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Teaching Tips ("Illustrations That Work") for Sexton 5e General Introductory comments: It is not the purpose of this section to tell professors how to teach economics. You do not need to be told to be sure to use Figure X to illustrate concept Y, or to remember to develop some implications of important principles or techniques, unnecessary advice which makes up a large part of many instructor’s manuals. You don’t need to be reminded to talk about critical concepts that every introductory course develops. You don’t need a “one size fits all” approach, which conflicts with the various unique teaching styles you have found to be effective. That would be a waste of time and effort. The intent of this section is to provide analogies, illustrations, examples and extensions that instructors may find helpful in bringing economics to life in their classroom. They closely parallel the order of presentation of the text, but can be utilized in any manner desired. Chapter 1: The Role and Method of Economics 1. The connection between economics and other social sciences can be illustrated by behavior modification in psychology. Behavior modification can be shown to be an application of the rule of rational choice, where you raise the marginal benefit or lower the marginal cost of behavior you want to encourage (like a market subsidy) and lower the marginal benefit or raise the marginal cost of behavior you want to discourage (like a market tax). 2. A useful illustration of self-interest is to ask what kind of nails a steel maker would likely make if it was rewarded on the basis of the weight of nails produced (railroad spikes, as it is less costly to produce a given weight of nails that way) and contrast it to what it would likely make if it was rewarded on the basis of the number of nails made (pins, as it is less costly to produce a given number of pins than of larger nails). Those results can then be compared to what would happen if the steel maker was rewarded by being allowed to keep any profits (it would make those products it thought people valued at more than the cost of producing them, which depends on what people value in their current circumstances). 3. Students sometimes struggle with economics’ self-interest assumption because they often consider themselves to be acting altruistically. Point out to students that the belief that they are more altruistic than they really are is consistent with self-interest (we want to think well of ourselves), and then ask them whether they think self-interest or altruism is a more reliable way to get others to coordinate behavior in a society (as in Adam Smith’s famous quote). This can result in an interesting classroom discussion. 4. The text emphasizes economics as a disciplined way of thinking, not the source of clear-cut answers for every circumstance. It is worth emphasizing why the economic way of thinking points towards “it depends” as the first part of the answer to general questions (because the expected marginal benefits and expected marginal costs of choices depend on so many factors). 5. It is worth emphasizing that that economic principles allow economists to know better what not to do than what to do. We can identify choices that would do poorly in achieving intended goals, but we don’t know what course of action will be the best possible in a complex world of uncertainty. 6. As an example of the approach used in economic theorizing and modeling, ask students whether an airplane model needs to have wings and seats. Typically some will say both and others will say only wings are necessary. Then ask what difference it makes whether the model is intended to train stewardesses in their jobs or to investigate its aerodynamics. They will quickly see that the right sort of model will reflect its intended use; abstracting from those aspects that are unimportant to the question at hand to better focus on the important considerations you want to investigate. 7. A useful illustration of how models come to be accepted in science is the replacement of the Ptolemaic geocentric model of the solar system (everything revolves around the earth at the center) with the Copernican heliocentric model of the solar system (everything revolves around the sun). With the


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development of improving telescopes, more of the solar system could be seen. But as a result, it eventually became impossible to construct a geocentric model that was consistent with empirical observations, while those observations were consistent with a heliocentric model, leading to the replacement of one previously accepted model with another. 8. The text’s emphasis on empirical testing of theories can be reinforced by getting students to see that a major part of economic research is the search to design tests that will discriminate among different hypotheses proposed to explain something. When something is consistent with multiple hypotheses, we don’t have much of an idea of what is going on, so that a test that distinguishes among hypotheses in that circumstance can be very valuable. 9. I find rain dancing to be a good illustration of confusing correlation with causation. If a group of people decides that a deity that brings them rain needs its anger appeased by rain dancing at the beginning of the normal rainy season and they dance long enough, it will rain. It will not rain because they danced, but because the rainy season started. But once a belief in the necessity of rain dancing has begun, it can be very hard to change, since every time they dance (if they dance long enough), it rains. 10. Weather can be used to illustrate problems of establishing causation. Since heaters come on in the winter and air conditioners in the summer, one could conclude that heaters cause the house to be colder and air conditioners cause it to be hotter. Similarly, chill drafts can be blamed for catching a cold in the winter (since looking back, its easy to remember being exposed to some recent draft in the winter), even though the more scientific reason is that you are inside more, closely exposed to more of other people’s “bugs,” in the winter than in the summer. 11. In addition to the fallacy of composition illustrations in the text, you could add leaving early to beat the traffic (similar to arriving early to beat the crowd) and cutting your price to take sales from rivals (which doesn’t work if all rivals lower their prices). 12. Emphasize that disagreements about economic policy can occur even when people agree on the list of benefits and costs of an action or policy (positive statements), as long as they disagree about the relative weights or values to place on those outcomes (normative statements). This is often the case of when people perceive conflicts between freedom and fairness (the text example). President Harry Truman=s famous complaint that he couldn’t find a one-armed economist (who would tell him which policy was the right one), but only the two-armed kind, whose policy answers were always on the one hand (the benefits)...and on the other hand (the costs)..., forcing him to decide whether the list of benefits was more valuable than the list of costs, is also an excellent illustration. Chapter 2: The Economic Way of Thinking 1. It is crucial to clearly discuss the basic paradigm that underlies all that we do in economics. Show what we mean by scarcity; how scarcity implies the necessity to making choices; how choices imply the bearing of opportunity costs; and how, when combined with the assumption of self-interest, that results in the Rule of Rational Choice: whatever the choice or action, do "it" if and only if E(MB)>E(MC). This, in turn, when continued as long as that inequality holds, becomes the basic intuition leading to what economists define as equilibrium (there is no incentive to change your behavior, absent a change in incentives). When this is clear, it can become the focus for student retention (e.g., how is this technique or diagram an application of the rule of rational choice), and there is almost no end to the examples and illustrations that can be made to show students the applicability of the economic way of thinking. 2. A useful way to integrate student understanding of how value is created and the crucial role of entrepreneurship in the process is to show students that all forms of creating value involve one or more of the following: Resources are being moved from less to more valuable forms (what we typically thing of as production does not create atoms; it simply rearranges them); from less to more valuable locations (the value created in transportation); from less to more valuable time periods (the value created in speculation); or from lower valuing to higher valuing uses and/or users (the value created in exchange).


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In each case, there is a large aspect of entrepreneurship in trying to discover higher valued forms, locations and times, and higher valuing users than others have discovered. Further, this reinforces the fact that the incentives facing entrepreneurs are crucial to the value creating process. 3. A good way to illustrate entrepreneurship to students is to discuss in class how each of them is an entrepreneur when it comes to discovering the best way to “produce” higher grades in the course. Different people learn better in different ways, handle pressure differently, have different attitudes toward the risk of getting a lower grade if they do less well than expected, different time constraints, etc. Further, not all courses are the same, and what works well in one course (e.g., memorization of terms) may not work well in another (e.g., one requiring application). Should you always go to class? Is it more effective to read before class or after class or not read at all? Should you use a study guide? Should you study in groups? All these questions are entrepreneurial in nature. 4. A good way to get students thinking about scarcity is to ask them what is scarce when one is dieting. We usually think of food as being scarce, yet in this case, it is healthier food (with fewer calories rather than more) and self-restraint in eating that are scarce. 5. An unusual, literate illustration of scarcity and opportunity cost comes from Homer’s Odyssey. In it, Calypso, the sea princess and immortal child of the gods, envies Ulysses’ mortality, because he gets to make decisions that will have real consequences, particularly life or death consequences (Calypso will live no matter what she chooses to do). That makes Calypso feel that Ulysses’ life is more meaningful than hers. 6. A good opportunity cost illustration is that of celebrities donating their time and services for “good causes.” If they are turning down an alternative “gig” to show up, the foregone income is an opportunity cost to the celebrity; but if they are not turning down a potential paid opportunity to appear, the opportunity cost of them appearing may be far less than their “asking” price for an appearance. 7. Since this chapter introduces appropriate handling of the concept of opportunity cost, it needs to be emphasized that costs attach to choices, not goods. One effective way to do this in class is to ask "What is the cost of a car?" One can then lead students to see that their answers do not make sense without a verb describing what action involving a car is being contemplated. One can speak of the varying costs of different ways of verbing (buying, owning, driving, insuring, borrowing, selling, etc.) a car, but not sensibly of the cost of a car. 8. A good, close-to-home illustration of opportunity cost for students is to discuss with them why there is less dating during finals week, then leading them to see that the reason is that the opportunity cost of time for dating is higher during finals week than at other times of the school year. Another education illustration that can get their attention is to ask why people ever stop going to school, and leading them to see that the reason is that the opportunity cost of additional time spent in education rises, the greater the market value of the skills and knowledge you already have. At some point, it becomes too costly to continue going to school. The same reason helps explain why those who go straight from graduation to MBA programs typically go during the day, while experienced, working managers (with higher opportunity costs of foregoing daytime jobs than those who have just graduated) tend to go in the evening. 9. A good way to illustrate opportunity cost to students is to ask them whether a human life is of infinite value. Someone in class is bound to say yes. Then you can show them that saving lives in “costly” ways can result in a net reduction in lives saved, if those resources would have been spent instead on lower cost ways of saving lives. This can also be presented in terms of a production possibilities curve with different types of lives saved on the axes, to show the tradeoffs involved. 10. There are several ways to illustrate the importance of the rational behavior assumption of economics. One way would be to show how traditional detective work is an example--the search for a weapon, an opportunity and a motive presume the criminal is rational. Another way is to ask students for illustrations that clearly violate rational choice, where the difficulty they have coming up with such


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illustrations will help reinforce the power of the assumption of rationality in predicting behavior. 11. A potential mugging illustrates the importance of focusing on the relevant margin with muggers. Say you are walking through Central Park with $200 in your wallet. When someone tries to mug you, you don’t start negotiating: You can have $200 if you leave me alone, $150 if you rough me up a little, $100 if you take a swipe at me with a knife...How much a mugger will take and how he will treat you are not choices under your control. In this situation, you basically have an all-or-nothing choice between handing over the money and taking your chances by resisting. This illustration can then be extended to other examples of the often crucial importance of focusing on the relevant margin (the choice actually being made). 12. An interesting illustration of marginal incentives is the case of bounty hunters in the Old West. If a posse is chasing a bandit who just robbed the local bank, they do not have incentives to catch the bandit if they can more easily chase him into another territory where he will rob other areas’ banks. The posse has an incentive to stop chasing him at that point. However, a bounty hunter, faced with a “Wanted: Dead or Alive” reward, knows that all his previous costs are sunk, and continues to chase, as long as the expected additional costs of catching the bandit from that moment on are less than the benefit of the reward. Similarly, a railroad company (as in “Butch Cassidy and the Sundance Kid”) would want to hunt them down, since chasing them away would only result in more robberies of their trains in other locations. 13. You can illustrate the role of incentives by discussing with your class whether you should reward marginal exam improvement by giving higher grades to the students who improve the most from their first exam results to the final. There are conflicting incentives facing students here. There are great incentives to improve (you don’t stop studying because you think you will get a C no matter what you do on the final), but such a grading system would also give students incentives to do terribly on the first test, so that they could improve more. 14. An analogy to the question of whether we want zero pollution discussed in the text is to ask whether the goal of education is zero ignorance. The answer is no, and for the same reason. The cost of eliminating some forms of ignorance is greater than the benefits. This can also be extended to show that one of the advantages of specialization and exchange is the vast saving in the costs of becoming informed. 15. There are many illustrations that can be used to emphasize the importance of recognizing differences in the incentive structures that are faced by different parties. Examples include why your athletic team’s coach wants you in better shape than you do (he gets some of the benefits, but none of the costs), why your mother wants you to get better grades than you do (she gets some of the benefits, but none of the costs), why military draftees tend to be used inefficiently (those in charge need not incur the true opportunity cost of using human resources), why a dictator might choose to move a society inside its otherwise attainable production possibilities curve (they can benefit themselves by policies which hurt their citizens), why damage deposits arise as a way to make renters act more like they were owners (otherwise renter damage costs will be imposed on owners), etc. 16. A birdwatching analogy can help students see the usefulness of the economic way of thinking. Just as training and experience shows birdwatchers “where to look" and Awhat to look for@ to spot various birds (everything from what a bird looks and sounds like to where they tend to nest, what they feed on and when, when and where they migrate, etc.), the economic way of thinking shows students to look at decisionmakers’ incentives to "see" the predictable consequences of actions and policies. This is why those trained in economics can often find predictable policy consequences others are unable to grasp very easily (for example, the predictable consequences of price controls). 17. Another analogy that can help students understand the power of the economic way of thinking is to the framing of a building: Just as buildings will not be structurally sound if the framing is not done correctly, economic analyses will be faulty unless they build on the framework of the set of incentives


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faced by the relevant decisionmakers. This is why economists spend so much effort trying to properly specify the incentives facing actors involved, because predictions that are inconsistent with actors' incentives are likely to be incorrect, and more so the longer the train of reasoning (the larger the building) that is built on a poor foundation. 18. In talking about incentives, one helpful illustration is to show that sometimes it is cheaper to make mistakes than to be right. This is true whenever the costs associated with being wrong a certain fraction of the time are expected to be low compared to the costs of avoiding such mistakes (although these expectations themselves may prove incorrect). Examples run the gamut from dating ("you've got to kiss a lot of frogs before you find your prince") to exams (you don’t generally want to incur the costs to get every problem on an exam correct, because you can miss some and still get an A) to buying "off brands" when shopping (where you trade off lower prices for greater risks of unsatisfactory product performance). 19. A good way to get students to see that incentives matter is in terms of gold-wired or copper-wired electric motors. Gold is a better conductor of electricity, so that it is more efficient from an engineering perspective, but since gold is so much more expensive than copper, copper is typically more economically efficient for wiring, which is why copper is typically used for that purpose. However, there are cases, such as in satellites, where gold wiring is used to conserve on even scarcer orbital lift capacity (to carry the necessary power source or solar power collection devices). 20. One way of introducing the issue of specialization and exchange vs. self sufficiency is to ask students why people are always portrayed as being so self-sufficient in Westerns, then lead them to see that the reason was that when the cost of trading (particularly transportation) was very high, the cost of trading outweighed the gains from specialization. However, when the costs of trading become lower, increasing specialization and trade is the result. 21. A useful connection between property rights and specialization and trade can by made by asking students whether there would be any bicycles produced if someone owned a bike only as long as he or she was sitting on it. Bicycle production would stop because no one would be willing to pay the cost of producing a bicycle for the benefit of just one ride. 22. An interesting ethics question can be used in class as an example of specialization and exchange, by asking why students aren’t allowed to buy papers. The reason is that the point of education is more that of teaching the process of how to do something than the final product, per se. Buying a paper allows students to “produce” a paper without learning anything, which is the real purpose of writing papers (where the final product is used to judge the extent of learning). If all that mattered was the final product (say, a paper), and who did it and how were unimportant (as is typical in most market purchases of goods and services), then purchasing a paper would be fine. 23. A good analogy to the importance of the price mechanism as a form of communication is foreign travel, where one does not speak the language of the country. Ask if any of the students have ever traveled in a country where they did not speak the language. Ask one of those who have how well they found out what they wanted to know and how well they did at achieving their objectives as a result. For most, the honest answer is not so well. For those who insist they did just fine, ask them how often it was because foreigners knew English, and how often it was because prices were clearly indicated in those countries. 24. Since most students have heard that market systems built on private property rights are based on the selfishness of people, it is often interesting to ask students whether market systems are based on people’s selfishness or on protecting people from others’ selfishness. They will tend to answer “selfishness.” Then you can show that property rights, while they do allow you to do “selfish” things with your own property, also prevent others from selfishly using or abusing your property without your consent or without paying sufficient compensation to acquire your consent. Given that each of us is vastly outnumbered by “others,” property rights’ protections against others’ selfishness may well be its most important function.


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25. One way to get across the idea that our wants will always exceed our productive abilities is to imagine a genie who gives students a couple minutes to write down their wishes, which he then grants, with the proviso that they come back in 6 months. Would students discover new wishes in the meantime? If they did it again (and again…), would they continue to discover new wishes? If that answer is yes, we cannot produce our way out of scarcity. 26. Another good example of opportunity cost is the cost of going to a particular class meeting. For example, does it include the cost of driving to campus? (It depends—would they have driven even if they skipped that particular class) Does it include the cost of depreciation? (Yes, for mileage related depreciation; no, for time related depreciation—unless it is Dad’s car). Does it include one day’s worth of insurance? (No—you are on the hook for this anyway) Does it include gas? (Yes, if you are paying for it; no, if Dad is paying for it) 27. Choosing a major is a useful example of specialization and trade (including why, in markets systems, no one needs to force students to choose something they are relatively good at for career preparation) that students can easily identify with. Chapter 3: Scarcity, Tradeoffs, and Production Possibilities 1. You can show students that the prototypical “Ugly American,” who complains that “they don=t do it like back home” when they travel, is someone who fails to recognize that there isn’t a single right way (the way you are used to) to do something, but rather that the best way to do things in different circumstances changes due to different relative scarcities. For example, you don’t see nearly as many large cars where gasoline is far more expensive, streets are narrower and parking is much more difficult. 2. In talking about the economic questions all societies face, emphasize that the various answers are interdependent. For example, “what gets produced” is not independent of “who gets what,” because the “who gets what” answer determines the incentives facing producers. 3. The circular flow model is primarily designed to remind students that in the economy as a whole--the macroeconomy—“everything depends on everything else.” As a result, if you wish, you could use a more developed circular flow model to trace the many effects of a given change in one market on others, as well as identify some of the changes in other markets that would impact on any particular market. 4. It is often worth reinforcing the point that the production possibilities curve does not establish “the” efficient solution for an economy, which also depends on preferences. One way to do it is draw a production possibilities curve with meat and vegetables on the axes, and ask students where the efficient output combination is. Students will typically pick a point other than the extremes (reflecting the fact that most do not just consume one thing). Then ask them what difference it makes if it is a society of vegetarians, to get them to see that such different preferences would lead to different efficient results. You can also do this with guns (or cruise missiles) and butter (or Big Macs) in a world of military “hawks” versus one of military “doves.” 5. You can introduce issues of institutional reform and how it can shift the effective production possibilities curve of a society by giving examples of how rulers can benefit themselves in ways that reduce total societal output (e.g., the selling of monopoly privileges), then asking students both whether they can think of other examples of such policies (e.g., protectionist policies) and what would happen to potential output in such a society if those inefficient policies were ended. 6. A useful way to liven up the consumption versus investment production possibilities curve discussion is to talk about the productive possibilities curve between human capital investment and entertainment (consumption) at your university. You can also use this to make disparaging remarks about the choices offered or made at rival schools. 7. It is probably worth reinforcing the point that even though higher rates of investment can make an


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economy’s production possibilities curve shift outward at a faster rate, it will take a smaller economy quite a long time to “catch up” to a larger economy with a slower growth rate. This can be used to discuss why the young have far more of an interest in increasing growth rates (a larger cumulative effect on them than on older generations) as well as why faster growth high investment policies often lead to unrest in countries when results do not improve as fast as rising expectations. 8. Emphasize to students that when we talk about inefficiently unemployed resources, we don’t take complete and continuous use of every resource as the standard. For instance, most farm equipment is idle at night (because the added cost of lighting the farms and hiring agricultural workers outweighs the benefit of making better use of farm equipment). Similarly, it may be efficient for university classrooms to be empty (unemployed) at midnight, and bathrooms and kitchens not to be in continuous use. Another example would be how the falling opportunity cost of computers has made it efficient to increase the proportion of “unemployed” computer time (computers not being used all the time) to save even more on other costs. 9. Since this chapter is the one that emphasizes efficiency issues, it is helpful to student comprehension to show them that the (first part of the) right answer to any efficiency question is "it depends," but that the crucial analytical questions pertain to what it depends on and how importantly it depends on each of the determinants of the answer. For example, you can show students that the most efficient car for a given decisionmaker to drive (and it is important to emphasize that the answer varies with the decisionmaker and the situation faced) depends on a huge number of variables, including age, height, driving record, distance traveled to work, insurance costs, whether one is married, whether one has children, attitudes toward risk, etc. Similarly the most efficient grade to get in a course depends on major, difficulty of grading, difficulty of the material, whether you will see the same instructor again, whether you are on academic probation, whether you are an intercollegiate athlete in season, etc. There are many ways in which this message can be communicated to students, but showing them a real world discussion of what the efficient choice depends on is crucial to them understanding this point. 10. Another way to make the point that the most efficient way to produce varies with circumstances is to compare different countries. For example, fireplaces were once used to heat homes in the U.S. at the same time that most U.K. homes were heated with stoves. This didn’t reflect inefficiency or backwardness in the U.S., but rather a situation where wood was less scarce relative to labor (to cut up wood into smaller pieces to put into stoves). Any international travel illustrations you have personally observed, or that you can get your students to share, would also help make for a lively discussion (e.g., differences in allowable freeway speeds can make the Autobahn in Germany a faster way to “produce” a trip between major cities, where the same distance trip in the U.S. would be faster by plane). 11. There are several examples of seemingly inefficient behavior that students would recognize which can be used to make efficiency issues clearer to them. They include such things as students taking textbooks home for the holidays when they often don’t read them (which looks like incurring the cost of taking books back and forth for no benefit, but can be seen as efficient insurance against Mom imposing on you to help clean the house or go to a family get-together you would rather avoid); senioritis (which can be viewed as an efficient response to “end of period” incentives students face as the end of their senior year approaches); procrastination (which, by making it obvious you couldn’t possibly handle anything more, reduces how much work you have to do by imposing it on others); strategic inefficiency (being obviously incompetent at some task, like doing laundry, as a way to avoid being required to do it); etc. 12. Another good classroom example of efficiency (and a tie to the later discussion of the search cost rationale for frictional unemployment) is to suggest to students that it might be more efficient to fall in love at college than once you are working at a job, for several reasons, including: 1) Being poor while in school is not considered a predictor of future success, while being poor when working is an indicator of lack of success, so cheap dates (low cost search) may be acceptable only while in school; 2) there is a larger supply of unmarried prospective partners at school than at most jobs; 3) some information about prospective partners may be more readily available at school than at work (e.g., how do they handle--and


