; none As a result of these transactions, the money supply was reduced by a total of $[fill in appropriate value].

Explanation: Institution or Body

Asset Type

Asset Value

Liability Type

Liability Value

Maple Leaf Bank

Maple Leaf Bank‘s deposit at the Bank of Canada

- ($bonds sold)

Depositors deposit at Maple Leaf Bank

- ($bonds sold)

Maple Leaf Bank‘s deposit at the Bank of Canada

- ($bonds sold)

Bank of Canada

Bonds

- ($bonds sold)

Depositors

Deposit at Maple Leaf Bank

- ($bonds sold)

The results of this exercise will be that the Bank of Canada will sell bonds to both students C and D.

Students C and D will each write cheques against their account at Maple Leaf Bank to pay for the bonds they buy. (The amounts of the cheques will be different for each team.)

The Bank of Canada sends both cheques to Maple Leaf Bank, which deducts each amount from the accounts of students C and D (i.e., the bank clears the cheques written to the Bank of Canada). This automatically reduces the money supply by the total amount of the two cheques.

Meanwhile, Maple Leaf Bank has its account at the Bank of Canada reduced by the total amount of the two cheques. This reduction in Maple Leaf Bank‘s cash reserves means that its excess cash reserves are reduced by the total amount of the two cheques minus an amount equal to 0.05 (the reserve ratio) times the total amount of the two cheques.

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As Maple Leaf Bank calls in loans to maintain its desired reserve ratio, a further drop in the money supply takes place, equal to the drop in excess reserves multiplied by the money multiplier.

Values in the table will depend on the particular values students choose during the simulation.

3. Discussion Questions (essay) 1. Describe a chart that show the transactions by which a purchase of bonds works to increase the money supply.

2. You have a student loan, and you notice that the prime rate has gone up significantly. What could have caused this?

3. Find an article online or in the newspaper that talks about monetary policy. Is this expansionary or contractionary policy? Explain why or why not.

Explanation: 1. All charts should show the Bank of Canada buying bonds from members of the public. A member of the public then receives a cheque from the Bank of Canada, which they deposit into their bank. This increases the amount of money the bank has to lend.

2. The prime rate may have gone up because of a rise in the overnight rate, caused by the Bank of Canada engaging in a contractionary monetary policy.

3. Answers will vary.

4. Multiple Choice Questions

1. The Bank of Canada is in charge of instituting: a) contractionary policy, but not expansionary policy. b) both fiscal and monetary policy. c) monetary policy, but not fiscal policy.* 1-278 Copyright © 2023 by McGraw Hill

d) Only banking policy. e) fiscal policy, but not monetary policy.

2. If the Canadian economy is facing a recession, the Bank of Canada should: a) give bonds to chartered banks. b) take bonds away from chartered banks. c) purchase bonds.* d) increase the overnight rate. e) sell bonds.

3. A contractionary monetary policy is one that involves the: a) sale of bonds.* b) purchase of private employment contracts. c) purchase of bonds. d) purchase of chartered bank loans. e) sale of chartered bank loans.

4. An expansionary monetary policy is used when: a) interest rates are fluctuating too often. b) there is a recession.* c) the number of chartered banks needs to be increased. d) there is an economic boom. e) the number of chartered banks needs to be decreased.

5. Bond purchases; a) increase money demand. b) increase the money supply.* c) decrease the money supply. d) keep the money supply constant. e) decrease money demand.

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Explanation: 1. The Bank of Canada is in charge of instituting monetary policy, but not fiscal policy.

2. If the Canadian economy is facing a recession, the Bank of Canada should purchase bonds.

3. A contractionary monetary policy is one that involves the sale of bonds.

4. An expansionary monetary policy is used when there is a recession.

5. Bond purchases increase the money supply.

Chapter 14 Teaching Tips

The Capital Account versus the Financial Account Statistics Canada‘s use of separate capital and financial accounts dates back over a decade and aligns Canadian practice with evolving international standards. According to these standard definitions, the capital account includes purchases and sales of intangible (often referred to as ‗non-produced and non-financial‘) assets and capital transfers which do not involve market exchanges of assets. On the other hand, the financial account includes purchases and sales of financial assets, broken down into direct investment and portfolio investment as well as several other more minor accounts.3

The Changes in Official Reserves Account As shown in Figure 14.3, the changes in official reserves account provides a mirror image for a balance-of-payments surplus or deficit. When there is a balance-of-payments surplus, shown by some positive dollar amount, the changes in official reserves account is the negative value of this dollar amount. Likewise, when there is a balance-of-payments deficit, indicated by a negative dollar amount, the changes in official reserves account is the corresponding positive dollar amount. The chapter‘s treatment differs in one important way from Statistics Canada‘s own presentation of the balance-of-payments accounts. In the official accounts, changes in official 3

See the OECD Glossary of Statistical Terms, Organisation for Economic Co-operation and Development, 2007, p. 53.

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reserves are included in the financial account. That convention means one cannot derive the size of the balance-of-payments surplus or deficit by adding the balances on the current, capital and financial accounts as they are shown in the official accounts. It is in order to make this simplifying equality possible that we keep the changes in official reserves separate from the financial account.

Direct versus Portfolio Investment Direct investment is defined as financial investment that gives the buyer 10 percent of the voting shares. Otherwise, the financial investment is classified as portfolio investment. In practice, deciding whether or not this condition is met can be a relatively tricky task. That‘s because a voting interest in a company may depend not just on the buyer‘s direct ownership of the company‘s shares but also indirect ownership of shares by another enterprise that the buyer controls.

Canada’s International Investment Position Students with some background in accounting may be interested in the accounting aspects of the balance of payments – the fact that the financial account shows changes in Canadians‘ holdings of marketable assets, but that there is no indication in these accounts of overall holdings. In fact, these holdings are the subject of a separate account published as an annual summary table by Statistics Canada. Known as Canada‘s International Position, this account shows total assets, which are Canadians‘ ownership of foreign stocks, bonds as well as other financial instruments, as well total liabilities, which are foreigners‘ ownership of Canadian stocks, bonds and other financial instruments. This account is often used to measure the difference between total assets and total liabilities, known as Canada‘s net international investment position, which because of significant foreign ownership in the Canadian economy has a large negative value.

Answers to Thinking about Economics Questions

TAE I Section 14.2: With the expected increase in foreign-held Canadian debt, speculators will forecast that there will be downward pressure on the value of the Canadian dollar. Speculators will sell Canadian dollars, hastening the dollar‘s depreciation.

TAE II Section 14.3: With a lower oil price, the value of Canada‘s exports decrease, reducing the demand for Canadian dollars. The resulting fall in the price of the Canadian dollar in terms of US 1-281 Copyright © 2023 by McGraw Hill

dollars makes Canadian exports to the US more attractive and reduces the attractiveness of American imports for Canadians. The subsequent rise in net exports partly counteracts their initial fall due to the reduction in the oil price.

Answers to Chapter Problems 14.1 Practice Problems

1. a) Screening a film is a service so this transaction is part of trade in services. Because a Canadian firm is purchasing a foreign product the transaction is classified as a payment. b) A trailer is a tangible good so this transaction is part of merchandise trade. Because a foreigner is purchasing a Canadian product the transaction is classified as a receipt. c) A monetary gift is a transfer so this transaction is part of transfers. Because a foreigner is receiving the transfer from a Canadian the transaction is classified as a payment. d) Share dividends are part of investment income. Because a Canadian is receiving this income from a foreign source it is classified as a receipt. e) Bond interest is part of investment income. Because a foreigner is receiving this income from a Canadian source it is classified as a payment. f)

Travel is a service so this transaction is part of trade in services. Because the tourist is purchasing a Canadian service the transaction is classified as a receipt.

2. a) The purchase of bonds is portfolio investment. Because a foreigner is buying bonds from a Canadian government this transaction is classified as a receipt. b) The purchase of an entire company is direct investment. Because a Canadian-owned corporation is buying a foreign company this transaction is classified as a payment.

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c) A day-to-day purchase of shares on the stock market is portfolio investment. Because a foreigner is buying shares on a Canadian stock exchange this transaction is classified as a receipt. d) The receipt of a monetary bequest is part of the capital account. Because a Canadian is receiving the funds from a foreigner this transaction is classified as a payment. e) The opening of a bank deposit is part of other financial investments. Because a foreign company is opening a bank account in Canada this transaction is classified as a receipt. f)

The purchase of a patent is included in the capital account. Because a Canadian is buying the patent from a foreigner this transaction is classified as a payment.

