Introduction to Economics Social Issues and Economic Thinking Solution Manual

Stock Introduction to Economics Social Issues and Economic Thinking

Introduction to Economics: Social Issues and Economic Thinking

Instructor’s Manual

Chapter 1: An Introduction to the Economic Way of Thinking Chapter Outline 1. An Introduction to the Economic Way of Thinking 1.1. Microeconomics and Macroeconomics 1.2. Why Study Economics?

2. Scarcity and Basic Economic Resources 3. How Do Decision Makers Make Choices?

3.1. Decision Makers Compare Benefits and Costs 3.2. Decision Makers Maximize 3.3. Ceteris Paribus 3.4. Decisions Are Made Incrementally or “At the Margin” 3.5. Law of Diminishing Marginal Benefits 3.6. Law of Increasing Marginal Costs 3.7. The Marginal Decision Rule 4. Appendix: Working with Graphs 4.1. Constructing Graphs 4.1.1. Obtain Data 4.1.2. Draw and Label Axes 4.1.3. Plot Points 4.1.4. Draw the Curve 4.2. Interpreting and Modifying Graphs 4.2.1. Intercepts 4.2.2. Slope 4.2.3. Moving Along a Curve versus Shifting a Curve

Learning Objectives After studying this chapter, students should be able to: • Define economics • Explain how scarce resources influence choices • Describe the influence of benefits and costs on deciding among alternatives • Identify the decision rules individuals and firms use to make choices • Explain why decisions are made “at the margin” • Assess the general conditions that generate maximum utility or profits .

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Teaching Notes Students in your class are typically taking this class for one reason only, to fulfill a graduation requirement. This first chapter begins an opportunity to provide chapter after chapter of examples and illustrations in their real world of the relevancy of economics. Economics is not a “dismal” science. It is alive and in need of our attention.

Economics exists because of the condition of scarcity. If societies did not have to contend with scarcity there would not be a need to observe behavior. What is scarce? In economics, the fundamental economic problem is that there are scarce resources to fulfill unlimited wants.

Choices need to be made as to how to use them and because there are choices, there are costs, or opportunity costs. A triangle can be used to illustrate this concept. Also referred to as the Fundamental Economic Triangle, this visual demonstrates the relationship of scarcity of resources, choices made, and the costs of these decisions.

Because our economic resources are scarce, limited in quantity and have alternative uses, choices need to be made to determine the most efficient use of the resources. Does society want to use the available resources to build parks or tractors? Parks will provide immediate benefits to individual consumers. However, tractors will allow society to grow more food. Regardless of how society decides to use the scarce resources (more on this Chapter 2) a choice needs to be made. When a choice is made something will be given up, the cost of the decision. In economics, this cost is called an opportunity cost. Have students consider what their opportunity cost for coming to class was. For some it may be lost income, for others it may be foregone sleep. An opportunity cost is the cost of the next best alternative choice.

The Economic Triangle also illustrates the concepts of costs and benefits in the decision making process. When a choice is made it is inferred that the option chosen was because some sort of .

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benefit was received relative to the cost. Review activities suggested in Teaching Tips for ideas on how to present this concept in class. We make decisions that provide us some benefit considering the cost.

Why the emphasis on the margin? The most control of anything is on the next unit. We have the most control over the next dollar spent, the next hour of time, etc. Margin means extra, or next, in economics. Therefore economic choices are concerned with the benefits received versus the cost of the next unit consumed or produced. If I consume another cup of coffee what will be the benefits versus the costs for this decision? Decisions are made at the margin. Traditional theory on economics behavior tells us that with each additional unit consumed our benefits decrease, or diminishes. For additional units to be consumed the cost will need to decrease. On a hot summer day after mowing the back yard you will be willing and able to purchase and consume a cold beverage to quench your thirst. How able and willing would you be to purchase and consume a second, or a third? How would your decision be affected if the price would decrease for the second beverage and again for the third? This demonstrates the Law of Diminishing Marginal Returns.

An important concept in the decision making process that students tend to stumble over is a sunk cost. A sunk cost is a consequence of a decision that cannot be changed, or recovered. A sunk cost should not be considered as a cost of the decision. For example, you decide to spend your afternoon at a movie. You purchase a ticket and settle in with your additional purchases of popcorn and soda. Thirty minutes into the movie you find you find nothing about the movie interesting and decide to leave. You will not get a refund on the ticket, will you? No. This is a sunk cost for your time. If you consider doing something else that afternoon, the movie should not be part of the decision making process.

Teaching Activities 1. An exercise to introduce the concepts of scarcity, choice and cost is with a group activity that requires them to make decisions on how to use resources to build something.

Adapted from an Army ROTC team building task, the Tower Building Exercise is a small group activity that allows student to develop an understanding of the fundamental economic challenge of limited resources and unlimited wants before a formal presentation in class. Approximately 50 minutes will be needed for this exercise. Time can be adjusted to accommodate different class structures. a. Set Up: 6 – 8 minutes i. Break students into small groups directing them to move any personal items out of the way and clear space in their individual area ii. Goal is to build the tallest, free-standing tower using given resources only

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iii. Give each group a bag of “resources” to be used to build a tower 1. Review the materials provided in the bag (these material are suggestions and can be adapted/changed as needed) a. 1 sheet of legal size paper b. 1 foam or paper cup c. 1 foam or paper plate d. 2 – 5”x7” index cards e. 4 – 3”x5” index cards f. 1 roll of masking tape g. 1 pair of scissors h. 1 pencil or marker i. 1 pencil iv. Explain the rules 1. Everyone must participate 2. They may only use the items provided 3. They may manipulate the items in any way desired with the exception of taking apart the scissor 4. They do NOT have to use all the items 5. They may NOT adhere the structure to the floor, ceiling, or any other surface 6. The tower must withstand a slight breeze v. Ask questions for clarification b. Execute: Total 20 minutes (5 minutes PLANNING, 15 minutes BUILDING) i. Direct students to begin the PLANNING PHASE. ii. After 5 minutes, direct students to begin the BUILDING PHASE. iii. After 15 minutes, have students stop and bring their towers to the front of the room for evaluation.

1. Bonus points can be provided for the team with the tallest tower. c. Processing: 10 minutes i. After class discussion about scarcity of resources, choices and the costs of decisions assign students with the following questions 1. How did the Tower Building Exercise illustrate the fundamental economic problem of scarce resources and choices?

2. Using the Tower Building Exercise provide specific illustrations of marginal costs and marginal benefits. ii. Responses can be collected from individual students or from groups shared with the class.

2. Provide opportunities for the students to give examples of decisions made and the benefits received and the costs for the decision

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a. Why did they choose this economics class rather than another class b. Did they buy their text or rent it? E-text or physical? c. What is their cost of missing one class? (Prior to class calculate the cost of each class using tuition to illustrate the cost of each class missed.)

Additional Questions and Discussion 1. Using the “Think-Pair-Share” method of class discussion will assist students in taking their thought processes to a higher level. Ask student to consider the following.

Adam Smith stated that behavior was based on incentives that provided benefits greater than the costs. “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”

Think: From this consider what economics assumes about consumer motivation and behavior. Give students five minutes to consider and five minutes to write down at least two observations of human behavior about this.

Pair: Have students pair with one other student to share their observations and formulate a hypothesis about consumer motivation and behavior.

Share: Allow students to share their thoughts and observations on motivation and behavior.

2. Give two examples of marginal analysis in your life.

Answers will vary. Should the student take 12 credit hours or 15? Should the student work the extra shift on the weekend? Should the student stay on campus over the weekend?

3. You and your friend decide to go to a professional sporting event. This decision requires the cost of the ticket for admission, $120 which requires you to stand in line for approximately 1.5 hours. Explain the opportunity cost of going to this sporting event.

The opportunity cost would be your next best alternative use of the cost of the ticket and the time spent standing in line for the ticket.

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Answers to "Think for Yourself" Questions 1. (1) The opportunity cost of taking a class involves the tuition, fees, and books associated with the class. It also involves giving up time that could be spent in other classes, at work, or enjoying leisure activities. (2) The opportunity cost of putting money in a savings account is the value of the items you could have purchased if you had spent the money instead of saving it. (3) The opportunity cost having a mutually exclusive relationship is the opportunity to have a relationship with someone else.

2. The law of diminishing marginal utility implies that the utility we would get from watching each additional hour of TV would decline as more and more TV is watched, so TV watching would be less and less enjoyable as time passed. For most people, the marginal utility would eventually be low enough to entice them to do something else besides watch TV nonstop.

3. $18.00; 2

Answers to Discussion Questions and Problems 1. a. Even though your price is lower, you may not book more clients because the rivers are closed to fishing. b. You will likely get an increase in clients, but it would not be clear whether the increase is due to your lower price or due to the movie release.

2. a. The cost of studying for an exam includes the time that could have instead been spent working or in leisure. The cost also involves mental effort and fatigue. b. The cost of going skiing includes the cost of transportation, the ski pass, and the equipment. The cost also includes the decrease in learning that you would experience by missing class. c. The cost of taking a job includes the value of the next best job that is foregone. d. The cost of watching television includes the cost of electricity to power the television, as well as the value of the time spent watching, which could have instead been spent working, studying, or engaging in other activities.

3. You would need to know the opportunity cost of her time as well as the utility she gains from opening her own business. For example, if she could have earned $50,000 in a different job last year, she would need to have gained at least $25,000 in utility by owning her own business instead of working in a different job in order for her investment to be worthwhile.

4. Even if someone gives you the lunch for free, there is still an opportunity cost of the lunch.

The time that you spend at the lunch could have instead been spent working, for example.

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5. Because we have access to a large quantity of water, the law of diminishing marginal utility implies that the value of water at the margin is relatively low. The price of water reflects this marginal value of water. The supply of diamonds is much smaller than the supply of water, so the value of one more diamond is higher than the value of one more glass of water.

6. For someone who is overweight and does not exercise or restrict their calories, a change in exercise and diet can usually generate weight loss. As a person gets closer to his or her ideal weight, however, losing an additional ten pounds would involve more time and effort.

7. The marginal cost of each additional hour spent studying economics is the decrease in the score you earn on the accounting exam by not spending the hour studying accounting. The marginal cost of each additional hour spend studying accounting is the decrease in the score you earn on the economics exam by not using the hour to study economics. The table below illustrates these marginal costs.

Hours Expected Studying Score on Economics Economics per week Exam

1 2 3 4 5 6

62 76 86 94 100 100

Marginal Benefit of Studying Economics (increase in economics score) 18 14 10 8 6 0

Marginal Hours Expected Cost of Studying Score on Studying Accounting Accounting Economics per week Exam (decrease in accounting score) 0 1 80 0 2 88 2 3 94 6 4 96 8 5 96 10 6 96

Marginal Benefit of Studying Accounting (increase in accounting score) 10 8 6 2 0 0

Marginal cost of Studying Accounting (decrease in economics score) 2 6 8 10 14 18

The fourth hour spent studying economics has marginal benefit of 8 points in economics and marginal cost of 6 points in accounting. The fifth hour spent studying economics has marginal benefit of 6 points in economics, but marginal cost of 8 points in accounting. Thus, the optimal time to spend studying economics is four hours per day. The second hour spent studying accounting has marginal benefit of 8 points in accounting, and has marginal cost of 6 points in economics. The third hour spent studying accounting yields 6 more points in accounting, but costs 8 points in economics. Thus, the optimal time to spend studying accounting is two hours per day.

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Answers to Multiple Choice Questions 1. b 6. b

.

2. c 7. d

3. c 8. c

4. c 9. e

5. b 10. d

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Chapter 2 Production Possibilities Chapter Outline 1. Models in Economics 2. Production Possibilities Model 2.1. Scarcity and Tradeoffs 2.2. Attainable and Unattainable Choices 2.3. Efficiency and Inefficiency 2.4. Ceteris Paribus 2.5. Economic Growth 2.6. Opportunity Cost 2.7. Increasing Costs and Specialized Resources 3. The PPF, Opportunity Costs, and the Theory of Comparative Advantage 4. Where to Produce on the PPF

Learning Objectives After studying this chapter, students should be able to: • Explain the importance of models in economics • Describe the production possibilities model • Illustrate the use of the production possibilities model • Calculate opportunity costs of production • Define the concept of comparative advantage • Apply the concept of comparative advantage to demonstrate the benefits of specialization and trade • Discuss the difference between positive and normative economics

Teaching Notes This chapter introduces students to the construction of models and provides them an opportunity to expand on their understanding of what is a model and the information that is provided.

What is a model? A model is a picture of reality. It is a moment of time captured to provide information. A model can be presented in three methods: 1. As an anecdotal statement: The Law of Demand states there is an inverse relationship between price and quantity demanded 2. As a mathematical equation: P= 𝑏 − 𝑚𝑄𝑑

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Where P = price b = the Y-axis intercept m = slope Qd = Quantity demanded 3. As a graph Figure 1: Demand

Figure 1 represents the economic concept of demand as a graph. It illustrates the relationship between price and quantity demanded as represented in the other two models.

Students are very familiar with models, but often stumble over translating what they know about models to the economic concept. This can be helped by taking the time to allow students to develop an understanding rather than giving the students models and asking them to simply memorize. Allow them to discuss logical sequences of model development.

The production possibilities model presents unique challenges to students because it represents choices for individuals, groups, or an entire economy given a set amount of resources. Also the function is to illustrate possible combinations of output for an economy, not a relationship between two variables. Therefore, there is not an independent or dependent variable. There are two goods.

For students the challenge is often with identifying their choices as production possibilities and that this output can be in the form of a test score or a shift at work. The production possibilities frontier illustrates tradeoffs and the opportunity cost of alternative choices. It reinforces the concepts of scarcity and opportunity costs. Because resources have alternative uses and are limited something must be given up to have more of a good.

Also, the shape of the production possibility frontier for an individual can be straight, or constant, whereas the shape of the production possibility frontier for an entire economy is concave, or bowed out from the origin. The reason for this is the cost of the resources, or opportunity cost of the resources used. For an individual an hour of time can be used

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equally to prepare for an econ exam or for a math exam. For an economy to increase production of one good over another requires using more resources, more specialized resources.

Figure 2: Production Possibilities Frontier Model

Take the time to reinforce the important relationships that are typical of any production possibilities model. Having a working, relevant knowledge of the production possibilities frontier will provide the students additional insights to their output options.

1. Scarcity and Tradeoffs: Back to the basic economic concepts in Chapter 1, because resources are scarce and have alternative options for their use, individuals and economies must decide how to use their resources. These choices will reflect the mix of goods and services produced. Another important aspect of the tradeoff an economy faces with the PPF is production for consumption today or for consumption tomorrow. To illustrate this concept consumer goods and capital goods can be used as the two goods on the production possibilities curve. A consumer good is a good or service that produced for the end consumer. Examples of a consumer good include food and clothes. A capital good, on the other hand a good produced to produce another good or services. A tractor, for example, is a capital good. It is produced for the sole purpose of an agricultural tool to provide food. The reason for the difference is that economic growth occurs through the accumulation of capital goods, not consumer goods. Economies need to choose if the scarce resources will be used to produce parks for members of the society to enjoy now, or a factory that produces the desks to be used in classroom for the service good of education. An excellent historical example of this trade off occurred when Stalin became dictator of Russia.

The Russian economy was the simplest of agrarian economies. Stalin stated after taking office that Russia would become a member of the world’s power countries in 10 years. This was accomplished. But the tradeoff was the death of over 16 million citizens who died of starvation, froze to death, or died from lack of medical attention because resources were diverted away from the peasants and farmers to the cities and the plants built to produce capital equipment.

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2. Attainable and Unattainable Choices: Another important relationship illustrated by the production possibilities frontier is the ability of an economy to produce. When the output combination falls within the PPF, the economy is not producing at full employment. The combination is possible, but not all available resources are being used. An important distinction about full employment can be provided at this point.

Full employment means that all available resources are being employed, not all resources. Help students understand the difference. For example, in the United States a labor characteristic is over 16 years of age. Children are potential sources of labor in other economies, but not in the United States. They are not available. Another example is when farmers allow fields to remain unplanted to regain nutrients. The land is a resource, but it is not available.

The other notable relationship is points outside the PPF. A point that lies outside the PPF is not able at this time. The economy needs to expand, grow, in either ability to produce or sources of resources before the combination can be met.

3. Efficiency and Inefficiency: This relationship focuses on the use of the resources and the output. Efficiency is the comparison of output versus input. A point inside the PPF is not achieving the most output for the resources. There is waste, unused possibilities.

4. Ceteris Paribus: The PPF contains three assumptions: 1) there are two goods; 2) resources are fixed; and 3) fixed technology. These assumptions are needed because the model is a picture of a moment of time. There are factors that would change production possibilities but these are being held constant.

5. Economic Growth: A rightward shift of the PPF represents economic growth, a greater amount of goods and services produced. This growth, for an economy represented by an increase in the percentage change in real GDP, can come from an increase in the quantity or quality of resources or from an increase in technology, the ability to produce.

It is also helpful for students to have experience with economic growth that is focused on one production process and not all. Figure 3 illustrates the changes to the production possibilities frontier when the ability to produce more with a given set of resources applies to a specific production function rather than for all goods and services produced. For example, in Graph A economic growth occurred in the production of consumer goods but not for capital goods. This growth could be a result of an increase in consumer demand. Graph B, however, illustrates the changes

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to the production possibilities frontier when the growth occurs only for the production of capital goods. The curve shifts outward for capital goods only, leaving the point of goods produced for consumer goods stationary.

Figure 3: Economic Growth

6. Opportunity Cost: Similar to the first important relationship, the opportunity cost can be illustrated using the slope of the PPF. The slope of a curve represents the ratio of the change of the Y-axis good to the change of the X-axis good. This ratio illustrates the trades off. What was given up compared to what was gained. Consider Figure 3 on the next page. If the economy is at point C, the opportunity cost of one more unit of food is 6 units of Housing per year. The opportunity cost is equal to what was given up in ratio to what was gained. Now compare what takes place when the economy is at point E and produces additional units of housing per year. The opportunity cost of producing one more unit of housing is 1/6, or .17 units of food. At point C the opportunity cost of one more unit of housing is the reciprocal of the opportunity cost of one more unit of food.

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Figure 4: Opportunity Costs

7. Increasing Costs and Specialized Resources: The final important relationship is that in the real world shifting additional resources away from the production of one good to another comes with increasing costs because the ability to specialize quality in addition to quantity of resources. In the real world the PPF is bowed out, away from the origin because all resources are not equally suitable for the production of all goods and services. For example, as resources are transferred from the production of food to the production of housing per year, the first of the resources used will be those that are equally applicable for both goods, i.e., pens, pencils, tables, etc. There function would be the same for both production processes. However, as more and more resources are used more specialized, therefore more costly, resources will be taken from the production of food to the production of housing. Expensive farmland will be used to build apartments; resources of skills used to design tractors may be used to swing a hammer to construct apartments. The skills are not equally suitable for both.

The PPF, Opportunity Costs, and the Theory of Comparative Advantage The concepts of absolute and comparative advantage may be stumbling blocks for the students especially with the math to calculate comparative advantage. To begin with it is helpful for students to understand the concept of relative. Help students understand that opportunity costs are typically measured in relative terms or in terms of the physical goods and services given up.

Creating a table that lists the opportunity costs may help students develop the connection. For example, consider the example of the production possibilities for Dan and Betty in the text.

Dan Betty Bagels per day 1B = 1/5Y = 0.2Y 1B = 1/3Y = 0.33Y Yogurt per day 1Y = 5B 1Y = 3B

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For Dan the opportunity cost of producing one more bagel in relative terms would be the number of yogurts that he can produce. In the example in the text, Dan can use all of his resources available and produce 300 bagels or 60 pints of yogurt. Dan’s opportunity cost of producing one bagel is 0.2 pints of yogurt. His opportunity cost of producing one pint of yogurt is 5 bagels.

Betty’s opportunity cost for producing one more bagel is .33 pints of yogurt. Her opportunity cost of producing one more pint of yogurt is 3 bagels. By comparing the relative opportunity costs in the table, students can easily see that the opportunity cost of producing bagels is less for Dan and the opportunity cost for producing yogurt is less for Betty. Dan should produce bagels and Betty yogurt. Having a lower opportunity cost means that fewer other goods are foregone.

Teaching Activities 1. Before introducing the economic concepts of what is a model and types of models ask students to build a model airplane (or other model). Depending on the size of the class, this could be with paper airplanes, or a physical pressboard or Styrofoam model found at most hardware, dime stores. Have them explain why the “model” replicates something in the real world and how this pertains to economic models.

2. Developing high levels of thought process will be of benefit to the students for this class and their other classes. After introducing what a PPF is and how it is constructed break them into small groups and give them a problem similar to the economics and finance problem provided in the chapter for them to break down and present solutions.

3. Have students list examples of opportunity costs they have had that day in relative terms.

Additional Questions and Discussion 1. Consider the graphs. What conclusions can be drawn from each?

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Figure 5: Production Possibilities Frontiers

The PPF for student in Graph A illustrates that the student is equally proficient in both Economics and Math. The opportunity cost for increasing either grade is constant. The PPF illustrated in Graph B, however, illustrates a situation where opportunity costs are increasing as more resources are transferred from the production of one good to the other.

2. Draw a graph of a PPF. Indicate a point that is inefficient and a point that is unattainable.

Explain.

Answers will vary.

3. Explain why the shape of the PPF. The concave, or bowed-out, shape of the PPF illustrates the increasing opportunity cost found in the real world because of the lack of perfect suitability of resources for all producing other goods.

Answers to "Think for Yourself" Questions 1. 4 points per day; 9 points per day; each point earned in economics per day has an opportunity cost of one point earned in finance per day; each point earned in finance per day has an opportunity cost of one point earned in economics per day.

2. The table shows the amount of housing gained and food given up as we move from E to D to C, and so on. The move from E to D generates a gain in housing of 8 units per year. The opportunity cost of this gain is the loss of 1 food unit per year. On average, this means that each unit of housing gained between point E and point D costs 1/8 unit of food. The move from D to C generates a gain in housing of 6 units per year at a cost of 1 one unit of food per year. On average, each unit of housing gained between point D and point C costs 1/6 unit of

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food per year. The move from point C to point B generates a gain of 4 housing units per year at a cost of one food unit per year, or an average of 1 housing unit per ¼ food units. Finally, between point B and point A, 2 housing units are gained per year and 1 food unit is given up, so the cost per housing unit between point B and point A is ½ food unit. Because the amount of food given up to obtain each housing unit rose as we moved from point E to point D, C, and so on, the opportunity cost of housing increases as more housing is produced.

Opportunity Cost of Housing Move (in Figure 4) E→D D→C C→B B→A

Gain (housing units per year) 8 6 4 2

Cost (food units per year) 1 1 1 1

Cost (food units per housing unit) 1/8 1/6 1/4 1/2

350 300 250 200 150 100 50 0

Dan

Betty

Production Possibilities

Production Possibilities

Consumption Possibilities

250

Bagels per day

Bagels per day

3. The consumption possibilities frontiers are drawn below.

Consumption Possibilities

200 150 100 50 0

0

10

20 30 40 50 Pints of yogurt per day

60

0

10

20 30 40 50 Pints of yogurt per day

60

2. An improvement in technology used for the production of good X but not good Y will rotate the PPF outward along the X-axis, as shown by the movement from the solid to the dotted PPF in the figure A2 at right.

Units of good X per period

Figure A2: Production Possibilities After Technological Innovation that Improves Production of Good X Units of Y produced per period

1. An increase in resources will shift the PPF outward, as shown by the movement from the solid to the dotted PPF in figure A1 at right.

Units of good Y per period

Figure A1: Production Possibilities with an Increase in Resources

Answers to Discussion Questions and Problems

Units of X produced per period

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Figure A4.1: Production Possibilities with Unemployed Resources

A

Units of good X per period

Units of good Y per period

4. When there are unemployed resources in an economy, production is below the economy's potential. Point A in the Figure A4.1 illustrates the situation of unemployed resources. The economy has the potential to reach its PPF, but because it is not using its resources efficiently, it operates below that potential. A reduction in available resources generates an inward shift in the PPF, as shown by the movement from the solid to the dotted PPF in Figure A4.2.

Units of good Y per period

3. Normative economics deals with value judgments and decisions regarding how things should be. Positive economics is more objective and provides descriptions of how things are.

Figure A4.2: Production Possibilities with a Reduction in Resources

5. a. 6 units of education per year; b. 4 units of agricultural goods per year; 8 units of agricultural goods per year. c. About 1 unit of agricultural goods per year; about 2.75 units of agricultural goods per year.

The PPF illustrates increasing costs of production of education. d. About 0.3 units of education production per year; about 0.5 units of education per year; about 1.25 units of education per year. This PPF illustrates increasing costs of production of agricultural goods.

Units of good X per period

6. a.

Number of trained runners per season 15 12 9 6 3 0

Number of trained shot putters per season 0 1 2 3 4 5

Figure A6.1: Ted's Production Possibilities

Shot putters per season

5

4

3

2

1

0 0

3

6

9

12

15

Runners per season

b.

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c. 6 runners per season. d. 6 runners per season. e. Constant opportunity costs. Each time Ted trains 2 more shot putters per season, he must forego training 6 runners per season. Ted's PPF is linear. This is probably not realistic, since Ted is likely to be better skilled at training either runners or shot putters, not equally skilled at training both. f. 3 runners per season; 1/3 shot putter per season g. Ted would be operating inside his PPF, since if he trains 3 shot putters, he also has the resources to train 6 runners. h. This represents a reduction in Ted's resources. His PPF would shift inward, as shown by the movement from the solid to the dotted PPF in Figure A6.2. The inward shift reflects the fact that Ted cannot train as many runners and shot putters as before since his resources are now lower. i. This represents an increase in Ted's resources. His PPF would shift outward, as shown by the movement from the solid to the dotted PPF in Figure A6.3. The outward shift reflects the fact that Ted can train more runners and shot putters than before since his resources are increased.

Figure A6.2: Ted's Production Possibilities

Shot putters per season

5 4 3 2 1 0

0

3

6

9

12

15

Runners per season

Figure A6.3: Ted's Production Possibilities

Shot putters per season

7 6 5 4 3 2 1 0

0

3

6

9

12

15

18

Runners per season

Answers to Multiple Choice Questions 1. f 6. a

2. b 7. a

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3. f 8. c

4. d 9. c

5. e 10. d

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Chapter 3: Demand and Supply Chapter Outline 1. Demand 1.1. Demand Table 1.2. Demand Graph 1.3. The Law of Demand 1.3.1. Changes in Demand 1.3.2. Factors That Shift Demand 2. Supply 2.1. Supply Table 2.2. Supply Graph 2.3. The Law of Supply 2.4. Changes in Supply 2.5. Factors That Shift Supply 3. Market Equilibrium 3.1. Market Surplus 3.2. Market Shortage 3.3. Market Adjustments to Changes in Demand and Supply 3.4. Market Adjustment to an Increase in Demand 3.5. Market Adjustment to a Decrease in Demand 3.6. Market Adjustment to an Increase in Supply 3.7. Market Adjustment to a Decrease in Supply 3.8. Market Adjustments to Simultaneous Shift s in Demand and Supply

Learning Objectives After studying this chapter, students should be able to: • Describe the relationship between price and quantity demanded • Describe the relationship between price and quantity supplied • Diagram demand and supply relationships and identify market equilibrium • Describe factors that shift demand and supply • Illustrate how changes in demand or supply affect market equilibrium

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Teaching Notes 1. Having a strong understanding of the economic concepts found in this chapter is very important in their understanding of the forces of a Market economy. Taking the time to supplement their understanding will pay off in the future when more complex concepts are explored. Employ their ability to provide examples of how government policies have led to shortages and surpluses. Provide historical examples that illustrate these concepts.

Depending on the size of the class, you may want to plan on two classes for demand and two for supply. By allocating extra time students will be able to develop understanding and knowledge through activities and discussion.

2. Also on the topic of time, separate the class time to check on progress periodically with short activities. These do not need to be graded but will provide a checkpoint for you and for the student.

3. Involving students in active learning activities allows students to build and develop their knowledge of demand and supply compared to students simply taking notes and memorizing terms. A simple activity that can be used that requires limited set-up time but provides multiple opportunities for students to discuss and develop the mechanism behind the theory is constructing a demand curve, described below in Suggested Teaching Activities.

4. Begin the chapter by challenging students to provide a definition and description of what a market is. By illustrating that understanding the concept of a market will provide a stronger foundation to understanding the forces of a market and a market system itself where consumers are sovereign and the dollar votes.

5. Separate development of “change in demand” and “changes in quantity demanded” by asking students to use individual graphs to compare what occurs and what was the cause.

Guide their discussion to include cause and effect. Repeat this for a “change in supply” and “changes in quantity supplied.”

6. At this level of economics many students have limited skill with using and interpreting graphs. Hopefully, when graphing was discussed time was spent explaining that a graph is one of three of the types of models. Use hypothetical numbers to illustrate demand and supply. This tends to be more beneficial to students with limited proficiency with graphs.

7. Most students intuitively follow discussion about demand because they are well acquainted with consuming. Students are not as intuitive with the supply side of the

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equation. Take time to emphasize how a supply would approach a production decision.

Use 8. After developing market equilibrium is a good time to discuss “fair” versus “efficient.”

Is that price fair as well as efficient? Using a T-P-S (Think-Pair-Share) approach to the topic allows students to begin to form an opinion individually, develop it by pairing with one other student, and finally sharing with the class.

Teaching Activities 1. A tried and true method of introducing the concepts of demand and supply is by creating a “class market” demand curve. This exercise can be as simple or elaborate as your time allows. Ask students to imagine that the physical confine of the classroom is an economy. Tell them each student has $5 income to spend on the products produced by the economy. There are three products produced. I typically use two which would be obviously viewed as substitutes and one that is a complement. For example, a. 1 20-ounce bottle of Pepsi, b. 1 20 ounce bottle of Coke c. 1 bag of chips I explain that these are general product, The Pepsi is any of the Pepsi products commonly consumed, Coke represents any of the Coca-Cola products, and the chips represent any personal size bag of chips. You can bring physical products, put pictures on a power point slide or simply list them on the board.

Ask students to consider the products and, for this exercise, imagine that these are the only products available to give them quality in their lives. What would they consume? Ask them to determine how many of each product they would buy with their $5 income if each of the products was $1. They can buy all of one product or any combination of products that would give them the most for their money. But they are to use all of their income. After a minute or two break up the class into six or seven groups. Ask each group to determine how many Pepsis were consumed, how many Coke, how many bags of chips.

If the classroom has a computer and projector, students like to watch the construction of this demand curve. Pull up an Excel spreadsheet on the computer and set up a spread sheet similar to the following. Record how many of each product each group would consume.

Pepsi = $1 Group 1 # of Pepsi for

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Coke =$1 Group 1 # of Cokes for

Chips = $1 Group 1 # of bags of

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Group 1 Group 2 Group 3 Group 4 Group 5 Total

Group 1 Group 2 Group 3 Group 4 Group 5 Total

Chips for Group 1 Group 2 Group 3 Group 4 Group 5 Total

After totals have been calculated for Pepsi, Coke and Chips when the price of each product is $1, tell the class that due to a change in the economy for Pepsi the price has increased to $1.25 for one bottle of Pepsi. Ask them to again determine, using as much of their $5 income as possible (will be more difficult since the prices are not whole numbers, what they would be able and willing to consume at the new prices, first individually and then as a group. Record their totals in a table as illustrated below.

Pepsi = $1.25 Group 1

# of Pepsi for Group 1

Group 2 Group 3 Group 4 Group 5 Total

Coke =$1 Group 1 Group 2 Group 3 Group 4 Group 5 Total

# of Cokes for Group 1

Chips = $1 # of bags of Group 1 Chips for Group 1 Group 2 Group 3 Group 4 Group 5 Total

You can stop at this point since two points will make a line, or you can continue with a third round and explain that the price of Pepsi has increased again to $1.50 a bottle. Repeat calculating totals.

Explain to the students that what has occurred is a horizontal summation for consumer’s demand for Pepsi, Coke and chips.

Ask students to first consider the market for Pepsi products in the classroom. Construct a schedule of Price and Quantity for Pepsi.

Pepsi Price Quantity $1.00 $1.25 $1.50

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Ask students to consider what observations they can make from the results of this exercise.

