SOLUTIONS MANUAL For Economics 12th Global Edition By Michael Parkin by digitaldownload87

CHAPTER 1

Use headlines from the recent news to illustrate the potential for conflict between self-interest and the social interest. One example of an issue concerns the income necessary to live in an apartment building in San Francisco. A May 5, 2014 headline from The San Francisco Chronicle was “S.F. Landlord: Make $100K or Get Out.” This story discusses an owner’s attempt to make the tenants prove that their annual income is at least $100,000. The owner is following his self-interest because he wants to have only high-income residents who, presumably, create less damage and might be willing to pay more rent. The head of San Francisco’s Housing Rights Committee, Sara Shortt, believes that the requirement is not in the social interest. She asserts that the effort “definitely reads like a harassment tactic” and that the effort to force tenants to move is illegal. She believes that the social interest is served by having a variety of tenants in the apartments.

Page 48 1.

Explain the idea of a tradeoff and think of three tradeoffs that you have made today. A tradeoff reflects the point that when someone gets one thing, something else must be given up. What is given up is the opportunity cost of whatever is obtained. Three examples of tradeoffs that are common to students include: a) When a student sleeps in rather than going to his or her early morning economics class, the student trades off additional sleep for study time. The opportunity cost of the decision is a lower grade on the exam. b) When a student running late for class parks his or her car illegally, the student trades off saving time for the risk of a ticket. The potential opportunity cost of the decision is the goods and services that cannot be purchased if the student receives an expensive parking ticket. c) A student trades off higher income by spending time during the day working at a part-time job for less time spent at leisure time and study. The opportunity cost for the higher income is less leisure and lower grades in classes.

Explain what economists mean by rational choice and think of three choices that you’ve made today that are rational. A rational choice is one that compares the costs and benefits of the different actions and then chooses the action that has the greatest benefit over cost for the person making the choice. Three rational choices made by students include: a) The choice to skip breakfast to go to class. In this case the benefit is the higher grade in the class and the cost is the breakfast forgone. b) The choice to stop talking with a friend on the phone and start studying for an impending exam. In this case the benefit is the resulting higher grade in the class and the cost is the conversation forgone. c) The choice to do laundry today rather than watch television. In this case the benefit is the fact the student will have clean clothes to wear and the cost is the loss of the entertainment the television show would have provided.

Explain why opportunity cost is the best forgone alternative and provide examples of some opportunity costs that you have faced today. When a decision to undertake one activity is made, often many alternative activities are no longer possible. Often these activities are mutually exclusive so only the highest valued alternative is actually forgone. For instance, the decision to go to a student’s 8:30 AM class eliminates the possibility of sleeping in during the hour and of jogging during the hour. But in this case, it is impossible to both sleep in and to jog during the hour, so the opportunity cost cannot be both activities. What is lost is only the activity that otherwise would have been chosen—either sleeping in or jogging—which is whatever activity would have been chosen, that is, the most highly valued of the forgone alternatives. For students, attending class, doing homework, studying for a test are all activities with opportunity costs.

WHAT IS ECONOMICS?

Explain what it means to choose at the margin and illustrate with three choices at the margin that you have made today. Choosing at the margin means choosing to do a little more or a little less of some activity. Three common examples students encounter are: a) When a student faces a chemistry and an economics final exam in one day, the student must determine whether spending the last hour studying a little more chemistry or a little more economics will yield a better contribution (marginal benefit) to his or her overall GPA. b) A college student buying a computer must decide whether the marginal benefit of adding 1 GB of additional memory is worth the marginal cost of the additional memory. c) A student football fan with a choice of a cheap seat in the student bleachers located at the far end of the playing field or a more expensive seat located on the 30 yard line must determine whether the marginal benefit of watching the game from a better seat is worth the marginal cost of the higher ticket price.

Explain why choices respond to incentives and think of three incentives to which you have responded today. People making rational decisions compare the marginal benefits of different actions to their marginal costs. Therefore people’s choices change when their incentives, that is the marginal benefit and/or marginal cost, of the choice changes. Just as everyone else, students respond to incentives; a) A student studies because of the incentives offered by grades. b) A student is more likely to attend a class if attendance is factored into the grade. c) A student might attend a meeting of a club if the student’s significant other is eager to attend the meeting.

Page 49 1.

Distinguish between a positive statement and a normative statement and provide examples. A positive statement is a description of how the world is. It is testable. A normative statement is a description of how the world ought to be. It is, by its very nature, not testable because there is no universally approved criterion by which the statement can be judged. “I will receive an A for this course,” is a positive statement made by an economics student—it might not be true, but it is testable. “I will receive a good grade for this course,” is a normative statement. Whether someone agrees with it depends on his or her interpretation of what makes for a “good” grade.

What is a model? Can you think of a model that you might use in your everyday life? A model is a description of some aspect of the economic world. It includes only those features that are necessary to understand the issue under study. An economic model is designed to reflect those aspects of the world that are relevant to the user of the model and ignore the aspects that are irrelevant. A typical model is a GPS map. It reflects only those aspects of the real world that are relevant in assisting the user in reaching his or her destination and avoids using information irrelevant to travel.

How do economists try to disentangle cause and effect? Economists use models to understand some aspect of the economic world. Testing the predictions of models makes it necessary to disentangle cause and effect. To overcome this problem, economists have three methods of testing their models: Using a natural experiment, using a statistical investigation, and using economic experiments. A natural experiment is a situation that arises in the ordinary course of life in which one factor being studied varies and the other factors are the same. This method allows the economist to focus on the effect from the factor that differs between the two situations. A statistical investigation looks for correlations between variables but then determining whether the correlation actually reflects causation can be difficult. An economic experiment puts people into decision making situations and then varies the relevant factors one at a time to determine each factor’s effect.

How is economics used as a policy tool? Individuals, businesses, and governments use economics as a policy tool. Individuals use the economic ideas of marginal benefit and marginal cost when making decisions for such topics as attending college, paying cash or credit for a purchase, and working. Businesses also use the concepts of marginal benefit and marginal cost when making decisions about what to produce, how to produce, and even how many hours to stay open. Finally governments also use marginal benefit and marginal cost when deciding issues such as the level of property taxes, the amount to fund higher education, or the level of a tariff on Brazilian ethanol.

CHAPTER 1

Answers to the Study Plan Problems and Applications 1.

Apple Inc. decides to make iTunes freely available in unlimited quantities. a. Does Apple’s decision change the incentives that people face? Apple’s decision changes people’s incentives. For example, it increases people’s incentives to buy an iPod to take advantage of the newly “free” music available on iTunes.

b. Is Apple’s decision an example of a microeconomic or a macroeconomic issue? Apple’s decision is a microeconomic decision because it affects a single company and a single market.

Which of the following pairs does not match? a. Labor and wages Labor earns wages, so this pair matches.

b. Land and rent Land earns rent, so this pair matches.

c. Entrepreneurship and profit Entrepreneurship earns profit, so this pair matches.

d. Capital and profit Capital earns interest, so this pair does not match.

Explain how the following news headlines concern self-interest and the social interest. a. Starbucks Expands in China Starbucks’ expansion is a decision made by Starbucks to further Starbucks’ interest. Thus the decision is directly in Srarbucks’ self interest. The social interest is affected because Starbucks’ expansion will have an effect in China. For instance, more Chinese citizens might drink coffee rather than tea and fewer coffee shops run by Chinese firms might open.

b. McDonald’s Moves into Gourmet Coffee McDonald’s decision to serve gourmet coffee is a decision made by McDonald’s to further McDonald’s interest. Thus the decision is directly in McDonald’s self interest. The social interest is affected because more people will drink coffee rather than other drinks such as sodas.

c. Food Must Be Labeled with Nutrition Data The decision to require that food must be labeled with nutrition information is made in the social interest. This decision is not made by any one single firm and so does not (necessarily) reflect anyone’s self interest.

The night before an economics test, you decide to go to the movies instead of staying home and working your MyEconLab Study Plan. You get 50 percent on your test compared with the 70 percent that you normally score. a. Did you face a tradeoff? Yes, you faced a tradeoff. The tradeoff was between a higher test score and an evening with your friends at the movies.

b. What was the opportunity cost of your evening at the movies? The opportunity cost of going to the movies is the fall in your grade. That is the 20 points forgone from choosing to see the movie rather than study.

WHAT IS ECONOMICS?

Cost of Sochi Winter Olympics The Russian government spent $6.7 billion on Olympic facilities and $16.7 billion upgrading Sochi area infrastructure. Sponsors spent $27.6 billion on hotels and facilities hoping to turn Sochi into a year-round tourist magnet. Source: The Washington Post, February 11, 2014 Was the opportunity cost of the Sochi Olympics $6.7, $23.4, or $51 billion? Explain your answer. The $6.7 billion spent on Olympic facilities is definitely an opportunity cost of the Sochi Olympics. The $16.7 billion spent upgrading the Sochi area infrastructure and the $27.6 billion spent on hotels and facilities are an opportunity cost of the Sochi Olympics if the funds would not have spent otherwise. However, if there were already plans underway to upgrade the Sochi area infrastructure then the cost is not an opportunity cost of the Sochi Olympics because the cost would have been paid even if Sochi did not host the Olympics. Similarly, if there were already plans underway to build hotels and facilities in Sochi then the cost is not an opportunity cost of the Sochi Olympics because the cost would have been paid even if Sochi did not host the Olympics.

Which of the following statements is positive, which is normative, and which can be tested? a. The United States should cut its imports. The statement is normative and cannot be tested.

b. China is the largest trading partner of the United States. The statement is positive and can be tested.

c. If the price of antiretroviral drugs increases, HIV/AIDS sufferers will decrease their consumption of the drugs. The statement is positive and can be tested.

CHAPTER 1

Answers to Additional Problems and Applications 7.

Rapper Offers Free Tickets for Concert Eminem will hit the road with Rihanna offering an awesome deal—buy one and get one free! Source: Mstars News, February 24, 2014 When Eminem gave away tickets, what was free and what was scarce? Explain your answer. The seats in the arenas are scarce—there are only a limited number. Also scarce is the time the enthusiastic fans spend in line to acquire the tickets. In addition, if the fans who with the “free” ticket attended the concert rather than sell their free tickets, they incurred the opportunity cost of the foregone ticket price. So the concert was far from “free” for the concert-goers. The publicity that Eminem receives is free to him but the publicity used reporters’ scarce time to report on the lines for the tickets rather than reporting on other news worthy events.

How does the creation of a successful movie influence what, how, and for whom goods and services are produced? The “what” question is affected in two ways. First, one good or service that is produced is the successful movie. Second, spinoffs (Iron Man II) and/or similar films likely will be created in the future. The “how” question is affected to the extent that movies use different production methods. Some movies, for instance, have a lot of special effects while other movies have few or none. The “for whom” question is influenced because those people who, as the result of the blockbuster movie, have higher incomes so that more goods and services are produced for them.

How does a successful movie illustrate self-interested choices that are also in the social interest? The a successful movie increases the income of the people involved with the movie. Hence these people’s choices are driven largely by self interest. However the creation of a successful movie also increases the quantity of widely enjoyed entertainment. The amount of entertainment available in the economy increases which benefits society. So the choices the people made in their self interest also reflected choices made in the social interest.

10.

The rising star of Brazilian football, Neymar Jr., signed his first professional contract at the age of 17 with Santos Football Club for $1.2 million a year. Six years later, he signed with FC Barcelona a 5-year contract, making his average annual salary $15.4 million. a. How do you expect the professional success of Neymar Jr. to influence the opportunity cost of signing a contract with him? Neymar Jr.’s success had encouraged numerous football clubs, including Barcelona, to bid competitively to secure a contract with him. If his success continues, the opportunity cost to football clubs of hiring Neymar Jr. will keep increasing.

b. How does Neymar Jr.’s success change the incentives for football clubs to hire him? There are two effects on the incentives of football clubs to hire Neymar Jr. First, because the opportunity cost of hiring Neymar Jr. increased, the incentive to hire him decreased. However because of Neymar Jr.’s great success, there is a stronger incentive for football clubs to sign contracts with him as they believe that he could help them win.

11.

What might be an incentive for you to take a class in summer school? List some of the benefits and costs involved in your decision. Would your choice be rational? Early graduation, smaller class sizes, and/or retaining eligibility for a scholarship are examples of incentives that encourage taking summer classes. The benefits of taking summer classes might include early graduation, more personal attention from the instructor, retained eligibility for a scholarship, and increased knowledge about some aspect of the world. Costs potentially include forgone summer jobs or internships, less time to spend with friends, and additional tuition and other class-related expenses if the class I not one that would be taken otherwise. The choice is rational as long as the student determines that taking summer classes offers the highest benefit over cost for the use of his or time and efforts.

12.

Look at today’s BBC News. What is the leading economic news story? With which of the big

WHAT IS ECONOMICS?

economic questions does it deal and what tradeoffs does it discuss or imply? On March 9, 2015, the top economic news story discussed cutting the defense spending in the United Kingdom by cutting thousands of jobs held by the army, navy and the royal air force. This comes about as a result of the overall need to practice austerity measures in public spending. This news story addresses the “what” question because the government has decided to cut back on security spending, specifically the employment of personnel as opposed to the cost of military equipment. It also touches upon the “how” question as it specifies that this saving will be done by cutting up to 30,000 jobs. The story implicitly illustrates a tradeoff: For the government to decrease its spending and save more, the security of the country will be affected.

Source: BBC News; http://www.bbc.com/news/uk-31798029

13.

Provide two microeconomic statements and two macroeconomic statements. Classify your statements as positive or normative, and explain your classifications. Microeconomic statements are: Fewer deep water oil wells should be drilled in the Gulf of Mexico. If less oil is produced, the price of oil will rise. The first statement is normative because it relies on what the person thinks “should” be done. The second statement is positive because it is possible to test the effect of less oil being produced. Macroeconomic statements are: The currently unemployment rate is too high. The current unemployment rate is higher for blacks than for whites. The first statement is normative because it depends on what is deemed “too high.” The second statement is positive because it can be checked to determine its validity.

Appendix

GRAPHS IN ECONOMICS

Answers to the Review Quiz Page 66 1.

Explain how we “read” the three graphs in Figs. A1.1 and A1.2. The points in the graphs relate the quantity of the variable measured on the one axis to the quantity of the variable measured on the other axis. The quantity of the variable measured on the horizontal axis (the x-axis) is measured by the horizontal distance from the origin to the point. Similarly, the quantity of the variable measured on the vertical axis (the y-axis) is measured by the vertical distance from the origin to the point. The point relates these two quantities. For instance, in Figure A1.2a, point A shows that at a price of $1.37 per song, 3.8 million songs are downloaded.

Explain what scatter diagrams show and why we use them. Scatter diagrams plot the value of one economic variable against the value of another variable for a number of different values of each variable. We use scatter diagrams because they quickly reveal if a relationship exists between the two variables. Moreover, if a relationship exists, scatter diagrams show whether increases in one variable are associated with increases or decreases in the other variable.

Explain how we “read” the three scatter diagrams in Figs. A1.3 and A1.4. The scatter diagram in Figure A1.3 shows the relationship between box office ticket sales and DVDs sold for 9 popular movies. The figure shows that higher box office sales are associated with a higher number of DVDs sold. But the figure shows that the relationship is weak. The scatter diagram in Figure A1.4a shows the relationship between income, in thousands of dollars per year, and expenditure, also in thousands of dollars per year, for the years 2001 to 2011. The scatter diagram shows that higher income leads to higher expenditure. The figure also shows that the relationship is relatively strong. The scatter diagram in Figure A1.4b shows the relationship between the inflation rate and the unemployment rate for the years 2001 to 2011. The figure shows that for most of the years, there was a weak relationship between these variables, with perhaps higher inflation being associated with lower unemployment.

