Instructor Manual for Karlan Morduch, Microeconomics, 2nd Canadian Edition

Type:

Instructor Manual

Resource:

Microeconomics

Edition:

2nd Edition

Author(s):

Dean S. Karlan Jonathan J. Morduch Rafat Alam Andrew Wong

Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

CHAPTER 1 ECONOMICS AND LIFE Chapter Overview Economists approach problems differently from many other people. Underlying economics is the basic principle of rational behavior—that people make choices to achieve their goals in the most effective way possible. In this chapter we have introduced the basic concepts economists use, as well as four questions they ask to break down problems. Throughout this book, students will see these concepts and questions over and over again: 1. Scarcity: What are the wants and constraints of those involved?

2. Opportunity cost: What are the trade-offs?

3. Incentives: How will others respond?

4. Efficiency: Why isn’t everyone already doing it?

In later chapters, as we progress to more complicated problems, students should use these four questions to break down problems into manageable pieces, ones they can understand using the fundamental concepts presented in this chapter.

Learning Objectives LO 1.1: Explain the economic concept of scarcity.

LO 1.2: Explain the economic concepts of opportunity cost and marginal decision making.

LO 1.3: Explain the economic concept of incentives.

LO 1.4: Explain the economic concept of efficiency.

LO 1.5: Distinguish between correlation and causation.

LO 1.6: List the characteristics of a good economic model.

LO 1.7: Distinguish between positive and normative analysis.

Chapter Outline OPENING STORY: MAKING AN IMPACT WITH SMALL LOANS The Basic Insights of Economics Scarcity (LO 1.2) Performance and decision making (LO 1.3) BOX FEATURE: WHAT DO YOU THINK? – THE OPPORTUNITY COST OF A LIFE Incentives (LO 1.4) Efficiency (LO 1.5) An Economist’s Problem-Solving Toolbox richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

Correlation and Causation (LO 1.6) Correlation without Causation (LO 1.6) Omitted variables (LO 1.6) BOX FEATURE: FROM ANOTHER ANGLE – DOES ICE CREAM CAUSE POLIO? Reverse causation (LO 1.6) Models (LO 1.7) BOX FEATURE: REAL LIFE – TESTING MODELS AGAINST HISTORY Positive and Normative Analysis (LO 1.8) BOX FEATURE: WHAT DO YOU THINK? – THE COST OF UNIVERSITY EDUCATION

Conclusion Beyond the Lecture Class Discussion: Scarcity (LO 1.2) Have students review this recent TED talk by Peter Diamandis. Peter highlights the impact of human ingenuity on scarcity and argues that we should be optimistic about the use of technology to address problems in the future. This is a great springboard for discussion.

1. Do students think that technology will continue to improve living standards and mitigate the problems associated with scarcity?

Writing Assignment: Opportunity Cost and Marginal Decision Making (LO 1.3) Have students review this article by Russell Roberts on opportunity cost. It highlights some basic examples that are familiar to students. Require students to write a brief essay on the opportunity costs associated with decisions in their lives, decisions that firm’s make, or government decisions. This can be used as a catalyst for class discussion as well.

Class Discussion: Opportunity Cost and Marginal Decision Making (LO 1.4) Consider playing the song “Should I Stay or Should I Go” by The Clash to start an early class. It is a great way to start a conversation about marginal decision making, a topic that can be difficult for students to understand. This example is found at the website “From Abba to Zeppelin, Led: Using Music to Teach Economics,” located here.

1. How should someone make a decision based on additional benefits and costs?

2. What information does the decision maker need?

Class Discussion: Incentives (LO 1.5) In order to highlight the importance of incentives, consider discussing Chapter 3 of Freakonomics by Steven Levitt and Stephen Dubner with your students. The chapter provides insight into the career of an individual who is involved in the illegal drug market. You could also ask students to review this Los Angeles Times commentary on the chapter, also written by Levitt and Dubner.

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

1. Ask students to consider why an individual would be willing to endure the risks associated with the illegal drug market given the relatively low pay and poor working conditions that many workers endure. Students really enjoy this interesting discussion.

2. How does this market compare to other markets? There are surprising similarities and differences between legal markets and the black market.

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Suppose you are shopping for new clothes to wear to job interviews, but you’re on a tight budget. In this situation, what are your wants and constraints? What does it mean to behave rationally in the face of scarcity? [LO 1.2] Answer: If you are deciding what to buy for a job interview, your want is to buy clothing that looks clean and professional, so you can present the best possible impression to potential employers. Your constraint is the amount of money you can spend on this clothing. A person behaving rationally would buy the nicest clothes they could afford.

2. You are a student with a demanding schedule of classes. You also work part-time and your supervisor allows you to determine your schedule. In this situation, what is your scarce resource? How do you decide how many hours to work? [LO 1.2] Answer: Your scarce resource is time. You need both time to study and time to work.

Presumably, you want to do well in school and also make money. You will try to balance your schedule so that you work as much as possible while still having enough time to study and do well in school.

3. Think about the definition of scarcity that you learned in this chapter. Name three ways that you confront scarcity in your own life. [LO 1.2] Answer: We face scarcity in many aspects of our lives. I love to travel and explore new places. I face scarcity in both time and money that keeps me from traveling as often as I would like. In my professional life, I also face scarcity. There are lots of worthy projects I would like my department to take on, but I am limited in my available resources of employees, time, and budget. Collectively, as a society, we want more camping sites in the summer months. But there are limited number of sites available.

4. When shopping for your interview clothes, what are some trade-offs you face? What is the opportunity cost of buying new clothes? What are the benefits? How do you balance the two? [LO 1.3] Answer: The money you spend on clothes for a job interview could be spent on other things instead, so it is one opportunity cost. Another opportunity cost is the time you spend shopping, which could be spent preparing for your interview or playing Frisbee. The benefits include looking put-together during the interview, which provides a boost to your job

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

prospects. You balance the costs and benefits by accepting costs that are less than (or no greater than) the benefits they provide.

5. You have an 8:00 class this morning but you are feeling extremely tired. How do you decide whether to get some extra sleep or go to class? [LO 1.3] Answer: If you are behaving rationally, you decide by comparing the trade-offs. The opportunity cost of going to class is missing out on some extra sleep. Depending on what else in on your schedule that day (perhaps an important job interview), it may make sense to choose extra sleep over class. The opportunity cost of extra sleep is that you will miss the lecture. If your grade will suffer significantly by your absence, you may want to grab some coffee and go to class!

6. It’s Friday night. You already have a ticket to a concert, which cost you $30. A friend invites you to go out for a game of paintball instead. Admission would cost you $25, and you think you’d get $25 worth of enjoyment out of it. Your concert ticket is nonrefundable. What is your opportunity cost (in dollars) of playing paintball? [LO 1.3] Answer: The opportunity cost of going to play paintball is whatever amount of enjoyment (in dollars) you would get out of going to the concert. The thirty dollars you paid for the concert ticket is not relevant to the decision, as it is a sunk cost and is nonrefundable regardless of what you do.

7. Suppose you have two job offers and are considering the trade-offs between them. Job A pays $45,000 per year and includes health insurance and two weeks of paid vacation. Job B pays $30,000 per year and includes four weeks of paid vacation but no health insurance.

[LO 1.3] a. List the benefits of Job A and the benefits of Job B. b. List the opportunity cost of Job A and the opportunity cost of Job B. Answer: a. The benefits of Job A are the extra pay and health insurance. For Job B, the benefit is two extra weeks of vacation. b. The opportunity cost of Job A is losing out on the extra two weeks of vacation that comes with Job B. For Job B, the opportunity costs are the extra $15,000 in salary along with the health insurance.

8. Your former neighbor gave you his lawnmower when he moved. You are thinking of using this gift to mow lawns in your neighborhood this summer for extra cash. As you think about what to charge your neighbors and whether this idea is worth your effort, what opportunity costs do you need to consider? [LO 1.3] richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

Answer: You need to consider the opportunity cost of your time. Your lawn mowing business would need to cover the opportunity cost of what you could earn in another summer job. You also need to consider the cost of gasoline for the mower and the value of the lawn mower itself. Just because it was a gift does not mean that it has no opportunity cost. The opportunity cost of using the lawnmower for your business is its sale value, if you decide to sell the gift rather than use it yourself. Your lawn mowing business needs to cover all of these costs (the value of your time in another job, gasoline, and the sale value of the lawnmower) in order for it to be a worthwhile endeavor.

9. Think of a few examples of incentives in your daily life. How do you respond to those incentives? [LO 1.3] Answer: Throughout the day, I am reminded to not park in the wrong spot (lest I get a ticket), get five cents for every glass I recycle, and set aside five percent of my income to a RRSP. For the most part, I respond rather favorably to these incentives.

10. You supervise a team of salespeople. Your employees already receive a company discount.

Suggest a positive incentive and a negative incentive you could use to improve their productivity. [LO 1.4] Answer: For a positive incentive, you could offer a reward such as a bonus, a gift certificate, or an extra discount on company merchandise to the most productive employee of the month. For a negative incentive, you could announce that employees who fail to meet targets will lose their company discount.

11. Your boss decides to pair workers in teams and offer bonuses to the most productive team.

Why might your boss offer team bonuses instead of individual bonuses? [LO 1.4] Answer: Your boss is creating a reward system for a project that requires group effort. Even if you are not motivated to compete for an individual bonus, you are likely to feel responsibility to your teammate and make a greater effort to be productive. Your teammate can encourage, pressure, and/or help you to achieve greater productivity.