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look under--the stress of final exams, do they cheat, etc.). 13. It can be worth expanding the labor as human capital discussion to show that investment principles apply to education (how much education to get, which major to choose, how hard to work, etc.), just as to other investments. This can increase student interest and cement their understanding of the issues. 14. A tradeoff example related to the tourism application in the text would be the decision about whether to continue to allow people to take their cars to and around the Grand Canyon (because of the added pollution) or to force people to park somewhere away from it and go by less polluting buses. Chapter 4: Supply And Demand 1. A close-to-home example of a market about which students may have strong negative feelings is the used book buyback market, where the bookstore acts as a middleman between past textbook users and future textbook users. Point out that while students routinely complain that they get ripped off by the low prices paid for their used books, if they choose to sell back to the bookstore, it means that they believe doing so is a better deal than incurring the transactions cost of selling their old books themselves. What they are really complaining about is that they wish they had better options, not that the bookstore makes them worse off than their alternatives. 2. A good illustration of a relatively unorganized market (to contrast with highly organized exchanges) is the market for babysitting services. The good in question and the terms of trade are not standardized, information is limited, good babysitters soon find other more lucrative market alternatives or attractive entertainment possibilities (often about when they get their driver=s licenses), etc. 3. Note that less organized markets (e.g., garage sales) will have higher search costs, and therefore a higher variation in the terms of trade, than more highly organized markets. 4. Discussing whether grades are subject to the law of demand (students are willing to “buy” fewer As the higher the “price” in terms of effort) is a good way to emphasize the generality of law of demand to areas students wouldn’t have thought of as “economic.” 5. Using the example of water as something people “need,” but in fact has a large number of substitutes for most uses (though the substitutes are not sought for or utilized when water is so cheap that it is less costly to “waste” it than to conserve it) is a good way to drive home point that there are substitutes for everything, and that relative prices are the key to which alternatives are chosen. Ask students how they would expect Saudi Arabia (where water is more expensive than gasoline) or other desert area to differ from the U.S. in this area. 6. One way to get students to illustrate the difference between “need” and willingness to pay, as reflected in demand curves, is to ask them about the context in which they hear the word need used in conversations. Whether it is we need new freeways, I need an A, etc., the typical meaning is really "I want, but shouldn’t be forced to bear the cost of," because someone willing to bear the cost would do so rather than complaining that they needed it. 7. One example some students bring up as an alleged exception to the law of demand is the case of prestige goods, where a person may buy more at a higher price. However, rather than refuting the law of demand, show them that this actually reinforces the law of demand. Those few who buy more at a higher price because a good then has more prestige are really buying more because others follow the law of demand--since others buy less at higher prices, there is more prestige and exclusivity from buying at a higher price. If the law of demand did not hold, there would be no more prestige to be had at a higher price than at a lower price and those seeking prestige would not buy more at a higher price. 8. Include a few examples of the need to adjust for inflation, in order to focus on real, inflation-adjusted prices as the relevant prices for supply and demand analysis.


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9. A good illustration of the difference between a change in demand and a change in quantity demanded is to ask students: “Which is a better way to increase demand for drinks during happy hour--lowering the price of drinks or giving away free food to go with the drinks.” Some will typically answer lowering the price of drinks, which allows you to remind them that a reduction in price of drinks will increase the quantity of drinks demanded, but it will not increase the demand for drinks. In contrast, giving away complementary food will increase the demand for drinks. 10. I have found it useful to illustrate the various demand shifters by using an extended supply and demand story involving a single good, say, coffee. You first get students to understand the particular story involved and then you can help them generalize by asking “What part of the coffee story is this situation the same as?” You can talk about shifts when tea (a substitute) or creamer of doughnuts (complements) change in price; whether you drink more (it is a normal good because you really like coffee and you would buy more if your income constraint was eased) or less (it is inferior, because when you are poorer, you work longer hours and drink more coffee to stay awake) when your income increases; what happens to current purchases and consumption when the expected future price rises or falls; the effects of advertising on tastes; and similarly for the supply side. 11. Remind students to beware of generalizing from their own situations to general market behavior. For instance, I might not buy more hot dogs at a slightly lower price, but some people will; mustard is not a substitute for catsup for me, because I happen to dislike mustard, but they are substitutes for some people; creamer or sweetener may not be complements for coffee for me, but they are for some. 12. One offbeat illustration of complementary goods is to think of love as complementary neuroses. If people fall in love with those who complement them, then wouldn’t the same be true of their neuroses? For instance, a “macho man” who wanted to be in control would tend to fall in love with someone who was overly dependent, while a domineering woman would tend to fall in love with a man who liked to be mothered. As an extension, you could ask your class what will happen when someone either acquires a new neurosis or is cured of an existing one. Since the partners’ neuroses have become less complementary, there is a risk that they will fall out of love (and say things like “I changed but he or she didn’t) 13. Remember to make the point that complementarities between goods need not be equally strong both ways. It is easier for people to drink beer at a bar without eating peanuts than it is to eat peanuts at a bar without drinking beer, which is why they don’t charge for the peanuts and give the beer away. 14. There are many inferior goods examples that can be humorous to use in class. For instance, you could ask students how many really want to go to work by going around to pick up 40 strangers of uncertain hygiene to share the ride, to illustrate why public transportation tends to be an inferior good (and you can extend that example to why mass transit systems often lose increasing amounts of money over time as real incomes rise); you could talk about dog food for human consumption; or you could discuss taking store brand beer or a box of wine as a gift for a host at a party (just imagine how impressed the host will be), which can be extended to discuss the marketing of alcohol during the Christmas season (which often consists largely of dressing up the presentation to make the product look more expensive than it really is). 15. Remind students that a good can be normal over some income ranges (e.g., the high quality, Velveeta macaroni and cheese instead of the store brand or the bus instead of walking when you are really poor) and inferior over other income ranges (e.g., meat instead of Velveeta macaroni and cheese and your own car instead of mass transit over higher income ranges) 16. A good example of the role of price expectations is to ask students why stores so often announce that sales involve quantities that are limited or that sales will soon end (you’d better get it soon before we run out and prices go up--which would tend to shift the current demand curve to the right), but typically fail to inform you that a sale on the item you are considering will soon begin (which would tend to shift the


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current demand curve to the left). 17. Because most university students are far more experienced with the demand side of markets than with the supply side, it is worth emphasizing that the law of supply has the same logic as the law of demand, except that price is on the E(MB) side of the rule of rational choice, instead of on the E(MC) side 18. Remind students that suppliers need not be producers in all cases. People who would be consumers at lower prices can choose to supply goods from their existing stocks at higher prices, even if they are not producers of the goods. 19. Some students may think that the law of supply is refuted by those who work in professions where they make less than they could elsewhere with their skills, such as many teachers. However, we need to make sure students realize such examples are really violations of the “other things equal” assumption behind the supply curve. Many people are willing to give up income for other aspects of a job, such as the feeling that you are contributing something important. But that does not violate the law of supply, because the higher are teachers’ salaries, the smaller the penalty for becoming a teacher, and the more people who will be willing to teach. 20. Students are so used to technological advances shifting supply to the right, they may think of that as the only possible case. It is worth reminding them that technological changes can also reduce supply. Two such examples are the ban on DDT on the supply of agricultural products and the ban on the refrigerant used most commonly in refrigeration and air conditioning units. 21. Remind students that the price expectations shifts of supply are in the opposite direction from the price expectations shifts of demand. An expected increase in the future price increases current demand (it is expected to be cheaper to buy now than to buy later) but decreases current supply (it is expected to be more valuable to sell later than now). This can be reinforced by going through examples where both suppliers and demanders expect higher prices and one where suppliers expect higher prices in the future while demanders expect lower prices in the future. 22. One way to help students understand how taxes affect supply is to get them to think of a tax as an input called “government permission to produce and sell.” The more this input costs, just like other inputs entrepreneurs must bear, the higher the cost of production to the supplier and supply is reduced (shifted left). 23. This chapter begins to throw many new technical economics terms at students, making it a good time to emphasize that economics, like every other scientific field, has a specialized language, because certain forms of precision are crucial to the proper application of the principles involved (e.g., changes in demand versus changes in quantity demanded). It is necessary for students to understand this specialized language, so they can understand the necessary analytical distinctions, but they also need to be able to explain what they mean in non-specialized language if they really are to understand (e.g., can they explain their analysis to a plumber?). An analogy to psychology would be to Freud’s analysis in terms of the id, the ego, and the superego. Chapter 5: Bringing Supply and Demand Together 1. Reinforce to students that while the actual details and speed with which markets adjust may vary (e.g. organized exchanges with price adjusting almost instantaneously, compared with less organized markets such as the retail furniture market, where adjustment is slower and other variables than prices, like quality, financing or delivery terms, may often be the variables changed), in all cases it is the frustrated plans of either buyers or sellers unable to transact as much as they would like at present prices that is the incentive that leads markets toward equilibrium--the key is whose plans to transact (to buy or to sell as much as they would like) are frustrated at the current price.


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2. An often helpful analogy to help students understand the process of adjusting toward equilibrium and the role of comparative static equilibria in understanding the market process is to a marble in a perfectly round-bottomed bowl. A marble placed at the exact bottom of the bowl with no momentum will tend to stay there because there is no force pulling it away; placed anywhere else, there will be a force (gravity) pulling it back toward the bottom. In market systems, the force that replaces gravity is the frustration of transactors unable to trade at current prices: Frustrated buyers at below equilibrium prices have incentives to offer sellers a better deal as a way to be able to trade, and the converse is true for sellers at above equilibrium prices. Just as with the marble in the bowl, however, adjustment is not instantaneous, there may be some overshooting, and predicting the actual dynamic movements over time is far more difficult than comparisons of static equilibria. 3. There are several good ways to illustrate the invisible hand of the market. A discussion of “I, Pencil,” which shows that nobody on earth knows every aspect of what it takes to make a product even as apparently simple as a pencil is one. Another is to get students to discuss the question: “How many people are involved in feeding or clothing you?” 4. It is worth emphasizing to students that predicting the actual adjustment path in a particular market in response to a particular change is far more difficult than the stylized results of our standard comparative statics models, as it involves many more variables and all sorts of dynamic issues. The comparative statics models are only a starting point for discussing such issues, not the final word. 5. It is important to emphasize to students that supply and demand is not just a large set of diagrams to memorize and keep straight. Students who view it that way will have a difficult time, as those diagrams get quite a workout in principles courses. Get students to see it as an organized way--a filing system--of keeping track of the large number of opportunity cost or incentive stories that are important determinants of real world behavior. Show them that demand and supply curves represent different incentive stories; that each of the supply and demand shifters represents a different class of incentive stories (whose names--substitutes, complements, normal and inferior goods, etc.--help describe the relationships involved); that the determinants of the various elasticities are incentive stories involving the cost of changing behavior; that the reason markets tend to move toward equilibrium is another incentive story; that the effects of price controls are the incentive stories that arise when markets are prevented from moving toward the equilibrium price; etc. And these separate stories can then be connected to tell more extended incentive stories that we couldn’t keep consistently straight without the help of our filing system to break down complex stories into smaller parts. 6. While the book focuses primarily on the price and output results of the various supply and demand cases, the stage is set for professors who want to extend the discussion to begin introducing what happens to total revenue, profits, employment and unemployment, etc., in the industry in question (and extend the logic to that of aggregate supply and demand for the economy as a whole). You can also set the stage for a discussion of the elasticity of demand’s total revenue effects as you move along a demand curve by showing that more information is needed before you know what will happen to total revenue when a supply curve shifts. 7. It is important to remind students that the analytical and predictive power of supply and demand (and elasticity extensions) is not just in its ability to predict what will happen in a particular market when a supply or demand shifter changes. That is just the first step in a chain of logical relationships that can stretch from what happens in the initial market, following the connections of the supply and demand shifters to understand what happens in the markets for substitutes, substitutes of substitutes, complements, inputs, etc., as well. One good way to do this is with Hayek’s tin example in “The Use of Knowledge in Society.” 8. An excellent place to find good classroom material about the interrelationships among markets is the commentary in the Wall Street Journal “Commodities” section. You can often see discussed there how a change in price in one market affected the costs of another, which changed that price, which changed the demand for something else, etc. I tell students they should be able to see how a increase in the tastes


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for leather will affect the profits of chicken producers, as an example (it increases the demand for cattle, which increases the supply of beef, which decreases the price of beef, which shifts the demand for chicken to the left, which reduces the price, sales and profits of chicken producers). 9. Emphasize to students that when supply and demand both shift, we “add up” the direction of effects for prices and quantities, where the direction of change of one variable will be known and the direction of change of the other variable depending on the relative magnitudes of the supply and demand curve shifts. This helps them to see that the way economists use their tools is to break down complex incentive stories into a series of simpler incentive stories, so that we can arrive at consistently correct conclusions. One way to illustrate this in class is to pick a student, make them the employment manager of a dress shop, tell them that dressmakers wages are rising (reducing supply) and that a competing shop three blocks away just went out of business (increasing demand), then ask him whether he should be trying to hire more or fewer workers. You can show how such choices are judgment calls about the relative sizes of two different shifters. 10. A good supply and demand application is why exports tend to be predominantly higher quality variants of products--the transportation costs add relatively less to the cost of a more expensive product than a less expensive product, making the more expensive variant relatively cheaper export markets than “at home” (You might extend this to asking whether the best Florida orange juice, Washington apples, Belgian chocolate, etc. is sold, as well as produced, in Florida, Washington, or Belgium, respectively). 11. Since American college students have had limited experience with the effects of price ceilings and floors, a useful way to help them through the analysis is to use a series of guided questions using a familiar good (I like to use bread), that once it is asked, students can reason to (or be led to reason to) the correct answers. By asking the right questions (which I insist to students is the primary skill of economists), students can see what happens to the quantity traded (progressively over time), the opportunity cost of acquiring the good, the quality of the good, the extent of discrimination, the incentives toward the creation of black markets and other ways around the controls (like barter and vertical integration), the costs of enforcement and evasion, etc. Once they are comfortable with the analysis of price ceilings and floors in this particular market, the results can be generalized to other markets and examples as well. 12. Especially at state universities, you can show that many of students’ frustrations can be viewed as the result of a price ceiling--tuition is set below the equilibrium level. That is why many courses aren’t offered as frequently as they wish, why they often cannot get into more popular classes, why they often cannot get the class times they prefer, etc. 13. Use the rock concert scalper illustration to emphasize how hard it is to successfully underprice goods on purpose, because the arbitrage profits created by such an attempt lead others to undermine such a strategy. 14. It is an interesting twist on the rent control discussion to add that maximum rent control can also be viewed as a maximum income or wage for landlord. Then ask students whether the argument for a wage floor for low skill workers (the minimum wage) is consistent with wage ceilings (rent controls) for small landlords. 15. Make sure students see that the minimum wage is not the only example of a price floor. For instance, show them that many of the effects of union wages (discussed later in the text) and the DavisBacon prevailing wage law are similar. 16. Make sure students recognize that price floors and price ceilings have the exact opposite effects in some areas (e.g., quality, who is frustrated at the current price, who becomes more likely to discriminate) and the same effects in others (e.g., the quantity traded, the opportunity cost of purchases (including search costs), an increasing extent of discrimination, attempts to evade the law, etc.).


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17. Remind students that in the case of price ceilings, price and opportunity cost (including search costs) move in opposite directions, so that when price falls as a result of a price ceiling, the demand for complements falls and the demand for substitutes rises (both of which are the opposite of when the equilibrium price falls). 18. Note that the increased search costs which raise the opportunity costs of finding rental housing under rent control are not borne by those who are already renters in that location (who are the ones who get to vote on rent control), but only by those who will try to find rental housing afterward. This can explain why rent control is more politically popular in majority rental communities and why it is more popular than other price ceilings (where everyone would face some of the adverse consequences of price ceilings). 19. Emphasize to students that the effects of price floors when the government buys up the surplus (like traditional agricultural price supports), which is that of an increase in demand facing sellers (both price and sales, including government purchases, rise, increasing profits, with no sellers frustrated by their inability to sell), are very different than price floors when the government does not buy up the surplus (like for minimum wages). 20. When finished with the material through chapter 5, you may find it useful to give students (in addition to emphasizing the need to practice the many problems in the study guide) what I call a brief supply and demand question sampler, which shows them some of the major kinds of questions they should be able to answer at this point. One version if this is given here: a) Which of the following will shift demand (supply) right? The answer would have to be a change in one of the demand (supply) curve shifters that shifts it to the right [Any of higher prices of substitutes, lower prices of complements, higher incomes for normal goods, lower incomes for inferior goods, consumer expectations of higher prices in the future, increases in tastes (preferences), or increases in the number of buyers would increase demand; any of lower input prices, technological advances, decreased prices of productive substitutes, increased prices of productive complements, or producer expectations of lower future prices would increase supply]. This question of which curve shifts which way is also the first step in answering questions about which of the following will in(de)crease price, quantity, employment, unemployment, total revenue, profits, etc. b) Which of the following would in(de)crease price but de(in)crease the equilibrium quantity traded? The answer would have to be something that would de(in)crease supply, because only that would result in the price and quantity changes given. Alternatively, any question involving both price and quantity moving in the same direction would have to be caused by a shift in demand (an in(de)crease in demand would in(de)crease both price and quantity. c) If A and B are substitutes, a reduced price of A would do what in the B market? A reduced price of A would shift the demand for B to the left, resulting in lower price, lower quantity, lower employment, higher unemployment, lower total revenues, lower profits, and eventual exit/contraction in the B industry. The same sort of questions could be started with changes in the market for complements, income, etc. on the demand side, or input prices, technology changes, etc. on the supply side. d) A decrease in both supply and demand would have what result? Both effects would reduce the equilibrium quantity traded, but effects on price (and therefore total revenue) are ambiguous, unless you know which shift was of greater magnitude (the effects of the larger shift will dominate the net result). Remember, in any question where both curves shift, you simply add up the effects the each shift would cause alone, where one variable will always be determinate, but the other will be indeterminate unless you know about the relative magnitude of the shifts. e) What would happen if a major existing source of tin was to disappear? There are a huge number of questions that could be asked from this information: 1) Since the supply of tin was reduced, we know that the results in the tin market will be those of a


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decrease in supply. 2) Since tin will be more costly, we know that the supply curve for goods that have tin as an input will also decrease, with all the results that follow. 3) Since tin will be more costly, the demand for substitutes for tin will increase, with all the results that follow. 4) Since tin will be more costly, the demand for complements of tin will decrease, with all the results that follow. 5) In any situation where the total revenue of producers can be determined, so can the direction the demand curves for normal and inferior goods shift in areas specialized to producing that good (total revenue of producers is also total income). f) Which of the following would increase total revenue of X producers? The answer could be any of three cases: 1) An increase in demand. 2) An increase in supply (lower price), if demand is elastic. 3) A decrease in supply (higher price), if demand is inelastic. The cases for decreases in total revenue are symmetric. A change in demand always gives an unambiguous change in total revenue as the market moves along its supply curve, but a change in supply or any other case where you are moving along a demand curve requires that you know the elasticity of demand before you know the change in total revenue. Knowing what happens to total revenue is also the first step in determining what happens to profits. Chapter 6: Elasticities 1. It is worth emphasizing to students that elasticities are just extensions of supply and demand analysis to "how far" types of questions (if you want to know how much price and quantity change rather than just in which direction, or which direction total revenues move when price and quantity move in opposite directions). 2. Emphasize that the intuition behind the elasticities of supply and demand is that of the cost of changing behavior. The more costly it is for demanders (say, because there are few good substitutes for a good) or suppliers (say, because of limited time to adjust) to change their behavior, the less a given change in incentives will change their behavior, which we describe as a smaller elasticity. 3. As a setup for the coming chapter on perfect competition (as well as the section on the difficulties of maintaining collusive agreements against cheating), ask students why the elasticity of demand for the output of one farmer can be very high (there are a large number of good substitutes--the similar crops of the large number of other farmers), even if the elasticity of the market demand curve for that crop is relatively low (there may be few good substitutes for the crop). 4. A good class discussion topic involving elasticity issues is that for years, the U.S. has tried multiple subsidy programs to increase college attendance by low income students. If the elasticity of demand for college education is low among these groups, ask students how successful they think such programs have been (not very). Extend the discussion to ask why students think that elasticity might be low, and point out that one possible reason is the fact that financial aid does not cover the opportunity cost of the time students could have been working. This discussion can then be extended to help students see that how successful any subsidy programs (e.g., road building subsidies) are at increasing outputs depends on the elasticity of demand for the relevant good. 5. As an elasticity application, ask students why the elasticity of demand facing hospitals for baby deliveries, which traditional insurance covered 80% of, is likely to be low. Show students that a $100 reduction in the hospital=s price would only lower the price to a patient by $20, and so would be likely to have a small effect in increasing the quantity demanded. This can then be extended to other illustrations of how insurance can change the elasticity of demand for goods and services (such as why plastic surgery, not usually covered by insurance, may have a more elastic demand than most medical services