APPENDIX 1

Draw a graph to show the relationship between two variables that move in the same direction. A graph that shows the relationship between two variables that move in the same direction is shown by a line that slopes upward. Figure A1.1 illustrates such a relationship.

Draw a graph to show the relationship between two variables that move in opposite directions. A graph that shows the relationship between two variables that move in the opposite directions is shown by a line that slopes downward. Figure A1.2 illustrates such a relationship.

GRAPHS IN ECONOMICS

Draw a graph of two variables whose relationship shows (i) a maximum and (ii) a minimum. A graph that shows the relationship between two variables that have a maximum is shown by a line that starts out sloping upward, reaches a maximum, and then slopes downward. Figure A1.3 illustrates such a relationship with curve B. A graph that shows the relationship between two variables that have a minimum is shown by a line that starts out sloping downward, reaches a minimum, and then slopes upward. Figure A1.3 illustrates such a relationship with curve A.

Which of the relationships in Questions 4 and 5 is a positive relationship and which is a negative relationship? The relationship in Question 4 between the two variables that move in the same direction is a positive relationship. The relationship in Question 5 between the two variables that move in the opposite directions is a negative relationship.

What are the two ways of calculating the slope of a curved line? To calculate the slope of a curved line we can calculate the slope at a point or across an arc. The slope of a curved line at a point on the line is defined as the slope of the straight line tangent to the curved line at that point. The slope of a curved line across an arc—between two points on the curved line—equals the slope of the straight line between the two points.

How do we graph a relationship among more than two variables? To graph a relationship among more than two variables, hold constant the values of all the variables except two. Then plot the value of one of the variables against the other variable.

10.

Explain what change will bring a movement along a curve. A movement along a curve occurs when the value of a variable on one of the axes changes while all of the other relevant variables not graphed on the axes do not change. The movement along the curve shows the effect of the variable that changes, ceteris paribus (holding all of the other non-graphed variables constant).

11.

Explain what change will bring a shift of a curve. A curve shifts when there is a change in the value of a relevant variable that is not graphed on the axes. In this case the entire curve shifts.

APPENDIX 1

Answers to the Study Plan Problems and Applications Use the spreadsheet to work Problems 1 to 3. The spreadsheet provides data on the U.S. economy: Column A is the year, column B is the inflation rate, column C is the interest rate, column D is the growth rate, and column E is the unemployment rate.

1 2 3 4 5 6 7 8 9 10 11

A 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

B 1.6 2.3 2.7 3.4 3.2 2.9 3.8 −0.3 1.6 3,1 2.1

C 1.0 1.4 3.2 4.9 4.5 1.4 0.2 0.1 0.1 0.1 0.1

D 2.8 3.8 3.4 2.7 1.8 −0.3 −2.8 2.5 1.8 2.8 1.9

E 6.0 5.5 5.1 4.6 4.6 5.8 9.3 9.6 8.9 8.1 7.4

Draw a scatter diagram of the inflation rate and the interest rate. Describe the relationship. To make a scatter diagram of the inflation rate and the interest rate, plot the inflation rate on the x-axis and the interest rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.4. The pattern made by the dots tells us that as the inflation rate increases, the interest rate usually increases so there is a (weak) positive relationship.

Draw a scatter diagram of the growth rate and the unemployment rate. Describe the relationship. To make a scatter diagram of the growth rate and the unemployment rate, plot the growth rate on the x-axis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.5. The pattern made by the dots tells us that when the growth rate increases, the unemployment rate usually decreases so there is a negative relationship.

GRAPHS IN ECONOMICS

Draw a scatter diagram of the interest rate and the unemployment rate. Describe the relationship. To make a scatter diagram of the interest rate and the unemployment rate, plot the interest rate on the x-axis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.6. The pattern made by the dots tells us that when the interest rate increases, the unemployment rate usually decreases so there is a negative relationship.

Use the following news clip to work Problems 4 to 6. Lego Shatters More Records: Source: Boxofficemojo.com, Data for weekend of February 14-17, 2014 4.

Draw a graph of the relationship between the revenue per theater on the y-axis and the number of theaters on the x-axis. Describe the relationship.

Movie The LEGO Movie About Last Night RoboCop The Monument Men

Figure A1.7 shows the relationship. As the figure shows, there is a positive relationship.

Calculate the slope of the relationship between 3,775 and 2,253 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($16,551 − $12,356)/(3,775 − 2,253) which equals $2.76 per theater.

Calculate the slope of the relationship in Problem 4 between 2,253 and 3,372 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($12,356 − $7,432)/(2,253 − 3,372 which equals −$4.40 per theater.

Theaters (number ) 3,775 2,253 3,372 3,083

Revenue (dollars per theater) $16,551 $12,356 $7,432 $5,811

APPENDIX 1

Calculate the slope of the relationship shown in Figure A1.8. The slope is −5/4. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the x-axis. To calculate the slope, you must select two points on the line. One point is at 10 on the y-axis and 0 on the x-axis, and another is at 8 on the x-axis and 0 on the y-axis. The change in y from 10 to 0 is associated with the change in x from 0 to 8. Therefore the slope of the curve equals −10/8, which equals −5/4.

Use the relationship shown in Figure A1.9 to work Problems 8 and 9. 8.

Calculate the slope of the relationship at point A and at point B. The slope at point A is −2, and the slope at point B is −0.25. To calculate the slope at a point on a curved line, draw the tangent to the curved line at the point. Then find a second point on the tangent and calculate the slope of the tangent. The tangent at point A cuts the y-axis at 10. The slope of the tangent equals the change in y divided by the change in x. The change in y equals −4 (6 minus 10) and the change in x equals 2 (2 minus 0). The slope at point A is −4/2, which equals −2. Similarly, the slope at point B is −0.25. The tangent at point B goes through the point (4, 2). The change in y equals 0.5, and the change in x equals −2. The slope at point B is −0.25.

Calculate the slope across the arc AB. The slope across the arc AB is −1.125. The slope across an arc AB equals the change in y, which is 4.5 (6.0 minus 1.5) divided by the change in x, which equals −4 (2 minus 6). The slope across the arc AB equals 4.5/−4, which is −1.125.

Price (dollars per ride) 5 10 15

Balloon rides (number per day) 50F 70F 90F 32 40 50 27 32 40 18 27 32

GRAPHS IN ECONOMICS

Use the table to work Problems 10 and 11. The table gives the price of a balloon ride, the temperature, and the number of rides a day. 10.

Draw a graph to show the relationship between the price and the number of rides, when temperature is 70°F. Describe this relationship. Figure A1.10 shows the relationship between the price and the number of balloon rides when the temperature is 70F. The relationship between the price and the number of rides is inverse; that is, when the price rises, the number of rides decreases.

11.

What happens in the graph in Problem 10 if the temperature rises to 90°F? If the temperature rises to 90F, the curve shifts rightward. This shift is illustrated in Figure A1.11. In that figure, both the initial curve, which applies when the temperature is 70F, and the new curve, which applies when the temperature is 90F, are illustrated. The curve when the temperature is 90F lies to the right of the curve when the temperature is 70F indicating that at every price, more balloon rides are taken when the temperature is 90F rather than 70F.

APPENDIX 1

Answers to Additional Problems and Applications Use the spreadsheet to work Problems 12 to 14. The spreadsheet provides data on oil and gasoline: Column A is the year, column B is the price of oil (dollars per barrel), column C is the price of gasoline (cents per gallon), column D is U.S. oil production, and column E is the U.S. quantity of gasoline refined (both in millions of barrels per day).

12.

1 2 3 4 5 6 7 8 9 10 11

A 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

B 31 42 57 66 72 100 62 79 95 94 98

C 160 190 231 262 284 330 241 284 354 364 353

D 5.7 5.4 5.2 5.1 5.1 5.0 5.4 5.5 5.7 6.5 7.5

E 8.9 9.1 9.2 9.3 9.3 9.0 9.0 9.0 9.1 9.0 9.1

Draw a scatter diagram of the price of oil and the quantity of U.S. oil produced. Describe the relationship. Figure A1.12 shows the scatter diagram between the price of a barrel of oil and the quantity of U.S. oil produced. It shows a very weak relationship.

13.

Draw a scatter diagram of the price of gasoline and the quantity of gasoline refined. Describe the relationship. Figure A1.13 shows the scatter diagram between the price of a gallon of gasoline and the quantity of gasoline refined. It shows a weak positive relationship.

GRAPHS IN ECONOMICS

14.

Draw a scatter diagram of the quantity of U.S. oil produced and the quantity of gasoline refined. Describe the relationship. Figure A1.14 shows the scatter diagram between the quantity of U.S. oil produced and the quantity of gasoline refined. It shows a negative relationship.

Use the following data to work Problems 15 to 17. Draw a graph that shows the relationship between the two variables x and y in the table to the right.

x y

0 25

1 24

2 22

3 18

4 12

To make a graph that shows the relationship between x and y, plot the x variable on the x-axis and the y variable on the y-axis. Figure A1.15 shows this graph.

15. a. Is the relationship positive or negative? The relationship is negative because x and y move in opposite directions: As x increases, y decreases.

b. Does the slope of the relationship become steeper or flatter as the value of x increases? The slope becomes steeper as x increases.

c. Think of some economic relationships that might be similar to this one. The less expensive a good, the greater is the number of people who buy it. The higher the interest rate, the smaller is the number of people who take out home mortgages. The less expensive gasoline, the greater the miles car owners drive.

16.

Calculate the slope of the relationship between x and y when x equals 3. The slope equals −4.0. The slope of the curve at the point where x is 3 is equal to the slope of the tangent to the curve at that point. Plot the relationship and then draw the tangent line at the point where x is 3 and y is 18. Now calculate the slope of this tangent line by finding another point on the tangent. When x equals 5, y equals 10 on the tangent, so another point is x equals 5 and y equals 10. The slope equals the change in y, 8, divided by the change in x, −2, so the slope is −4.0.

5 0

17.

APPENDIX 1

Calculate the slope of the relationship across the arc as x increases from 4 to 5. The slope is –12. The slope of the relationship across the arc when x increases from 4 to 5 is equal to the slope of the straight line joining the points on the curve at x equals 4 and x equals 5. When x increases from 4 to 5, y falls from 12 to 0. The slope equals the change in y, 12 (12 minus 0), divided by the change in x, −1 (4 minus 5), so the slope across the arc is −12.0.

18.

Calculate the slope of the curve in Figure A1.16 at point A. The slope is −2. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the xaxis. To calculate the slope, select two points on the line. One point is at 18 on the y-axis and 0 on the x-axis, and another is at 9 on the x-axis and 0 on the y-axis. The change in y from 18 to 0 is associated with the change in x from 0 to 9. Therefore the slope of the curve equals −18/9, which equals −2.

Use Figure A1.17to work Problems 19 and 20. 19. Calculate the slope at point A and at point B. The slope at point A is −4, and the slope at point B is −1. To calculate the slope at a point on a curved line, draw the tangent to the line at the point. Then find a second point on the tangent and calculate the slope of the tangent. The tangent at point A cuts the x-axis at 2.5. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 6 (6 minus 0) and the change in x equals −1.5 (1 minus 2.5). The slope at point A is 6/−1.5, which equals −4. Similarly, the slope at point B is −1. The tangent at point B cuts the y-axis at 5. The change in y equals 3, and the change in x equals −3. The slope at point B is −1.

20.

Calculate the slope across the arc AB. The slope across the arc AB is −2. The slope across the arc AB equals the change in y, which is 4 (6 minus 2) divided by the change in x, which equals −2 (1 minus 3). The slope across the arc AB equals 4/−2, which equals −2.

GRAPHS IN ECONOMICS

Use the following table to work Problems 21 to 23. The table gives information about umbrellas: price, the number purchased, and rainfall in inches. 21.

Draw a graph to show the relationship between the price and the number of umbrellas purchased, holding the amount of rainfall constant at 1 inch. Describe this relationship.

Price (dollars per umbrella) 20 30 40

Figure A1.18 shows the relationship. To draw a graph of the relationship between the price and the number of umbrellas when the rainfall equals 1 inch, keep the rainfall at 1 inch and plot the data in that column against the price. This curve is the relationship between price and number of umbrellas when the rainfall is 1 inches. The relationship between the price and the number of umbrellas is an inverse relationship; as the price rises, the number of umbrellas decreases.

22.

What happens in the graph in Problem 21 if the price rises and rainfall is constant? If the price rises, the number of umbrellas decreases. In Figure A1.18, there is a movement upward along the (unchanged) curve.

23.

What happens in the graph in Problem 21 if the rainfall increases from 1 inch to 2 inches? As shown in Figure A1.19, the curve shifts rightward. In that figure, both the initial curve, which applies when the rainfall is 1 inch, and the new curve, which applies when the rainfall is 2 inches, are illustrated. The curve when the rainfall is 2 inches lies to the right of the curve when the rainfall is 1 inch indicating that at every price, more umbrellas are purchased when the rainfall is 2 inches than when the rainfall is 1 inch.

0 4 2 1

Umbrellas (numbers per day) 1 2 (inches of rainfall) 7 4 2

8 7 4

C h a p t e r

THE ECONOMIC PROBLEM

Answers to the Review Quizzes Page 72 1.

How does the production possibilities frontier illustrate scarcity? The unattainable combinations of production that lie beyond the PPF illustrate the concept of scarcity. There simply are not enough resources to produce any of these combinations of outputs. Additionally, while moving along the PPF to increase the production of one good requires that the production of another good be reduced, which also illustrates scarcity.

How does the production possibilities frontier illustrate production efficiency? The combinations of outputs that lie on the PPF illustrate the concept of production efficiency. These points are the maximum production points possible and are attained only by producing the goods and services at the lowest possible cost. Any point inside the frontier reflects production where one or both outputs may be increased without decreasing the other output level. Clearly, such points cannot be production efficient.

How does the production possibilities frontier show that every choice involves a tradeoff? Movements along the PPF frontier illustrate that producing more of one good requires producing less of other good. This observation reflects the result that a tradeoff must be made when producing output efficiently.

How does the production possibilities frontier illustrate opportunity cost? The negative slope of the production possibility curve illustrates the concept of opportunity cost. Moving along the production possibility frontier, producing additional units of a good requires that the output of another good must fall. This sacrifice is the opportunity cost of producing more of the first good.

Why is opportunity cost a ratio? The slope of the PPF is a ratio that expresses the quantity of lost production of the good on the y-axis to the increase in the production of the good on the x-axis moving downward along the PPF. The steeper the slope, the greater ratio, and the greater is the opportunity cost of increasing the output of the good measured on the horizontal axis.

Why does the PPF bow outward and what does that imply about the relationship between opportunity cost and the quantity produced? Some resources are better suited to produce one type of good or service, like pizza. Other resources are better suited to produce other goods or services, like DVDs. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. Consider a PPF with pizza measured on the x-axis and DVDs measured on the y-axis. A small increase in pizza output when pizza production is relatively low requires only a small increase in the use of those resources still good at making pizza and not good at making DVDs. This yields a small decrease in DVD production for a

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large increase in pizza production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF over this range of output. However, the same small increase in pizza output when pizza production is relatively large will require society to devote to pizza production those resources that are less suited to making pizza and more suited to making DVDs. This reallocation of resources yields a relatively small increase in pizza output for a large decrease in DVD output, creating a relatively high opportunity cost reflected in the steep slope of the PPF over this range of output. The opportunity cost of pizza production increases with the quantity of pizza produced as the slope of the PPF becomes ever steeper. This effect creates the bowed out effect (the concavity of the PPF function) and means that as more of a good is produced, the opportunity cost of producing additional units increases.