12. Think of a public policy—a local or national law, tax, or public service—that offers an incentive for a particular behavior. Explain what the incentive is, who is offering it, and what they are trying encourage or discourage. Does the incentive work? [LO 1.4] Answer: Provincial and federal governments provide subsidy on green energy projects. This provides an incentive for electricity producers to switch their production to renewable sources. They are trying to encourage the production of green energy to reduce the carbon emission in Canada. This incentive will change the composition of electricity production in the long run. richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

13. Why do individuals or firms usually provide the goods and services people want? [LO 1.5] Answer: If firms didn’t produce goods that people want, no one would buy their goods.

These firms would lose money and go out of business, and would be replaced by firms that did produce goods that customers want.

14. You may have seen TV advertisements for products or programs that claim to teach a surefire way to make millions on the stock market. Apply the Why isn’t everyone already doing it? test to this situation. Do you believe the ads? Why or why not? [LO 1.5] Answer: Guessing which stocks are going to perform well and which are going to tank is a hard if not impossible task, which makes it very hard to make millions in the stock market.

You should not believe the ads for that reason. (If there really was a surefire way to make millions, you can bet everyone would already be doing it!)

15. Describe an innovation in technology, business, or culture that had a major economic impact in your lifetime. [LO 1.5] Answer: The Internet has completely changed the way people do business. While writing this textbook, we have collaborated with people all over the country, sharing documents online that we once would have had to send through the mail.

16. Why do people confuse correlation with causation? [LO 1.6] Answer: Correlation means that two events occur together. Since the two often occur together, people often believe that one causes the other, but this is not always true. People once thought that ice cream caused polio, for example. The real relationship was that people ate more ice cream in the summer, and this also happened to be the time of year that the polio virus spread more rapidly.

17. Name two things that are positively correlated and two things that are negatively correlated. [LO 1.6] Answer: Things that are positively correlated tend to occur together. In my household, candy and children are positively correlated. I don’t have much of a sweet tooth, but I always stock up on candy when the nieces and nephews visit. Things that are negatively correlated tend not to occur together. According to auto insurers, good grades and the risk of getting in a car accident are negatively correlated. (People with higher grades tend to be safer drivers.) richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

18. Why is it important for a good economic model to predict cause and effect? [LO 1.7] Answer: A good model must predict cause and effect so that it can explain something about what we have observed and can help us anticipate what will happen in future observations.

19. Why is it important for a good economic model to make clear assumptions? [LO 1.7] Answer: A good model must make clear assumptions so we know when the model will do a good job at explaining or predicting our observations and when it will not.

20. Describe an economic model you know. What does the model predict about cause and effect? [LO 1.7] Answer: As mentioned in this chapter, the model of demand that you will explore in Chapter 3 predicts that a rise in price will cause a decrease in the quantity of a good consumers want to buy and a decrease in price will cause an increase in the quantity of a good consumers want to buy. Think about your own willingness to purchase goods. For most goods, you want to purchase more when the price falls and less when the price goes up. The model does a good job at predicting cause and effect.

21. Describe an economic model you know. What assumptions does the model make? Are the assumptions reasonable? [LO 1.7] Answer: In predicting that price increases will cause consumers to purchase less of a good, the model of demand assumes that consumers behave rationally, respond to incentives, and are aware of other alternatives to consuming the good whose price has gone up. These are reasonable assumptions. For most goods, consumers are aware of their preferences and available alternatives. And consumers can usually be relied upon to act rationally enough to spend their resources on the best bundle of goods they can afford.

22. What is the difference between disagreeing about a positive statement and disagreeing about a normative statement? [LO 1.8] Answer: A positive statement is something that is supposed by fact, whereas a normative statement is a value judgment. So disagreeing with a normative statement means you disagree with someone’s opinion. Disagreeing with a positive statement means disputing the truth of fact.

23. Would a good economic model be more likely to address a positive statement or a normative statement? Why? [LO 1.8] Answer: A good model predicts cause and effect and can be tested with evidence. Thus, positive statements are more likely to be addressed by a good model. richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

24. Write a positive statement and a normative statement about your favorite hobby. [LO 1.8] Answer: Positive statement: Cultures around the world use food to convey social values.

Normative statement: Food is the best way to understand the social values of a culture.

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

Problems and Applications 1. Think about how and why goods and resources are scarce. Goods and resources can be scarce for reasons that are inherent to their nature at all times, temporary or seasonal, or that are artificially created.

Separate the goods listed below into two groups; indicate which (if any) are artificially scarce (AS), and which (if any) are inherently scarce (IS). [LO 1.2] a. air of any quality b. land c. patented goods d. original Picasso paintings Answer: Goods and resources can be scarce for reasons that are inherent to their nature at all times, temporary or seasonal, or artificially created. a. Not scarce. Air (of any quality) is abundant and need not be rationed through prices or some other allocation mechanism b. Inherently scarce. Land is finite in supply; land is available for development, but no new land can be created. c. Artificially scarce. Patented goods are scarce by law; only the patent holder may supply these goods d. Inherently scarce. Original Picasso paintings are finite; no new Picasso’s can be created beyond those that currently exist 2. You are looking for a new apartment in Edmonton. Your income is $4,000 per month, and you know that you should not spend more than 25 percent of your income on rent. You have come across the following listing for one-bedroom apartments on Kijiji. You are indifferent about location, and transportation costs are the same to each neighborhood. [LO 1.3] Downtown

$1,500

Allendale

1,200

MacEwan

1,000

Queen Mary Park

900

a. Which apartments fall within your budget? (Check all that apply.) b. Suppose that you adhere to the 25 percent guideline but also receive a $1,000 cost-ofliving supplement since you are living and working in Toronto. Which apartments fall within your budget now?

Answer: richard@qwconsultancy.com

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a. MacEwan and Queen Mary Park. Your income and income guidelines represent a constraint on the choices available. Under these guidelines, 25 percent of your monthly income is $1,000. So the only apartments you can afford within your budget are located in MacEwan (at $1,000) and Queen Mary Park ($900). All others are unattainable to you. b. The $1,000 monthly cost-of-living supplement expands your set of living options. You can now afford any apartment that costs $2,000 or less. All the various areas are now a possibility.

3. Suppose the price of a sweater is $15. Julia’s benefit from purchasing each additional sweater is given in the table below. Julia gets the most benefit from the first sweater and less benefit from each additional sweater. If Julia is behaving rationally, how many sweaters will she purchase? [LO 1.3]

Answer: Julia will purchase all of the sweaters for which the marginal benefit is greater than the marginal cost. If the price of a sweater is $15, this is the marginal cost, as each additional sweater will cost $15. For the first four sweaters, the marginal benefit exceeds the marginal cost, so Julia will purchase four sweaters. For the fifth sweater, the marginal cost of $15 exceeds the marginal benefit.

1st sweater 2nd sweater 3rd sweater 4th sweater 5th sweater 6th sweater

Marginal Benefit $50 $35 $30 $23 $12 $8

Marginal Cost $15 $15 $15 $15 $15 $15

4. Sweaters sell for $15 at the crafts fair. Allie knits sweaters and her marginal costs are given in the table below. Allie’s costs increase with each additional sweater. If Allie is behaving rationally, how many sweaters will she sell? [LO 1.3]

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Answer: Allie will sell all of the sweaters for which the marginal benefit is greater than the marginal cost. If the price of a sweater is $15, this is the marginal benefit, as Allie will receive $15 for each additional sweater she sells. For the first three sweaters, the marginal benefit exceeds the marginal cost, so Allie will sell three sweaters.

1st sweater 2nd sweater 3rd sweater 4th sweater 5th sweater 6th sweater

Marginal Cost $5 $8 $12 $18 $25 $32

Marginal Benefit $15 $15 $15 $15 $15 $15

5. Last year, you estimated you would earn $5 million in sales revenues from developing a new product. So far, you have spent $3 million developing the product, but it is not yet complete. Meanwhile, this year you have new sales projections that show expected revenues from the new product will actually be only $4 million. How much should you be willing to spend to complete the product development? [LO 1.3] a. $0. b. Up to $1 million. c. Up to $4 million. d. Whatever it takes.

Answer: Up to $4 million. The $3 million you have spent already is a sunk cost and cannot be recovered. Therefore, the $3 million you have spent is irrelevant to the decision of how much to spend going forward. This year, the relevant decision is: How much are you willing to spend to have $4 million in revenue? If you had known that product development may cost you more than you will gain in revenues, you should not have started this project. But at this point, by thinking on the margin you can see that you should be willing to move forward as long as the costs of going forward are not greater than the benefits of going forward ($4 million). richard@qwconsultancy.com

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6. Consider the following examples. For each one, say whether the incentive is positive or negative. [LO 1.4] a. Bosses who offer time-and-a-half for working on national holidays. b. Mandatory minimum sentencing for drug offenses. c. Fines for littering. d. Parents who offer their children extra allowance money for good grades.

Answer: a. Positive. b. Negative. c. Negative. d. Positive.

7. Consider the following events that change prices. For each one, say whether the opportunity cost of consuming the affected good increases or decreases. [LO 1.4] Affected good a. A local movie theater offers a student discount. b. A tax on soft drinks passes in your province. c. Subsidies on corn are cut in half. d. Your student union begins offering bus passes for free.