3. a) Balance-of-Payments Accounts (Arcadia $ millions) Receipts

Payments

Balance

Merchandise Trade

196.4

143.2

53.2

Trade in Services

72.3

82.7

-10.4

Investment Income

40.2

74.9

-34.7

Employee Compensation

2.2

3.8

-1.6

Transfers

8.3

19.6

-11.3

2.9

1.4

1.5

Direct Investment

32.4

41.7

-9.3

Portfolio Investment

39.4

23.2

16.2

Other Financial Investments

12.6

18.9

-6.3

Current Account

Capital and Financial Accounts Capital Account Financial Account

Receipts on merchandise trade are $196.4 million (= $143.2 million + $53.2 million), the balance on trade in services is -$10.4 million (= $72.3 million − $82.7 million), payments on investment income are $74.9 million (= $40.2 million + $34.7 million), the balance on employee compensation is -$1.6 million (= $2.2 million − $3.8 million) and the balance on transfers is $11.3 million (= $8.3 million − $19.6 million). Payments on the capital account are $1.4 million (= $2.9 million − $1.5 million), the direct investment account balance is -$9.3 million (= $32.4 million − $41.7 million), receipts on portfolio investment are $39.4 million (= $23.2 million + $16.2 million), and payments on other financial investments are $18.9 million (= $12.6 million + 1-283 Copyright © 2023 by McGraw Hill

$6.3 million). b) Arcadia has a current account deficit of -$4.8 million (= $53.2 million − $10.4 million − $34.7 million − $1.6 − $11.3 million), and the capital and financial accounts have a surplus of $2.1 million (= $1.5 million − $9.3 million + $16.2 million − $6.3 million). c) Arcadia has a balance of payments deficit of -$0.4 million (= -$4.8 million + $2.1 million + $2.3 million), which is the sum of the current and capital and financial account balances as well as the statistical discrepancy. d) Arcadia’s “change in official reserves” has a value of +$0.4 million, which matches the -$0.4 million balance of payments deficit, so that Arcadia’s balance of payments accounts sum to zero.

This means that Arcadia’s central bank bought $0.4 million of its own currency and sold foreign currency in order to keep up the value of Arcadia’s currency.

14.2 Practice Problems

1. a)

The initial equilibrium values of the price of Canadian dollars and the quantity traded in the market, $1.00 and $6 billion, are found at the intersection of D0 and S0.

b) Because of the increase in quantity demanded in this market at every price the demand 1-284 Copyright © 2023 by McGraw Hill

curve for Canadian dollars shifts to the right by $2 billion. Meanwhile, the decrease in quantity supplied at every price means that the supply curve for Canadian dollars shifts to the left by $2 billion. The result is a higher equilibrium price at $1.05 with the rightward shift in demand and the leftward shift in supply cancelling each other out so that equilibrium quantity in the market remains $6 billion, as found at the intersection of D1 and S1. c) The interest rate must have increased. This makes Canadian bonds more attractive to Americans, causing a rightward shift in the demand for Canadian dollars, and Canadian bonds are also more attractive to Canadians, so that they purchase fewer American bonds, which shifts the supply curve for Canadian dollars to the left.

2. When the exchange rate of the Canadian dollar in terms of the US dollar rises, the Canadian dollar buys more in terms of US dollars. This increases the incentive for Canadians to engage in cross-border shopping. For Americans the US dollar buys less in terms of Canadian dollars which decreases the incentive for Americans to engage in cross-border shopping.

14.3 Practice Problems 1. a) The purchase of bonds is portfolio investment. Because a foreigner is buying bonds from a Canadian government this transaction is classified as a receipt. b) A target value for the Canadian dollar set below the equilibrium level requires that the Bank of Canada sell Canadian dollars and buy US dollars. c) Because the Bank of Canada is selling Canadian dollars, the changes in official reserves account is negative to ensure that, given the balance-of-payments surplus, the overall balance of payments sum to zero.

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In this graph, the equilibrium level of the exchange rate is found at the intersection of D and S at point a. The size of the balance of payments surplus at the target exchange rate is shown by the distance between points b and c.

End of Chapter Problems

1. a) A boom in the American economy creates additional demand for Canada’s exports, increasing Canada’s merchandise and nonmerchandise trade receipts. On the other hand, Canada’s imports are not affected. Overall, this has a positive effect on Canada’s balance of trade. b) A higher value of the Canadian dollar in terms of the US dollar makes Canadian products more expensive relative to those from the U.S. Canadian exports therefore become less attractive in the US, pushing down Canada’s merchandise and nonmerchandise trade receipts, and American imports become more attractive in Canada, pushing up Canada’s merchandise and nonmerchandise trade payments. Both trends have a negative effect on Canadas balance of trade. c) As more Canadian resources are processed in Canada, Canadian exports rise, pushing up Canadas merchandise and nonmerchandise trade receipts, and foreign imports fall, pushing

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down Canadas merchandise and nonmerchandise trade payments. Both trends have a positive effect on Canada’s balance of trade. d) A “made in Canada” recession does not affect Canada’s exports but reduces Canadian demand for foreign imports, pushing down Canada’s merchandise and nonmerchandise trade payments.

This has a positive effect on Canada’s balance of trade. e) A political crisis that dampens output European countries’ output reduces demand for Canada’s exports, pushing down Canada’s merchandise and nonmerchandise trade receipts. On the other hand, Canada’s imports are not affected. Overall, this has a negative effect on Canada’s balance of trade.

2. a) An antique clock is a tangible good, so this purchase is part of merchandise trade. Because a Canadian dealer is purchasing a foreign product the transaction is classified as a payment.

b) The receipt of a bond interest payment is part of investment income. Because a foreign bondholder is receiving this payment from a Canadian government the transaction is classified as a payment. c) The receipt of dividends is part of investment income. Because a Canadian shareholder is receiving these funds from a foreign company the transaction is classified as a receipt. d) Foreign travel is a service, so this is part of trade in services. Because a Canadian is travelling in a foreign country this transaction is classified as a payment. e) A television series is a service, so this purchase is part of trade in services. Because a foreign network is buying the product from a Canadian this transaction is classified as a receipt. f)

A gift of money is a transfer. Because a Canadian is sending these funds to foreigners the transaction is classified as a payment.

g) Paper stationery is a tangible good, so this purchase is part of merchandise trade. Because a foreign consumer is buying a Canadian product the transaction is classified as a receipt.

3.

a) The starting of a business is direct investment. Because a foreign company is starting a business in Canada this transaction is classified as a receipt. b) A day-to-day purchase of shares on the stock market is portfolio investment. Because a Canadian is buying shares on a foreign stock exchange this transaction is classified as a payment. c) The addition of funds to a bank account is included in other financial investments. Because a foreign company is adding funds to its Canadian bank account this transaction is classified as a receipt.

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d) The purchase of a bond is portfolio investment. Because a foreigner is buying a Canadian government bond this transaction is classified as a receipt. e) The purchase of a foreign business is direct investment. Because a Canadian business is taking over a foreign one this is classified as a payment. f)

The opening of a bank account is included in other financial investments. Because a Canadian firm is opening a foreign bank account this transaction is classified as a payment.

g) Transfers between bank accounts are included in other financial investments. Because the funds are being transferred from a foreign to a Canadian bank this transaction is classified as a receipt. h) A financial bequest is included in the capital account. Because a foreigner is receiving the bequest from a Canadian this transaction is classified as a payment. i)

The purchase of a patent is included in the capital account. Because a foreigner is buying the patent from a Canadian this transaction is classified as a receipt.

4. a) Delphi’s Balance-of-Payments Accounts (Delphi $ millions) Receipts

Payments

Balance

Merchandise trade

183.4

323.6

-140.2

Trade in services

187.9

97.4

90.5

Investment income

192.3

157.9

34.4

Transfers and Employee Compensation

56.8

24.5

32.3

4.7

3.5

1.2

Direct investment

65.9

86.1

-20.2

Portfolio investment

32.7

45.8

-13.1

Other financial investments

38.1

15.2

22.9

Current Account

Capital and Financial Accounts Capital Account Financial Account

The merchandise balance of trade is -$140.2 million (= $183.4 million − $323.6 million), payments on trade in services are $97.4 million (= $187.9 million − $90.5 million), the investment income balance is $34.4 million (= $192.3 million − $157.9 million), and receipts on transfers employee compensation are $56.8 million (= $32.3 million + $24.5 million). The capital account balance is $1.2 million (= $4.7 million − $3.5 million), payments on the direct investment account are $86.1 million (= $65.9 million + $20.2 million), the portfolio investment balance is -

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$13.1 million (= $32.7 million − $45.8 million), and receipts on other financial investments are $38.1 million (= $22.9 million + $15.2 million). b) Delphi’s balance of trade of -$49.7 million is found by adding the merchandise balance of trade and nonmerchandise balance of trade (= -$140.2 million + $90.5 million). c) Delphi has a current account surplus of $17.0 million (= -$140.2 million + $90.5 million + $34.4 million + $32.3 million), and the capital and financial accounts have a balance of -$9.2 million (= $1.2 million − $20.2 million − $13.1 million + $22.9 million). d) Delphi has a balance of payments surplus of $12.3 million (= $17.0 million − $9.2 million + $4.5 million), which is the sum of the current and capital and financial account balances as well as the statistical discrepancy. e) Delphi’s “change in official reserves” has a value of -$12.3 million, which matches the $12.3 million balance of payments surplus, so that Delphi’s balance of payments accounts sum to zero.