Direct discussion to the inverse relationship between price and quantity demanded. Now ask the students to graph this relationship.

Using this example ask them what took place when the price changed from $1.00 to $1.25, and again from $1.25 to $1.50, if applicable. Direct their observation to the fact that the curve did not move, only the placement on the demand curve. Explain that this Change in Quantity Demanded resulted when price changed resulting in a change in quantity demanded, i.e., the two variables being used in the chart.

This exercise can be expanded as desired to illustrate concepts such as Change in Demand, by pointing out that demand for Coke increased when the price of Pepsi products increased because these two products are typically considered to be substitute products.

2. The above exercise can also be used to illustrate income and substitution effect which tend to be stumbling blocks for students. Another active learning technique that can be used is “Think-Pair-Share.” Ask students to individually consider the following questions. a. What happened to purchasing patterns when the price of Pepsi increased? i. For some of the students, because price increased, their income was insufficient to purchase what they “wanted.” b. How was the Consumer Substitution Effect observed in the class activity? i. The response to an increase in price of Pepsi products was a decrease in quantity demanded and substituting Coke.

After about five minutes ask student to pair with another student to consider the above questions. (If the room has an odd number of students there may need to be a group of threes.)

After five minutes of sharing thoughts on the questions, groups can share what they observed.

Additional Questions and Discussion Points 1. Does market equilibrium represent efficient use of resources, equitable distribution of products, or both? Explain o While market equilibrium does represent an efficient allocation of resources, it does not necessarily represent an equitable distribution of products. Products are not

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equally distributed in a market economy but instead are purchased by those who are able and willing to purchase.

2. What would cause a supply curve to be vertical? What would cause a demand curve to be horizontal? o A vertical supply or demand curve would represent a situation where quantity supplied and quantity demanded is constant regardless of the price. In the case of supply it would mean that there is a finite quantity able to be supplied, such as one of a kind, or the products found at a community Farmer’s Market.

3. How is the Law of Diminishing Marginal Benefits observed in the students’ consumer patterns for a specific product such as a Nintendo Wii, or Xbox? o Responses will vary but should indicate that the longer they owned the product the less it was used.

Teaching Activities 1. To provide a semester project to emphasize how non-price determinants of demand and supply are observed have students monitor different stocks of their choosing. Have them keep a diary of closing prices and market conditions that may have affected the prices with their personal observations.

2. Advanced Analysis Project: Ask students to collect information and data on gas prices and ethanol production in the United States for the period of 2000 – present. What observations can be made? a. The goal of this project is to highlight the scale effect of ethanol production in the United States. As the price of gas increased, there was an increased incentive to increase quantity supplied of ethanol.

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Answers to "Think for Yourself" Questions 1.

An Increase in Demand for iTunes Downloads

P ($)

P ($)

An Decrease in the Price of iPods

A B

D' D

D

QD (iTunes downloads/period)

QD (iPods/period)

2.

P ($)

A Decrease in Supply A Decrease in Demand P ($)

S' S

D' QS (#/period)

D

QD (#/period)

P ($/unit )

A decrease in the price of barley

S

A

P ($/unit )

An increase in the supply of wheat

3.

S S'

B

QS (units/period)

QS (units/period)

4.

P ($/unit )

An increase in supply

S S'

QS (units/period)

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5. (1) The increase in supply would cause equilibrium price to fall and equilibrium quantity to rise. The decrease in demand would cause equilibrium price to fall and equilibrium quantity to fall. The demand and supply changes both contribute to the fall in equilibrium price but cause equilibrium quantity to move in opposite directions. On net, the equilibrium quantity will rise since the shift in supply is larger than the shift in demand. Thus, equilibrium price falls and equilibrium quantity rises.

(2) The decrease in supply would cause equilibrium price to rise and equilibrium quantity to fall. The increase in demand would cause equilibrium price and quantity to both rise. The demand and supply changes both contribute to an increase in the equilibrium price, but have opposing effects on equilibrium quantity. Because the change in demand is larger than the change in supply, the net effect will be to increase equilibrium quantity. Thus, equilibrium price rises and equilibrium quantity rises.

(3) The decrease in supply would cause equilibrium price to rise and equilibrium quantity to fall. The decrease in demand would cause equilibrium price to fall and equilibrium quantity to fall. The demand and supply changes both contribute to a decrease in equilibrium quantity, but have opposing effects on equilibrium price. Because the change in demand is larger than the change in supply, the net effect will be to reduce equilibrium price. Thus, equilibrium price falls and equilibrium quantity falls.

(4) The decrease in supply would cause equilibrium price to rise and equilibrium quantity to fall. The increase in demand would cause equilibrium price and quantity to both rise. The demand and supply changes both contribute to an increase in the equilibrium price, but have opposing effects on equilibrium quantity. Because we do not know whether the shift in supply is larger or smaller than the shift in demand, we cannot make a prediction about what will happen to equilibrium quantity. Thus, equilibrium price rises, but the effect on equilibrium quantity is unknown.

Answers to Discussion Questions and Problems

P ($/ticket)

1. Having “too few” parking spaces means there is a shortage of parking spaces. Shortages occur when the price of a good is below its equilibrium price. A solution to the shortage that focuses on price would be to charge a fee to park at the store or the mall. A solution that focuses on a shift in demand would be to offer discounts for customers who walk or ride their bikes to the store or mall. A solution that focuses on a shift in supply would be to build a Ticket Scalping and Adjustment to Equilibrium bigger parking lot.

S 2. Because there are only a fixed number of seats in a football stadium, the supply curve for tickets to a football game is a vertical line. Scalpers take advantage of a shortage in the quantity of tickets, as shown by the difference between points A and B. Because they charge prices higher than those charged at the box office, they generate a movement to equilibrium.

B

A

D Q (tickets/game)

3. Answers to this question will vary depending on people’s own views of which goods are normal and inferior for them. When your income rises, your demand for normal goods will increase and your demand curve will shift outward. When your income falls, your demand for normal goods will fall and your

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demand curve will shift inward. For inferior goods, when your income increases your demand decreases.

When your income decreases, your demand decreases for inferior goods.

4. a. Equilibrium quantity is 1600 sweatshirts per year; equilibrium price is $40 per sweatshirt, shown as point E in the graph.

Market for Sweatshirts

60

P ($/sweatshirt)

b. The decreased cost of cotton will cause the supply of sweatshirts to increase to S’. The new equilibrium price is $30 per sweatshirt and the new equilibrium quantity is 2400 sweatshirts per year, shown as point E’.

S

S'

50

E

40

E"

30

E'

20

c. The higher price of sweatpants will cause the demand for sweatshirts to fall to D’. The new equilibrium price is $30 per sweatshirt and the new equilibrium quantity of sweatshirts is 1200 per year, shown as point E”.

D

D'

10 0 0

400

800

1200

1600

2000

2400

2800

3200

3600

4000

Q (sweatshirts/year)

Answers to Multiple Choice Questions 1. c 6. a

2. c 7. d

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3. a 8. a

4. c 9. d

5. c 10. b

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Chapter 4 Consumer Surplus, Producer Surplus, and Economic Efficiency Chapter Outline 1. Consumer Surplus 2. Producer Surplus 3. Economic Surplus and Economic Efficiency 3.1. Price Ceilings 3.2. Price Floors 3.3. Quotas

Learning Outcomes After studying this chapter, students should be able to: • Describe consumer surplus, producer surplus, economic surplus, and deadweight loss • Illustrate and compute consumer surplus, producer surplus, and deadweight loss • Describe how economic surplus can represent social welfare and economic efficiency • Assess the impact of market interventions on economic surplus and social welfare • Identify groups who benefit and are hurt by market interventions

Teaching Notes The purpose of this chapter is to focus on benefits that both the consumers and producers receive when they trade with one another. Why is this important? These benefits received are signals and measures of social welfare and economic efficiency. Consumer and producer surpluses are extensions of demand and supply and should be taught in conjunction or immediately after. The concepts of net benefits received from both consumers and producers are also useful tools in highlighting welfare economics, or to evaluate well-being in a society.

The time dedicated to these concepts will be beneficial to the students for three primary reasons.

(1) Understanding consumer and producer surpluses aides in their development of the incentives behind the decision making process for the consumer and the producer and the construction of the demand and supply curves. (2) As tools of welfare economics, knowledge of consumer and producer surpluses further builds on the students’ understanding of the concept of market efficiency. (3) An increase in literacy of these concepts allows students to better analyze public policy issues. Consider taxes. How is market efficiency affect and who benefits and who loses?

Involve students in the development of these concepts. It is easier for students to associate with the decision making process of the consumer as all of them have experience of being a consumer. Ask them to identify a recent purchase. What did they pay for the item? What would

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they have paid for the item? Ask them to explain the difference. Direct the conversation to the benefits received from the difference, if any.

The decision making process of a producer is more of a consideration for some. Associating the supply curve with the decisions making process of a producer will help students better understand the net gain of benefits for the producer.

Why the need to spend time on efficiency? Remind students that economics is the study of decision making by individuals and society to determine the optimal use of scarce resources. To achieve this optimal use of resources should be a reflection of producing the correct amount of goods and services with available resource, but also the maximum amount of wanted goods and services to maintain and increase individual well-being.

It may be helpful for students to ask them, before presenting the concepts of public policy and price ceilings and price floors, to explain why there are price limits in the wheat markets and other agricultural goods, rents, and minimum wage (see Teaching Tips). Allow students to develop the concept that is relevant to them.

Teaching Activities 1. The class before class discussion of the topic, have student write down a price that they would have been willing to pay for their text book. Ask them to research prices and find the least expensive price for their text. Use this example to explain consumer surplus and show how the reverse is applicable for the producer. The difference between the equilibrium price of a good and what the seller receives would provide additional benefits.

2. Text books is one good that all of the students can relate to. Identify three - five students who obtained their text from different sources, paying different prices. Have them identify this price to their willingness to pay. Use the average of their prices as the “market price.” If the market price is $70 and the student was able and willing to pay $100, their consumer surplus is the difference. Plot the prices of the text books to construct a demand curve. For example: a. Student A’s Text = $100 b. Student B’s Text = $90 c. Student C’s Text = $70 d. Student D’s Text = $50 e. Student E’s Text = $40

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110 100 90 80 70 Price of 60 Text Book 50 ($) 40 30 20 10 0

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Student A’s surplus: $100 - $70 = $30 Student B’s surplus: $100 - $0 = $10 Price = $70

3. Students will often question price floors and ceilings feeling that they are reversed. A tried and true method of explaining these concepts to students is to reference the room they are in. A price ceiling is a maximum price limit set. An example of a price ceiling is rent control. The purpose of the price ceiling is to increase benefits to consumers of a product, to increase their well-being. Therefore, a price ceiling is set below the market equilibrium price and a price cannot go above the established price ceiling. This is comparable to the ceiling above their heads. The air in the room cannot go above the ceiling.

Similar to this is a price floor. The purpose of a price floor is to set a minimum price limit. Prices cannot go below this amount, such as the air cannot go to the room below because of the floor.

4. Ask students, before presenting the concepts of public policy and price ceilings and price floors, to explain why there are price limits in the wheat markets and other agricultural goods, rents, and minimum wage. Pros and Cons allows for both sides of the issues to be presented. Remind students to keep the tone of the discussion in economics, not politics.

How do these public policies affect consumer and producer well-being, market efficiency and efficient use of scare resources?

Additional Questions and Discussion 1. Have students research what cities use rent controls and determine similarities between these cities. Compare these to cities that do not have rent controls. What is the difference?

Cities with rent controls will vary, but most likely will include New York and Berkeley, California. Cities without rent controls may include Denver, Colorado; Chicago, Illinois; and

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Seattle, Washington. The difference falls back to the basic economic concept of scarcity. When land, vacant land, is plentiful will not require controlling. Cities that have high population densities will have higher rents and, ultimately, consumer cries for equality.

2. Think-Pair-Share/1-Minute paper activity on efficiency and well-being. Ask students to consider this scenario. You, the instructor, control all of the scarce resources. You prefer a more retro lifestyle and decide that you will use all of the available resources to produce Celtic music eighttrack tapes. Ask them to consider what would they be willing to pay for one such product, how would this reflect their well-being and market efficiency? After five minutes have student pair with another student and compare thoughts. After an additional five minutes of discussion have students present their conclusions in a 1-minute paper.

Answers will vary. It may be necessary to walk around and help direct conversations to keep the topic centered on economic efficiency and well-being. Most students would have little interest in purchasing a Celtic music eight-track tape. First, few have equipment needed to play it. Others would prefer the quality of today’s sources. Most will find that scarce resources will not be used efficiently because there would be little gain to society from using available resources to produce these goods.

Answers to "Think for Yourself" Questions 1. (.5 * ($45 - $25) * 4) = $40/week; (.5 * ($45 - $10) * 7) = $122.50/week 2. (.5 * ($20 - $15) * 1) = $2.50/week; (.5 * ($40 - $15) * 5) = $62.50/week 3. (.5 * ($45 - $35) * 2) + [(.5 * ($25 - $15) * 2) + ($35 - $25) * 2] = $10 + $10 + $20 = $40/week 4. (.5 * ($40 - $20) * 2) = $20/week 5. PS = [(.5 * ($20 - $25) * 1) + ($40 - $20) * 1] = $2.50 + $20 = $22.50/week; CS = (.5 * ($45 $40) * 1) = $2.50/week; Economic surplus = $25/week; DWL = (.5 * ($40 - $20) * 2) = $20/week.

Answers to Discussion Questions and Problems

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Demand and Supply of Boxed Lunches Price ($/lunch)

1. a. See the graph at right b. CS = .5 * 12 * ($10 - $4) = $36 per day; PS = .5 * 12 * ($4 - $1) = $18 per day; Economic surplus = $54 per day c. $8.00; $2.00 d. QS = 8 lunches/day, QD = 14 lunches/day, market shortage = 6 lunches/day, 8 lunches per day will be traded; CS = (.5 * 8 * ($10 - $6)) + (8 * ($6 - $3)) =

10 9 8

S

7 6 5 4 3 2 1 0 0

2

4

6

8

10

12

14

16

18

D

20

22

Quantity (lunches/day)

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$16 + $24 = $40 per day, PS = (.5 * 8 * ($3 - $1)) = $8 per day; DWL = (.5 * (12 - 8) * ($6 $3)) = $6 per day. e. QS = 20 lunches/day, QD = 8 lunches/day, market surplus = 12 lunches/day, 8 lunches per day will be traded; CS = (.5 * 8 * ($10 - $6)) = $16 per day, PS = (.5 * 8 * ($3 - $1)) + (8 * ($6 - $3)) = $8 + $24 = $32 per day; DWL = (.5 * (12 - 8) * ($6 - $3)) = $6 per day.

Demand and Supply of Boxed Lunches Price ($/lunch)

2. a. A reduction in the demand for boxed lunches could come from a decrease in consumers’ incomes (assuming boxed lunches are normal goods), from an increase in the price of a complement good to boxed lunches, from a decrease in the price of a substitute to boxed lunches, from a reduction in the number of consumers in the boxed lunch market, from a change in tastes and preferences for boxed lunches, or from a change in consumer expectations. b. The new demand is shown as D’ in the graph at right. The new equilibrium price of boxed lunches is $3 and the equilibrium quantity of boxed lunches sold per day is 8. Economic surplus is (.5 * 8 * ($7 - $3) + (.5 * 8 + ($3 - $1)) = $16 + $8 = $24 per day.

10 9 8 7 6 5 4 3 2 1 0

S 0

2

4

6

8

10

12

D 14

16

18

D

Quantity (lunches/day)

3. By allowing buyers to state but not immediately bid their maximum willingness to pay, EBay helps buyers obtain the maximum consumer surplus possible. By allowing sellers to set but not immediately accept their reserve price, EBay helps sellers obtain the maximum producer surplus possible.

4. If sellers knew buyers’ maximum willingness to pay, they have incentive to charge that maximum willingness to pay to their customers. If buyers always pay the maximum amount they are willing to pay, no consumer surplus would be obtained in the market.

Answers to Multiple Choice Questions 1. e 2. b 3. d 4. d 5. b 6. c 7. e 8. e 9. b 10. c

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Chapter 5: Elasticity Chapter Outline 1. What Is Elasticity?

2. Categories of Elasticity 2.1. Elastic Demand and Inelastic Demand 2.2. Perfectly Inelastic Demand, Perfectly Elastic Demand, and Unit Elastic Demand 3. The Elasticity Coefficient 4. Elasticity and Total Revenue 5. Determinants of the Price Elasticity of Demand 5.1. The Availability of Substitutes 5.2. Luxury versus Necessity Goods 5.3. The Length of Time Available to Adjust to a Price Change 6. Appendix: Elasticity and the Slope of Demand

Learning Outcomes After studying this chapter, students should be able to: • Define elasticity • Classify elasticity values into inelastic and elastic categories • Use the elasticity coefficient to assess the price elasticity of demand • Assess the relationship between elasticity and total revenue • Describe the factors that determine the price elasticity of demand

Teaching Notes While this chapter could most likely require only two class sessions, take the extra time needed to review necessary mathematical abilities. Most students know the differences between a percent of and percent change, but may stumble with what should be used when. Allowing students to develop, or renewing, their knowledge of the needed math will help them considerably in understanding the concepts.

In addition to the required math skills take time to help students recognize that elasticity is a measurement of responsiveness, relative responsiveness. Their ability and willingness to respond to a price change is established by the determinants of price elasticity of demand. The better students can understand this relationship and the math the easier it will be for them to understand, rather than simply memorize for an assessment.

This chapter will cover elasticity of demand and the relationships of this concept to the development of a demand curve.

After introducing the elasticity of demand and the differences between elastic and inelastic ask students to consider what the relationship of each would be to total revenue. Allow students the time to reason through the rationale rather than memorizing a table of responses.

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Keep it visual! Keep it interactive and allow the students to develop and rationalize the concepts. This may take more time but will allow for better understanding.

Remind students that total revenue is equal to price times quantity. 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑇𝑅) = 𝑃𝑟𝑖𝑐𝑒 (𝑃) × 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 (𝑄) Remind students that while slope is a measurement of change, or responsiveness, elasticity is not the same as slope. To illustrate this consider a linear demand curve. The slope is constant but the elasticity of demand is not.

The best way to help students develop this concept is practice, practice, practice. Provide multiple examples of elasticity for students to work through.

The absolute value of the elasticity of demand coefficient is assumed because it will always be negative since the demand relationship is negative.

Teaching Activities 1. One method of introduction for elasticity is to ask them to consider their consumption patterns of a good, such as gas. Ask them to write down how many gallons of gasoline each person uses each week, on average. Now ask them to total up how many gallons of gasoline are used for their row.

Horizontally sum the total gasoline usage for the entire class. After a total has been calculated for the entire class, now ask students to repeat this exercise for their consumption pattern for carrots.

Ask them to give their best individual estimation of the amount of carrots, in pounds, they consume each week. Calculate for each row and then for the entire class. Set an average price per gallon for gas that would be a fair and accurate representation of an average of the region’s gas price and for a pound of carrots. For example, say that there were 100 gallons of gas consumed at $3.30 per gallon and five pounds of carrots at the current price of $1.00 per pound.

Now, ask the students to consider how their consumption pattern would change if the price of gasoline and carrots increased 25%. Ask them to consider their current budgetary requirements and determine, to the best of their ability, the number of gallons of gasoline that they would consume at a price of $4.125 and the amount of carrots at $1.25 per pound of carrots. Compare the results.

Most likely, the response to the increase in the price of carrots will have a greater change of consumption than the gasoline. This will depend on to what extent gasoline is a necessity to the students’ lives. Both way, this exercise will illustrate the concept of elasticity and that it is a measurement of relative responsiveness.

2. Introduce the topic with a discussion of how consumption patterns change, and why they change.

For example, ask them to give examples of when they are likely to buy a product during one time

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of the year but not another. Be prepared for seasonal choices, such as ice cream or changes in consumption due to other variables such as income and budget constraints. I once had a student list that his consumption of Ramon noodle soup had increased because he lost a roommate.

Price ($)

3. The traditional method of comparing the demand curve and the total revenue curve is a tried and true visual for students when they are allowed to develop the concept.

45 40 35 30 25 20 15 10 5 0 0

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0

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QD 60

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Total Revenue

700 600 500 400 300

200 100 0 40

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60 QD

When elasticity of demand is in the elastic range of the demand curve, total revenue increases when price decreases. However, when the good has an inelastic demand total revenue decreases as price decreases.

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Additional Questions and Discussion 1. After presentation and discussion of elasticity of demand give students a 1-minute paper assignment to answer the following question: What does the elasticity coefficient tell us?

Responses will vary but should explain that the elasticity of demand illustrates the level of responsiveness consumers are able and willing to have for a product. Mathematically it is the percentage change of quantity demanded divided by the percentage change of price.

2. Think-Pair-Share Question: Have students list the determinants of the price elasticity of demand and explain how they impact elasticity, using examples. After five minutes have students pair up with one other student to compare notes and form observations to share with the class.

Responses and examples will vary.

Answers to “Think for Yourself” Questions 1. QD would fall by 13.2%; QD would rise by 26.4% 2. E = -10/25 = -0.4. If P rises by 1%, QD would fall by 0.4%; inelastic 3. Elastic; inelastic; total revenue would not change 4. When demand is unit elastic, total revenue does not change in response to price changes 5. Those in rural communities will have more inelastic demand for gasoline because there are fewer substitutes available.

Answers to Discussion Questions and Problems 1. a. TR = $15 * 100 = $1500 per week b. TR = $22.50 * 90 = $2025 per week; E = -10 / 50 = -0.2; inelastic c. TR = $22.50 * 40 = $900 per week; E = -60 / 50 = -1.2; elastic d. Answers vary, but the availability of substitutes matters. If more animals are available from other sources, demand for adoptions from the animal shelter will be more elastic.

2. When demand is elastic, an increase in price will reduce TR. When demand is inelastic, an increase in price will increase TR. When demand is elastic, a decrease in price will increase TR. When demand is inelastic, a decrease in price will reduce TR.

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3. a. If demand is perfectly inelastic, a change in supply will have no effect on the quantity of the good traded. Thus this choice is incorrect. b. If demand is relatively inelastic, a change in supply will have a relatively small impact on the quantity of the good traded. Thus the choice is incorrect. c. If demand is relatively inelastic, a change in supply will have a relatively large impact on the quantity of the good traded. Thus this choice is correct. d. When demand increases, ceteris paribus, the equilibrium quantity of the good traded increases.

Thus, if demand increases at the same time that supply decreases, the increase in quantity traded generated by the increase in demand will at least partly offset (i.e., make smaller) the decrease in the equilibrium quantity generated by the supply change. Thus this choice is incorrect.

4. The reduction in the supply of milk will increase the price of milk and decrease the quantity of milk demanded. If the demand for milk is inelastic, the total revenue for milk suppliers will increase as a result of the reduction in the supply of milk.

Answers to Multiple Choice Questions 1. c 2. b 3. b 4. c 5. b 6. c 7. d 8. c 9. a 10. b

APPENDIX: Answers to Discussion Questions and Problems 1. a.

Price QD TR ($ per TV) (# TVs per semester) ($/semester) 250 0 0 200 10 2000 150 20 3000 100 30 3000 50 40 2000

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0

50

0

b. falls c. rises d. rises e. falls 2. D1 is more elastic. For the price change, the quantity demanded rises from 25 to 35 when price falls from $25 to $15. On curve D2, the quantity demanded rises from 25 to only 30. D1 has a larger change in quantity demanded for the same change in price, so it depicts relatively more elastic demand than curve D1.

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Chapter 6: Measuring Economic Activity Chapter Outline 1. The Circular Flow of Economic Activity 2. Gross Domestic Product 2.1. Consumption 2.2. Investment 2.3. Government Expenditure and Investment 2.4. Net Exports 2.5. GDP Across Time 2.6. International GDP Comparisons 3. Ad/AS Models 3.1. Shifts in AD and AS 4. Business Cycles 4.1. Aggregate Demand and Aggregate Supply in Business Cycles

Learning Outcomes After studying this chapter, students should be able to: • Explain the circular flow model • Define gross domestic product • Describe differences in GDP across countries and time • Describe what business cycles are and how they occur • Illustrate the workings of the aggregate demand/aggregate supply model

Teaching Notes This chapter focuses on how economists measures economic activity for an entire economy. It provides an introduction of the performance, or health, of a national economy. Beginning with a visual of the economic activity for a closed economy, without government, through the circular flow diagram the chapter dialogs through the components that make up the physical and financial flows.

Using the circular flow relative to the lives of the students helps to illustrate the relevancy to the material at hand. Students understand and appreciate that their “output” can be measured in real terms, or a physical count, or in nominal, or current dollar terms. They can produce, for example, four hours of labor and in return receive a wage for this output.

Introduce the term aggregate, by highlighting the changes in individual decision and aggregate trends created by decisions made up individuals in an economy. Use real data from government websites such as the Bureau of Economic Analysis (www.bea.gov). Using the data from the BEA allows the students

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an opportunity to develop their own perception of the components of real GDP. Take time to break these down by category and explain what each component is and what it measures.

For example, the tables of data from the BEA site time can be used to understand that the GDP component of investment does not refer to stocks and bonds because the Gross Domestic Product measures current production, not financial tools. Stocks and bonds, while they do facilitate the ability to produce through the development and growth of industries, they do not directly contribute to the production of a good or service.

Following this line of thought, helps students distinguish between what is and what is not included in the GDP. GDP measures current production of goods and services. It does not include intermediate goods, the sale of used goods, and domestic output such as the housekeeping you do or your garden out back.

Gross Domestic Product is a measurement of an increase in output.

Students may be familiar with the term GNP rather than GDP. Provide a distinction of the difference of the two when presenting the definition of GDP. It may be helpful to provide an exaggerated model of the Aggregate Supply curve to illustrate how equilibrium at different regions provides different concerns for an economy.

Figure 1: Aggregate Demand and Aggregate Supply -Horizontal or Keynesian Range

Illustrate to the students how an increase in Aggregate Demand due to an increase in spending will shift the Aggregate Demand curve to the right. Output, or real GDP, increases but there is no pressure on the price level. Because the actual output is less than potential output there is unemployment and unused resources ready to be used without putting pressure on prices. However, if the increase in Aggregate Demand occurs in the long run, or vertical, portion of the Aggregate Supply, as illustrate in Figure 2, all of the pressure is on the price level because the economy is at full employment and the prices for the available resources are bidden up by those wanting them.

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Figure 2: Aggregate Demand and Aggregate Supply-Horizontal Range

Students may have a preconceived belief that business cycles are just that, cyclic, and the fact that the phases are not consistent in length or size may come as a surprise. Using data from the National Bureau of Economic Research will help bring this information to life.

Gross Domestic Product is not a good indicator of a standard of living. Gross Domestic Product per capita provides a better indication.

Teaching Activities 1. Think-Pair-Share: Compare the goals of an aggregate economy with that of the individual students. Give students one to two minutes to consider and write down some of their personal goals. After this is completed have students work with another student for about 10 minutes to compare what they wrote with their thoughts on what are the goals of an aggregate economy. Have groups share. If possible have students write their responses on sheets of large sheets of paper to be posted around the room.

Responses will vary but direct the conversation around to the three main goals of an economy: 1) Achieve economic growth; 2) maintain stable prices; and 3) fullemployment. Most students have personal goals that reflect personal growth in some fashion, as do economies. Also most students have goals of maintain a certain life style that allows for this growth and comfort of living. Again, so will an aggregate economy.

Their responses can be saved by pictures on a power point slide for future reference to start a discussion.

2. Allow time for exploration of current real-world data to help instill relevancy of topics to students. Using data found on the Bureau of Economic Analysis website, www.bea.gov,

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have students compare the changes in aggregate patterns. For example, have students prepare graphs of real GDP over a span of 10-15 years. The same can be done with the components of GDP to illustrate which component is the largest, the most volatile, etc.

Can students identify the fluctuations of a business cycle? Connect the phases of a business cycle to real world events that illustrate what fuels each phase.

This exercise can help students experience the actuality of the concepts being discussed and how economics is an everyday aspect of our lives.

3. Economics U$A, http://www.learner.org/resources/series79.html, is an excellent source of videos that can be downloaded in the classroom that brings a historical aspect to the topics. Of particular value for this chapter is the video on business cycles, From Booms to Bust, which focuses on the nation’s cycles through the teachings of Economists Joseph Schumpeter, Karl Marx, John Maynard Keynes, and others.

4. Have students compare actual GDP data from different data using the World Bank website. Assign students five or six countries at different levels of development and have students compare their Gross Domestic Product and their Gross Domestic Product per capita.

5. Assign students Beyond Economic Growth: Meeting the Challenges of Global Development, http://www.worldbank.org/depweb/beyond/beyondco/beg_all.pdf, a book published by the World Bank that addresses aspects of economic development.

Additional Questions and Discussion 1. Explain why the GDP component does not include stocks and bonds.

Response: Stocks and bonds are not current production of goods and services.

2. Introduce GDP the first week of class with a brief introduction of the components of GDP and specifically the categories of Personal Consumption. Provide a handout of what constitutes durable, nondurable and service items of GDP. Have students track the consumption of durable and nondurable goods during the semester. When this chapter is reached ask students to provide their observations as to which grew or contracted more during this time. Which, in their opinion, would be more impacted by business cycles and which would not? Have them explain in terms of their data observations, current events, and economics.

Response: Durable goods would be more affected by changes in the business cycle.

People will postpone the new car or bedroom set when the economy experiences a slowdown. However, groceries and other “staples” will probably be less affected. This Copyright © John Wiley & Sons, Inc.

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can also serve as a reminder to students of elasticity and the difference between luxury and normal goods.

3. Propose the following scenario to students. Consider the simple circular flow diagram.

The amount of consumer expenditures on goods and services from the households to the output market is $500. The cost of the resource of labor is $400. How is this possible if total income is equal to total spending in a simple circular flow diagram?

Response: Labor is not the only resource earning an income in the Input Market. The remaining $100 pays for the land and capital traded for rent and interest.

Answers to “Think for Yourself” Questions 1. All final goods and services are traded in output markets, including new houses, bikes, and cars as well as entertainment services like movies and Broadway shows. Households are the primary demanders in output markets, and businesses are the primary suppliers in output markets. Factors of production are sold in input markets. These include the land used for production of food, the labor used in the production of medical services, and the machines used in the production of clothing. Households are the primary suppliers in input markets, while businesses are the primary demanders in input markets.

2. Answers to this question can vary. If consumers expect that economic activity will slow in the future, they may cut their spending today in order to save money to weather the downturn.

Increased consumer saving will result in reduced consumption and reduced GDP. 3. A decrease in AD will cause a fall in GDP and the price level. Depending on where the AD curve intersects AS, the fall in GDP can be large, as when AD intersects the flatter portion of the AS curve, or small, as when AD intersects the steeper portion of the AS curve. A decrease in AS will cause a reduction in GDP and an increase in the average price level in the economy.

Answers to Discussion Questions and Problems 1. GDP is composed of consumption (C), which includes spending on vacations, clothing, food, and other household purchases of final goods and services, investment (I), which includes business spending on machines and equipment as well as growth in business inventories of goods and services, government spending on goods and services (G), which includes salaries paid to government workers and government purchases of cars, tanks, and office supplies, and net exports (X-M), which includes exports of domestically produced crops, cars, and services, but subtracts imports of goods and services produced abroad but purchased in the US. 2. If calculation of GDP included intermediate goods, like the paper used to print this text book, as well as final goods, like this textbook itself, it would double count the value of production since the price of the textbook will include the cost of the paper used to produce it.

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3. GDP per capita measures the average amount of income earned per person in an economy, but it does not indicate how that income is distributed among the people in an economy.

4. The income approach measures the amount of income suppliers earn for their goods and services. The expenditures approach measures the amount of money spent to purchase those goods and services. Since everything that is sold is also bought, the two approaches measure similar flows of production and spending.

5. One component of GDP is government purchases of goods and services. When the government purchases a piece of equipment like a car or copier, the value of that equipment is counted in GDP as long as the equipment was produced domestically during the period covered by the GDP measure. In the AD/AS model, increases in government purchases generate outward shifts in AD. Although this will increase GDP, it can also increase the level of prices in the economy, particularly if the economy is on the steeper portion of the AS curve.