Movie tickets Soft drinks Corn subsidies Bus passes

Answer: a. Decreases. b. Increases. c. Increases. d. Decreases.

8. Your best friend has an idea for a drive-through bar. Indicate the best explanation for why others have not taken advantage of her idea: true innovation, market failure, government intervention, unprofitable. [LO 1.5] Answer: Government intervention. In most places, drive-thru bars are (wisely) illegal.

9. Your best friend has an idea for a long-distance car service to drive people across the country. Indicate the best explanation for why others have not taken advantage of her idea: true innovation, market failure, intervention, unprofitable. [LO 1.5] Answer: Unprofitable. There are alternatives for customers that can be cheaper than car service. For example, buses can offer cheaper prices than a car service could. While a car is richard@qwconsultancy.com

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less costly to operate than a bus, a bus can more than make up the difference in operation cost by accommodating many more passengers.

10. Determine whether each of the following questionable statements is best explained by correlation without causation, an omitted variable, or reverse causation. [LO 1.6] a. In cities that have more police, crime rates are higher. b. Many retired people live in provinces where everyone uses air conditioning during the summer. c. More people come down with the flu during the Winter Olympics than during the Summer Olympics. d. For the last five years, Wiarton Willie has seen his shadow on Groundhog Day, and spring has come late.

Answer: a. Reverse causation. b. Omitted variable. c. Correlation without causation. d. Correlation without causation.

11. For each of the pairs below, determine whether they are positively correlated, negatively correlated, or uncorrelated. [LO 1.6] a. Time spent studying and test scores. b. Vaccination and illness. c. Soft drink preference and music preference. d. Income and education.

Answer: a. Positively correlated. e. Negatively correlated. f. Uncorrelated. g. Positively correlated.

13. Each statement below is part of an economic model. Indicate whether the statement is a prediction of cause and effect or an assumption. [LO 1.7] a. People behave rationally. b. If the price of a good falls, people will consume more of that good. c. Mass starvation will occur as population outgrows the food supply. d. Firms want to maximize profits.

Answer: a. Assumption. richard@qwconsultancy.com

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b. Prediction of cause and effect. c. Prediction of cause and effect. d. Assumption.

14. From the list below, select the characteristics that describe a good economic model. [LO 1.7] a. Includes every detail of a given situation. b. Predicts that A causes B. c. Makes approximately accurate assumptions. d. Fits the real world perfectly. e. Predicts things that are usually true.

Answer: A good model should predict cause and effect (b), state its assumptions clearly (c) and predicts things that are usually true (e). Economists test their models by observing what happens in the world and collecting data that can be used to support or reject their models.

15. Determine whether each of the following statements is positive or normative. (Remember that a positive statement isn’t necessarily correct; it just makes a factual claim rather than a moral judgment.) [LO 1.8] a. People who pay their bills on time are less likely than others to get into debt. b. Hard work is a virtue. c. Everyone should pay his or her bills on time. d. China has a bigger population than any other country in the world. e. China’s One-Child Policy (which limits families to one child each) helped to spur the country’s rapid economic growth. f. Lower taxes are good for the country.

Answer: A statement that makes a factual claim about how the world actually works is called a positive statement. A statement that makes a claim about how the world should be is called a normative statement. Economics is a field in which people frequently confuse positive statements with normative statements. However, you do not have to adopt a particular moral or political point of view to use economic concepts and models. a. Positive. b. Normative. c. Normative. d. Positive. e. Positive. f. Normative.

16. You just received your midterm exam results and your professor wrote the following note: “You received a 70 on this exam, the average score. If you want to improve your grade, you should study more.” Evaluate your professor’s note. [LO 1.8] a. Is the first sentence positive or normative? richard@qwconsultancy.com

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b. Is the second sentence positive or normative?

Answer: A statement that makes a factual claim about how the world actually works is called a positive statement. A statement that makes a claim about how the world should be is called a normative statement. Economics is a field in which people frequently confuse positive statements with normative statements. However, you do not have to adopt a particular moral or political point of view to use economic concepts and models. a. Positive. b. Normative.

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

CHAPTER 2 SPECIALIZATION AND EXCHANGE Chapter Overview

Specialization and trade can make everyone better off. It is not surprising, then, that in an economy driven by individuals seeking to make a profit or to make the biggest difference in their communities, people specialize so as to exploit their comparative advantages. The principle is as true for countries, like Canada and China, as it is for individuals picking their careers. No government intervention is required to coordinate production. The great economic thinker Adam Smith suggested the term invisible hand to describe this coordinating mechanism:

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 [self-interest]. . . . he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. (A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776.)

The functioning of the invisible hand depends on a lot of other assumptions, such as free competition, full information, and many others that do not always hold true in the real world. Later in the book we will discuss these assumptions, and when they work and when they do not.

Most people take for granted the prevalence of specialization and trade in their everyday lives. Few stop to think about the benefits and where they come from. In this chapter we tried to dig down to the bottom of the assumptions people make and expose the logic behind the gains from trade. As we proceed—especially when we return to topics like international trade and government intervention in the markets—students must

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remember the underlying incentive that drives people to interact with one another in economic exchanges.

Learning Objectives

LO 2.1: Construct a production possibilities graph and describe what causes shifts in production possibilities curves.

LO 2.2: Define absolute and comparative advantage.

LO 2.3: Define specialization and explain why people specialize.

LO 2.4: Explain how the gains from trade follow from comparative advantage.

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Chapter Outline

OPENING STORY: THE ORIGINS OF A T-SHIRT Production Possibilities Drawing the Production Possibilities Frontier (LO 2.1) Choosing Among Production Possibilities Shifting the Production Possibilities Frontier Absolute and Comparative Advantage Absolute Advantage (LO 2.2) Comparative Advantage BOX FEATURE: FROM ANOTHER ANGLE – STORY OF MULTI-TALENTED ATHLETS Why Trade?

Specialization (LO 2.3) BOX FEATURE: REAL LIFE – SPECIALIZATION SAUCE Gains from Trade (LO 2.4) BOX FEATURE: WHAT DO YOU THINK? – IS SELF-SUFFICIENCY A VIRTUE? Comparative Advantage over Time BOX FEATURE: REAL LIFE – CALL CENTERS

Beyond the Lecture

Class Discussion: Production Possibilities (LO 2.1)

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In order to highlight the concept of the production possibilities curve, have students consider the production possibilities curve for a student deciding how to study for two exams given a fixed timeframe. This helps to highlight the concept of tradeoffs for students, as you can ask them to consider the tradeoff between grades on the two exams. Assume that the students have a fixed number of hours in one evening to study for two large exams the following day.

3. What tradeoffs does a student face when deciding how to spend his or her time?

4. What factors should the student consider when making the decision regarding how to study?

5. Why might different students make different decisions regarding how to spend the hours studying?

Class Discussion: Absolute and Comparative Advantage (LO 2.2) Have students view a brief clip from the movie Tommy Boy to highlight comparative advantage, specifically from 52:26 – 55:43 (or a little longer if you prefer). In the clip, Tommy (Chris Farley) and Richard (David Spade) realize their relative strengths: Tommy is a people person and Richard is good with numbers.

1. What are Tommy’s skills relative to Richard’s?

2. How could they utilize their relative strengths? Do they do this in the movie?

3. How do people try to leverage their comparative advantage in reality?

Writing Assignment: Specialization (LO 2.3) Have students read (or listen to the audio book for) I, Pencil by Leonard E. Read. Ask students to write a brief essay on why no single individual can personally produce even a seemingly simple product like a pencil.

Class Activity: Gains from Trade (LO 2.4) A simple trading exercise can highlight the concept of gains from trade for students. Bring a few bags of chips or other snacks to class and distribute them to students (you may choose only a few students for this activity in a large lecture).

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1. Ask each student to rate their satisfaction with the snack you’ve given them on a scale from 1-10, with 1 being highly dissatisfied and ten being highly satisfied.

Record their answers somewhere where all students can see.

2. Ask the students if they want to trade, and give them a few minutes to interact and exchange snacks. (Remind them that it must be voluntary—they do not have to trade if they do not wish to.)

3. Ask the students about their satisfaction again, this time with their new snack. Have the students explain any changes in their answer from before.

After trading, students should be at the very least equally as well off in terms of satisfaction as the first time they answered. This exercise can be used to highlight the gains from trade.

You can also discuss the fact that the original distribution matters as well. This can tie into a number of discussions, including income distribution and comparative advantage.

Solutions to End-of-Chapter Questions and Problems

Review Questions

1. You’ve been put in charge of a bake sale for a local charity, at which you are planning to sell cookies and cupcakes. What would a production possibilities graph of this situation show? [LO 2.1] Answer: On one axis, the production possibilities graph would show the total number of cookies you could bake if you spent all of your time and resources baking cookies.

The other axis would show the total amount of cupcakes you could bake if you spent all of your time and resources baking cupcakes. The two endpoints would be connected by a downward-sloping line. The slope of this line would represent the tradeoff (opportunity cost) you face between baking cookies and baking cupcakes. If you bake more cupcakes, you must bake fewer cookies. The production possibilities graph would show all of the combinations of cookies and cupcakes you could produce with your time and resources.

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2. You manage two employees at a pet salon. Your employees perform two tasks: giving flea baths and grooming animals. If you constructed a single production possibilities frontier for flea baths and grooming that combined both of your employees, would you expect the production possibilities frontier to be linear (a straight line)? Explain why or why not. [LO 2.1] Answer: You would not expect a production possibilities frontier that combined both of your employees to be linear. Each worker would likely differ in her relative skills at grooming and giving flea baths and would therefore differ in the opportunity cost for performing each task.