This means that Delphi’s central bank sold $12.3 million of its own currency and bought foreign currency in order to keep down the value of Delphi’s currency.

5. a) US dollar price = Canadian dollar price × US dollars to buy CDN $1.00 = $520 × $0.91 = $473.20. b) Canadian dollar price = US dollar price × Canadian dollars to buy US $1.00 = $24,000 × $1.03 = $24,720. c) US dollar price = Canadian dollar price × US dollars to buy CDN $1.00 = $3.00 × (1 / $1.06) = $2.83. d) Canadian dollar price = US dollar price × Canadian dollars to buy US $1.00 = $82 × (1 / 0.97) = $84.54.

6. a)

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b) With a flexible exchange rate, the Canadian dollar has its equilibrium value of US$0.95. c) A target exchange rate of US$0.96 contributes to a balance of payments deficit of $20 billion and a value of $20 billion for Canada’s “changes in official reserves” (since the combined effect of the balance of payments accounts must be zero). To maintain the value of the Canadian dollar above its equilibrium value, the Bank of Canada must be buying Canadian dollars and selling foreign currency. d) A target exchange rate of US$0.93 leads to a balance of payments surplus of $40 billion and a value of -$40 billion for “changes in official reserves” (since the combined effect of the balance of payments accounts must be zero). To maintain the value of the Canadian dollar below its equilibrium value, the Bank of Canada must be selling Canadian dollars and buying foreign currency.

7. a)

The initial equilibrium values of the price of Canadian dollars and the quantity traded in the market are $0.85 and $300 million, found at the intersection of D0 and S0. b) Because of the decrease in quantity demanded in this market at every price the demand curve for Canadian dollars shifts to the left by $100 million. Meanwhile, the increase in quantity supplied at every price means that the supply curve for Canadian dollars shifts to the right by $100 million. The equilibrium price drops to $0.80, and with the leftward shift in demand and the rightward shift in supply cancelling each other out equilibrium quantity in the market remains $300 million, as found at the intersection of D1 and S1. c) The inflation rate must have increased. This makes Canadian products less attractive to 1-290 Copyright © 2023 by McGraw Hill

Americans, causing a leftward shift in the demand for Canadian dollars, and Canadian products are also less attractive to Canadians, so that they purchase more American imports, which shifts the supply curve for Canadian dollars to the right.

8.

Graph A

Graph B

Graph C

Graph D

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Graph E

Graph F

a) A rise in Canadian interest rates makes Canadian bonds more appealing to financial investors in both Canada and the United States. With more American purchases of Canadian bonds, the demand for Canadian dollars in this foreign exchange market increases. Similarly, Canadians are more likely to buy Canadian rather than American bonds, decreasing the supply of Canadian 1-292 Copyright © 2023 by McGraw Hill

dollars. The result is a rise in the price of the Canadian dollar in terms of US dollars as shown in graph B. b) Falling real output in the United States means a drop in American spending on Canadian exports.

This decreases the demand for Canadian dollars in this foreign exchange market. At the same time, a rise in Canada’s real output causes more Canadian spending on American imports, increasing the supply of Canadian dollars. The result is a fall in the price of the Canadian dollar in terms of US dollars as shown in graph A. c) As Americans make more financial investments in Canada, the demand for Canadian dollars in this foreign exchange market increases. In this case, there is no effect on the supply curve for Canadian dollars. The result is a rise in the price of the Canadian dollars in terms of US dollars as shown in graph D. d) As “snowbirds” become more likely to travel outside Canada, the supply of Canadian dollars in this foreign exchange market increases. In this case, there is no effect on the demand curve for Canadian dollars. The result is a fall in the price of the Canadian dollars in terms of US dollars as shown in graph F. e) As Americans choose to make more financial investments in Canada, the demand for Canadian dollars in this foreign exchange market increases. Meanwhile, Canadians will also choose to make more financial investments in Canada. Therefore, the supply for Canadian dollars in this market decreases. The result is a rise in the price of the Canadian dollars in terms of U.S. dollars as shown in graph B. f)

A fall in Canadian interest rates makes Canadian bonds less appealing to financial investors in both Canada and the US. As Americans purchase fewer Canadian bonds the demand for Canadian dollars in this foreign exchange market decreases. Meanwhile because Canadians are more likely to buy American rather than Canadian bonds the supply of Canadian dollars in this market increases. Both movements cause a fall in the price of the Canadian dollar in terms of US dollars, as shown in graph A.

g) As Americans make fewer financial investments in Canada the demand for Canadian dollars in this foreign exchange market decreases. In this case, there is no effect on the supply curve for Canadian dollars in this market because Canadians do not change their financial investment behaviour. The result is a fall in the price of Canadian dollars in terms of US dollars, as shown in graph C. h) Falling real output in Canada means a drop in Canadian spending on imports. This decreases the supply of Canadian dollars in this foreign exchange market. Constant real output in the US means that there is no change in the demand for Canadian dollars in this market. The result of the first trend is a rise in the value of the Canadian dollar in terms of US dollars, as shown in graph E.

9.

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a) When the Bank of Canada raises its target range for the overnight rate, other interest rates rise as well. Investment and consumption spending on durables decrease, shifting the AD curve leftward and reducing inflationary pressures. At the same time, the rise in interest rates heightens the value of the Canadian dollar, decreasing net exports and adding to the AD curve’s leftward shift, while also cutting the inflation rate due to the fall in import prices. b) The exchange rate adjustment reinforces Bank policy and makes monetary policy more effective than it would otherwise be. c) Given the reinforcing nature of exchange rate adjustments, with flexible exchange rates, this system makes monetary policy more effective than would be the case with fixed exchange rates.

10. With the gradual growth in the net flow of direct and portfolio investment to emerging economies, the demand for the emerging economies’ currencies will increase, gradually pushing up the exchange rates of these currencies.

Advancing Economic Thought Problems

1. A large portion of companies in the service sector, which was most heavily affected by lockdowns, are small and medium-sized. In addition, at any given time a relatively significant portion of small and medium-sized businesses are financially vulnerable, and this portion tends to be higher than for large firms. Financially vulnerable small and medium-sized firms, especially in the service sector, were especially likely to be harmed by COVID-19 lockdowns.

2. According to the theory, the worldwide provision of a good with spillover benefits, such as a vaccine, is optimized when the excess benefit for the good is maximized in every country. In the case of the COVID-19 vaccine, this would have required the number of vaccinations in each country be at that country’s optimal point, with demand, once incorporating spillover benefits, intersecting the relevant supply curve.

With the country-specific approach, the gaps between actual outcomes and the optimal points were often very large, especially in lower-income countries. Moreover, the country-specific approach minimized the potential for shifting out the supply curve for the vaccine in these same countries.

Due to both factors, the country-specific approach was far inferior, in welfare terms, to what could have been achieved with a coordinated global program.

Simulation 1-294 Copyright © 2023 by McGraw Hill

1. Introductory Information

Time: Approximately 30 minutes.

Materials: none

Set-up: Divide the class into teams of three.

Key Concepts Covered: appreciation balance of trade depreciation exchange rate merchandise balance of trade

Learning Objectives: - Demonstrate an understanding of the impact of an appreciation or depreciation of the exchange rate of a country‘s currency on the production and sale of that country‘s products.

- Evaluate the impact of exchange rate changes on the balance of trade and the merchandise balance of trade.

2. Exercise

Recall that students have been divided into groups of three.

Timekeeper: N/A 1-295 Copyright © 2023 by McGraw Hill

Stage 1: In each team one student will be elected to represent China, another to represent Canada, and the third to represent the US.

Each student will be responsible for calculating how much it would cost to produce tables with domestic labour in their own country, and to decide whether it would be better to import wood and/or paint from one of the other countries in order to minimize the cost of producing tables, or whether instead it would be better to use domestic supplies of wood and paint. Use the following information:

The materials needed to make tables are the same in all three countries. They are: - 3 planks of wood - 1 bucket of paint - 4 hours of labour

China: - has wood for 100 yuan per plank - has paint for 200 yuan per bucket - labour for 15 yuan per hour

Canada: - has wood for CDN$3 per plank - has paint for CDN$12 per bucket - has labour for CDN$13.50 per hour

The US: - has wood for US$5 per plank - has paint for US$8 per bucket - has labour for US$10 per hour

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Shipping costs of wood are: - CDN$0.50 to ship each plank from Canada to the US or from the US to Canada - CDN$1.50 to ship each plank from China to either the US or Canada and the same amount to ship each plank from either the US or Canada to China

Shipping costs of paint are: - CDN$0.10 to ship each bucket from Canada to the US or from the US to Canada - CDN$0.30 to ship each bucket from China to either the US or Canada and the same amount to ship each bucket from either the US or Canada to China

Exchange rates: - CDN$1 = US$0.80 - CDN$1= 10 yuan - US$1= 12.5 yuan

Stage 2: Calculate the cost of imported wood and paint, including shipping costs, in your home country‘s currency, then compare these calculations with the costs of domestic supplies of wood and paint.