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covered by insurance). 6. A good way to check on student understanding of the connection between the elasticity of demand and total revenue is to present an argument between two partners in a business, where the first partner argues that they need to raise their price to increase their revenues, while the second argues for a price reduction for the same reason--to increase total revenue, then ask students what each of the partners is arguing about the elasticity of demand for their product. 7. Why good elasticity of demand illustration is why a college might want to increase regular session tuition (inelastic demand during the regular school year, because of few good substitutes, especially for existing students), but decrease tuition during the summer (more elastic demand, because of more good substitutes). Further, one can discuss how discounted summer tuition can be disguised (e.g., as reduced room and board charges) to reduce complaints from regular term students. 8. Give students additional examples of lower prices for more elastic demanders. For instance, lower prices per ounce for 2-liter bottles than cans (because it implies you drink more soda, which would otherwise go flat), making it a larger part of your budget, and likely making the demand for 2-liter bottles of soda more elastic, resulting in a lower price per ounce) and overnight stays on a Saturday as a requirement for lower airline ticket prices, as a way to give more elastic demand vacation travelers lower prices than business travelers. 9. As a test of student knowledge, a good in class question to ask is: “Suppose the government of the District of Columbia reasoned that because the demand for gasoline is relatively inelastic, they could raise a substantial amount of extra tax revenue by imposing a city tax on retail gasoline sales. Do you think their reasoning is accurate?” Then you can get students to see that while the elasticity of demand for retail gasoline may be low, there are so many good substitutes for gasoline in Washington, D.C. (gasoline in Maryland and Virginia, whose borders are very close) that the elasticity of demand for retail gasoline in Washington, D.C., may be very high, and a city tax on gasoline would be a poor way to raise added tax revenue. 10. One way to reinforce the fact that linear demand curves have different elasticities at different ends is the commonsense observation that the average price is higher (making the percentage change in price lower) and the average quantity demanded is lower (making the percentage change in quantity higher) near the top than near the bottom. 11. Reinforce student understanding of cross and income elasticities as just extensions of what they already know. They already know what it means to be a substitute or a complement, but the cross elasticity of demand allows them to know how strong the relationship is. Similarly, they already know what normal and inferior goods are, but the income elasticity of demand allows them to know how strong the relationship is. 12. A good in-class checkup question to test for student confusion about the various elasticities is to ask why a change in total revenue does not depend on the elasticity of supply when demand changes (since both price and quantity exchanged change in the same direction in that case, so does total revenue), while the change in total revenue does depend on the elasticity of demand when supply changes (since price and quantity exchanged change in opposite directions in that case, the direction their product--total revenue--changes depends on the relative magnitudes of those changesBthat is, on the elasticity of demand. 13. It is often worth making a point to students than non-economists routinely underestimate the power of market mechanisms (that is, the magnitudes of the relevant elasticities of supply and demand) because they don’t recognize the large number of margins of adjustment that exist for any good. E.g., there are lots of substitutes for water, but most people don’t recognize this because while water is cheap, no one has the incentive to discover or utilize those alternatives. Economists know that, given the incentive of a sharply changed price, people will typically (entrepreneurially) even find ways that no one anticipated in advance to economize in response.


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14. A good analogy to elasticity and tax incidence questions is to the game of dodge ball. The government throws the balls (taxes) because they want to hit the players (raise revenue, which can only come from someone in society), so they want to throw balls where they will successfully hit people, that is, where the people cannot dodge very well (inelastic suppliers or demanders). If people could dodge perfectly, there would be no point in throwing the balls. What fraction of the burden is borne by the each of the two groups, suppliers and demanders, in each case (incidence), is determined by who can most easily alter their behavior to dodge the tax (whichever group's behavioral responses are more elastic will be better able to dodge the tax, dumping a larger share of the burden on others). 15. Good extensions of the tax incidence analysis in the text include why the employer half of Social Security and Medicare taxes are actually largely, if not completely, borne by workers, and why property taxes on rental property are borne by owners (at least in the short run). 16. A good historical illustration of markets in action was the response to tax differences of Canadians crossing the border to the U.S. to buy Canadian blend cigarettes, which they then smuggled back into Canada, in response to taxes that could make buying a pack of Canadian cigarettes cost far more to buy in Canada than in the U.S., despite the added transportation and transactions costs. Several colorful attempts were documented, including smuggling by kayakers, cigarettes stuffed inside car doors, turkeys, etc. This can also be used to bring up discussion of the likely consequences of recent increases some states’ cigarette taxes. 17. An excellent application of tax analysis is to discuss the question of tax exporting. Showing students how state corporation taxes, corporate property taxes, hotel bed taxes, airport fees, other taxes deductible against federal tax liabilities, etc., involve the exportation of a portion of the local burden to others helps them to apply the "economic way of thinking" to their state and local government decisions. A further application would be to raise the question about whether taxes paid to lower level governments (presumably in exchange for valuable services) should be deductible at the federal level. 18. Remind students that both supply and demand elasticities are greater in the long run than in the short run for the same reason—the time it takes to discover new alternatives, make complementary changes, etc. Chapter 7: Market Efficiency and Welfare 1. Emphasize to students that lost consumer and producer surplus are not just of minor importance in considering efficiency issues. It is a large part of the efficiency rationale for opposing monopoly, collusion, price ceilings, price floors, tariffs, quotas and other international trade restrictions, inefficient regulations and market failures from ignoring external benefits, all of which reduce the extent of mutually beneficial trade and reduce total consumer and producer surplus as a result. 2. As a consumer surplus example, you might talk about the value to society of property rights, laws, stable monetary values, etc., that lower transactions costs and allow more mutually beneficial transactions to take place by better exploiting comparative advantage and specialization. 3. Make sure you emphasize the parallels between consumer surplus and producer surplus, so that students understand that the underlying logic is the same; it is just applied to different market participants. 4. To show students the importance of correctly understanding incidence analysis as well as the political incentives involved in tax policy, it is often worth discussing why there are so many hidden taxes, designed to burden people without them being very aware of government as the source of that burden (the squawk minimization principle). Examples include the employer half of Social Security taxes, corporate income taxes, mandated benefits for employers, etc. Further illustrations with sometimes surprising results to students are the actual incidence of tax free municipal bonds on interest rates and that of the employer half of Social Security taxes on wages.


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5. Reiterate to students that as the elasticity of supply and/or demand gets greater, the “good” effect of a tax--the tax revenue raised by the government--gets smaller and the bad effect--the welfare cost--gets larger. 6. It is worth noting to students that anything that reduces the quantity traded below the supply and demand equilibrium causes a welfare cost. That is why the welfare cost analysis of price controls is the same as that for taxation. The same will be true of monopoly and collusion, as well. 7. Make sure students see that the tax incidence analysis can be used to evaluate the effects of regulations (e.g., costly environmental controls) and restrictions that change the costs faced by sellers. 8. If you want to challenge your students, you could go beyond the welfare cost analysis in the book, and show students that the marginal welfare cost of taxation rises much faster than the cumulative marginal tax rate. This is why, the larger the government is now, and hence the higher the already existing tax rates, the more costly it is to society for the government to raise the revenue to finance additional expenditures. Chapter 8: Market Failure 1. Dorm noise rules, much like nighttime noise rules in residential neighborhoods, are good (and familiar to students) illustrations of the issues involved in the attempt to deal with potential negative externalities. 2. Apartment damage deposits are a good illustration of using market contracts to prevent the costs of damage (external costs) from being imposed on the owners, by making the tenants “owners at the margin” (since they make renters bear the cost of additional damage that may be done, at least up to the amount of the damage deposit). A further extension is to ask students what would be likely to happen to the number of parties held when it becomes apparent that particular renters will not get any of their damage deposit back. 3. Catalytic converters can be used as an example of regulation trying to deal with the free rider problem. When they were originally offered, they were options that few people purchased. (why bear the cost to clean up someone else’s air?) Making them mandatory overcame the free rider problem (“I won’t clean up my own pollution”) in this case. 4. An interesting class discussion can be raised when talking about the external benefit argument for subsidized education. Ask students how large the tuition subsidy should be (to get them to separate the issue of their self interest from that of the efficient solution of equating the size of the subsidy to the marginal external benefits). Then ask whether efficiency would indicate that the subsidy should vary by major, classes or grades earned (Yes, if the marginal external benefits are different). You can also extend the discussion further by bringing up the possibility that added education may also impose external costs on society (say, by training smarter burglars and robbers). 5. It can be a useful class exercise to ask students what efficiency would require in dealing with an industry that produced both external benefits and costs. Would that imply the industry should be subsidized or taxed? Get them to see that the answer depends on the relative magnitudes of the externalities, as well as on income distribution considerations. 6. It is important to make clear to students that the textbook’s discussion of solutions to externality problems are attempts to mimic what a competitive private market would have generated if the property rights in question were clearly defined and enforced. (i.e., a tax equal to the marginal external costs of some form of pollution would be the competitive price necessary to purchase the agreement of those whose air or water would be polluted, if those rights were privately owned and traded with minimal transactions costs)


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7. This is a good chapter to give students additional examples of unintended consequences (e.g., child proof caps that actually increased accidental poisonings, because arthritis sufferers couldn’t open them either and left the caps off more frequently, or air bags that were made powerful enough for unbelted men, and as a result, killed some belted small women and children who might have otherwise survived accidents). 8. Moral codes and traditions can be used as illustrations of social means of coordinating expectations and overcoming potential free rider problems. (if some things “are just not done” in a society, it lowers the difficulty of predicting others’ behavior, and allows more effective social coordination) 9. A rich source of analogies that help students to understand the analysis of public goods and externalities, particularly the free rider problem, comes from roommate problems. Whether one considers the generally poor condition of common areas, problems of noise or taste pollution, the transactions costs incurred in trying to internalize externalities, the importance of the number of parties involved, etc., roommate illustrations can make the analytical points about market failures clearer. 10. The free rider problem can also be illustrated in a context very familiar to students by discussing the difficulties associated with group projects or assignments. 11. Cleaning house, doing laundry and other household chores can be used as examples of the analysis of trying to get public goods provided in a society. 12. A provocative question for classroom discussion is to ask whether the protection of property rights might be a public good (benefiting all through making possible the gains of market systems) that is underprovided by the government (because those rights are violated by the government to get the resources to fund redistributional programs). 13. In talking about choices and information costs, one helpful illustration is to show that sometimes it is cheaper to make mistakes than to be right. This is true whenever the costs associated with being wrong a certain fraction of the time are expected to be low compared to the costs of avoiding such mistakes (although these expectations themselves may prove incorrect). Examples run the gamut from dating ("you've got to kiss a lot of frogs before you find your prince") to exams (you don’t generally want to incur the costs to get every problem on an exam correct, because you can miss some and still get an A) to buying “off brands" or store brands when shopping (where you trade off lower prices for greater risks of unsatisfactory product performance). 14. A useful Illustration of some problems dealing with information is why rules exist against bypassing the real estate agent (by exchanging the house directly between the buyer and seller with no agent) who first connected a home buyer with a particular home seller. Once the agent has connected the buyer and seller, he or she has already provided most of their valuable services, but they would be unwilling to incur the costs of that information gathering work unless there was a mechanism to insure that they were paid for it through their commission on sales. 15. The issue of whether the government should use mandates or provide consumers more accurate information so that they can choose more wisely when consumer information might be too limited otherwise can be discussed in terms of the mandatory refrigerator and other appliance stickers revealing their energy efficiency, contrasted with some states’ bans on the sale of air conditioners or other appliances with less than a certain thermal efficiency. 16. A good illustration of who can solve an informational asymmetry at the lowest cost is car transmission warranties. The manufacturer accepts liability up to a certain period of time or number of miles, because they can determine far more cheaply than customers the quality of the transmission when the car is new. But over time, the way the car is driven has a greater effect on wear and tear and the quality of the transmission after a period of time or mileage, and since the driver knows that information better, he accepts the risk of transmission problems after the warranty expires.


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17. Another good example of asymmetric information and the lemon problem is that of online purchased or free research papers. The user has far less information than the provider about quality (having not done the research), and the quality is often very poor. Some sites now even provide the grade the paper received and some comments, but since these are self-provided by the person who turned in the paper, they are not very reliable indicators of quality. 18. A good example of moral hazard to use in class is a discussion of why there is no “lunch insurance.” Since students will tend to eat lunch whether they are insured or not, there would be no real insurance (risk or uncertainty reduction) involved. However, by lowering the marginal cost of added helpings or higher quality food, it would dramatically increase the cost of food eaten (the moral hazard problem once someone is insured). Chapter 9: Public Sector and Public Choice 1. Make sure that students recognize that government can be the source of market power (e.g., public schools, regulations, barriers to entry, etc.), as well as the protector of citizens, by thwarting private sector market power or lack of information. 2. It is important to emphasize in this chapter that public choice analysis has the same intuition as market analysis, but the ideas are harder to test because it is harder to define the dominant incentive stories in particular situations and to accurately measure the results than for market analysis. Similarly, analogies can be made to raising children, where behavior modification amounts to taxing unwanted behavior and subsidizing desired behavior, but precise quantification of the incentive structures is difficult. 3. A good illustration of public choice analysis is the government’s preference for hidden taxes (e.g., the employer half of Social Security and Medicare) as a way of minimizing opposition from rationally ignorant voters. 4. A useful public choice illustration of information differences between the public and private sectors is rational student ignorance (it is rational to be relatively more ignorant of things thought less likely to be on the test, since incentives to know them are less) as an analogy to rational voter ignorance. 5. The following can be a good way to illustrate how self interest works in both the market sector and the government. Pick a student and assert that he wants to get rich. Ask him whether getting richer through market trading will make others richer or poorer (the answer is “richer,” since trading is voluntary, except for cases of externalities). Then ask the same of trying to get rich through the government (the answer is “it depends,” since you could get rich by using government power to take from others involuntarily, but you could also do so by finding a better way to solve some market failure, which would benefit others). 6. Remind students that “fixing” a particular market failure or other problem with government funds means that another problem must be created somewhere else by the government’s need to tax others to acquire the necessary resources, creating welfare costs where the resources were drawn from. 7. An interesting class discussion starter is to ask how best to measure the size of government. Should you count the costs of taxes or the level of spending (when there is a deficit)? What about the cost of regulations? What about the welfare costs from the distortions caused by both taxation and subsidies? What about compliance costs? What about the costs of rent seeking? 8. A good illustration of public choice is how some people can claim Social Security is a regressive tax (as a tax alone, it is proportional up to a wage earnings cap, but zero beyond that cap), but when looked at as a program of both taxes and the present value of benefits it promises people in retirement (which treats low earning retirees far better relative to their “contributions”), it is actually progressive, treating higher income earners substantially worse than lower income earners.


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9. You could extend the Social Security example to point out that each time the system is expanded, it allows those near retirement to benefit without paying almost any of the cost, resulting in substantially increased redistribution from the young to the old. It also means that there is currently no fair way out of the current system, since the over-promises of the past ensure that every option must be seriously unfair to someone. 10. You may want to discuss the fact that “ability to pay” sounds great as a principle of taxation, but it is very difficult to apply. For instance, exactly how much more would a couple have than a single person to have the same ability to pay? What about people with children versus those without? What about families with teenagers versus families with preschoolers? What about those with large and unexpected medical bills? 11. With reference to the median voter discussion, you may want to note to students that “get out the vote” campaigns can be viewed as an attempt to change the identity of the median voter, thereby changing the median voter position. 12. You may want to talk about gerrymandering with regard to the median voter result. If you can create a district after you already know people’s political preferences, you can virtually guarantee party control of the district. 13. In discussing the median voter result, it is worth asking students what difference it would make if the median voter in an election paid no taxes or very little in taxes (e.g., the lowest 40% of income earners already pay net negative federal income taxes, once the effects of the refundable earned income tax credit is taken into account), and connect it to a discussion of tax progressivity. 14. It may be worth noting that the special interest effect not only explains why inefficient programs get created, it also explains why it is so hard to kill special interest programs once they are created (in fact, the creation of such a program will create a constituency to defend it). Further, if a program’s effects have been capitalized into some asset prices and those assets have since been sold (e.g., cab drivers in New York who bought their licenses after their quantity had already been restricted, capitalizing the value of the restriction in the sales price), there may be no fair way to undo it—those who gained are no longer the owners, so that costs imposed on current owners do not simply undo the effects of the initial creation of the program (giving rise to the quip that the only fair way to kill a special interest program is before it starts). Chapter 10: Consumer Choice Theory 1. Since this chapter emphasizes the application of the rule of rational choice (e.g., consumer equilibrium), it may be worth quickly reviewing the rule at the beginning of this chapter. 2. A good classroom example of diminishing marginal utility is how you feel after going out to an allyou-can-eat meal. You feel overstuffed, because you continued to eat as long as the marginal utility was positive, far more than you would usually eat (and since there is a bit of a time lag before what you eat makes you feel full, half an hour later, you may feel later that you ate until marginal utility was negative, and swear to never do it again). 3. It is worth going over additional examples of quantity discounts (beer illustrations--kegs versus cases versus 12-packs versus 6-packs--seem to catch students’ attention) to supplement the text’s example of pizza discount coupons (the second one is at a lower price or even free) as a reflection of diminishing marginal utility, to show how much behavior (especially price discrimination) is understandable with that simple concept. 4. As an extension of the text analysis, you can show students that you do not necessarily “save” the dollar amount of a quantity discount, in terms of being better off. Say you would buy only one unit of a


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good at $60, because you value a second one at less than $60 (say, $50, for example). If you got a quantity discount of 2 for $100 ($40 for the second unit instead of $60), you don’t really “save” the $20, as their advertising would claim, but the only the $10 difference between what you would have been willing to pay for that unit ($50 in our example) and the price of that unit ($40). 5. It is useful to do added numerical examples of consumer equilibrium to make sure students understand. One good way to get students involved in the process is to let different ones choose whatever numbers they want for the marginal utilities and prices of any two goods and ask them to explain how and why behavior would change, if those numbers were correct. They will then have to describe the process of moving toward consumer equilibrium, rather than you doing it for them (and if no one wants to participate, this is a good time to offer to pay the first successful volunteer a small sum of money for their answer). 6. One useful way to illustrate the logic in this chapter is to ask students what would have to be true about the price of a good for someone to want to maximize the total utility from consuming a good, and lead them to see that it would only make sense when the price was zero. At any positive price per unit, consumers would not want to maximize their total utility from consuming a good. However, if there was a large enough subsidy per unit of output to make the effective price negative, a consumer would consume beyond the point where marginal utility was zero. 7. Since this chapter often focuses on the equilibrium results in certain situations, it can be worth emphasizing that the primary analytical purpose of consumer equilibrium is not the equilibrium, but to show how predictable behavior will result when a self-interested person is out of equilibrium, which is what allows us to analyze changes in behavior when changes occur. Chapter 11: The Firm: Production and Costs 1. A good way to reinforce students’ understanding of the need to include the opportunity cost of all owned resources in determining economic profit is to ask them how to calculate the profit of a farmer who works for himself on his own land, using his own equipment and electricity generated by a windmill on his own property. If you failed to include the opportunity costs of all of those owned resources, your estimate of economic profit would be dramatically wrong, and you could even conclude that a farmer earning economic losses was actually earning substantial economic profits. 2. A good classroom illustration of implicit versus explicit costs is to ask students whether it is cheaper to drive on a freeway or a tollway, then guiding them to see that under some circumstances it could be cheaper to drive on a tollway when you include both the explicit toll and the difference in the opportunity cost of the time involved from the different levels of congestion. 3. To reinforce correct student application of opportunity cost, make sure students recognize that the lowest opportunity cost mode of travel is a function of the value of time. For some with very high time values, the fastest way is frequently the lowest cost way, even if the dollar price is very expensive. 4. Another good illustration of opportunity cost is to compare the opportunity cost of a draft (where the cost is largely borne by the draftee in below opportunity cost wages) versus the opportunity cost of an all volunteer army (borne largely by taxpayers). It can then be extended to illustrating why a drafted army might be noted for inefficiency (they are using artificially cheap--to the army, at least--labor). The same sort of issues can be raised about jury duty, which is another form of a draft. 5. Make sure students avoid a very common error, by recognizing that a firm could earn zero economic profits (earning a normal rate of return on a large investment), or even losses (earning a below-normal rate of return on a large investment), at the same time it is earning large accounting profits. 6. A good illustration of sunk costs is guilt. If someone feels guilty, and that guilt leads them to change their behavior, then the benefits of guilt may outweigh the costs. However, if someone just felt guilty


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about something in the past, but they didn’t change what they did in the present or future, they would just be committing the sunk cost fallacy. 7. A close to home illustration of sunk costs is the cost of a student attending or skipping class. Once the student or his or her parent has committed to pay tuition, the proportion of tuition represented by one class is sunk and no longer relevant to the cost of either attending or skipping a class. 8. Give students several examples of sunk costs (like the gambler’s fallacy: “I have to gamble some more to get my money back”) to make sure they realize that sunk costs are not really costs at all. 9. A useful example for discussing production functions, fixed and variable factors, etc., is to talk about production functions for grades in the course. You can talk about varying the proportions of different inputs (e.g., time in class versus time studying at home, study guides, tutors, etc.); about increasing and decreasing returns to the number of hours invested (at first, some work is required to “get it," but beyond some point the payoff to added studying starts to fall); about implicit costs (which TV show are you giving up to study this half hour?); etc. The question of how productively one studies can also be brought up. If you don’t study productively—don’t read first, don’t use study aids, skip class, etc.--you will “produce” less than you would studying more productively with the same effort. For further reinforcement, you may want to make up a numerical production function relating hours spent studying and the percentage score on a coming economics exam. 10. Emphasize to students that there are many different costs that are fixed over different periods of time, so that there can be several different short runs for different decisions. 11. Students sometimes claim that they studied more and got a lower grade (implying that they studied to the point where they had a negative marginal product) on an exam. Note that while, if correct, this would indeed mean they should study less, since their marginal product is negative, the result could be from other causes (other things may not be equal), such as too little sleep, a harder exam, classmates who worked harder for this exam, or too little preparation prior to the last minute cram. 12. Do more than one simple in-class illustration of the intuition of a production function. For example, in a factory with 100 machines, up to 100 workers, some workers will have to move between multiple machines; with 100 workers, each can work one; with more than 100 workers, you could expand up to 2 or 3 shifts of workers (deferring maintenance); beyond 300, some must share machines, even if there are 3 shifts of workers working each day. 13. Do a brief numerical illustration connecting marginal product and marginal cost to reinforce student understanding. Even something as simple as calculating marginal cost when the wage equals $10 an hour, and marginal product is first 20; then 30; then 10; can help some math-phobic students. 14. Make sure students understand the important graphical relations, as we will later presume students know them in using market models. Be sure to emphasize the verbal logic (intuition) of the concepts and illustrations as an anchor for understanding, otherwise students will memorize the definitions and the graphs, but be unable to understand well enough to apply the material to any real world situations. 15. Emphasize that the long run can best be thought of as dealing with a point in time prior to a firm being in an industry, as it does not yet face any fixed factors of production. For firms already in an industry, there is never a point in time when you have zero fixed costs. 16. The question of how many firms there would be in an industry and how large they would be should be related to whether there are economies of scale, diseconomies of scale, or constant returns to scale in the industry. 17. Food courts (rather than stand alone restaurants) in shopping malls are good, familiar examples of economies of scale.