3. Back at the bake sale (see review question 1), suppose another volunteer is going to help you bake. What would it mean for one of you to have an absolute advantage at baking cookies or cupcakes? Could one of you have an absolute advantage at baking both items? [LO 2.2] Answer: If you have an absolute advantage in the production of cupcakes (or cookies) it means that you can produce more cupcakes (or cookies) in total with the same amount of resources than the other volunteer. Absolute advantage is about having greater productivity. You could have an absolute advantage in baking both cupcakes and cookies if you are more productive in both goods than the other volunteer.

4. What would it mean for you or the other volunteer to have a comparative advantage at baking cookies or cupcakes? Could one of you have a comparative advantage at baking both items? [LO 2.2] Answer: If you had a comparative advantage in baking cookies, it would mean that you have a lower opportunity cost (you give up fewer cupcakes for each cookie you bake) than the other volunteer. It is not possible for you to have a comparative advantage in baking both goods. If you have a comparative advantage in baking cookies, the other volunteer will have a comparative advantage in baking cupcakes.

5. Suppose you have a comparative advantage at baking cookies, and the other volunteer has a comparative advantage at baking cupcakes. Make a proposal to the volunteer richard@qwconsultancy.com

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about how to split up the baking. Explain how you can both gain from specializing, and why. [LO 2.3] Answer: If you have a comparative advantage in baking cookies and the other volunteer has a comparative advantage in baking cupcakes, then you should specialize in baking cookies and the other volunteer should specialize in baking cupcakes. If you spend all of your time baking cookies and the other volunteer spends all of his time backing cupcakes, you will wind up with more cookies and cupcakes between you than you would have if you each spent half of your time baking each good.

6. At the flower shop, where you manage two employees, your employees perform two tasks: caring for the displays of cut flowers and making flower arrangements to fill customer orders. Explain how you would approach organizing your employees and assigning them tasks. [LO 2.3] Answer: You would have your employees specialize by caring for the displays of cut flowers to the worker who has the comparative advantage (lower opportunity cost) in doing that task. This worker should care for the flowers and switch to filling customer orders only grooming if there are orders left to do after all the cut flowers have been cared for (water changed, old blooms removed, etc.). You would assign making floral arrangements to fill customer orders to the worker who has the comparative advantage in that task. This worker should fill customer orders and switch caring for the cut flower displays only if there is such work left to do after customer orders have been filled.

7. Suppose two countries produce the same two goods and have identical production possibilities frontiers. Do you expect these countries to trade? Explain why or why not.

[LO 2.4] Answer: We would not expect countries with the same production possibilities frontiers to trade. Identical production possibilities frontiers would indicate that the two countries faced the same opportunity costs. The basis for gains from trade is specializing according to differing opportunity costs.

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8. Brazil is the largest coffee producer in the world, and coffee is one of Brazil’s major export goods. Suppose that in twenty years, Brazil no longer produces much coffee and imports most of its coffee instead. Explain why Brazil might change its trade pattern over time. [LO 2.4] Answer: Brazil would change from exporting to importing coffee if its comparative advantages change. Over time, Brazil could lose its comparative advantage in coffee if its opportunity costs for growing coffee increase. If this were the case, we would expect Brazil to gain a comparative advantage elsewhere.

Problems and Applications

1. Your friend Sam has been asked to prepare appetizers for a university reception. She has an unlimited amount of ingredients but only 6 hours to prepare them. Sam can make 300 mini-sandwiches or 150 servings of melon slices topped with smoked salmon and a dab of sauce per hour. [LO 2.1] a. Draw Sam’s production possibilities frontier. b. Now suppose that the university decides to postpone the reception until after the big game, and Sam has an extra 4 hours to prepare. Redraw her production possibilities frontier to show the impact of this increase in resources. c. Now, in addition to the extra time to prepare, suppose Sam’s friend Chris helps by preparing the melon slices. Sam can now make 300 mini-sandwiches or 300 melon appetizers per hour. Redraw Sam’s production possibilities frontier to show the impact of increased productivity in making melon appetizers.

Answer: richard@qwconsultancy.com

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a. 300 mini-sandwiches/hr = 1,800 mini-sandwiches in 6 hours. This is the endpoint on the Y-axis. 150 melon appetizers/hr = 900 melon appetizers in 6 hours. This is the endpoint on the X-axis. b. 300 mini-sandwiches/hr = 3,000 mini-sandwiches in 10 hours. This is the endpoint on the Y-axis. 150 melon appetizers/hr = 1,500 melon appetizers in 10 hours. This is the endpoint on the X-axis. c. 300 mini-sandwiches/hr = 3,000 mini-sandwiches in 10 hours. This is the endpoint on the Y-axis. 300 melon appetizers/hour = 3,000 melon appetizers in 10 hours. This is the endpoint on the X-axis.

2. Your friend Sam has been asked to prepare appetizers for the university reception. She has an unlimited amount of ingredients and 6 hours in which to prepare them. Sam can make 300 mini-sandwiches or 150 servings of melon slices topped with smoked salmon and a dab of sauce per hour. [LO 2.1] a. What is Sam’s opportunity cost of making one mini-sandwich? b. What is Sam’s opportunity cost of baking one melon appetizer? c. Suppose the reception has been postponed, and Sam has an extra 4 hours to prepare. What is the opportunity cost of making one mini-sandwich now? d. Suppose the reception has been postponed, and Sam has an extra 4 hours to prepare. What is the opportunity cost of making one melon appetizer now? e. Suppose Sam’s friend Chris helps by preparing the melon slices, increasing Sam’s productivity to 300 mini-sandwiches or 300 melon appetizers per hour. What is the opportunity cost of making one mini-sandwich now? richard@qwconsultancy.com

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f. Suppose Sam’s friend Chris helps by pre-paring the melon slices, increasing Sam’s productivity to 300 mini-sandwiches or 300 melon appetizers per hour.

What is the opportunity cost of making one melon appetizer now?

Answer: The opportunity cost is the value of what you have to give up in order to get something. It is the value of your next-best alternative. a. To make 1 more mini-sandwich you have to give up 1/2 melon appetizer. b. To make 1 more melon appetizer you have to give up 2 mini-sandwiches. c. To make 1 more mini-sandwich you still have to give up 1/2 melon appetizer. The opportunity cost has not changed. d. To make 1 more melon appetizer you still have to give up 2 mini-sandwiches. e. To make 1 more mini-sandwich you have to give up 1 melon appetizer. The opportunity cost has changed. f. To make 1 more melon appetizer you have to give up 1 mini-sandwich.

3. Suppose that Canada produces two goods: lumber and fish. It has 18 million workers, each of whom can cut 10 feet of lumber or catch 20 fish each day. [LO 2.1] a. What is the maximum amount of lumber Canada could produce in a day? b. What is the maximum amount of fish it could produce in a day? c. Write an equation describing the production possibilities frontier. d. Use your equation to determine how many fish can be caught if 60 million feet of lumber are cut.

Answer: a. The maximum amount of lumber Canada could produce in a day is 10 feet x 18 million workers = 180 million feet. b. The maximum amount of fish Canada could produce in a day is 20 fish x 18 million workers = 360 million fish. c. The equation that describes this production possibilities frontier is 0.1X + 0.05Y = 18 million, where X = the quantity of lumber produced and Y = the quantity of fish produced. d. 0.1(60M) + 0.05 Y = 18M 6M + 0.05Y = 18M 0.05Y = 12M Y = 240 million fish

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4. The graph in Figure 2P-1 shows Tanya’s weekly production possibilities frontier for doing homework (writing papers and doing problem sets). [LO 2.1] a. What is the slope of the production possibilities frontier? b. What is the opportunity cost of doing one problem set? c. What is the opportunity cost of writing one paper?

Answer: a. The slope of the production possibilities frontier is -(6/2) = -3. b. The opportunity cost of doing one problem set is (2 papers/6 problems sets) = 1/3 paper. c. The opportunity cost of writing one paper is (6 problems sets/2 papers) = 3 problems sets.

5. Use the production possibilities frontier in Figure 2P-2 to answer the following questions. [LO 2.1] a. What is the slope of the PPF between point A and point B? b. What is the slope of the PPF between point B and point C? c. Is the opportunity cost of producing hammers higher between points A and B or between points B and C? d. Is the opportunity cost of producing screwdrivers higher between points A and B or between points B and C? Answer: a. The slope of the production possibilities frontier between Point A and Point B is -(5/1) = -5. b. The slope of the production possibilities frontier between Point B and Point C is (10/1) = -10. c. The opportunity cost of producing hammers is higher between points B and C (10 hammers) than between points A and B (5 hammers). d. The opportunity cost of producing screwdrivers is higher between points A and B (1/5 screwdriver) than between points B and C (1/10 screwdriver).

6. For each point on the PPF in Figure 2P-3, note whether the point is attainable and efficient, attainable and inefficient, or unattainable. [LO 2.1] Answer: Points that lie on the frontier are called efficient, because they squeeze the most output possible from all available resources. Points within (inside) the frontier are

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inefficient because they do not use all available resources. Points outside the frontier are unattainable with current resources. a. b. c. d.

Attainable and efficient.

Unattainable.

Attainable and inefficient.

Attainable and efficient.