6. a. This reduction in G will reduce aggregate demand, GDP, and the price level. b. The ban on imports from the US to the UK will reduce exports from the US, which will reduce aggregate demand, GDP, and the price level. c. The expansion of military operations represents an increase in aggregate demand, which will increase GDP and the price level. d. A restriction on the supply of oil will cause a reduction in aggregate supply, which will reduce GDP and increase the price level. e. A ban on imports from Canada will increase net exports and, at least initially, increase GDP by increasing AD. If the ban generates an increase in the prices of inputs, however, the ban could also reduce AS, which would reduce GDP and increase the price level.

Answers to Multiple Choice Questions 1. a 2. c 3. c 4. b 5. a 6. d 7. b 8. a 9. c 10. c

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Chapter 7: Inflation and the Measurement of Prices

Chapter Outline 1. The Value and Uses of Money 1.1. The Definition and Evolution of Money 2. Measuring Prices and Inflation 2.1. Price Index 2.2. The Inflation Rate 3. Winners and Losers from Inflation 3.1. Savers and Borrowers 3.2. People on Fixed Incomes 4. Sources of Inflation 4.1. Aggregate Demand and Aggregate Supply 5. Measuring Nominal and Real Values

Learning Outcomes After studying this chapter, students should be able to: • Explain the difference between the face value of money and the purchasing power of money • Describe inflation and calculate inflation across time periods • Describe the winners and losers from inflation • Distinguish the sources of inflation • Illustrate the difference between real and nominal values

Teaching Notes This chapter provides a discussion about the relationship between money and the health of an economy. Money has a role in any economy. In fact it has three roles and all facilitates trade and growth of an economy. Understanding this relationship will provide valuable information in, not only this class, but also the personal lives of students.

This chapter begins with a discussion of what is money and how it functions in today’s economy.

Money has taken on different forms throughout history, and a primary of function is to facilitate trade, to act as a medium of exchange. However, for “something” to be money it must also be recognized as a unit of account and as a store of value. Today, most paper currency in the world is “fiat” money, or money that has value by government law or regulation. It is not backed by anything other than the words of the government.

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Understanding how money works within a society will be helpful for students in understanding inflation. Students should remember the forces of demand and supply in a market economy and how prices are determined. The purchasing power of the money is also determined in the markets.

Students may have difficulty transitioning from the concept of money to price indexes and inflation. Help this transition by first introducing what is a price index and how it is used.

Students may read this term and think they understand what it involves but stumble later when trying to apply it. A price index measures the level of prices in an economy. It illustrates how prices have changed over time.

The news media will be a valued friend for this chapter as current events helps to motivate students. Use the local, regional and national news on prices to supplement information they have found on inflation on government web sites such as the Bureau of Labor Statistics, www.bls.gov.

It is important for the students to understand and realize the sources of inflation both demand and supply. As all students are consumers demand-pull inflation is relevant to their lives. They have all seen the effects of increases in demand on prices, the Tickle-Me Elmo doll, for example a few Christmases ago. Demand increased the price of the doll. When people are working, they have income they want to spend. As they spend more the increase of demand causes pressure on available resources to accommodate this demand. Also referred to as “too much money chasing too few goods” typically occurs in an expanding economy.

Cost-push inflation, on the other hand, may be less intuitive for the students as few of them are producers. They do not intuitively consider the producer’s decision making process. Help students visualize how costs of production are pushing up prices. Because firms are running at full production capacity and maximized productivity, companies cannot maintain profit margins by producing the same amounts of goods and services. Therefore, the increased costs are passed onto consumers, causing a rise in the general price level.

Teaching Activities 1. To prep students for this chapter have students establish a “market basket” of goods and services they typically consumer in the eight major groups found in the Bureau of Labor Statistics’ market basket for the Consumer Price Index at the beginning of the semester/quarter. Ask students to list two items in each of the following that they purchase on a regular basis.

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a. b. c. d. e. f. g. h.

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FOOD AND BEVERAGES HOUSING APPAREL TRANSPORTATION MEDICAL CARE RECREATION EDUCATION AND COMMUNICATION OTHER GOODS AND SERVICES

Additional information on the items found in each of these categories can be found on the BLS website, http://www.bls.gov/cpi/#faq A worksheet can be used to create a consistent tool for organizing the information. (See suggested worksheet at end of this chapter.) Have students monitor prices twice a week until reaching this chapter. By calculating this information, students can share their observations on how prices have changed and, potentially, affected their purchasing power and how prices have affected the value of money.

Questions for students to consider: i.

Calculate the total of the cost of the market basket at the beginning and at the end of the observation period. What is the price index for the student’s market basket? ii. Has inflation/deflation/disinflation occurred? Explain your response. a. Graph the fluctuations of the cost of the market basket using price indexes. iii. How has purchasing power been affected? iv.

Through the observations of the changes in the price levels and occurrences in the market, explain how the markets determine the purchasing power of the money.

2. Begin the discussion of this chapter with what students perceive as money. Hold up a $5 bill. Pick a student and ask her/him if she/he would trade their pen/pencil for the piece of paper you are holding up. More than likely the student will agree. Ask the class how many other students would make this trade. Now hold up a clean piece of copier paper and ask who would be willing to make the trade? Most will not agree to the trade. Ask them to explain why not. Explain that there is considerably less “function” with the small piece of, actually fabric as currency paper is composed of 75% cotton and 25% linen.

There is very little room to do remaining on it to do anything else. The clean sheet of paper, however, has nothing on it and can provide ample room for note-taking, letterwriting, etc. In fact, the clean sheet of, PREMIUM, copier paper probably has more value

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than the worn out, small piece of fabric. Ask if anyone has changed their mind? More than likely, not. Ask them to explain to you why. Direct their conversation to develop an understanding of value and exchange. The reason the U.S. currency has value is because it is managed.

Think-Pair-Share After this demonstration, ask students why the management of the U.S. currency would be important to the health of the economy. After one or two minutes have students pair with one other student and share ideas. Provide the pair about five minutes to organize their thoughts. Have groups share their findings.

3. Introduce the concept of price index with something most of the students are very familiar with, Christmas. There are several online sites that track the prices for the gifts in the holiday tune, The Twelve Days of Christmas. PNC Financial Services Group, for example, has created a website for the Christmas Price Index. http://content.pncmc.com/live/pnc/microsite/CPI/index.html#start Somewhat lengthy, this interactive site humorously provides information about inflation and other basic economic concepts. Another site that lists the Christmas Price Index is USA Today, http://www.usatoday.com/story/money/business/2012/11/26/12-days-of-christmas107k/1726807/.

4. If your class is a smart room with access to the web, use an inflation calculator to illustrate how prices have changed over time. The Bureau of Labor Statistics is one such option. http://www.bls.gov/data/inflation_calculator.htm Take the cost of a new car today and show students what the same buying power at a different period of time. For example, $30,000 today had the same buying power as $10,737.51 in 1980 or $1,694.02 in 1933. Students are often curious about these changes.

Additional Questions and Discussion 1. Explain the relationship between the value of money and the price level as illustrated in the following hypothetical model. MS represents the money supply and MD represents total demand for money. When the supply of money increases from MS1 to MS2 the price level increases from a price level of two to four. The value of the money, however, decreases from ½ to ¼.

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Correct Response: When the demand for money is stationary, or constant, and the supply of money increases in an economy, this increases the price level but decreases the value of money and purchasing power. The value of money refers to what a unit of money can buy and would be determined by the level of prices. When more money is infused into an economy it takes more money to buy the same amount of goods.

LO-1 Level of Difficulty: Difficult 2. For class discussion: Ultimately, What is the best way to handle inflation?

Give students time to reflect on this and to discuss in small groups. They will not find this in a text and it will take a perceptive mind. Provide time for students to “build their case” on what they feel is a correct answer. Perhaps provide an incentive of bonus points to the group with the most convincing argument that is collaborated and illustrated.

Correct Response: Don’t allow it to begin in the first place. Money supply, ability to consume (i.e., credit rates), and costs of production should be monitored to maintain a stable price level. No, this is not a trick question; it is theoretical, but applicable LO-1 Level of Difficulty: Difficult 3. How much money should an economy have?

Correct Response: To support goods and services produced LO-1 Level of Difficulty: Medium

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4. What category of goods and services appears to have more volatility in their price level?

Have students research the Consumer Price Index for the different categories of goods and services found in the Bureau of Labor Statistics’ market basket of goods. Using the following website, http://data.bls.gov/cgi-bin/surveymost?cu, have students retrieve data for these categories and graph or compare the results. After retrieving the data, click on the graph function to provide students a graph to use for comparison. Ask for explanations as to any volatility that is observed.

Correct Answer: Responses will vary with different time periods. For example, the results obtained during the writing of this Instructor Manual results are as follows.

(Bureau of Labor Statistics, 2012) The following graphs were taken from the BLS web site and are not seasonally adjusted data for 2002 to 2012.

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Food and beverages

Housing

Apparel

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Transportation

Medical Care

Medical Care Services

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Recreation

Education

Answers to "Think for Yourself" Questions 1. The NASDAQ and the S&P 500 are other indexes of stock prices 2. With three gallons of milk, the basket prices are: 1980: $6.10; 1990: $7.75; 2000: $9.50;

2010: $10.50. If eggs cost $2.00 in 2010, the basket price in 2010 is $9.00 when two gallons of milk are in the basket and $12.00 when three gallons of milk are in the basket.

The price index values given that eggs cost $2.00 in 2010 and three gallons of milk are in the basket are: 1980: (6.10/7.75)*100 = 79; 1990: 100; 2000: (9.50/7.75)*100 = 123; 2010: (12.00/7.75)*100 = 155.

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3. Savers would win from deflation because their savings could purchase more in the future

than when they put their money in the bank. Borrowers would lose from deflation because they would have purchased items at higher prices and would face interest charges on their loans.

4. If your earnings are $47,500, they are 7.31 times higher than your grandmother's

earnings, but since prices are 7.4 times higher in 2009 than in 1960, your real income is lower than your grandmother's real income. If your earnings are $50,000, they are 7.7 times higher than her earnings. This means your real income would be greater than your grandmother's real income.

5. ($47,500/220.2)*100 = $21,571; ($50,000/220.2)*100 = $22,707.

Answers to Discussion Questions and Problems 1. a.

Year 2010 2011 2012

CPI base 2010 570/570*100 = 100 695/570*100 = 122 840/570*100 = 147

CPI base 2011 570/695*100 = 82 6995/695*100 = 100 840/695*100 = 121

CPI base 2012 570/840*100 = 68 695/840*100 = 83 840/840*100 = 100

b. 122-100/100 = .22 or 22 percent c. 147-122/122 = .20 or 20 percent

2. Savers see the purchasing power of their savings eroded by inflation. Borrowers are able to purchase items before inflation raises their prices, and are so helped by inflation.

Interest rates tend to mitigate these effects for both savers and borrowers.

3. Money serves as a medium of exchange, unit of account, and store of value. As a medium of exchange, money facilitates transactions by serving as a commonly accept means of payment. As a unit of account, money facilitates transactions by serving as a common benchmark against which to compare the value of goods and services. As a store of value, money allows us to save for future purchases.

4. Demand-pull inflation is caused by increases in aggregate demand and tends to occur during economic expansions. Cost-push inflation is caused by decreases in aggregate supply and tends to generate economic contractions.

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5. A decrease in the supply of oil is likely to raise the price of oil. This will in turn decrease aggregate supply and generate cost-push inflation. This situation is illustrated in Figure 5 in the chapter.

Answers to Multiple Choice Questions

1. c 2. a 3. c 4. a 5. e 6. c 7. a 8. b 9. a 10. b

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My Personal CPI Worksheet Market Basket Food and Beverage Items

Week 1 Monday’s Thursday’s Price Price

Week 2 Monday’s Thursday’s Price Price

Week 3 Monday’s Thursday’s Price Price

Week 4 Monday’s Thursday’s Price Price

1. Ex.: Gallon of Milk 2.

Housing Item 1.

2.

Apparel 1.

2.

Transportation 1.

2.

Medical Care 1.

2.

Recreation 1.

2.

Education and Communication 1.

2.

Other Goods & Services 1.

2.

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Chapter 8: The Power and Limits of Markets

Chapter Outline 1. Systems of Resource Allocation and Resource Ownership 1.1. Resource Allocation: Command and Market Systems 1.2. Resource Ownership: Socialist and Capitalist Systems 2. Types of Economic Systems 2.1. Examples of Economic Systems 3. Judging Among Alternative Economic Systems and Policies 3.1. Efficiency 3.2. Equity 3.3. Liberty 3.4. Security 4. Market Failure and the Limits of Market Capitalist Economic Systems 4.1. Monopolies 4.2. Public Goods 4.3. Externalities 4.4. Imperfect Information

Learning Outcomes After studying this chapter, students should be able to:

• • • • • •

Describe the resource allocation and resource ownership decisions facing societies Classify the basic types of economic systems Describe the differences in types of ownership of resources Describe the differences in types of decision making about resource allocation Evaluate the tradeoffs between efficiency and equity; security and liberty Understand the concept of market failure

Teaching Notes This chapter explains how scarce resources are allocated and the basic economic questions of what to produce, how to produce, and for who to produce are answered. The difference between resource allocation and resource ownership are explored explaining the impact on resources under each classification.

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Revisit with students the economic triangle of scarcity, choice, and opportunity cost with students. Because resources are scarce, a decision on how they are used must be made. This will result in a trade-off or opportunity cost. A society’s structure provides the answer for this trade off.

It will be helpful to re-establish clearly in the student’s minds the concept of a market before a discussion begins. Why is the foundational makeup of the system important? A market is an economic system that engages in exchange. The make-up of this system determines how this exchange takes place. What differences would the students expect from markets found in different political climates? Direct discussions but allow students to develop, or clarify, their perception between command systems and socialist systems as these terms are commonly used interchangeably in common conversation. In economics there is a distinct difference between who owns the resources and how they are allocated, used, to produce goods and services. Using spectrums as a visual, or class worksheets, may be helpful.

Provide space for students to list characteristics and examples of these systems.

How these two functions combine to provide markets are explained on page 134 of text. Using these types of spectrum will help create basic information to help students better understand the Table 1.

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Students are provided with clarification to the tradeoffs for the different economic systems.

Understanding that the type of economic system provides different types of benefits will help students in later chapter. Equity is a tradeoff for efficiency and security is often the cost of liberty.

Students may recognize that different types of efficiency can exist in a market. A common understanding of the meaning of the word efficiency equates a maximum output with the minimum of output. In other words, getting most produced with the least amount of resources is an accepted definition of the word. This, however, does not mean that society is maximizing its utility, or satisfaction. What is occurring can be explained by two different types of efficiencies.

1. Allocative Efficiency: Efficiency achieved when the quantities of goods and services produced are those most valued by society. In other words, the goods and services provide the most satisfaction for society.

2. Productive Efficiency: Efficiency achieved when the maximum amount of output is realized with the minimum amount of resources.

The chapter concludes with a discussion of how markets can and do fail and the limits of markets. Does a market have a limit, or constraints? The answer is yes. A free market can work effectively only where the full benefits of goods and services go solely to the purchaser, and cannot be used without cost by anyone else. Students may not connect with the definition of a market failure, having more experience with the common usage of the term. Spend some time with students helping them to develop an understanding that a market failure occurs when output is inefficient or requires an over or under allocation of resources. A market failure occurs when all costs of production are not born by the producer and not benefits are received only by those paying for the goods or service.

Illustrate externalities with graphs of under and over production of goods that results when the market experiences an over/under allocation of resources. Use examples that the students experience in their lives. Provide examples of both positive and negative externalities that reduce efficiency in the use of scarce resources.

BE CAREFUL…at this stage of learning, a thorough understanding of the technicalities of HOW efficiency works is not as important as understanding how a market failure can result in an over production or underproduction of a product.

Reinforce with students that there are different causes for market failures. In addition to externalities help students understand how a monopoly, discussed more in Chapter 18, limits the ability for competition and has power over price. A public good results in a market failure because either a product is not produced because of extreme costs and lack of control of who can consume the good. Public goods, because of their nature, are prohibitively costly and few people

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have the ability to produce them. The typical example is defense. You can put up monitors and security devices to protect your property, but do you want to pay the expense for your entire neighborhood? It will provide more security for you, but at an extreme cost. It is also difficult to control who uses it. Therefore a public good is not produced in a market capitalist system without government assistance.

Imperfect Information is also a culprit of market failure. Market failure can be created when imperfect information provides one party, buyer or seller, with more information than the other.

The price of an item is a signal of the value of the good to the buyer. If information is withheld about the product that would affect the value, and the price, an inaccurate decision and level of satisfaction would be realized. Chapter 15 will provide additional information on the implications of imperfect information.

Teaching Activities 1. A take-off of a discussion used by Milton Friedman can help students realize the complexity of markets in the world and how they are interwoven. Ask students to consider a plain pencil. Hold up a common #2 pencil. From start to finish consider how the pencil was created. Assuming the pencil is made out of wood a tree was grown and someone harvested the tree. Another person was responsible for making the graphite and another someone was responsible for growing the rubber that made the eraser. Each part of the pencil, from the yellow color to the little metal band that holds the eraser in place was part of a market. And that is just in the construction of the pencil. Consider also the markets involved in the distribution of the pencil. The pencil you are holding also required someone, or some machine monitored by a unit of labor, to package it and ship it. Next, there were probably wholesalers involved prior to the pencil reaching the retail market. These many markets worked together and provided this pencil. Did all of these markets have the same structure? Most likely not. Discussion can be directed to help student recognize that the political environment would affect markets found in the economy. Consider the person who grew the rubber. This most likely occurred in an economy that had different political and economic structures than is experienced in the United States. How would this have influenced the decisions made in this market?

2. Before discussion on the chapter begins allow them to decide (allocate) some desirable resources. Divide the class into small groups. Give each group the following directions a. Consider the following hypothetical scenario. On (date of next class) desks will be re-assigned according to the needs of the building. Each classroom will receive (ten less desks than number of students in class). There are (number of students in class) of students in this class.

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b. How should these desks be allocated? i. Additional desks cannot be brought in…these are the full extent of the number of desks allowed for this classroom. c. Develop a system that allows for i. Efficiency of the resource ii. Equity of the resources iii. Security of members of the society iv. Least infringement of liberty Allow students time to discuss their approach to this situation. After an appropriate amount of time have each group explain their response to the situation.

Thoughts to ponder a. How should this dilemma be solved? b. Because resources are scarce, decisions must be made on how they will be used. There are a variety of allocation methods that can be used. How did your group make these decisions and how do you think these decisions affected the following? i.

Efficiency ii.

Equality (everyone getting equal parts) iii. Security iv.

Liberty

Additional Questions and Discussion 1. To emphasize the impact of efficiency versus equality to students display a normal distribution curve and explain that the mean represent the average for everyone observed.

So to be “fair” to everyone that grades should follow this same thought process. Some may have greater skills and aptitude than the average, or a grade of C, others will fall short of average in skills and aptitude. Therefore, in an effort to be fair everyone will receive a grade of C. How will this affect class work and effort? Is this policy efficient?

Why or why not?

Correct Response: Having a policy that everyone will receive a grade of C will reduce effort in the class. Why would anyone want to try to excel if there is not a reward, or payment, for this effort. Therefore, the policy is not efficient because the students’ resource of time will not be allocated towards this class. In economics-speak an under allocation of resources will occur.

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Another take on this scenario would be to ask what would be fair to students. Most will probably reply that everyone should receive an A. This would be “fair.” Using this logic than, why wouldn’t it be equal if everyone received an F? LO-5 Level of Difficulty: Moderate 2. A colleague, who lived and worked in a major U.S. metropolitan city, was looking for a simpler way of life upon retirement. To prepare for this landmark event she accepted a position in a more rural community that provided her with a slower paced life. She had anticipated a decrease in her income but also anticipated a comparable decrease in her cost of living. This was experienced except for one area. Her income decreased by about 40%, her housing expenses also decreased comparably. However, the amount she paid for her utilities increased a whopping 1000%. Explain how this could occur? What changes in her markets would create this significant difference?

Correct Answer: Basically, in the city there was competition allowing for choices on the utilities. In Adam Smith’s Wealth of Nations he explained how competition led selfinterested consumers and producers to provide choices to the market. He called this selfregulating mechanism of allocation the invisible hand.

LO-5 Level of Difficulty: Difficult 3. Create a market failure.

Provide students with a demand and supply model similar to this. Explain to the students they own a paper mill and produce reams of paper.

At the going market value for your product you produce 20,000 reams of paper each month at $8 each. (This is a quality paper) What does this model suggest about the efficiency in the market if production is at equilibrium? How would this explanation change if it became known that through the production process you create a toxic waste that is dealt with by dumping it into the river that is adjacent to your firm? Explain.

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Correct Answer: Consider the following graph. If you were required to pay for the cost of removing or cleaning up the toxic waste your costs of production would increase. This would result in a shift of your supply curve to the left. Capturing all costs results in the reduction of reams of paper produced at each price level. Equilibrium production with all costs of production is at point B, 15,000 reams of paper each month at a price of $9 per ream.

The efficient allocation of resources to society is for 15,000 reams of paper. Before costs of the pollution were not included there was an over allocation of resources to the market. By pushing one of the costs of production to society, pollution, more resources were being used than what provided value to society.

LO-5 Level of Difficulty: Difficult

Answers to "Think for Yourself" Questions 1. Examples of command systems in the US include the military, the public school system, and the rules regarding the use of national forests and parks. Examples of market systems include the local pizza parlor, clothing stores, and car dealerships. Command systems are characterized by public decisions about how resources are used. These decisions often take the form of government regulations. Market systems are characterized by private decisions about how resources are uses, such as the private decision about how much pizza to buy, how much to work, which shirt to wear, and which car to drive.

2. Examples of socialist ownership systems include public buildings and spaces. Examples of capitalist ownership systems include private land ownership, private ownership of a business, and private ownership of stock in a business. Socialist systems are characterized by public or communal ownership of resources. Capitalist systems are characterized by private property ownership.

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3. Societies trade efficiency for equity when they encourage unrestrained market capitalism.

Allowing firms and employees to freely choose they wages they will pay and accept rather than setting limits on wages is be one example of trading efficiency for equity.

Having economic safety nets like the minimum wage, unemployment insurance, or federally funded financial aid for college students is an example of trading equity for efficiency.

4. Examples of ways that societies trade liberty for security include imposing income taxes in order to redistribute income to those with lower incomes and regulating product and worker safety. Examples of ways that societies trade liberty for security include allowing entrepreneurs the freedom to start their own businesses, which often entails substantial risk.

Answers to Discussion Questions and Problems 1. Answers here can vary widely. Some examples include dividing the candy equally among the members of the group, giving the candy out on a first-come first-served basis, or giving the candy to those who have the most money to pay for the candy. For the equal distribution, the pros could include a perception of fairness and the simplicity of the method, while the cons could include inefficiency since some members of the group may not even like the candy bars will get one anyway, while others who like the candy a lot will only get one piece. For the distribution based on first-come first-served, the pros could include simplicity, while the cons could include wasted resources since people will spend time and effort in order to be the first in line. For the distribution based on money, the pros include simplicity and a method to gauge how much people want the candy based on how much they are willing to pay for it, while the cons include a perceived unfairness if some in the group have more money than others.

2. Market capitalist systems generate efficient allocations of resources because they result in production levels where the marginal benefits of production are equal to the marginal costs of production. We learned in Chapter 4 that markets can maximize economic surplus, which is one definition of efficiency. Efficiency is an important goal because when we waste resources we produce below our potential.

3. In market capitalist systems, goods and services are allocated to individuals and businesses who have the highest willingness and able to pay for them. Because people have different abilities and endowments of resources, the ability to pay for goods and services is not equally distributed among the members of a society.

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4. When societies emphasize security and equity, their governments need to be bigger in order to redistribute income, enforce regulations, and so on. Under pure market capitalist systems, governments would be relatively small.

5. Many changes will have to take place at the individual and governmental level as economies transition from command socialist toward market capitalist systems. One of the most important changes is the development of political and governmental institutions that encourage and enforce private property rights and private business activities.

Individuals will need to face incentives to specialize and trade according to comparative advantage rather than government regulation.

Answers to Multiple Choice Questions 1. a 2. a 3. c 4. d 5. a 6. d 7. b 8. d 9. a 10. b

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Chapter 9: Wage Determination and Superstar Salaries

Chapter Outline 1. The Buyers of Labor 1.1. The Marginal Cost of Labor 1.2. The Marginal Benefit of Hiring Labor 1.2.1. Marginal Product of Labor 1.2.2. Marginal Product and Value of Marginal Product 1.2.3. Determinants of MPL and VMPL 1.3. The Firm’s Profit maximizing Hiring Decisions 1.3.1. Optimal Number of Workers to Hire 1.3.2. Minimum Wage to Pay a Given Worker 1.3.3. The Firm’s Demand Curve for Labor 1.3.4. The Sellers of Labor 2. Labor Market Equilibrium 3. The Superstar Labor Market 3.1. Endorsements 4. The Importance of Thinking at the Margin

Learning Outcomes After studying this chapter, students should be able to: • Explain how buyers in the labor market make hiring and salary decisions • Demonstrate the importance of the value of the marginal product of labor and the marginal cost of labor • Explain why there are pay differences across occupations • Explain why individual salary comparisons are not valid for determining how much society values different occupations

Teaching Notes Students are curious about how their wages are determined and to what extent their skills and abilities contribute to what they make. They may have some disillusioned thoughts about what their value is or how their skills and talents should be valued by society. It may be a constructive use of time to touch base with circular flow diagram once more. In addition to supplementing the information found in this diagram, it illustrates to students that in the labor market

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households are the suppliers and businesses are on the demand side. Emphasize to students that the labor market is about the demand and supply of labor not jobs.

As with any economic decision, wage determination is made on the margin. The most control of anything is found on the margin. We have the most control of the next dollar spent, the next dollar earned. What would the marginal benefit be to hiring one more unit of labor? What would be the marginal cost of that additional unit of labor? Economic terms will play an important part of understanding in this chapter.

The chapter begins with the demand side of the labor market, the buyers of labor. The demand for labor is considered derived. The demand for labor is dependent upon the demand for the product being produced. If decisions are made on the margin, businesses need to compare the benefit received from the next unit of labor with the cost of that next unit of labor. The business needs to consider the marginal benefit versus the marginal cost of the next unit of labor.

To a business the benefit of hiring labor is the product that will be produced from that resource.

The marginal benefit of labor will depend on output and the firm’s production function. The production function shows the amount of output that can be produced with different amounts of inputs. This output will depend on both the availability of inputs that includes capital, labor, and raw materials. The production function also depends on available technology.

The production function demonstrates a process. It relates output to amounts and types of inputs, or resources. It is helpful to explain to students that the production function illustrates technology, not economic behavior. The production function describes how a combination of resources combined with available technology provides a certain amount of output.

For this chapter the focus is on the valuation of labor as a resource. Capital is fixed.

From the development of a production function, students should find the marginal product more intuitive. Emphasize that what has occurred is the marginal product of labor. One of the most important theories of microeconomics, it is the change in the quantity of output with the addition of another unit of labor.

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Note: This focus on additional units of a good produced can be on capital also. Holding the amount of labor constant, the marginal product of capital is the change in the quantity of output with the addition of another unit of capital.

Mathematically, the marginal product of labor can be expressed as 𝑀𝑃𝐿 = ∆𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡⁄∆𝐿𝑎𝑏𝑜𝑟 Students often hesitate when anything that resembles math is involved. Take the time to reenforce the benefit of this skill of having the ability to recognize that this is also a model that provides information. Remind them that math is their friend, and the above equation illustrates the properties of the production function and the marginal product of labor.

1. The MPL is positive 2. The MPL decreases and the units of labor increases when capital is fixed These properties are easily illustrated in class with a graph. It is important, however, to keep students activity involved. Provide students with a handout of a numeric example that includes a table, blank for their calculation and a grid for graphing. A sample worksheet on the demand side of the labor market is included at the end of this chapter to help walk students through the process.

As additional units of labor are added to a fixed capital base, the increase of output may be increasing but at a decreasing rate. The reason for this becomes more obvious as student workers are vying for the one stapler or market. The process of production slows because of inefficiencies. Workers may need to stand by and wait for needed capital.

Students may not make the connection between the marginal benefit of labor and the marginal cost of labor. If decisions are made at the margin with an analysis of marginal benefits against marginal cost understanding what the value of the next unit of product produced is necessary compared to the cost. To a business firm, the incentive for production is profit. What will each additional unit produce provide the firm in terms of revenue. This value of the marginal product is equal to the marginal product of labor times the price of the product. If the marginal product of a unit of labor is three units of the goods and each product is priced at $10, the value of this unit of labor to the firm is 3 x $10 = $30.

The marginal cost of labor is the wage paid to that next unit of labor. An analysis of the marginal Benefits, or value of the marginal product, with the marginal cost of the next unit of labor describes the decision making process of the producer. As long as the value of the marginal product exceeds the wage, the additional unit of labor is hired.

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Make the connection…help students understand that a firm will hire units of labor up to the point at which the value of marginal product equals the wage rate. If the value of marginal product of labor is greater than the marginal cost of labor, the wage rate, the firm is realizing a profit.

However, if the value of marginal product of labor is less than the marginal cost of labor, the firm will experience a loss of profit.

Teaching Activities 1. The following is an activity that can be used to introduce this chapter to students and stimulate their involvement. The issue of the large discrepancy in earnings is especially attractive to students. This topic is parallel to Adam Smith’s diamond-water paradox.

Why are super stars commanding billion dollar settlements while our teachers, the educators of our human capital, earn subsistence earnings? This exercise allows students to develop an understanding about the factors that contribute to labor markets and the fair value price of labor.

Have students research base salaries for current sports and entertainment figures and other occupations. The Bureau of Labor Statistics Occupational Statistics provides mean hourly and annual wages to use for comparison for educators. http://www.bls.gov/oes/current/oes_stru.htm After salary information has been gathered and organized, ask students to use their knowledge of how demand and supply allow for a fair allocation of resources and prices, to explain why an NFL quarterback such as Denver Bronco Peyton Manning can earn a base salary of $18 million in 2012 while the national average annual wage for the same year for secondary teachers in the United States was $56,760? Are the skills and abilities of a teacher as valuable to the economy as a football quarterback?

Responses will vary. However direct their discussion to include the fact that superstar athletes and entertainers possess scarce skills. The respective demand and supply curves for this scarce commodity would reflect the lack of substitutes available and the inelasticity of both demand and supply.

The demand and supply model for educators would be less inelastic because of the number in the occupation and the skill being more common.

It is the demand and supply for the labor that determines the salary not the contribution to future economic growth and success. Income is determined by the perceived value of the resources brought to the market.

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2. Producing widgets: To help illustrate to students that the production function is upward sloping as total product is plotted versus with labor and that it becomes flatter as additional units of labor is added to a fixed plant size. Tell students that we will be producing widgets. You produce widgets, a fast growing fad among corporate America.

Everyone who is anyone has a widget adorning their desk/work space.

Illustrate how widgets are made. Crease a sheet of paper in half and cut along the crease.

Cut on crease

Crease each half in half. Cut on this crease

Take two quarters and carefully staple on top left and top right corners.

With marker draw a smiley face

The resulting product should be able to stand up on its own on a desk.

Production Process A. Use a table as the plant. Explain to students that this table is a fixed capital along with one stapler and the one marker needed to complete the widget.

B. Announce that a work day will be five minutes. Ask for ONE student to serve as a unit of labor to produce widgets. After five minutes record on the board, the number of widgets completed for the one unit of labor.

Units of Labor Total Product Marginal Product 0 1 2 .

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. .

Begin with one student volunteering to produce widgets for this work day. Continue adding student units of labor and recording the number of widgets produced until diminishing marginal product becomes obvious as the production become inefficient.

Put a price on the widgets and ask students to rationalize what they would be willing to pay as a wage and how many units of labor would they hire at that wage. Direct discussions to allow students formulate general observations on the relationship between units of labor, wages and the market price of the widget.

Additional Questions and Discussion 1. Should the government become involved in wage/income equality?

Answer: Encourage students to demonstrate understanding of the information with explanations of wage determination through supply and demand and elasticities.