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18. At one time in California, when they had just added large amounts of new electrical generating capacity, the electrical utility mounted a “live better electrically” campaign. Ask students what would happen to electricity rates if that campaign was phenomenally successful and electrical usage quickly grew, assuming there are large economies of scale in electricity generation. 19. A good historical illustration of economies of scale is when railroads dramatically lowered transportation costs, allowing much larger optimal production scales, and lower delivered prices, as large firms became able to outcompete higher cost, local producers from a single location. 20. Another good illustration of economies of scale is highway lanes. As you go from 1 to 2 lanes in each direction, the number of cars highways can carry per hour more than doubles (as passing is far easier). Beyond 2 lanes, there are added economies of scale if the additional lane sufficiently reduces congestion, but at some point, additional lanes appear to be subject to constant returns to scale. 21. Note that the long run average cost curve we are discussing does not consider such further questions as output variability, market growth rates, whether future changes in technology might make the current production facility obsolete, etc. Considerations of those issues are extensions that take long run average cost curves as a starting point. 22. If you use the appendix, it is worth doing several classroom examples of present value if that require students to use the table in the text. Chapter 12: Firms in Perfectly Competitive Markets 1. It is worth emphasizing at the beginning of this chapter that the forthcoming discussion will focus both on how the different market models of perfect competition, monopoly, monopolistic competition, and oligopoly are similar and how they are different or have different implications. 2. Emphasize that firms in pure competition are more than just price takers. They are market condition takers, where the various aspects of quality, service, etc., are also “given” from their perspective. 3. It is worthwhile to note to students how important market institutions are for understanding real world market behavior. Organized exchanges, which are designed to standardize all aspects of trading except the price and quickly clear the market (because traders have profit incentives to maximize the number of mutually beneficial trades that take place, for a given commission structure), may work differently in some of the details than less well organized markets (e.g., retail furniture stores)--say, by not clearing so quickly or by changing some other variable than the explicit price (e.g., a free footrest with each chair or a change in quality at a given price), which, for simplicity, we treat as equivalent to a change in price in the diagrammatics of the models--even if there are large numbers of participants in both cases. 4. It is crucial to communicate to students that the competitive model works well at the industry level (supply and demand implications) because there are large numbers of people searching to make all the mutually beneficial trades possible, where dollars represent generalized purchasing power (e.g., converting costs to sellers from waiting to paying dollars changes them into a form that benefits sellers, rather than being wasted from their perspective). It is this search that drives real world results toward the competitive (supply and demand) model implications. This is true even though the model may be descriptively and analytically inaccurate at the firm level in some ways (e.g., how many non-farmers can sell all they want at a given price without incurring added selling costs, but have no power over price or other terms of trade?). An excellent place to find examples of how real world markets correspond to competitive model results is in the "Commodities" section in The Wall Street Journal. 5. A good analogy to price taking in the competitive model is gambling in Las Vegas or at a horse racing track. A gambler must take the odds and rules of a casino or track as given, then try to do the best he can under those rules and the “prices” represented by the odds. 6. Emphasize how the perfectly competitive firm’s horizontal demand curve is consistent with a


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downward sloping industry demand curve. 7. Emphasize that while perfectly competitive firms are price takers, there is no implication that prices are stable. In such markets, the market clearing price changes with any change in the determinants of supply or demand. 8. A good example of firms as price takers is where the government establishes a price floor and buys up the surplus. Each firm is a price taker at the government support price. 9. Emphasize that the marginal revenue equals marginal cost profit maximization rule is just an extension of the rule of rational choice (continue to do something until E(MB) = E(MC)) to the case where the benefit is the price received from others. 10. It is important to emphasize that firms are in fact profit seekers, not profit maximizers, in a world of uncertainty. In a world of certainty (i.e., the standard models), these reduce to the same thing, but in the real world, we cannot ignore the importance of uncertainty to real world actions. For instance, what if you were a price-taking farmer, whose crop had a three month growing season; the price you may anticipate taking as given when you plant need not be the price you actually take as given when you sell your crop later. 11. Make sure students get the three step method now, as it will be used again for other market models. 12. A good test of student understanding is to ask students what difference it would make if the government imposed a tax of $1 per unit on just one price taker firm or it taxed all the firms in a perfectly competitive industry $1 per unit. 13. Emphasize that the zero profit long run equilibrium solution is based on free entry (no barriers to entry), not on the fact that they are price takers--one could be a price taker with barriers to entry resulting in persistent profits (that would become capitalized into the value of the firm’s assets). 14. Note that it is not just entry into an industry which drives economic profits to zero, but that both entry and capitalization of the prices of inputs responsible for superior performance together drive economic profits to zero. This is why farm price supports don’t keep farmers= profits high--profits get capitalized into the value of the farmland and other specialized inputs. 15. Unskilled labor in a large city is a good example of a probable constant cost industry, in contrast to markets for various kinds of skilled labor. 16. Note that firm cost curves end up in the same positions as before once long run equilibrium has been reestablished following a permanent increase demand, in a constant cost industry, but higher than before in an increasing cost industry. Chapter 13: Monopoly 1. Since there are substitutes, but not necessarily good ones, for any product, monopoly is a matter of degree. This is why antitrust (anti-monopoly) suits often turn on the definition of the appropriate market. The prosecution always argues for the narrowest market definition, because that implies larger market shares and more market power; the defense argues for the broadest market definition, because that implies less market power (e.g., the famous Cellophane case). Who wins in this dispute is often who wins the case. 2. Locks are a good way of illustrating barriers to entry. You use locks as a barrier against others getting what is yours, but what if you could lock up other peoples’ things for yourself (e.g., the right to offer goods for sale in competition with you)? Property rights are a form of such societal locks to keep others from stealing. One role for government is making sure legitimate locks work, but a risk of government police


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power it that it might allow government to create locks (legal barriers to entry) that allow some in society to take from others by creating monopoly power where it might not otherwise exist. This can then lead to a discussion of the analysis of licensing issues, etc. 3. A good way to check on student understanding of the monopoly model is to ask in class why the existence of a price taking monopolist would violate the law of demand. Either a correct student answer or a response to an incorrect answer can be used to make clear that since an industry (market) demand curve must slope down, and a monopolist is the only seller of a product, it must face the downward sloping industry demand curve as its demand curve. 4. Connecting back explicitly to the elasticity of demand-total revenue rule discussed earlier in the text is very helpful here to make the meaning of marginal revenue being positive or negative clear (especially since the diagrams in the text are truncated for the case where marginal revenue is negative): a) If demand is relatively elastic, TR rises as Q rises; therefore MR is positive, since MR is the change in TR as Q increases by one unit. b) If demand is relatively inelastic, TR falls as Q rises; therefore MR is negative, since MR is the change in TR as Q increases by one unit. c) If demand is unit elastic, TR stays unchanged as Q rises; therefore MR is zero, since MR is the change in TR as Q increases by one unit. 5. Make sure students recognize that the case of a perfectly competitive firm is an extension of the monopoly model to the case of a horizontal demand curve; the exact same approach is used, except that marginal revenue equals price in the competitive model because of the horizontal demand curve, but is less than price for the monopoly model. 6. A good test of student understanding of the monopoly model is to ask about the following extensions: a) Why would a firm with a higher marginal cost curve choose a profit maximizing point on a more elastic range of its demand curve, other things equal (demand would be more elastic where a higher marginal revenue equals marginal cost); b) What would be the elasticity of demand at the profit maximizing price and output combination for a monopolist if marginal cost was equal to zero (Since MR = MC at the profit maximizing point, that would be where MR = 0, which is where the elasticity of demand = 1 (as compared with situations where MC > 0, where a monopolist would charge where MR > 0 (the elasticity of demand was greater than one); c) What would be the elasticity of demand at the profit maximizing price and output combination for a monopolist if it received a government subsidy greater than marginal cost, so that its effective marginal cost was negative (Since MR = MC at the profit maximizing point, that would be where MR < 0, which is where the elasticity of demand < 1, so that demand would be relatively inelastic at the profit maximizing equilibrium). 7. As an illustration that monopolies need not be profitable, a buggy whip monopoly during the period where cars replaced horse drawn buggies is a good example (it also avoids the implication that the firm in question is inefficient). In addition, the monopolist producer of whatever toy introduction has been the most famous recent failure makes a good current example. 8. Regarding the question of whether monopoly retards innovation, it is worth emphasizing the point that monopoly, in the form of patents and/or copyrights, may be necessary to provide incentives to induce the discovery of new information, by providing a mechanism for rewarding that information. And in the long run, the incentives to discover new innovations may be far more important than â&#x20AC;&#x153;efficientâ&#x20AC;? pricing on already existing products. A further extension that can be interesting is why students and their grandparents may disagree on restrictions on the prices for drugsâ&#x20AC;&#x201D;grandparents have a shorter time horizon and so may prefer lower costs for already existing drugs, but students, with far longer time horizons, would not want to restrict drug prices, for fear of undermining the incentives for discovering and developing new drugs. 9. Reiterate to students that the welfare cost of monopoly represents the same analysis as that for


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collusion, taxes, costly regulations, price floors and price ceilings, trade restrictions, etc.Bwiping out mutually beneficial (wealth creating) trades. It may also be worth discussing Gordon Tullock’s analysis of how, when the government is the source of monopoly, the costs of rent seeking to get the monopoly can exhaust the monopoly profits to be gained, converting the transfer to the monopolist into an additional welfare cost. 10. Make sure you draw the connection between the price greater than marginal cost result of the single price (non-price discriminating) monopoly model to the incentive facing a monopolist to price discriminate: looking for a way to sell more to some customers at a price greater than marginal cost in a way that would not force me to decrease the price to other customers, as well. 11. A good classroom illustration of some of the administrative problems with average cost pricing would be to ask students: “If you would be paid a wage based on your cost of education, what would you try to counts as relevant costs of your education?” The many ways they would find to include all sorts of irrelevant (sunk) ones given such an incentive shows how hard it would be to successfully implement such an approach. 12. A good example of the difficulty with cost-based government price regulation is AT&T. When it was a regulated monopolist of interstate long distance telephone calls, it would throw in all sorts of false (not marginal) costs to regulatory commissions to justify charging higher interstate phone rates, but when that market was opened to competition, they had to switch gears and argue to regulatory commissions that they should be allowed to charge lower rates, their “costs” used to justify reduced long distance rates suddenly became far, far lower. 13. Note to students that average cost pricing for natural monopolies may be more efficient if the welfare cost of raising the tax revenue (elsewhere) that would be necessary to subsidize the losses from marginal cost pricing is included. When subsidies are required, you must weigh the marginal gain from reducing the inefficiency in one market against the marginal cost of increasing inefficiency elsewhere via increasing taxes. 14. With respect to the natural monopoly discussion in the text, remind students that, as Harold Demsetz showed in “Why Regulate Monopolies,” in the Journal of Law and Economics, economies of scale in wiring neighborhoods need not imply a single supplier of electricity, if competing producing firms had access to that delivery on equal terms. 15. Show students just how common price discrimination is, by expanding on the examples in the text, such as with matinees, negotiations (where prices can be a function of the time costs of negotiation), returnable vs. non-returnable bottles, 12 packs vs. 6 packs, 2 liter bottles vs. cans, reduced supply prices charged to large discount chains, etc. 16. As a further development of the diagram and analysis of price discrimination in movie ticket prices, you could show why the price differential between hardback and paperback books is far greater than the small difference in marginal cost of production. You can extend the discussion to pointing out that the result is that your school’s library, which buys the hardback books for their durability, is in the higher price group. 17. Show how charging different lunch and dinner prices at a restaurant can be an example of efficient peak load pricing. 18. Show how peak load pricing is particularly important for efficiency in cases where there is a sharply rising marginal cost curve (near capacity), with California retail price controls on electricity an example of what can happen from failing to use appropriate peak load pricing. Chapter 14: Monopolistic Competition and Product Differentiation


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1. Emphasize to students that monopolistic competition involves large numbers of substitutes, where no one individual rival is likely to take a large number of sales away, because that is why it is not dominated by strategic interaction issues. A good analogy may be to taking a test in a very large class, where there will be 50 students who get an A, so that one student does not view other students as direct rivals (as there would be if there would only be one A in a small class). 2. Catalog shopping and internet shopping may be good monopolistic competition model illustrations, because of the ease of entry involved (since anyone can relatively easily send out a catalog or set up a web site, as the mail during the Christmas shopping season attests). 3. The long running Lite beer “Tastes great—Less filling” advertisements make a good example of trying to shape a product’s image to appeal to its intended audience (the largest beer drinking audience is middle aged males, for whom the image of their former sports heroes still having a good time, still surrounded by beautiful women, even though they have put on quite a few pounds, is appealing). 4. One good illustration of a currently popular way for a firm to differentiate its products is by giving some profits to charity, to show that “we care.” Examples include Ben and Jerry’s Ice Cream and Target stores (which give 10% of their profits to charity). 5. In talking about location as a form of differentiation, note that if transportation (distance) is very costly, location may imply that there are only a very few relevant sellers close by, and oligopoly interdependence may replace monopolistic competition as the relevant model. 6. Remind students that the monopolistic competition model is basically the short run monopoly model in terms of its mechanics (although firms face higher elasticities of demand because of a large number of substitutes), where the firm maximizes short run profits with the same three step analysis as before, combined with the assumption of free entry, which (unlike the monopoly model) erodes profits in the long run. 7. Make sure students see why, as with the monopoly model, marginal revenue diverges farther from linear demand curve as the price falls (the further one moves down along the demand curve, the more Aprevious@ units must be reduced in price for any additional unit of output to be sold). 8. Emphasize to students that the “go up to the demand curve at the optimal quantity” rule simply reflects the fact that the height of the demand curve at that point shows the price at which that optimal sales quantity can be successfully sold. 9. Introduce the shorthand marginal revenue drawing rule--marginal revenue is halfway from the vertical axis to the demand curve at any price, for a linear demand curve--so students can quickly “play” with the models tools for themselves. 10. It is easier for some students to ”see” the area representing profits by starting from the definition that profits equal total revenue minus total cost, then showing that since average revenue, or price, equals total revenue divided by the output quantity and average cost equals total cost divided by the same output quantity, TR - TC = AR x Q* - AC x Q* = (AR-AC) x Q* = (P-AC) x Q*, or the rectangular area indicated in the diagrams. 11. To emphasize to potential explanatory reach of the monopolistic competition model to students, you might note that it has been used by some to try to analyze the competition for members of different religious groups in terms of different characteristics. 12. It is important to emphasize to students that monopolistic competition does not literally require zero profits for all firms (without additional assumptions); it only must be true of the expectations (in present value terms, not just current profits) of marginal potential entrants (though to the extent that interfirm differences become expected, the difference will be capitalized into the value of the asset or assets


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thought to be responsible). Typical monopolistically competitive markets have both entry and exit going on at the same time (e.g., restaurants and gas stations), and potential entrants may not succeed in their attempts at making close substitutes for the output of existing firms. 13. Another way to think of monopolistic competition is to think of it as a search for mutually beneficial characteristics of products in a world of uncertainty, not primarily as a comparative static model. 14. Reiterate that the monopolistic competition zero profit tangency solution is the source of the excess capacity result. Those highly successful in a monopolistically competitive industry, however, need not have excess capacity (e.g., trendy clubs or restaurants with lines of people waiting to be let in or seated), because they need not earn zero economic profits. 15. You may want to show students how many excess capacity examples can be understood as means of lowering search costs or other costs even more. For instance, as Armen Alchian demonstrated, bathrooms, dining rooms, classrooms, computers, bedrooms, empty apartments, used car lots, etc.--can all be understood this way (e.g., unused farm equipment at night, when the extra costs necessary to use it would be greater than the savings). 16. Note that if strong consumer preferences imply that some firm’s profits need not be competed down to zero, there may be less excess capacity in the real world than the illustration in the chapter indicates. 17. Note to students that if a new product is created that attracts strong consumer preferences (so that its production is profitable and price can exceed marginal cost) consumers are better off than in their prior situation (because they chose the new product instead of the existing alternatives), even though the result would violate the static equilibrium price equals marginal cost efficiency standard. 18. Note that it is not differentiation that firms are looking for, but forms of differentiation that consumers are willing to pay enough more for to make profitable. 19. Note that the search for successful product differentiation--intended to increase firm demand and make it more inelastic--is often the search for unique advertising or promotions. A better (more successful) promotional campaign is typically one that succeeds in being different in a popular way (such as the intended romantic image in perfume advertisements at Christmas). However, more standard types of sales promotions (such as detergent ads) may actually result in increased elasticity of demand for a firm’s products, because they inform customers more fully about substitute products. 20. In judging how inefficient monopolistic competition is, it is worth reminding students that producers are free to come out with cheaper more generic products. If consumers choose to buy the differentiated products at a higher price, they are revealing that the quality, information or image is worth the higher cost to them. Chapter 15: Oligopoly and Strategic Behavior 1. In addition to chess or bridge as illustrations of strategic interdependence, you could include many sports (basketball, football, etc.) and war. It may also apply to getting a job, once you have made the “short list,” even though getting to that point may be an example of monopolistic competition. 2. A good way to get a class discussion going is to ask whether the competition among fraternities and/or sororities would be better described as monopolistic competition or oligopoly. In some ways (such as recruiting a particular desired student or winning some particular competition), oligopoly is probably appropriate, but in others, monopolistic competition is probably appropriate. 3. One illustration of the importance of the underlying assumption of strategic interdependence in oligopoly but not monopolistic competition could be “plain wrap” store products. They were introduced to take some sales from each “name” brand, but not so many as to provoke a strategic response (as in monopolistic competition), and were originally quite successful. However, the “name” brands lost so


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many sales that they targeted the “plain wrap” store product customers with coupons (to lower the effective price of their products to those customers with low time values--and, to the extent possible, only those customers), converting the relevant model to one of oligopoly with strategic interdependence. The name brands were highly successful in taking back market share with this approach. 4. Note that the possibility of internet shopping may decrease transport cost differences between firms, and increase the number of relevant competitors, converting the analysis of some industries from oligopoly to that of monopolistic competition. 5. For oligopoly analysis, it is important for students to see that we are increasing the numbers of both decisionmakers and variables being considered, so that the level of analytical determinacy falls dramatically, and the result depends on far more things than in simpler comparative static market models. 6. Point out to students that colluding on test preparations or assignments is an example of how difficult it is to put together and maintain an effective collusion. For instance, show students that a policy of giving the highest score on a multiple choice final an A, regardless of the score, is an open invitation for students to collude on the answers, where if they all stuck to those answers, every student would get an A. Even then, you can show that it is likely to be in some student’s interest (with a simple payoff matrix) to pick a correct answer rather than the agreed answer, causing the collusion to fail. This example can be extended by asking what difference it makes whether the professor posts all the exam scores by name, and whether the assignment in question is to be in-class or a take-home assignment. It could also provide an opportunity to discuss your school’s ethics code in terms of penalties and enforcement issues. 7. OPEC can be used to show that countries with large oil reserves and those with small oil reserves would likely disagree about the appropriate price and output strategy because of their different time horizons (more years of reserves implies a longer relevant time period, a more elastic relevant demand curve and a lower desired price), as well as showing the different incentives to cheat on OPEC agreements based on how large a producer is (smaller producers firms are less likely to make enough of a difference to get “punished” for evading agreements). 8. Remind students that the same principles of collusion now being talked about on the selling side of the market are also true of the buying side of some markets as well, to show that the principles are the same. 9. The cereals case is a good antitrust example to use in discussing the issues involved in oligopoly, particularly as an example of non-price competition and its analysis. 10. Remind students that the kinked demand curve uses the standard monopoly tools, except that the kink makes a difference between the elasticity of demand for increases versus decreases in price. 11. It is worth reminding students that since in the kinked demand curve model, there is a tendency toward price stability, that would mean that in such markets, history matters--the best price to charge today is clearly a function of the price charged yesterday--which is not true in the other market models. 11. An application of the kinked demand curve analysis that might be useful in class is how an announced policy of meeting any competitors’ lower price might be adopted to ensure that price cuts by rivals will not successfully take away customers from other sellers. 12. Emphasize to students the difficulty of raising prices versus lowering prices in the kinked demand curve model. Any seller can force others to lower their prices to match if it announces a lower price, but no seller can force others to increase price to match their higher announced price. In such industries, this can also lead to the development of mechanisms to make sure your price increase is followed before it takes effect (such as advance announcements of forthcoming price increases, which are rescinded if others don=t match the increase).