Based on your calculations, decide whether or not you will use domestic or imported wood and paint. Then compute the lowest possible cost of producing each table in your home country‘s currency.

For the purpose of this exercise, it will be assumed that tables are made subject to constant returns to scale, and that costs are calculated on a per table basis.

Fill in the table below.

Country

China

Cheapest Cost of Wood Cheapest Paint Cost of Paint Total Cost of a Wood Source per plank (incl. Source (incl. per bucket Table (incl. (incl. shipping) shipping) shipping) (incl. shipping) labour) Canada

[45] yuan

the U.S.

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[103] yuan

[298] yuan

Canada

Canada

CDN$[3]

the U.S.

CDN$[10.10]

CDN$[73.10]

U.S.

Canada

US$[2.80]

the U.S.

US$[8.00]

US$[56.40]

What is the impact of changes in exchange rates on import and exports?

A depreciation of the domestic currency will result in a decrease in imports and decrease in exports.

An appreciation of the domestic currency will result in an increase in imports and decrease in exports.* A depreciation of the domestic currency will result in an increase in imports and decrease in exports.

A depreciation of the domestic currency will result in an increase in imports and increase in exports.

If the US dollar appreciated relative to both the yuan and the Canadian dollar, how would it affect the relative prices of wood and paint from both Canada and the US in all three countries.

Chinese paint would become cheaper relative to Canadian paint in all three countries.

Canadian paint would become cheaper relative to American paint in all three countries.* American paint would become cheaper relative to Canadian paint in all three countries.

Canadian paint would become cheaper relative to Chinese paint in all three countries.

Chinese paint would become cheaper relative to American paint in all three countries.

American paint would become cheaper relative to Chinese paint in all three countries.

Explanation: The students‘ results should be as follows:

China:

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- Wood from Canada is 30 yuan (= CDN$3 × 10 yuan per CDN$) per plank plus shipping costs of 15 yuan (= CDN$1.50 × 10 yuan per CDN$) per plank, giving a total cost per plank of 45 (= 30 +15) yuan; wood from the US is 62.5 yuan (= US$5 × 12.5 yuan per US$) per plank plus shipping costs of 15 yuan (= CDN$1.50 × 10 yuan per CDN$) per plank, giving a total cost per plank of 77.5 (= 62.5 + 15) yuan; domestic wood is 100 yuan per plank.

The cheapest source of wood is from Canada, at 45 yuan per plank (including shipping costs).

- Paint from Canada is 120 yuan (= CDN$12 × 10 yuan per CDN$) per bucket plus shipping costs of 3 yuan (= CDN$0.30 × 10 yuan per CDN$) per bucket, giving a total cost per bucket of 123 (= 120 + 3) yuan; paint from the US is 100 yuan (= US$8 × 12.5 yuan per US$) per bucket plus shipping costs of 3 yuan (= CDN$0.30 × 10 yuan per CDN$) per bucket, giving a total cost per bucket of 103 (= 100 + 3) yuan; domestic paint is 200 yuan per bucket.

The cheapest source of paint is from the US, at 103 yuan per bucket (including shipping costs).

- Using Canadian wood at 45 yuan per plank and American paint at 103 yuan per bucket, as well as domestic labour, the cost of each table in China will be 298 yuan [= (3 planks × 45 yuan per plank) + (1 bucket × 103 yuan per bucket) + (4 hours of labour × 15 yuan per hour)].

Canada: - Wood from China is CDN$10 (= 100 yuan × CDN$0.10 per yuan) per plank plus shipping costs of CDN$1.50 per plank, giving a total cost per plank of CDN$11.50 (= CDN$10 + CDN$1.50); wood from the US is CDN$6.25 (= US$5 × CDN$1.25 per US$) per plank plus shipping costs of CDN$0.50 per plank, giving a cost per plank of CDN$6.75 (= CDN$6.25 + CDN$0.50); domestic wood is CDN$3 per plank.

Hence the cheapest source of wood is domestic wood from Canada, at $3 per plank.

- Paint from China is CDN$20 (= 200 yuan × CDN$0.10 per yuan) per bucket plus shipping costs of CDN$0.30 per bucket, giving a total cost per bucket of CDN$20.30 (= CDN$20 + CDN$0.30) yuan; paint from the US is CDN$10 (= US$8 × CDN$1.25 per US$) per bucket plus shipping costs of CDN$0.10 per bucket, giving a cost of CDN$10.10 (= CDN$10 + CDN$0.10); domestic paint is CDN$12 per bucket.

Hence the cheapest source of paint is from the US, at CDN$10.10 per bucket (including shipping costs).

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- Using Canadian wood at CDN$3 per plank and American paint at CDN$10.10 per bucket, as well as domestic labour, the cost of each table in Canada will be CDN$73.10 [= (3 planks × CDN$3 per plank) + (1 bucket × CDN$10.10 per bucket) + (4 hours of labour × CDN$13.50 per hour)].

US: - Wood from China is US$8 (= 100 yuan × US$0.08 per yuan) per plank plus shipping costs of US$1.20 (= CDN$1.50 × US$0.80 per CDN$) per plank, giving a total cost per plank of US$9.20 (= US$8 + US$1.20); wood from Canada is US$2.40 (= CDN$3 × US$0.80 per CDN$) per plank plus shipping costs of US$0.40 (= CDN$0.50per plank × US$0.80 per CDN$), giving a cost per plank of US$2.80 (= US$2.40 + US$0.40); domestic wood is US$5 per plank.

Hence the cheapest source of wood is wood from Canada, at US$2.80 per plank.

- Paint from China is US$16 (= 200 yuan × US$0.08 per yuan) per bucket plus shipping costs of US$0.24 (= CDN$0.30 × US$0.80 per CDN) per bucket, giving a total cost per bucket of US$16.24 (= US$16 + US$0.24); paint from Canada is US$9.60 (= CDN$12 × CDN$0.80 per US$) per bucket plus shipping costs of US$0.08 (= CDN$0.10 per bucket × US$0.80 per CDN$), giving a cost of US$9.68 (= US$9.60 + US$0.08); domestic paint is US$8 per bucket.

Hence the cheapest source of paint is domestic paint from the US, at US$8 per bucket.

- Using Canadian wood at US$2.80 per plank and domestic paint at US$8 per bucket, as well as domestic labour, the cost of each table in the US will be US$56.40 [= (3 planks × US$2.80 per plank) + (1 bucket × US$8 per bucket) + (4 hours of labour × US$10 per hour)].

Further Learning: - Discuss the impact of exchange rates on import and exports.

- Discuss what would change if the US dollar appreciated relative to both the yuan and the Canadian dollar. (This would affect the relative prices of wood and paint from both Canada and the US in all three countries. In particular, Canadian paint would become cheaper relative to American paint in all three countries.)

3. Discussion Questions (essay)

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1. Based on your own research, determine the percentage change in the exchange rates of the Canadian dollar relative to the US dollar and the euro in the past three months. What do these two changes imply for the attractiveness of Canada‘s exports to buyers in the US and the euro region? For the attractiveness of imports from the US and the euro region to buyers in Canada?

2. In recent years, several countries have allowed their citizens to use US dollars as legal tender.

Speculate on why a government would make this decision. What are the possible benefits and costs of such a policy?

Explanation: 1. When the Canadian dollar rises in value relative to the US dollar, Canadian exports to the US become more expensive, reducing the attractiveness of these goods and services to Canadians.

The opposite occurs in the case where the Canadian dollar falls relative to the US dollar. Similar trends apply to the case of the value of the Canadian dollar against the euro.

2. A government may do this when the country‘s own currency is undergoing rapid changes in value, especially in the case of hyperinflation. Allowing the country‘s citizens to use the US$ is one way of trying to stabilize the economy until the fluctuations in the domestic currency can be dealt with. A possible benefit of this policy is that it can help reduce the arbitrary changes in living standards that result from variations in the domestic currency‘s value. A cost is that citizens may be reluctant to return to using the domestic currency, in which case the country has lost the ability to engage in its own monetary policy.

4. Multiple Choice Questions

1. If the current exchange rate is CDN$1= US$0.83 and you own CDN$58, then you have [$14.48; $48.14*; $58.00; $69.87; $83.00] in US currency.

2. If Canada exports more goods and services than it imports, it has a(n): a) merchandise trade deficit.

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b) merchandise trade surplus. c) trade deficit. d) trade surplus.* e) none of the above

3. When Canada’s net exports are negative, it has a(n):

a) merchandise trade deficit. b) merchandise trade surplus. c) trade deficit.* d) trade surplus. e) none of the above

4. When a country's currency appreciates relative to the currencies of its major trading partners:

a) domestic employment is increased. b) domestic output is increased. c) inflation falls.* d) inflation rises. e) none of the above

5. When the Canadian dollar appreciates relative to the US dollar, Canada’s:

a) exports increase. b) exports and imports will both decrease. c) exports and imports will both increase. d) imports decrease. e) exports decrease.*

Explanation: 1. If the current exchange rate is CDN$1= US$0.83 and you own CDN$58, then you have $48.14 (= $58 × 0.83) in US currency.