LO-3 Level: Moderate 2. Think-Pair-Share Activity Individually have students consider why demand for labor can be considered a derived demand?

After two or three minutes have students pair up with at least one other student, no more than two other students, to compare thoughts. Ask them to also consider together an example of a change in product demand that would increase and one that would decrease labor demand.

Answer: The demand for labor is a derived demand because depends on the demand for the product that uses the resources. A change in product demand that would increase labor demand would include changes of tastes or preferences that increases demand for the good. An example would be an increase in marketing efforts for a resort that would increase demand for workers at the resort.

An example of a change in product demand that would decrease labor demand would include the decrease of glass blowers because of the ability of machines to provide an equitable product at a lower cost.

LO-1 Level: Difficult

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3. Would you be in favor of increasing the minimum wage by $1/hour, $5/hour, $10/hour?

Why or why not?

Answer: Many of the students may have currently been working at a job that pays minimum wage. They may agree that a $1/hour would be helpful and may contribute to their productivity at their job. They may be able to argue that the work they do is worth an additional $1/hour. However, their ability to argue the value of their individual skill has an additional value of $5/hour will be more difficulty.

LO-3 Level: Moderate

Answers to Think for Yourself Questions 1. An increase in the demand for movies would increase the equilibrium price of movies and thus increase Depp’s VMPL. A decrease in the demand for football would decrease the price of football-related items (tickets, TV advertising revenue, and merchandise) and would decrease the VMPL of Manning.

2. 6 workers per hour; 2 workers per hour; 5 workers per hour.

3. Workers in the US have more access to capital and equipment than do workers in less developed countries. The access to capital increases US workers’ productivity and thus their VMPL. Higher VMPL for workers in the US translates into higher wages for US workers.

4. As workers age, their productivity in certain industries falls. For example, fashion and other magazines tend to favor photos of young models and younger players tend to be more competitive than older players in some sports. As Armstrong has gotten older, his cycling times have slowed and he wins less often, which translated into a lower VMPL in cycling.

5. Comparing the compensation of the CEO to that of other workers in a company does not compare the value of the CEO to the value of the company’s workers since the salaries reflect the value of the marginal unit of labor hired, not the value of labor in total. A CEO like Ralph Lauren attracts millions of customers to the company, while a typical worker at Ralph Lauren is unlikely to generate as much additional revenue. The VMPL of the CEO is thus higher than that of the typical worker, which is reflected in the higher CEO wage.

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Answers to Discussion Questions and Problems 1. The table at right expands Workers/hour Total Product MPL VMPL Total (wuzzies/hour) (wuzzies/hour) Revenue ($/hour) the production function to ($/hour) include the MPL, VMPL, 0 0 ------------0 and Total Revenue at 1 19 19 38 38 2 36 17 34 72 WAS corporation.

3 51 15 30 102 a. $22; $124; $14; 4 62 11 22 124 $158 5 72 10 20 144 b. $20 (the 5th 6 79 7 14 158 7 84 5 10 168 worker’s VMPL); TR = $144, TC = $20*5 = $100; Profit = $44 per hour c. $14; TR = $158; TC = $14*6 = $84; Profit = $74 per hour d. If the price is $4, the VMPL of the 5th worker is $40 per hour, so the maximum amount WAS should pay the 5th worker is $40 per hour. TR = 72*$4 = $288 per hour; TC = $40*5 = $200 per hour; profit = $88 per hour.

2. The audience for professional soccer in the US is smaller than the audience for professional baseball in the US. This means that the VMPL of professional soccer players is lower than the VMPL of professional baseball players, so the earnings of professional soccer players is lower than that of professional baseball players.

3. If a professional sports player like Kobe Bryant has the ability to attract tens of thousands of fans to his games, then the answer is yes. Kobe Bryant and other superstars generate substantial revenues for their teams, and thus earn a wage commensurate with the value of their marginal product of labor.

4. a. 60 boxes of apples per week; b. $800 per week; c. $600 per week

6. An increase in the demand for a product will increase the equilibrium price of the product. In turn, the increased price of the product will increase the VMPL of

$ per hour

5. If firms expect that the steroid revelation will make fans and customers less likely to buy their products when Rodriguez is associated with them, the demand for Rodriguez as an endorser will decrease.

S

W'

D

Q*

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S'

W*

Q'

Workers per hour

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the workers that produce the product so the demand for those workers will increase.

7. An increase in the supply of labor from S to S’ will generate a reduction in the equilibrium wage from W* to W’ and an increase in the equilibrium employment level from Q* to Q’.

Answers to Multiple Choice Problems 1. c 2. d 3. c 4. a 5. c 6. a 7. e 8. a 9. b 10. d

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CHAPTER 9: WAGE DETERMINATION Worksheet Consider the following table of data for a firm that produces Widgets. The market price of these widgets is $5 each. The current wage is Labor Units Total Marginal Product Value of marginal Product (Per Hour) Product of Labor, MPL of Labor ($/hr) (1) (2) (3) (4) 0 0 1 10 2 19 3 27 4 34 5 40 6 45 7 49 8 52 9 54 10 55 Consider the data in the table above. What is the additional output when increasing units of labor are added? (Units of capital are fixed) Fill in Colum 3.

In the space provided below, graph Total Product

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1. What general statement can you make about Total Product? How can you explain this observation?

2. Think-Pair-Share What would be the value to the firm of each additional unit of labor? Fill in Column 4 and explain how this is determined. a. Think: Personal Observations

b. Pair: Share your thoughts with one additional person and draw conclusions (Be prepared to share your observations)

3. Can the MPL be negative? Explain why or why not.

4. If the going wage is $20 dollars per hour, what is the optimal number of workers that firm should hire?

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CHAPTER 9: WAGE DETERMINATION Worksheet KEY Consider the following table of data for a firm that produces Widgets. The market price of these widgets is $5 each.

Labor Units (Per Hour) (1) 0 1 2 3 4 5 6 7 8 9 10

Total Product (2) 0 10 19 27 34 40 45 49 52 54 55

Marginal Product of Labor, MPL (3)

Value of marginal Product of Labor ($/hr) (4)

10 9 8 7 6 5 4 3 2 1

50 45 40 35 30 25 20 14 10 5

Consider the data in the table above. What is the additional output when increasing units of labor are added? (Units of capital are fixed) Fill in Colum 3.

In the space provided below, graph Total Product

Total Product (Widgets Per hour)

60

TP

50 40 30 20 10 0 0

1

2

3

4

5

6

7

8

9

10

Labor Units per hour

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1. What general statement can you make about Total Product? How can you explain this observation?

Total Product increases and then flattens out. This is because of the law of diminishing marginal product. As additional units of a variable input, labor in this case, is added to a fixed capital base, at some point marginal product decreases.

2. Think-Pair-Share What would be the value to the firm of each additional unit of labor? Fill in Column 4 and explain how this is determined. a. Think: Personal Observations b. Pair: Share your thoughts with one additional person and draw conclusions (Be prepared to share your observations) Marginal benefits = Marginal Cost If the marginal cost is equal to the wage rate ask students to develop their perception as to what is the benefit to the firm. Guide the discussion so that students can make the connection with the price the firm is receiving. Therefore, the value of each additional unit of labor, the VMPL, would be equal to the marginal product of labor times the price of the product.

3. Can the MPL be negative? Explain why or why not.

No, the marginal product of labor falls as the amount of labor increases when capital is held constant, but it cannot be negative. Each worker has a positive marginal product but adds less output than the previous worker.

4. If the going wage is $20 dollars per hour, what is the optimal number of workers that firm should hire? 7 units of labor should be employed.

Labor Units (Per Hour) (1) 0 1 2 3 4 5 6 7 8 9 10

Total Product (2) 0 10 19 27 34 40 45 49 52 54 55

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Marginal Product of Labor, MPL (3) 10 9 8 7 6 5 4 3 2 1

Value of marginal Product of Labor ($/hr) (4) 50 45 40 35 30 25 20 14 10 5

Wage ($/Hour) 20 20 20 20 20 20 20 20 20 20 20

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Chapter 10: The Minimum Wage Chapter Outline 1. What Are Minimum Wages 1.1. History of Minimum Wages 1.2. State-Level Minimum Wages 2. The Theoretical Impacts of the Minimum Wage 2.1. Demand for Labor 2.2. Supply of Labor 2.3. Above-Equilibrium Minimum Wage 2.4. Below-Equilibrium Minimum Wage 3. The Winners and Losers From the Minimum Wage 3.1. Workers 3.2. Businesses and Consumers 4. Why Are Minimum Wages Controversial?

5. Minimum Wage Research

Learning Objectives After studying this chapter, students should be able to: • Define the minimum wage • Describe the history of the minimum wage • Describe the difference between the real and nominal values of the minimum wage • Assess the theoretical impacts of the minimum wage on the labor market • Explain why minimum wage laws are controversial • Describe research findings regarding impacts of the minimum wage

Teaching Notes Building on the previous chapter on wage determination, this chapter focuses on the definition, history, and supply and demand analysis of the current minimum wages in the United States. This chapter allows students to develop a better understanding of the previous and current theories of this economic price floor.

What do students know about the minimum wage laws in the United States? Are they aware that it is not a “one wage fits all”? Allow students to explore what are currently the laws in the United States. Using information from the Department of Labor will help students gain information about the current status.

One source of information about laws by state is http://www.dol.gov/whd/minwage/america.htm.

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Using this chapter as a supplement to Chapter 7’s discussion of inflation and Chapter 4’s price controls provides students a real-world topic to develop their understanding of nominal and real values and the efficiency versus equality debate.

The minimum wage is a price floor. This means that it does place a restriction only on downward movements in the wage. Consider the following diagram. When the market wage is at WE the issue becomes market efficiency or income equality. When the current wage is inefficient to maintain a desired standard of living the concept of placing a price floor to limit this inequality becomes an issue. A price floor, as studied in Chapter 4 limits downward price movement. Businesses cannot offer a wage below this price control. While allowing for a higher wage the market moves away from an efficient, optimal level of production for society.

Using the demand and supply model will give students a visual of the economic concepts of a price floor and impact of this price control. When developing the demand and supply analysis of minimum wages remind students that the demand for labor is a derived demand. The need for units of labor is determined from the demand for the product being produced. The demand for labor is from the business side. The demand curve for labor illustrates the price of labor, the wage per hour, and the quantity of labor demanded per period. The supply curve illustrates the quantity of labor from the population that is willing and able to provide their resource of labor to the market.

This chapter is also a beneficial supplement to Chapter 9’s wage determination because it provides an opportunity to allow the students to consider decision making as a producer and not their typical economic role of consumer. Everyone wants a higher wage, but what if you are the person signing the paychecks? How will this affect your ability to produce?

There are losers to minimum wage laws, both for businesses and consumers. The chapter provides a discussion on how a price floor intended to limit income inequality. In a market economy the market forces of demand and supply determine an efficient price for a product. In the labor market these same forces also indicate the optimal allocation of resources for the quantity. However, society may deem this price to be too low to sustain a desired level or standard of living. Therefore, a price floor is established to provide this base wage. When there is a deviation from the market efficient level of output where MSB =

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MSC, there will be winners and losers. Helping students realize the good, bad, and not so pretty side of economic concepts provides added understanding of the interwoven facets of the economy.

Teaching Activities 1. Introduce this chapter with a discussion of the effects of a price floor on market efficiency.

Use the above model and a Think-Pair-Share activity to discuss and develop their knowledge of a price floor.

Think: Why would a wage of WPF be needed in a labor market?

After a few minutes have students pair up with one or two students to compare what they observed.

Add the following for the small groups to discuss.

Pair: a) If the wage was increased to WPF what would be the effect on this labor market? b) What would be the result of the numbers hired? c) Who would be winners and losers of this higher wage? d) How was efficiency in the market affected?

Share: Have groups share what was discussed.

Possible answers will include: The need for WPF would be because the equilibrium rate is too for members of society. a) When the price control is initiated the quantity demanded of workers decrease and the numbers will to supply labor increases. Businesses (demand) are have less benefits from hiring the original equilibrium quantity, lowering their ability and willingness to hire the larger amount. b) A surplus is created in the market c) Winners will be who retain or receive a job. Losers would be those who lose their jobs, or are not hired. d) Because the market moves away from the level of production where MSB = MSC there is a loss to society. The amount of the loss will depend upon the elasticity of the demand for the product being produced.

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2. A stumbling block may be in an understanding and appreciation of the differences between the nominal value of the minimum wage and the real value of the minimum wage. Nominal is a measurement in current dollars. Real value represents their purchasing power. Students can use data from the following website and construct a graph of nominal and real values of minimum wage http://www.data360.org/dsg.aspx?Data_Set_Group_Id=762. Ask students to compare the differences with rates of inflation. What observations can they make?

3. Using the information on Colorado’s minimum wage law, have students research what states have a minimum wage law. What are the pros and cons of having a minimum wage law?

Additional Questions and Discussion Points 1. Colorado’s minimum wage law is indexed to the rate of inflation. What does this mean and what are implications of this practice?

Indexed is the practice of increasing nominal values to maintain a desired level of purchasing power, or real value. The up side of this inflation adjustment is that a certain level of purchasing power would be maintained. The down side of this practice is that wages could go down in cases of deflation.

LO-3 Level of Difficulty: Moderate 2. Use a demand and supply model and the concept of producer surplus to explain the overall impact of a minimum wage on a labor market.

At the initial equilibrium, producer surplus is equal to WEAG. With the minimum wage in place, the producer surplus changes to area GJBWPF. Producer surplus has increased by area WEHBWPF when the minimum wage is in place. However, producer surplus has also fallen by the area of HAJ. Whether the increase in producer surplus is greater than the decrease in producer surplus depends on the elasticity of the demand and the supply curves. A clear, quantifiable amount cannot be determined. The loss to society is represented by the deadweight loss of area JBA. LO-4

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Level of Difficulty: Difficult 3. What would be at the heart of the controversy of the minimum wage law?

The heart of the controversy of the minimum wage law is how the person believes what the impact on society has been as an antipoverty policy. Proponents argue that the minimum wages help the poor by raising their incomes. Proponents also argue that the increase in worker incomes does not come at the direct expense of taxpayers, because the minimum wage is paid by businesses not the government.

Opponents argue that minimum wages do not reduce poverty and instead reduce overall social welfare because minimum wages benefit relatively few poor workers at the expense of other poor workers. Also because some workers are able to keep their jobs when the minimum wage increases, others do not nor have their employment hours reduced. Opponents also argue that by raising the cost of labor, minimum wages provide incentives for some businesses to use substitute inputs such as machines or lower-cost workers in foreign countries instead of domestic workers.

LO-5 Level of Difficulty: Easy

Answers to Think for Yourself Questions 1. The US Bureau of Labor Statistics website (www.bls.gov) has extensive information on federal and state minimum wages, as well as information on average wages by state. In 2011, the Federal minimum wage was $7.25. Some of the benefits of a minimum wage that automatically adjusts for inflation are that the minimum wage would move upward when inflation increases so that the real value of the minimum wage would not deteriorate over time and that the movements in the minimum wage would be less subject to political debate. One cost of an automatically adjusting minimum wage is that it can move down when inflation falls, reducing worker incomes.

2. When the minimum wage is $8 per hour instead of $7.25 per hour, the unemployment generated by the minimum wage would be larger since quantity demanded would be lower and quantity supplied would be higher at the higher minimum wage. The unemployment generated by the minimum wage would be smaller if the minimum wage were $6 per hour instead of $7.25 per hour.

3. If the equilibrium wage is $7.50 per hour, a minimum wage of $10 per hour would generate unemployment in the local labor market. If the equilibrium wage is $7.50 per hour and the minimum wage is set at $6 per hour, the minimum wage would have no impact since it lies below the equilibrium wage.

4. For a given wage increase, firms change their quantity of labor demanded by a larger amount when demand is more elastic than when demand is more inelastic. An increase in the minimum wage will generate a larger decline in quantity demanded, and thus a larger increase in unemployment, when demand is more elastic.

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Answers to Discussion Questions and Problems 1. Since 1968 inflation has increased faster than the nominal value of the minimum wage has increased, so the real value of the minimum wage has declined.

2. It is not clear that teenagers as a whole are better off or worse off from an increase in the minimum wage. On the one hand, some teens are better off because they have higher earnings. On the other hand, teens who lose their jobs or are not hired into jobs when they would have been otherwise are worse off from an increase in the minimum wage.

3. Increases in the minimum wage increase the costs to businesses. Some businesses that were on the margin of profitability before a minimum wage increase may find it too costly to remain open when their labor costs increase; others may have to reduce their hours of operation. The bottom line is that increases in the minimum wage reduce the profits of businesses.

4. Answers here can vary, but the key is that students who are on the margin between staying in school and dropping out will be more likely to leave school when the minimum wage is increased. Students who are on the margin are likely to be those who do not enjoy school or students who are interested in jobs that do not require as much schooling.

5. a. $4; 200,000 workers per month. b. Consumer surplus = $.5*4*200,000 = $400,000 per month; Producer surplus = $.5*4*200,000 = $400,000 per month; Total surplus = $800,000 per month. c. QD = 50,000 workers per month; QS = 350,000 workers per month. The quantity of labor hired will be 50,000 workers per month. d. Consumer surplus = (.5*$1*50,000) = $25,000 per month; Producer surplus = (.5*$1*50,000) + ($6*50,000) = $325,000 per month; Total surplus = $350,000 per month; Deadweight loss is $800,000 - $350,000 = $450,000 per month. e. the winners are those who keep their jobs and get the now higher wage. The losers are those who either lose their jobs or can't find jobs they would have had the minimum wage not been imposed.

Firms also lose from the minimum wage, as illustrated by the loss in consumer surplus when the minimum wage is imposed on this market.

Answers to Multiple Choice Questions 1. d 2. a 3. c 4. d 5. a

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6. d 7. a 8. c 9. a 10. b

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Chapter 11: International Trade of Goods

Chapter Outline 1. The Extent of International Trade 2. Why Do We Trade?

2.1. Comparative Advantage 2.2. Absolute Advantage 2.3. Terms of Trade 3. The “Winners” and “Losers” From International Trade 3.1. Impact of Exports on the Domestic Market 3.2. Impact of Imports on the Domestic Market 4. Intervening in International Trade 4.1. Protecting Jobs 4.2. National Security 4.3. Differences in Environmental or Labor Policy 5. Forms of Trade Restrictions 5.1. Tariff 5.2. Quota 5.3. Regulations 6. Forms of Trade Liberalization 6.1. Regional Trade Agreements 6.1.1. World Trade Organization

Learning Objectives After studying this chapter, students should be able to: • Discuss the extent of U.S. international trade • Explain the concepts of comparative advantage and absolute advantage • Analyze the costs and benefits of international trade • Describe the distribution of the costs and benefits from international trade • Assess the arguments for and against limiting international trade • Describe the costs, benefits, and mechanisms of limiting international trade • Describe some of the forms of trade liberalization

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Teaching Notes This chapter highlights the magnitude of international trade and the underlying economic factors that drive international trade. A simple glance at the goods and services that make up our daily lives underscores how interwoven our economies actually are.

The chapter begins with a definition of international trade and a discussion of the extent of this global trade. The foundation of international trade begins with the goods and services produced domestically but sold abroad, exports, and those goods and services produced abroad but sold domestically, imports. The difference of the two establishes a country’s trade balance. Students have heard of the U.S.’ negative trade balance, but showing students actual data will give them a better appreciation for how global economies affect this balance.

Use data from the governmental sources, such as the Bureau of Economic Analysis and the National Debt Clock to illustrate the U.S. trade balance and that it is because the U.S. exports more than is imported.

Source: Bureau of Economic Analysis; http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&903=6

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Real time amounts for U.S. trade deficit and the balance of goods traded between U.S. and China

Source: U.S. Debt Clock; http://www.usdebtclock.org/

A stumbling block for students on the importance of the information found in this chapter may be from the students themselves in their lack of recognition to possible implications to their lives.

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Students may not be aware of how involved the majority of countries are with international trade.

Using a map of the world such as the one above have students identify the top 10 exporters and top 10 importers of the world.

The chapter also spotlights the fact that world history is rich with implications of international trade. While not the most accurate source of information, Wikipedia does have an interesting listing of the timeline of international trade that would provide a source to initiate a discussion of how international trade has influenced many civilizations. http://en.wikipedia.org/wiki/Timeline_of_international_trade Following the discussion of what is international trade and the extent of trade the chapter turns its attention to why countries trade. Trade generates benefits to the trading partners. Trade also allows for efficient use of resources at the least cost, in particular, the least opportunity cost.

Students typically associate a cost with a dollar amount and find the concept of opportunity costs in relative terms confusing. Opportunity costs represent what was given up to gain something else, but not in value of dollars, but in terms of another good or service.

While developing students’ understanding of a production possibilities frontier, help them identify why the slope of the curve is the opportunity cost of the good on the x axis. Consider Figure 1 on page 181 of your text, pictured on the left. The curve is downward sloping representing an inverse, or negative, relationship. Remind students that this means the two variables presented change in opposite direction, when the good on the x axis, units of shoes, increases, the good on the y axis will, by definition decrease.

Now, tie in the concept of an opportunity cost, the next best alternative, or the option that was given up, in relative terms.1 What is the opportunity cost of one more unit of shoes? One computer is given up and therefore is the opportunity cost. The slope of the production possibilities curve illustrates what was given up to gain another unit of a good.

Students sometimes have difficulties keeping separate the differences between absolute advantage and comparative advantage. Helping students with a strong understanding of opportunity costs will benefit them when explaining the concepts of comparative advantage.

Absolute advantage is more intuitive for students. The concept of comparative advantage is more problematic. One method to help explain comparative advantage is to use more personal examples. Ask students how many CAN change their own car’s oil and how many of them actually do? How many students CAN make their own bread for their sandwiches and how many of them actually do? The differences illustrate that we choose not change our own oil and bake our own bread because our time is better used doing other things. Should a highly trained 1

Relative in that the cost is in terms of another good or service.

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medical doctor and researcher take time out of valuable studies on disease control to make their own clothes and food? No, the opportunity costs would be too great.

International trade provides benefits for trading partners but as the chapter discusses, there are winners and losers from international trades which causes controversy. There are costs and benefits involved with trade. The controversy arises because the distribution of these costs and benefits are not equal. Simple demand and supply models are helpful for students to identify who wins and who loses when a country exports or imports. An activity that allows students to develop an understanding of who wins and who loses is provided below in Teaching Tips.

Because there are winners and losers, countries have dealt with the controversies with different approaches to views of international trade, either one of protectionism or one of free trade.

Protectionism is through increased regulations against trade such as tariffs, quotas and regulations.

Teaching Activities 1. Awaken students’ awareness to how interwoven global economies are by beginning this chapter with a simple exercise. Have students list all the things they have on and what they brought to class that is identified as being from another country by a label. This will include items such as the t-shirt and/or cap they are wearing to their book bags. Now, ask them to consider the potential interrelatedness of countries in the construction of that item. For example, the t-shirt they may be wearing may have a tag stating that it was made in China. But what about the individual parts of producing that t-shirt. The cotton may be an export of the U.S. as well as the screen printing on the front.

2. To supplement the exercise #1, assign The Travels of a T-Shirt in the Global Economy: An Economist Examines the Markets, Power, and Politics of World Trade. (Rivoli, 2005) prior to the discussion in #1. An engaging, “quick-read,” students will follow the construction of a t-shirt.

3. Use a Think-Pair-Share activity to develop individual understanding of winners and losers from international trade. Two handouts are provided at the end of this chapter that can be reproduced and used.

Additional Questions and Discussion Points 1. An introductory topic that provides a current view of how open countries are to international trade and how this has changed is to ask students to calculate the index of openness of Copyright © John Wiley & Sons, Inc.

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different countries using data from the World Bank or International Monetary Fund. The index of openness is a comparison of exports and imports to a country’s gross domestic product. Also known as the trade-to-GDP ratio can be used to measure the importance of international trade relative to domestic transactions. It is the sum of exports and imports of goods and services relative to GDP. Index of Openness = (Exports + Imports)/Gross Domestic Product The higher the number the larger the influence of trade on domestic activities. Related to this discussion possibility is a short article on trade openness provided by OECD. 2. Why is Buy American actually very difficult to support?

Answer: While support for domestic industry protects jobs for the domestic labor force, it is actually very difficult to define and support. Is purchasing a Ford over a Toyota “buying” American? Toyotas are produced in the U.S. and some parts in the Ford are produced in other countries. Many final products produced in the U.S. are actually composed of parts from around the world.

LO-5 Level of Difficulty: Moderate 3. How is absolute and comparative advantage applicable to your life?

Answer: While we have the ability to produce our food and clothes and other daily items, what we have to give up doing this will be high. Our talents are better used producing where we are more efficient.

LO-2 Level of Difficulty: Easy

Answers to Think for Yourself Questions 1. Absolute advantage occurs when a person, firm, or country can produce more of a good or service than another person, firm, or country. Comparative advantage occurs when a person, firm, or country can produce a good or service at a lower opportunity cost than another person, firm, or country. Comparative advantage is more important when determining whether it is beneficial to engage in international trade, since even a country with absolute advantage relative to another country can gain by trading if the other country has comparative advantage in production.

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Landia

2. See the graphs at right. The solid lines represent the PPFs for Landia and Seavia. If Landia produces only computers and Seavia produces only shoes and the two countries trade with one another at the rate of 1S = 4.5C, the consumption possibilities curves are the dotted lines in the graphs.

Seavia

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3. The more elastic the demand for the imported good, the smaller the price change in the good will be. The more inelastic the demand for the imported good, the larger the price change in the good will be.

4. Before the tariff, PS = ½ * 50 * $500 = $12,500 per day and CS = ½ * $(1000-500) * 50 = $12,500 per day. After the tariff is in place, CS = ½ * ($1000-$600)*40 = $8,000 per day and PS = ½ * 400 * 40 = $8,000 per day. The tax revenue is equal to ($200 * 40) = $8,000 per day. The deadweight loss is ½ * $(600-400)*10 = $1,000 per day.

Answers to Discussion Questions and Problems 1. a. 10T = 2C so 1T = 2C; 1C = 0.5T b. 2T = 5C so 1T = 2.5C; 1C = 0.4T c. Tommy Trout has comparative advantage in producing trout; Coleen Coffee has comparative advantage in producing coffee.

Tommy Trout Coleen Coffee 10 9 8

Pounds of trout per day

Pounds of trout per day

d. See the graphs at right. The dotted lines show the consumption possibilities for Tommy and Coleen when the terms of trade are 1T = 1C. Since the consumption possibilities lie outside both producers’ PPFs, the terms of trade can make them both better off.

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2. a. Since it takes less labor to produce a TV in country A, country A has absolute advantage in producing TVs relative to country B.

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b. Since it takes less labor to produce a computer in country A, country A has absolute advantage in producing computers relative to country B. c. The opportunity cost of producing 1 TV in country A is 1 computer, since both goods require 2 units of labor to produce. Since it takes 3 units of labor to produce a computer in country B, 1 unit of labor can produce 1/3 C in country B. Similarly, 1 unit of labor can produce ¼ TV in country B. The opportunity cost of producing one TV in country B can be found be equating the number of TVs and computers that can be produced with one unit of labor in country B, or ¼ TV = 1L = 1/3 C. So ¼ TV = 1/3 C, or 1 TV = 4/3 C. Since the opportunity cost of producing 1 TV in country A is 1 C and the opportunity cost of producing 1 TV in country B is 4/3 C, country A has comparative advantage in producing TVs. d. The opportunity cost of producing 1 C in country A is 1 TV. The opportunity cost of producing 1C in country B is ¾ TV. Thus, country B has comparative advantage in producing computers.

3. Answers here can vary, but by protecting industries, we may be altering the incentives for industries to be more competitive and find the most efficient use of our society' limited resources. Retaliation by other countries can result in further increases in prices, in less output, and wasted opportunities to make both societies better off. The cost of protectionism is high in dollar terms. As Table 4 illustrated, research has shown that the cost of the typical job saved is very high, averaging $231,000 per year. Other job programs could generate job growth much more cheaply.

Answers to Multiple Choice Questions 1. a 6. d

2.d 7. e

3. c 8. c

4. c 9. d

5. c 10. d

References Rivoli, P. (2005). The Travels of a T-Shirt in the Global Economy: An Economist Examines the Markets, Power, and Politics of World Trade. Hoboken, New Jersey: John Wiley & Sons, Inc.

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WINNERS AND LOSERS OF INTERNATIONAL TRADE Exports Think-Pair-Share 1. Individually Consider the graph on the left.

Identify what would happen to price when demand increases.

Answer: When demand increases, the curve shifts to the right, increasing price.

2. With one, or two, more people How would this graph change if the country began to export? Identify how this connects with #1.

Answer: If a country begins to export it would increase their demand causing equilibrium price to increase.

3. Who wins with exports? Who would lose with exports?

Answer: When a country exports, the increase in price benefits the supplier. The losers would be the domestic consumers who now are facing higher prices and a decrease in quantity demanded.

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WINNERS AND LOSERS OF INTERNATIONAL TRADE Imports Think-Pair-Share 1. Individually Consider the graph on the left.

Identify what would happen to price when supply increases.

Answer: When supply increases, the curve shifts to the right, decreasing price.

2. With one, or two, more people How would this graph change if the country began to export? Identify how this connects with #1.

Answer: If a country begins to import it would increase their supply of that good causing equilibrium price to decrease.

3. Who wins with exports? Who would lose with exports?

Answer: When a country imports, the decrease in price benefits the domestic consumer. The losers would be the suppliers who now are facing a lower price and an increase in quantity supplied.

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Chapter 12: Immigration and the International Trade of Labor

Chapter Outline 1. The Extent of U.S. and International Immigration 2. The Costs and Benefits of Immigration 2.1. Costs and Benefits for Immigration 2.2. Costs and Benefits of Immigration for Host Countries 2.2.1. Impacts of Immigration on Host Country Labor Markets 2.2.1.1.

Impact on Substitutes 2.2.1.2.

Impact on Complements 2.2.1.3.

The Importance of Immigrants’ Skills 2.2.2. Impacts of Immigration on Product Markets 2.2.3. Impacts of Immigration on Host Country Resources 2.3. Costs and Benefits of Immigration for Home Countries 2.3.1. Impacts of Emigration on Labor Markets 2.3.2. Impacts of Emigration on Product Markets 2.3.3. Remittances 3. Outsourcing and Offshoring as International Trade in Labor

Learning Objectives After studying this chapter, students should be able to: • Describe the extent of international migration • Assess the costs and benefits of migration for migrants • Assess the costs and benefits of migration for host and home countries • Define and describe the extent of outsourcing and offshoring

Teaching Notes Depending on the region of the country this chapter may be more emotionally charged than others. The topic of immigration is more prevalent in areas that face issues of illegal immigration as an everyday real controversy. Political and social debates that are commonly heard in these areas may have skewed the tolerance of some of your students about this topic. It may be

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necessary to remind students multiple times during the study of this material that the discussion being presented is from an economic mindset and not as a political or social issue.

Following a synopsis of the Arizona state law, SB 1070, the chapter begins with a definition and discussion of the extent of international immigration. Asking students to consider SB 1070 and formulate their own opinion and defense of their opinion on the validity of this law will initiate a discussion that can be continued throughout the chapter.

Have students consider the immigration population patterns by state as provided by Figure 2 on page 198 of the text. Note where the immigration populations are denser and where they tend to be sparser. States, such as California and Texas, are closer to borders and have more opportunities for income than smaller states that are farther away from borders. Have students formulate opinions about reasons for these patterns. These will aide students in understanding cost and benefit analysis of immigration.

The chapter provides a thorough discussion on the costs and benefits of immigration. Part of the controversy surrounding this issue is that the costs of immigration are borne by different groups from those who enjoy the benefits. Also, the costs are different depending on from which viewpoint is being taken, from the host country (the country receiving the immigrants) or from the home (the country that serves as homeland to the immigrant).

The chapter presents four predictions about immigration that will provide students an economic perspective to the immigration debate. Using these predictions as a guide for discussions will also aide students in developing an understanding of the costs and benefits of immigration.

Prediction #1: Improvement in earnings opportunities will affect immigration patterns • If there is an economic expansion in the host country there will be an increase in immigration because of improved earning opportunities • If there is an expansion of jobs in the home country there will be a decrease in immigration because of the increased opportunity cost of migrating.