7. For each point on the PPF in Figure 2P-4, note whether the point is attainable and efficient, attainable and inefficient, or unattainable. [LO 2.1] Answer: Points that lie on the frontier are called efficient, because they squeeze the most output possible from all available resources. Points within (inside) the frontier are inefficient because they do not use all available resources. Points outside the frontier are unattainable with current resources. a. b. c. d. e.

Attainable and efficient.

Attainable and efficient.

Attainable and efficient.

Attainable and inefficient.

Unattainable.

8. Suppose that three volunteers are preparing cookies and cupcakes for a bake sale.

Diana can make 27 cookies or 18 cupcakes per hour; Andy can make 25 cookies or 17 cupcakes; and Sam can make 10 cookies or 12 cupcakes. [LO 2.2] a. Who has the absolute advantage at making cookies? b. At making cupcakes?

Answer: If a producer can generate more output than others with a given amount of resources, that producer has an absolute advantage. When a producer can make a good at a lower opportunity cost than other producers, we say it has a comparative advantage at producing that good. a. Of the three workers, Diana has the absolute advantage at making cookies. She can make the most cookies (27) in an hour compared with Andy (25) and Sam (10).

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b. Diana also has the absolute advantage at baking cupcakes. She can bake 18 cupcakes in an hour, whereas Andy can only bake 17 and Sam can only bake 12.

9. Paula and Carlo are coworkers. Their production possibilities frontiers for counseling clients and writing memos are given in Figure 2P-5. [LO 2.2] a. Which worker has an absolute advantage in counseling clients? b. Which worker has an absolute advantage in writing memos? c. Which worker has a comparative advantage in counseling clients? d. Which worker has a comparative advantage in writing memos?

Answer: Absolute advantage is the ability to produce more of a good or service than others can with a given amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others.

a. Paula has the absolute advantage in counseling clients because she can produce more of this service than Carlo can with a given amount of resources. b. Paula has the absolute advantage in writing memos because she can write more of them than Carlo can with a given amount of resources. c. Paula has the comparative advantage in counseling clients because her opportunity cost of counseling a client is 0.25 memos compared to Carlo's opportunity cost of 0.33 memos. d. Carlo has the comparative advantage in writing memos because his opportunity cost of writing a memo is 3 counseled clients compared to Paula's opportunity cost of 4 counseled clients.

10. Two students are assigned to work together on a project that requires both writing and an oral presentation. Steve can write 1 page or prepare 3 minutes of a presentation each day. Anna can write 2 pages or prepare 1 minute of a presentation each day. [LO 2.2] a. Who has a comparative advantage at writing? b. Suppose that Steve goes to a writing tutor and learns some tricks that enable him to write 3 pages each day. Now who has a comparative advantage at writing?

Answer: Absolute advantage is the ability to produce more of a good or service than others can with a given amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. richard@qwconsultancy.com

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a. Anna has a comparative advantage at writing because she has the lower opportunity cost. She gives up 0.5 minutes of presentation for each page she writes, whereas Steve gives up 3 minutes of presentation for each page he writes. b. If Steve goes to a writing tutor and increases his productivity in writing, his opportunity costs change. If Steve is now able to write 3 pages a day, it means his opportunity cost for each page he writes is now 1 minute of presentation. However, Anna still has a comparative advantage at writing because she still only gives up 0.5 minutes of presentation for each page he writes.

11. Suppose that the manager of a restaurant has two new employees, Rahul and Henriette, and is trying to decide which one to assign to which task. Rahul can chop 20 pounds of vegetables or wash 100 dishes per hour. Henriette can chop 30 pounds of vegetables or wash 120 dishes. [LO 2.3] a. Who should be assigned to chop vegetables? b. Who should be assigned to wash dishes?

Answer: Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Henriette should chop vegetables, as she has the lower opportunity cost for chopping vegetables. Henriette’s opportunity cost for chopping 1 vegetable is a loss of 4 dishes washed, whereas Rahul’s opportunity cost for chopping 1 vegetable is a loss of 5 dishes washed. b. Rahul should be assigned to wash dishes, as she has the lowest opportunity cost for washing dishes. Rahul’s opportunity cost for washing 1 dish is a loss of 0.2 vegetables chopped, whereas Henriette’s opportunity cost for washing 1 dish is a loss 0.25 vegetables chopped.

12. The Dominican Republic and Nicaragua both produce coffee and rum. The Dominican Republic can produce 20 thousand tons of coffee per year or 10 thousand barrels of rum. Nicaragua can produce 30 thousand tons of coffee per year or 5 thousand barrels of rum. [LO 2.3] a. Suppose the Dominican Republic and Nicaragua sign a trade agreement in which each country would specialize in the production of either coffee or rum. Which country should specialize in coffee? Which country should specialize in producing rum? richard@qwconsultancy.com

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b. What are the minimum and maximum prices at which these countries will trade coffee?

Answer: a. If the Dominican Republic and Nicaragua sign a trade agreement in which each country would specialize in production, coffee and rum will be produced according to which country has a comparative advantage in the production of each good. Comparing their opportunity costs for producing coffee, we see that Nicaragua has a lower opportunity cost for producing coffee (1/6 of a barrel of rum, versus the Dominican Republic's opportunity cost of 1/2 barrel of rum). Nicaragua, therefore, should specialize in coffee.

Comparing their opportunity costs for producing rum, we see that the Dominican Republic has a lower opportunity cost for producing rum (2 tons of coffee, versus 6 tons for Nicaragua). The Dominican Republic, therefore, should specialize in rum. b. The minimum price at which these countries will trade coffee is 1/6 (0.167) of a barrel of rum and the maximum is 1/2 (0.500) of a barrel of rum.

If it’s any less than 1/6, Nicaragua could produce its own coffee for less. If it’s any more than 1/2, the Dominican Republic could produce its own coffee for less.

13. Eleanor and her little sister Joanna are responsible for two chores on their family’s farm: gathering eggs and collecting milk. Eleanor can gather 9 dozen eggs or collect 3 litres of milk per week. Joanna can gather 2 dozen eggs or collect 2 litres of milk per week. [LO 2.3] a. The family wants 2 litres of milk per week and as many eggs as the sisters can gather. Currently, Eleanor and Joanna collect one litres of milk each and as many eggs as they can. How many dozens of eggs does the family have per week? b. If the sisters specialized, which sister should gather the milk? c. If the sisters specialized, how many dozens of eggs would the family have per week?

Answer: Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Eleanor’s opportunity cost for collecting a gallon of milk is 3 dozen eggs.

Therefore Eleanor will gather 9-3 = 6 dozen eggs. Joanna’s opportunity cost for collecting a gallon of milk is 1 dozen eggs. Therefore, Joanna will gather 2-1 = 1

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dozen eggs. Together the sisters will gather 7 dozen eggs. b. Joanna should specialize in collecting milk because she has the lower opportunity cost. c. If they specialize, Joanna will collect both litres of milk and no eggs. Eleanor will collect 9 dozen eggs and no milk. The family will now have 9 dozen eggs with their 2 litres of milk, more than they were able to have before the sisters specialized.

14. Suppose Russia and Sweden each produce only paper and cars. Russia can produce 8 tons of paper or 4 million cars each year. Sweden can produce 25 tons of paper or 5 million cars each year. [LO 2.4] a. Draw the production possibilities frontier for each country. b. Both countries want 2 million cars each year and as much paper as they can produce along with 2 million cars. Find this point on each production possibilities frontier and label it “A.” c. Suppose the countries specialize. Which country will produce cars? d. Once they specialize, suppose they work out a trade of 2 million cars for 6 tons of paper. Find the new consumption point for each country and label it “B.” Answer: a. and b. See graph below.

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c. Russia will produce cars because Russia has a lower opportunity cost for producing cars than Sweden. d. Russia will produce 4 million cars and trade 2 million cars to Sweden for 6 tons of paper. Sweden will produce 25 tons of papers and trade 6 tons of paper to Russia for 2 million cars.

15. Maya and Max are neighbors. Both grow lettuce and tomatoes in their gardens. Maya can grow 45 heads of lettuce or 9 pounds of tomatoes this summer. Max can grow 42 heads of lettuce or 6 pounds of tomatoes this summer. If Maya and Max specialize and trade, the price of tomatoes (in terms of lettuce) would be as follows: 1 pound of tomatoes would cost between __ and __ heads of lettuce.

Answer: If Maya and Max specialize and trade, the price of tomatoes (in terms of lettuce) would be: 1 pound of tomatoes would cost between 5 and 7 heads of lettuce.

Maya will grow tomatoes because she has the lower opportunity cost (Maya’s opportunity cost is 5 heads of lettuce for 1 pound of tomatoes, whereas Max’s is 7 heads of lettuce for 1 pound of tomatoes). She must receive at least 5 heads of lettuce from richard@qwconsultancy.com

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Max for a pound of tomatoes or she is better off growing the lettuce herself. Max will buy tomatoes from Maya but only if she charges him no more than 7 heads of lettuce.

Otherwise, Max is better off growing the tomatoes himself. If, for example, Maya charges Max 6 heads of lettuce for a pound of tomatoes both neighbors would be better off than what they can do on their own.

CHAPTER 3 MARKETS Chapter Overview

By the time students reach the end of this course, they should be quite familiar with the words supply and demand. We take our time on this subject for good reason: An understanding of supply and demand is the foundation of economic problem solving. Students will be hardpressed to make wise economic choices without it. Although markets are not always perfectly competitive, they may be surprised at how accurately many real-world phenomena can be described using the simple rules of supply and demand. In the next chapters we’ll use these rules to explain how consumers and producers respond to price changes and government policies.