Page 75 1.

What is marginal cost? How is it measured? Marginal cost is the opportunity cost of producing one more unit of a good or service. Along a PPF marginal cost is reflected in the absolute value of the slope of the PPF. In particular, the magnitude of the slope of the PPF is the marginal cost of a unit of the good measured along the x-axis. As the magnitude of the slope changes moving along the PPF, the marginal cost changes.

What is marginal benefit? How is it measured? The marginal benefit from a good or service is the benefit received from consuming one more unit of it. It is measured by what an individual is willing to give up (or pay) for an additional that last unit.

How does the marginal benefit from a good change as the quantity produced of that good increases? As the more of a good is consumed, the marginal benefit received from each unit is smaller than the marginal benefit received from the unit consumed immediately before it, and is larger than the marginal benefit from the unit consumed immediately after it. This set of results is known as the principle of decreasing marginal benefit and is often assumed by economists to be a common characteristic of an individual’s preferences over most goods and services in the economy.

What is allocative efficiency and how does it relate to the production possibilities frontier? Production efficiency occurs when production takes place at a point on the PPF. This indicates that all available resources are being used for production and society cannot produce additional units of one good or service without reducing the output of another good or service. Allocative efficiency, however, requires that the goods and services produced are those that provide the greatest possible benefit. This definition means that the allocative efficient level of output is the point on the PPF (and hence is a production efficient point) for which the marginal benefit equals the marginal cost.

What conditions must be satisfied if resources are used efficiently? Resources are used efficiently when more of one good or service cannot be produced without producing less of some of another good or service that is valued more highly. This is known as allocative efficiency and it occurs when: 1) production efficiency is achieved, and 2) the marginal benefit received from the last unit produced is equal to the marginal cost of producing the last unit.

Page 77 1.

What generates economic growth? The two key factors that generate economic growth are technological change and capital accumulation. Technological change allows an economy to produce more with the same amount of limited resources, Capital accumulation, the growth of capital resources including human capital, means that an economy has increased its available resources for production.

How does economic growth influence the production possibilities frontier? Economic growth shifts the PPF outward. Persistent outward shifts in the production possibility frontier—economic growth—are caused by the accumulation of resources, such as more capital equipment or by the development of new technology.

What is the opportunity cost of economic growth? When a society devotes more of its scarce resources to research and development of new technologies, or devotes additional resources to produce more capital equipment, both decisions lead

THE ECONOMIC PROBLEM

to increased consumption opportunities in future periods at the cost of less consumption today. The loss of consumption today is the opportunity cost borne by society for creating economic growth.

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Explain why Hong Kong has experienced faster economic growth than the United States. Hong Kong chose to devote a greater proportion of its available resources to the production of capital than the United States. This allowed Hong Kong to grow at a faster rate than the United States. By foregoing consumption and producing a greater proportion of capital goods over the last few decades, Hong Kong was able to achieve output per person equal to 94 percent of that in the United States.

Does economic growth overcome scarcity? Scarcity reflects the inability to satisfy all our wants. Regardless of the amount of economic growth, scarcity will remain present because it will never be possible to satisfy all our wants. For instance it will never be possible to satisfy all the wants of the several thousand people who all would like to ski the best slopes on Vail with only their family and a few best friends present. So economic growth allows more wants to be satisfied but it does not eliminate scarcity.

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What gives a person a comparative advantage? A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else, If the person gives up the least amount of other goods and services to produce a particular good or service, the person has the lowest opportunity cost of producing that good or service.

Distinguish between comparative advantage and absolute advantage. A person has a comparative advantage in producing a good when he or she has the lowest opportunity cost of producing it. Comparative advantage is based on the output forgone. A person has an absolute advantage in production when he or she uses the least amount of time or resources to produce one unit of that particular good or service. Absolute advantage is a measure of productivity in using inputs.

Why do people specialize and trade? People can compare consumption possibilities from producing all goods and services through selfsufficiency against specializing in producing only those goods and services that reflect their comparative advantage and trading their output with others who do the same. People can then see that the consumption possibilities from specialization and trade are greater than under self-sufficiency. Therefore it is in people’s own self-interest to specialize. It was Adam Smith who first pointed out in the Wealth of Nations how individuals voluntarily engage in this socially beneficial and cooperative activity through the pursuit of their own self-interest, rather than for society’s best interests.

What are the gains from specialization and trade? From society’s standpoint, the total output of goods and services available for consumption is greater with specialization and trade. From an individual’s perspective, each person who specializes enjoys being able to consume a larger bundle of goods and services after trading with others who have also specialized, than would otherwise be possible under self-sufficiency. These increases are the gains from specialization and trade for society and for individuals.

What is the source of the gains from trade? As long as people have different opportunity costs of producing goods or services, total output is higher with specialization and trade than if each individual produced goods and services under self-sufficiency. This increase in output is the gains from trade.

THE ECONOMIC PROBLEM

Page 83 1.

Why are social institutions such as firms, markets, property rights, and money necessary? These social institutions factors necessary for a decentralized economy to coordinate production. Firms are necessary to allow people to specialize. Without firms, specialization would be limited because a person would need to specialize in the entire production of a good or service. With firms people are able to specialize in producing particular bits of a good or service. For a society to enjoy the fruits of specialization and trade, the individuals who comprise that society must voluntarily desire to specialize in the first place. Discovering trade opportunities after a person has specialized in his or her comparative advantage in production is what allows that person to gain from his or her own specialization efforts. Trading opportunities can only take place if a market exists where people observe prices to discover available trade opportunities. Money is necessary to allow low-cost trading in markets. Without money, goods would need to be directly exchanged for other goods, a difficult and unwieldy situation. Finally people must enjoy social recognition of and government protection of property rights to have confidence that their commitments to trade arrangements will be respected by everyone in the market.

What are the main functions of markets? The main function of a market is to enable buyers and sellers to get information and to do business with each other. Markets have evolved because they facilitate trade, that is, they facilitate the ability of buyers and sellers to trade with each other.

What are the flows in the market economy that go from firms to households and the flows from households to firms? On the real side of the economy, goods and services flow from firms to households. On the monetary side of the economy, payments for factors of production, wages, rent, interest, and profits, flow from firms to households. Flowing from households to firms on the monetary side of the economy are the expenditures on goods and services and on the real side are the factors of production, labor, land, capital, and entrepreneurship.

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Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 to 3. Brazil produces ethanol from sugar, and the land used to grow sugar can be used to grow food crops. The table to the right sets out Brazil’s production possibilities for ethanol and food crops. 1. a. Draw a graph of Brazil’s PPF and explain how your graph illustrates scarcity. Figure 2.1 shows Brazil’s PPF. The production possibilities frontier indicates scarcity because it shows the limits to what can be produced. In particular, production combinations of ethanol and food crops that lie outside the production possibilities frontier are not attainable.

Ethanol (barrels per day) 70 64 54 40 22 0

and and and and and and

Food crops (tons per day) 0 1 2 3 4 5

b. If Brazil produces 40 barrels of ethanol a day, how much food must it produce to achieve production efficiency? If Brazil produces 40 barrels of ethanol per day, it achieves production efficiency if it also produces 3 tons of food per day.

c. Why does Brazil face a tradeoff on its PPF? Brazil faces a tradeoff on its PPF because Brazil’s resources and technology are limited. For Brazil to produce more of one good, it must shift factors of production away from the other good. Therefore to increase production of one good requires decreasing production of the other, which reflects a tradeoff.

2. a. If Brazil increases ethanol production from 40 barrels per day to 54 barrels per day, what is the opportunity cost of the additional ethanol? When Brazil is production efficient and increases its production of ethanol from 40 barrels per day to 54 barrels per day, it must decrease its production of food crops from 3 tons per day to 2 tons per day. The opportunity cost of the additional ethanol is 1 ton of food per day for the entire 14 barrels of ethanol or 1/14 of a ton of food per barrel of ethanol.

b. If Brazil increases food production from 2 tons per day to 3 tons per day, what is the opportunity cost of the additional food? When Brazil is production efficient and increases its production of food crops from 2 tons per day to 3 tons per day, it must decrease its production of ethanol from 54 barrels per day to 40 barrels per day. The opportunity cost of the additional 1 ton of food crops is 14 barrels of ethanol.

c. What is the relationship between your answers to parts (a) and (b)? The opportunity costs of an additional barrel of ethanol and the opportunity cost of an additional ton of food crop are reciprocals of each other. That is, the opportunity cost of 1 ton of food crops is 14 barrels of ethanol and the opportunity cost of 1 barrel of ethanol is 1/14 of a ton of food crops.

Does Brazil face an increasing opportunity cost of ethanol? What feature of Brazil’s PPF illustrates increasing opportunity cost? Brazil faces an increasing opportunity cost of ethanol production. For instance, when increasing ethanol production from 0 barrels per day to 22 barrels the opportunity cost of a barrel of ethanol is 1/22 of a ton of food while increasing ethanol production another 18 barrels per day (to a total of 40 barrels per day) has an opportunity cost of 1/18 of a ton of food per barrel of ethanol. The PPF’s bowed outward shape reflects the increasing opportunity cost.

THE ECONOMIC PROBLEM

Use the above table (for Problems 1 to 3) to work Problems 4 and 5. 4. Define marginal cost and calculate Brazil’s marginal cost of producing a ton of food when the quantity produced is 2.5 tons per day. The marginal cost of a good is the opportunity cost of producing one more unit of the good. When the quantity of food produced is 2.5 tons, the marginal cost of a ton of food is the opportunity cost of increasing the production of food from 2 tons per day to 3 tons per day. The production of ethanol falls from 54 barrels per day to 40 barrels per day, a decrease of 14 barrels per day. The opportunity cost of increasing food production is the decrease in ethanol product, so the opportunity cost of producing a ton of food when 2.5 tons of food per day are produced is 14 barrels of ethanol per day.

Define marginal benefit. Explain how it is measured and why the data in the table does not enable you to calculate Brazil’s marginal benefit from food. The marginal benefit of a good is the benefit received from consuming one more unit of the good. The marginal benefit of a good or service is measured by the most people are willing to pay for one more unit of it. The data in the table do not provide information on how much people are willing to pay for an additional unit of food. The table has no information on the marginal benefit of food.

Distinguish between production efficiency and allocative efficiency. Explain why many production possibilities achieve production efficiency but only one achieves allocative efficiency. Production efficiency occurs when goods and services are produced at the lowest cost. This definition means that production efficiency occurs at any point on the PPF. Therefore all of the production points on the PPF are production efficient. Allocative efficiency occurs when goods and services are produced at the lowest cost and in the quantities that provide the greatest possible benefit. The allocatively efficient production point is the single point on the PPF that has the greatest possible benefit.

A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced. a. Make a graph that illustrates the farm’s PPF. The PPF is illustrated in Figure 2.2 as PPF0. Because the marginal cost of both wheat and pork increase as more of the good is produced, the PPF displays increasing opportunity cost so it has the “conventional” bowedoutward shape.

b. The farm adopts a new technology that allows it to use fewer resources to fatten pigs. On your graph sketch the impact of the new technology on the farm’s PPF. The new technology rotates the PPF outward from PPF0 to PPF1.

c. With the farm using the new technology described in part (b), has the opportunity cost of producing a ton of wheat increased, decreased, or remained the same? Explain and illustrate your answer. The opportunity cost of producing wheat has increased. The opportunity cost of a bushel of wheat is equal to the magnitude of 1/(slope of the PPF). As illustrated in Figure 2.2, for each quantity of wheat the slope of PPF1 has a smaller magnitude than the slope of PPF0 so the opportunity cost of a bushel of wheat is higher along PPF1. For a specific example, the opportunity cost of increasing wheat product from 600 bushels per week to 800 bushels per week along PPF1 is 6,000 pounds of pork but is only 3,000 pounds of pork along PPF0.

d. Is the farm more efficient with the new technology than it was with the old one? Why? The farm is able to produce more with the new technology than with the old, but it is not necessarily more efficient. If the farm was producing on its PPF before the new technology and after, the farm was production efficient both before the new technology and after.

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In one hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. a. Calculate Sue’s opportunity cost of producing a cap. Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of producing one cap is (4 jackets)/(40 caps) or 0.1 jacket per cap.

b. Calculate Tessa’s opportunity cost of producing a cap. Tessa forgoes 4 jackets to produce 80 caps, so Tessa’s opportunity cost of producing one cap is (4 jackets)/(80 caps) or 0.05 jacket per cap.

c. Who has a comparative advantage in producing caps? Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps.

d. If Sue and Tessa specialize in producing the good in which they have a comparative advantage, and they trade 1 jacket for 15 caps, who gains from the specialization and trade? Tessa specializes in caps and Sue specializes in jackets. Both Sue and Tessa gain from trade. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket)/(15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa also gains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap.

Suppose that Tessa buys a new machine for making jackets that enables her to make 20 jackets an hour. (She can still make only 80 caps per hour.) a. Who now has a comparative advantage in producing jackets? Sue forgoes 40 caps to produce 4 jackets, so Sue’s opportunity cost of producing one jacket is (40 caps)/(4 jackets) or 10 caps per jacket. Tessa forgoes 80 caps to produce 20 jackets, so Tessa’s opportunity cost of producing one jacket is (80 caps)/(20 jackets) or 4 caps per jacket. Tessa has the comparative advantage in producing jackets because her opportunity cost of a jacket is lower than Sue’s opportunity cost.

b. Can Sue and Tessa still gain from trade? Tessa and Sue can still gain from trade because Tessa (now) has a comparative advantage in producing jackets and Sue (now) has a comparative advantage in producing caps. Tessa will produce jackets and Sue will produce caps.

c. Would Sue and Tessa still be willing to trade 1 jacket for 15 caps? Explain your answer. Sue and Tessa will not be willing to trade 1 jacket for 15 caps. In particular, Sue, whose comparative advantage lies in producing caps, can produce 1 jacket at an opportunity cost of only 10 caps. So Sue will be unwilling to pay any more than 10 caps per jacket.

10.

For 50 years, Cuba has had a centrally planned economy in which the government makes the big decisions on how resources will be allocated. a. Why would you expect Cuba’s production possibilities (per person) to be smaller than those of the United States? Cuba’s economy is almost surely less efficient than the U.S. economy. The Cuban central planners do not know people’s production possibilities or their preferences. The plans that are created wind up wasting resources and/or producing goods and services that no one wants. Because firms in Cuba are owned by the government rather than individuals, no one in Cuba has the self-interested incentive to operate the firm efficiently and produce goods and services that consumers desire. Additionally Cuba does not actively trade so Cuba produces most of its consumption goods rather than buying them from nations with a comparative advantage. Because Cuba uses its resources to produce consumption goods, it cannot produce many capital goods so its economic growth rate has been low.

THE ECONOMIC PROBLEM

b. What are the social institutions that Cuba might lack that help the United States to achieve allocative efficiency? Of the four social institutions, firms, money, markets, and property rights, Cuba’s economy has firms and money. Markets, however, are less free of government intervention in Cuba. But the major difference is the property rights in the Cuban economy. In Cuba the government owns most of the firms; that is, the government has the property right to run the producers. Because the firms are not motivated to make a profit, the managers of these firms have little incentive to operate the firm efficiently or to produce the goods and services that consumers desire. In the United States, firms are owned by individuals; that is, people have the property right that allows them to run firms. These owners have the self-interested incentive to operate the firm efficiently and to produce the goods and services people want, an incentive sorely lacking in the Cuban economy.