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13. An interesting long run oligopoly example is the U.S. airline industry under CAB regulation of minimum fares, entry into profitable routes, other competitive fronts, etc. Even under CAB regulations and barriers to entry (and it is worth reminding students that the government is a much more effective “enforcer” of barriers to entry than agreements not backed by government power), airline profits were not unusually high because they were eroded by the large number of unregulated ways to compete, from the frequency and timing of flights to pretty stewardesses to steak “sandwiches” at lunch to free drinks). Then, with deregulation, entry into profitable routes reduced those profits further, and forced much of the competition away from service to (then allowed) lower prices, resulting in dramatically lower fares on major routes. Because of the resulting losses, airline exit then occurred to move the industry back toward a sustainable equilibrium. 14.. Note that charging a price below the short run profit maximizing level to deter entry can also be viewed as profit maximization with a longer run (present value) time horizon, where the relevant elasticity of demand would be greater and the resulting profit maximizing price lower, the longer the time horizon considered or the lower the discount rate applied to future effects. 15. In comparing cooperative and non-cooperative games, it can be useful to show students how government enforcement of collusive agreements can make such an oligopoly situation into a cooperative game, while on the other hand, government prosecution of such agreements for antitrust violations would instead tend to make their strategic interactions a non-cooperative game. 16. Other simple prisoners’ dilemma illustrations that could easily be used in class include a two person litter/don’t litter payoff matrix showing dirty parks to be the likely result and a two person become politically informed/not become politically informed payoff matrix showing remaining not informed (rational voter ignorance) to be the likely result. 17. It is important to note that it is possible for there to be fewer firms and more competitive (proconsumer) results (though not structure) at the same time, such as when reduced transportation costs with the advent of railroads allowed larger optimal production scales and lower delivered prices, although it resulted in fewer firms (which out-competed smaller firms in terms of lower prices and better quality). 18. An interesting example of the bandwagon effect is advertising that stresses how having a product shows that the buyer is unique or a rugged individualist, because it displays the irony of trying to get each of a large number of buyers to show their unique individuality in the exact same way. 19. Note that the snob effect is not a refutation of the law of demand, but an illustration of it—those individuals who buy a good for its exclusivity and may even buy more at a higher price only do so because others buy less at the higher price, otherwise it would not be more exclusive or prestigious at the higher price. 20. You might want to note as an extension of the switching cost section that for software, the initial market leader faces a very similar problem as potential entrants when they introduce a new version of their software—they must convince those using earlier versions that the new one is enough better to be worth the switching costs. Chapter 16: The Markets for Labor, Capital and Land 1. As an extension of derived demand discussion in the text, it is worth making a point of discussing the fact that the resource thought to be responsible for superior performance will be bid up in price to reflect that market judgment (but mistakes can be made, because identifying the responsible party is difficult in a team productive process), as was illustrated in the movie “Working Girl.” 2. In cementing the idea that the payment to (cost of) an input is the income to the owner of the input, it can be useful to show that a maximum rent law (rent control) is also a maximum income ceiling on


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apartment owners. 3. Remind students that labor hiring and pricing decisions are just one more example of the expected marginal benefit (marginal revenue product) versus expected marginal cost (wage) rule of rational choice. 4. An interesting application of the text discussion here would be why aging superstars in sports (especially in baseball, with more otherwise empty seats that could be filled by a well known star) can be so much more valuable than their present statistics seem to justify. The marginal revenue from added seats filled by aging sports heroes, not the change in the win-loss record of the team that results, is often the answer. However, during the stretch drive, one player’s addition may be very valuable to a team that may or not make into the playoffs or may or may not have home field advantage as a result, while that player may be far less valuable to a team already out of the playoffs, especially for a proven player with a costly contract. This is one reason for restrictions on late season trades in sports leagues--to prevent a “rich” team from “buying” a victory at the last minute. 5. A good classroom check of student understanding of this material is to ask them why the marginal product of the “last” worker will rise if the wage is increased (It is not that the worker will necessarily change, but that an employer will lay off those whose marginal products are below the new higher wage). 6. Make sure students see that a horizontal labor supply curve to a firm in competitive labor markets (firms as wage takers) is the analog to being a price taker in the output markets in the perfect competition model. Also as in that case, it is worth emphasizing the consistency of even a relatively inelastic market supply curve of labor with the perfectly elastic supply curve of labor to a firm. 7. A useful extension of labor supply and demand is the case of what happens to both substitute labor (whose demand falls) and complementary labor (whose demand increases) when new technology is adopted in an industry. 8. To remind students not to forget the power of their supply and demand skills beyond a single application in a single market, it could be worth extending the text illustration of a fall in input prices in one market to the expected effect on complementary and substitute inputs, as well as on the derived demand for inputs in other industries whose outputs are complements or substitutes to the output of the initial industry in question. 9. Emphasize to students that cost minimization does not mean cutting every possible corner on safety, on the job training, etc. Rather, it means that those fringe benefits (including added safety and training) employers believe employees value at more than the after tax cost will be provided, but wages will be lowered by the amount of those costs (still leaving employees better off in real terms). 10. Many universities pay scales are based on rank (where an equal rank implies an equal salary), yet the equilibrium wage varies, often substantially, by discipline. You could show student how a university could give professors in different fields different real compensation packages, without violating the equal pay for equal rank principle, by offering extra summer school money, fewer courses or preparations for the same salary, extra research money, more teaching assistants and graders, more sabbaticals, better computers, etc. 11. An extension of the amenities discussion might be the question of how much salaries would have to be increased to compensate professors for giving up the security of tenure which they already have. 12. An extension of incidence issues to the labor market would be to ask students how variable incomes would be in a labor market where the supply of labor was relatively inelastic in the short run, but the demand for that labor was highly variable (e.g., aerospace engineers), to get them to see that specialized workers in such industries would have extremely variable incomes.


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13. A good extension of the labor supply and demand analysis here is to discuss why workers bear the incidence of their employerâ&#x20AC;&#x2122;s half of their Social Security and Medicare taxes, and why such burdens placed on employers means that workers being underpaid (where they receive less than their added product in added take home pay) at the margin is an equilibrium condition. 14. Note the substantial difference in the data when one looks at total compensation instead of wages, making it misleading to look at wages alone. One way to do this is to talk about the effects of mandated benefits as an example. 15. You may want to ask students whether it would make a difference if all people were trained more, rather than just a relatively small number. The market supply curve would shift right along with the demand for those workers (due to their increased productivity), changing the results. As a particular example, you could ask what would happen to the college education premium in the job market if far more people went to college. This case of increasing the relevant labor supply can also be contrasted with the case of union restriction of labor supply. 16. A potentially interesting example of local monopsony would be the only college in a relatively isolated region. 17. An interesting classroom topic can be to tie why unionization is far greater where the unions deal with governments rather than with for-profit employers to the different incentives the employers face in the two situations. 18. As an extension of the text discussion of the role of unions, you can ask students when would unions that both increase workersâ&#x20AC;&#x2122; marginal productivity and restrict the supply of labor to a group of firms, result in greater employment at the resulting higher wages? That would only be the case if they shifted workersâ&#x20AC;&#x2122; marginal products (labor demand) up more than the supply of labor curve shifted up (left). 19. A good union application is to discuss why unions would lobby for prevailing wage laws (especially when the prevailing wage is considered the union wage) in their industries--it raises the cost of hiring non-union labor relative to the cost of hiring union labor, increasing the demand for union labor. 20. If unionization reduces employment in an industry, you should note to students that the higher union wage does not raise wages in other industries. Rather, it increases the supply of labor to non-unionized industries, pushing down wages in those industries. 21. A good application using the inelasticity supply of land is to ask student why, if the supply of land was perfectly inelastic, a permanent doubling in the price of the crops grown on the land will double the price of the land, while it will less than double the price of the land if land is less than perfectly inelastic. Chapter 17: Income and Poverty 1. As an application of the Lorenz curve, it might be worth asking students whether an increase in the proportion of the population who were retired, young, or divorced would affect the Gini coefficient in a predictable way (it would, by increasing the number of households with low measured income). 2. A good in-class test of whether students understand life cycle effects in evaluating income redistribution is to ask them why efforts to redistribute from those with current high incomes to those with current low incomes entail redistributing from you to yourself in large part. Since you are relatively rich in your peak earning years and relatively poor when you are young and old, this involves redistributing from you in middle age to yourself when you are young and old. 3. Note to students that differentials in average wages for different groups are substantially biased by differences in the age distribution across those groups. Relatively young groups will look relatively poorer and more middle aged groups will look richer.


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4. There are several interesting classroom discussion questions that can be based on this material. For instance: How can a decrease in the top tax bracket affect secondary workers more than primary workers? Who gets the biggest tax cut? What would this do to the incentives for high income men to marry high income women, or to form DINK (double income no kids) households, and thus to measures of family inequality? 5. Note that if noncash benefits (which are not counted in official income distribution measures) increase for low income people, it may cause reductions in the measured earnings of low income people, as they respond to the increased incentives to remain or become eligible (e.g., Medicaid), and appear to worsen measured inequality at the same time it actually benefits those with low income. 6. Note to students that given the progressive nature of the income tax, expanding generally available programs from income tax revenues (e.g., Medicare) can substantially redistribute income from higher income taxpayers to lower income recipients. 7. To illustrate some of the incentive problems that income redistribution can cause over time, ask students what would happen if highly progressive taxation not just lowered the take home pay of current high income earners, but also reduced the after tax return to added human capital investments (say, in becoming a doctor) as a result. The compressed after tax “equilibrium pay differential” (rate of return on added human capital) would lead to a reduced future supply of doctors and other high skill workers, which would raise their before tax pay differentials compared with other groups, and worsen measured income inequality (as the official measures don’t adjust for the effects of taxes). 8. An interesting classroom discussion starter question about income redistribution is: Is it fair to help the poor through government, funded by taxation? This can trigger a discussion of the different meanings people attach to “fair,” particularly the difference between egalitarian views of fairness (we help the poor because their humanity means they deserve it) and libertarian views of fairness (it is unfair to involuntarily take my income, which was voluntarily paid to me by others, through taxation, for government spending I do not support). 9. One interesting extension that can be done here is to point out that the more the government already does of other things, the higher the tax rates necessary to fund those things, and the more difficult it will be for the government to successfully raise added tax revenue to redistribute additional income to lower income people (or to do anything else, for that matter). 10. As a classroom discussion starter about whether discrimination reflects economic factors, it can be useful to ask what kind of wages an employer who had to invest $40,000 in training a worker would offer to equally competent men and women, if men (based on historical experience) were expected to stay at that job an average of 8 years, but women were only expected to stay at that job 5 years. The different time periods allowed for the firm to recover its training investment would lead it to offer higher wages to men or to prefer to hire men at the same wages. 11. Note that if information is costly to obtain, not only might group averages be used as imperfect but low cost indicators, but only by members of a group being better than the prior group average can the group average be raised. 12. An interesting discussion about discrimination can be started based on a minimum wage illustration from South Africa years ago. White South African labor unions pushed through legislation mandating equal pay for blacks as whites (an effective higher minimum wage for blacks than before), and much of the rhetoric was about helping blacks. But what actually happened was that, given the requirement to pay blacks the same wages as whites, employers sharply cut black employment and increased their demand for white workers instead, harming blacks but helping white labor union members. 13. Note that self-employment is often a way around discrimination. This can lead to a lively class


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discussion of why the government frequently enforces barriers to entry to self employment (such as limiting cab licenses as a barrier to becoming one’s own cab driver, cosmetology licenses as barrier to entry to self-employed hairstylists, enforced membership or requirements to be “in good standing” with certain professional association, etc.). 14. The Alchian and Kessel analysis of why regulated firms may discriminate more than other firms-because there is a lower cost to owners (since they wouldn’t get to keep the profits from eliminating discrimination due to non-productivity based discrimination) in terms of foregone profits to allowing the management to exercise any discriminatory personal preferences they might have--could lead to a very lively in-class discussion. 15. A sometimes useful analogy to the difference between absolute and relative measures of poverty is that you can raise the number of students who score >70% on an exam (reducing absolute ignorance), but you can’t move every student up in relative class standing (or relative ignorance). An interesting extension of this could be how pressures to make one school’s or one major’s or one teacher’s students look relatively better (higher grades) can result in absolute grade inflation. 16. A connection between measurement issues and poverty issues can be drawn by discussing how over-indexing the poverty line by tying it to changes in the consumer price index has affected the number of people officially in poverty. 17. A welfare reform extension you might find useful is to ask students why it gets progressively harder to move people on welfare to work as the number of people on welfare shrinks (It takes a bigger increase in skills to get the remaining people jobs than it did for those who have already gotten jobs). 18. A current policy that you may want to discuss in class because it acts as a wage subsidy (at least over the range of income where earnings are subsidized) is the earned income tax credit. 19. You might want to point out that if there are large life-cycle effects, apparent redistribution from currently higher income households to currently lower income households is largely redistribution from the same people when they are in their peak earning years to themselves when they are young and when they are old. 20. The text discussion of the national income tax mentions that a NIT has a work disincentive effect. You might want to ask students if it has a greater disincentive effect than what it would replace. It is not clear that it would, because many of the programs it is intended to replace also take away benefits as income increases. You might then ask them about disincentive effects if a NIT was added onto the current welfare system rather than substituted for it, because then it is clear that the cumulative benefit reduction rate (which acts as an income tax rate) would then be larger than before. Chapter 18: The Environment 1. Suggestions number 1-6, 10 and 11 from Chapter 8 on “Market Failure” may be worth discussing or revisiting here. 2. Roommates are good illustrations of negative externalities, and noise and visitation rules (such as in many university dormitories) can be discussed as attempts to reduce some of the potential externality problems. 3. It is worth noting that markets may internalize more externalities than commonly supposed (e.g., if workers valued the right to a smoke-free environment, but customers valued the right to smoke, a producer would have an incentive (higher profits) to take both sets of preferences into account (workers’ preferences would affect wages, and therefore costs, and consumer preferences would affect demand). On the other hand, once the government steps in to “solve” a problem, the majority, who expects to win politically, has little incentive to negotiate with or accommodate the minority’s preferences.


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4. Plastic surgery can be a humorous illustration of externalities that can be viewed as positive (you may benefit from dating prospects looking better) or negative (you may want your dating “competition” to look worse). 5. The problem of externalities came be used to talk about why morality matters in a society. After all, the government cannot internalize all externalities effectively. Moral and ethical codes can often reduce negative externalities in a society more effectively than government intervention, and government intervention typically works poorly in a society not committed to the rule of law (e.g., how well would society work if no one felt anything was wrong with stealing whenever you thought you could get away with it?). 6. Emphasize that market-based (tax and subsidy) solutions to externality issues are attempts to mimic the results that a market would have generated if property rights had been clearly defined (i.e., a pollution tax equal to the marginal external costs of pollution is the same as what it would take to buy the right to create that pollution in a competitive market for those rights. You might also want to talk about other effects of pollution taxes than just the obvious, such as their ability to both reveal and minimize the cost of abatement, create a market for pollution-reducing innovations (as others are willing to pay you up to the value of the pollution taxes saved for such an innovation), etc. 7. Note that both pollution taxes and transferable pollution rights make firms price takers in the pollution reduction market (the price is equal to the pollution tax in the first case and the market price of a pollution right in the second case, with the typical efficiency results of a competitive market. Similar results can be achieved with various deposit arrangements (including bottle and can deposits as ways to reduce litter), as illustrated by the abandoned car illustration the text. 8. The history of the Clean Air Act can be used as an example to show how political solutions to environmental problems are often hamstrung by political interests. The lowest cost way to reduce sulfur dioxide emissions from coal fired power plants at the time would have been to switch to burning low sulfur coal (even though low sulfur coal was more expensive than high sulfur coal). That is what many of those plants would have started burning if they had been faced with emissions taxes. However, while efficient, that would have resulted in the loss of West Virginia high sulfur coal mining jobs, which the Clean Air Act saved by mandating that plants install more costly electrostatic precipitators to reduce emissions, with which power plants would continue to use high sulfur coal. Similarly, political interests in the northeast imposed more stringent restrictions on new sources of pollution than existing sources in the Act, which was inefficient, but was an attempt to limit the ability of manufacturers to relocate their plants from the northeast “Rust Belt” for new locations in the “Sun Belt.” As in these cases, political interests in environmental disputes often dominate concerns for efficiency. 9. A useful analogy to the property rights and care for the environment discussion is why many car leases include free maintenance services (it overcomes the incentive not to care about the car’s condition beyond the terms of the lease), and some even offer free car pickup and loaners during service. 10. One way of illustrating property rights’ effects on conservation would be to ask students what difference they would expect between someone logging their own land and logging on land they have leased from the government for one or two years. Owners will take into account how their logging will affect the value of their land in the future, but not their effect on the future value of leased government land (unless their lease contract gives them those incentives). 11. It is often useful discuss the role of property rights in species extinction. For instance, you can ask students why the buffalo were wiped out, but not cows, to illustrate the problem. The discussion could be extended to issues of whales and fisheries, and other examples of un-owned resources. 12. Remember that in talking about conservation, not everything is efficient to conserve. Assets that are


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expected to go up in value faster than the cost of financing ownership are efficient to conserve, while assets that don’t appreciate at least that fast are worth more in present value terms now. Without private property rights to give the owners the incentives to optimally conserve environmental resources, the government sometimes “over-conserves” resources and sometimes “under-conserves” them. 13. Another interesting environmental issue that may be worth discussing in class is the landfill “crisis” of a few years ago (including loud condemnation of disposable diapers and non-recycled drink containers), and worries about there being no place left to dispose of our garbage. In particular, it might be interesting to have students investigate what happened to make that crisis go away. 14. One traditional environmental scare tactic that might be worth discussing in class is the assertion that the world will run out of food, water, space, etc. if we don’t “do something” about it. It is important to know that while we will indeed run out of anything if we use it up at the exponential growth rates doomsday forecasts assume, but those forecasts ignore the fact that in such circumstances, the relative price of an increasingly scarce good would rise sharply, and that would reduce the use of those resources below the forecast rates, as well as increase the search for new sources or new substitutes. 15. Remind students that legal rights, if not enforced, are not really property rights (examples would include access to your own driveway if others aren’t prevented from blocking it and the right to keep other people’s dogs from “dirtying” your lawn, when nothing is done to prevent it). For a right to be real, it must be enforced against others’ encroachments. 16. In discussing property rights as creating the rules of the road, emphasize that social coordination does not work well if the rules are unclear and changing (Calvinball, from the Calvin and Hobbes comic strip, where they made up the rules as they went, is an excellent example). 17. It is often useful to discuss family fights over rules and responsibilities as an example of trying to define property rights in ever changing circumstances (e.g., at what age should children be given increasing allowances and/or particular increased responsibilities?). Chapter 19: Health Care 1. It can be worth extending the discussion of healthcare as “a basic human right” to the question of whose responsibility is it to provide that right, if the recipients need not pay for it, and what happens to their “basic human” right of keeping the income they earn. 2. As a classroom example, it might be worth asking whether, if the increasing share of GDP going to health care was solely due to an aging population and rising real incomes, it would constitute a problem for society. In that case, the increasing expenditure on health care represents welfare enhancing choices, not a problem to be solved. However, if the increasing share of GDP going to health care results from the artificially low prices facing insured patients, then that would be an inefficient result that would be a social problem. 3. It is worth reminding students that while there are few good substitutes for many kinds of major and emergency surgery, leading to a relatively inelastic demand curve, there are many good substitutes for many other kinds of medical care, such as self-diagnosis and self-medication with over the counter drugs for what you think is a cold, rather than going to the doctor. 4. As an elasticity of demand application, ask students why the elasticity of demand facing hospitals for baby deliveries, which most insurance companies cover 80% of, is likely to be low. Show students that a $100 reduction in the hospital’s price would only lower the price to a patient by $20, and so would be likely to have a small effect. This can then be extended to other illustration of how insurance can change the elasticity of demand for goods and services (such as why plastic surgery, not usually covered by insurance, may have a more elastic demand—and may be more widely advertised, since price will matter more--than most medical services covered by insurance).