Prediction #2: An increase in the monetary, or other costs of moving, will decrease the likelihood of immigration • A host country’s immigrants are more likely to come from nearby countries because of the smaller costs of moving shorter distances

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Prediction #3: Ceteris paribus, those who immigrate are more likely to have more access to wealth and resources than their nonimmigrant counterparts Prediction #4: Younger individuals are more likely to migrate than older individuals The economic impacts of immigration on host and home countries become issues of demand and supply. Provide multiple of examples using models for the students to manipulate. Revisit economic concepts of consumer and producer surplus and nonprice determinants of demand substitutes and complements prior to discussion.

Have students consider and identify what economic markets are affected by immigration for both the host country and the home country and who are the winners and losers from immigration in the host country.

Host Country Winners • • • •

Immigrants Firm owners Consumers that pay lower prices Native workers who are complements to immigrant workers

•

Losers Native workers who are substitutes for immigrant workers

Home Country Winners • •

Emigrants Those receiving remittances from emigrants

Losers •

Firm owners

The chapter concludes with a discussion on the effects of outsourcing and offshoring as international trade in labor. The two concepts tend to confuse students and are two concepts that are often equated with political controversy and may be viewed as synonymous and necessary evils to the home economy. It will benefit students to emphasize the economic differences and references rather than social and/or political.

Outsourcing is another example of the law of comparative advantage at work and provides net benefits to the economy. The controversy arises because the distribution of the costs and benefits of outsourcing are not equally shared. Provide students opportunities to develop an understanding of winners and losers of outsourcing. (See Teaching Tips)

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Teaching Activities 1. As part of the introduction to the chapter divide class into small groups to research and develop pros and cons of Arizona’s SB 1070 using an economic thought process. Allow students time to create a short, informal presentation to share with the class on their findings. What are the costs and benefits of the law to the state of Arizona? Who are winners and losers? Using demand and supply models in their analysis will be of benefit to the students. This will help set the stage for a process to approach cost and benefit issues of immigration.

2. Think-Pair-Share activities on the issue of immigration provide students the opportunity to develop their own understanding of costs and benefits for both the hosts and home countries. Work sheets that can be used as a class activity is provided at the end of the chapter. For each worksheet provide five minutes for students to consider the questions posed individually and an additional five to seven minutes with one or two other students.

Have the groups share with the class what they hypothesized.

3. Use data from the Department of Homeland Security to provide real-world data on historical immigration trends. http://www.dhs.gov. Students can use data from this source to research immigration patterns in their region.

4. Who are the winners and who are the losers of outsourcing? Have students consider the costs and benefits of outsourcing. Using critical thinking strategies have students discuss the justification for the costs and benefits. See handout below.

Additional Questions and Discussion Points 1. Have students discuss how has the American society and culture been impacted by immigration and why do people immigrate? Remind them that this should focus on economic reasoning.

Answer: Immigration has contributed to increases in economic growth by providing additional resources of labor when the immigrants were considered complements to domestic laborers. Immigration has also contributed to native laborers to lose their jobs when considered as substitutes. People typically immigrate to increase income opportunities.

LO-2 Level of Difficulty: Medium

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2. Why is outsourcing a form of comparative advantage?

Answer: By definition, outsourcing occurs when someone hires another person or firm to produce a good or service. Comparative advantage is producing those goods and services with which opportunity costs are lower. By outsourcing, a company is using resources that have a comparative advantage is providing a specific part of the production process. An example would be when a company outsources their accounting or finance needs to a company specializing in that area, rather than trying to handle it themselves with less expertise.

LO-5 Level of Difficulty: Difficult 3. Have students access the World Bank database to research the amount of personal remittances as a percent of GDP for different countries. Access http://search.worldbank.org/data?qterm=emmigration%20remittances&language=EN and select Workers’ remittances and compensation of employees, received (% of GDP)

This will provide you a pop-up window of personal remittances as a percent of GDP by countries.

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For a spreadsheet view of the data, click on the spreadsheet icon in upper right hand corner. Why do some countries have zero remittances while others have a larger share of GDP? Why did Liberia’s personal remittance jump from 2.43% in 2010 to 23.29% in 2011?

Answer: The differences reflect the abilities to earn an economic income in that country.

Higher percentages of personal remittances received reflect an economy that is limited in opportunities for earning income and accumulating wealth. Lower percentages reflect economic environment where opportunities are more plentiful to earn income and accumulate economic wealth.

LO-4 Level of Difficulty: Difficult

Answers to "Think for Yourself" Questions 1. Younger individuals are more likely to migrate than older individuals because younger individuals have more time to earn the higher earnings in the host country and to recoup the costs of immigrating. Immigrating involves transportation and moving costs, and those who immigrate are more likely than their non-migrating counterparts to have enough income to cover these costs. A decrease in transportation costs lowers the cost of immigration and makes it more likely for someone to immigrate. A decline in the potential earnings in the host country lowers the benefits of immigrating and decreases the likelihood of immigration.

2. When immigrants and native workers are substitutes, native workers lose from immigration because their wages and employment levels will fall. Consumers and businesses win because

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lower costs of production generate lower prices for goods and services and higher profits for firms.

3. When immigrants and native workers are compliments, native workers win from immigration because the demand for their labor increases. Consumers and businesses also win because lower costs of production generate lower prices for goods and services and higher profits for firms 4. In the original equilibrium, the supply curve S(native labor) represents the supply of natives who do not emigrate and those who do emigrate, while the supply curve S(native – emigrant labor) represents the supply of natives who do not emigrate. Since we are interested in the producer surplus of natives who do not emigrate, the supply curve S(native – emigrant labor) should be used to compute producer surplus. This is the area above the native worker supply curve and below the original equilibrium price, so PS = .5*$(15-12)*300 = $450 per hour in the original equilibrium.

In the post-emigration equilibrium, PS = .5*$(16-12)*400 = $800 per hour. Thus, the native workers are better off after the emigration.

5. Much debate arises over what to do about immigration and outsourcing, particularly for those who bear the cost of increased global competition in the labor market. Some groups advocate restrictions on immigration to protect domestic jobs. Although this may help those workers in the short term, it is likely to be detrimental to firms and domestic economies in the longer term because it hampers their global competitiveness. Alternative reactions to protectionist policies on immigration and outsourcing would include job training and educational opportunities for workers displaced by international trade in labor.

Answers to Discussion Questions and Problems 1. The benefits of immigration include increased output, lower prices, higher profits, and increased overall employment in the economy. Workers who are compliments to immigrants benefit from higher wages and increased employment. The costs of immigration include lower wages and employment for workers who are substitutes for immigrant labor.

2. (1) The cost of moving. The lower the cost of moving, the more likely the person is to move.

Thus, a worker is more likely to make moves of a shorter distance, moves that are paid for by employers, and moves with fewer language and cultural barriers; (2) The remaining length of the work life. The longer the remaining work life, the more time the workers has to recoup the upfront costs of moving. Thus younger workers are more likely to move than older workers; (3) The relative earnings in the home and host countries. The higher the earnings in the host country, the more likely the worker will immigrate.

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3. The primary reason that more developed nations have larger immigrant populations than less developed nations is because more developed nations tend to have higher wages and better employment opportunities than less developed nations. Some immigrants may also move to developed nations because of government or cultural differences.

4. Firms will consider the costs and benefits of moving production overseas. The costs include transportation, cultural and language differences, and any fees or taxes associated with bringing the product back to the home country. The benefits could include lower cost inputs and perhaps fewer governmental regulations.

5. Ceteris paribus, the shrinking distance between the US and China makes it less costly for US firms to use Chinese workers, increasing the probability that jobs will move there. However, it is not the cost of labor alone that affects the incentives to substitute Chinese for US workers, but also the relative productivity of Chinese and US workers. One way to offset the movement of jobs from the US to China is to increase the relative productivity of US workers.

Answers to Multiple Choice Questions 1. d 6. d

2. e 7. a

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3. c 8. d

4. c 9. c

5. c 10. c

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IMMIGRATION AND THE INTERNATIONAL TRADE OF LABOR Costs and Benefits for Host Country Immigration impacts the host countries in many ways.

1. Individually, focus on the impacts of immigration on labor markets in the host country.

What economic impact would be realized?

Using the following graph, how would the supply and demand model be changed because of immigration? Write down your explanation for what would support this proposed change.

Provide support for why you think this.

Who are winners and who are losers in the labor market of the host country?

2. Pair with one or two other students and compare your responses. Formulate one or two general statements on what happens to in the host country labor markets and who are the winners and losers. Consider that labor is a derived demand and also nonprice determinants of demand for that labor.

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IMMIGRATION AND THE INTERNATIONAL TRADE OF LABOR Costs and Benefits for Home Country Immigration impacts the host countries in many ways.

1. Individually, focus on the impacts of emigration on labor markets in the home country.

What economic impact would be realized?

Using the following graph, how would the supply and demand model be changed because of emigration? Write down your explanation for what would support this proposed change. Provide support for why you think this.

Who are winners and who are losers in the labor market of the home country?

2. Pair with one or two other students and compare your responses. Formulate one or two general statements on what happens to in the home country labor markets and who are the winners and losers.

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OFFSHORING VS. OUTSOURCING Who wins and who loses

What is offshoring?

What is outsourcing?

Which of the two would be an example of the law of comparative advantage at work? Explain your answer.

Consider the graph on the left. What would be the impact of outsourcing on this demand and supply model for the home country labor markets?

Who would benefit from outsourcing? Who would lose from outsourcing?

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Chapter 13: Foreign Exchange and the International Trade of Money

Chapter Outline 1. Foreign Exchange Markets 2. Demand and Supply of Foreign Currencies 2.1. Changes in Demand and Supply 2.1.1. Shifters in the Demand for Euros and the Supply of Dollars 2.1.1.1.

Tastes and Preferences 2.1.1.2.

Income 2.1.1.3.

Expectations 2.1.1.4.

Interest rates and Risk 3. Foreign Currency Valuation and International Trade 4. Fixed and Flexible Exchange Rates

Learning Objectives After studying this chapter, students should be able to: • Understand how foreign exchange markets operate • Demonstrate how foreign exchange rates are determined • Describe how foreign exchange rates influence international trade

Teaching Notes This chapter continues with the concept of international trade by expanding discussion on several important aspects of the international trade of money. The chapter begins with an explanation and discussion of what is a foreign exchange market followed by an explanation of how rates are determined in these markets, including how demand and supply is changed creating fluctuations in the price of a currency.

The thought process that a currency is a marketable “product” may be difficult for students to recognize at first. If your students have not traveled to another country that required exchanging their currency they may have never thought of a need of a “market price” for their currency.

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Providing multiple examples and problems that allow them to “walk through” their progression of understanding will be helpful to them.

The exchange rate illustrates the value of the domestic currency compared to another currency.

Take the time to introduce the model of the demand and supply for the currency slowly, developing each component to ensure that the students understand what they are viewing. It is also helpful to look at one currency at a time rather than jumping from one to another.

Consider Figure 1 on page 213 of your text.

Carefully identify the variables of what the students are comparing and their relationship. .

What are the students looking at? This demand and supply model is illustrating the demand for Euros (on the horizontal axis). Why is the Euro on the horizontal axis? It is the “product,” in this case currency, that is being demanded. At what price? The consumers of the Euro are U.S. citizens. Their currency is the dollar. Therefore the price of each Euro is in U.S. dollars and is charted on the vertical axis. Focus on one currency at a time, treating the currency as a product.

Emphasize that the exchange rate is the rate is usually stated in terms of how many units of one currency can be bought with one unit of a different currency.

It may be beneficial for students to take some time to review the function of nonprice determinants in their ability to change the position of a demand and supply curve. These are those variables that cause a change in demand. When one of these variables increase, an increase in demand occurs and the demand curve shifts to the right. This will cause the price, or in this case, the exchange rate to increase. When there is a decrease in one of these variables there is a decrease in demand and the curve shifts to the left resulting in a decrease in the price, exchange rate. If there is an increase in supply the curve shifts to the right also. However, this rightward shift of the supply curve is accompanied by a decrease in the price, exchange rate. A leftward shift, or decrease, of the supply curve results in an increase in the exchange rate. The demand and supply shifters of the exchange rate are 1) tastes and preferences, 2) income, 3) expectations, and 4) interest rates and risks. Provide students with multiple examples illustrating how these nonprice determinants for the exchange market affect the exchange rate of different currencies.

Providing examples using different currencies will also aide students in understanding this concept. It will assist student in seeing that not all currencies are basically equivalent.

The dynamics of the exchange market is reflected in the changes in the value of one currency relative to the value of another currency. This is another area that should be approached carefully

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and methodically. Again, using an example from your text, consider Figure 3 found on page 215. This figure illustrates the value of Euros in U.S. dollars.

When the demand for Euros increases, to purchase goods and services requiring Euros for payment, more U.S. dollars are needed for each Euro. In relation to the U.S. dollar, the Euro has appreciated.

The reverse occurs when the demand for Euros decrease. Should the demand for goods and services requiring Euros for payments falls, for example, the demand for Euros will fall. This will decrease the number of U.S. dollars needed to purchase one Euro and the Euro is depreciated How will these valuations affect international trade? Again, using demand and supply models help students walk through what occurs when there is an appreciation/depreciation of a currency.

Consider the above exchange rate for Euros as illustrated in Figure 3. When the price, in U.S. dollars, for one Euro increases that make the good or service being consumed relatively more expensive relative to other options. With this increase in relative cost the quantity demand decreases. This appreciation of the Euro relative to the U.S. dollar will lead to a decrease in European exports to the U.S. Conversely, a depreciation of the Euro will make the European product less expensive relative to U.S. products and will increase European exports to the U.S. How will this affect the trade balance?

The chapter also includes a discussion on a country’s trade balance and the effects on a currency because of this balance. The chapter concludes with a discussion of what the difference between a fixed and a flexible exchange rate.

Teaching Activities When including this chapter in your syllabus, provide sufficient time to cover the material at a comfortable, but challenging, pace for your students. Provide multiple opportunities for students to develop through discussion and problem based learning activities an understanding of the

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financial side of international trade. Seeds of knowledge will be planted that will provide them with needed information further on down their lifeline. Following are some suggestions.

1. Use a variation of The Big Mac Index to illustrate the discrepancies of currency equivalencies. Developed in 1986 by The Economist, it was meant to serve as a humorous guide of currency misalignment. Information on the history of this tool can be found at http://www.economist.com/content/big-mac-index. A worksheet that can be used for outside class research to initiate a discussion is provided at the end of this chapter.

Identify a selection of countries for students to research. Use a variety of countries from different parts of the world, developed and developing. Have students find exchange rates through a currency conversion site (i.e., the XE Currency Converter web site: http://www.xe.com/currencyconverter/) to calculate the cost of a Big Mac in that country.

For example, say the exchange rate per U.S. dollar for the Belarusian Ruble is 1R = 0.000115340 USD This is the actual exchange rate listed for the time of this writing. If the Big Mac costs $4.37 in the U.S. what will it cost in the Republic of Belarus? First how many U.S. dollars will be exchanged for one Belarusian Ruble?

4.37/0.000115340 = 37,887 Belarusian Rubles 2. An interesting article about international trade and the U.S. dollar can be found through the Federal Reserve Bank of Minneapolis web site. http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3258 Use this article as supplemental reading to initiate discussion on the current valuation of the U.S. dollar.

3. Consider incorporating the U.S. Dollar Index in your presentation of this chapter and class activities. The U.S. dollar index evaluates the dollar against other major currencies.

Originally founded in 1973 by the New York Board of Trade it was created to measure the value of the U.S. against a basket of major currencies including the Euro, Canadian Dollar, British Pound, and the Japanese Yen. Primarily the index is used to provide a gauge of monetary strength in the U.S. Sources of information on this index include a. Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/series/DTWEXB/downloaddata b. Daily FOREX: http://www.dailyfx.com/forex_market_news/us-dollarindex?engine=google+dailyfx&adg=usd+index&CMP=SFS70160000000L8OJAA0 c. FXStreet.com: http://www.fxstreet.com/rates-charts/usdollar-index/

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Additional Questions and Discussion Points 1. Is a trade deficit bad for an economy? Since the last recession considerable media attention has been given to the valuation of the U.S. dollar. What do students think about the trade deficit? Do they realize the dynamic changes that have occurred since the last recession?

Using real-world data provides a starting point for this discussion. The Bureau of Economic Analysis, www.bea.gov, will provide actual data about the U.S. trade balance. Students can discuss readily available reports, data, and articles on the pros and cons of the U.S. trade deficit.

Answer: Guiding the discussion to include changes in demand and supply of currency will benefit students’ understanding. Because of macroeconomic conditions changes in the evaluation affected the prices of U.S. goods and services and the trade balance.

LO-3 Level of Difficulty: Moderate 2. Think-Pair-Share on foreign exchange markets. Have students contemplate why foreign exchange markets are necessary. After a couple of minutes for students to compile a short list of why they think foreign exchange markets are necessary, give them five – seven minutes to share their thoughts with one or two other students. Provide another five – seven minutes for them to analyze their collective thoughts and prepare a list for sharing with class.

Answer: Quite simply, the foreign exchange markets facilitate international transactions by providing markets for international currencies. A simple response but is necessary for students to identify the purpose of this market.

LO-3 Level of Difficulty: Easy 3. Are all currencies basically equivalent? Have students follow daily exchange rates found online or in the WSJ Potential Responses: The purpose of this exercise is to provide students with experience in reading the foreign exchange markets. This can be used as a semester project that students can track the effects of other social, political, and macroeconomic variables on the foreign exchange rate for different countries.

LO-2 Level of Difficulty: Difficult

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Answers to Think for Yourself Questions 1. $50; $200 2. 1 EUR = 0.5 USD; 1 EUR = 2 USD 3. A decrease in US income would reduce the demand for European goods and decrease the demand for Euros. Imports from Europe to the US would fall.

4. The price of 700 CFA francs per Euro is above the equilibrium exchange rate. In order to keep the price above equilibrium, the Malian government would need to increase the demand for Euros or decrease the supply of CFA francs in Mali, so the government could either buy Euros or sell CFA francs.

Answers to Discussion Questions and Problems 1. One cost of a fixed exchange rate system is that it takes a lot of resources to maintain.

Governments under a fixed exchange rate system must maintain substantial holdings of currency to manipulate the supply and demand in the markets. In addition, governments would need analysts and other bureaucrats to monitor and participate in foreign exchange markets, all of which come at the opportunity cost of other activities. A benefit of a fixed exchange rate system is that it may reduce the uncertainty associated with foreign exchange.

2. An increase in the demand for pesos could come from an increase in incomes in Mexico relative to the US, an increase in US tastes and preferences for Mexican goods and services, expectations about the future price of pesos, or higher interest rates in Mexico.

3. a. 1MXN = .575 ZAL b. 1 ZAL = 1/.575 MXN = 1.74 MXN c. 3 billion Pesos d. 3 billion MXN * 1.74MXN/ZAL = 5.22 billion ZAL e. The Peso will appreciate against the Rand, and the Rand will depreciate against the Peso.

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Answers to Multiple Choice Questions 1. f 6. f

2.e 7. c

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3. f 8. f

4. e 9. e

5. e 10. e

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FOREIGN EXCHANGE AND THE INTERNATIONAL TRADE OF MONEY The Big Mac Index Consider the average price of a Big Mac in our community. The average price is $4.37. What is the cost in other countries?

Country

U.S. Exchange Rate (as of _____________ )

Cost of Big Mac

Using a foreign exchange rate site, identify the exchange rate for the U.S. dollar in the above countries. Calculate the cost of the Big Mac in these countries.

Are the currencies equivalent? Why or why not?

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Chapter 14: Farm Policy Chapter Outline 1. Characteristics of Agriculture 1.1. Declining Employment and Increased Concentration 1.1.1. Supply-side Explanations: Technological Change and Increased Productivity 1.1.2. Demand-side Explanations: Increased Incomes and Increased Population 1.2. Inelastic Demand 2. Agricultural Policy 2.1. Price Supports 2.2. Supply Restrictions 2.3. Demand Enhancement 2.4. Income Support 3. The Costs and Benefits of Agricultural Policy 3.1. Increased Incomes for Agricultural Policy 3.2. Increased Incomes for Agricultural Producers 3.3. Higher Prices for Consumers 3.4. Higher Taxes 3.5. Reduced Competitiveness 3.6. Higher Costs for Farmland 3.7. Inefficient Use of Resources

Learning Objectives After studying this chapter, students should be able to: • Describe the history and evolution of government agricultural policy • Demonstrate how inelastic demand influences agricultural goods’ prices • Describe the main components of U.S. farm policy • Demonstrate the impacts of price supports in agriculture • Illustrate the impacts of supply restriction policies • Illustrate the impacts of demand enhancement policies • Assess the costs and benefits of recent U.S. farm policy

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Teaching Notes If time does not allow the teaching of this chapter as a stand-alone concept, it can be used as supplemental reading to chapters on product elasticity, market structures and governmental interference with market prices.

This chapter begins with a quick synopsis of one window of the history of the U.S. Farm Policy.

If teaching in an urban area students may have one perspective of the agricultural policies in the U.S., and that would be from the political viewpoint. There would be little, if any, relevance to the student. This relevance will need to be developed. If, on the other hand, this chapter is being presented in a part of the country where agriculture is predominant students may have viewpoints that are skewed towards their families’ needs. Understanding the economic concerns of the effects on prices and market efficiencies will need to be developed.

The characteristics of agriculture provide students a view of the nuances of this industry and help to explain why there has been a long-standing involvement of government policy in this industry.

Regardless of the type of industries found in your region, having students research current trends in agriculture through the Department of Agriculture site will help set the stage for the material presented in the text. The National Agricultural Statistics Service through the USDA, http://www.nass.usda.gov/Publications/Trends_in_U.S._Agriculture/, provides students pertinent information on current trends, including Farm population and labor, farm numbers and land in farmers, and productivity.

Having a sound understanding about the factors that have affected the changes in the agricultural industry over time relies on the understanding that both forces of the market are important to these changes. Supply issues of agriculture have changed because of technology and productivity. Demand for products has also created changes in the industry due to increased numbers and income. Walk through each side individually to emphasize the effects. Remind students that when there is an increase in supply AND an increase in demand the effects of market equilibrium price and quantity is mixed. An increase in quantity is expected. However, the change in equilibrium price will be indeterminate. ↑D: ↑Pe ↑Qe ↑S: ↓Pe ↑Qe ?Pe ↑Qe If the magnitude of the change in demand is greater than the magnitude of the change in supply equilibrium price will increase. If the magnitude of the change in supply is greater than the change in demand equilibrium price will decrease. Because of increases in productivity supply

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has increased faster than demand resulting in a decrease in the inflation-adjusted prices of agricultural goods and services The chapter concludes with a thorough discussion of the agricultural policy including definitions and explanations needed to understand the rationale behind the established programs. Helping rural students understand the need for the subsidies and agricultural support will be beneficial to students. Toward this end have students research the history and timeline of the farm policy to develop an understanding of the reasons behind the government policies.

What are some of the pros and cons of this governmental interference? The United States Department of Agriculture’s Economic Research Service provides an electronic report on the 20th Century Transformation of U.S. Agriculture and Farm Policy. (Dimitri & Efflan Conklin, 2005) This information provides historical data and the developments caused by changes in the agricultural industry.

Teaching Activities provides additional information and ideas on arguments for and against the farm policy.

When discussing price supports, it may be necessary to remind students of the effects of a price floor. A price floor is a government mandated price that is above the market equilibrium. The market price cannot be below this price floor. Remember that, as illustrated in the graph below, when a price floor is established in the market quantity demanded of the product is less than the quantity supplied to the market. This creates a surplus of the product.

Teaching Activities 1. As a pre-chapter research project have students determine how agriculture ranks as an industry in their region. What agriculture is present in their region of the country? What is the economic health of the agricultural industry in their region? One source of

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information that will be “user-friendly” for the students is the Federal Reserve Beige Book. The Summary of Commentary on Current Economic Conditions by Federal Reserve District, is published eight times each year and provides an anecdotal summary of current economic conditions in the twelve Federal Reserve Districts and a summary of the nation on a whole.

In addition to general information on the agricultural industry in their region, an interesting component to the farm policy controversy is the amount of government payments received. Students can investigate the amounts received by state through the USDA Economic Research Service web site on farm income and wealth statistics. http://www.ers.usda.gov/data-products/farm-income-and-wealth-statistics.aspx Students can follow the link to a spreadsheet with information on government payments.

2. Have students develop a general timeline of ag structure and policy in the United States.

The above referenced USDA report on the 20th Century Transformation of U.S. Agriculture and Farm Policy (Dimitri & Efflan Conklin, 2005) provides an abbreviated look at this timeline. Another source from USDA is A Condensed History of American Agriculture 1776-1999. (US Department of Agriculture) 3. “Team-teach” pros and cons of governmental ag policies. This activity is similar to Think-Pair-Share with the exception that it is meant to be a conversation about an issue with students taking different sides on that issue. On the board, or a power point, ask the following question, should there be so much government involvement in the agriculture industry or should the market be allowed to determine prices and quantities? Either allow students to take a stance, or divide the class into groups representing both sides, government involvement should remain and allow the market to make price and output decisions. a. Initially set four students together--two government and two market--to list their reasons for their stance. Remind the students that this is not a debate; it is a conversation to “enlighten” the people with a different perspective. b. After 3 – 5 minutes of the four, join two groups of four to compare their thoughts. c. After 3 – 5 minutes of this discussion have student submit a paragraph of what they took from the conversation, first identifying what was their original position.

Additional Questions and Discussion Points 1. Have students the 2013 Super Bowl Ad, God Made A Farmer, http://www.youtube.com/watch?v=AgFiRFpEtcA , and ask them what do they identify with the agricultural industry? Do they agree with the ad, or has the industry changed sufficiently.

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The goal behind this activity is to, for many students, open a different perspective of the role of the farmer in our economy. By increasing the perspectives viewed by the students their ability to think critically about the subject is also increased.

Answer: There is no correct answer, but, encourage presentations of different perspectives.

LO-7 Level of Difficulty: Easy 2. What makes this industry so different from other industries to warrant a history of government involvement?

Answer: The industry faces unpredictable and uncontrollable production threats from nature. For example, other industries are not affected by weather and insects that can destroy total output. The market structure limits any ability to influence prices by an individual producer. The market structure for the agricultural industry is close to perfect competition and each individual producer provides a homogeneous, or standardized, product that the individual output cannot be distinguished from another producer. Also, the producer provides too small an amount to have any impact on the market price. Another reason for the continued government involvement is the perception of the role of the family farm as an institution in our economy. As stated in the test, farmers have been called, “the founders of human civilization.”

LO-1 Level of Difficulty: Moderate 3. How have technology and other scientific developments have affected the agricultural industry?

Answer: There are many potential answers including: ethanol production; genetic engineering of plants; cloning of animals; and use of land. Ethanol production, for example, has changed rural industries to include ethanol production. This changes the demand for corn. T LO-7 Level of Difficulty: Difficult 4. What is the opportunity cost of farmland?

Answer: The opportunity cost of farmland is the next best use of the land. For some regions the opportunity cost of farmland is greater than for other regions of the country. For example, the cost of land in New York City is considerably more expensive than in rural Nebraska.

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LO-5 Level of Difficulty: Moderate

Answers to “Think for Yourself” Problems 1. a. Price and quantity will both rise b. Price will rise and quantity will fall c. Price and quantity will both fall 2. A decrease in supply will cause the equilibrium price to rise and quantity to fall. The price increase will be larger when demand is relatively inelastic. The decrease in quantity will be smaller when demand is relatively inelastic. The price increase will be smaller when demand is relatively elastic. The decrease in quantity will be larger when demand is relatively elastic.

3. A price floor that is set below the equilibrium price will have no effect on the market since the market will be free to adjust to the equilibrium.

4. Since the demand for pork is relatively more inelastic than the demand for milk, the policy will cause a larger increase in price in the pork industry than it would cause in the milk industry.

Answers to Discussion Questions and Problems 1. Answers here can vary, but political pressure certainly plays a role. Those who “win” from farm subsidies place pressure on politicians to keep the policies in place.

2. If the price ceiling is set below the equilibrium price, we would expect many farmers to go out of business or cut their production drastically because they cannot cover their costs of production at the new, lower price. Chavez' policy will (and did) generate a shortage of food.

3. a. This could explain the situation. A change in technology allows for lower costs of production of wheat, which increases the supply of wheat and lowers its market price. b. This could not explain the situation. A price floor above $7 per bushel would generate a higher price than $5.

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c. This could not explain the situation. An increase in consumers' incomes would generate an increase in the demand for wheat, which would in turn generate an increase in the price of wheat. d. This could explain the situation. A decrease in the population would decrease the demand for wheat, which would in turn decrease the equilibrium price of wheat. e. This could explain the situation. A price ceiling set below $7 per bushel could be at $5 per bushel.

4. a. Price would increase b. Price would not change c. There would be an increase in supply this year, and as a result, the price of Penelope's Pumpkins would decrease as supply shifted out. Next year, we would expect price to rise back to its initial level since supply will decrease.

5. The ethanol subsidy causes an increase in the demand for corn and an increase in the supply of corn. If the demand shift is larger than the supply shift, the price of corn will rise. Because the subsidy can cause an increase in the price of corn, producers of other crops, like soybeans for example, will decrease the supply of soybeans and instead produce corn.

6. a. Consumer surplus = .5*600*600 = $180,000 per week. Producer surplus = 5*600*600 = $180,000 per week. b. Consumer surplus is .5*300*300 = $45,000 per week and producer surplus is (.5*300*300) + (600*300) = 45,000 + 180,000 = $225,000 per week. c. If the government supports the price floor by buying up the surplus cheese, it will need to spend $1000*(900-300) = $600,000 per week. If they do this, consumer surplus is .5*300*300 = $45,000 per week and producer surplus is .5*900*900 = $405,000 per week. d. Producers are helped. If the government does nothing but impose the price floor, their producer surplus rises from $180,000 per week to $225,000 per week. If the government imposes the price floor and supports it by buying up surplus cheese, producer surplus rises from $180,000 to $405,000 per week. e. Consumers are hurt. Their consumer surplus falls from $180,000 per week to $45,000 per week as a result of the price floor. If the government buys up the surplus cheese created from the price floor, taxpayers are hurt because they must spend $600,000 per week.

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Answers to Multiple Choice Questions 1. b 6. b

2. e 7. a

3.f 8. d

4.a 9. b

5. e 10. b

References Dimitri, C., & Efflan Conklin, N. A. (2005, June). USDA Economic Research Service. Retrieved from United States Department of Agriculture: http://www.ers.usda.gov/publications/eibeconomic-information-bulletin/eib3.aspx US Department of Agriculture. (n.d.). A Condensed History of American Agriculture 1776 1999. Retrieved from USDA: http://www.usda.gov/documents/timeline.pdf

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Chapter 15: The Economics of Illegal Drugs Chapter Outline 1. The incidence of drug use in the U.S. 2. The market for drugs 3. Market failures associated with illegal drugs 3.1. Externalities 3.2. Imperfect information 4. Reducing drug use 4.1. Demand-side policies 4.2. Supply-side policies 4.2.1. The importance of elasticity 5. The economics of legalization 5.1. Negative externalities

Learning Objectives After studying this chapter, students should be able to: • Describe the Incidence of drug use • Model the externalities associated with drug use • Describe the incomplete information problem associated with drug use • Appraise the policy responses to drug use • Analyze supply and demand issues in regulation policy • Analyze the impacts of drug legalization

Teaching Notes The simple fact is that a majority of our students have experienced illegal drugs, directly or indirectly.

This chapter highlights the economics of decision making for an individual unit and for society. This relevant and timely topic for students can be a powerful learning tool to supplement understanding of economic theory as it highlights concepts ranging from rational decision making to government policies.

Review with the students the concepts of elasticity of demand, supply and market failures. It may be difficult for students to understand what a market failure is and that its occurrence is more frequent than they would think.

Provide students sufficient time for a class conversation about the externalities of illegal drug prior to the distribution of class material on the subject. Direct their conversation to cover the externalities for both consumption and supply. This conversation can also distinguish the differences in externalities because of

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illegality of drugs, i.e. transporting drugs, from externalities because of drug use, i.e. inability to maintain a job, etc.