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Answers to Additional Problems and Applications Use the table to work Problems 11 and 12. Suppose that Yucatan’s production possibilities are given in the table. 11. a. Draw a graph of Yucatan’s PPF and explain how your graph illustrates a tradeoff. Yucatan’s PPF is illustrated in Figure 2.3. The figure illustrates a tradeoff because moving along Yucatan’s PPF producing more of one good requires producing less of the other good. Yucatan trades off more production of one good for less production of the other.

Food (pounds per month) 300 200 100 0

and and and and

Sunscreen (gallons per month) 0 50 100 150

b. If Yucatan produces 150 pounds of food per month, how much sunscreen must it produce if it achieves production efficiency? If Yucatan produces 150 pounds of food per month, then the point labeled A on the PPF in Figure 2.11 shows that Yucatan must produce 75 gallons of sunscreen per month to achieve production efficiency.

c. What is Yucatan’s opportunity cost of producing (i) 1 pound of food and (ii) 1 gallon of sunscreen? Yucatan’s PPF is linear so the opportunity cost of producing 1 pound of food is the same at all quantities. Calculate the opportunity cost of producing 1 pound of food when increasing the production of food from 0 to 100 pounds per month. Between these two ranges of production, the quantity of sunscreen produced falls from 150 gallons per month to 100 gallons per month, a decrease of 50 gallons. The opportunity cost is 50 gallons of sunscreen to gain 100 pounds of food. The opportunity cost per pound of food equals (50 gallons of sunscreen)/(100 pounds of food), or an opportunity cost of 0.5 gallon of sunscreen per pound of food. Yucatan’s PPF is linear so the opportunity cost of producing 1 gallon of sunscreen is the same at all quantities. Calculate the opportunity cost of producing 1 gallon of sunscreen when increasing the production of sunscreen from 0 to 50 gallons per month. Between these two ranges of production, the quantity of food produced falls from 300 pounds per month to 200 pounds per month, a decrease of 100 pounds. The opportunity cost is 100 pounds of food to gain 50 gallons of sunscreen, or (100 pounds of food)/(50 gallons of sunscreen) which yields an opportunity cost of 2.0 pounds of food per gallon of sunscreen.

e. What is the relationship between your answers to part (c)? Answers (c) and (d) reflect the fact that opportunity cost is a ratio. The opportunity cost of gaining a unit of a good moving along the PPF equals the quantity of the other good or service forgone divided by the quantity of the good or service gained. The opportunity cost of one good, food, is equal to the inverse of the opportunity cost of the other good, sunscreen.

12.

What feature of a PPF illustrates increasing opportunity cost? Explain why Yucatan’s opportunity cost does or does not increase. If opportunity costs increase, the PPF bows outward. Yucatan’s PPF is linear and along a linear PPF the opportunity cost is constant. Yucatan does not face an increasing opportunity cost of food because the opportunity cost remains constant, equal to 0.5 gallons of sunscreen per pound of food. Yucatan’s resources must be equally productive in both activities.

THE ECONOMIC PROBLEM

13.

In problem 11, what is the marginal cost of 1 pound of food in Yucatan when the quantity produced is 150 pounds per day? What is special about the marginal cost of food in Yucatan? The marginal cost of a pound of food in Yucatan is constant at all points along Yucatan’s PPF and is equal to 0.5 gallons of sunscreen per pound of food. The special point about Yucatan’s marginal cost is the fact that the marginal cost is constant. This result reflects Yucatan’s linear PPF.

14.

The table describes the preferences in Yucatan. a. What is the marginal benefit from sunscreen and how is it measured?

Sunscreen (gallons per month) 25 75 125

The marginal benefit from sunscreen is the benefit enjoyed by the person who consumes one more gallon of sunscreen. It is equal to the willingness to pay for an additional gallon. For example, in the table when 75 gallons of sunscreen are produced, the marginal benefit of a gallon is 2 pounds of food per gallon.

Willingness to pay (pounds of food per gallon) 3 2 1

b. Use the table in Problem 11. What does Yucatan produce to achieve allocative efficiency? To achieve allocative efficiency, the marginal benefit of a gallon of sunscreen must equal the marginal cost of a gallon of sunscreen. Yucatan’s marginal cost of a gallon of sunscreen is 2 pounds of food per gallon. When Yucatan produces 75 gallons of sunscreen, the table shows that Yucatan’s marginal benefit is 2 pounds of food per gallon. Therefore allocative efficiency is achieved when 75 gallons of sunscreen and, from the PPF, 150 pounds of food are produced.

15.

Sales of Digital Movies Surge The U.S. home entertainment market is changing; online movie sales have surged to a significant proportion, while sales and rentals of physical discs are declining. Source: The Wall Street Journal, January 7, 20147 a. Draw the PPF curves for online movie sales before and after the Internet became available. Before the availability of Internet, there were no online movie sales and the production possibilities frontier was PPF0 in Figure 2.4. After the Internet was developed, several companies started selling movies online. The Internet is a technological advance that rotates the production possibilities frontier outward to PPF1 in Figure 2.4.

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b. Draw the marginal cost and marginal benefit curves for physical disc retailers and online movie retailers before and after the Internet became available. Online movie retailers have a lower marginal cost of delivering digital movies than do physical disc retailers. The marginal benefit for digital movie is the same regardless of whether the movie is bought online or from a physical disc retailer. Therefore in Figure 2.5, the marginal benefit curve for digital movies is MB, the marginal cost of physical disc retailers is MC0 and the marginal cost of online movie sales is MC1.

c. Explain how changes in production possibilities, preferences or both have changed the way digital movies are retailed. The change in production possibilities, which has created online digital movie stores such as iTunes, has changed the way digital movies are purchased. Because the marginal cost of buying movies is less using an online store, and also because of easy and early availability of digital movies on online stores, today purchasing movies online is preferred. Consequently, sales and rentals of physical discs are declining.

Use the following news clip to work Problems 16 and 17. Malaria Eradication Back on the Table In response to the Gates Malaria Forum in October 2007, countries are debating the pros and cons of eradication. Dr. Arata Kochi of the World Health Organization believes that with enough money malaria cases could be cut by 90 percent, but it would be very expensive to eliminate the remaining10 percent of cases, so countries should not strive to eradicate malaria. Source: The New York Times, March 4, 2008 16.

Is Dr. Kochi talking about production efficiency or allocative efficiency or both? Dr. Kochi is talking about allocative efficiency. His assessment is that the last 10 percent eradication has such a high marginal cost that it almost surely exceeds its marginal benefit.

THE ECONOMIC PROBLEM

17.

Make a graph with the percentage of malaria cases eliminated on the x-axis and the marginal cost and marginal benefit of driving down malaria cases on the y-axis. On your graph: (i) Draw a marginal cost curve and marginal benefit curve that are consistent with Dr. Kochi’s opinion. (ii) Identify the quantity of malaria eradicated that achieves allocative efficiency. Figure 2.6 shows a marginal cost curve and a marginal benefit curve that are consistent with Dr. Kochi’s views. Dr. Kochi believes the last 10 percent of malaria would be very expensive to eradicate. The marginal cost curve in the figure reflects this view because marginal cost curve rises rapidly after 90 percent of malaria is eradicated. The marginal benefit curve is downward sloping, reflecting diminishing marginal benefit from malaria eradication. The allocatively efficient quantity malaria eradicated is 90 percent because that the quantity for which the marginal benefit of eradication equals the marginal cost of eradication. This outcome demonstrates Dr. Kochi’s conclusion that countries should not attempt to completely

18.

that the

of is

Capital accumulation and technological change bring economic growth: Production that was unattainable yesterday becomes attainable today; production that is unattainable today will become attainable tomorrow. Why doesn’t economic growth bring an end to scarcity one day? Scarcity is always being defeated yet will never suffer defeat. Scarcity reflects the existence of unmet wants. People’s wants are infinite—regardless of what a person already possesses, everyone can easily visualize something else he or she wants, if only more time in the day to enjoy their possessions. Because people’s wants are insatiable, scarcity will always exist regardless of economic growth.

19.

Toyota Plans to Build a Better Company Toyota will continue to produce 3 million cars per year and use the balance of its resources to upgrade its workers’ skills and create new technology. In three years’ time, Toyota plans to produce better cars and be more productive. Source: Financial Post, April 7, 2014 a. What is the opportunity cost of upgrading its workers’ skills and creating new technology? The opportunity cost of upgrading workers’ skills and creating new technology is the next best alternative forgone by these changes. The story indicates that the next best alternative for Toyota is building new cars, so the opportunity cost of upgrading workers’ skills and creating new technology is the current production of new cars that are forgone.

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b. Sketch Toyota’s PPF and mark its production point in 2014. Now show on your graph Toyota’s PPF in 2018. Figure 2.7 shows Toyota's PPF in 2014 and in 2018. The upgrade in workers’ skills and the new technology shift Toyota’s PPF outward so that its PPF in 2018 lies beyond its PPF in 2014. Toyota’s production point in 2014 is labeled A.

Use the following data to work Problems 20 and 21. Kim can produce 40 pies or 400 cakes an hour. Liam can produce 100 pies or 200 cakes an hour. 20. a. Calculate Kim’s opportunity cost of a pie and Liam’s opportunity cost of a pie. If Kim spends an hour baking pies, she gains 40 pies but forgoes 400 cakes. Kim’s opportunity cost of 1 pie is (400 cakes)/(40 pies), or 10 cakes per pie. If Liam spends an hour baking pies, he gains 100 pies but forgoes 200 cakes. Liam’s opportunity cost of 1 pie is (200 cakes)/(100 pies), or 2 cakes per pie.

b. If each spends 30 minutes of each hour producing pies and 30 minutes producing cakes, how many pies and cakes does each produce? Kim produces 20 pies and 200 cakes. Liam produces 50 pies and 100 cakes. The total number produced is 70 pies and 300 cakes.

c. Who has a comparative advantage in producing (i) pies and (ii) cakes? Liam has the comparative advantage in producing pies because his opportunity cost of a pie is less than Kim’s opportunity cost. Kim has the comparative advantage in producing cakes because her opportunity cost of a cake is less than Liam’s opportunity cost.

THE ECONOMIC PROBLEM

21. a

Draw a graph of Kim’s PPF and Liam’s PPF and show the point at which each produces when they spend 30 minutes of each hour producing pies and 30 minutes producing cakes.

Kim’s PPF is illustrated in Figure 2.8; Liam’s PPF is illustrated in Figure 2.9. Point A in both figures shows their production points when each spends 30 minutes making cakes and 30 minutes making pies.

b. On your graph, show what Kim produces and what Liam produces when they specialize. Kim will specialize in cakes and Liam will specialize in pies. Point B in both figures shows the production points when each specializes.

c. When they specialize and trade, what are the total gains from trade? Kim will specialize in cakes and Liam will specialize in pies. If they specialize and trade, the total production of both cakes and pies increase. When each spends 30 minutes making cakes and 30 minutes making pies, together they produce 300 cakes and 70 pies. When they specialize, together they produce 400 cakes and 100 pies. The 100 increase in cakes and the 30 increase pies is the gains from trade.

d. If Kim and Liam share the total gains equally, what trade takes place between them? Kim will trade 50 cakes (half of the gain in cake production) to Liam in exchange for 15 pies (half of the increase in pie production).

Tony’s Production Possibilities Snowboards Skis (units per (units per week) week) 25 and 0 20 and 10 15 and 20 10 and 30 5 And 40 0 And 50

Patty’s Production Possibilities Snowboards Skis (units per week) (units per week) 20 and 0 10 and 5 0 and 10

22.

CHAPTER 2

Tony and Patty produce skis and snowboards. The tables show their production possibilities. Tony produces 5 snowboards and 40 skis a week; Patty produces 10 snowboards and 5 skis a week. a. Who has a comparative advantage in producing (i) snowboards and (ii) skis? (i) Tony’s opportunity cost of a snowboard is (10 skis)/(5 snowboards), or 2 skis per snowboard. Patty’s opportunity cost of a snowboard is (5 skis)/(10 snowboards), or 0.5 skis per snowboard. Patty’s opportunity cost of a snowboard is lower than Tony’s opportunity cost, so Patty has the comparative advantage. (ii) Tony’s opportunity cost of a ski is (5 snowboards)/(10 skis), or 0.5 snowboards per ski. Patty’s opportunity cost of a ski is (10 snowboards)/(5 skis), or 2.0 snowboards per ski. Tony’s opportunity cost of a ski is lower than Patty’s opportunity cost, so Tony has the comparative advantage.

b. If Tony and Patty specialize and trade 1 snowboard for 1 ski, what are the gains from trade? Tony has a comparative advantage in producing skis, so he specializes in producing skis. Patty has a comparative advantage in producing snowboards, so she specializes in snowboards. Tony now produces 50 skis and Patty produces 20 snowboards. Before specializing they produced a total of 45 skis (Tony’s 40 plus Patty’s 5) and 15 snowboards (Tony’s 5 plus Patty’s 10). By specializing, the total production of skis increases by 5 and the total production of snowboards increases by 5. This increase in total production is the gains from trade. By trading 1 ski for 1 snowboard, they can share these gains. Tony obtains snowboards from Patty for less than it costs him to produce them and Patty obtains skis from Tony for less than it costs her to produce them.

23.

Indicate on a graph of the circular flows in the market economy, the real and money flows in which the following items belong: a. You buy an iPad from the Apple Store. Figure 2.10 shows the circular flows in a market economy. Your purchase of an iPad from Apple is the purchase of a good from a firm. This flow is in the black arrow indicated by point a in the figure. When you pay for the iPad, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled a.

b. Apple Inc. pays the designers of the iPad. Apple’s payment to the designers of the iPad is the payment of a wage to a factor of production. This flow is in the grey arrow indicated by point b in the figure. The flow of design services from the designer to Apple is in the black arrow in the opposite direction to the grey arrow labeled b.

c. Apple Inc. decides to expand and rents an adjacent building. Apple’s decision to expand by renting a building means that Apple is increasing the capital it uses. This flow is in the black arrow indicated by point c in the figure. The flow of the payment for the rental services of the building is in the grey arrow in the opposite direction to the black arrow labeled c.

THE ECONOMIC PROBLEM

d. You buy a new e-book from Amazon. Your purchase of an e-book from Amazon is the purchase of a good from a firm. This flow is in the black arrow indicated by point d in the figure. When you pay for the e-book, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled d.

e. Apple Inc. hires a student as an intern during the summer. Apple’s decision to hire a student intern is Apple increasing the labor it uses. The flow of labor services is in the black arrow indicated by point e in the figure. The flow of the payment for the labor services is in the grey arrow in the opposite direction to the black arrow labeled c.

Economics in the News 24.

After you have studied Reading Between the Lines on pp. 84–85, answer the following questions. a. How has “fracking” changed U.S. production possibilities? Fracking has expanded U.S. production possibilities.

b. How have advances in technologies for producing other goods and services changed the U.S. production possibilities? The advances in technology have expanded U.S. production possibilities.

c. If “fracking” had been the only technological advance, how would the PPF have changed? If fracking had been the only technological advance, the PPF would have rotated outward. The maximum quantity of other goods and services would not have changed but the maximum quantity of oil and gas would have increased. For any quantity of other goods and services, more oil and gas could be produced after the introduction of fracking technology.

d. If “fracking” had been the only technological advance, how would the opportunity cost of producing oil and gas have changed? Would it have been lower or higher than it actually was? If fracking had been the only technological advance, the PPF would have rotated so that for any quantity of other goods and services the slope of the new PPF would be smaller than the slope of the initial PPF. Consequently, for any quantity of other goods and services the opportunity cost of producing oil and gas would be lower after the fracking technology was used.