2. If Canada exports more goods and services than it imports, it has a positive value on its trade account or a trade surplus.

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3. When Canada’s net exports are negative, it has a trade deficit.

4. When a country’s currency appreciates relative to the currencies of its major trading partners inflation falls because imports become cheaper in domestic currency.

5. When the Canadian dollar appreciates relative to the US dollar, Canada’s exports decrease because these products become more expensive for American buyers.

Chapter 15 Teaching Tips

Shares of Global GDP The current and projected trends featured in Figure 15.1 tell an important story about the impact of varying growth rates on GDP shares in the global economy. However, students should be reminded that projections of the future, while suggestive, are subject to uncertainty. This applies especially to the high economic growth rates projected for some large and important emerging economies, such as China and India, which are driving so much of the transformation shown in Figure 15.1. There are a variety of factors that could dampen future growth prospects for these economies. For China, one important issue is the aging of the country‘s population as family planning measures that applied in the recent past continue to reduce the proportion of the population who are of working age. For India, there is a continuing economic gap between the country‘s rural and urban areas.

Absolute versus Comparative Advantage It is important to note that absolute advantage is simply a special case of the law of comparative advantage. When absolute advantage applies, for example, Country A may be more efficient at producing Good X and Country B may be more efficient at producing Good Y. In this case, the opportunity costs of the two products will be such that Country A‘s opportunity cost of producing X is less than for Country B. Meanwhile, Country B‘s opportunity cost of producing Y is less than for Country A. Based on the law of comparative advantage, Country A should specialize in Good X and Country B in Good Y. The law of comparative advantage also extends this logic to cases where one country – for example Country A – is more efficient at producing both goods. Even then, as long as the opportunity costs of producing each good differ in the two countries, specialization and trade will create economic benefits to both countries.

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Customs Unions and Common Markets Free trade areas are relatively common and easy to identify in practice, given that they represent a fairly limited form of economic integration that involves just a few countries (for example, three in the case of CUSMA). Because customs unions and common markets require far deeper integration, they tend to be rarer. And even the best-known contemporary instances of both are marked by some indefiniteness.

In the case of custom unions, this can be seen in the illustration cited in the chapter. Mercosur‘s full members (Argentina, Brazil, Paraguay, Uruguay and Venezuela, with Venezuela‘s membership suspended at the time of writing) meet the conditions of a custom union, with common tariffs imposed on other countries. But it also has seven associate members (Bolivia, Chile, Colombia, Ecuador, Guyana, Peru, and Suriname) that do not have to maintain the common external tariff.

Answers to Thinking about Economics Questions TAE I, Section 15.2: If the country being sanctioned is the major producer of an essential good on the world market, then it is very likely that the trade balance of the sanctioning country will worsen, given that sanctions will likely increase the global price of this good. An example occurred in the immediate aftermath of Russia‘s war on Ukraine, when the sanctions imposed by Ukraine‘s western allies led to a significant rise in the price of oil, Russia‘s major export. In addition, if the sanctioned country is a major buyer of the sanctioning country‘s exports, then the export revenues for the latter are likely to decrease.

TAE II, Section 15.3: Given its skepticism towards the benefits of free trade agreements, the United States pulled out of the negotiations that preceded the finalization of the CPTPP.

Answers to Chapter Problems 15.1 Practice Problems

1. a) Aries is more efficient at producing discs because a worker‘s daily output of discs is higher in Aries (25) than in Pisces (20). Pisces is more efficient at producing players because a worker‘s daily output of players is higher in Pisces (4) than in Aries (1).

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b) In Aries the opportunity cost of players is 25 (= 25 /1) discs and the opportunity cost of discs is 0.04 (= 1 / 25) players because a worker in Aries can produce 25 times as many discs (25) as players (1). In Pisces the opportunity cost of players is 5 (= 20 / 4) discs and the opportunity cost of discs is 0.20 (= 4 / 20) players because a worker in Pisces can produce 5 times as many discs (20) as players (4) in a day. c) On the basis of absolute advantage each country should specialize in the good that it is most efficient at producing. Therefore, Aries should make discs and Pisces should make players. d) The terms of trade are based on the opportunity costs in each country. Therefore, they must be somewhere between 1 player traded for 25 discs in Aries and 1 player traded for 5 discs in Pisces.

2. a) Sari is more efficient at ironing a pair of jeans since she can do it in less time (10 minutes) than it takes Anthony (12 minutes). Sari is less efficient at cooking a meal, since she does it in more time (40 minutes) than it takes Anthony (36 minutes). b) Sari can iron 4 (= 40 / 10) pairs of jeans in the 40 minutes it takes her to cook one meal.

Therefore, her opportunity cost of cooking a meal is the 4 pairs of jeans she could have ironed instead and her opportunity cost of ironing a pair of jeans is the 0.25 (= 10 / 40) meals she could have cooked instead. Anthony can iron 3 (= 36 / 12) pairs of jeans in the 36 minutes it takes him to cook one meal. Therefore, his opportunity cost of cooking a meal is the 3 pairs of jeans he could have ironed instead and his opportunity cost of ironing a pair of jeans is the 0.33 (= 12 / 36) meals he could have cooked instead. c) Based on absolute advantage each person should specialize in the activity in which they are more efficient. In terms of opportunity costs, this means that Sari should specialize in ironing jeans because the opportunity cost of this activity is less for her (the 0.25 meals she could have cooked instead) than for Anthony (0.33 meals). Anthony should specialize in cooking meals because the opportunity cost of this activity is less for him (the 3 jeans he could have ironed instead) than for Sari (4 jeans).

3. a) Vega is more efficient at producing home assistants because a worker‘s daily output of home assistants is higher in Vega (10) than in Sirius (4). Vega is also more efficient at producing computer tablets because a worker‘s daily output of tablets is higher in Vega (2) than in Sirius (1).

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b) In Vega, the opportunity cost of computer tablets is 5 (= 10 / 2) home assistants and the opportunity cost of home assistants is 0.20 (= 2 / 10) computer tablets because a worker in Vega can produce five times as many home assistants (10) as computer tablets (2). In Sirius, the opportunity cost of computer tables is 4 home assistants (= 4 / 1) and the opportunity cost of home assistants is 0.25 (= 1 / 4) computer tablets because a worker in Sirius can produce four times as many home assistants (4) as computer tablets (1) in a day. c) On the basis of comparative advantage, each country should specialize in the good whose opportunity cost is lower than in the other country. This means that Vega should produce home assistants because this good‘s opportunity cost is lower in Vega (0.20 computer tablets) than in Sirius (0.25 computer tablets). Sirius should specialize in computer tablets because this good‘s opportunity cost is lower in Sirius (4 home assistants) than in Vega (5 home assistants). d) The terms of trade must be somewhere between 1 computer tablet traded for 5 home assistants in Vega and 1 computer tablet traded for 4 home assistants in Sirius.

4. a) Virgo is more efficient at producing monitors because a worker‘s daily output of monitors is higher in Virgo (2) than in Taurus (1). Virgo is also more efficient at producing TVs because a worker‘s daily output of TVs is higher in Virgo (6) than in Taurus (2). b) In Taurus, the opportunity cost of monitors is 2 (= 2 /1) TVs and the opportunity cost of TVs is 0.5 (= 1 / 2) monitors because a worker in Taurus can produce twice as many TVs (2) as monitors (1). In Virgo, the opportunity cost of monitors is 3 (= 6 / 2) TVs and the opportunity cost of TVs is 0.33 (= 2 / 6) monitors because a worker in Virgo can produce three times as many TVs (6) as monitors (2) in a day. c) On the basis of comparative advantage, each country should specialize in the good whose opportunity cost is lower than in the other country. This means that Taurus should produce computer monitors because this good‘s opportunity cost is lower in Taurus (2 TVs) than in Virgo (3 TVs). Virgo should specialize in TVs because this good‘s opportunity cost is lower in Virgo (0.33 monitors) than in Taurus (0.5 monitors). d) The terms of trade must be somewhere between 1 monitor traded for 2 TVs in Taurus and 1 monitor traded for 3 TVs in Virgo.

15.2 Practice Problems

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1. a) Because the tariff raises the price of imports and allows domestic producers to charge more than before, equilibrium price is higher, which reduces quantity demanded. The higher price means that domestic quantity supplied increases, while imports are lower. b) Consumers lose due to the tariff because they pay a higher price and purchase fewer units. c) Domestic producers benefit due to the tariff because they receive a higher price and, given the reduction in imports, sell more units. d) Foreign producers lose due to the tariff. While they receive the same price as before, the reduction in imports means that they sell fewer units. e) The country‘s government benefits due to the tariff because of the additional tax revenue raised by the tariff.

2. a) In the absence of foreign imports, equilibrium in this market occurs at the intersection of the demand curve (D) and domestic supply curve (Sd0) which is point c in the graph.

Equilibrium price is $16 and equilibrium quantity is 400 million bottles. b) An unlimited quantity supplied of foreign imports available at a price of $12 would be shown by drawing a horizontal line Si0 that passes through points a and e in the graph.