When modeling externalities, walk the students through the construction of the demand and supply model for an illegal drug. Allow them sufficient time to identify the external cost to society.

When reviewing the differences of demand curves of different Elasticities, it may be necessary to draw a set of supply and demand models to illustrate the effects. For example, when the demand curve is steeper, what is the effect on quantity and price when there is an increase?

Teaching Activities 1. A college community often has some sort of history of illegal drug use and abuse. Invite law enforcement officers/representatives from the judicial system to talk to the class about the costs to their specific community because of the drug use and abuse. Is there a specific event or time during the semester, i.e. homecoming or during final week, that there is an increase activity? What has been the trend for illegal drug use in the community? Is it increasing, decreasing, or about the same? Ask students to determine what are externality costs to the community?

2. An excellent source of examples for teaching about illegal drugs can be found in a journal article by Burrus, Sackley, and Sollars, Illicit Drugs and Economics: Examples for the Principles Classroom.

(Illicit Drugs and Economics: Examples for the Principles Classroom, 2007) 3. Divide the class in to groups for and against the decriminalizing marijuana for a class debate on the subject. Have them research the potential “costs” and “benefits” for society if marijuana was legalized. One additional consideration on the topic in addition to the economic externalities associated with drug use is the inherent intrapersonal externalities. (An intrapersonal externality occurs when a personal decision affects future personal decisions.)

4. Using data to substantiate have students create reports on illicit drug use in the U.S. since 2000 to the Present.

Additional Questions and Discussion 1. Are additional negative externalities created because of the laws to eliminate the negative externality of drugs?

Yes. If marijuana and meth, for example, were legalized there would be less violence such as robberies to get the money to pay for the drugs, or shootings to protect territory.

2. Explain why actual output is not optimal output.

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If a negative externality is present, the optimal output will be less than the actual market output because a negative externality creates an over allocation of resources. Not all costs are considered creating a supply that is greater. If a positive externality exists, the actual output in the market is less than the optimal output because there is an under allocation of resources.

3. Identify the states that have legalized marijuana for medical purposes. What additional costs and benefits have occurred to the state?

Answers to "Think for Yourself" Questions 1. Benefits might include relaxation and relief from some health problems. Costs include the risk of fines or imprisonment as well as health risks. The costs of imprisonment would be larger for older people, those with more education, and the employed since older individuals and those with higher levels of education tend to have higher paying jobs, ceteris paribus.

2. The factors that shift the demand for Huxsoma include people’s incomes, tastes and preferences, the prices of substitutes and complements to Huxsoma, people’s expectations, and the number of consumers in the Huxsoma market. The factors that shift the supply of Huxsoma include the costs of production for Huxsoma, the prices of alternative goods that could be produced, producer expectations, and the number of sellers in the Huxsoma market.

3. Research on the negative externalities associated with drug use is relatively scarce. Advocates of marijuana legalization argue that the negative externalities associated with marijuana are smaller than the negative externalities associated with tobacco, alcohol, or methamphetamine, while those against marijuana legalization view the negative externalities associated with marijuana to be as large as or larger than those for other substances. The larger the negative externality associated with a drug, the greater the difference between the unregulated market and socially optimum levels of drug use will be.

4. If drugs are addictive at first use, learning by doing will not be a good method of assessing the costs and benefits of drug use. Once someone tries the drug, they could be addicted and it would then be too late for those who decide that the costs of drug use are higher than the benefits of drug use to quit.

5. If drugs and alcohol are substitutes, policy makers could reduce the use of drugs through policies that reduce the price of alcohol. Obviously such policies would be unpopular among those who seek to reduce alcohol consumption.

6. Costs of marijuana legalization include an increase in the negative externalities associated with marijuana use plus costs of regulation of the marijuana market. Benefits of marijuana legalization could include decreased spending on law enforcement to keep marijuana off the market as well as potential tax revenues (assuming that legalized marijuana would be taxed). Whether the benefits outweigh the costs is a matter of debate.

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Answers to Discussion Questions and Problems 1.

a. $7 b. 600 c. Yes. Health costs (including higher insurance premiums for residents of Bozeman, longer wait times because of increases in health issues, increased demand for health services that raises their prices), social costs including the costs of drunk driving itself (accidents, injuries, fatalities) and increased costs of finding and punishing drunk drivers (policing, courts, etc.), higher car insurance premiums due to more car accidents, etc. d. No. There are likely to be negative externalities associated with beer consumption that are not included in the private marginal cost values above. e. Based on the economist’s estimates, the Social marginal costs associated with beer are shown below. The socially optimal price of beer is $8 and the optimal quantity is 400 six-packs per week. This is the level where social marginal costs are equal to marginal benefits.

Quantity Produced/Consumed (# six-packs per week) 200 400 600 800 1000

Private Marginal Costs (Supply) 5 6 7 8 9

Private Marginal Benefits (Demand)

Social Marginal Costs

9 8 7 6 5

7 8 9 10 11

f. A tax of $2.00 per six-pack or a quota of 400 six-packs sold per week would move the market to the socially optimal quantity of six-packs.

2. Answers to this question can vary. One argument is that the negative externalities from marijuana are so much larger than those of alcohol that the socially optimal level of marijuana is zero.

Other arguments are that the differential status of marijuana and alcohol are a matter of politics rather than economics.

3. If medical marijuana patients were obtaining the drug illegally, the legalization of medical marijuana would likely increase the demand and the supply of legal marijuana. The demand and supply of illegal marijuana would likely fall.

4. Answers to this question can vary. On the one hand, crime would be reduced because it would not be illegal to produce and use drugs. On the other hand, increased drug use could lead to more drug-related crimes like automobile accidents, domestic violence, and theft.

5. a. Assuming that the scales on the axes in both figures are the same, the demand curve in Figure B is steeper, and thus represents more inelastic demand for cocaine. Assuming that casual users

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have more elastic demand than addicts, Figure A would reflect the demand of casual users and Figure B would reflect the demand of addicts. b. Legalizing cocaine would likely increase the supply of cocaine. If legalizing cocaine does not change the demand for cocaine, the increased supply will have the largest impact on use among casual users, since their demand for cocaine is relatively more elastic.

Answers to Multiple Choice Questions 1. c 2. a 3. a 4. b 5. a 6. a 7. a 8. b 9. c 10. e

References Burrus Robert; Sackley, William; Sollars, David (2007). Illicit Drugs and Economics: Examples for the Principles Classroom. Journal of Econmoics and Finance Education, 75-86.

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Chapter 16: Pollution, the Environment, and Global Warming

Chapter Outline 1. The Cost-Benefit Approach to Environmental Preservation 1.1. Costs of Pollution 1.2. The Optimal Level of Pollution in the Market 2. Externalities 3. Approaches to Environmental Preservation 3.1. Command-and-Control 3.1.1. Taxes and Fees 3.1.2. Emissions Limits 3.2. Assignment of Property Rights 3.2.1. Common Property Resources versus Private Property Resources 3.2.2. Tradable Pollution Rights

Learning Objectives After studying this chapter, students should be able to: • Describe the benefits and costs of pollution • Model the externalities associated with pollution • Describe the policy responses to pollution • Assess methods to address pollution problems

Teaching Notes This chapter and the next, The Economics of Education focus on two kinds of one specific type of market failure emphasizing their impact on resource allocation. If not studied as standalone chapters, they are excellent supplements to Chapters 3 or 4.

The importance of these two chapters is the resulting inefficient use of resources when market failures occur. Chapters 16 and 17 provide real world issues that model the economic concepts of externalities. Before exploring the issues it will be beneficial to students if they understand why the issue illustrates the economic inefficiency of externalities.

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So what is an externality? We learned in Chapter 4 economic efficiencies occur when consumer’s willingness to pay equals what producers are willing to produce. This equilibrium provides the market a balance of consumers’ and suppliers’ utility and an efficient allocation of resources for this balance. An externality exists when the market fails to allocate resources efficiently government intervention may be needed. An externality exists when benefits and costs of the good or service spills over to someone other than the primary consumer or producer.

There are two types of externalities, positive and negative. A positive externality occurs society receives benefits from personal consumption of a good or service. Chapter 17 illustrates the economic concepts of a positive externality. When you invest in your education society benefits from your advanced skills and abilities. You pay for your education, but the benefits spills over to society. A negative externality occurs when costs of production are not entirely captured by the producer’s supply curve. Society also bears a portion of the costs of the production.

Pollution is an example of a negative externality. It will be helpful to first explain why pollution is an economic issue. In addition to permanently damaging our eco system, pollution creates an inefficient allocation of resources to the markets creating pollution. Costs of production are shifted to society creating a deadweight loss to society and an over allocation of resources.

Government policy is often needed to help re-establish a more equitable and efficient market allocationof resources. Students may be thinking So what’s the big deal? Ask them who receives the income for providing the product to the society? Obviously the producer. Should you also contribute to the payment of producing these products when you are not receiving the benefit of a profit? When pollution is present in the market part of the costs of production are borne by society.

Using a cost-benefit approach through developments of demand and supply models help students visualize the effects of a negative externality on a market and the loss of efficiency to society.

Negative externalities are supply-side market failures. The total costs of the product is not captured by the producer, but are shared by society also.

Consider the example used in the text, the production of electricity. Benefits are provided to consumers who “buy” units of electricity. The curve that represents this willingness to pay is downward sloping because of diminishing marginal benefits. The benefits received for each additional unit of electricity falls. The marginal cost curve for the producer will represent the costs of generating an additional unit of electricity.

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Using Figure 3 found in Chapter 16 combines marginal benefits received and marginal costs.

Identifying what each of the curve represents in the market to those behind the forces, consumers and suppliers will help remove difficulties students may have in visualizing the negative externality created and the over allocation of resources that occur.

Help student recognize that if we are to assume that the supply curve captures all costs of production including the costs of the pollution on society, than this is not the private marginal cost but the social private cost. What would the private marginal cost look like? Where would it be in relation to the social marginal cost curve?

Direct the discussion of students to identify that the private marginal cost curve would be below that of the social marginal costs curve. Figure 4 in the text illustrates this. The amount of the negative externality is equal to the social marginal cost minus the private marginal cost. Provide multiple opportunities for students to identify and quantify this negative externality.

When the market failure is caused by spill over costs and benefits government intervention can correct the inefficiencies found in the market by correcting the allocation of resources caused by the externality. In the approach to a negative externality and environmental preservation a market failure occurs and too much product is produced resulting in more pollution than is socially optimal. Having students relate these environmental policies to their lives will provide a better understanding of the controversy that surrounds them. They may also be able to identify inefficiencies that may be created because of the governmental policies. Have students The chapter concludes with a discussion of environmental policies in used and the importance of property rights in limiting negative externalities.

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Teaching Activities 1. A critical thinking exercise, Chalk Talk1, can be used to initiate a discussion of the different student perspectives of what they consider pollution. Place a line of butcher paper on a wall of the classroom. (See below.) In the center of the paper write in a box What is pollution? Without discussion provide students time to write their thoughts, questions, and analysis of other thoughts on the paper. Lines can be drawn to connect related statements/questions. For example, if one student writes graffiti and other students write other forms of pollution, a line can be drawn to connect these. All of this is to occur without the students talking. Chalk Talk represents an inner reflection of their perspective of pollution and questions concerning other perspectives. Instructor participation should be an integral part of this activity as students will learn to model critical thinking through the instructor’s actions.

This activity, in addition to revealing how the students view the concept of pollution, it provides an opportunity to think critically by identifying assumptions that frame our thinking and determine our actions.

2. After identifying different student perceptions of what is pollution, have students consider their tolerance of pollution. Separated by one class period, repeat the activity in Teaching Tip #1 but now for the question in the center of the paper ask How much pollution is optimal? This provides the instructor an opportunity to guide thoughts and tolerances of pollution. Consider domestic pollution and world pollution. What about development of the economy? For example, would the U.S. have experienced the rate of growth through the industrial revolution had there been environmental and pollution controls in place? Again, the instructor should help students by modeling the activity and including your thoughts and participation.

11

Additional information about Chalk Talk and other critical thinking activities can be found in the work of Dr. Stephen D. Brookfield, Teaching for Critical Thinking: Tools and Techniques to Help Students Question Their Assumptions. (Brookfield, 2012)

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3. Use an activity that hits home to the students. Identify a critical topic on campus and develop a marginal cost- benefit example. For example, what if your campus is surrounded by a close, supportive community with historical homes that are not protected by a historical preservation certificate. Parking is a critical issue on campus. Currently, parking options are a very precious few parking spots for students on campus with the majority parking spots found past the historical homes at an approximate distance of one mile or more. Students would like to see more parking made available closer to campus.

The streets with the historical homes are permit protected against student parking.

Violators attempting to sneak in and out will surely have their vehicles towed. A proposed plan is to purchase several lots, demolishing or having the homes removed to build a parking garage. In addition to the cost of the parking permit to park in the garage students will see a three percent increase in their students fees to help pay for the garage.

Will this parking garage create a negative externality? Will this capture all costs of the garage? Direct discussion to include possible loss of good will from the community and an increase in traffic in a residential area.

4. Divide students into two basic groups to present the pros and cons of environmental policy alternatives, taxes and fees and emission limits Command-and-Control Taxes and Fees

Emission Limits

Rather than a “formal,” static, presentation, on the assigned day have students post large post-it sheets while explaining a pro or a con of that governmental policy, including current examples and issues. For larger classes, groups can contribute and be randomly called on to provide a component of the presentation. Randomly assign a type of environment policy to students. Explain to them that on they are to research the pros and cons, the costs and benefits, of the assigned environment policy. On the due date randomly call students to provide a pro or con/cost or benefit and to post on a large post-it sheet to be hung on the wall.

Each student will need to be individually prepared for the presentation. After pros and cons have been sufficiently exhausted move on to current examples and issues. Again, randomly call on students to post and explain a current example/issue. Emphasize to students that they are to come prepared with multiple different examples for posting.

Additional Questions and Discussion Points 1. How bad is pollution, really? Is it a marketing ploy for consumers to pay more for the “green” products, or is it a real concern? Use economic theory to justify your response.

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Answer: While consumers need to make informed decisions about “green” products, the marketing of these products is a separate issue from the economic concept of pollution.

Pollution creates an inefficient allocation of resources, an over allocation of resources. More products are being produced than would be socially optimal if all costs were captured. The private social marginal costs do not capture the costs of pollution.

LO-2 Level of Difficulty: Moderate 2. Can all costs of pollution be captured by the producer? Explain why or why not?

Answer: The most probable answer would be probably not. But the correct economic response would be that in the short run all costs may be identified but it would not be probable to identify all long run costs of the pollution. What would be cost of potential health issues caused by the pollution?

LO-1 Level of Difficulty: Moderate 3. The key to understanding the tragedy of the commons is understanding what common property resources are. Provide examples of common resources and how collective ownership of the resources can lead to overuse and destruction of the resource.

Answer: Possible answer includes • Air: The air above a specific building can be ordinance but the movement of the air cannot. Air pollution will cause damage to air in other areas. A historical example of this is the acid rain in the northeast section of the U.S. that traveled to Canada before regulation was established to protect Canadian air.

• Water: Water in the seas and oceans are common resources. Water in lakes and rivers are often owned by municipalities such as cities or states.

• Fish of the sea With all of these when specific ownership is not established there is no personal repercussion of overuse and/or of pollution.

LO-3 Level of Difficulty: Moderate

Answers to "Think for Yourself" Questions 1. Laws prohibiting driving while on a cell phone or texting while driving are one way that cities have attempted to mitigate the negative externalities associated with cell phones. Cell phones are

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associated with a wide array of negative externalities, including increased traffic accidents and general “noise pollution” in public places.

2. Electric cars produce fewer pollutants from the cars themselves, but the generation of electricity to fuel electric cars produces air pollution and greenhouse gas emissions. Electric cars are also more expensive than traditionally-fueled cars. In the US, approximately 45% of electricity is produced by burning coal, which contributes to global warming. To produce the same amount of energy, coal emits more carbon dioxide than gasoline. Evidence on the net pollution impact of electric versus traditional cars is mixed, with some researchers finding lower net carbon dioxide emissions from electric cars, but others finding no difference in net pollution.

3. Banning elephant hunting involves tradeoffs. On the one hand, hunting elephants obviously reduces the elephant population. On the other hand, increasing the economic value of elephants nearby residents by selling safari hunting of elephants provides an incentive for nearby residents to preserve elephant habitat and elephants themselves. After Kenya banned all elephant hunting in 1977, the population of elephants in Kenya declined dramatically. In Zimbabwe, the World Wildlife Fund helped implement the Communal Areas Management Programme for Indigenous Resources (CAMPFIRE) in 1989. This CAMPFIRE program gave local residents the rights manage natural resources to the local level, including the right to allow safari hunting of elephants. By 2003, elephant numbers in Zimbabwe had doubled from 4,000 to 8,000.

4. Tax breaks to producers of ethanol provide an incentive for corn growers to divert their corn from food use to fuel use. In addition, growers of other crops switch their land to corn ethanol production. The result is a decrease in the supply of other crops as well as a decrease in the supply of corn on the food market. The decrease in supply causes the prices of food to rise.

Answers to Discussion Questions and Problems 1.

a. $5 per box b. 300 boxes per week c. Yes. Paper production generates large amounts of byproduct water that must be disposed of. Paper manufacturing also generates air and noise pollution. The pollution may generate negative health outcomes for nearby residents and may also reduce nearby land values. d. No. There are likely to be negative externalities associated with paper production that are not included in the private marginal cost values in the table. e. Based on the economist’s estimates, the social marginal costs associated with paper production are shown below. The socially optimal price of paper is $6 per box and the socially optimal quantity of paper sold is 200 boxes per week.

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Quantity Produced/Consumed (# boxes per week) 100 200 300 400 500

Private Marginal Costs (Supply) 3 4 5 6 7

Private Marginal Benefits (Demand) 7 6 5 4 3

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Social Marginal Costs 5 6 7 8 9

f. A tax of $2.00 per box of paper or a limit of 200 boxes produced per week would move the market to the socially optimal quantity of paper.

2. a. ($75*400) + ($100*400) + ($125*400) = $120,000 b. [($100*200) + ($200*200) + ($300*200)] + [($75*200) + ($125*200) + ($175*200)] = $195,000 c. [($100*400) + ($200*200)] + [($75*400) + ($125*200)] = $135,000 3. People do not generally have a property right to American Bison. Their populations fell largely because of the tragedy of the commons. Cattle are the private property of the ranchers who own them. The ranchers have an economic interest in maintaining an economically viable cattle population.

4. When the price of fair trade coffee increases, the quantity of fair trade coffee demanded falls.

At the same time, the demand for “regular” coffee rises since regular coffee and fair trade coffee are substitutes. The reduction in the quantity of fair trade coffee sold may raise or lower fair trade coffee growers’ incomes, depending on the elasticity of demand for fair trade coffee. If the demand for fair trade coffee is relatively elastic, the higher price of fair trade coffee would actually reduce growers’ incomes.

5. The benefits of recycling include reduced use of landfill space, reduce use of primary resources to produce products, and reduced emissions associated with new product production.

The costs of recycling include pollution from the recycling process, any transportation costs and related pollution generated above and beyond those incurred from throwing products away. In many cities, taxes must be used to subsidize recycling because market prices for recycled products do not cover the costs of recycling.

6. Examples of moral suasion include appeals for people to “reduce, reuse, recycle,” and encouraging people and firms to voluntarily reduce the amount of pollution they generate.

Research on the effectiveness of moral suasion finds mixed results.

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Answers to Multiple Choice Questions 1. c 6. e

2.e 7.c

3. c 8. a

4.a 9. a

5. e 10. c

References Brookfield, S. D. (2012). Teaching for Critical Thinkiing: Tools and Techniques to Help Students Question Their Assumptions. San Francisco: Jossey-Bass.

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Chapter 17: The Economics of Education

Chapter Outline 1. Costs and Benefits of Education 1.1. Costs of Education 1.1.1. Marginal Costs 1.2. Benefits of Education 1.2.1. Marginal Benefits 2. The Optimal Level of Education 3. Externalities 3.1. Why Is Education Publically Provided?

4. Education Spending and Education Outcomes 4.1. Education Spending 4.2. Education Outcomes 5. Education Reform 5.1. School Choice 5.2. Changes in Teachers’ Pay

Learning Objectives After studying this chapter, students should be able to: • Describe the level and changes in educational attainment over time • Describe the costs and benefits of education • Define human capital • Model the positive externalities associated with education • Evaluate why some education is publicly provided • Describe some of the issues surrounding education reform

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Teaching Notes Education is an economic issue because of the positive externality that is created in the market.

In Chapter 16 the over allocation of resources caused by the negative externality of pollution is explained. This chapter addresses what happens in a market when benefits spill over to the market. Students may question why this is even an issue. Therefore it is important to remind students that economics is the science of decision making and the ability to maintain an efficient allocation of resources. In Chapter 16 when the private marginal cost curve did not capture the entire cost of production, that society bore part of the cost creating a negative externality and an over allocation of resources. Too many resources are used to produce a particular good or service.

In this chapter the discussion illustrates the scenario of when benefits from the private consumption of a good spills over to society. In this case there are too few resources provided to the market. There is an under allocation of resources. Again, government policy may be used to eliminate this externality.

It is often of interest for students to discover what are their perceived “costs” and “benefits” of education. They know what their tuition and fees are but what other costs are involved. What about education in general? Costs also include less direct costs such as loss income, or loss of interest. In addition to the ability to earn a higher income, benefits include better decision making skills and greater knowledge as a whole. People who increase their education are typically more informed.

This chapter begins with a discussion of the costs and benefits of education. Students may immediately recognize direct costs of education but ignore the opportunity cost. Ask students to consider what they would be doing if they were not sitting in the classroom. A prominent response may be that they would be working. Ask them to consider what they are giving up in wages. Remind them that this value of this other alternative for their time is their opportunity cost for being in class. Therefore the cost of this class would include their direct costs of tuition, fees, and, perhaps, transportation, it also includes their opportunity cost of their lost income.

It will benefit students to gain a more thorough understanding of the marginal costs and benefits of education by carefully developing the demand and supply model for the market of education.

By a careful development of a demand and supply model for education will help students see that the private marginal benefit curve does not “capture” all of the benefits received from the education consumed. In fact, it may not be able to fully reflect this amount because of the inability of society to determine a long-run value of the benefits of education.

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Using a model similar to Figure 6 will provide students a needed visual. It will also help to provide examples that allow students to create their own demand and supply model. (See Teaching Tips) By providing students an opportunity to develop a demand and supply model that illustrates a positive externality students can better make a connection that government policies can be used to increase demand to increase benefits equal to the amount desired by society. The private benefits received for number of years of education is less than the socially optimal level of educational attainment.

There is an under allocation of resources to education to achieve an efficiency in the market.

What will provide an incentive to increase years of education? Incentives to increase years of education will create this needed change of demand. Providing relevant examples will help students understand the rationale behind government educational programs. Because the social optimal level of education is greater than private level of benefits received subsidies and funding provide the incentives for private individuals to increase their demand for education.

Education, a service, generates positive externalities in the market. Because of this governments are asked to increase incentives to increase demand by providing grants and low-interest loans.

Teaching Activities 1. Provide a scenario that allows students to visualize the effects of the positive externality on a market. Jane has gone back to school to complete her college degree. It is necessary to apply for an administrative position at her job. Following is a table of marginal benefits and marginal costs for each additional class she takes.

Total MB for Years MC MBJane MBJane’s Work Society 1 $2 $10 $3 $13 2 4 8 2 10 3 6 6 1 7 4 8 4 0.5 4.5 5 10 2 0 2 However, because of Jane’s increases in thinking critically and problem solving at her business additional benefits are being realized. Help students realize that the resources

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allocated to the market for education reflects not the total benefits received by society, but only those received by Jane.

2. Use similar Chalk Talk activities as with Chapter 16. For day one insert the question What are the marginal costs and benefits of your education? Without comments have students write down their perceptions and responses or analysis of other comments written by other students. Draw lines to connect remarks that are related.

On Day #2 use What is the optimal amount of education? for students to query. Provide sufficient time for reflection and comments.

3. Help students make the connection between the benefits of education, human capital, and benefits received by society. It is not just the learning of the skills that increase the positive externality, but it is the ability to be more productive that increases the benefits to society. As you increase productivity you increase efficiency of the use of resources.

Additional Questions and Discussion Points 1. Why is education publicly provided? Should it be?

Answer: If education were privatized there would not be sufficient resources as the private market would probably not want to pay for the positive externality created by society also receiving benefits. If education was privatized and is considered a “normal” good people with higher incomes would have the ability to provide more education than those with lower incomes.

LO-5 Level of Difficulty: Moderate 2.

Compare the information on educational spending in the U.S. and educational outcomes observed. Have the educational reforms been successful? Do the educational reforms address the economic issue of education?

Answer: Controversy exists over when spending is compared to outcomes in the U.S. Research does not support the idea that additional spending will generate better student performance. Research on school choice voucher programs have provided little evidence that systematic academic benefit is received. Education reform such as school choice and changes in teacher’s pay co not specifically address the positive externality of education.

LO-6 Level of Difficulty: Difficult

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Answers to "Think for Yourself" Questions 1. There are many ways to increase one’s human capital including on-the-job training, self-study, and learning through experience.

2. Answers will vary here depending on the individual, the discipline, and the economy.

Potential marginal benefits include increased job opportunities and potential earnings, and increased knowledge. Potential marginal costs include direct costs of tuition, books, etc. and opportunity costs, which will be higher on average for a college graduate than for a high school graduate considering obtaining a bachelor's degree.

3. Economists argue that good neighbors tend to generate positive externalities for those nearby.

Their yards may be pleasant to look at, they may be helpful in watching pets and plants while you are away, and they tend to raise the value of your property when it comes time to sell.

Vaccinations also generate positive externalities because people around you benefit when you get a vaccination because your vaccination reduces their likelihood of getting sick.

4. The positive externalities associated with of having a population with a basic literacy and skills are likely larger than those for having a population with more advanced knowledge. Since the positive externalities of K-12 education are larger than those of a university education, university education system does not receive as much funding per student as K-12 education.

5. If school choice results in more high performing students attending schools with other high performing students, low performing students will not benefit from the positive peer effects associated with attending school with high performing students. The concentration of high performing students into some schools and low performing students into others could potentially exacerbate differences in educational outcomes across these groups.

Answers to Discussion Questions and Problems 1. A purely private market for education would not be socially efficient. Because education is associated with positive externalities, a purely private educational system would result in too little education from a social efficiency perspective.

2. On the one hand, increasing teacher pay would attract more high-quality teachers to the profession. On the other hand, if increasing spending on K-12 education translates into more pay in a seniority-based rather than merit-based system, educational outcomes may not improve.

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3. Vaccinations are associated with positive externalities because they reduce the spread of disease, even among people who do not get vaccinated. Thus, requiring vaccinations is one way to move toward a socially optimal level of vaccinations.

4. Answers here can vary, but one reason why private colleges are more expensive is that they do not receive state funding for education.

5. a. The opportunity cost of education increases as more education is obtained. Higher levels of education also tend to entail higher direct costs for tuition, fees, books, etc. b. On average, higher levels of education tend to generate smaller marginal gains in productivity. c. The private and social marginal benefits of education differ from one another because education is associated with positive externalities. d. At low levels of education, the positive externality is large because having basic literacy and social skills have the largest impacts on third parties through crime rates, more job readiness, etc. As educational attainment expands, the positive externality from education becomes smaller because the reduction in crime and social stability are greater for completing lower levels of education than for completing higher levels of education. e. 5 years of university education, since this is the level of education where the private marginal benefits are equal to the marginal costs. f. 6 years of university education, since this is the level of education where the social marginal benefits are equal to the marginal costs. g. Governments subsidize education by using taxpayer dollars to offset some or all of the costs of attending school by providing free primary and secondary schooling, by funding lowinterest student loan programs, and by providing grants and other financial aid to decrease the private marginal costs of attending college.

Answers to Multiple Choice Questions 1. b 6. e

2. b 7. d

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3. c 8. c

4. a 9. b

5. d 10. c

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Chapter 18: Competition and Monopoly

Chapter Outline 1. Output, Prices, Revenues, Costs, and Profits 1.1. Output and Cost 1.1.1. Marginal Cost 1.2. Output and Revenue 1.2.1. Marginal Revenue 2. The Profit-Maximizing Output Level 3. Perfect Competition 3.1. Identical Products 3.2. Complete Information 3.3. Many Buyers and Sellers 3.4. Ease of Entry and Exit 4. Monopoly 4.1. Demand, Price and Marginal Revenue for Monopoly Firms 4.2. Profit-Maximizing Output for Monopoly Firms 5. Comparing Perfect Competition and Monopoly 5.1. Output and Prices under Perfect Competition and Monopoly 5.2. Profit under Perfect Competition and Monopoly 5.3. Perfect Competition, Monopoly, and Efficiency 6. Monopoly Regulation

Learning Objectives After studying this chapter, students should be able to: • Understand how firms determine the optimal level of output • Demonstrate the differences in output choices between firms in perfect competition and monopoly • Compare profits for perfectly competitive firms and monopolies • Assess the economic efficiency of firms in perfect competition versus monopolies • Understand why some economists argue for regulation of monopoly power

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Teaching Notes This chapter examines the basis of the science of economics as it pertains to the firm, that of decision making. The ability of a firm to earn an economic profit is reflected by the type of market structure of the industry of the firm.

Students may be presented with a land mine of stumbling blocks that will be coming at them from more than one direction in this chapter. Try not to rush the development of these economic concepts. Being tested will be multiple skills and points of knowledge, including the student’s knowledge and ability of using, constructing, and analyzing graphs; working off schedules (tables) of data; and recognizing a specific vocabulary. For example, the word competition has a different meaning and application to the students than what will be used in this chapter.

Remember to take your time developing the necessary models to illustrate the necessary curves and profit. It may also be difficult for students to understand why they are studying a market that is not found in the real world. An explanation to this is that the market is used as a standard, or a benchmark, to compare current situations. Also helpful for students is providing information about the purpose of studying markets when considering efficiency of our economic resources.

In Chapter 8 the power and limits of a market were discussed. It may be helpful to again clarify for students what is a market. A market is an economic system that engages in exchange. The make-up of this system determines how this exchange takes place. The ability to have power over price and the effect on short run and long run profit capabilities are defined by the market structure.

The two structures being studied in this chapter are “bookends” of a spectrum of market structures.

Competition and Monopoly set up the bookends of the markets that combine characteristics of both competition and monopoly. The markets inside this spectrum combine varying degrees of characteristics of both of these end markets. The types of structures are characterized by four main identifiers 1. Number of buyers and sellers 2. Type of product produced in the industry 3. Distribution of information

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4. Ease of entry and exit The ability to make decisions on output and profit depends on these characterizations as does the ability to display market power. For example, for the monopolist the firm is the market.

Therefore, within the constraints of demand for the product, the monopolist has considerable more power than the competitive firm which faces so many sellers with a product that is homogenous, or standardized, that this producer must take that market price and faces a perfectly elastic demand curve.

This chapter provides students an understanding of the decision making process of firms. Firms are in business for a profit. Provide students with multiple exercises to help them gain a better understanding of the different concepts being presented. Marginal is another potential landmine for students. Recognizing that margin means extra, or next, they may have difficulties applying this. Repeated explanations and explorations of problems will help them build this necessary knowledge.

The distinction for monopolists that the firm IS the market will also benefit students in understanding the profit structure of the two models being studied. Because the perfectly competitive market firm is one of so many it must take the price that the market determines. The monopolist, however, being the only firm in the market needs to only consider what the market will bear.

Industry Firm Perfect Competition

Monopolist

Walk through this concept for students one market at a time, emphasizing the difference.

The discussion of the method and ability of these two markets continues with a comparison of the two markets and the loss of efficiency when competition is removed from the market structure. Two methods of understanding the loss of efficiency are provided. The chapter concludes with an explanation of the purpose of antitrust laws and monopoly regulation.

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Teaching Activities 1. Have student develop a matrix of the characteristics found in the different market structures. While only the book end markets are presented in the chapter, the remaining primary structures of monopolistic competition and oligopoly are easily found online along with their characteristics.