25.

CHAPTER 2

LCD, LED, Plasma Impact: Curved-box TV Set To Be History In 4 Years CRT televisions will soon disappear from the market as the focus has shifted to LCD technology. According to analysts the speed of adoption of newer technology is very fast. CRT television segment will eventually be phased out of the market. Source: The Economic Times, December 27, 2010 a. How has LCD technology changed the production possibilities of television sets and other goods and services? LCD technology has increased the production possibilities.

b. Sketch a PPF for television sets and other goods and services before LCD technology. The PPF should have television sets on one axis and other goods and services on the other as illustrated in Figure 2.11 by PPF0. The PPF is bowed outward as a conventional PPF.

c. Show how the arrival of LCD technology has changed the PPF. The arrival of LCD technology shifts the PPF outward as shown by the change from PPF0 to PPF1 in Figure 2.11. The intersection of the new PPF along the axis measuring television sets increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

d. Sketch a marginal benefit curve for video entertainment. The marginal benefit curve should be a conventional downward-sloping marginal benefit curve as shown in Figure 2.12. The marginal benefit from visual entertainment at home is measured along the vertical axis and the quantity of video entertainment is measured along the horizontal axis.

e. Show how LCD technology which provides a better television-viewing experience to the consumer than the traditional CRT TV sets has changed the marginal benefit for video entertainment. The marginal benefit to the consumer increases because the consumer will be able to take advantage of a better television-viewing experience through LCD technology than the traditional CRT TV sets. In Figure 2.12, the marginal benefit curve shifts rightward from the initial marginal benefit curve, MB0, to the new marginal benefit curve, MB1.

THE ECONOMIC PROBLEM

Explain how the efficient quantity of video entertainment has changed. The arrival of broadband has decreased the marginal cost of providing video entertainment, so the marginal cost curve shifts rightward. This shift is illustrated in the Figure 2.13 by the rightward shift of the marginal cost curve from MC0 to MC1. As Figure 2.13 shows, the allocatively efficient quantity of video entertainment increases. In Figure 2.13, the allocatively efficient quantity increases from 5 million units per year to 8 million units per year.

C h a p t e r

DEMAND AND SUPPLY

Answers to the Review Quizzes Page 94 1.

What is the distinction between a money price and a relative price? The money price of a good is the dollar amount that must be paid for it. The relative price of a good is its money price expressed as a ratio to the money price of another good. Thus the relative price is the amount of the other good that must be foregone to purchase a unit of the first good.

Explain why a relative price is an opportunity cost. The relative price of a good is the opportunity cost of buying that good because it shows how much of the next best alternative good must be forgone to buy a unit of the first good.

Think of examples of goods whose relative price has risen or fallen by a large amount. Some examples of items where both the money price and the relative price have risen over time are gasoline, college tuition, and food. Some examples of items where both the money price and the relative price have fallen over time are personal computers, HD televisions, and calculators.

Page 99 1.

Define the quantity demanded of a good or service. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

What is the law of demand and how do we illustrate it? The law of demand states: “Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.” The law of demand is illustrated by a downward-sloping demand curve drawn with the quantity demanded on the horizontal axis and the price on the vertical axis. The slope is negative to show that the higher the price of a good, the smaller is the quantity demanded and the lower the price of a good, the greater is the quantity demanded.

What does the demand curve tell us about the price that consumers are willing to pay? For any fixed quantity of a good available, the vertical distance of the demand curve from the x-axis shows the maximum price that consumers are willing to pay for that quantity of the good. The price on the demand curve at this quantity indicates the marginal benefit to consumers of the last unit consumed at that quantity.

List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand.

CHAPTER 3

Influences that change the demand for a good include: The prices of related goods. A rise (fall) in the price of a substitute increases (decreases) the demand for the first good. A rise (fall) in the price of a complement decreases (increases) the demand for the first good. The expected future price of the good. A rise (fall) in the expected future price of a good increases (decreases) the demand in the current period. Income. An increase (decrease) in income increases (decreases) the demand for a normal good. An increase in income decreases (increases) the demand for an inferior good. Expected future income and credit. An increase (decrease) in expected future income or credit increases (decreases) the demand. The population. An increase (decrease) in population increases (decreases) the demand. People’s preferences. If people’s preferences for a good rise (fall), the demand increases (decreases).

Why does demand not change when the price of a good changes with no change in the other influences on buying plans? If the price of a good falls and nothing else changes, then the quantity of the good demanded increases and there is a movement down along the demand curve, but the demand for the good remains unchanged and the demand curve does not shift.

Page 103 1.

Define the quantity supplied of a good or service. The quantity supplied of a good or service is the amount of the good or service that firms plan to sell in a given period of time at a specified price.

What is the law of supply and how do we illustrate it? The law of supply states that “other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.” The law of supply is illustrated by an upward-sloping supply curve drawn with the quantity supplied on the horizontal axis and the price on the vertical axis. The slope is positive to show that the higher the price of a good, the greater is the quantity supplied and the lower the price of a good, the smaller is the quantity supplied.

What does the supply curve tell us about the producer’s minimum supply price? For any quantity, the vertical distance between the supply curve and the x-axis shows the minimum price that suppliers must receive to produce that quantity of output. As a result, the price is the marginal cost of the last unit produced at this level of output.

List all the influences on selling plans, and for each influence, say whether it changes supply. Changes in the price of the good change the quantity supplied. They do not change the supply of the good. Influences that change the supply of a good include: Prices of factor of production. A rise (fall) in the price of a factor of production increases firms’ costs of production and decreases (increases) the supply of the good. Prices of related goods produced. If the price of a substitute in production rises (falls), firms decrease (increase) their sales of the original good and the supply for the original good decreases (increases). A rise (fall) in the price of a complement in production increases (decreases) production of the original good, causing the supply of the original good to increase (decrease). The expected future price of the good. A rise (fall) in the expected future price of the good decreases (increases) the amount suppliers sell today. This change in expectations decreases (increases) the supply in the current period. The number of sellers. An increase (decrease) in the number of sellers in a market increases the quantity of the good available at every price, and increases (decreases) the supply.

DEMAND AND SUPPLY

Technology. An advance in technology increases the supply. The state of nature. A good (bad) state of nature, such as good (bad) weather for agricultural products, increases (decreases) the supply.

What happens to the quantity of cell phones supplied and the supply of cell phones if the price of a cell phone falls? If the price of cell phones falls and nothing else changes, then the quantity of cell phones supplied will decrease and there is a movement down along the supply curve for cell phones. The supply of cell phones, however, remains unchanged and the supply curve does not shift.

Page 105 1.

What is the equilibrium price of a good or service? The equilibrium price is the price at which the quantity demanded by the buyers is equal to the quantity supplied by the sellers.

Over what range of prices does a shortage arise? What happens to the price when there is a shortage? A shortage arises at market prices below the equilibrium price. A shortage causes the price to rise, decreasing quantity demanded and increasing quantity supplied until the equilibrium price is attained.

Over what range of prices does a surplus arise? What happens to the price when there is a surplus? A surplus arises at market prices above the equilibrium price. A surplus causes the price to fall, decreasing quantity supplied and increasing quantity demanded until the equilibrium price is attained.

Why is the price at which the quantity demanded equals the quantity supplied the equilibrium price? At the equilibrium price, the quantity demanded by consumers equals the quantity supplied by producers. At this price, the plans of producers and consumers are coordinated and there is no influence on the price to move away from equilibrium.

Why is the equilibrium price the best deal available for both buyers and sellers? The equilibrium price reflects that the highest price consumers are willing to pay for that amount of the good or service and is just equal to the minimum price that suppliers require for delivering it. Demanders would prefer to pay a lower price, but suppliers are unwilling to supply that quantity at a lower price. Suppliers would prefer a higher price, but demanders are unwilling to pay a higher price for that quantity. Hence neither demanders not suppliers can do business at a better price.

Page 111

What is the effect on the price and quantity of MP3 players (such as the iPod) if 1. The price of a PC falls or the price of an MP3 download rises? (Draw the diagrams!) A fall in the price of a PC decreases the demand for MP3 players because a PC is a substitute for an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls and the quantity of MP3 players decreases. A rise in the price of an MP3 download decreases the demand for MP3 players because an MP3 download is a complement of an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls and the quantity of MP3 players decreases.

More firms produce MP3 players or electronics workers’ wages rise? (Draw the diagrams!) An increase in the number of firms that produce MP3 players increases the supply of MP3 players. The supply curve of MP3 players shifts rightward. Demand remains unchanged. The price of an MP3 player falls and the quantity of MP3 players increases. You can illustrate this outcome by drawing a diagram like Figure 3.9 on page 108. A rise in the wages of electronic workers decreases the supply of MP3 players because it increases the cost of producing MP3 players. The supply curve of MP3 players shifts leftward. Demand remains unchanged. The price of an MP3 player rises and the quantity of MP3 players decreases.

CHAPTER 3

Any two of these events in questions 1 and 2 occur together? (Draw the diagrams!) There are six combinations: (1) If the price of a PC falls and the price of an MP3 download rises, demand decreases, supply is unchanged, so the price falls and the quantity decreases. (2) If the price of a PC falls and more firms produce MP3 players, demand decreases and supply increases so the price falls and the quantity might increase, decrease, or not change. (3) If the price of PC falls and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise, fall, or not change. (4) If the price of an MP3 download rises and more firms produce MP3 players, demand decreases and supply increases so the price falls and quantity might increase or decrease or remain the same. (5) If the price of an MP3 download falls and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise or fall or remain the same. (6) If more firms produce MP3 players and the wages paid electronics workers rise, supply might increase or decrease or remain unchanged, demand is unchanged, so the outcome cannot be predicted.

DEMAND AND SUPPLY

Answers to the Study Plan Problems and Applications 1.

In April 2014, the money price of a carton of milk was $2.01 and the money price of gallon of gasoline was $3.63. Calculate the relative price of a gallon of gasoline in terms of milk. The relative price of a gallon of gasoline in terms of milk equals ($3.63 per gallon of gasoline)/($2.01 per carton of milk) = 1.81 cartons of milk per gallon of gasoline.

The price of food increased during the past year. a. Explain why the law of demand applies to food just as it does to other goods and services. The law of demand applies to food because there is both a substitution and an income effect that reinforce each other. When the price of food rises, people substitute to different foods. For instance, some might substitute home cooked meals for dining at a restaurant. And when the price rises, there is a negative income effect, so people buy less food overall with the rising price. On both counts, the higher price of food decreases the quantity of food demanded.

b. Explain how the substitution effect influences food purchases when the price of food rises and other things remain the same. When the price of food rises, people substitute away from (some) foods and toward other foods and other activities. People substitute cheaper foods for more expensive foods and they also substitute diets for food.

c. Explain how the income effect influences food purchases and provide some examples of the income effect. Food is a normal good so a rise in the price, which decreases people’s real incomes, decreases the quantity of food demanded. In the United States, restaurants suffer as the negative income effect from a higher price of food leads people to cut back their trips to restaurants. At home, people will buy fewer steaks and instead will buy more noodles. In poor countries (and among the poor in the United States), people literally eat less when the price of food rises and in extremely poor countries starvation increases.

Which of the following goods are likely substitutes and which are likely complements? (You may use an item in more than once.): coal, oil, natural gas, wheat, corn, pasta, pizza, sausage, skateboard, roller blades, video game, laptop, iPad, cellphone, text message, email Substitutes include: coal and oil; coal and natural gas; oil and natural gas; wheat and corn; pasta and pizza; pasta and sausage; pizza and sausage (they type of sausage that cannot be used as a topping on pizza); skateboard and roller blades; skateboard and video game; roller blades and video game; laptop and iPad; and, text message and email. Complements include: pizza and sausage (the type of sausage that can be used as a topping on pizza); skateboard and iPad; roller blades and iPad; video game (those played on a computer) and laptop; cellphone and text message; and, cellphone (smart cellphone) and email.

As the average income in China continues to increase, explain how the following would change: a. The demand for beef Beef is a normal good. The increase in income increases the demand for beef.

b. The demand for rice Rice is probably an inferior good. The increase in income decreases the demand for rice.

In 2013, the price of corn fell and some corn farmers will switch from growing corn in 2014 to growing soybeans. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. This fact illustrates the law of supply: the lower price of corn decreases the quantity of corn grown.

b. Why would a corn farmer grow soybeans? Corn and soybeans are substitutes in production and soybeans have become more profitable. A corn farmer would switch to soybeans because the profit from growing soybeans exceeds that from growing corn.

CHAPTER 3

Dairies make low-fat milk from full-cream milk, and in the process they produce cream, which is made into ice cream. The following events occur one at a time: (i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With a drought forecasted, dairies raise their expected price of low-fat milk next year. (v) New technology lowers the cost of producing ice cream. Explain the effect of each event on the supply of low-fat milk. (i) Dairy workers are a factor used to produce low-fat milk. The price of a factor of production rises, which decreases the supply of low-fat milk. (ii) Cream and low fat milk are complements in production. The price of a complement in production rises, which increases the supply of low fat milk. (iii) A rise in the price of low-fat milk does not change the supply of low-fat milk. It does, however, increase the quantity of low-fat milk supplied. (iv) The higher expected price of low-fat milk decreases the (current) supply of low-fat milk. (v) Ice cream and low-fat milk are complements in production. The lower cost of producing ice cream increases the quantity of ice cream produced, which increases the supply of low-fat milk.

The demand and supply schedules for gum are in the table. a. Suppose that the price of gum is 70¢ a pack. Describe the situation in the gum market and explain how the price adjusts.

Price (cents per pack) 20 40 60 80

Quantity Quantity demanded supplied (millions of packs a week) 180 60 140 100 100 140 60 180

At 70 cents a pack, there is a surplus of gum and the price falls. At 70 cents a pack, the quantity demanded is 80 million packs a week and the quantity supplied is 160 million packs a week. There is a surplus of 80 million packs a week. The price falls until market equilibrium is restored at a price of 50 cents a pack.

b. Suppose that the price of gum is 30¢ a pack. Describe the situation in the gum market and explain how the price adjusts. At 30 cents a pack, there is a shortage of gum and the price rises. At 30 cents a pack, the quantity demanded is 160 million packs a week and the quantity supplied is 80 million packs a week. There is a shortage of 80 million packs a week. The price rises until market equilibrium is restored at a price of 50 cents a pack.

The following events occur one at a time: (i) The price of crude oil rises. (ii) The price of a car rises. (iii) All speed limits on highways are abolished. (iv) Robots cut car production costs. Explain the effect of each of these events on the market for gasoline. (ii) and (iii) and (iv) change the demand for gasoline. The demand for gasoline will change if the price of a car rises, all speed limits on highways are abolished, or robot production cuts the cost of producing a car. If the price of a car rises, the quantity of cars bought decrease and the demand for gasoline decreases. If all speed limits on highways are abolished, people will drive faster and use more gasoline. The demand for gasoline increases. If robot production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be bought. The demand for gasoline increases. (i) changes the supply of gasoline. The supply of gasoline will change if the price of crude oil (a factor of production used in the production of gasoline) changes. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases.