Learning Objectives

LO 3.1: Identify the defining characteristics of a competitive market.

LO 3.2: Draw a demand curve and describe the external factors that determine demand.

LO 3.3: Distinguish between a shift in and a movement along the demand curve. richard@qwconsultancy.com

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LO 3.4: Draw a supply curve and describe the external factors that determine supply.

LO 3.5: Distinguish between a shift in and a movement along the supply curve.

LO 3.6: Explain how supply and demand interact to drive markets to equilibrium.

LO 3.7: Evaluate the effect of changes in supply and demand on the equilibrium price and quantity.

Chapter Outline

OPENING STORY: MOBILES GO GLOBAL Markets What Is a Market?

What Is a Competitive Market? (LO 3.1) Demand The Demand Curve (LO 3.2) Determinants of Demand BOX FEATURE: REAL LIFE – CAN INSTANT-NOODLE SALES PREDICT A RECESSION? Shifts in the Demand Curve (LO 3.3) Supply The Supply Curve (LO 3.4) Determinants of Supply Shifts in the Supply Curve (LO 3.5) Market Equilibrium Reaching Equilibrium (LO 3.6)

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BOX FEATURE: REAL LIFE – LABOUR SHORTAGE IN CANADIAN ICT INDUSTRY Changes in Equilibrium (LO 3.7) BOX FEATURE: REAL LIFE – GIVE A MAN A FISH Conclusion

Beyond the Lecture

Class Discussion: Demand and Shifts in the Demand Curve (LO 3.2, LO 3.3) Have students view a brief clip from the movie Tommy Boy, specifically from 34:30 – 36:40 (be careful to start at exactly 34:30 due to a swear word just prior). In the clip, Tommy (Chris Farley) and Richard (David Spade) are trying to convince retailers that the automobile parts they produce are high-quality. Tommy’s dad, the former CEO of the company, has just passed away, and retailers are concerned about how well the company will function without him. This is a great clip, as it highlights demand from a retailer’s point of view rather than as an end consumer.

1. What determines the demand for their firm’s brake pads?

2. How does the death of Tommy’s dad affect the retailer’s demand for Callahan brake pads?

3. Could the loss of an owner, boss, or key employee really affect demand?

Class Discussion: Shifts versus Movements in Demand and Supply (LO 3.3, LO 3.5) Consider discussing the past prohibition of alcohol in Canada to stimulate a conversation about changes in supply, demand, and price. This topic can also be used to highlight the difference between shifts in demand and supply and movements along the demand and supply curves.

6. Ask students how they think the introduction of prohibition impacted demand, supply, and price.

7. Ask students if other things remained constant.

8. Ask students to consider what occurred when prohibition was repealed.

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This can be extended to consider any prohibited goods or services. Students generally find this conversation interesting. There are numerous examples in popular media that can be paired with this discussion. For example, consider the debate about legalizing Marijuana in Canada.

Class Discussion: Supply, Demand, and Equilibrium (LO 3.7) Show students a brief clip from the television show The Office to highlight supply and demand.

In this episode, there is a doll that is a very popular gift item during the holiday season. Dwight buys all of the dolls in the area and resells them to parents, charging a price above the retail price, but one which parents are gladly willing to pay. This example was discussed in a Businessweek article by Claire Suddath, which discusses some of the media ideas of Dirk Mateer, an economics professor at Pennsylvania State University.

Class Discussion/Class Activity: Supply, Demand, and Equilibrium (LO 3.7) To help students understand how an equilibrium price may be reached, it is often useful to discuss auctions. While auctions are different from the way many goods and services are purchased, students can understand how buyers and sellers come to an agreement on price and terms. It may be useful to show an example of an online auction from eBay. 1. How does an online auction like eBay function?

2. How is a price determined?

3. Ask students if they have ever participated in this type of buying or selling. Have them describe their decision making through the process.

Alternatively, you can make this an activity instead of a discussion. Auction a $5 bill in your class, starting bids at one penny. In order to make it interesting, tell students that both the highest and second highest bidder must pay. This activity highlights how a price can be determined, and also involves critical thinking.

Class Discussion/Class Activity: Supply, Demand, and Equilibrium (LO 3.7) Ask students to think about the price of tickets to popular athletic events, concerts, etc. Have them think about the sticker price of the ticket relative to the price that they might have to pay to acquire the ticket. Consider showing them Stubhub, a popular online ticket resale website. richard@qwconsultancy.com

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1. How much do tickets for really popular events tend to sell for online, relative to the retail price of the ticket?

2. Why don’t the original sellers of the tickets just charge a higher price?

3. How do ticket resellers impact the market? Are resellers helping or harming buyers?

Solutions to End-of-Chapter Questions and Problems Review Questions

1. Think about a competitive market in which you participate regularly. For each of the characteristics of a competitive market, explain how your market meets these requirements. [LO 3.1] Answer: The market for eggs in my city is competitive. Here, there are lots of small markets (called convenience stores) for groceries and various convenience items. They are located very conveniently in every neighbourhood. Also there are large grocery stores all over the city. So when I want to buy eggs, I go to a grocery store or a convenience store.

Standardized good: Eggs are a standardized good. There are different kinds of eggs, of course, but each unit of a particular type of egg will be standardized. Full information: The ubiquity of bodegas makes it easy for buyers and sellers to gather information about the price of eggs. No transaction costs: There are no transaction costs or other limits to buying and selling eggs. Buyers and sellers can easily find each other. Participants are price takers: I am one consumer among thousands in my city and my purchase patterns have no effect on the market price. Likewise, there are so many places to buy eggs that sellers are also price takers. Given that eggs are standardized, if I go into a store where a dozen eggs are more expensive than they are the next street over, I’ll just walk an extra block. Therefore, I do not see a wide range of prices for eggs in a given neighborhood.

2. Think about a noncompetitive market in which you participate regularly. Explain which characteristic(s) of competitive markets your market does not meet. [LO 3.1] Answer: I take the subway to work every day. Public transportation is not a competitive market. There is only one subway system, so there is no competition. The subway is a natural monopoly (students will learn about monopolies in a later chapter). For now, it is enough to know that without competition, the TTA (Toronto Transit Commission)--which richard@qwconsultancy.com

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operates the subway system in Toronto--is not a price taker. The passengers are certainly price takers, but the operator is not.

3. Explain why a demand curve slopes downward. [LO 3.2] Answer: The demand curve slopes downward because as prices increase, quantity demanded decreases. Price and quantity move in opposite directions and have a negative relationship for demand. Think about your incentives when the price of a good you want to purchase increases. The quantity you demand of that good is likely to move in the other direction and decrease. When price and quantity move in opposite directions, the result is a downward sloping curve.

4. In each of the following examples, name the factor that affects demand and describe its impact on your demand for a new cell phone. [LO 3.2] a. You hear a rumor that a new and improved model of the phone you want is coming out next year. b. Your grandparents give you $500. c. A cellular network announces a holiday sale on a text-messaging package that includes the purchase of a new phone. d. A friend tells you how great his new cell phone is and suggests that you get one, too.

Answer: a. Expectations. Your current demand will decrease in the present as you postpone purchasing under the expectation that a new model will be released next year. b. Incomes. Your purchasing power has increased due to the money given to you by your grandparents. Your demand will increase. c. Price of Related Goods. When the price of text messaging package (a complementary good) goes down due to the sale, demand for cell phones increases. d. Consumer Preferences. Your friend influences your interest in purchasing a cell phone.

Your friend’s enjoyment of his phone and suggestion that you also purchase a phone increases your demand.

5. Consider the following events: a. The price of cell phones goes down by 25 percent during a sale. b. You get a 25 percent raise at your job.

Which event represents a shift in the demand curve? Which represents a movement along the curve? What is the difference? [LO 3.3] richard@qwconsultancy.com

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Answer: The relationship between price and quantity demanded is directly reflected in the demand curve. A change in price will mean a movement along an existing curve. Factors of demand that are held constant, such as income, cause a shift in the demand curve when they change. a. When the price of cell phones goes down by 25 percent, this is a movement along the demand curve for cell phones. b. When your income increases by 25 percent, there is a shift in the demand curve, as income is a factor of demand held constant in any given demand curve.

6. What is the difference between a change in demand and a change in quantity demanded?

[LO 3.3] Answer: When we refer to a change in demand, we are referring to a shift of the entire curve. This happens when a non-price factor changes--such as income, expectations, prices of related goods, consumer preferences or the number of buyers. A change in quantity demanded refers to a change in the specific numerical quantity demanded due to a change in price.

7. Explain why a supply curve slopes upward. [LO 3.4] Answer: The supply curve slopes upward because as prices increase, quantity supplied also increases. Price and quantity move in the same direction and have a positive relationship for supply. Think about the incentives facing a producer when the price of the good she is producing increases. The quantity she is willing and able to supply of that good is likely to also increase. When price and quantity move in the same direction, the result is an upward sloping curve.

8. In each of the following examples, name the factor that affects supply and describe its impact on the supply of cell phones. [LO 3.4] a. Economic forecasts suggest that the demand for cell phones will increase in the future. b. The price of plastic goes up. c. A new screen technology reduces the cost of making cell phones.