Perfect Competition Monopolist Number of One, Sellers So many seller is Firm is a price a price taker maker Type of Homogeneous, Unique Product Identical Distribution Completely Complete of equal, information is Information So many players not available, it is difficult not ease to keep to have complete information information from going known public Ease of Significant Entry and Easy, no barriers barriers Exit 2. What is an identical product found in the perfect competition model? To help students understand just what is an identical market pass around, or display, multiple bags of kernels of wheat. If this is difficult to find in your area, use un-popped popcorn seeds to represent corn. Ask students if they could make an honest case for distinguishing one kernel of corn to be better the other. Could they market one over another? No, because they are identical. In economic-ese these products are considered homogeneous, or standardized. Move this discussion to why it would be difficult for a farmer to identify his product as better and ask a higher price than others. In other words, why a farmer is a price taker.

3. Another example to help illustrate how agriculture is a close representation of a perfectly competitive market structure. Provide an example that illustrates how the amount of product produced by one supplier is inefficient to affect the market price. Either has students research the needed information to calculate how much wheat is produced by an average wheat farmer or use approximate averages to illustrate the point. For example, in

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2012/2013 the average U.S. farm size was 450 acres. The average yield (bushels/acre) of wheat was approximately 46 bushels. This means an average wheat farmer produced approximately 20,700 bushels of wheat, or 559.5 metric tons. How does this compare to the world production of wheat? Remind students that if producers reduce supply because of expectations the result will be an increase in equilibrium price. Will a farmer have similar effects on market price? The world production for 2012/2013 was approximately 600 MILLION metric tons. Removing about 600 metric tons would not have a significant effect on price.

4. If class size and time allows a simulation on the effects of competition (or the lack of) provides an opportunity for students to develop a better understanding of profit opportunities and efficiencies in a market. Some prep time will be needed. If you already use a student response system such as Socrative (www.socrative.com) or Polleverywhere (www.polleverywhere.com) some of this will be done for you. If you do not have one in place, it would be beneficial to look into signing up for one. Many are at no cost to the student and the majority of students in the classroom have mobile phones, iPads, etc. that allow them access. If they do not have one, students can set up an account online and possibly make arrangements with another student to use their mobile device. More time consuming but an alternative.

Have students pick a card when they enter the room. On the card will be a number from one to ten. (I typically use cards from a standard deck of poker cards. The numbers provided to the students can be changed to affect the end results.) Have students add one zero to their number and that is their income. Tell them that widgets are a necessary component of the quality of life for the students. The more widgets a person have the greater the accumulation of wealth. Also, in addition to be consumers of widgets, each of the students produces widgets for society. The number on their card represents the number of widgets they have to supply to the market. a. First, determine the quantity of widgets supplied to the market using your real time audience response system b. Next, determine demand for the widgets given the price of approximately one to two percent of supply or some other arbitrarily determined number. c. For the first round all students are suppliers of widgets. Give them five minutes to sell as many widgets as they can. i. Where students able to change prices to sell more and increase their revenue? d. Round two: Decrease the number of suppliers of widgets by five percent. Repeat the selling of widgets to consumers. i. Where students able to change their price to change their total revenue?

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e. Round three: Decrease the number of suppliers to a number that represents 10 suppliers. Repeat the selling of widgets to consumers. i. Where students able to change their price to change their total revenue? f. Round four: Decrease the number of suppliers to one. i. What opportunities did this provide the lone producer to influence price to the consumers? Was there a limit to the price of the widgets?

Following the simulation discuss with the students the changes they observed going from a perfect competition market structure to a monopolist in a. ability to influence price b. efficiency in the market

Additional Questions and Discussion Points 1. Why are monopolies considered a form of a market failure? Use demand and supply models to explain your response.

Answer: Because the output chosen by a monopoly is not socially efficient, monopolies are a form of market failure. Figure 4 in the text provides an illustration of this inefficiency. Both markets will produce where MR = MC. For a perfectly competitive firm where MR = P = D, this point represents where the price to society equals MC. For a monopolist, however, P > MR, this reflects a loss to society.

In this graph, this loss is also represented by the deadweight loss of triangle ABC. LO-4 Level of Difficulty: Difficulty

2. What is (are) the purpose(s) of antitrust laws? Are they still needed today?

Answer: The purpose of antitrust laws is to ensure that markets remain competitive to reduce the power over prices by a smaller number of firms in an industry. They are to promote competition and prohibit anti-competitive behavior by firms, such as collusion and price setting. They are still needed to protect consumers from this type of behavior.

LO-5 Level of Difficulty: Moderate

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3. Explain the effects on price and economic efficiency when a firm moves from the perfect competition end of the spectrum to the monopolist side.

Answer: As a firm moves from the perfectly competitive end of the market structure spectrum to the monopolistic side there are less firms to compete. The demand curve ceases to be perfectly elastic and reflects the law of demand through a downward sloping demand curve.

In order to entice the consumption of an additional unit of the product price will need to be lowered. This causes a marginal revenue curve that is below the market demand curve.

Producing at a level of profit maximization, MR = MC, the firm can now charge a price that is greater than marginal revenue, creating a deadweight loss to society.

LO-4 Level of Difficulty: Moderate

Answers to "Think for Yourself" Questions 1. Marginal costs would not change if total costs were $5 higher at each output level. Marginal costs associated with the total costs listed are: $35, $33, $30, $33, $35, $43, $50, $57, $65, $73.

2. If Econoweb charged $40 per report, Econweb’s marginal revenue would be $40 for each report.

3. The normal profits are TR – TC = $60,000 – ($30,000 + $30,000) = $0 per year. Your friend is earning zero normal profit. If total revenue were $100,000, normal profits are $100,000 $60,000 = $40,000. Because your friend is earning normal profits above zero, she is earning economic profits.

4. If pharmaceutical companies were not allowed to patent their new drugs, it would be more difficult for them to cover the large up-front investment needed for the research and development needed bring the new drugs to market. As a result, fewer new drugs would be developed.

5. A price taker is a small firm in a large industry that cannot influence the market price of its good or service and instead must simply make its decisions based on the market price. A price setter is a firm that can influence the price of its product.

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Answers to Discussion Questions and Problems 1. A perfectly competitive firm cannot influence the price of its product and must instead just charge the market equilibrium price. Because the market equilibrium price does not change when a perfectly competitive firm adjusts its output level, price and marginal revenue are the same for a perfectly competitive firm. A monopoly can only sell more output if it also lowers the price of its good, so marginal revenue is less than price for a monopolist.

2. A monopolist cannot charge whatever it wants for its product because it is constrained by the demand curve. If a monopolist raises its price, the quantity of its good demanded will fall.

3. Monopolies produce output at a level where the price of the good is greater than the marginal cost of producing the good. Since the price of the good represents consumers’ willingness to pay for the good, monopoly firms do not produce the level of output where the marginal benefits of the good to consumers are just equal to the marginal costs of producing the good. As a result, consumer surplus and producer surplus are lower under monopolies than they would be under perfectly competitive firms.

4. A firm that is earning normal profit is earning enough to cover all the direct and opportunity costs of operation, but no more than that. A firm that is earning economic profit is earning more than enough to cover all the direct and opportunity costs of operation.

5. a. The firm’s marginal cost, total revenue, marginal revenue, and profit associated with each level of output are shown in the table below.

Units of Output per period 0 1 2 3 4 5 6 7 8

Total Cost ($ per period)

Marginal Cost ($)

Price ($ per unit)

Total Revenue ($ per period)

Profit ($ per period)

50 150 300 500 750 1050 1400 1800 2250

----100 150 200 250 300 350 400 450

350 350 350 350 350 350 350 350 350

0 350 700 1050 1400 1750 2100 2450 2800

-50 200 400 550 650 700 700 650 550

b. The profit-maximizing output level is 6 units per period, since this is the level of output were MR = MC. Profits at that level of output are $700 per period.

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c. The profit-maximizing level of output when the price is $400 per unit is 7 units per period. Profits at that level are TR – TC = ($400*7) – ($1800) = $1000 per period. d. The profit maximizing level of output when price is $250 per unit is 4 units per period.

Profits at that level of output are TR – TC = ($250*4) - $750 = $250 per period.

6. The total revenue, marginal revenue, total cost, and profit associated with each level of output for the firm are shown in the table below.

Quantity demanded per period 0 1 2 3 4 5 6 7 8 9 10

Price

TR

MC ($)

Profit

($ per period)

MR ($)

TC

($ per unit)

($ per period)

($ per period)

20 19 18 17 16 15 14 13 12 11 10

0 19 36 51 64 75 84 91 96 99 100

----19 17 15 13 11 9 7 5 3 1

----11 8 7 9 11 14 18 22 27 33

0 11 19 26 35 46 60 78 100 127 160

0 8 17 25 29 29 24 13 -4 -28 -60

P, MR, MC ($)

b. The demand, marginal revenue, and marginal cost curves are shown below.

36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0

MC

D

MR

0

1

2

3

4

5

6

7

8

9 10 11

Quantity of output per period

c. The profit maximizing level of output is 5 units per period, since this is where MR = MC. The price of the good is $15, since this is the price that corresponds to Q = 5 on the demand curve. The profits at this level of output are $29 per period.

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Answers to Multiple Choice Questions 1. c 6. d

2. d 7. b

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3. a 8. c

4. c 9. d

5. e 10.

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Chapter 19: The Economics of Labor Market Discrimination

Chapter Outline 1. Race and Gender in the U.S. Workforce 2. Why Are There Pay Gaps Among People?

3. What is Discrimination?

4. Economic Models of Discrimination 4.1. Taste-based Models of Discrimination 4.1.1. Employer Discrimination 4.1.2. Customer Discrimination 4.2. Incomplete Information Models 5. Antidiscrimination Policies in the United States 5.1. The Theoretical Impacts of Antidiscrimination Laws 5.2. Economics Research on the Effects of Antidiscrimination Laws 5.2.1. Race 5.2.2. Gender 5.2.3. Age and Disability

Learning Objectives After studying this chapter, students should be able to: • Describe the sources of earnings differences among people • Define discrimination • Summarize the predominant economic models of discrimination • Model the effects of discrimination • Discuss the main antidiscrimination policies in the U.S. and the research findings on the effectiveness of these policies

Teaching Notes This chapter provides a discussion about what is labor market discrimination. It begins with a breakdown of the current demographics of the labor participants. The economics of Labor

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Market Discrimination focuses on how efficiency of the labor market is affected when demand for labor is based on something other than productivity. Students are hit with a mass of statistics and numbers which is not difficult, but without relevance does not mean anything. Recognizing the general trend is more important than memorizing actual numbers.

Begin with asking students to share their experiences with labor discrimination. Many of the students will have examples. Direct the discussion with students to ensure an understanding of what labor discrimination is and the forms of labor discrimination. Emphasize the definition.

Students may themselves have practiced some form of discrimination themselves. Ask them to consider if they had ever foregone having someone in a class project because the person is not a friend or some other desired characteristic, such as gender, nationality, or race. It would be interesting to have to use a student response system to poll the class.

Students may have heard, via the media, about models of discrimination not discussed in the chapter. Remind students that there are different names for the economic models of discrimination but that the basic focus of these different models is the foundation of the discrimination. Is it a matter of taste or preference, either from the consumer or the employer who has a prejudice towards another demographic or is it from a statistical basis, when information is used to create the discrimination rather than personal preference?

The chapter continues with why there are gaps among the labor market participants followed by the economic models of discrimination. There are two broad models presented. Students may have difficulty understanding Statistical Discrimination; even though they probably are part of this type of discrimination if they are a traditional age student each time pay their car insurance.

Statistical discrimination is situations when people are viewed through characteristics of a group formed from statistical trends. Car insurance for younger and male segments of the population is higher than for more established drivers. Also, some industries prefer to hire males rather than females because of statistical trends of what physical restrictions of females tend to have versus their male counterparts.

How does discrimination affect a labor market? Remind students that demand for labor is derived. Help students by providing multiple examples and experiences to consider potential effects on a market. Use current events in the national and local news to help build relevancy with the students.

Teaching Activities 1. Use a critical thinking exercise (initially discussed in Chapter 16) to discover student’s perspectives and assumptions about labor discrimination. Place a line of butcher paper

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on a wall of the classroom. In the center of the paper write in a box What is discrimination and How is it created? Tell the students to quietly consider their thoughts and perspectives on this question. After about two minutes of quiet consideration have students write their thoughts, questions, and analysis of other thoughts on the paper.

Lines can be drawn to connect related statements/questions. For example, if one student writes degrading and other students write other forms of emotional reactions, a line can be drawn to connect these. All of this is to occur without the students talking. Chalk Talk represents an inner reflection of their perspective of discrimination and questions concerning other perspectives. Instructor participation should be an integral part of this activity as students will learn to model critical thinking through the instructor’s actions.

2. Using information found on the Bureau of Labor Statistics web site, www.bls.gov, have students compare changes in earnings ratios among men and women and other demographic groups. A useful tool for this purpose is the Bureau of Labor Statistics Economic News Release, Table 2: Median usual weekly earnings of full-time wages and salary workers by selected characteristics, quarterly averages, not seasonally adjusted. A search at the BLS web site will provide the needed information. Have students compare also compare historical data with changes in the past year. An important point to highlight is the other factors that have contributed to these changes in addition to antidiscrimination laws, such as increased incentives to attend college and post graduate studies, in addition to changes in family tolerances of education for females.

3. An age-old activity that emphasizes the effects of discrimination on the labor market is to use discrimination in the class. Divide the class into quadrants or more divisions.

Delegate specific characteristics to different section of the room. Or tell them that only those with a math major can attempt the homework as they will, statistically, have the most success. After the activity, ask students how did discrimination limit the ability to achieve efficiency in the class room? Allow them to think outside the box in this one and allow them to explore other perspectives and reasons why.

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Additional Questions and Discussion Points 1. Provide economic support for the following chart.

Answer: the goal of antidiscrimination laws is to increase the demand for protected workers. The initial demand curve is D1. After antidiscrimination laws are passed, protecting a segment of the labor market, the demand increases to D2.

LO-5 Level of Difficulty: Moderate

2. Of the forms of discrimination presented in the text, is one more spiteful than the other?

Answer: Statistical discrimination, while still discrimination, is more accepted in our society. A firm when hiring someone for a position that will require extensive, and expensive, training of a specific skill may refrain from hiring women because, statistically, women tend to want to leave the workforce to have children.

LO-3 Level of Difficulty: Easy 3. Why can’t the market eliminate discrimination rather than use governmental policies?

Answer: The science of economics is based on decision making, the observation of consumers. Consumers are not exact; therefore the science of economics, and the theories of a market, cannot be exact. Only after people eliminate personal biases will the market be able to eliminate discrimination.

LO-1 and 5

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Level of Difficulty: Moderate

Answers to "Think for Yourself" Questions 1. The black female/white male earnings ratio is 0.65, so white male/black female earnings ratio is 1 / 0.65 = 1.54. The pay gap between black females and white males is 0.54. White males earn 54 percent more than black females. The black male/white male earnings ratio is 0.75, so white male/black female earnings ratio is 1 / 0.75 = 1.33. The pay gap between black females and white males is 0.33. White males earn 33 percent more than black females.

2. Since earnings differences can arise for a wide array of reasons, including discrimination, it would be helpful to know about differences in the fields of specialization for male and female professors, since some fields pay more than others. If would also be useful to know about the professors’ relative experience levels. If possible, it would be useful to compare the professors’ relative productivity in terms of classes taught, research publication output, and success in obtaining research grants.

3. Yes. Insurance companies charge certain groups higher rates because most automobile insurance companies do not have adequate resources to verify that any particular driver is a safe driver. Instead, their rates are based in part on the driving records of those in the same demographic group. Because the rate of accidents is higher for younger drivers than for older drivers and for single drivers relative to married drivers, teenagers and single drivers face higher insurance premiums.

Teaching and Clerical

Waitress, Domestic Servant, and manufacturing Positions

Wage per hour ($)

Wage per hour ($)

S' 4. For teaching and clerical positions, the laws would result Positions S in a decrease in the supply of labor since women would no longer be able to work in those occupations. The decrease in supply from S to S’, illustrated in the figure at right, would D raise the wages for men in teaching and clerical positions.

Hours per week The laws increase the supply of labor in waitress, domestic servant, and manufacturing jobs from S to S’ since women will move to these jobs and out of teaching and clerical jobs. The increased supply of labor in those jobs will cause wages to fall.

Answers to Discussion Questions and Problems 1. Major factors include differences in the occupation mix of males and females, differences in the years of labor market experience of males and females (since females disproportionately leave the labor force to raise children), differences in education, and differences in industry.

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After accounting for these factors, however, almost two-thirds of the male/female pay gap is unexplained, indicating that discrimination may also play a role.

2. An earnings ratio measures the earnings of one group as a percentage of the earnings of another group. If the female/male earnings ratio were equal to 1, males and females would have equal earnings. If the black/white earnings ratio declines, the earnings of blacks have fallen relative to the earnings of whites.

3. The black/white earnings ratio for females rose dramatically after the Civil Rights Act, but has declined somewhat since the mid-1970s. The black/white earnings ratio for males also rose after the Civil Rights Act, but not as dramatically as the increase for females; it continued to rise through the 1990s, but had remained fairly steady since then. Possible explanations for the increased black/white earnings ratios include reduced discrimination and better employment opportunities because of the Civil Rights Act, as well as improvements in educational attainment and educational quality after desegregation. The white female/white male earnings ratio did not change after the passage of the Civil Rights Act, although it has grown fairly steadily since the 1980s. There is not much evidence that the Civil Rights Act was a large cause of the increase in the white female/white male earnings ratio. The black female/black male earnings ratio increased after the Civil Rights Act, which would be consistent with reduced discrimination against black females. The black female/black male earnings ratio leveled off in the 1990s.

4. If attorneys have to make arguments in clients’ trials, better looking attorneys might be able to win more cases if jurors have preferences for better looking people. When attorneys win more cases, they make more money.

5. The protective legislation effectively reduced the supply of labor in the jobs listed. Men in those jobs would benefit because the reduced labor supply would increase their wages. Women pushed out of those jobs would move instead into other jobs, increasing labor supply and decreasing wages there.

6. If employers believe that blue-eyed people are less productive, they will have lower demand for blue-eyed workers. As a result, the employment and wages of blue-eyed people will be lower than of brown-eyed people. Of course, a nondiscriminatory employer who was smart enough to realize that he could hire equally productive blue-eyed people for lower wages than brown-eyed people would hire only blue-eyed people and have higher profits than employers who hire brown-eyed people.

7. a. Secretarial and clerical jobs are still predominantly held by women, as are elementary school teaching jobs and registered nursing jobs. Men disproportionately hold construction jobs, as well as jobs as mechanics, airline pilots, engineers, and economists.

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Wage per hour ($)

Wage per hour ($)

Occupation C b. There are 12 million men. In equilibrium, Occupations A and B 24 S 24 22 S 22 20 the men will be evenly split evenly between 20 18 18 16 16 14 occupation B and occupation A. Why? If the 14 12 12 10 10 8 men are not evenly split between A and B, one 8 6 D 6 4 D 4 2 occupation will have higher wages which will 2 0 0 Millions of workers per year Millions of workers per year generate a movement of workers from the low paying to the high paying occupation. Thus, there will be 6 million men in occupation A and 6 million men in occupation B. The figure at right shows the supply and demand in occupations A and B. At equilibrium, the wage in each occupation is $17. There will be 12 million women in occupation C, as shown in the figure at right. The equilibrium wage for women is $11.

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8 10 12 14 16

8 10 12 14 16

Occupations A, B, and C

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c. The law will cause the supply of labor to be the same in all three 24 S 22 20 18 occupations. Since there are 12 million male and 12 million female 16 14 12 workers, 4 million of each sex will be employed in each occupation. The 10 8 6 figure at right shows the resulting supply curve in all three occupations.

D 4 2 0 The equilibrium wage will be $15 per hour. Women would gain from the Millions of workers per year law because their wages would rise from $11 per hour to $15 per hour.

Men would lose from the law because their wages would fall from $17 to $15 per hour.

0

2

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8 10 12 14 16

Answers to Multiple Choice Questions 1. a 6. b

2. b 7. d

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3. d 8. c

4. c 9. c

5. c 10.b

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Chapter 20: Poverty and the Distribution of Income

Chapter Outline 1. Income Distribution 1.1. U.S. Income Distribution 1.2. Global Income Distribution 2. Measuring Income Inequality 2.1. Income Ratios 2.2. Gini Coefficient 3. Measuring Poverty 3.1. Poverty Lines 3.2. Poverty Rates 3.3. Relative versus Absolute Poverty Lines 4. Causes of Poverty 4.1. Individual-level Causes of Poverty 4.1.1. Productivity 4.1.2. Restricted Opportunities 4.1.3. Incentives and Preferences 4.2. Structural Causes of Poverty 4.2.1. Macroeconomic Downturns 4.2.2. Resource Availability and Resource Use 4.2.3. Governmental Institutions 4.2.4. Disease 4.3. Poverty Policy 4.3.1. U.S. Poverty Policy 4.3.1.1.

Direct Payments 4.3.1.2.

Food, Health, and Housing and Education Programs 4.3.1.3.

Tax Policy and Regulation 4.3.2. Global Poverty Policy

Learning Objectives After studying this chapter, students should be able to: • Describe the distribution of income in the U.S. and the global distribution of income

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Explain various measures of income inequality Describe various measures of poverty Summarize the issues surrounding global poverty and inequality Describe some of the primary causes of poverty Describe the impacts of various poverty policies

Teaching Notes This chapter focuses on the distribution of income found in the U.S. and around the globe and the resulting poverty created because of the inequality of the distribution of this income. As part of the introduction to this chapter, pull up the list of the top 100 richest people in the world on the room’s computer and project the results. If this is not possible in your classroom, provide handouts of this information. One such web site would be to access Celebrity Networth for this information. At the time of writing this chapter Bill Gates at $72.7 billion was battling with a tie for second consisting of Carlos Slim Helu of Mexico and Vladimir Putin, Russia, both with a net worth of $70 billion. For the females in the room, number 10 in the list goes to Christy Walton of Wal-Mart family. Students should also find the perception of division of wealth in the U.S. as reported in the text.

If students are having difficulty reading and understanding income distribution charts provide plenty of opportunities for students to work together in developing an understanding of how to read the charts. Also, using a normal distribution curve for comparison may be helpful.

For a “normal” distribution, the highest point would Source: Chart prepared by represent the the New York State Education Department average amount.

When considering a normal distribution of income, this would represent the average, or median, income. Fifty percent would earn more and fifty percent would earn less. The data provided in the chapter illustrates that this is not the case.

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How income inequality is measured is discussed next including definitions and explanations of income ratios and the Gini coefficient. Gini ratios measure income inequality. The higher the value the more income inequality is present in the society. If students ask about how the Gini coefficient is calculated explain the process using a Lorenz curve for income distribution. A Lorenz curve is often used to represent income distribution. Consider the following Lorenz Curve. The percent of income is placed on the vertical axis and the percent of households is placed on the horizontal axis.

If income was equally distributed, 10 percent would have 10 percent of the income, 20 percent of the population would have 20 percent of the income, and so on. The line in the center represents this relationship of equitable distribution of income. The curve lying below the equitable distribution line is the Lorenz curve which shows the actual income distribution. The Gini coefficient is the ratio of the area between the Lorenz curve and the equal distribution line to the total area below the equal distribution line. The Gini Coefficient is the ratio of A to the area of A+B. Stated mathematically, The Gini Coefficient = A/(A+B) Knowing what the components of the coefficient, and how it is calculated, will help the students recognize the meaning of the coefficient. As an economy works towards more equality the area represented in area A would become smaller and the coefficient will become smaller. If there was perfect equality in the economy the area of A would be zero and so would be the Gini coefficient. However, if an economy’s inequality of income distribution was increasing, the area of A would be increasing and so would the Gini Coefficient. Hypothetically, if only one household received all of the income, area B would disappear and the Gini coefficient would be 1. Typically, the smaller the value of the Gini coefficient the more equitable income distribution is in an economy. Have students compare the Gini coefficients for different economies around the world. Have students first provide their guess of what they think the country’s income distribution equality coefficient is. Potential sources for this search include: - The World Bank: http://data.worldbank.org/indicator/SI.POV.GINI - CIA: https://www.cia.gov/library/publications/the-world-factbook/fields/2172.html Have students compare changes in Gini coefficients over a period of time. This comparison will allow for a discussion of global event and possible effects on income distribution.

A discussion follows in this chapter on how poverty is measured, absolutely and relatively, with an explanation of the poverty rate and causes of poverty.

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The chapter concludes with a description of poverty policy in the U.S. and globally.

Teaching Activities 1. What is the class’ perception of income distribution in the U.S.? In the introduction to the chapter, the author describes a national survey of over 5,000 Americans polled in 2005.

They were asked to describe the division of wealth in the U.S. Wealth is a stock of what is owned and is typically closely related to income. Take a poll of the students to determine how think income/wealth is distributed in the U.S. among quintiles (or fifths) of the population.

What percent of wealth/income do What percent of you think is held by… wealth/income do you think SHOULD be held by…

Top 20% of households 2nd 20% of households Middle 20% of households 4th 20% of households Bottom 20% of households 100% 100% Compare results with the national average. This will also open up discussion on possible different percents. Some may feel that there should be inequality because the market system rewards the innovative and risk takers. Others may feel that greed and other behavioral characteristics have created a less then level playing field and more government policy needs to be included to ensure more equality.

2. Encourage students to consider an alternative perspectives and views such as those presented in Myths of Rich & Poor, Author W. Michael Cox and Richard Alm (Cox & Alm, 1999) The book provides the perspective that “real wealth” has increased and that the poor have not gotten poorer and other myths about income inequality.

3. The Council for Economic Education has a lesson plan on its econedlink directing students on how to graph a Lorenz Curve and calculate the Gini coefficient,

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http://www.econedlink.org/lessons/index.php?lid=885&type=educator. The lesson plan is for AP Microeconomic students but could be suitable for an introductory economics class.

Additional Questions and Discussion Points 1. Is there an inherent inequality in the market economy system? Or, should there be?

Answer: Yes, traditionally, the market system represents a more efficient system, but a less equitable system. The market system rewards the innovative, the risk takers.

LO-2 Level of Difficulty: Easy 2. Are the rich getting richer and the poor getting poor?

Answer: According to the data provided, the data is consistent with the thought that the rich is getting richer, because the share of income earned by the top quintile has grown over the last 40 years. However, the same cannot be said for the poor. Because the income pie has more than tripled between 1969 and 2009, it appears that the poor has also increase their wealth also.

LO-2 Level of Difficulty: Easy 3. What would be potential trade-offs for the various poverty policies?

Answer: The trade-off for policies that attempt to establish more equality is a loss of output and efficiency in the market.

LO-6 Level of Difficulty: Moderate

Answers to "Think for Yourself" Questions 1. Answers to this question can vary. One cost of having an unequal income distribution is that some people in the economy will be poor. If a society wants to ensure a minimum standard of living for its citizens, having an unequal income distribution may necessitate a redistribution of income from richer to poorer citizens. One benefit of having an unequal income distribution is that it provides strong work incentives for individuals because their income is not redistributed to others.

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2. If the 90:10 ratio is 8, people at the 90th percentile of the income distribution earn 8 times higher incomes than people at the 10 percentile of the income distribution. A falling 80:20 ratio would indicate that the income distribution is becoming more equal.

3. Answers to this question will vary based on individual preferences and opinions.

4. If you use a relative measure of poverty, there will always be people in the US who are poor based on that measure. For example, suppose your poverty threshold is set at half of the median income earned in the US. Unless the income in the US is divided equally, there will always be people with less than half the median income in the US. For this reason, most poverty policies are evaluated based on an absolute measure of poverty.

5. The primary reason for our mix of poverty policies is that policy makers and taxpayers don’t tend to want the poor to have unlimited choices on how their poverty assistance is spent.

Instead, we want to ensure that spending is focused on food, housing, and health, particularly for children.

Answers to Discussion Questions and Problems 1. Country A has a 90:10 ratio of 2, which means that those at the 90th percentile of the income distribution earn twice as much as those at the 10th percentile. Country B’s 90:10 ratio of 4 implies that those at the 90th percentile of the income distribution earn four times as much as those at the 10th percentile. Thus, Country A has a more equal income distribution than Country B. The 90:10 ratio does not tell us about the portion of global income earned by people in either country.

2. The 80:20 ratio measures the incomes of people at the 80th percentile of the income distribution relative to the incomes of people at the 20th percentile of the income distribution. An increase in the 80:20 ratio indicates that income inequality in the country has increased.

3. Poverty rates tend to be higher among single-parent households, among children, among those with less education, and among some minority groups. Single parent households and households with children have higher poverty rates because they have fewer income earners.

4. A welfare program that cuts payments by $1.00 every time the family earns $1.00 in income would not provide a strong incentive for people to work since they would lose a large amount of their welfare benefits by working. A program that cuts payments by $0.50 would provide more incentives for people to work.

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5. a. Both Maria and Dustin make incomes below the poverty threshold so both families would be considered poor. b. Maria’s family would likely feel the effects of poverty more strongly because living in San Francisco is more expensive than living in a small town in Nebraska.

Answers to Multiple Choice Questions 1. c 6. d

2. c 7. b

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3. a 8. a

4. b 9. c

5. a 10. b

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Chapter 21: The Economics of Health Care

Chapter Outline 1. The Cost and Quality of Health Care 2. Why Health Care Expenditures Have Increased 2.1. Technology 2.2. Behavioral Factors 2.3. Insurance 2.4. Fee-for-Service 3. Externalities in the Health Care Market 3.1. Marginal Benefits and Marginal Costs of Health 3.2. Externalities 3.3. Why Is the Government Involved in the Health Care Market?

4. Health Care Reform 4.1. Expanding Insurance Coverage 4.2. Government Insurance

Learning Objectives After studying this chapter, students should be able to: • Describe the trends in costs and quality of U.S. health care • Compare the cost and quality of U.S. healthcare relative to other developed nations • Describe the factors that have contributed to the rising cost of health care • Analyze the role that externalities play in the health care market • Assess the potential impacts of healthcare reform proposals

Teaching Notes This chapter addresses one of the most volatile economic and political issues of the past decade.

The controversy over these issues extends past the economic issues of cost and access to the split over potential additional government involvement.

The chapter begins with a discussion of the historical trends of healthcare spending in the U.S. since the 1960s. If your class is of younger students they may have limited experience with health care costs and limited exposure to the debate that surrounds the topic. More background will be needed to help these students understand the implication and ramification of the issues.

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The cost and quality of health care is explained followed by an explanation of why health care expenditures have increased. Prior to discussing the text material in class, poll students as to what they consider leading causes of the increase of healthcare costs.

The factors of behavioral and insurance can be used as sources of a class discussion of our assessed worth of quality of life. Poll students concerning the following issues 1. How many have memberships to gyms?

2. How many times has the students been to a doctor in the past six months? a. 0 times b. 1 – 3 times c. 3 – 6 times d. more than 6 times 3. How many have uses a third-party payment?

The results of this poll may also highlight the moral hazard problem that is found in the health care market. Moral hazard can be of two types. Because of having a third-party payer, people may be less careful with their health. Also because not all of the cost of the health care is born by the direct consumer there may be an incentive to over consume the service.

The externalities of the health care market are discussed using a marginal benefit and marginal cost model to establish the optimal level of healthcare. Additional information can be found on negative externalities in Chapter 16: Pollution and Chapter 17: The Economics of Education for positive externalities.

The government involvement and the current health care reform are also discussed. It has been long acknowledged the positive externality created in the health care industry and the need for government involvement to eliminate the positive externality and for a more efficient allocation of resources. The chapter concludes with an explanation of the pros and cons of government insurance.

Teaching Activities 1. Would students be willing to pay more in taxes to increase health care insurance? Poll students to determine their preferences. Remind the students that economic decisions involve trade-offs. While increasing insurance coverage will improve access of healthcare to those who previously did not have access and increase the quality of health for this group also, it will come at an increase in taxes.

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2. Provide a model of the positive externality for students to study and develop. Going through this model carefully will assist students in their understanding of this market failure.