DEMAND AND SUPPLY

In Problem 7, a fire destroys some factories that produce gum and the quantity of gum supplied decreases by 40 million packs a week at each price. a. Explain what happens in the market for gum and draw a graph to illustrate the changes. As the number of gum-producing factories decreases, the supply of gum decreases. There is a new supply schedule and, in Figure 3.1, the supply curves shifts leftward by 40 million packs at each price to the new supply curve S1. After the fire, the quantity supplied at 50 cents is now only 80 million packs, and there is a shortage of gum. The price rises to 60 cents a pack, at which the new quantity supplied equals the quantity demanded. The new equilibrium price is 60 cents and the new equilibrium quantity is 100 million packs a week.

b. If, at the time as the fire the teenage population increases and the quantity of gum demanded increases 40 million packs a week at each price. What is the new market equilibrium? Show the changes on your graph. The new price is 70 cents a pack, and the quantity is 120 million packs a week. The demand for gum increases and the demand curve shifts rightward by 40 million packs at each price. Supply decreases by 40 millions packs a week and the supply curve shifts leftward by 40 million packs at each price. These changes are shown in Figure 3.2 by the shift of the demand curve from D to D1 and the shift of the supply curve from S to S1. At any price below 70 cents a pack there is a shortage of gum. The price of gum rises until the shortage is eliminated.

10.

CHAPTER 3

Frigid Florida Winter is Bad News for Tomato Lovers An unusually cold January in Florida destroyed entire fields of tomatoes. Florida’s growers are shipping only a quarter of their usual 5 million pounds a week. The price has risen from $6.50 for a 25-pound box a year ago to $30 now. Source: USA Today, March 3, 2010 a. Make a graph to illustrate the market for tomatoes before the unusually cold January and show how the events in the news clip influence the market for tomatoes. Figure 3.3 shows the tomato market in January 2009 and January 2010. In both years the demand curve is labeled D. The supply curve for 2009 is labeled S0 and the supply curve for 2010 is labeled S1. The supply curve for 2010 lies to the left of the supply curve for 2009 because the cold January was a bad state of nature and decreased the supply of tomatoes. The cold weather shifted the supply curve leftward, from S0 to S1. The equilibrium price of a box of tomatoes rises from $6.25 per box to $30.00 per box and the equilibrium quantity decreases from 5 million pounds of tomatoes per week to 1.25 million pounds of tomatoes per week.

b. Why is the news “bad for tomato lovers”? The news is bad for tomato lovers because the price of tomatoes rises and “tomato lovers” respond to the higher price by decreasing the quantity of tomatoes they consume. Tomato lovers consume fewer of the tomatoes they love.

DEMAND AND SUPPLY

Answers to Additional Problems and Applications 11.

What features of the world market for crude oil make it a competitive market? The world oil market is a competitive market because there are a large number of sellers and a large number of buyers. There are so many sellers and so many buyers that no individual seller or individual buyer can influence he price of oil.

12.

The money price of a Persian rug is $100 and the money price of an Egyptian kaftan is $25. a. What is the opportunity cost of a Persian rug in terms of an Egyptian kaftan? A Persian rug costs $100 and an Egyptian kaftan costs $25. Purchasing 1 Persian rug, forces the buyer to give up 4 Egyptian kaftans. So the opportunity cost of a Persian rug in terms of Egyptian kaftans is 4 Egyptian kaftans per Persian rug.

b. What is the relative price of an Egyptian kaftan in terms of Persian rugs? The relative price of an Egyptian kaftan in terms of Persian rugs equals ($25 per Egyptian kaftan)/($100 per Persian rug), which is 1/4 of a Persian rug per Egyptian kaftan.

13.

The price of gasoline has increased during the past year. a. Explain why the law of demand applies to gasoline just as it does to all other goods and services. When the price of gasoline rises, people decrease the quantity of gasoline they demand. Both the substitution effect and the income effect lead consumers to decrease the quantity of gasoline demanded.

b. Explain how the substitution effect influences gasoline purchases and provide some examples of substitutions that people might make when the price of gasoline rises and other things remain the same. When the price of gasoline rises, people substitute other goods and services for gasoline. For instance, people substitute public transport (such as buses), carpools, motorcycles, walking, and bicycles for driving alone in a car to work.

c. Explain how the income effect influences gasoline purchases and provide some examples of the income effects that might occur when the price of gasoline rises and other things remain the same. When the price of gasoline rises, people’s real incomes fall. People respond by decreasing their demand for normal goods, such as gasoline. In the gasoline market, some people trade in large, fuel guzzling cars because they can no longer afford to fuel the large vehicle. Others will not purchase a car or truck because they are not able to afford the gasoline necessary to use it.

14.

Think about the demand for the three game consoles: Xbox One, PlayStation 4, and Wii U. Explain the effect of the following events on the demand for Xbox One games and the quantity of Xbox One games demanded, other things remaining the same. The events are: a. The price of an Xbox One falls. An Xbox One and an Xbox One game are complements. When the price of an Xbox One falls, consumers respond by increasing the quantity of Xbox Ones demanded so the equilibrium quantity of Xbox Ones increases. Consumers increase their demand for Xbox one games because an Xbox One console is useless without Xbox One games.

b. The prices of a PlayStation 4 and a Wii U fall. A PlayStation 4 and a Wii U are substitutes for an Xbox One. When these game consoles fall in price, the demand for Xbox One consoles decreases and so the equilibrium quantity of Xbox Ones decreases. Consumers decrease their demand for Xbox One games because an Xbox One game is useless without an Xbox One console.

c. The number of people writing and producing Xbox One games increases. The increase in the number of people writing Xbox One games increases the supply of Xbox One games. The demand for Xbox One games does not change but the increase in the supply lowers the price of an Xbox One game. The fall in the price of Xbox One games increases the quantity of Xbox Ones demanded.

CHAPTER 3

d. Consumers’ incomes increase. Xbox One games are surely a normal good. So an increase in consumers’ incomes increases the demand for Xbox One games.

e. Programmers who write code for Xbox One games become more costly to hire. The increase in the cost of programmers decreases the supply of Xbox One games. When the supply of a good or service decreases, the price of that good or service rises. Xbox One games are not an exception, so the price of an Xbox One game rises. The rise in the price of an Xbox One game decreases the quantity of Xbox One games demanded.

The expected future price of an Xbox One game falls. When the price of an Xbox One game is expected to fall, the (current) demand for Xbox One games decreases.

g. A new game console that is a close substitute for Xbox One comes onto the market. The new game console decreases the demand for Xbox One consoles. As a result, the equilibrium quantity of Xbox One consoles decreases. Consumers decrease their demand for Xbox One games because an Xbox One game is useless without an Xbox One console.

15.

Classify the following pairs of goods and services as substitutes in production, complements in production, or neither. a. Lumber and sawdust For a sawmill that produces both lumber and sawdust, they are complements in production.

b. Condominiums and bungalows For a construction company that builds both condominiums and bungalows, they are substitutes in production. (For a consumer, they are substitutes.)

c. Cheeseburger and fries For a restaurant that produces both cheeseburgers and fries, they are neither complements nor substitutes in production. (For consumers, they are complements.)

d. Cars and gasoline Cars and gasoline are neither complements nor substitutes in production. (For a consumer, cars and gasoline are complements.)

e. Cappuccino and latte For a café that produces both cappuccino and latte, they are substitutes in production. (For a consumer, cappuccino and latte are substitutes.)

16.

When a farmer uses raw milk to produce skim milk, he also produces cream which is used to make butter. a. Explain how a rise in the price of cream influences the supply of skim milk. The rise in the price of cream motivates farmers to make more cream, which increases the quantity supplied of skim milk, as skim milk and cream are complements in production.

b. Explain how a rise in the price of cream influences the supply of butter. As cream is a factor of production used to make butter, a rise in the price of cream will reduce the supply of butter.

DEMAND AND SUPPLY

17.

New Maple Syrup Sap Method With the new way to tap maple trees, farmers could produce 10 times as much maple syrup per acre. Source: cbc.ca, February 5, 2014 Will the new method change the supply of maple syrup or the quantity supplied of maple syrup, other things remaining the same. Explain. The new technology increases the supply of maple syrup. At each price, the new technology increases the quantity that will be supplied. The supply curve shifts rightward.

Use Figure 3.4 to work Problems 18 and 19. 18. a. Label the curves. Which curve shows the willingness to pay for a pizza?

The demand curve is the downward sloping curve and the supply curve is the upward sloping curve. The demand curve shows the willingness to pay for a pizza.

b. If the price of a pizza is $16, is there a shortage or a surplus and does the price rise or fall? If the price of a pizza is $16, there is a surplus of pizza; the quantity supplied of pizzas exceeds the quantity demanded. The surplus forces the price lower to the equilibrium price of $14 a pizza.

c. Sellers want to receive the highest possible price, so why would they be willing to accept less than $16 a pizza? Sellers are willing to accept less than $16 because if they charge $16 the surplus means that some sellers have unsold pizzas. From their perspective it is better to have a lower price for the pizza and sell the (decreased) quantity they produce than to keep the price at $16 and be left with unsold pizza.

19. a. If the price of a pizza is $12, is there a shortage or a surplus and does the price rise or fall? If the price of a pizza is $12, there is a shortage of pizza; the quantity demanded of pizzas exceeds the quantity supplied. The shortage forces the price higher to the equilibrium price of $14 a pizza.

b. Buyers want to pay the lowest possible price, so why would they be willing to pay more than $12 for a pizza? If the price of a pizza is $12 the shortage means that not all buyers can buy a pizza. From their perspective they would rather pay more than $12 and be able to purchase a pizza than to keep the price at $12 and leave them without a pizza.

20.

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The demand and supply schedules for potato chips are in the table. a. Draw a graph of the potato chip market and mark in the equilibrium price and quantity. Figure 3.5 draws the supply and demand curves for this market. The equilibrium price is 65¢ a bag, and the equilibrium quantity is 145 million bags a week.

Price (cents per bag) 50 60 70 80 90 100

b. If the price is 60¢ a bag, is there a shortage or a surplus, and how does the price adjust? At 60¢ a bag, there is a shortage of potato chips and the price rises. At 60¢ a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 140 million bags a week. The difference is a shortage of 10 million bags a week. The price rises until market equilibrium is restored—65¢ a bag and 145 million bags a week.

21.

In Problem 20, a new dip increases the quantity of potato chips that people want to buy by 30 million bags per week at each price. a. Does the demand for chips change? Does the supply of chips change? Describe the change. As the new dip comes onto the market, the demand for potato chips increases. Supply does not change. The demand curves shifts rightward.

b. How do the equilibrium price and equilibrium quantity of chips change? Demand increases by 30 million bags a week. The demand curve shifts rightward as shown in Figure 3.6 by the shift from D to D1. The quantity demanded at each price increases by 30 million bags. The quantity demanded at 65¢ is now 175 million bags a week of potato chips. The price rises to 80¢ a bag, at which the quantity supplied equals the quantity demanded (160 million bags a week). The new equilibrium price is 80¢ per bag and the new equilibrium quantity is 160 million bags.

Quantity Quantity demanded supplied (millions of bags a week) 160 130 150 140 140 150 130 160 120 170 110 180

DEMAND AND SUPPLY

22.

In Problem 20, if a virus destroys potato crops and the quantity of potato chips produced decreases by 40 million bags a week at each price, how does the supply of chips change? The supply of potato chips decreases, and the supply curve shifts leftward by 40 million bags. The price rises to 85¢ a bag and the quantity decreases to 125 million bags a week.

23.

If the virus in Problem 22 hits just as the new dip in Problem 21 comes onto the market, how do the equilibrium price and equilibrium quantity of chips change? The result by itself of the new dip entering the market is a price of 80¢ a bag and a quantity of 160 million bags. But now with the virus affecting the market, at this price there is a shortage of potato chips. The price of potato chips rises until the shortage is eliminated. The new equilibrium price is 100¢ a bag, and the new equilibrium quantity is 140 million bags a week.

24.

Asian Rubber Farmers Switch Crops as Prices Dive For the last four years, the price of rubber has been falling. With the sagging price, many Southeast Asian producers of rubber have switched to other crops such as oil palm, and those employed in rubber tapping have begun to look for jobs in factories and mines. Source: Reuters, May 29, 2014 a. Explain how the market for rubber would have changed if farmers had continued to plant rubber trees instead of switching to palm oil trees. If farmers continued to plant rubber trees, the supply of rubber would have increased. The demand for rubber would have remained unchanged. The supply curve would have shifted rightward as a result of the increase in supply and the demand curve would have remained unchanged. As a result, the equilibrium price of rubber would have decreased and the equilibrium quantity would have increased.

b. Describe the changes in demand and supply in the market for palm oil. Farmers are cultivating oil palm, which bears fruit within three years unlike rubber trees that takes six years to mature and produce latex. As a result, they have increased the supply of palm oil, while the demand for palm oil did not change.

25.

“Popcorn Movie” Experience Gets Pricier Cinemas are raising the price of popcorn. Demand for field corn, which is used for animal feed, corn syrup, and ethanol, has increased and its price has exploded. That’s caused some farmers to shift from growing popcorn to easierto-grow field corn. Source: USA Today, May 24, 2008 Explain and illustrate graphically the events described in the news clip in the market for a. Popcorn As illustrated in Figure 3.7, the farmers’ actions decrease the supply of popcorn and the supply curve of popcorn shifts leftward. The demand curve does not shift. The equilibrium price of popcorn rises and the quantity decreases.

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b. Movie tickets In the market for movie tickets—essentially the market for viewing movies in the theater— popcorn and viewing movies are complements. The increase in the price of popcorn decreases the demand for attending movies in the theater. As a result, Figure 3.8 shows the demand curve shifting leftward. The equilibrium price of attending a movie in the theater falls and the equilibrium quantity decreases.

26.

Watch Out for Rising Dry-Cleaning Bills In the past year, the price of dry-cleaning solvent doubled. More than 4,000 dry cleaners across the United States disappeared as budget-conscious consumers cut back. This year the price of hangers used by dry cleaners is expected to double. Source: CNN Money, June 4, 2012 a. Explain the effect of rising solvent prices on the market for dry cleaning. Solvents are used to produce dry cleaning, so a rise in the price of solvents increases the cost of dry cleaning. The increase in the cost of dry cleaning decreases the supply of dry cleaning and the supply curve of dry cleaning shifts leftward. The demand for dry cleaning does not change. By itself, the decrease in the supply raises the equilibrium price of dry cleaning and decreases the equilibrium quantity of dry cleaning.

b. Explain the effect of consumers becoming more budget conscious along with the rising price of solvent on the price of dry cleaning. Consumers becoming more budget conscious means that the demand for dry cleaning decreases and the demand curve for dry cleaning shifts leftward. Combined with the decrease in supply from rising solvent prices, the equilibrium quantity of dry cleaning decreases. The effect on the equilibrium price of dry cleaning, however, is ambiguous. If the decrease in supply exceeds the decrease in demand, the price rises; if the decrease in supply is less than the decrease in demand, the price falls; and, if the decrease in supply equals the decrease in demand, the price does not change.

c. If the price of hangers does rise this year, do you expect additional dry cleaners to disappear? Explain why or why not. The increase in the price of hangers raises the costs of dry cleaners but the cost increase is much smaller than the cost increase that resulted from the doubling of the price of dry-cleaning solvent. Therefore the decrease in supply is smaller, which means that the decrease in the equilibrium quantity of dry cleaning also is smaller. If the small decrease in the equilibrium quantity leads some additional dry cleaners to close, the number will be small.

DEMAND AND SUPPLY

Economics in the News 27.