Equilibrium price drops to this level. Quantity demanded rises to 600 million and domestic quantity supplied declines to 200 million. Imports of 400 million make up the difference. This is shown by the distance from points a to e in the graph. c) With a $2 tariff, an unlimited quantity supplied is now available at a new equilibrium price of $14, as would be shown by drawing a horizontal line through points b to d in the graph. When compared with the case of freely available imports, quantity demanded falls to 500 million and domestic quantity supplied rises to 300 million, with foreign imports of 200 million making up the difference. This is shown by the distance from points b to d in the graph. d) Consumers lose due to the tariff because they pay a higher price and purchase fewer watches than previously. Domestic producers benefit from the higher price and their greater quantity supplied. Foreign producers are harmed. However, they receive the same price as previously, but they sell fewer watches in the Canadian market. The Canadian government benefits because of the $400 million additional tax revenue found by multiplying the $2 tariff by the 200 million in foreign imports. e) An import quota of 200 million bottles a year means that there is now a new combined domestic and foreign supply curve that is parallel to Sd0 and passes through point d in the graph. This supply curve is based on an increase in quantity supplied equal to 200 million at every possible price. Instead of the initial equilibrium at point c, equilibrium in the 1-307 Copyright © 2023 by McGraw Hill

market is now at a price of $14 and quantity demanded is now 500 million. This is met by 300 million in domestic quantity supplied and 200 million in imports (point d in the graph). f) When comparing points c and d in the second graph, consumers lose due to an import quota because they pay a higher price and purchase fewer watches. In contrast domestic producers benefit from the higher price and their greater quantity supplied. Foreign producers lose because they sell fewer watches in the Canadian market.

3. a) The quota reduces the quantity imported which raises equilibrium price and reduces quantity demanded. The higher price means that domestic quantity supplied increases at the same time as the quantity imported is reduced. b) Consumers lose due to the quota because they pay a higher price and purchase fewer 1-308 Copyright © 2023 by McGraw Hill

units. c) Domestic producers benefit due to the quota. They receive a higher price and, given the reduction in imports, sell more units. d) Foreign producers lose due to the quota. They receive a higher price than before but the reduction in imports means that they sell fewer units. e) The country‘s government is not affected due to the quota because there is no change in tax revenue.

15.3 Practice Problems 1. a) Mercosur is an example of an emerging customs union, which is attempting to impose common trade barriers with the rest of the world. b) NAFTA is an example of a free trade area. Canada, Mexico and the United States impose separate trade barriers on outside countries. c) The European Union is an example of a common market, with common trade barriers on outside countries and free movement of labour and capital among member nations.

2. As countries participating in a trade war impose added trade barriers on exports from the others, total trade between them decreases, reducing total expenditures and real output in all of them.

End of Chapter Problems 1. a) Ada is more efficient at preparing a tax return since she can do it in less time (4 hours) than it takes Paulo (12 hours). Ada is less efficient at painting a kitchen, since she does it in more time (10 hours) than it takes Paulo (2 hours). b) Ada can prepare 2.5 (= 10 / 4) tax returns in the 10 hours it takes her to paint one kitchen.

Therefore, her opportunity cost of painting a kitchen is the 2.5 tax returns she could have prepared instead and her opportunity cost of preparing a tax return is the 0.40 (= 4 / 10) kitchens she could have painted instead. Paulo can prepare 0.167 (= 2 / 12) tax returns in the 2 hours it takes him to paint one kitchen. Therefore, his opportunity cost of painting a kitchen is the 0.167 tax returns he could have prepared instead and his opportunity cost of preparing a tax return is the 6 (= 12 / 2) kitchens he could have painted instead. c) Based on absolute advantage each person should specialize in the activity in which they are more efficient. In terms of opportunity costs, this means that Ada should specialize in preparing tax returns because the opportunity cost of this activity is less for her (the 0.4 1-309 Copyright © 2023 by McGraw Hill

kitchens she could have painted instead) than for Paulo (6 kitchens). Paulo should specialize in painting kitchens because the opportunity cost of this activity is less for him (the 0.17 tax returns he could have prepared instead) than for Ada (2.5 tax returns).

2. a) Orion is more efficient at producing consoles because a worker‘s daily output of consoles is higher in Orion (12) than in Centaur (10). Centaur is more efficient at producing headsets because a worker‘s daily output of headsets is higher in Centaur (5) than in Orion (2). b) In Orion the opportunity cost of consoles is 0.17 (= 2 / 12) headsets and the opportunity cost of headsets is 6 (= 12 / 2) consoles because a worker in Orion can produce 6 times as many consoles (12) as headsets (2). In Centaur the opportunity cost of consoles is 0.5 (= 5 / 10) headsets and the opportunity cost of headsets is 2 (= 10 / 5) consoles because a worker in Centaur can produce 2 times as many consoles (10) as headsets (5) in a day. c) On the basis of absolute advantage, each country should specialize in the good that it is most efficient at producing. Therefore, Orion should make consoles and Centaur should make headsets. d) The terms of trade are based on the opportunity costs in each country. Therefore, they must be somewhere between 1 headset traded for 6 consoles in Orion and 1 headset traded for 2 consoles in Centaur.

3. a) Pacifica is more efficient at producing video games, since a worker‘s daily output of games in Pacifica is higher (10) than in Atlantica (8). Atlantica is more efficient at producing digital cameras, since a worker‘s daily output of cameras is higher in Atlantica (4) than in Pacifica (2). b) In Atlantica the opportunity cost of cameras is 2 (= 8 / 4) games and the opportunity cost of games is 0.5 (= 4 / 8) cameras, since a worker in Atlantica can produce twice as many games (8) as cameras (4) in a day. In Pacifica the opportunity cost of cameras is 5 (= 10 / 2) games and the opportunity cost of games is 0.2 (= 10 / 2) cameras, since a worker in Pacifica can produce five times as many games (10) as cameras (2) in a day. c) On the basis of absolute advantage each country should specialize in the good that they are most efficient at producing. Therefore, Pacifica should make games and Atlantica should make cameras.

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d) The terms of trade are based on the opportunity costs in each country. Therefore, they must be somewhere between 1 camera traded for 2 games in Atlantica and 1 camera traded for 5 games in Pacifica. e) Before specialization and trade daily output in Atlantica is 12 million games (= 1.5 million workers × 8 games per worker) and 6 million cameras (= 1.5 million workers × 4 cameras per worker). In Pacifica daily output is 20 million games (= 2 million workers × 10 games per worker) and 4 million cameras (= 2 million workers × 2 cameras per worker). Therefore, total output in the two countries before specialization and trade is 32 million (= 12 million + 20 million) games and 10 million (= 6 million + 4 million) cameras. After specialization and trade, daily output in Atlantica is 12 million cameras (= 3 million workers × 4 cameras per worker) and daily output in Pacifica is 40 million games (= 4 million workers × 10 games per worker). The result is a gain in the two countries‘ output of both products with 2 million (= 12 million - 10 million) more cameras and 8 million (= 40 million - 32 million) more games.

4. a) Aquarius is more efficient at producing T-shirts, since a worker‘s daily output of T-shirts is higher in Aquarius (40) than in Capricorn (30). Aquarius is also more efficient at producing jeans, since a worker‘s daily output of jeans in Aquarius is higher (4) than in Capricorn (2). b) In Aquarius the opportunity cost of 1 pair of jeans is 10 (= 40 / 4) T-shirts and the opportunity cost of 1 T-shirt is 0.10 (= 4 / 40) jeans because a worker in Aquarius can produce 10 times as many T-shirts (40) as jeans (4) in a day. In Capricorn the opportunity cost of 1 pair of jeans is 15 (= 30 / 2) T-shirts and the opportunity cost of 1 T-shirt is 0.07 (= 2 / 30) jeans because a worker in Capricorn can produce 15 times as many T-shirts (30) as jeans (2) in a day. c) On the basis of comparative advantage each country should specialize in the good whose opportunity cost is lower than in the other country. This means that Capricorn should specialize in T-shirts because this good‘s opportunity cost is lower in Capricorn (0.07 jeans) than in Aquarius (0.10 jeans). Aquarius should specialize in jeans because this good‘s opportunity cost is lower in Aquarius (10 T-shirts) than in Capricorn (15 T-shirts). d) The terms of trade are based on the opportunity costs in each country. Therefore, they must be somewhere between 1 pair of jeans traded for 10 T-shirts in Aquarius and 1 pair of jeans traded for 15 T-shirts in Capricorn. e) Before specialization and trade, daily output in Aquarius is 4 million T-shirts (= 100,000 workers × 40 T-shirts per worker) and 400,000 jeans (= 100,000 workers × 4 jeans per worker). In Capricorn daily output is 4.5 million T-shirts (= 150,000 workers × 30 T-shirts 1-311 Copyright © 2023 by McGraw Hill

per worker) and 300,000 jeans (= 150,000 workers × 2 jeans per worker). Therefore, total output in the two countries before specialization and trade is 8.5 million (= 4 million + 4.5 million) T-shirts and 700,000 (= 400,000 + 300,000) jeans. After specialization and trade daily output in Aquarius is 800,000 jeans (= 200,000 workers × 4 jeans per worker) and daily output in Capricorn is 9 million T-shirts (= 300,000 workers × 30 T-shirts per worker). The result is a gain in the two countries‘ output of both products with 500,000 (= 9 million - 8.5 million) more T-shirts and 100,000 (= 800,000 - 700,000) more jeans.