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5. A good extension of the insurance discussion is to ask students whether health insurance could lead to “too much” technological advance in medicine. The answer is yes. If insurance made people demand (at the far lower price they must pay for it) higher quality care, investing in, say, a diagnostic test machine that is very costly, but slightly increases the odds of a correct diagnosis, would not be likely to be profitable in the absence of the incentive distortion from insurance. But if the price to the patient of higher quality from using the slightly better but more expensive diagnostic machine is very low, once they are insured, they may well demand the better test, making the diagnostic machine profitable to its producer. 6. A good illustration of insurance and moral hazard is why there is no such thing as “lunch insurance.” Since there is no real uncertainty about whether you will eat lunch, such a policy would provide no real insurance against risk. However, by lowering the price of lunch to those insured, there would be a large moral hazard problem, from increasing the quantity and quality of the lunch that would be purchased. Between the moral hazard problem and covering the administrative costs of such a policy, it would cost so much that no one would be willing to buy such insurance. 7. It is worth reminding students that the effects of price ceilings in the health care market are different in detail, but the same in essence, as any price ceiling, and referring them back to the earlier section in the text that dealt with those effects. 8. In discussing the market for human organs, it might be worth asking whether anyone else in the entire system besides the donor—the hospitals, physicians, etc.—does it for purely altruistic reasons, without compensation. You might then ask why if it is not ethical to pay donors, it is ethical to pay the others involved. 9. Emphasize that the basic intent of Health Savings Accounts (HSAs) is to allow for coverage for what makes the most sense under principles of insurance (very costly, low probability catastrophic events with relatively inelastic demand curves, such as major medical events), without subsidizing those events that make less sense under principles of insurance (relatively inexpensive and predictable health care expenses--which are more like pre-paid health care than actual insurance against unforeseen events— and those for which the elasticity of demand is large). Chapter 20: Introduction to Macroeconomics 1. It is important to emphasize that macroeconomic goals all deal with social coordination issues, because the better we coordinate our behavior with one another, the more successful we are at advancing our own interests. Coordination failures have adverse consequences for real people, not just numbers. 2. Given that people have different preferences, point out that it is not surprising that there are disagreements when tradeoffs between macroeconomic goals are faced. Further, people’s situations (i.e., their particular cost-benefit tradeoffs), such as whether they are at risk of being unemployed or whether they are working for a company that is a major exporter or a competitor of imports, go a long way toward explaining what they place the higher priority on at a given time. 3. The high unemployment discussion is a good time to emphasize that despite what many assume about economics, economics is not about numbers, but about people; the numbers represent in a highly aggregated way real things happening to real people. Just because the analysis relies on statistics does not mean it is about statistics. 4. A humorous illustration of some of the difficulties with unemployment measurement is to point out that if you sent Danny DeVito (in his obnoxious, berating character) into unemployment offices throughout the country to harangue the people there about what losers they were and that they would never find jobs, the unemployment rate would fall without the level of employment rising, to the extent that those people


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believed the harangue and stopped looking for work (becoming discouraged workers). On a more serious note, you can show students how an increase in discouraged workers during recessions means the rising unemployment rate understates the increasing difficulty of finding a job. 5. Emphasize that it is useful in general to look at both employment and unemployment data to understand the labor market, as a check on “odd” results (such as sharp changes in labor force participation) biasing one measure--as when both employment and unemployment rates both rise or fall together, as well as looking at underlying data for further analysis (e.g., job losers vs. quits vs. new entrants). 6. An interesting addition to the unemployment discussion is to show students that job leavers as a percentage of the unemployed increase when economic times are good, and that the percentage of job leavers of those unemployed may be a reasonable economic indicator of economic optimism by those in the labor force. 7. A good analytical extension of the unemployment data is to note that when fringe benefits rise as a percentage of total compensation, you would expect part-time employment to rise (which could reduce overall unemployment if it substitutes more than one part-time job for each of some former full time jobs), because part-timers tend not to get such fringe benefits. On the other hand, to the extent that overtime pay does not typically add much to fringe benefits, while new hires do, higher fringe benefits could make overtime among existing workers more attractive than new full time hires, tending to raise measured unemployment (but increasing average hours worked, another important labor market indicator). 8. A good illustration of structural unemployment would be someone who had excellent skills using a slide rule--forty years ago, those skills were valuable, but now virtually valueless. 9. You can make a useful analogy from unemployment to body temperature for students. Frictional plus structural unemployment equals “normal” body temperature, while cyclical unemployment is like being sick with greater than optimal temperature (a fever). 10. Emphasize to students that full employment (unemployment equal to its natural rate), and therefore potential output, is not an immutable constant, but a function government policy (e.g., welfare rules, minimum wages, unemployment benefits) and demographics. 11. If you discuss seasonal unemployment, it is worth mentioning that national unemployment rates are adjusted for seasonal factors, but local measures (e.g., Ventura County, California) are not. Therefore, one must be careful in interpreting any comparison between local changes and national changes whenever seasonal factors might be at work. 12. It is worth noting that increases in the minimum wage, the union wage premium and the efficiency wage premium would each tend to raise the natural rate of unemployment, because they would each increase the extent to which wages exceed opportunity costs for some groups. 13. Make sure students recognize that the wage premium currently earned by union members does not imply that if all workers were unionized, all would be paid more (as bumper stickers that say “Live Better, Work Union” would suggest). 14. It can be worth noting that higher efficiency wage and union wage premiums should reduce the number of job leavers among the unemployed. 15. A good way of illustrating some of the issues involving job search is by an analogy to dating. For instance, is the person you see at a job interview or on a first date the “real” you? (it is better than the real you, because you are trying to make a good impression). Or how well would couples be matched if they had to decide whether to marry within one month of beginning to date?


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16. It can be worth extending the unemployment insurance discussion to show how increasing the replacement rate offered by unemployment insurance would decrease the opportunity cost of remaining unemployed, increasing the average duration of unemployment and the unemployment rate. 17. Note to students that the unemployment insurance analysis of how it lowers the opportunity cost of remaining unemployed implies that there might well be a big increase in the number of unemployed who get jobs when unemployment insurance benefits run out, since the opportunity cost of remaining unemployed would jump at that point in time. 18. The skill-based technical change discussion can be usefully related back to the earlier income distribution discussion. It can also be related back to the supply and demand material by pointing out that, in essence, such technology is a substitute for low-skill workers but a complement for high-skill workers—with results exactly as we would have expected in Chapter 5. 19. Reinforce the idea that falling prices as well as rising prices can cause plan coordination difficulties (for instance, with unexpected inflation, money is too poor a store of value, while with substantial deflation, it is too good a store of value, crowding out real investments). 20. Emphasize the difference between anticipated inflation and unanticipated inflation. Even those with long term contracts aren’t hurt if their contracts correctly reflect anticipated inflation. 21. A good analogy to price inflation may be grade inflation--in both cases the ultimate problem is that the information conveyed to others (by prices or grades) deteriorates in accuracy, making it harder for decisionmakers to recognize and act on accurate information, reducing the quality of resulting decisions. 22. It may be worth going through the case where borrowers and lenders in the loanable funds market have different inflation expectations as well as where both expect higher inflation rates, to cement student understanding. In such cases, the gainers from price changes are always those who have more correctly anticipated inflation. 23. Emphasize that the demands for investment goods and consumer durables are more cyclical because such purchases can be relatively easily delayed in hard times and accelerated in good times. 24. Note that building a “road to nowhere” can increase current business activity, but it doesn’t imply meaningful growth, because it does not add to a country’s ability to produce what is valued. 25. A reminder of the importance of macroeconomic conditions to people’s decisions is the Edsel. It was introduced as a somewhat more upscale car in 1956, right at the beginning of the 1957-58 recession, and was a spectacular financial failure (although, relative to other cars of the time, not the “lemon” we think of it as today). 26. You may wish to note to students that there are all sorts of price indexes constructed like the CPI, from a kiddie price index (heavily weighted in candy bars, soda, and comic books) to a “Twelve Days of Christmas” index to a senior citizen index (more heavily weighted toward prescription drugs and health care and less heavily weighted toward housing costs). You might even want students to pick any five or ten goods and construct an index of their own from past data (e.g., odd goods, alleged to be the typical consumption basket of students at a rival school). 27. Note that upward biases in the CPI lead to downward biases in the growth rates of all the “real” data that is produced by adjusting by the CPI, such as real wages, household incomes, and the poverty rate. Chapter 21: Measuring a Nation’s Production, Income, and Spending 1. It is worth emphasizing that every variable macroeconomics tries to deal with has limitations--nothing is measured perfectly. Knowing those limitations can keep one from being fooled by others’ misuse of


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the data or your own lack of understanding, so macroeconomics includes a bit of “statistical self-defense” by discussing those limitations. It is important that students know something about macroeconomics measurement issues, because the easiest way to mislead people in if A, then B, macroeconomic arguments is by using inappropriate or biased measures that appear to be plausible premises for a position. 2. A way to motivate student interest in how well macroeconomic variables such as GDP are measured and why it could matter is to ask them whether they are at all concerned with whether their grades accurately measure their comprehension in their classes. 3. You may wish to emphasize that because the circular flow variables (C, I, G, X-M) are theoretically important, we have to know something about how well those variables are measured, because if we can’t measure them, we can’t reliably establish the relevant theoretical relationships. The more difficult measurement issues (e.g., measuring the overall price level instead of the price of a six-pack of soda at the local market) are one way in which macroeconomics is more difficult and more distant from students’ day to day lives than microeconomics. 4. You may wish to note that “double counting” may be better described as over-counting or multiple counting, to keep any students from thinking that adding up all the transactions would always result in a number twice that of the price of the final good (with simple production processes with only one or two steps, the result would typically be less than double the final price, while with complex production processes with many steps, the result would typically be more than double the final price). 5. You may wish to remind students that while exchanges of financial assets such as stocks, bonds and houses are not counted in GDP, the broker fee or commission you pay is counted as a newly produced service. 6. Note that if the fact that substantial amounts of consumption can be consumer durables, which are really largely forms of investment, is ignored, and all of measured consumption is thought of as used up immediately, substantial judgment errors could follow. For instance, the “we borrowed foreign funds and threw a party” (current consumption) view of the 1980s is very different from one where “we borrowed foreign funds and largely invested them in consumer durables.” Further, the fact that consumer durables are really largely investments means that official measures of investment and comparisons of such measures across countries may seriously misrepresent reality (e.g., investment comparisons between Japan and the U.S.), when differences in consumer durable investments are factored in. 7. A useful classroom question to highlight some difficulties in categorizing components of GDP is to ask students whether education spending should be viewed as consumption of a current service or as investment in human capital. 8. You may wish to note to students that fixed investment must be intended (you don’t accidentally build a steel mill), but some of inventory investment may be unintended (you may intentionally add to inventories or you can add to inventories because you were unable to successfully sell the output you intended). Intended investment is part of AD, but unintended (unplanned inventory) investment is an “error term,” included in GDP but not in Aggregate Demand, that tells producers how their plans were incorrect, and signals which way to adjust their behavior (output, employment and prices) in response. 9. Note that when the government produces something where no market reveals what it is worth (e.g., aircraft carriers), GDP accounts assume those outputs are worth what they cost to produce, which could well substantially overstate or understate their “true” values. 10. Remind students that GDP values are determined by market prices. Emphasize that as a result, our knowledge of the value of output is very “iffy” when there is no market to reveal such values through voluntary trade (e.g., household production, aircraft carriers, environmental quality, etc.), which is why we do not include some production—it is better to have more precise measures, while being aware of their


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limitations, than to include things where measurement error is unavoidably huge. 11. For students who are taking microeconomics as well as macroeconomics, you might need to remind them that in microeconomics, profits are not considered a factor payment, but rather a residual after all other costs have been paid, while in macroeconomics, profits are included as factor payments, because they provide income to households. 12. Note that if dollars are a yardstick of value, any errors in estimating the changing value of dollars over time amount to measuring with an inaccurate yardstick, and will result in mistaken measures of all real (adjusted for inflation) variables. 13. An extension of the text discussion of per capita measures that may be useful in class would be to ask students whether if population growth slowed, a slowdown in real GDP growth would necessarily be a concern (per capita trends would be determined by whether population growth or real GDP growth slowed more). 14. Make sure students realize that different relative sizes of non-market and underground economies can affect several important size comparisons between countries, such as GDP, GDP growth rates, income per capita, etc. 15. A good classroom way to reinforce GDP measurement issues is to ask what happens to GDP when a student goes from public school to home schooling. 16. A good class discussion starter is to ask students why the size of the underground economy would be expected to be a function of marginal tax rates and regulatory burdens, and why underground economies in different countries (e.g., the U.S. versus Russia or Italy) are of different relative sizes as a result. 17. Another good class discussion starter is to as students if they can see how inflation can be considered to be a tax on the underground economy, which escapes taxation through more conventional means (it is a “tax” on holding cash, intensively used in the underground economy, by reducing its value over time). 18. A good classroom discussion starter is to ask students how measured GDP growth would tend to overstate “real” output growth when there are sharp increases in the labor force participation rate (formerly non-measured output is now being measured, and reductions in leisure are not). Another good question is to ask how a natural disaster could increase measured GDP in the immediately following period. 19. A useful thought question is to ask students whether they would be better or worse off (worse, looking back) and whether GDP would go up or down (up) if you could be “fooled” into taking a job because you thought the wage was far higher than it turned out to be. This can then be tied to the unexpected inflation discussion later in the text. 20. It should be pointed out to students that the difficulties in measuring macroeconomic variables make it difficult to establish valid economic relationships (e.g., the relationship between unemployment--with measurement problems--and real GDP--biased by any biases in measuring nominal GDP and any biases in estimating changes in the overall price level. 21. It is worth emphasizing that the circular flow’s main use is to remind us of the various mechanisms by which different markets interact with each other, which is helpful because of how complex those chains of relationships can be. Chapter 22: Economic Growth in the Global Economy 1. Make sure you connect students back to the basics of economics by reminding them that economic


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growth as a goal arises from the fact of scarcity. 2. The growth rate versus stability issue could be illustrated by a world where taking risks and trying new approaches is generally productive (which could be illustrated by gambling, say with dice, if the expected payout was positive)--a world where more risk taking is generally productive may face more instability but have a higher growth rate. 3. Make sure students understand why potential output is also called the natural level of output (and similarly for other economics terms, which are named to reflect underlying economic relationships). 4. It may be worth highlighting that once we introduce the AS/AD analysis, anything that shifts out a society’s PPF curve will also shift both the SRAS and the LRAS to the right. 5. As a peek ahead to supply-side issues, you may want to mention that ultimately, incentives are crucial determinants of the growth of the production possibilities curve over time, by leading to changes in work effort, savings and investment, risk taking, etc. 6. It can be worth emphasizing that even if a poorer country has a higher real economic growth rate, it can take a long time to close a per capita real income gap, which can lead citizen expectations to outpace reality and “the crisis of rising expectations.” 7. The complex determinants of economic growth can be used to explain to students why a great deal of economic research involves multi-variable regression analysis, where researchers are trying to establish the contribution of each of several different variables to some phenomenon. 8. It can be worth expanding the labor as human capital discussion to show that investment principles apply to education (how much education to get, which major to choose, how hard to work, etc.), just as to other investments. This can increase student interest and cement their understanding of the issues. 9. You may wish to note that a country that increased investment based on the typical relationship between investment and growth would be less successful if it increased investment in areas that did not embody technological advances as opposed to investment in areas that did embody technological advances (since the typical relationship counts some of the contribution of added technology as a contribution due to increased capital). 10. When referring to the savings rate-GDP growth connection, it is often worth emphasizing that different measures of savings produce very different numbers (e.g., some ignore the increasing value of stock market investments as adding to income and therefore savings), and that any errors in measuring income or consumption will also introduce similar biases into savings measures. 11. A connection to earlier discussions in the text can be drawn by asking students why weak protection of property rights would reduce the incentives to both work hard and invest. 12. You may want to tie economies of scale and protection of property rights together by emphasizing that there are huge economies of scale to the protection of property rights (the government could do it at lower cost), so that when the government doesn’t protect property rights, more costly alternative arrangements must be employed, leaving fewer resources for increasing output. 13. A good way to reinforce the Malthusian idea is to ask students why it makes the rate of technological advance such an important determinant of real per capital economic growth in a society. 14. It can be worth noting that a move to freer markets will generally yield a growth spurt as the society moves to a now higher effective productive possibilities curve. However, once the economy has caught up to that now higher curve, that temporarily higher transition growth rate will no longer be sustainable (although the growth rate can still remain higher than before the move to freer markets began).


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Chapter 23: Financial Markets, Saving and Investment 1. Explain to students why those who are most optimistic about a firm’s future profit prospects would prefer holding common stock over holding preferred stock or bonds in the corporation. 2. Two good examples of the principal-agent problem are to discuss how effectively students act as agents of their professors (e.g., studying) and as agents of their parents (e.g., cleaning their rooms). 3. Emphasize that stock prices change when expectations change, rather than waiting until an event occurs (e.g., the credible announcement of higher corporate taxes, beginning in a year, will lower the stock price today). 4. You might extend the discussion of reinvestment discussion to the tax treatment of capital gains (higher taxation of capital gains discourages reinvestment), since reinvestment pays off to investors through stock price appreciation. 5. A good illustration of whether one can consistently pick winners is why get rich quick schemes fail. Even if I had a strategy that actually worked, as soon as lots of other people tried to use the same strategy, it wouldn’t work any longer because asset prices would be bid up by others trying to do the same thing I was, eliminating the potential for unusual profits. 6. Note the connection between the idea that stock prices are a random walk and index funds and “buy and hold” mutual funds. 7. You may find it worthwhile to delve more deeply into the information available on the financial pages than the text does, if your class shows a particular interest in those issues. 8. Emphasize that while a price/earnings ratio tells you some information about different firms, unless future prospects of two firms were identical, even if their current performances were identical, you would not expect them to have the same price/earnings ratio. 9. When discussing financing a corporation, it can be worth emphasizing that different forms of financial claims (stocks, bonds, etc.) allow people to specialize in the risks they are willing to bear (and monitor). For example, one can think of stockholders as specializing in normal business risks and bondholders as specializing in bearing bankruptcy risk. In that vein, you may want to ask students why owners of a firm’s common stock may be more optimistic (because they will capture the value of “good” surprises) about its prospect than owners of its preferred stock or bonds (who will not). 10. In discussing the idea of the separation of ownership and control, remember to take capitalization into account. For instance, if an owner knew a manager would “misbehave” because of bad incentives, he would offer less to purchase a share in the first place. Managers might also limit current misbehavior because of the effect on the present value of their future incomes as managers. Takeovers also reflect capitalization, when managerial misbehavior lowers current stock prices, and can make a takeover attempt profitable. 11. This is a good time to re-emphasize the crucial importance of understanding the underlying incentive stories for shifters of the supply of loanable funds and the demand for loanable funds, because if students don’t know those stories, they will be unable to apply the tools they are learning to real world situations. 12. Make sure you go through each of the four basic shift scenarios in the investment and saving market. Further, remind students that in any multiple shift case, we simply “add up” the effects of each of the shifts separately.