After you have studied Economics in the news on pp. 112–113, answer the following questions: a. What would happen to the price of bananas if TR4 spread to Central America? The price of bananas would rise.

b. What are some of the substitutes for bananas and what would happen to demand, supply, price, and quantity in the markets for these items if TR4 were to come to America? Banana consumers could substitute other fruits, such as apples, peaches, or apricots. These changes would not change the supply of these products. The demand for these products, however, would increase, thereby raising their price and quantity.

c. What are some of the complements of bananas and what would happen to demand, supply, price, and quantity in the markets for these items if TR4 were to come to America? The classic complement for bananas is cereal. A rise in the price of bananas decreases the demand for cereal, so the demand curve for cereal shifts leftward. The supply of cereal is unaffected. The decrease in the demand for cereal lowers the equilibrium price of cereal and decreases the equilibrium quantity of cereal.

d. When the price of bananas increased in 2008, did it rise by as much as the rise in the rise in the price of oil? Why or why not? In 2008 the price of oil rose by about 70 percent, so the 20 percent price hike in the price of bananas was much less than the rise in price of oil. The price of oil is a cost of producing bananas. When the price of oil rose, the cost of producing bananas rose, so that the supply of bananas decreased. In response, the price of bananas rose. But there are other costs of producing bananas. The other costs did not rise by as much as the price of oil, so the decrease in the supply of bananas was smaller and, accordingly, the rise in the price of bananas was less than of oil.

e. Why would the expectation of the future arrival of TR4 in the Americas have little or no effect on today's price of bananas? If TR4 arrives in the Americas, the supply of bananas will decrease, thereby raising the price. The rise in the future expected for some goods can decrease the current supply and increase the current demand. But these changes assume that the good is storable. For example, the current supply decreases when the expected future price rises because producers store the product to sell in the future when its price is expected to be higher. Bananas, however, are not storable. Therefore producers (and demanders) do not respond to the higher expected future price.

C h a p t e r

ELASTICITY

Answers to the Review Quizzes Page 128 1.

Why do we need a units-free measure of the responsiveness of the quantity demanded of a good or service to a change in its price? The elasticity of demand is a units-free measure. Compare it as a measure of the responsiveness to some other candidate that depends on the units, such as the slope. The slope of the demand curve changes as the units measuring the same quantity of the good change (going from pounds to ounces, for example). The value of the elasticity is independent of the units used to measure the price and quantity of the product. As a result, the elasticity can be compared across the same good when quantity is measured in different units and/or the price is measured in different currencies. The elasticities of different goods also can be compared even though they are measured in different units.

Define the price elasticity of demand and show how it is calculated. The price elasticity of demand is units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same. It equals the absolute value (or magnitude) of the ratio of the percentage change in the quantity demanded to the percentage change in the price. The percentage change in quantity (price) is measured as the change in quantity (price) divided by the average quantity (price).

What makes the demand for some goods elastic and the demand for other goods inelastic? The magnitude of the price elasticity of demand for a good depends on three main influences: Closeness of substitutes. The more easily people can substitute other items for a particular good, the larger is the price elasticity of demand for that good. The proportion of income spent on the good. The larger the portion of the consumer’s budget being spent on a good, the greater is the price elasticity of demand for that good. The time elapsed since a price change. Usually, the more time that has passed after a price change, the greater is the price elasticity of demand for a good.

Why is the demand for a luxury generally more elastic (or less inelastic) than the demand for a necessity? Demand for a necessity is generally less elastic than demand for a luxury because there are fewer substitutes for a necessity. Because there are more substitutes for a luxury than a necessity, the elasticity of demand for a luxury is larger is than the elasticity of demand for a necessity.

What is the total revenue test? The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue, given a change in price, holding all other things constant. The total revenue test shows

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that a price cut increases total revenue if demand is elastic, decreases total revenue if demand is inelastic, and does not change total revenue if demand is unit elastic.

Page 132 1.

What does the income elasticity of demand measure? The income elasticity of demand measures how the quantity demanded of a good responds to a change in income. The formula for the income elasticity of demand is the percentage change in the quantity of the good demanded divided by the percentage change in income.

What does the sign (positive/negative) of the income elasticity tell us about a good? The sign of the income elasticity of demand reveals whether a good is a normal good or an inferior good: The income elasticity of demand is positive for normal goods and negative for inferior goods.

What does the cross elasticity of demand measure? The cross elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good. The formula for the cross elasticity of demand is the percentage change in the quantity of the good demanded divided by the percentage change in the price of the related good.

What does the sign (positive/negative) of the cross elasticity of demand tell us about the relationship between two goods? The sign of the cross elasticity of demand reveals whether two goods are substitutes or compliments: The cross elasticity of demand is positive for substitutes and negative for complements.

Page 134 1.

Why do we need a units-free measure of the responsiveness of the quantity supplied of a good or service to a change in its price? The elasticity of supply is a units-free measure. We need a units-free measure of the elasticity of supply for the same reason we need a units-free measure of the elasticity of demand: Because the value of the elasticity of supply is independent of the units used to measure the price and quantity of the good, the elasticity of supply can be compared across the same good when quantity is measured in different units and/or the price is measured in different currencies. In addition, the elasticities of supply of different goods also can be compared even though they are measured in different units.

Define the elasticity of supply and show how it is calculated. The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. The elasticity of supply is calculated by the percentage change in the quantity supplied divided by the percentage change in the price.

What are the main influences on the elasticity of supply that make the supply of some goods elastic and the supply of other goods inelastic? The main influences on the elasticity of supply are: Resource substitution possibilities: the greater the suppliers’ ability to substitute resources, the greater will be their ability to react to price changes and the greater the elasticity of supply. Time frame for the supply decision: the greater the amount of time available after the price change, the greater is the suppliers’ ability to adjust quantity supplied, and the greater the elasticity of supply.

Provide examples of goods or services whose elasticities of supply are (a) zero, (b) greater than zero but less than infinity, and (c) infinity. Here are some examples: a)

The momentary supply of wheat is perfectly inelastic. Once farmers have brought their wheat to market, there is no other alternative use for it and they sell it all regardless of the going price.

The short-run supply of wheat. If the farmers already have a mature wheat crop but have not yet harvested it, farmers with both relatively high and low yield fields may chose to harvest both types of fields if the price for wheat is high. However, the farmers will not harvest their low yield fields when the price of wheat is relatively low to economize on added labor costs.

ELASTICITY

The supply of wheat to an individual buyer. Any one buyer can purchase as much wheat at the going price as he or she desires. However, no quantity of wheat will be supplied at a lower price.

How does the time frame over which a supply decision is made influence the elasticity of supply? Explain your answer. The momentary supply, short-run supply, and long-run supply all illustrate the response of suppliers to changes in the price, but they differ according to how much time has elapsed after the price change. The momentary supply is frequently the least elastic and shows how suppliers cannot easily respond to a price change immediately after the price change occurs. Changing the quantity produced means changing the inputs into the production process, which takes time to complete. Sometimes the momentary supply is perfectly inelastic. The short-run supply shows suppliers’ response after enough time has elapsed for some, but not all, of the possible technological adjustments have occurred. Short-run supply generally is intermediate in elasticity between the momentary supply and the long-run supply. The long-run supply shows how suppliers react after enough time has passed that all possible adjustments to factors of production have been made to accommodate the price change. It usually is the most elastic of the three supplies.

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Answers to the Study Plan Problems and Applications 1.

Rain spoils the strawberry crop, the price rises from $4 to $6 a box, and the quantity demanded decreases from 1,000 to 600 boxes a week. a. Calculate the price elasticity of demand over this price range. The price elasticity of demand is 1.25. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price rises from $4 to $6 a box, a rise of $2 a box. The average price is $5 a box. So the percentage change in the price is $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity decreases from 1,000 to 600 boxes, a decrease of 400 boxes. The average quantity is 800 boxes. So the percentage change in quantity is 400 divided by 800, which equals 50 percent. The price elasticity of demand for strawberries is 50 percent divided by 40 percent, which equals 1.25.

b. Describe the demand for strawberries. The price elasticity of demand exceeds 1, so the demand for strawberries is elastic.

If the quantity of dental services demanded increases by 10 percent when the price of dental services falls by 10 percent, is the demand for dental services inelastic, elastic, or unit elastic? The demand for dental services is unit elastic. The price elasticity of demand for dental services equals the percentage change in the quantity of dental services demanded divided by the percentage change in the price of dental services. The price elasticity of demand is 10 percent divided by 10 percent, which equals 1. The demand is unit elastic.

The demand schedule for hotel rooms is in the table. a. What happens to total revenue when the price falls from $400 to $250 a room per night and from $250 to $200 a room per night?

Price (dollars per night) 200 250 400 500 800

Quantity demanded (millions of rooms per night) 100 80 50 40 25

When the price is $400, the total revenue is equal to $400 × 50 million rooms, or $20 billion. When the price is $250, the total revenue is equal to $250 × 80 million rooms, or $20 billion. So the total revenue does not change when the price falls from $400 to $250 a night. When the price is $250, the total revenue is equal to $250 × 80 million rooms, or $20 billion. When the price is $200, the total revenue is equal to $200 × 100 million rooms, or $20 billion. So the total revenue does not change when the price falls from $400 to $250 a night.

b. Is the demand for hotel rooms elastic, inelastic or unit elastic? The total revenue is the same at all prices, $20 billion. Because a change in price does not change the total revenue at any price, the demand is unit elastic at all prices.

ELASTICITY

The figure shows the demand for pens. Calculate the elasticity of demand when the price rises from $4 to $6 a pen. Over what price range is the demand for pens elastic? The price elasticity of demand is 0.72. When the price of a pen rises from $4 to $6, the quantity demanded of pens decreases from 80 to 60 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $4 to $6, an increase of $2 a pen. The average price is $5 per pen. So the percentage change in the price equals $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity decreases from 80 to 60 pens, a decrease of 20 pens. The average quantity is 70 pens. So the percentage change in quantity demanded equals 20 divided by 70 and then multiplied by 100, which equals 28.6 percent. The price elasticity of demand for pens equals 28.6 percent divided by 40 percent, which is 0.72. The demand for pens is elastic at all prices higher than the price at the midpoint of the demand curve, which indicates that the demand for pens is elastic at prices between $12 per pen and $6 per pen.

In 2003, when music downloading first took off, Universal Music slashed the average price of a CD from $21 to $15. The company expected the price cut to boost the quantity of CDs sold by 30 percent, other things remaining the same. a. What was Universal Music’s estimate of the price elasticity of demand for CDs? Using the data in the question, the price elasticity of demand is 0.90. The change in the price is $6 and the average of the two prices is $18, so the percentage change in the price is ($6/$18)  100, which equals 33.3 percent. The increase in the quantity demanded was estimated to be 30 percent. The price elasticity of demand equals (30.0 percent)/(33.3 percent), or 0.90.

b. If you were making the pricing decision at Universal Music, what would be your pricing decision? Explain your decision. The demand is inelastic, so if nothing else changes the price cut leads to a decrease in Universal Music’s total revenue. However, downloaded music and CDs are substitutes for each other and the quantity of downloaded music was forecast to rise substantially. Effectively, the price of downloading music fell as more people gained access to the Internet and download sites proliferated. The fall in the price of the substitute, downloaded music, decreases the demand for Universal Music’s CDs, so the decision to cut prices most likely was forced as the result of the (forecasted) decrease in demand for CDs.

When Judy’s income increased from $130 to $170 a week, she increased her demand for concert tickets by 15 percent and decreased her demand for bus rides by 10 percent. Calculate Judy’s income elasticity of demand for (a) concert tickets and (b) bus rides.

a. b.

The income elasticity of demand for (a) concert tickets is 0.56 and (b) bus rides is −0.375. The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $40 and the average income is $150, so the percentage change in income equals 26.7 percent. The change in the quantity demanded of concert tickets is 15 percent. The income elasticity of demand for concert tickets equals 15/26.7, which is 0.56. The change in the quantity demanded of bus rides is 10 percent. The income elasticity of demand for bus rides equals 10/26.7, which is 0.375.

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If a 12 percent rise in the price of orange juice decreases the quantity of orange juice demanded by 22 percent and increases the quantity of apple juice demanded by 14 percent, calculate the a. Price elasticity of demand for orange juice. The price elasticity of demand for orange juice is 1.83. The price elasticity of demand is the percentage change in the quantity demanded of the good divided by the percentage change in the price of the good. So the price elasticity of demand equals 22 percent divided by 12 percent, which is 1.83.

b. Cross elasticity of demand for apple juice with respect to the price of orange juice. The cross elasticity of demand between orange juice and apple juice is 1.17. The cross elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. So the cross elasticity of demand is the percentage change in the quantity demanded of apple juice divided by the percentage change in the price of orange juice. The cross elasticity equals 14 percent divided by 12 percent, which is 1.17.

If a rise in the price of sushi from 98¢ to $1.02 a piece decreases the quantity of soy sauce demanded from 101 units to 99 units an hour and decreases the quantity of sushi demanded by 1 percent an hour, calculate the: a. Price elasticity of demand for sushi. The price of sushi rises by ($1.02 − $0.98)/$1.00 = 4 percent. Therefore the price elasticity of demand for sushi equals |( −1 percent)/(4 percent)|, which is 0.25.

b. Cross elasticity of demand for soy sauce with respect to the price of sushi. The quantity of soy sauce decreases by (99 – 101)/100 = −2 percent. Therefore the cross elasticity of demand for soy sauce with respect to the price of sushi equals |( −2 percent)/(4 percent), which is −0.5.

The table sets out the supply schedule of jeans. a. Calculate the elasticity of supply when the price rises from $125 to $135 a pair.

Price (dollars per pair) 120 125 130 135

Quantity supplied (millions of pairs per year) 24 28 32 36

The elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in price. The percentage change in the quantity demanded equals [(36 − 28)/32] × 100, which is 25.0 percent. The percentage change in the price equals [($135 − $125)/$130] × 100, which is 7.7 percent. The elasticity of supply equals (25.0 percent/7.7 percent), which is 3.25.

b. Calculate the elasticity of supply when the average price is $125 a pair. To find the elasticity at an average price of $125 a pair, change the price such that $125 is the average price—for example, a rise in the price from $120 to $130 a pair. To calculate the elasticity when the average price is $125, calculate the elasticity over the price range from $120 to $130. The percentage change in the quantity demanded equals [(32 − 24)/28] × 100, which is 28.6 percent. The percentage change in the price equals [($130 − $120)/$125] × 100, which is 8.0 percent. The elasticity of supply equals (28.6 percent/8.0 percent), which is 3.58.

c. Is the supply of jeans elastic, inelastic, or unit elastic? The supply of jeans is elastic.

ELASTICITY

Answers to Additional Problems and Applications 10.

With higher fuel costs, airlines raised their average fare from 75¢ to $1.25 per passenger mile and the number of passenger miles decreased from 2.5 million a day to 1.5 million a day. a. What is the price elasticity of demand for air travel over this price range? The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The quantity demanded changes by 1.0 million passenger miles and the average passenger miles is 2.0 million. The percentage change in the quantity demanded is (1.0 million)/(2.0 million)  100, which is 50 percent. The price changes by $0.50 and the average price is $1.00. The percentage change in the quantity demanded is ($0.50 /($1.00)  100, which is 50 percent. So the price elasticity of demand is (50 percent)/(50 percent), or 1.00.

b. Describe the demand for air travel. The demand for air travel between these two prices is unit elastic. The 50 percent price hike leads to a 50 percent decrease in the quantity of air miles traveled.

11.

Figure 4.2 shows the demand for DVD rentals. a. Calculate the elasticity of demand when the price of a DVD rental rises from $3 to $5. The price elasticity of demand is 2. When the price of a DVD rental rises from $3 to $5, the quantity demanded of DVDs decreases from 75 to 25 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $3 to $5, an increase of $2 a DVD. The average price is $4 per DVD. So the percentage change in the price equals $2 divided by $4 and then multiplied by 100, which equals 50 percent. The quantity decreases from 75 to 25 DVDs, a decrease of 50 DVDs. The average quantity is 50 DVDs. So the percentage change in quantity demanded equals 50 divided by 50 and then multiplied by 100, which equals 100 percent. The price elasticity of demand for DVD rentals equals 100 percent divided by 50 percent, which is 2.

b. At what price is the elasticity of demand for DVD rentals equal to 1? The price elasticity of demand equals 1 at $3 a DVD. The price elasticity of demand equals 1 at the price halfway between the origin and the price at which the demand curve intersects the y-axis. That price is $3 a DVD.