3. A mountainous amount of information found in the media on this subject is easily available to students. The topic provides an excellent source of discussion for students. A critical thinking tool that employs small groups to develop a thought process on a subject can be used. Form small groups of five and give them the following question, Why is the health care cost issue so serious and what should be done? a. Provide students two to three minutes of silent preparatory time to organize their thoughts and determine what they want to share with their group. b. First round of conversation: Students go around the circle in order and each person has up to one minute of UNINTERRUPTED time to give their viewpoint on the question. c. Second round of conversation: After everyone has had the chance, uninterrupted, to voice their thoughts, the discussion is opened. Participants are now only allowed to talk to another person’s ideas that have already been shared in the opening round. There does not need to be an agreement, it can be a question, an elaboration, an illustration, or an extension. A disagreement is also allowed.

Additional Questions and Discussion Points 1. A lot of information is available concerning the economics of health care. What is health care? Is it the same as health?

Answer: First, health care and health are different. Healthcare is about caring for, and treating, and managing through services available our health. Health is a condition, healthcare is maintaining that condition.

LO-1 Level of Difficulty: Easy 2. Explain the increased costs of health care expenditures.

Answer: The primary factors that have contributed to the increased cost of health care include technology, behavior factors, insurance, and the fee-for-service system. In addition to the dramatic increase of technological advancements in the field of health care, the accessibility of these advancements has also increased. The ability to be proactive about health issues have been facilitated through this technology. In addition to technology,

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changes in behavioral factors such as rich diets and consumption of tobacco and alcohol have contributed to the high U.S. health care costs. Insurance has provided a subsidy for the increased consumption of health care.

LO-3 Level of Difficulty: Easy 3. Why is the role of the government important in the healthcare industry?

Answer: The role of government is needed to help reduce the market failure caused by the positive externality. The role of government should be sufficient to negate the amount of the positive externality.

LO-4 Level of Difficulty: Moderate

Answers to "Think for Yourself" Questions 1. Moral hazard implies that people with insurance will consume more healthcare than is optimal since they only pay a fraction of the cost. Since cosmetic surgery is usually an optional procedure, insurance companies tend to make people pay the costs themselves to avoid the moral hazard problem.

2. It is likely that physician-induced demand would fall if physicians were paid based on the health outcomes for their patients rather than on a fee-for-service basis, since unnecessary lab testing or other procedures would be less common.

3. The marginal benefits of using an exercise program include things like increased stamina and energy, lower blood pressure, and lower weight. The marginal costs of using an exercise program include time, risk of injury, and any direct costs associated with joining a gym or obtaining exercise equipment. The MB curve for exercise is likely to be downward-sloping like the MB curve in Figure 6 because the law of diminishing marginal returns would lead to smaller and smaller incremental health improvements as exercise increases. The MC curve is also likely upward sloping since the risk of injury increases as exercise increases.

4. The positive externality associated with health improvements falls because health improvements like vaccinations and hand washing can have large impacts on the probability that other people get sick, while health improvements like running 6 instead of 5 miles per day probably have only small impacts on public health. The government subsidizes vaccinations but not running shoes because the positive externalities associated with childhood vaccinations are large, but the positive externalities associated with people running more are smaller.

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5. The benefit of not having health insurance is the money saved by not paying health insurance premiums, which could be in the tens of thousands of dollars per year. The cost of going without health insurance is the risk of having healthcare costs that are more than you can afford to pay.

For some people, particularly those with low health risk and large savings, it may be optimal to go without health insurance.

Answers to Discussion Questions and Problems 1. When third-parties pay some of the costs of visiting the doctor, the cost of the visit to the patient is lowered. When people do not pay the full costs of going to the doctor, they are more likely to go to the doctor for health issues that could be resolved more cheaply.

2. Because there are positive externalities associated with healthcare, a purely private market would result in too little healthcare than is socially optimal.

3. a. The opportunity cost of exercising rises as people exercise more, the risk of injury also increases as people exercise more. b. The marginal improvement in health in terms of reduced risk of hypertension, diabetes, or obesity from the 8th hour of exercise per week is smaller than the marginal improvement in health from the 5th or 6th hour of exercise per week. c. The private and social marginal benefits of exercise differ from one another because exercise is associated with positive externalities. d. The positive externality decreases because the first few hours of exercise per week are more likely to reduce obesity and other diseases that impose costs on others than the 7th or 8th hour of exercise per week will. e. 5 hours of exercise per week, since this is the level of exercise where the marginal private benefits of exercise are equal to the marginal costs of exercise. f. 6 hours of exercise per week, since this is the level of exercise where the marginal social benefits of exercise are equal to the marginal costs of exercise. g. The physical education classes taught in public schools are one example of moving from the private to social optimum level of exercise. Public service messages encouraging exercise also serve to push people toward the social optimum level of exercise.

4. The benefits of having employers pay some of the costs primarily come in the form of tax advantages for employees. For people with employer-provided health insurance, the value of their employer-provided health insurance is currently not counted as part of income for tax purposes. The cost of having employers pay for health insurance includes the bureaucratic burden on employers, higher prices for goods and services, and lower wages for employees.

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5. One benefit of mandated health insurance is that it would reduce the costs that are passed on to others when an uninsured person seeks treatment in a hospital. One cost of mandated health insurance is that it reduces people’s freedom to choose whether they want insurance or not.

Answers to Multiple Choice Questions 1. b 6. d

2. c 7. d

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3. c 8. c

4. b 9. b

5. d 10.b

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Chapter 22: Monetary Policy and the Federal Reserve Chapter Outline 1. The Evolution of the Monetary System 1.1. The Functions of Money 2. The Money Supply 3. The Banking System 3.1. Bank Balance Sheet 3.2. The Market for Loans 3.3. Banks and Money Creation 3.4. Bank Regulation 4. The Federal Reserve System 4.1. The Structure of the Federal Reserve System 4.2. Federal Reserve and Monetary Policy 4.2.1. Open Market Operations 4.2.2. The Discount Rate 4.2.3. Reserve Requirement 4.3. Monetary Policy and the Economy 4.4. Advantages and Disadvantages of Monetary Policy

Learning Objectives After studying this chapter, students should be able to: • Define the concept of money • Explain how the fractional reserve banking system allows banks to create money • Explain how the market for loans functions • Describe the structure of the Federal Reserve System • Summarize the roles of the Federal Reserve • Explain how monetary policy takes place • Illustrate the impact of monetary policy on the economy • Assess the tradeoffs associated with monetary policy

Teaching Notes This chapter introduces students to the U.S. financial system. It provides an overview of what money is and the role of money in our society. The chapter opens with an overview of the evolution of the monetary system. The development of the monetary system provides a synopsis of what makes something

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money in our economy today. Understanding the evolution of the monetary system will help students gain a better understanding of the functions of money.

The chapter also provides a discussion on what is accepted as the money supply. Impress upon students that the definition of money supply does differ. The definition of M1 does change over time as different forms of money become available and accepted. For example, traveler’s checks are listed as a part of M1.

However, these are increasingly obsolete in today’s society.

There are many sites available for students to learn interesting facts about money. The U.S. Bureau of Engraving and Printing provides Fun Facts and Money Trivia that are useful for bonus point games or activities. http://www.moneyfactory.gov/uscurrency.html. For example, the largest bill in circulation in the U.S. is the $100 bill, or approximately 70% of the bills in circulation are actually held outside of the United States.

Of special interest to students will be the ability of the banking system to create money. It will be important to emphasize that money is created not printed. (Printing of money is done by the Bureau of Engraving and Printing, not by the central bank.) But this is also a potential stumbling block as the process can become quickly complex. Take time to provide students several examples of the process and opportunities to develop their understanding. Examples of this progression will also provide students an opportunity to see how the process of money creation through the banking system has a multiplier effect.

Included in the discussion of the banking system is an analysis of the market for loans and setting of the price for loans, or the interest rate. As with any price, this interest rate is the opportunity cost for using money. It can be an incentive to stimulate the economy or serve as a deterrent for spending.

The chapter finishes with a discussion of how this ability to create money is monitored and regulated by the central bank of the United States, the Federal Reserve System, or the Fed. The structure of the Fed is an important feature. The Fed was created to remove the political incentives by establishing both a private and a public (government) component. The Board of Governors in Washington and the Federal Open Market Committee represents the government component of the Fed’s structure. The 12 Regional District Banks constitute the private component.

Additional information about the Federal Reserve System and the 12 Regional Districts can be found at: • www.federalreserveeducation.org • http://www.federalreserve.gov/ • http://www.federalreserveonline.org/ (This site provides an interactive map of the 12 District Banks) The idea of a central bank is another stumbling block for students. Many students may not be aware of the role of a central bank in general, or the history and mission of the U.S. central bank. The Fed does not print money; it distributes money and manages the money supply of the U.S. In an effort to help expand on the knowledge of the purpose and role of the Federal Reserve, a four-part lecture series developed for college students has been made available at the following web site http://www.federalreserve.gov/newsevents/lectures/about.htm. The four lectures include videos with

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content delivered by Fed Chairman Ben Bernanke and instructor’s resources, including transcripts, on the following topics: 1. Origins and missions of the Federal Reserve 2. The Federal Reserve after World War II 3. The Federal Reserve’s Response to the Financial Crisis 4. The Aftermath of the Crisis

Teaching Activities 1. In today’s techno society the functions of money is simply taken for granted. However, money facilitates trade and economic growth only if it is acceptable and usable. Help students develop an understanding of these functions. Begin by holding up a $5 bill and ask one student if they would be willing to trade their pencil/pen for this piece of paper you are holding. Do not identify it as money or as something of more value than the pen or pencil. Treat it as what it is, a piece of material that is composed of 70% cotton and 30% linen. (That is the reason it makes it through the washer and dryer without dissolving.) Most students will readily make the trade. Then tell the selected student that you are having some guilt about not providing an equitable trade and offer the student a clean sheet of copy paper. Explain to the student that the small printed piece of fabric has little function because there is little space to take notes or create a “to do” list. The clean sheet of paper, however, does provide more than ample space for any writing that needs to be done. Therefore it has more function.

Ask the student if he/she would trade the blank copy paper for the pen or pencil. Most students will change their minds and say no.

Direct the conversation on why the small green fabric would have value to the students while the clean white sheet of paper does not. The conversation will eventually settle on the fact that the $5 bill is more useful to them because it is accepted in exchange for items that cost about this amount. The piece of paper would require them to find someone who has what they may want and is willing to trade it for the paper. This would complicate their ability to trade. Therefore a function of money is to be accepted as a medium of exchange.

Encourage additional conversation about what else is required from this piece of fabric to be considered money. Ask them to explain what could be exchanged for this $5 bill. List the items on the board. Students will note that this $5 bill provides a guide as to what can be traded for it. It serves as a unit of account. A mental activity that can be used to ask students to mentally consider and describe a bike that cost $500, and compare this with a bike for sale listed at $5. The price provides information about the product. It serves as a unit of account.

Finally, for something to be considered as money it must also serve as a store of value. At one point of time fish served as a commodity money. However, one primary flaw is that fish has a shelf life. If you place the $5 bill in a drawer and forget about it for six months it will still be worth $5 when you take it out. (True, the purchasing power may have changed, but that piece of cotton and line will still purchase $5 worth of items.) Not true of the fish should you try this experiment with it. The $5 bill has a store of value.

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2. A question that students may ask when considering the money supply is how much money should there be in an economy. If too much money may result in inflation and too little may cause a slowdown in the economy, then how much is needed. You can revisit the simple circular flow diagram first introduced in Chapter 6 to help explain that the target amount (Remember the economy is dynamic!) is Money = Stuff.

The circular flow diagram provides an explanation of the flows in a simple market economy. This model consists of two sectors, businesses and households, two markets, the resource and product market and two flows, the physical and the financial. The resources are owned by the households and provided to the business sector through the resource market to be used to produce goods and services supplied to the product market to be consumed by households. The financial flow (the green arrows) represents the flow of money from the households to the product market for the goods and services which serves as revenue for the businesses and pays for the costs to the resource market which serves as income in the form of rent, wages, interest and profit to the households.

So how much money should the targeted supply be? Money = Stuff The targeted supply of money should be enough to support the market value of final goods and services produced.

3. Use the actual reserve requirement as an example to provide more substance to the theory being presented. The information can be found at the Federal Reserve Board of Governor’s web site http://www.federalreserve.gov/monetarypolicy/reservereq.htm. Students can also learn more about how the reserve rates are determined according to the financial institution’s assets and management style.

4. In addition to the recent financial crisis, the role of the Federal Reserve as the U.S.’s central bank to stabilize the economy was put to the test on September 11, 2001. The San Francisco Federal Reserve District Bank has provided a video-based lesson designed to address the following questions a. What is the purpose of a central bank? b. How did the crisis of 9/11 challenge the infrastructure of the U.S. financial system? c. What role does the central bank play in responding to a crisis situation?

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This web site provides another view of the rule and function of this important part of the economy as a dynamic player. http://www.frbsf.org/education/teachers/open/ 5. The tools of monetary policy allow for the use of the credit to influence the flow of money and credit and enhance the stability of the economy, indirectly. The most used tool of monetary policy is the use of the open market operations. The Open Market Operations Desk is at the Federal Reserve Bank of New York where the target rate is manipulated through the selling and buying of U.S. securities. If the need is to increase the money supply, the order to buy securities is given, increasing the money supply. If the need is to decrease the money supply and slow down the economy, the order to sell securities is given, decreasing the money supply.

The discount rate is the interest rate that the Federal Reserve charges banks for overnight loans. The amount of the loan is deposited into the bank’s reserve account. When the discount rate is low, there is more of an incentive to borrow from the Fed. This additional reserve allows banks to loan out more. When the discount rate is high there is not this incentive and less funds become available to loan.

Finally, the reserve rate also provides for potential funds to be loaned. When the reserve rate is increased fewer funds are available for loans. When the reserve rate is decreased more funds become available. The reserve rate is the tool that is seldom used as it is a strong message and can cause multiple issues for financial institutions when adjusted.

6. Use graphs of aggregate demand and aggregate supply when introducing the types of monetary policy. This will provide a visual to help illustrate the goal of the different type of policy. For example, when the challenge facing the economy is a slowdown in output and/or recession, the goal of the policy will be to stimulate the economy, to encourage additional spending in the economy. This can be done through an expansionary monetary policy where the aggregate demand is indirectly affected. The goal of an expansionary or sometimes referred to as easy, monetary policy is to provide incentives for increased spending through lower interest rates and additional funds available for loans.

By making credit “easy” more loans are given thus increasing aggregate spending. This will increase output and real GDP.

Economic Challenge: Recession

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Economic Challenge: Inflation

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When the economic concern is inflation, or an overstimulation of the economy, contractionary monetary policy, also referred to as tight monetary policy, is appropriate. The goal would be to slow down spending in the economy. By decreasing aggregate spending from AD1 to AD2 pressure on the price level is lowered. Contractionary monetary policy that that would indirectly have this effect would be to 1) sell U.S. securities, removing funds from reserve accounts and lowering the amount of funds available for loans; 2) increase discount rates causing the cost of borrowing to be higher; and 3) increase the reserve rate, removing funds available for loans.

Additional Questions and Discussion Points 1. The reserve requirement is 0 percent on the first $6.0 million in transaction deposits, 3 percent on amounts between $6.0 million and $42.1 million, and 10 percent on amounts above $42.1 million.

The First Bank of Econogreat has the following assets and liabilities (all amounts in millions of dollars) Assets Reserves 5.0 Loans 345.0 Securities 70.0 Liabilities Transaction deposits 75.0 Nontransaction deposits 315.0 Equity capital 30.0 a. Calculate the bank’s excess reserves. b. Suppose the First Bank of Econogreat makes a loan to a customer equal to the amount of the excess reserve you found in part a. Calculate the bank’s excess reserves before the customer spends the proceeds of the loan. Note to students: reserves account will remain the same. a. Calculate the bank’s excess reserves 1st 6 million: no reserve requirement 0.03 x (42.1million – 6.0 million) = $1.083 million 0.10 x (75.0 million – 42.1million) = $3.290 million Total Required Reserve $4.373 million Excess Reserves = 5.0 million – 4.373 million = $.627 million or $627,000 b. Amount of loans: $627,000 Transaction deposits increase by $627,000; reserve requirement on additional amounts (marginal reserve rate) is 10 percent, so required reserves rise by $627,000 x 0.10 = $62,700. No change in total reserves, so excess reserves reduced by $62,700: $627,000 - $62,700 = $564,300.

LO-2 Level of Difficulty: Difficult

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2. Why would it be important for both a private and a public component of the Federal Reserve?

The Federal Reserve System was created through a Congressional Act in 1913. Therefore, it is answerable to Congress. However, it is independent of congress is that changes in monetary policy do not require the approval of Congress. The structure of the Federal Reserve allows for a separation of political incentives and economic theory. Monetary policy is determined by the input of all 12 Federal District Banks, with five voting in the FOMC. The District Banks are private and are not under the control of the Congress.

LO-4 Level of Difficulty: Easy 3. Why are financial institutions that accept demand deposits required to hold a set amount of reserves?

How are they calculated and what is their importance to the money supply in the U.S.?

The Federal Reserve requires a set amount of reserves as a means to control the money supply.

Because financial institutions use a fractional reserve system they are required to keep only a small percentage of the funds deposited into their institutions. The remaining can be used to earn profit through the accumulations of assets such as loans. When the extra funds are used as loans and are then deposited into an account, money is created. The importance of this requirement is that if left unchecked too much money could be created. By requiring a set amount to be set aside and held as cash vault or on deposit at the District Federal Reserve Bank, the amount of money created can be regulated. This controlling of the excess reserves is vital to the management of the money supply and value of the available money.

LO-2 Level of Difficulty: Moderate

Answers to "Think for Yourself" Questions 1. $20 million; $5 million 2. The interest rate and quantity of loans both increase; the interest rate decreases and the quantity of loans increases 3. $8.1 – (.1*$8.1) = $7.29 million; $7.29 – (.1*7.29) = $6.56 million 4. $5 million*10 = $50 million; $10 million*5 = $50 million; $10 million*20 = $200 million 5. Buy securities; sell securities 6. Lower the discount rate; increase the discount rate 7. 10; 33.33; $50 million; $1.67 billion

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Answers to Discussion Questions and Problems 1. Decrease the discount rate, decrease the required reserve ratio, and purchase securities on the open market.

2. Money serves as a medium of exchange, unit of account, and store of value. As a medium of exchange, money facilitates transactions by serving as a commonly accept means of payment. As a unit of account, money facilitates transactions by serving as a common benchmark against which to compare the value of goods and services. As a store of value, money allows us to save for future purchases. Checks can be used as a medium of exchange and a unit of account, but a checking account that earns zero interest does not make for a good store of value since inflation will erode the checking account balance's purchasing power over time. Deposits in savings accounts serve as a store of value since they earn interest, but they cannot be used as a medium of exchange without first being converted into cash of checks.

3. Because banks only have to hold a fraction of their deposits as reserves under fractional reserve banking, they can create loans from their excess reserves. The loans of excess reserves create new money in the economy.

4. The money multiplier is the amount by which the money supply can potentially grow from a given deposit into a bank. The larger the money multiplier, the larger impact a given deposit can have on the money supply.

5. If all transactions were conducted in cash, banks would not have deposits or excess reserves. The money multiplier would be zero.

6. Although credit cards can be used to purchase goods and services, they are not money. When you purchase items with a credit card, you have essentially borrowed money from the credit card company and deferred the payment for the goods and services until you pay the credit balance.

Credit cards are loans, not money.

7. a. b. c. d. e.

The bank must maintain 0.10*$150,000,000, or $15,000,000 in required reserves. $30,000,000 - $15,000,000 = $15,000,000 All of its excess reserves, $15,000,000 1/.10 = 10 10 * $15,000,000 = $150,000,000

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Answers to Multiple Choice Questions 1. b 2. c 3. b 4. c 5. d 6. b 7. c 8. a 9. b 10. d

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Chapter 23: Fiscal Policy and the Federal Budget

Chapter Outline 1. The Federal Budget 1.1. Spending 1.2. Revenue 1.2.1. Taxes 1.2.2. Borrowing 2. Federal Deficits and Federal Debt 2.1. Controversies Surrounding Federal Deficits and Debts 2.1.1. Income Inequality 2.1.2. Foreign-Owned Debt 2.1.3. Dangerous Levels of Debt?

2.1.4. Burden on Current and Future Generations 2.1.5. Crowding Out 3. Fiscal Policy 3.1. Aggregate Demand/Aggregate Supply 3.2. Expansionary Fiscal Policy 3.3. Contractionary Fiscal Policy 3.4. Controversies Surrounding Fiscal Policy 3.4.1. Fiscal Policy timing Lags 3.4.2. Fiscal Policy and Politics

Learning Objectives After studying this chapter, students should be able to: • Summarize how the federal budget is allocated • Describe how the government raises money through taxes and borrowing • Explain the difference between government deficits and debts • Illustrate how fiscal policy impacts the economy using an aggregate demand and aggregate supply model • Assess the tradeoffs associated with fiscal policy

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Teaching Notes Short-run economic challenges of unemployment and inflation require different strategies. The strategies available continue with this chapter with a switch of the focus from policies targeting the money supply to policies that center on spending and the components of aggregate demand and aggregate supply, fiscal policy. This chapter looks at governmental efforts to stabilize the economy through spending and taxation, the two tools of fiscal policy.

The chapter begins with the topic of the national budget. How does a government pay for its bills? Helping the students realize what constitutes the national budget and how it is allocated provides them with the key to the understanding of fiscal policy, discretionary and nondiscretionary.

Make a clear distinction between discretionary fiscal spending, policies requiring an act of Congress, and nondiscretionary, federal policies in place that do not require an act of Congress to move forward. Many students may not know, or have not recognized, that unemployment benefits is a type of fiscal policy. The difference between this and an appropriation to create more forest land, for example, is that an application for unemployment benefits does not require approval Congress.

An attention-grabber to begin this chapter is showing students the U.S. Debt Clock, if the class has internet capabilities. Shown in real time, students can see the different components of the U.S. debt and how quickly it is accumulating. By clicking on any of the tabs an explanation is provided about that number in the center header. See below.

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By clicking on “Sequestered Cuts” an explanation is provided in the center header.

Source: http://www.usdebtclock.org/ Budgeting issues are discussed with a conversation of how the Federal Debt is accumulated.

Students are often concerned about the national debt because of the attention to it in the media.

Ask them what them major concern is about the debt. Often their major involves one of the discussed controversies. Spend some time discussing why these particular concerns and allow students time to do their own research to determine if their concern has merit or not.

The chapter concludes with an examination of types of fiscal policy used to address short-run economic concerns. Fiscal policy is an opportunity to use real world experiences to understand the theory.

Using a simple diagram that illustrates nondiscretionary fiscal policy is a good visual for deficit and surplus spending.

Nondiscretionary Fiscal Policy

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Nondiscretionary policy This diagram illustrates the types of budgetary spending. G represents government spending and T represents tax revenue.

Illustrate how nondiscretionary fiscal policy works for students. Also known as automatic stabilizers, nondiscretionary fiscal policy is affected by national income. Consider the diagram on the left of automatic stabilizers.

As real GDP increases, there are more goods and services being produced creating more demand for labor which increases disposable income allowing consumers an option to consume more.

With more people working less public welfare programs such as unemployment benefits are needed. When national income is increasing, taxes increase. When tax revenue is greater than government spending, surplus spending occurs.

However, when real GDP falls, there are fewer goods and services produced. There is more public welfare programs employed to help stabilize lost income, decreasing the demand for labor to produce them. National income falls as does taxes. When tax revenue is less than government spending, deficit spending occurs.

Another potential stumbling block is the recognition by students of the difference between the national debt and the deficit. The U.S. Treasury website provides a historical account of the U. S. from January 1791 to the present. This site, The Historical Debt Outstanding, lists the fiscal year deficit or surplus spending allowing students to recognize the difference. http://treasurydirect.gov/govt/reports/pd/histdebt/histdebt.htm Using Problem Based Learning (PBL) activities will provide students a tool to analyze the types of discretionary fiscal policy that would be appropriate for economic challenges of unemployment and inflation. These types of activities are also beneficial for developing an understanding of the controversies about the national debt and deficit spending. Specific examples follow in the Teaching Tips section.

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A strong potential for a stumbling block for students is the amount of information provided requiring processing on different levels. While this is understood information to you, it is new and potentially confusing to them. Introducing blocks of information to them at a time and allowing them to process this block will help them develop a level of understanding that will benefit them, not only as students, but as citizens.

Students most likely will have heard these terms from different sources, some with their own personal agendas. Providing them with a foundation of knowledge will help them become discernible citizens.

Teaching Activities 1. Using real world data provides a needed connection for students. This chapter touches their everyday lives in very real ways as many of them benefit from current fiscal policies such as student loans and PELL grants. Some may be receiving assistance such as unemployment benefits, Veteran’s Assistance or perhaps other programs that provide assistance for food, lodging, and health care. Examples such as these provide the students a connection to the type of policies that provide benefits based on eligibility requirements rather than political agendas and year-to-year changes.

Have students break into groups and research different types of nondiscretionary policy by accessing actual data from government sources to illustrate an estimate of total current nondiscretionary fiscal policies to the federal budget. The Congressional Budget Office, http://www.cbo.gov/, is a helpful site in providing information and data.

2. After introducing fiscal policy, its’ tools and goals, divide students into small groups of four or five. Ask them to list examples of fiscal policies that they are familiar with. Of course, offering an incentive to participate is helpful to keep the groups engaged. The ever popular bonus point (or two) can be awarded to the group with the most distinct examples of fiscal policies. Provide each group with a large piece of paper to list their conclusions. After approximately 10 minutes have each group hang their findings on the wall. Walk through each group’s results and ask if anyone has a question about any of the examples. Cross off any examples that are not a fiscal policy, i.e., changing interest rates, as obviously this would be an example of monetary policy.

If not included, have each group include interest payments on federal borrowing and changing the length of time the government pays unemployment insurance benefits. Now ask each group to discuss their examples and determine which ones are discretionary and

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which ones are nondiscretionary. Have students put a “D” by those examples that are discretionary and “ND” for the examples that are no discretionary.

3. Students will sometimes trip up over the difference between an average and the margin.

Provide a simple experiment that will give them a visual in their memory bank. Either actually calculate the average age of the students only in the room, or ask them to give you an estimate of the average age of the students in the room. Say it’s 20 years old.

Now ask them what would happen to the average if you add your age to the average.

Unless you are 20 years old, the average will increase. Why? Because adding one more age to the group, your age, will increase the average. Now, ask the student what is the value of the margin of this case? It’s 20. Because the margin is the value of the next person being added to the group.

The marginal tax rate is the rate of the next dollar of income. For example, your tax bracket is 10% on income between $10,000 and $25,000. However, when your income falls into the range of between $25,001 and $40,000 your tax obligation is 25%. What is the marginal tax rate for $25,001? It is 25%. It is the rate on the next dollar of income.

4. While the term is used frequently, do students recognize the magnitude of a trillion? Ask them to calculate how long it would take to spend a trillion dollars if they spent $1,000/days, $10,000/day. Answer: If you spent $1 trillion at a rate of $1,000 per day it would take you 2,739,726.03 years to get it all spent. If you upped your rate of spending to $10,000 per day it would take you considerable less to spend a million dollars, 273,972.6 years.

Additional Questions and Discussion Points 1. Let students be policy makers. Give students scenarios and ask them what would be their thoughts concerning fiscal policy? a. The economy has been growing at a steady, sustainable pace for about one year.

Unemployment is near natural rates of unemployment, and price levels have shown no signs of heating up. An unexpected and severe increase in the price of oil is experienced, causing prices of gasoline and other forms of energy to shoot up 25%. Businesses have begun to cut production to curtail costs. The average number of hours worked per week, as a national average, has fallen from 35 hours to 28 hours. What are your recommendations for fiscal policy options?

Answer: Answers will vary. Until this supply shock, the economy had been growing at a sustainable rate and had not shown signs of excessive unemployment

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or inflation. One prudent course of action at this immediate time would be to allow the automatic stabilizers handle decreases in income. Monitoring economic indicators would also be needed at this time to determine loss of confidence by consumer and increases in cyclical unemployment. If/When these indicators reveal a worsening economic conditions, discretionary policy can then be put into place.

LO-4 Level of Difficulty: Moderate b. If you were a current member of Congress, what would be your recommendations for fiscal policy?

Answer: Answers will vary. What is the intent of the student? Is it to shift aggregate demand to the right, or increase aggregate demand? Examples of expansionary fiscal policy are necessary. Is the goal of the students’ intent to slow the economy, shifting aggregate demand and aggregate supply to the left? If so, contractionary fiscal policy is necessary.

LO-4 Level of Difficulty: Moderate 2. What are the opportunity costs of fiscal policies?

Answer: The opportunity costs of fiscal policies depend upon the type of policy employed.

Contractionary fiscal policy is used to curb, or slow down, inflationary pressure, but it comes at a cost of lost production. Interesting Note: In the real world, it is interesting to note that because the aggregate demand side fiscal policy, cutting government spending and increasing taxes, rarely fit into political agendas they are seldom used and that Congress looks to Monetary policy to handle an economy that is heating up and experiencing pressure on prices.

When expansionary fiscal policies are employed, decreasing of taxes and increasing government spending, the opportunity cost of the increased output is raising price levels.

LO-5 Level of Difficulty: Moderate

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3. Consider the above graph. What would be appropriate changes in fiscal policy to increase Aggregate Demand from AD1 to AD2?

Answer: Discretionary fiscal policy to expand the economy would be appropriate. This would include an increase in Government spending and a decrease in taxes.

LO-4 Level of Difficulty: Moderate

Answers to “Think for Yourself” Questions 1. Discretionary spending is subject to policymaker choice. Nondiscretionary spending is not determined by policymaker choices. Spending on national defense is an example of discretionary policy since policymakers can decide on the level of national defense spending each year. Spending on social security is an example of nondiscretionary policy because social security is paid based on eligibility rather than on policymaker choices from year to year.

2. Your tax bill would be (8,375*0.10) + ((34,000-8,375)*0.15) + ((82,400-34,000)*0.25) + ((100,000-82,400)*0.28) = $21,709 3. A federal budget deficit occurs when the government spends more than it collects in tax revenue in a given year. The federal debt is the sum of all of the budget deficits from the past, plus their associated interest charges.

4. Crowding out will be larger when the supply of loans is more elastic because the decline in the quantity of loans made will be larger. Crowding out will be smaller when the supply of loans is more inelastic because the quantity of loans made will not change by much when supply is relatively inelastic.

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5. Between AD3 and AD4, the aggregate supply curve is relatively inelastic so changes in AD to not have very large impacts on GDP. Between AD1 andAD2, the aggregate supply curve is relatively elastic, so changes in AD cause larger changes in GDP.

Answers to Discussion Questions and Problems 1. Expansionary fiscal policy includes increased government spending or decreased taxation. One example of an expansionary fiscal policy is the Civilian Conservation Corps, a public works program where unemployed men built roads, bridges, and other infrastructure during the Great Depression. Other examples of expansionary fiscal policy include building tools and equipment to support national defense during World War II, and growing the “green jobs” industry in the US in response to the 2007-2009 recession.

Contractionary fiscal policy includes increased taxation or decreased government spending.

2. Contractionary fiscal policy is usually used to combat inflation, since reductions in aggregate demand are associated with reductions in the price level in the AD/AS model.

Governments enact expansionary fiscal policy to increase employment and spur economic activity during recessions.

3. No. Personal credit card debt is not part of the federal debt. The federal debt only includes borrowing by the federal government in response to budget deficits.

4. The most prominent benefit of federal debt is that debt allows for expansionary fiscal policy during recessionary periods. Many economists argue that recessions would be worse without the flexibility that incurring debt allows. The costs of federal debt include the interest charges, the tax burden that the debt places on future generations, crowding out, impacts on income inequality, and the potential risk associated with foreign ownership of the debt.

5. A balanced budget amendment would impose a legal restriction that prohibits the federal government from running a budget deficit. The benefit of a balanced budget amendment is that it would constrain policymakers from allowing more government spending than can be financed through taxes. Over time, this would reduce the federal debt. One cost of a balanced budget amendment is the loss of flexibility to use debt-financed expansionary fiscal policy during recessions.

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Answers to Multiple Choice Questions 1. b 6. d

2. e 7. b

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3. a 8. d

4. b 9. f

5. c 10. c

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