5. a) The opportunity cost of players is lower in South Korea (5 phones) than in Canada (10 phones) so South Korea exports players. The opportunity cost of phones is lower in Canada (0.10 players) than in South Korea (0.20 players) so Canada exports phones. b) The terms of trade must be somewhere between 1 player traded for 10 phones in Canada and 1 player traded for 5 phones in South Korea. c) Because Canadians export phones they want the lowest possible price of players in terms of phones which occurs when 1 player trades for its minimum value of 5 phones. Because South Koreans export players they want the highest possible price of players in terms of phones which occurs when 1 player trades for its maximum value of 10 phones.

6. a)

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In the absence of foreign imports, equilibrium in this market occurs at the intersection of the demand curve (D) and domestic supply curve (Sd0) which is point j in the graph above. Equilibrium price is $70 and equilibrium quantity is 1.6 million watches. b) An unlimited quantity supplied of foreign imports available at a price of $50 is shown by the horizontal line Si0 in the graph. Equilibrium price drops to this level. Quantity demanded rises to 2.0 million and domestic quantity supplied declines to 1.2 million.

Imports of 800,000 make up the difference. This is shown by the distance from points h to m in the graph. c) With a $10 tariff an unlimited quantity supplied is now available at a new equilibrium price of $60, as shown by the horizontal line Si1. When compared with the case of freely available imports quantity demanded falls to 1.8 million and domestic quantity supplied rises to 1.4 million, with foreign imports of 400,000 making up the difference. This is shown by the distance from points i to l in the graph. d) Consumers lose due to the tariff because they pay a higher price and purchase fewer watches than previously. Domestic producers benefit from the higher price and their greater quantity supplied. Foreign producers are harmed. Though they receive the same price as previously they sell fewer watches in the Canadian market. The Canadian government benefits because of the $4 million additional tax revenue as shown by the shaded area in the graph. e)

An import quota of 400,000 watches a year means that there is now a new combined domestic and foreign supply curve, S1, as shown in the graph above. This supply curve is 1-313 Copyright © 2023 by McGraw Hill

based on an increase in quantity supplied equal to 400,000 at every possible price. The equilibrium in the market is now at a price of $60 and quantity demanded is now 1.8 million. This is met by 1.4 million in domestic quantity supplied and 400,000 in imports (point n in the graph). f) When comparing points n and o on the second graph, consumers lose due to an import quota because they pay a higher price and purchase fewer watches. In contrast domestic producers benefit from the higher price and their greater quantity supplied. Foreign producers lose because they sell fewer watches in the Canadian market g) The loss suffered by foreign producers is less with a quota than with a tariff because in this case the impact of the lower quantity supplied is partly counteracted by the extra revenue they receive due to the higher price they can charge as shown by the shaded rectangle in the graph.

7. A legal requirement of bilingual labelling of products sold in Canada affects foreign producers of some imported items. For these businesses, items destined for Canada have to be treated separately during production. This may raise average costs of these items to such an extent that Canadian sales are no longer profitable. In such cases, labelling restrictions can act as an effective, though hidden, non-tariff barrier on imports. A possible example is a foreign-made board game whose packaging is considered to be an essential product attribute.

Because of the difficulty in supplying separate packaging for the Canadian market, the board game‘s producer may choose not to sell in Canada at all.

8. Domestic businesses in a particular industry can receive significant benefits when governments impose tariffs on foreign competitors or provide the domestic businesses with subsidies. If the benefits are due to a perception that the businesses are part of an infant industry, then those businesses will prefer to keep their perceived ―infantile‖ status.

9. The answer depends on the weighting of the costs and benefits for Canadian citizens of freer trade between Canada and those Latin American countries, who are the likeliest participants in an expansion of NAFTA. Supporters of expansion stress the added product variety, competition, and productivity gains that would stem from increased trade between Canada and the new NAFTA members. On a more immediate level, supporters also emphasize the new markets and investment opportunities for Canadian businesses and wealth-holders that would arise from an enlarged free trade area in the Americas. Critics of NAFTA‘s expansion emphasize the possible decline in Canadian environmental and safety standards as Canadian 1-314 Copyright © 2023 by McGraw Hill

governments react to the added incentives for businesses to move production to Canada to NAFTA countries whose standards are loosest. On a more immediate level, critics also focus on possible further declines in the wages of Canadian unskilled workers due to the movement of production that employs this type of labour to low-wage countries.

10. According to critics of trade liberalization, free trade between countries with divergent income levels leads to more environmental damage and worse employment safety standards, since businesses have an incentive to locate production in low-income countries, where environmental and safety standards tend to be lax. This puts pressure on high-income countries to reduce their standards to maintain their international competitiveness. According to critics, free trade between dissimilar countries can also put downward pressure on wages for unskilled labour in high-income countries, since businesses will make use of trade liberalization to employ unskilled workers in countries with low wage levels. On the other hand, supporters of trade liberalization suggest that free trade between countries with divergent income levels can be particularly beneficial to consumers in both types of countries, since the gains from comparative advantage are particularly pronounced when countries have significant cost differences. Supporters also argue that trade agreements can provide a framework for making environmental and safety standards more consistent among both high-income and low-income countries. Finally, supporters suggest that free trade‘s negative effect on unskilled workers in high-income countries is more than offset by the accompanying increase in average living standards in both low-income and high-income countries.

If the average cost per kilogram for launches remains constant for an extended period, then this constant average value means that the marginal cost and average cost will be equal. In this case, the demand curve for launches in the outward-facing portion of the space economy is likely to shift outward. At the same time, its elasticity will increase, as the entities demanding launches become more likely to respond to changes in price for launches.

Advancing Economic Thought Problems

3. If the average cost per kilogram for launches remains constant for an extended period, then 1-315 Copyright © 2023 by McGraw Hill

this constant average value means that the marginal cost and average cost of launching a kilogram will be equal.

4. In this case, according to O‘Sullivan, the demand curve for launches in the outward-facing portion of the space economy is likely to shift outward. At the same time, its elasticity is likely to increase, as the entities demanding launches become more likely to respond to changes in price for launches.

In-class Activities

1.Introductory Information

Time: Approximately 20 minutes.

Materials: none

Set-up: This simulation is an extension of the Chapter 14 simulation where the class was divided into teams of three.

Key Concepts Covered: absolute advantage comparative advantage export subsidy law of comparative advantage tariff

Learning Objectives:

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- Assess the significance of absolute advantage and comparative advantage, and apply the law of comparative advantage.

- Evaluate the economic impact of a tariff and export subsidy.

2. Exercise (essay)

Recall that the students have been divided into teams of two.

Timekeeper: Teams will be given five minutes to discuss trade and another five minutes for each scenario.

Stage 1: In each team one student will represent China and the other represent Canada. This simulation is an extension of the Chapter 14 simulation.

Now we take account of two products – phones and calculators – and allow for the fact that labour productivity in the two countries can differ for each product. We assume that shipping costs between the two countries are negligible.

The students will be given the following information: - In China, one worker can produce either 10 phones or 5 calculators in a day.

- In Canada, one worker can produce either 12 phones or 8 calculators during the same time.

First, each team will be given 5 minutes to discuss why trade between the two countries is worthwhile, and why China will choose to produce phones and Canada will choose to produce calculators. In confirming these statements, take explicit account of the concepts of absolute advantage, comparative advantage, and opportunity cost.

[Canada*; China] has an absolute advantage in the production of phones, and [Canada*; China] has an absolute advantage in the production of calculators.

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[Canada; China*] has a comparative advantage in the production of phones, and [Canada*; China] has a comparative advantage in the production of calculators.

The opportunity cost of phones in terms of calculators is 1 phone for [fill in appropriate value] calculators in China and 1 phone for [fill in appropriate value] calculators in Canada.

The opportunity cost of calculators in terms of phones is 1 calculator for [fill in appropriate value] phones in China and 1 calculator for [fill in appropriate value] phones in Canada.

Is the law of comparative advantage being met?

No, the law of comparative advantage is not being met.

Yes, the law of comparative advantage is being met.*

Stage 2: Now students in each team will be given 5 minutes to discuss each of the following two scenarios.

Scenario 1: Canadians are concerned about the number of domestic jobs being moved overseas.

In order to stimulate domestic employment, the Canadian government imposes a tariff on imported phones from China. What happens to the price of Chinese phones for Canadian consumers? What happens to employment in Canada? To employment in China? Is the team‘s Chinese representative in favour of this policy? Why? How might China respond to this policy?