Answer:

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a. Expectations. If demand for cell phones is expected to increase in the future, then the price of cell phones is expected to increase in the future. Current supply of cell phones may decrease if supplies are able to withhold inventory waiting on prices to increase.

Supply of cell phones will eventually increase as prices do rise. b. Prices of Inputs. Plastic is an input in the production of cell phones. If the price of plastic increases production costs increase and supply decreases. c. Technology. If advancement in screen technology reduces the cost of making cell phones, supply of cell phones will increase.

9. Consider the following events: a. A maggot infestation ruins a large number of apple orchards in British Columbia. b. Demand for apples goes down, causing the price to fall.

Which event represents a shift in the supply curve? Which represents a movement along the curve? What is the difference? [LO 3.5] Answer: Factors of supply that are held constant, such as number of suppliers, cause a shift in the supply curve when they change. The relationship between price and quantity supplied is directly reflected in the supply curve. A change in price will mean a movement along an existing curve. a. A maggot infestation will cause a shift in the supply of apples, as the number of orchards (sellers) able to supply to the market will decrease. b. When demand decreases and prices fall, there is a movement along the supply curve.

10. What is the difference between a change in supply and a change in quantity supplied? [LO 3.5] Answer: When we refer to a change in supply, we are referring to a shift of the entire curve.

This happens when a non-price factor changes--such as technology, expectations, prices of related goods, prices of inputs or the number of sellers. A change in quantity supplied refers to a change in the specific numerical quantity supplied due to a change in price.

11. What is the relationship between supply and demand when a market is in equilibrium?

Explain how the incentives facing cell phone companies and consumers cause the market for cell phones to reach equilibrium. [LO 3.6] Answer: When a market is in equilibrium, quantity supplied equals quantity demanded. We say that supply and demand are in agreement at market equilibrium. Cell phone sellers have richard@qwconsultancy.com

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an incentive for prices to rise and cell phone consumers would like for prices to fall. Because their incentives are not aligned, each side will create opposing pressure on market prices.

Equilibrium represents the price at which both consumers and suppliers of cell phones agree to buy/sell a given quantity.

12. Explain why the equilibrium price is often called the market-clearing price. [LO 3.6] Answer: The equilibrium price is often called the market clearing price because it is the price at which the market “clears” in the sense that there is neither excess quantity demanded nor excess quantity supplied. Quantity supplied equals quantity demanded at this price. Every buyer who wants to buy at this price can find supply and every supplier who wants to sell at this price can find a buyer.

13. Suppose an economic boom causes incomes to increase. Explain what will happen to the demand and supply of cell phones and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: If incomes increase, there will be an increase in demand for cell phones. If no other shifts occurred, both the price of cell phones and the quantity of cell phones traded would rise.

14. Suppose an economic boom drives up wages for the sales representatives who work for cell phone companies. Explain what will happen to the demand and supply of phones and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: If an increase in wages causes an increase in production costs for sellers of cell phones, supply of cell phones will decrease. If no other shifts had occurred, a decrease in supply would cause prices to rise and the number of cell phones traded to decrease.

15. Suppose an economic boom causes incomes to increase and at the same time drives up wages for the sales representatives who work for cell phone companies. Explain what will happen to the demand for and supply of phones and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: When both an increase in demand and a decrease in supply occur, we know that the price of cell phones will rise. It is unclear whether the quantity of cell phones traded will richard@qwconsultancy.com

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increase or decrease. It depends on whether the shift in demand is larger or smaller than the shift in supply.

Problems and Applications

1. Consider shopping for cucumbers in a farmers’ market. For each statement below, note which characteristic of competitive markets the statement describes. Choose from: standardized good, full information, no transaction costs, and participants are price takers.

[LO 3.1] a. All of the farmers have their prices posted prominently in front of their stalls. b. Cucumbers are the same price at each stall. c. There is no difficulty moving around between stalls as you shop and choosing between farmers. d. You and the other customers all seem indifferent about which cucumbers to buy.

Answer: A standardized good is a good for which any two units have the same features and are interchangeable. In a competitive market, you have full information about the price and features of the good being bought and sold. In competitive markets, there are no transaction costs, meaning that you don’t have to pay anything for the privilege of buying or selling in the market. In economic terminology, a buyer or seller who cannot affect the market price is called a price taker. a. Full information. b. Participants are price takers. c. No transaction costs. d. Standardized good.

2. Suppose two artists are selling paintings for the same price in adjacent booths at an art fair.

By the end of the day, one artist has nearly sold out of her paintings while the other artist richard@qwconsultancy.com

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has sold nothing. Which characteristic of competitive markets has not been met and best explains this outcome? [LO 3.1] a. Standardized good. b. Full information. c. No transaction costs. d. Participants are price takers.

Answer: A standardized good is a good for which any two units have the same features and are interchangeable. In a competitive market, you have full information about the price and features of the good being bought and sold. In competitive markets, there are no transaction costs, meaning that you don’t have to pay anything for the privilege of buying or selling in the market. In economic terminology, a buyer or seller who cannot affect the market price is called a price taker. This is not a standardized good. The booths are adjacent with prices clearly posted so full information is available without transaction costs. The prices of the paintings are the same, which may indicate that the artists are price-takers.

The best explanation for the difference in sales is that the paintings are not standardized.

The artists may have very different styles or levels of talent.

3. Using the demand schedule in Table 3P-1, draw the daily demand curve for slices of pizza in a university town. [LO 3.2] Answer:

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4. Consider the market for cars. Which determinant of demand is affected by each of the following events? Choose from: consumer preferences, prices of related goods, incomes, expectations, and the number of buyers. [LO 3.2] a. Environmentalists launch a successful One Family, One Car campaign. b. A baby boom occurred 16 years ago. c. Layoffs increase as the economy sheds millions of jobs. d. An oil shortage causes the price of gasoline to soar. e. The government offers tax rebates in return for the purchase of commuter rail tickets. f. The government announces a massive plan to bail out the auto industry and subsidize production costs.

Answer: The non-price determinants of demand can be divided into five major categories: consumer preferences, the prices of related goods, incomes, expectations of future prices, and the number of buyers in the market.

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Determinant of Demand

Increase in Demand

Decrease in Demand

Consumer preferences

A Buy Canadian ad campaign appeals to national pride, increasing the demand for An outbreak of E.coli decreases the Canadian demand for spinach. made sneakers.

Prices of related goods

A decrease in the price of hot dogs increases the demand for relish, a complementary good.

Incomes

An economic downturn lowers incomes, An economic downturn lowers incomes, increasing the demand for ground beef, an decreasing the demand for steak, a inferior good. normal good.

Expectations

A hurricane increases the demand for An announcement that a new smart papaya, because food prices are expected phone soon will be released decreases to rise after crops are destroyed. the demand for the current model.

Number of buyers

An increase in life expectancy increases the A falling birthrate decreases the demand demand for nursing homes and medical for diapers. care.

A decrease in taxi fares decreases the demand for subway rides, a substitute good.

a. Consumer preferences. b. Number of buyers. c. Incomes. d. Prices of related goods. e. Prices of related goods. f. Expectations.

5. If a decrease in the price of laptops causes the demand for cell phones to increase, are laptops and cell phones substitutes or complements? [LO 3.2] Answer: If a decrease in the price of laptops causes demand for cell phones to increase, laptops and cell phones are complements. A decrease in the price of laptops increases demand for laptops. If demand for cell phones also increases, consumers use laptops and cell phones together.

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6. If rising incomes cause the demand for beer to decrease, is beer a normal or inferior good?

[LO 3.2] Answer: If rising incomes cause the demand for beer to decrease, beer is an inferior good. If this is the case for beer, this could be because consumers substitute preferred drinks such as wine or liquor when their income rises.

7. Consider the market for corn. Say whether each of the following events will cause a shift in the demand curve or a movement along the curve. If it will cause a shift, specify the direction. [LO 3.3] a. A drought hits corn-growing regions, cutting the supply of corn. b. The government announces a new subsidy for biofuels made from corn. c. A global recession reduces the incomes of consumers in poor countries, who rely on corn as a staple food (assuming corn is a normal good). d. A new hybrid variety of corn seed causes a 15 percent increase in the yield of corn per acre. e. An advertising campaign by the beef producers’ association highlights the health benefits of corn-fed beef.

Answer: A change in the price of a good will cause a movement along the demand curve. A change in a non-price determinant will cause a shift of the demand curve. a. Movement along the curve. b. Shift in the curve; there is an increase in demand. c. Shift in the curve; there is a decrease in demand. d. Movement along the curve e. Shift in the curve; there is an increase in demand.

8. The demand curve in Figure 3P-1 shows the monthly market for sweaters at a local clothing store. For each of the following events, draw the new outcome. [LO 3.3] a. Sweaters fall out of fashion. b. There is a shortage of wool. c. The winter is particularly long and cold this year. d. Sweater vendors offer a sale.

Answer: A change in the price of a good will cause a movement along the demand curve. A change in a non-price determinant will cause a shift of the demand curve.

a. This is a change in a non-price determinant. The demand will shift left. richard@qwconsultancy.com

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b. A shortage of wool will increase the price of sweaters causing a movement up along the demand curve. c. This is a change in a non-price determinant. This will cause the demand to shift to the right. d. The price of sweaters decreases, causing a movement down along the demand curve.