Use the following table to work Problems 12 to 14. The demand schedule for computer chips is in the table. 12. a. What happens to total revenue if the price falls from $400 to $350 a chip and from $350 to $300 a chip? When the price of a chip is $400, 30 million chips are sold and total revenue equals $12,000 million. When the price of a chip falls to $350, 35 million chips are sold and total revenue is $12,250 million. The total revenue increases when the price falls.

Price (dollars per chip) 200 250 300 350 400

Quantity demanded (millions of chips per year) 50 45 40 35 30

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When the price is $350 a chip, 35 million chips are sold and total revenue is $12,250 million. When the price of a chip is $300, 40 million chips are sold and total revenue decreases to $12,000 million. The total revenue decreases as the price falls.

b. At what price is total revenue at a maximum? Total revenue is maximized at $350 a chip. When the price of a chip is $300, 40 million chips are sold and total revenue equals $12,000 million. When the price is $350 a chip, 35 million chips are sold and total revenue equals $12,250 million. Total revenue increases when the price rises from $300 to $350 a chip. When the price is $400 a chip, 30 million chips are sold and total revenue equals $12,000 million. Total revenue decreases when the price rises from $350 to $400 a chip. Total revenue is maximized when the price is $350 a chip.

13.

At an average price of $350, is the demand for chips elastic, inelastic, or unit elastic? Use the total revenue test to answer this question. The demand for chips is unit elastic. The total revenue test says that if the price changes and total revenue remains the same, the demand is unit elastic at the average price. For an average price of $350 a chip, cut the price from $400 to $300 a chip. When the price of a chip falls from $400 to $300, the total revenue remains at $12,000 million. So at the average price of $350 a chip, demand is unit elastic.

14.

At $250 a chip, is the demand for chips elastic or inelastic? Use the total revenue test to answer this question. The demand for chips is inelastic. The total revenue test says that if the price falls and total revenue falls, the demand is inelastic. When the price falls from $300 to $200 a chip, total revenue decreases from $12,000 million to $10,000 million. So at an average price of $250 a chip, demand is inelastic.

15.

Your price elasticity of demand for bananas is 4. If the price of bananas rises by 5 percent, what is a. The percentage change in the quantity of bananas you buy? The quantity of bananas you buy decreases by 20 percent. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. Rearranging this formula shows that the percentage change in the quantity demanded equals the price elasticity of demand multiplied by the percentage change in the price. The percentage change in the quantity demanded equals 4  5 percent, which is 20 percent.

b. The change in your expenditure on bananas? Your total expenditure decreases because your demand is elastic. The fall in expenditure is approximately 15 percent, the 5 percent rise in price offset by the 20 percent decrease in the quantity purchased.

16.

Over 15 million households plan to ration energy use this winter to cope with soaring bills The cost of energy is rising and British consumers are left to cope with a harsh winter. Seeing their energy bills rise, millions of households are planning to cut back as much as they can on their energy use despite the cold temperature, putting their health at risk. Many bill payers will cope by spending less on food so that they can afford to keep their homes warm. Household disposable income has been substantially affected by rising energy costs and prices are expected to keep increasing. Some estimate that the average UK home will spend £53 more on energy this year. Source: This is Money, November 6, 2014 a. List and explain the elasticities of demand that are implicitly referred to in the news clip. The elasticities of demand to which the clip refers are the income elasticity of demand, the price elasticity of demand, and the cross elasticity of demand. The price elasticity of demand is reflected in the news clip’s discussion of the rising price of energy. As the price increases, people will try to cut back on their energy consumption as much as possible (and decrease the quantity of energy demanded), despite the cold temperature. The income elasticity of demand is implied through references to the substantial effect rising energy costs have on household disposable income. In order to pay their high energy bills, people will ration their energy use with some saying they will even spend less on food. This

ELASTICITY

implies that there are things that households can do in response to increasing energy price, making a reference to cross elasticity of demand.

b. Why, according to the news clip, is the demand for energy inelastic? The demand for energy is inelastic because as the price of energy rises, the quantity demanded of energy decreases by as small an amount as possible. People will cut back on energy consumption, yet it remains a necessity.

Use this information to work Problems 17 and 18. Recession Has Led To Spending On Food Falling By 8.5%, Say Researchers Families in Britain, especially the ones with children, have altered their eating habits in the face of recession. Less is spent on fruit and vegetables and more on processed foods lacking in nutrition. Source: The Guardian, November 4, 2013 17.

Given the prices, is the income elasticity of demand for fruit and vegetables positive or negative? Are fruit and vegetables a normal good or an inferior good? Are processed foods a normal good or inferior good? As income falls in the recession, the income spent on fruits and vegetables decreases, the income elasticity of demand for fruit and vegetables is positive, so fruit and vegetables are a normal good. As income falls in the recession, the income spent on processed foods increases, the income elasticity of demand for processed foods is negative, so processed foods are an inferior good.

18.

Are fruits and vegetables and processed foods substitutes? Explain. Fruits and vegetables and processed foods are substitutes as food is a necessity. The article points out that in the face of the recession which began in 2008, families in Britain were substituting processed foods for fruits and vegetables. However, to be sure that they are substitutes, the cross price elasticity of demand should be calculated. In this case, prices are not given, so it cannot be computed.

19.

When Alex’s income was $3,000, he bought 4 bagels and 12 donuts a month. Now his income is $5,000 and he buys 8 bagels and 6 donuts a month. Calculate Alex’s income elasticity of demand for (a) bagels and (b) donuts. a.

20.

The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $2,000 and the average income is $4,000, so the percentage change in income equals 50 percent. The change in the quantity demanded is 4 bagels and the average quantity demanded is 6 bagels, so the percentage change in the quantity demanded equals 66.67 percent. The income elasticity of demand for bagels equals (66.67 percent)/(50 percent), which is 1.33. From part (a), the percentage change in income is 50 percent. The change in the quantity demanded is −6 donuts and the average quantity demanded is 9 donuts, so the percentage change in the quantity demanded is −66.67 percent. The income elasticity of demand for donuts equals (−66.67 percent)/(50 percent), which is −1.33.

Pampered Pets UK! The economy has slowed down again but Britain’s animal lovers have not stopped themselves from spending on gourmet pet food, spoiling their pets even though their budgets are tight. In fact, more than a third of pet owners claim that they would cut back on their own food purchases before that of their pets. Source: The Independent, April 14, 2015 a. What does this news clip imply about the income elasticity of demand for gourmet pet food? The news clip implies that the income elasticity of demand for gourmet food is positive but very small. As income falls, the quantity demanded of pet food barely changed, so the income elasticity of demand is very small.

b. Would the income elasticity of demand be greater or less than 1? Explain. The income elasticity of demand for gourmet pet food is less than 1 because the percentage change in the quantity demanded of pet food is smaller than the percentage change in income.

21.

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If a 5 percent fall in the price of chocolate sauce increases the quantity demanded of chocolate sauce by 10 percent and increases the quantity of ice cream demanded by 15 percent, calculate the: a. Price elasticity of demand for chocolate sauce. The price elasticity of demand for chocolate sauce equals the percentage change in the quantity of chocolate sauce demanded divided by the percentage change in the price of chocolate sauce. Using the data in the problem, the price elasticity of demand equals (10 percent)/(−5 percent), which is 2.0.

b. Cross elasticity of demand for ice cream with respect to the price of chocolate sauce. The cross elasticity of demand for ice cream with respect to the price of chocolate sauce equals the percentage change in the quantity of ice cream demanded divided by the percentage change in the price of chocolate sauce. Using the data in the problem, the cross elasticity of demand equals (15 percent)/(−5 percent), which is −3.0. Ice cream and chocolate sauce are complements.

22.

To Love, Honor, and Save Money In a survey of caterers and event planners, nearly half of them said that they were seeing declines in wedding spending in response to the economic slowdown; 12% even reported wedding cancellations because of financial concerns. Source: Time, June 2, 2008 a. Based upon this news clip, are wedding events a normal good or inferior good? Explain. Based on the news clip, wedding events are a normal good. The economic slowdown means that people’s incomes are falling and, as a result, the demand for wedding events is decreasing.

b. Are wedding events more a necessity or a luxury? Would the income elasticity of demand be greater than 1, less than 1, or equal to 1? Explain. Wedding events are a luxury. Wedding events are not necessities because couples can marry with plain weddings; indeed, couples can marry using a civil ceremony and with no wedding event at all. If wedding events are a luxury, their income elasticity of demand is greater than 1.

23.

The table sets out the supply schedule of long-distance phone calls. Calculate the elasticity of supply when a. The price falls from 40¢ to 30¢ a minute.

Price (cents per minute)

Quantity supplied (millions of minutes per day)

The elasticity of supply is 1. The elasticity 10 200 of supply is the percentage change in the 20 400 quantity supplied divided by the 30 600 percentage change in the price. When the price falls from 40 cents to 30 cents, the 40 800 change in the price is 10 cents and the average price is 35 cents. The percentage change in the price is 28.57 percent. When the price falls from 40 cents to 30 cents, the quantity supplied decreases from 800 to 600 calls. The change in the quantity supplied is 200 calls, and the average quantity is 700 calls, so the percentage change in the quantity supplied is 28.57 percent. The elasticity of supply equals (28.57 percent)/(28.57 percent), which is 1.

b. The average price is 20¢ a minute. The elasticity of supply is 1. The formula for the elasticity of supply calculates the elasticity at the average price. So to find the elasticity at an average price of 20 cents a minute, change the price such that 20 cents is the average price—for example, a fall in the price from 30 cents to 10 cents a minute. When the price falls from 30 cents to 10 cents, the change in the price is 20 cents and the average price is 20 cents. The percentage change in the price is 100 percent. When the price falls from 30 cents to 10 cents, the quantity supplied decreases from 600 to 200 calls. The change in the quantity supplied is 400 calls and the average quantity is 400 calls. The percentage change in the quantity supplied is 100 percent. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. The elasticity of supply is 1.

ELASTICITY

24.

Weak Coal Prices Hit China’s Third-Largest Coal Miner The chairman of Yanzhou Coal Mining reported that the recession had decreased the demand for coal, with its sales falling by 11.9 per cent to 7.92 million tons from 8.99 million tons a year earlier, despite a 10.6 percent cut in the price. Source: Dow Jones, April 27, 2009 Calculate the price elasticity of supply of coal. Is the supply of coal elastic or inelastic? The price elasticity of supply of coal equals the percentage change in the quantity of coal supplied divided by the percentage change in the price of coal. Using the data in the problem, the price elasticity of supply equals (–11.9 percent)/( –10.6 percent), which is 1.12. The elasticity exceeds 1.0 in value, so the supply of coal is elastic.

Economics in the News 25.

After you have studied Economics in the News on pp. 136–137, answer the following questions. a. Looking at Fig. 1 on p. 137, explain what must have happened in 2014 to the supply of coffee. The price of coffee soared in 2014, which indicates that the supply of coffee decreased.

b. Given the information in Fig. 1 and the estimated elasticity of demand for coffee, by what percentage did the quantity of coffee change in 2014 and in which direction? The price of coffee rose from $1.00 per pound to $1.60 per pound. Therefore the percentage increase in the price of coffee is ($1.60 – $1.00)/$1.30 = 46 percent. The price elasticity of demand is 0.26. Therefore the quantity of coffee decreased by 0.26 × 46 percent, which is 12 percent.

c. The news article says that farmers’ revenue shrank as the price of coffee fell. Explain why this fact tells us that the demand for coffee is inelastic. The total revenue test shows that total revenue falls when the price falls only if the demand for the product is inelastic. Therefore, because farmers’ total revenue from coffee fell when the price of coffee fell, the total revenue test means that the demand for coffee must be inelastic.

d. How does the total revenue test work for a rise in the price? What do you predict happened to total revenue in 2014? Why? If the demand for a product is inelastic and the price rises, the total revenue increases. Therefore, in 2014 when the price of coffee rose, coffee farmers’ total revenue increased.

e. Coffee isn’t just coffee. It comes in different varieties, the main two being Arabica and Robusta. Would you expect the elasticity of demand for Arabica to be the same as the elasticity of demand for coffee? Explain why or why not. There are more close substitutes for the specific type of coffee, Arabica, than there are for coffee in general, so the price elasticity of demand for Arabica is larger than the price elasticity of demand for coffee.

26.

Mobile Merger Set for Poor Reception from Users If Prices Rise Hutchinson Whampoa, owner of Three, UK’s fastest growing mobile network, has started exclusive talks to buy Telefónica’s O2 for £10.25 billion. This has caused price-rise concerns among British phone users. Source: The Financial Times, January 23, 2015 a. If the prices of telecom services rise because of the deal, how will this influence the supply of telecom services? The new clip points out that the deal has caused price-rise concerns among the users. It is likely that the deal will lead to higher prices for mobile tariffs and as a result will cause the overall supply to increase. As the price of telecom services rises, the quantity supplied of telecom services will increase. The supply of telecom service will not change.

b. Given your answer to part (a), explain why Hutchison Whampoa can afford to raise mobile tariffs? Hutchison Whampoa can afford to raise their prices for mobile tariffs because it assumes that the deal will leave fewer players in an essential market like the telecoms so users will not have many alternatives to choose from. This is because when consumers have less substitutes, their elasticity of demand for

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telecom services will be inelastic. When demand is inelastic, a price rise will increase Hutchison Whampoa’s total revenue.

c. What can you say about the price elasticity of demand for services in the UK telecoms market with respect to the deal between Hutchinson Whampoa and Telefónica? The price elasticity of demand for services in the UK telecoms market will become more inelastic as the deal would mean fewer available substitutes.

C h a p t e r

EFFICIENCY AND EQUITY

Answers to the Review Quizzes Page 145 1.

Why do we need methods of allocating scarce resources? Because resources are scare, it is not possible to fulfill everyone’s wants. As a result, some method of deciding which wants will be fulfilled and which will not—that is, some method of allocating resources—must be utilized.

Describe the alternative methods of allocating scarce resources. Resources can be allocated using: • Market price: People who are willing and able to pay the price get the resource. • Command: Someone in command decides who gets the resource. • Majority rule: The majority vote decides how resources are allocated. • Contest: Winners receive the resource. • First-come, first-served: People first in line get the resource. • Lottery: Randomly selected winners receive the resource. • Personal characteristics: People with the “right” characteristics get the resource. • Force: The stronger person or group gets the resource.

Provide an example of each allocation method that illustrates when it works well. Below are examples of when each allocation scheme works well: • Market price: Generally works well in competitive markets and for most goods and services. An example is the allocation of cat food. • Command: Generally works well in organizations where lines of authority are clear and it is easy to monitor subordinates. An example is in a fast food restaurant when the supervisor tells a worker to clean the tables. • Majority rule: Generally works well when large numbers of people are affected by the allocation. An example is an election in which people vote whether or not to support a tax to build more parks. • Contest: Generally works well when the efforts of the participates are hard to monitor. An example is the contest run by Pfizer in which three top managers competed to see who would be appointed CEO. • First-come, first-served: Generally works well when a resource can be used by only one user at a time. An example is a line at a movie ticket booth. • Lottery: Generally works well when there is no way to easily distinguish which user of a resource would use it most effectively. An example is the lottery used to allocate cell phone frequencies.