Scenario 2: Instead of imposing a tariff, the Canadian government chooses to impose a quota on the number of phones imported from China. What happens to the price of Chinese phones for Canadian consumers? What happens to employment in Canada? To employment in China? Is the team‘s representative of China in favour of this policy when compared with a tariff on Chinese phones? Why?

Explanation: Canada has an absolute advantage in the production of both goods. In the case of phones, one worker in Canada produces 12 per day, as opposed to 10 in China. For calculators, one worker in Canada can produce 8, as opposed to 5 in China.

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But Canada has a comparative advantage in the production in only one of these items. The opportunity cost of phones in terms of calculators is 1 phone for 0.5 [= (5/10)] calculators in China, and 1 phone for 0.67 [= (8/12)] calculators in Canada. Because China‘s opportunity cost of phones is lower than Canada‘s, China has a comparative advantage in phones, which means this is the item they should produce.

Meanwhile, the opportunity cost of calculators in terms of phones is 1 calculator for 2 [= (10/5)] phones in China, and 1 calculator for 1.5 [= (12/8)] phones in Canada. Because Canada‘s opportunity cost of calculators is lower than China‘s, Canada has a comparative advantage in calculators and should produce this item.

With China producing phones and Canada calculators, the law of comparative advantage is being met since each country is producing the item in which they have a comparative advantage.

Scenario 1: Canadian consumers pay a higher price for imported Chinese phones. As long as the tariff is high enough to make it profitable to produce phones in Canada, Canadian employment rises and Chinese employment falls. The team‘s representative of China should oppose this policy, due to the reduction in Chinese jobs that it causes. China will probably respond with a threat to impose a tariff on China‘s imports of Canadian calculators.

Scenario 2: As long as the import quota is tight enough to reduce the number of phones imported from China, Canadian consumers will pay more for imported Chinese phones. Canadian employment again rises and Chinese employment falls. But the representative of China might support this move by the Canadian government if it replaces a tariff on Chinese-made phones.

This is because Chinese firms will reap the higher price received on phones in the Canadian market – something that would not happen in the case of a Canadian tariff on phones, given that this revenue would be captured by the Canadian government instead.

Further Learning: - The instructor should pause for a brief class discussion surrounding the results of each scenario.

The students will gain valuable insight from the discussions.

- Discuss absolute and comparative advantage as well as opportunity cost in the trade that takes place between the two countries.

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3. Discussion Questions (essay)

1. Give an example of a product for which a particular country has a comparative advantage in production over Canada.

2. Have you ever tried to call the help desk for a computer company? Where were they located?

Why do you think they were located there?

Explanation: 1. Answers will vary. Typically, students will pick a product such as coffee in Columbia and they will explain that the climate is more conducive to growing coffee beans.

2. Answers will vary. Most students will have had an experience calling an American based company, whose call centre is clearly overseas. The students will explain that it is lower cost labour costs that give their named country a comparative advantage in this labour-intensive sector.

4. Multiple Choice Questions

1. When the government places a 10% tax on all units of a product that are imported, this is called a: a) local tax. b) trade tax. c) subsidy. d) domestic tax. e) tariff.*

2. When China can produce phones at a lower opportunity cost than Canada, it has a(n) a) absolute advantage in this product. b) comparative advantage in this product.* c) labour advantage in this product.

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d) production advantage in this product. e) none of the above

3. Jobs in Canada would be lost if: a) Canada gained an absolute advantage in the production of more products. b) Canada imposed a tariff on its imports of Chinese products. c) Canada imposed a subsidy on some its exports to China. d) China imposed a tariff on its imports of Canadian products.* e) all of the above

4. Export subsidies are used to: a) decrease production costs. b) encourage exports.* c) encourage imports. d) increase production costs. e) none of the above

5. Tariffs and import quotas are a form of: a) absolute advantage. b) comparative advantage. c) expansionist policy. d) protectionist policy.* e) all of the above

Explanation: 1) When the government places a 10% tax on all units of a product that are imported, this is called a tariff.

2) When China can produce phones at a lower opportunity cost than Canada, it has a comparative advantage in this product.

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3) Jobs in Canada would be lost if China imposed a tariff on its imports of Canadian products.

4) Export subsidies are used to encourage exports.

Skills Resource Teaching Tips Using this Resource This resource helps ensure students are sufficiently grounded in the foundations required to study economics. For many students, material under the heading Visual Materials is most crucial.

Facility in reading tables and graphs is crucial if students are to excel in economics. Instructors who do not have time to cover this material explicitly in class should consider assigning it, along with the relevant problems at the end. A few minutes spent reviewing these problems will soon reveal if there are gaps that need further attention. These gaps can then be addressed when instructors present the first tables and graphs in the course. For courses aligned with the book‘s subject order, this means the production possibilities model in Chapter 1 and demand and supply in Chapter 2.

Problems 16. c) Subtracting the initial value ($28 225) from the new value ($23 158), then dividing by the initial value, and multiplying by 100 gives the percentage change: [($23,158 – $28,225)/$28,225] × 100 = -18.0%. d) Subtracting the initial value ($20.3 b.) from the new value ($32.7. b.), then dividing by the initial value, and multiplying by 100 gives the percentage change: [($32.7 b. – $20.3 b.)/$20.3 b.] × 100 = 61.1%. e) The business‘s new profit is found by first calculating the change in profit, which is the initial profit ($402.3 m.) multiplied by the percentage change (21.2) divided by 100: [$402.3 m. × (21.2/100)] = $85.3 m. This change is then added to the initial value to give the greater new value: $402.3 m. + $85.3 m. = $487.6 m. f) The economy‘s new employment level is found by first calculating the change in employment, which is the initial employment level (12.7 million) multiplied by the percentage change (-8.2) divided by 100: [$12.7 m. × (-8.2/100)] = -$1.0 m. This negative value is then added to the initial value to give the smaller new value: $12.7 m. + -$1.0 m. = $11.7 m.

17.

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c) This statement inappropriately generalizes from an individual to an entire group. It is a fallacy of composition. d) This statement improperly assumes that because two trends occur simultaneously one causes the other. It is false causation. e) This statement assumes that, because two things share some characteristics, they share other characteristics as well. It is a false analogy. f) This statement contains a judgment based on the nature of the people making a particular argument. It is a personal argument. g) This statement presumes that, because two things share some characteristics, they share other characteristics as well. It is a false analogy. h) This statement presumes that because two trends occur at the same time one necessarily causes the other. It is false causation.

18. g) If there is a rise in the price of electric vehicles, fewer vehicles will be purchased at each average income. Hence all the numbers in the second column of the table will fall. The price of vehicles is assumed to be constant when analyzing the relationship in the table. h)

Point d on the graph corresponds to the numbers in the first row of the table, point c to the second row, point b to the third row, and point a to the fourth row. i) When average income rises from $60,000 to $80,000, the number of electric vehicles purchased increases from 10,000 to 14,000 (points a to b in the graph). The formula for slope is the change in the variable on the vertical axis divided by the change in the variable on the horizontal axis. In this case, it is new income minus the initial income divided by the new number of vehicles purchased minus the initial number of vehicles 1-323 Copyright © 2023 by McGraw Hill

purchased: ($80,000 – $60,000)/(14,000 – 10,000) = 20,000/4000 = 5. Because the changes in both variables have the same sign, the slope is positive, and because this curve is a straight line, slope is constant at all other points on the curve.

19. g) Employment of Construction Workers Wage ($ per hour)

Employment (thousands of workers)

$60

15

50

25

40

35

30

45

h) If the hourly wage falls by $10 from $30 to $20 (the same drop as when moving from any point to the next along the curve), the employment of construction workers will rise by 10,000 workers (the same jump as when moving from one point to the next along the curve), from 45,000 to 55,000 workers. i) The answer in part b is based on the assumption that the curve continues to be a straight line at wages below $30.

20. g) Drawing the line requires plotting sample points – for example, a, b, c, and d. At point a x = -2, which means y is (2 × -2) + 1 = -3. At point b x = 0, which means y is (2 × 0) + 1 = 1. At point c x = 2, which means y is (2 × 2) + 1 = 5. At point d x = 4, which means y is (2 × 4) + 1 = 9.

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h) Because the line rises from left to right, it is positively sloped. i) If x is 6, y has a value of 13. Using the equation, this is found by inserting the value of 6 for x in the equation: (2 × 6) + 1 = 13. Using the graph, this is point e. j) If y is 17, x has a value of 8. Using the equation, this is found by inserting the value of 17 for y in the equation: (2 × x) + 1 = 17. This rearranges to x = (17 – 1)/2 = 8. Using the graph, this is point f.

21. g)

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h) Manufacturing has experienced a change of -30.3% [= ((135,600 – 194,600/194,600) × 100] between 2017 and 2020; construction has experienced a change of (+)56.1% [= ((61,800 – 39,600/39,600) × 100]; and entertainment and hospitality has experienced a change of -45.1% [= ((16,100 – 29,300/29,300) × 100] . Construction has experienced the biggest percentage change – 56.1% – during the four-year period and manufacturing has experienced the smallest– -30.3%.

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