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13. One helpful way to make sure students have understood the supply and demand for investment and saving market is to give them a situation where two changes shift the same curve and ask them about what will happen. Some will think that two changes must have shifted different curves, which will give you a chance to warn them that there is no guarantee that any two changes must shift different curves. You can go further to show that if the changes shift the same curve the same way, the analysis is just like that of a single curve shifting. While if they shift the same curve in opposite directions, we don’t know anything unless we know which of the shifts was the greatest magnitude. 14. Emphasize that while the details are different because we are analyzing a different market than in other sections of the book, the intuition behind the move to equilibrium story is basically the same— competition by those frustrated in their ability to transact what they wish at the current price (interest rate). 15. The crowding-out effect discussed here is the reason why the most essential question about government deficits is whether the government spent those resources better than the private sector, because if not, we are worse of (but not essentially because of the deficit), but if so, we are better off despite the deficit. 16. Remind students that in the case where there is a government surplus and positive levels of public saving, what we have called the crowding-out effect will become a crowding-in effect, as lower interest rates increase the levels of private investment. 17. It can be worth connecting the open-economy capital flows here to the later discussion of domestic crowding-out versus international crowding out (international flows of funds reduce the magnitude of the interest rate change and the domestic crowding-out of investment, but because inflows increase the exchange value of the dollar in international currency markets, they crowd-out net exports). 18. A useful illustration of interest rate sensitivity is to show students how much more their higher education loans would cost at different interest rates. A change in those interest rates could affect decisions such as whether to go to college, whether to go to a public or private school, whether to go to a junior or community college and live at home for part of the time, etc. 19. A good illustration of the power of present values is to look at some sports star’s big money contract, especially where a great deal is deferred into the distant future, and compute its present value. 20. A good present value example is the option that California’s Lotto gives players between getting paid in installments that increase over time and a much smaller amount today, to figure out what interest rate gives the two options an equal present value. 21. Another good present value example is why accelerating tax deductible expenses from January to December of the previous year can be a good idea, but accelerating them from December to December of the previous year is unlikely to be a good idea. 22. Yet another present value example is why a game show will give away, say, a $1000 savings bond (typically with the most distant possible maturity date) rather than $1000 cash as a prize. It sounds like the same amount, but is worth far less in present value terms. 23. In discussing the financial crisis, you can help students understand why people can be hit with a sudden cash crunch from the sharp housing price declines in terms of the liquidity of their house or home equity as an asset. In boom times, those assets are highly liquid, so that if someone thinks they will always be liquid, they would reduce the amounts of other liquid assets they hold (like cash). When the boom turns to a bust, those assets are either not there (value declines) or not nearly as liquid as before, and people can be suddenly cash constrained. 24. When talking about the risks of “bad” loans, it is worth emphasizing that as long as an investor was


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confident Fannie Mae or Freddy Mac would buy their investment, it would appear to be a low risk investment, regardless of the underlying risk in the portfolio itself. When Fanny Mae and Freddy Mac go bankrupt, this helps explain the sudden jump in perceived risk. 25. In the discussion of the Fed’s maintenance of very low federal funds rates, students may get a better sense of how low if you show them that those rates were actually negative in real terms for at least part of the expansionary period. 26. It can be worth noting that home loans in the U.S. were historically safe because lenders maintained policies and standards that reduced the risk of default. What made them suddenly much riskier than people expected was the largely unrecognized changes in standards being applied to home loans. Chapter 24: Aggregate Demand and Aggregate Supply 1. Note to students that the large fraction of GDP that goes to consumption purchases explains why forecasters and business economists pay so much attention to economic indicators such as consumer confidence, consumer credit card and mortgage debt, etc. Anything that is a major determinant of consumption will be a major determinant of aggregate demand (AD). 2. Looking ahead, it is worth noting that changes in net taxes (taxes or transfer payments) do not change the demand for goods and services directly, but indirectly, by changing disposable income to the household sector, which changes consumption demand, which changes AD in the same direction. 3. As a prelude to the later discussion of stabilization issues, you might note to students that changes in investment could reflect volatile private sector expectations or “animal spirits,” but they could also reflect rational investors’ responses to drastically changing government policies. Whether the market sector or the government is “at fault” for a particular instance of private sector investment volatility remains an open question, without more information. 4. Note that a tax change that primarily affects households’ disposable incomes will primarily affect consumption demand, but a tax change that is focused on business income (e.g., capital gains taxes, corporate income taxes, investment tax credits, accelerated depreciation, etc.) will have its primary initial effect on investment. 5. It can be worth noting that, as in the Great Depression, net investment can actually be negative (when depreciation of the existing capital stock exceeds new investment). 6. A good application of the role of expectations is to ask students why, whenever there is a recession, the government tries to convince its citizens that times will soon get better (e.g., “A chicken in every pot and a car in every garage.”). If consumers and investors believe the economy will soon get better, they will spend and invest more now, increasing current AD. 7. Note that since the same arguments often apply to consumer durables as to investments, consumer durables may often exhibit behavior more like investment than the rest of consumption in many circumstances. This is important to remember, for example, when understanding how changes in real interest rates affect the economy. 8. Make sure that students understand why we talk of net exports in our analysis, even when they are negative, rather than net imports (net exports are the way foreign trade enters into AD). 9. You may want to show students why the fact that increases in net exports increase AD, leads countries to urge other countries to stimulate their economies (if trading partner economies grow faster, so will our exports and AD, without having to change domestic policy to try to achieve it), when they are faced with domestic recession worries.


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10. Make sure students see that the downward slope of AD is not for the same reason as the downward slope of demand for a particular product. It does not rely on substitution among products caused by changing relative prices of different goods or services, but on changing output prices relative to input prices. 11. Note that the magnitude of the real wealth effect is a function of how much of a country’s wealth is held in money, so this effect may be empirically small, if the fraction of wealth held as money is small. 12. Note that the real wealth effect does not apply to bonds, with fixed promised dollar payouts in the future, because while a higher price level erodes the real value of bondholders’ assets, it also correspondingly decreases the real value of bond issuers’ liabilities. 13. Note to students how the open economy effect of a change in the domestic price level implies that importers and exporters will disagree as to what appropriate price policy is with respect to changes in the price level. 14. This is a good point to extend the results of microeconomic supply and demand to AS/AD logic. If there is an increase in demand in some sector of the economy, prices in that industry (and the overall price level) will rise, output in that industry (and real GDP in the economy) would tend to rise, employment in that industry (and employment in the overall economy) would tend to rise, unemployment for those with skills used in that industry (and unemployment in the overall economy) would tend to fall, and total revenue of producers in that industry (and nominal GDP) would tend to rise. The opposite will be true if there is a fall in demand in some sector of the economy. 15. Emphasize the relative speeds of adjustment in the AS/AD model. The goods and services (output) market adjusts first (in response to a change in AD) in the short run, then, input markets adjust (except for the supply shock case, where that input market adjusts first), as the economy adjusts from the short run to the eventual long run equilibrium. 16. Local supermarkets provide a good example to reinforce the short run output price change relative to input price analysis: Output prices typically change weekly, with new newspaper ads, but the wages paid to checkers may be determined by three year union contracts. 17. Note that the definition of the long run makes both the reasons for the upward sloping SRAS disappear: The profit effect, caused by output prices changing relative to input prices, disappears, once input prices adjust, and the misperception effect disappears because people aren’t fooled in the long run. 18. To reinforce the idea of why the LRAS is vertical, it is often useful to show that if all prices doubled, no relative prices would change, and if no relative prices changed, we would expect no change in people’s behavior (real output). It is also useful to emphasize the connection between the LRAS and an economy’s PPF to make the point: Changes in the overall price level do not change any of the determinants of an economy’s PPF, so they will not change real output once people adjust. 19. Remind students that the long run is however long it takes for full adjustment, so that an important question for stabilization policy will be how long the long run is. The likelihood that government intervention will actually stabilize the economy is a function of how long it will take markets to adjust to shocks (Using a shooting illustration, the closer the market will come to the bull’s eye, the less likely government will do better and the more likely government will do worse, but the farther the market is from the bull’s eye, the more likely government will do better and the less likely government will do worse). 20. Emphasize the importance of distinguishing between real and nominal variables when talking about long run results, as real variables (e.g., real GDP, real wages, or real profits) will return to their original levels equilibrium levels, but nominal variables (e.g., nominal GDP, nominal wages, or nominal profits) will reflect the long run change in the price level.


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21. It is useful to remind students that the magnitudes of the AS/AD shifts we draw in the book or on a blackboard are greater than in reality (e.g., a roughly 3% annual real economic growth rate), so that it is easier to see the analysis graphically. 22. If, as many studies show, new technology takes many years before it substantially changes productivity, the ultimate effect of a technological advance may be far greater than indicated by the change in SRAS that results. 23. Note that while tax rates don’t affect the quantity of natural resources, technology, etc., directly, they are major determinants of the incentives to find and develop new natural resource deposits, invest in new capital or technology, etc., and therefore are crucial determinants of LRAS growth. 24. Note that in those cases where government regulations effectively address market failures, the value of the benefits would exceed the costs, and such government regulations may increase productivity, rather than decreasing it. 25. Note that if a natural disaster destroyed much of an area’s productive capacity or assets, there will be a long run effect unless those assets are brought back to at least their old levels (in this way, natural disasters are different than cases of temporary bad crop years). 26. Note that the reason for economists’ confidence that the AS-AD intersection meaningfully represents reality is the same as that for our confidence in supply and demand in individual markets--if we are not at such a point, it is in someone’s self-interest to change their behavior in a way that will lead us toward the supply and demand equilibrium. 27. A good analogy to temporarily producing beyond the LRAS is finals week, where students are willing to “supply” more academic output than they are willing to on a sustainable basis. 28. It can be worth reminding students that AS/AD equilibrium does not mean that each individual product market must be in equilibrium. 29. In contrasting cost-push versus falling AD recessions, make sure students see that real GDP and employment rise, and unemployment falls in the short run in both cases, but the price level rises with cost- push inflation, while it falls when triggered by a fall in AD. 30. Emphasize that the AS/AD model has different implications for each of three different time periods: the short run, the short run to long run adjustment, and the final long run result; so that students need to be careful that they answer questions for the time period indicated. 31. Emphasize that wages and prices are sticky downward, not equally sticky in each direction. This means that the major problem of slow economic adjustment is during recessions, not during booms. 32. Note to students that even if the market’s self-corrective mechanisms can “handle” one-time negative AD shocks reasonably quickly, they can still be overwhelmed by a series of negative AD shocks, as during the Depression. 33. A useful analogy to macroeconomic speed of adjustment issues is a marble placed off-center in a perfectly round-bottomed bowl. With little friction (stickiness), the marble moves quickly to the bottom, but then overshoots, so you might want to introduce some friction (e.g., put liquid in the bowl) to slow the adjustment down. However, if the liquid in the bowl is too thick, adjustment to the bottom may now be too slow, and you may want to accelerate it with a (government) push. 34. The short run to the long run “story” in the macroeconomy (because of the lag before input markets adjust) is very similar to the short run to the long run “story” in microeconomics (because of the lag before profit incentives lead to entry or exit). The big difference is that long run supply curves are more


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elastic than short run supply curves in microeconomics (because more resources can be attracted from other industries, given more time to do so), while the long run aggregate supply curve is more inelastic (vertical, or perfectly inelastic) than the short run aggregate supply curve (because people are no longer fooled by the price level into different choices than if they weren’t fooled by the price level.). Chapter 25: The Aggregate Expenditure Model 1. Emphasize the assumption being made of a fixed price level, so that real and nominal changes are the same. 2. Emphasize the difference between autonomous and induced consumption. Induced consumption--the basis of the multiplier effect--is why virtually any change that increases aggregate demand will increase consumption purchases. 3. Emphasize that autonomous consumption (or expenditures) is not changed by a change in income—a change in income causes a movement along the consumption (or expenditure) function, not change or shift in the function. 4. For reinforcement, it is worth going through not just cases where one shifter changes, but cases where more than one shifter changes. 5. Make sure you use examples with different MPCs to reinforce student understanding of the multiplier process. 6. A humorous connection you can use in the classroom is why parents’ assertions that for every dollar a student gets from them, they spend more than a dollar, would be impossible for the economy as a whole (MPC must be less than one for there to be a finite equilibrium). 7. Emphasize to students that the MPC and MPS are not separate pieces of information, but different ways of expressing the same thing. It is worth “warning” them that questions may be worded in terms of either of them. 8. It is worth emphasizing the implicit assumption in the Keynesian expenditure model that money saved does not lead to increased investment. 9. Emphasize that the 45-degree line reflects the fact that in equilibrium, output must equal expenditure. 10. Note the importance of unplanned inventory change as the signal that tells a firm whether demand is higher (negative unplanned inventory change) or lower (positive unplanned inventory change) than expected, and therefore whether to increase real output or decrease real output. 11. It might be worth noting that one could believe in the multiplier process increasing aggregate demand without also believing that the increase in real output will be the same as the increase in aggregate demand (i.e., that some of the effect could show up in changed prices as well). 12. It can be worth going through the multiplier process with different MPCs, which also allow you to talk about why a higher MPC implies a greater multiplier. 13. Emphasize that the multiplier process takes time, and if we only look at the eventual result, we will overlook the important issue of how long it takes, which is crucial to successful macroeconomic stabilization policy. 14. If you want to show students a look at a more advanced application using the multiplier, you could briefly talk about the effects of an income tax and a marginal propensity to import, and how each would reduce the multiplier.


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15. You may find an analogy between autonomous (independent of income) investment and the autonomic (independent of conscious control) nervous system useful. 16. Emphasize that while we can go from the aggregate expenditure model to AD, and see how shifts in the aggregate expenditure function create shifts in AD, the effect in the economy is determined by the interaction between that AD shift and the AS curve, and that we generally consider the AS curve to have a different shape than the Keynesian assumption, especially when we have not deviated far from full employment. Chapter 26: Fiscal Policy 1. Emphasize that taxes and transfer payments are different ways of changing net taxes, each of which changes the disposable incomes of households, which in turn changes AD by changing consumption demand. A tax increase has the same effect in this regard as a transfer payment decrease, while a tax decrease has the same effect in this regard as a transfer payment increase. 2. An interesting historical example involving different ways of changing net taxes was the 1984 Reagan-Mondale presidential campaign. Both candidates promised to increase net taxes, but in different ways and with different incidences. Reagan was going to cut transfer payments (welfare), improving incentives to be productive, while Mondale promised to raise taxes. 3. Make sure students recognize that budget deficits are not a measure of the size of government, but of the difference between government spending and taxes. The government can grow in size at the same time that the deficit can fall. 4. Emphasize that for fiscal policy, the deficit or surplus that matters is that of all levels of government together, not just the federal government, and that changes in state and local government purchases and/or taxes can either reinforce federal policy changes (e.g., matching grants to lower level governments) or offset federal policy changes (e.g., when purchase changes at one level of government are offset by changes at state and local government levels). 5. Make sure students recognize that the multiplier consists of income-induced changes in consumption, so that most of a change in AD, whatever category of purchases the initial change occurred in, is comprised of changed consumption. 6. You may want to create a table showing various MPCs and their corresponding multipliers (chosen for ease of calculation) to reinforce the MPC-multiplier relationship, especially if you intend to test students using examples with different MPCs or multipliers. 7. As an extension of the multiplier, you may want to spend a little time showing intuitively how income taxes reduce the multiplier (a change in income leads to a smaller change in disposable income and thus to a smaller change in consumption demand during each â&#x20AC;&#x153;roundâ&#x20AC;? of the process, so that the higher is the income tax rate, the lower is the multiplier). The same could be done, if desired, to illustrate the effects of imports as a leakage from the circular flow. 8. Make sure students understand why a change in net taxes has a smaller effect than an equivalent change in government purchases (a change in net taxesâ&#x20AC;&#x2122; initial effect in product markets is the smaller, induced change in consumption, while a change in government purchases has an equal dollar initial effect in product markets). 9. To reinforce understanding of the MPC and APC, you might ask students how fears of a collapse in the Social Security system could affect it (it would tend to increase private savings and therefore reduce both MPC and APC).


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10. Emphasize that the lag problem will create difficult timing and forecasting issues for attempts to stabilize the economy. 11. Note that the discussion of expansionary and contractionary fiscal policy implies that government intervention can potentially â&#x20AC;&#x153;solveâ&#x20AC;? market instability, but it also means that government intervention can be the source of economic instability, if improperly timed. Looking ahead, you may also want to note that overcorrecting for one problem (high unemployment) can be the cause of another problem (inflation). 12. Note to students the differences in effects between explicitly one-time changes in taxes versus permanent changes in tax rates, because of the difference in expectations about future disposable income that result. 13. Remember that the domestic crowding-out analysis also applies to consumer durables, and not just business investment. 14. You may want to extend the crowding-out analysis to include a discussion of the determinants of how large the crowding-out effect will be (e.g., How much will interest rates change? How responsive will desired investment be to changes in the interest rate?) 15. Because of the greater complexity of the open economy crowding-out analysis, you may want to also go through the case of a decreasing deficit in your classroom discussion. You may also want to extend this discussion to some of the determinants of the magnitudes involved (e.g., How large will the effect on exchange rates be? How much will net exports change in response to the changed exchange rates?). 16. Note that the text discussion implies a preference for changes in net taxes over changes in government purchases, if the speed with which the effects are felt is of particular importance. 17. Emphasize that automatic stabilizers trigger changes that both begin and end soon after business conditions change (as opposed to discretionary fiscal policy), solving much of the lag problem of discovering when economic conditions change and adopting a policy response. 18. In the supply side discussion, it is worth emphasizing that the determinants of the LRAS (PPF) are all in the long run a function of incentives. New investment and technology are functions of after tax rates of return, as are exploration and development of natural resources, the development of human capital, etc. 19. The supply-side effects of tax rates on worker can be shown clearly in terms of the 1980s tax rate reductionsâ&#x20AC;&#x2122; effects on take-home pay. A given percentage reduction in a higher tax rate (e.g., from 70% to 50%) causes a much larger percentage increase in take-home pay (from 30 cents on the last dollar to 50 cents) than the same percentage reduction from a lower tax rate (e.g., from 14% to 11.5%, which increases take-home pay from 86 cents on the last dollar earned to 88.5 cents). 20. The effect of taxation on saving incentives can be illustrated by the attraction of 401k plans and other deferred tax savings vehicles, as well as Roth IRAs, which can compound in a tax free manner. 21. Note that in a recession, different groups could agree that tax cuts are a good idea, but for different reasons. Some would base their support on the fact that tax cuts may act more quickly to increase AD, but supply-siders would support it because of the improved LR incentive effects on AS. 22. As a supply-side fiscal policy example, you could discuss how phasing in a tax rate cut over time could actually delay a business recovery, by making people delay new investment and income generating activities until after tax rates stop falling. 23. Make sure students see why government debt held by other government agencies imposes no net


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burden on American taxpayers. 24. The ultimate issue with respect to the debt--how well were the borrowed dollars spent--can be well illustrated in students’ lives by discussing whether their student loans make them better or worse off. Chapter 27: Monetary Institutions 1. Note that many of our expressions involving money reflect goods that at some time or place have functioned as money--bucks (buckskins), clams, bread, describing a quarter as two bits (two one-eighth bits of a Spanish dollar), etc. Further, there are lots interesting anecdotes about money (e.g., dimes and quarters have serrated edges, to guarantee that others had not shaved some of the valuable metal, when they were made of silver, but nickels and pennies do not, because the metal in them was not worth shaving them down). 2. Roy Radford’s classic article on the economic organization of a POW camp is a fine illustration of societies’ tendency to create something (cigarettes from Red Cross packages) to function as money. 3. You might want to note that the U.S. government keeps trying to replace dollar bills with dollar coins (with early Presidents on the current coins, after failures for Susan B. Anthony and Sacajawea), because they are cheaper (coins cost more to mint, but they last much longer in circulation), but many Americans (including those owning coin and bill operated vending machines, who would have to incur substantial expenses as a result) oppose the idea. 4. Note that given the use of currency to avoid taxes in the underground economy, a sharp increase in tax rates would tend to increase the demand for money for such purposes. 5. Note that disagreements about what we should count as money for various purposes implies that it is worth looking at multiple money measures as a check on whether the particular measure we are relying on may reflect some unusual factor or bias (e.g., changes in the demand for currency in circulation). 6. A good illustration involving money is to ask in class whether rubles in the old Soviet Union were money. What if “money” is not internationally exchangeable and stores that would accept it have nothing desired on their shelves? Such “money” is not really money, because it is not generally acceptable in exchange for goods and services. It is more like a coupon “good while supplies last,” when there are often no available supplies. 7. Note that the functions (advantages) of money underlie our concern about inflation and deflation, both of which reduce money’s ability to reduce transactions costs. 8. A good way to see how important money is to the operation of an economy, pick a common transaction (e.g., filling up your car with gas) and ask how easily such transactions could take place without money (Would cars even exist? How could prices be advertised? Would credit cards exist? How do you make change?). Similarly, you could ask students how easy retirement planning or long term investment plans would be without money as a means of deferred payment. 9. Note that in cases where another outside currency (e.g., U.S. dollars) exists to trade with, Gresham’s Law has a corollary: If contracts can be written in terms of more reliable or less reliable (in terms of value) currencies, people will prefer to contract in terms of the more reliable currency (good money drives out bad). 10. Fractional reserve goldsmithing, where goldsmiths (who had the safest places to store gold) would issue paper claims on gold, which circulated as money, and also lent out some of the gold, also circulating as money, is a popular analogy to modern fractional reserve banking. 11. Given the importance of the fact that loans and secondary reserves pay interest, but official reserves


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(vault case and reserves at the Fed) do not (or have just recently begun earning very low rates of interest, in the case of reserves at the Fed), to banks incentives, you may want to discuss the effects of the Fed starting to pay interest on reserves. 12. A useful in-class question to ask is: Is money an asset or a liability? It is both; an asset of the account holder, but a liability of the banding system. 13. Money is a good illustration of the fallacy of composition: Even though more money for me might be good for me, it does not mean that more money circulating in society must be good for us. 14. It may be worth going over the process of money destruction in more detail in class, to make sure students clearly understand the process involved as well as that of money creation (which is more intuitive). 15. It is often worth going through the calculation of different money multipliers for different required reserve ratios (using easy to calculate numbers) to cement student understanding of the multiplier, especially if you plan to test students using different required reserve ratios on their exam questions. 16. You may want to extend the money multiplier formula to include desired excess reserves in the banking system (MM = 1 / rr + er) in class, to show how desired excess reserves reduce both the money multiplier and the money supply. You may also want to show how changes in currency holding by the public can affect the money supply (a dollar in circulation counts as a dollar of money, but a dollar in a bank vault counts as a reserve, that can support multiple dollars of demand deposits through loan creation). 17. In class, you may want to ask how interstate banking may have reduced the extent of bank runs in the Depression (like Canada). There would have been less risk of insolvency as banks could have held more diversified loan (asset) portfolios. 18. An interesting question to ask to illustrate some issues of internet banking is: Why might imposing looking banks have acted as a form of depositor assurance against insolvency? Why does internet banking rely on to provide that assurance? (Deposit insurance) Chapter 28: The Federal Reserve System and Monetary Policy 1. If you wish to add a historical note to you class, you may want to discuss how the Fedâ&#x20AC;&#x2122;s structure arose from general distrust of New York financial interests. 2. Another historical note of potential interest may be why non-member banks are now subject to the same reserve requirements as Federal Reserve member banks (the penalty for holding larger percentages of non-interest bearing reserves for member banks, especially large member banks, than for those banks regulated by the states, led many to leave the system, reducing Fed control of the system, leading to the Monetary Control Act of 1980). 3. The discussion of the structure of the Fed may be a good time to show students just how much macroeconomic material is available for free from the Fed and regional branches (e.g., you might want to show them the Fedâ&#x20AC;&#x2122;s catalog of publications, or bring some of the ones you get with you to class). 4. Note that the ability of the Fed to change monetary policy more quickly than fiscal policy can be changed can be either an advantage (if they act in a way that helps stabilize the economy) or a disadvantage (if they act in a way that destabilizes the economy (say, due to lag and forecasting problems). 5. You may want to make sure that students see that velocity is just another way of viewing money demand (at a higher opportunity cost, you want to hold less money, which means that each dollar held


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has to work harder by being used more frequently to conduct a given volume of transactions). 6. Another useful way to think of velocity is to think of money as a hot potato, and the interest rate as its temperature. The higher the interest rate (temperature) the faster you want to pass the money (hot potato) to someone else and the more times money will change hands in a period of time. 7. Note that while expansionary monetary policy has the same effect as expansionary fiscal policy on GDP (as the text discusses), not all the variables of interest are effected the same way as for fiscal policy (particularly interest rates, investment and consumer durable goods demand). 8. Note that Friedman’s proposed 3% monetary growth rule, based on an average real growth rate of about 3% in the U.S. (and stable velocity, with stable prices as the inflationary ideal), as well as other monetary policy rules, can be easily discussed in terms of the quantity equation of money, when combined with the possibility of variable velocity. 9. A good classroom exercise about open market operations is to ask students why, if you write them a check to buy a government bond from them, there will be no change in the money supply, but if the Fed does the same thing, the money supply ultimately increases by an amount far more than the purchase. 10. You may want to show students how blunt an instrument changes in required reserves are by showing several examples using the money multiplier formula (e.g., a one percentage point change in reserve requirements from 10 to 9 percent would increase the money supply by over 11 percent). 11. A good classroom exercise for understanding the Fed’s policy variables is to ask students why the Fed would seldom do open market purchase at the same time it was increasing the discount rate or the required reserve ratio. You could also illustrate those policy variables by showing students how an open market purchase (sale), combined with an increase (decrease) in the required reserve ratio, could either increase or decrease the money supply, depending on the relative magnitudes (e.g., in increase in reserves from $10 million to $20 million, combined with a reserve requirement decrease from 10% to 5%, would leave the money supply unchanged). 12. Garage sales can illustrate the transactions motive for holding dollars, and its proportionality to the dollar value of transactions conducted. If the prices at garage sales rise, the amount of money I would have to take to buy the same goods would rise proportionately. Similarly, if I was to buy more goods, the amount of money I would have to take would rise proportionately. 13. A good illustration of the precautionary reason to hold money is the fact that the Fed decided to print an extra $50 billion in currency to respond to potential currency hoarding due to Y2K fears. 14. Note that increasing the availability and acceptability of credit cards (which were introduced earlier in the text as substitutes for holding money) would be a good way of introducing the analysis of a leftward shift in the money demand curve. A further example for rightward shifts in money demand would be that in traveling overseas, you need to take more currency with you when you get away from heavily touristed places, because many other places do not accept credit cards. 15. A potentially useful extension of the text’s discussion of the Fed’s monetary control would be to ask what would happen to the money supply if the Fed decreased the required reserve ratio in a situation of desired excess reserves by the banking system, as during the Depression (in terms of the money multiplier formula, the reduced rr would be offset by an equal increase in er, leaving the money multiplier, 1 / rr + er, and the money supply, unchanged). 16. Note that the fact that monetary policy can be changed faster than fiscal policy allows the Fed to “go last,” and change policy once fiscal policy is revealed, which is one of the reasons the Fed may have more ultimate power over the economy than fiscal policy makers. Also, this explains why good economic news sometimes results in lower stock prices--people are worried the Fed will act in the opposite


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direction for fear of possible inflation. 17. Emphasize that it is the interaction between forecasting (both what the situation will be and what the consequences of particular policy changes will be) and long and variable lags that makes effective macroeconomic stabilization policy so difficult. 18. Note that the different monetary policy lags for output/employment and inflation means that we can use monetary policy to “solve” one problem--high unemployment--by causing another problem laterBinflation. Chapter 29: Issues in Macroeconomic Theory and Policy 1. It is worth making sure the increasing steepness of the Phillips curve at lower unemployment rates is connected to the logic of fooling people into changing their behavior by changing inflation. 2. Make sure students see that since an increase in real GDP implies a decrease in unemployment, an upward sloping SRAS curve implies a downward sloping Phillips curve. 3. You might want to make an analogy between manipulating a Phillips curve policy menu (assumed to be stable) and Mickey Mouse in “The Sorcerer’s Apprentice.” The apprentice knew enough to start the magic spell to start the mops and brooms cleaning the laboratory in the cartoon (to stimulate aggregate demand to lower unemployment in the short run in terms of the Phillips curve) but could not control the long run consequences (accelerating inflation) by stopping things when he wanted. 4. You might want to show students that one reason to use the Phillips curve model rather than AS/AD in an inflationary environment is that it is a simpler way to see inflation dynamics (e.g., a stable Phillips curve at a positive rate of inflation is simpler to use than AS/AD when both of those curves would have to be shifted up each time period, and the dynamics of adjustments must be shown by those shifts being of different magnitudes). 5. Make sure students see that in the adaptive expectations standard Phillips curve model, the only way to decrease inflation (and therefore decrease expected inflation) is by causing a recession, raising unemployment above its natural rate by fooling people with lower than expected inflation. 6. Note that a persistent attempt to fool people with higher inflation, as people adjust, will ultimately lead to hyperinflation. 7. In the SR and LR Phillips curve analysis it is useful to think of the natural rate of unemployment as a benchmark for differentiating which way people were fooled (e.g., just as in football, 10 yards for a first down differentiates between two very different results), hence which way they can be expected to adjust. 8. Note that if you are fooled into increasing output and employment by a monetary policy “surprise” increasing inflation, looking back, while measured output will have risen, you will consider yourself worse off (the leisure you gave up, but is not measured in GDP data, may have been worth less than your expected real wage, but it was worth more than what the real wage turned out to be). So measured output in such a case is a misleading indicator of well being. 9. Note that under rational expectations, while accurate expectations imply that a change in government policy can have not beneficial real effect, it is also possible for people to underestimate resulting inflationary consequences (with the qualitative results the same as the standard adaptive expectations model) or overestimate the inflationary consequences, leading to both increased unemployment and increases inflation at the same time (with the qualitative results opposite that of the standard adaptive expectations model). The result is that there is no reliable relationship between changes in inflation and changes in unemployment under rational expectations.


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10. An interesting rational expectations illustration is the fact that as part of Robert Lucas’ divorce agreement prior to his winning the Nobel Prize in economics, his wife asked for part of any future Nobel Prize award, showing that even his wife had rational expectations. 11. A good illustration of expectations is how little students like unexpected “pop” quizzes, versus scheduled tests. A further such illustration is exam difficulty and student expectations (What if everyone got what they expected for questions? What if the questions asked something students didn’t expect or they were substantially harder or easier than expected?) 12. Another way of making the point that expected changes don’t fool people is the way asset prices change today to reflect the capitalization of expected future effects. 13. A good analogy to the difficulty of conducting stabilization policy in a world where predicting people’s expectations and therefore their responses is pitching a change-up in baseball: If the batter is expecting some other pitch, especially a fast ball, they can be fooled by it, but if they expect a change up, it is unlikely to lower a pitcher’s ERA. 14. The presence of inventories as buffer stocks for shortage when price ceilings are first imposed, but that are soon exhausted, shows one reason why the long run effects of price ceilings are far more damaging that the short run effects. 15. You might want to note to students that a negative supply shock (that requires a substantial change in relative prices), such as an increased price of oil, will require greater inflation to adjust to in a substantially indexed economy. 16. Good illustrations of productivity shocks for the real business cycle discussion are the beginning and the end of the canal-building and railroad booms in the United States. Those illustrations can be then connected to more modern possibilities, such as the computer boom and the potential for biotechnology or nanotechnology booms. 17. It can be worth graphically illustrating the difference between the real business cycle idea that the LRAS shifts in response to a productivity shock with the traditional good supply shock scenario, in which the SRAS but not the LRAS shifts. 18. It is a good idea to remind students that the ability to change AD is a very different thing than the ability to stabilize the economy by changing AD. 19. The rational expectations idea that households and firms will very quickly adapt, so that policy has little ability to “fool” people into changing their real behavior can be analogized to an unannounced pop quiz. The point is to find out if students are really doing their assignments. But if word of the pop quiz got out, because students would change their behavior, it would reveal the desired information. 20. It can be useful to use the section on Controversies in Macroeconomic Policy to review the different schools of thought and why they come to the conclusions they do about the effectiveness of macroeconomic policy. For example, many schools of thought agree that activist policy is very difficult to implement or unlikely to work, but they often have different reasons—e.g., those who focus is on productivity shocks in real business cycle theory doubt the effectiveness of policy, but for different reasons than those who emphasize slow adjustment of prices and wages or the effects of crowding-out. 21. It can be worth reminding students that the shorter inside lag for monetary policy is an advantage only under the assumption that when the Fed acts, it acts in an appropriate manner to stabilize the economy, which need not be true. 22. In discussing central bank independence, it is worth referring back to the way the Fed finances its operations out of its bond portfolio (since it doesn’t pay interest on reserve accounts), while returning any


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“excess” earnings to the Treasury. The ability to fund its own operations gives the Fed independence from threats to cut its funding if it didn’t do what the legislative or executive branch wanted (as illustrated by frequent proposals to undo that independence from congressional committees with banking oversight). 23. The monetary growth rule section can be profitably tied back to the growth version of the equation of exchange, combined with long term real growth potential estimates of around 3% per year. 24. In the example of inflation targeting, it might be worth graphically illustrating the case of a negative supply shock, if the Fed was pursuing a stable price level target—because an adverse supply shock reduces real output and increases the price level, monetary would have to be contractionary to counteract the price increases, which would make the fall in output greater than it would otherwise have been. 25. The asset price inflation discussion should be tied back to the earlier discussion of price indices by reminding students that those measures do not take into account changes in asset prices. 26. In talking about indexing, it can be worth emphasizing that it threatens what may be the market’s greatest strength—communicating changes in relative scarcities to decisionmakers. If most things are indexed, it keeps relative prices from changing to accurately reflect relative scarcities in an inflationary world. Chapter 30: International Trade 1. Remind students that international trade principles are the same as interpersonal trade principles. Is it in your interest to protect yourself from trading with others next door? Is it in your interest to stop buying from your local grocery store because you are running a balance of trade deficit with him? Why are these issues any different than when we are dealing with trading partners in other countries? Combining this fact with the In the News section on outsourcing can also lead to some interesting classroom discussions. 2. A good classroom discussion starter is to ask students why we might trade more with some more distant trading partners, especially if we are connected by ocean rather than land. The lower transportation cost of ocean shipping, plus the fact that more distant regions may face larger differences in the opportunity cost of production (comparative advantage) could explain such patterns. 3. Babe Ruth is a good illustration of comparative advantage. He was a great pitcher (64-31 with the Boston Red Sox from 1915-1917) but an even greater hitter, relative to other players of the time. Even though Ruth’s team would give up a great pitcher every fourth game or so, he was more valuable as a batter playing every day. Even though Ruth may have had an absolute advantage at both pitching and hitting over others, he had a comparative advantage as a batter, and so ended up specializing as a batter. 4. Teachers are always looking for new examples of the gains from specialization and trade. During the Reagan administration, I used one involving a “mythical” couple named Nancy and Ronnie to supplement the text presentation with some classroom success. Each must chop 1 cord of wood and decorate 1 room each day. Nancy can do either in 1hour; Ronnie can chop a cord of wood in 2 hours and decorate a room in 1 1/2 hours. Starting from this basic data, the normal conclusions an be drawn about absolute advantage and comparative advantage, how comparative advantage is just another term for lower opportunity costs, about the gains from trade and the limits on the terms of trade, and the limitations imposed by transactions costs (how long they haggle each day must be weighed against the time savings from specialization). This same approach can be used with whichever “mythical” couple is in the White House, with any alternative “chores” that might be appropriate to current events. 5.

A good example of comparative advantage involves charity. A sports or other entertainment “star”


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could often do more good for charity by doing what he or she has a comparative advantage in for pay, and then donating the money, than by being directly involved in the process of helping directly (e.g., Is LeBron James’ time worth more playing basketball or serving food at a homeless center?) Of course, if such a star was giving up time that would not have been spent in his or her specialty, the opportunity cost of direct involvement for those hours could well be far less (which may also be why lots of performers volunteer for charity productions (e.g., Farm Aid or Comic Relief), but few of them are turning down highly paid opportunities at the same time to do so). 6. A good classroom example of comparative advantage to talk about is America’s comparative advantage in higher education, where we “export” education services to much of the rest of the world through a very large number of foreign students. 7. A useful analogy to issues of absolute advantage versus comparative advantage is in school. Educational testing in a given course (grades) rewards absolute advantage rather than comparative advantage--a student who does absolutely better gets a higher grade. However, a student’s comparative advantage may be revealed by their grades in one discipline relative to their grades in other disciplines. 8. Emphasize to students that as long as wage rates are able to compensate for differences in absolute advantage, those with such absolute disadvantages can still find work and gain from trade, unlike what is implied by those who use Darwinian “survival of the fittest” rhetoric to describe the result. 9. A good classroom illustration of trade issues is to show students that self-interest implies that I want free trade (competition) for what they buy, because that benefits me through lower prices and/or higher quality at a given price. However, self-interest also implies that I want to restrict others with whom I compete, because that will benefit me by increasing the demand for what I sell. That is why people so often claim to be in favor of free trade, but find some reason to condone protectionism (but usually called fair trade) in so many circumstances. 10. It may be useful to connect the maximization of the sum of consumer surplus and producer surplus here to the general welfare cost argument against all sorts of restrictions on trade, whether they are taxes, regulations, price controls, etc. 11. An interesting way to tie together political issues with trade issues is to ask students why they think it has been politically easier to get the government to allow free trade in export markets than import markets. Since there are fewer producers--special interests--than consumers, each with more each at stake in a particular market, producers often dominate political trade policy decisions. Those producers typically want fewer restrictions on their ability to export, but they may want to restrict their foreign competitors in competing for American customers. 12. A good classroom application of trade issues (that also makes clear that the issues involved are not labor versus capital) is to ask why union members in export industries might disagree with union members in industries that compete with imports about whether import restrictions are a good idea. Import restrictions help import substitute producers, but they also reduce the foreign demand for the product of export industry by reducing their foreign exchange earnings from exports to us. 13. Since most students have heard of the Smoot-Hawley tariff at one time or another, but probably don’t know what is involved, it might be worth some classroom time to discuss it, and the dramatic plunge in the volume of international trade during the Great Depression. 14. Note that limiting imports, which seems on the surface to increase domestic demand (if you don’t buy from foreigners, you must buy more from domestic producers instead), actually lowers it, by reducing real incomes of consumers, reducing demand for exporters, etc. (a circular flow model can be used to illustrate these total effects of import restrictions through different transmission paths). 15. A good way of discussing protectionism is in terms of how it is portrayed. Those in favor of


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protectionism portray the issue as one of American producers versus foreign producers (where we should “obviously” support American producers). However, as the text demonstrates, a more accurate description of domestic protectionism would be a collusion between the American government and American producers to primarily hurt American consumers (through increased prices or decrease quality), as well as harming more efficient foreign producers. Portrayed that way, protectionism doesn’t sound nearly as attractive. 16. A good illustration of the difference between tariffs and quotas is how Japanese automakers dramatically increased their profits under U.S. automobile import quotas imposed on them in the 1980s (restricting their sales in the U.S. raised their profits sharply) while increased tariffs would have instead decreased their profits and raised more tariff revenue for the government. 17. It might be worth extending the sugar quota discussion to the effects on the corn syrup market and why corn syrup makers and corn growers are big and politically important backers of sugar quotas, even though they don’t produce sugar (they produce a close substitute for sugar), much like unions support higher minimum wages, even when their members make far more than minimum wage. Chapter 31: International Finance 1. Note that since our imports provide foreigners the means (dollars) by which they can buy our exports, one of the ways import restrictions or protectionist measures indirectly effect the domestic economy is by decreasing exports as well as imports. 2. Especially if you have a large number of foreign students in class, it is often interesting to them to point out that the export of higher education services (teaching foreign students) is a substantial credit in the U.S. balance of payments. 3. To reinforce the meaning of the statistical discrepancy here, I like to propose calling it the international official fudge factor (OFF) in class. 4. It is probably worth noting in class that the substantial balance of payments statistical discrepancy implies that official balance of payments numbers be taken “with a grain of salt.” 5. Notice that since the U.S. is a net importer of goods and a net exporter of services, those who want to make the international trade numbers look worse often cite the balance of trade (merchandise only) numbers rather than the balance of payments (including services) numbers. 6. A relatively intuitive way to reinforce student understanding of the balance of payments current and capital account is by showing them that students are generally running current account deficits, combined with capital account surpluses (student or parental loans). 7. Note that the demand for foreign currency is a derived demand in just the same way that the demand for inputs is derived from the value of the outputs they produce. 8. To reinforce the exchange rate-net exports connection, it might be worth bringing a student “volunteer” to the blackboard and lead him or her through a numerical example of how export prices of American goods are changed, and therefore the volume of exports, as well as the prices in the U.S. of foreign goods, and therefore the volume of imports, are affected by changes in exchange rates, to show the logic’s generality. 9. An interesting sidelight to exchange rates is that since foreign currency dealers won’t exchange coins, informal coin trading markets often arise among students in overseas programs (e.g., those who have already been to England for the last time exchange their coins with those who have not yet gone). 10. One possible interesting application to students might be to ask what happens to dollar-peso


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exchange rates, ceteris paribus, if a Mexican beer company buys $100 million worth of advertising in the U.S. and as a result, Mexican beer exports to the U.S. go up by $500 million (it would tend to rise, although the effect would be small, as the demand for pesos increase more than the supply of pesos). Similarly, you could ask students what would happen if the numbers were reversed. 11. Note to students that international currency markets have become so extensive that even governments are not able to offset currency market forces for long. 12. One useful way of thinking of the initial financial market effects of international trade is to think of money piling up on the shore of whichever countries have trade surpluses. 13. An interesting illustration of exchange rate effects involves oil prices in the 1980s. In the early to middle 1980s, oil prices in dollars (all oil sales are priced in dollars) resulting in a “good” supply shock in the U.S. At the same time, however, the exchange value of the dollar was rising sharply, leading to higher domestic currency prices for oil in much of Europe, resulting in a “bad” supply shock in Europe at the same time. 14. You might want to discuss how exchange rates changes in the 1980s were caused in part by relative fiscal policies in the 1980s (early on, U.S. taxes on capital fell relatively to other countries, but later, foreign taxes of capital fell relative to the U.S.), as well as relative monetary policy. 15. Remind students that exchange rates always move in the wrong direction for someone. E.g., exporters and the import substitute industry want a weaker dollar, while at the same time, importers want a stronger dollar. This is why there is always pressure on the government to manipulate exchange rates and why there are always complaints of some groups that they are being harmed by policy. 16. Given the recent furor over government controls over capital market flows, particularly flows out of countries, it might provide a good discussion topic for class or a short paper. 17. As an application of this material, ask students why producers in Thailand or Singapore might be very concerned about whether China chooses to devalue its currency. 18. An analogy to the fixed versus flexible exchange rate comparison would be to ask students whether they would prefer that what they buy at the market has prices that fluctuate often but by small amounts as conditions change, or infrequently and unpredictably by large amounts. Which would they prefer for their university tuition and fees? 19. Because of the introduction of the Euro, you might want to discuss some of the issues involved in deciding whether it is better to have one common currency or one currency per country, with flexible exchange rates.


Solution manual exploring microeconomics 5th edition sexton