9. Using the supply schedule found in Table 3P-2, draw the daily supply curve for slices of pizza in a university town. [LO 3.4] Answer:

Price ($) 4 3.5 3 2.5

2 1.5 1 0.5 0

0

100

200

300

400

Quantity of pizza slices

10. Consider the market for cars. Which determinant of supply is affected by each of the following events? Choose from: prices of related goods, technology, prices of inputs, expectations, and the number of sellers in the market. [LO 3.4] a. A steel tariff increases the price of steel. b. Improvements in robotics increase efficiency and reduce costs. c. Factories close because of an economic downturn. d. The government announces a plan to offer tax rebates for the purchase of commuter rail tickets. richard@qwconsultancy.com

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e. The price of trucks falls, so factories produce more cars. f. The government announces that it will dramatically rewrite efficiency standards, making it much harder for automakers to produce their cars.

Answer: Several non-price factors determine the supply of a good at any given price: They include the prices of related goods, technology, prices of inputs, expectations about the future, and the number of sellers in the market.

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Determinant of Supply

Increases in Supply

Decreases in Supply

Price of related goods

The price of clean energy production falls, The price of gas rises, so an automaker so the power company reduces the increases its production of smaller, amount of power it supplies using coal more fuel-efficient cars. power plants.

Technology

The installation of robots increases productivity and lowers costs; the supply of goods increases.

Prices of inputs

A drop in the price of tomatoes An increase in the minimum wage decreases the production cost of salsa; increases labor costs at food factories; the supply of salsa increases. the supply of processed food decreases.

Expectations

New research points to the deleterious Housing prices are expected to rise, so effect of eating papayas, leading to builders increase production; the expectations that the demand for supply of houses increases. papayas will fall. Fewer farmers plant papayas, decreasing the supply.

New technology allows corn to be made into ethanol, so farmers plant more corn and fewer soybeans; the supply of soybeans decreases.

Subsidies make the production of corn New licensing fees make operating a more profitable, so more farmers restaurant more expensive; some small Number of Sellers plant corn; the supply of corn restaurants close, decreasing the supply increases. of restaurants. a. Prices of inputs. b. Technology. c. Number of sellers. d. Expectations. e. Prices of related goods. f. Prices of inputs.

11. Consider the market for corn. Say whether each of the following events will cause a shift in the supply curve or a movement along the curve. If it will cause a shift, specify the direction.

[LO 3.5] a. A drought hits corn-growing regions. b. The government announces a new subsidy for biofuels made from corn. richard@qwconsultancy.com

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c. A global recession reduces the incomes of consumers in poor countries, who rely on corn as a staple food. d. A new hybrid variety of corn seed causes a 15 percent increase in the yield of corn per acre. e. An advertising campaign by the beef producers’ association highlights the health benefits of corn-fed beef.

Answer: A change in the price of a good will cause a movement along the supply curve. A change in a non-price determinant will cause a shift of the supply curve. a. Shift in the curve; there is a decrease in supply. b. Movement along the curve. c. Movement along the curve. d. Shift in the curve; there is an increase in supply. e. Movement along the curve.

12. The supply curve in Figure 3P-2 shows the monthly market for sweaters at a local craft market. For each of the following events, draw the new out-come. [LO 3.5] a. The price of wool increases. b. Demand for sweaters decreases. c. A particularly cold winter is expected to begin next month. d. Demand for sweaters increases.

Answer: a. This is a change in a non-price determinant. The supply will shift left. b. A decrease in the demand for sweaters will decrease the price of sweaters, causing a movement down along the supply curve. c. This is a change in a non-price determinant. This will cause the supply to shift to the right. d. An increase in the demand for sweaters will increase the price of sweaters, causing a movement up along the supply curve.

13. Refer to the demand and supply schedule shown in Table 3P-3. [LO 3.6] a. If pizza parlors charge $3.50 per slice, will there be excess quantity supplied or excess quantity demanded? What is the amount of excess quantity supplied or excess quantity demanded at that price?

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b. If pizza parlors charge $1.00 per slice, will there be excess quantity supplied or excess quantity demanded? What is the amount of excess quantity supplied or excess quantity demanded at that price? c. What are the equilibrium price and quantity in this market?

Answer: a. When the price is above the equilibrium price there is an excess quantity supplied. In this case, there is an excess quantity supplied of 400 slices. b. When the price is below the equilibrium price there is an excess quantity demanded. In this case, there is an excess quantity demanded of 100 slices. c. The equilibrium price occurs where the quantity demanded equals the quantity supplied, at $1.50. The equilibrium quantity is 200 slices.

The graph in Figure 3P-3 shows the weekly market for compact discs in a small town. Use this graph to answer Problems 14–16.

14. Which of the following events will occur at a price of $20? [LO 3.6] a. Equilibrium. b. Excess quantity demanded. c. Excess quantity supplied. d. No CDs supplied. e. No CDs demanded.

Answer: There is excess quantity supplied. $20 is above the equilibrium price, which will lead to excess supply.

15. Which of the following events will occur at a price of $10? [LO 3.6] a. Equilibrium. b. Excess quantity demanded. c. Excess quantity supplied. d. No CDs supplied. e. No CDs demanded.

Answer: There is excess quantity demanded. $10 is below the equilibrium price, which will lead to excess demand. richard@qwconsultancy.com

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16. What are the equilibrium price and quantity of CDs? [LO 3.6] Answer: The equilibrium price is $15, and the equilibrium quantity is 150 CDs.

17. The graph in Figure 3P-4 shows supply and demand in the market for automobiles. For each of the following events, draw the new market outcome, and say whether the equilibrium price and quantity will increase or decrease. [LO 3.7] a. Environmentalists launch a successful One Family, One Car campaign. b. A steel tariff increases the price of steel. c. A baby boom occurred 16 years ago. d. An oil shortage causes the price of gasoline to soar. e. Improvements in robotics increase efficiency and reduce costs. f. The government offers a tax rebate for the purchase of commuter rail tickets.

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Answer:

a. The new equilibrium point is A. Decrease in demand: price decreases and quantity decreases. b. The new equilibrium point is B. Decrease in supply: price increases and quantity decreases. c. The new equilibrium point is C. Increase in demand: price increases and quantity increases. d. The new equilibrium point is A. Decrease in demand: price decreases and quantity decreases. e. The new equilibrium point is D. Increase in supply: price decreases and quantity increases. f. The new equilibrium point is A. Decrease in demand: price decreases and quantity decreases.

18. Say whether each of the following changes will increase or decrease the equilibrium price and quantity, or whether the effect cannot be predicted. [LO 3.7] a. Demand increases; supply remains constant. b. Supply increases; demand remains constant. c. Demand decreases; supply remains constant. d. Supply decreases; demand remains constant. e. Demand increases; supply increases. f. Demand decreases; supply decreases. richard@qwconsultancy.com

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g. Demand increases; supply decreases. h. Demand decreases; supply increases.

Answer: a. The equilibrium price increases, and the equilibrium quantity increases. b. The equilibrium price decreases, and the equilibrium quantity increases. c. The equilibrium price decreases, and the equilibrium quantity decreases. d. The equilibrium price increases, and the equilibrium quantity decreases. e. The equilibrium price cannot be predicted, and the equilibrium quantity increases. f. The equilibrium price cannot be predicted, and the equilibrium quantity decreases. g. The equilibrium price increases, and the equilibrium quantity cannot be predicted. h. The equilibrium price decreases, and the equilibrium quantity cannot be predicted.

CHAPTER 4 ELASTICITY Chapter Overview Supply and demand may be the most common words in economics, but applying these concepts to the real world requires a bit of elaboration. Elasticity is the first of several concepts we will study that will help you to apply the concepts of supply and demand to business and policy questions. In this chapter we see how elasticity can be used to set prices so as to maximize revenue. In the coming chapters we will use elasticity to predict the effects of government intervention in the market, and we will dig deeper into the consumer and producer choices that drive elasticity.

Learning Objectives LO 4.1: Calculate price elasticity of demand using the mid-point method.

LO 4.2: Explain how the determinants of price elasticity of demand affect the degree of elasticity.

LO 4.3: Calculate price elasticity of supply using the mid-point method.

LO 4.4: Explain how the determinants of price elasticity of supply affect the degree of elasticity.

LO 4.5: Calculate cross-price elasticity of demand, and interpret the sign of the elasticity.

LO 4.6: Calculate income elasticity of demand, and interpret the sign of the elasticity.

Chapter Outline richard@qwconsultancy.com

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OPENING STORY: CANADA’S EVERYDAY DRINK What Is Elasticity?

Price Elasticity of Demand Calculating Price Elasticity of Demand (LO 4.1) Using the Mid-Point Method Determinants of Price Elasticity of Demand (LO 4.2) Using Price Elasticity of Demand BOX FEATURE: REAL LIFE – DOES CHARGING FOR BEDNETS DECREASE MALARIA? BOX FEATURE: WHAT DO YOU THINK? – SHOULD ENTRANCE FEES AT NATIONAL PARKS BE RAISED? Price Elasticity of Supply Calculating Price Elasticity of Supply (LO 4.3) Determinants of Price Elasticity of Supply (LO 4.4) Other Elasticities Cross-Price Elasticity of Demand (LO 4.5) Income Elasticity of Demand (LO 4.6) BOX FEATURE: WHERE CAN IT TAKE YOU? – PRICING ANALYST

Beyond the Lecture Class Activity: Calculating Price Elasticity of Demand (LO 4.1) Netflix enacted a large percentage price increase in the fall of 2011 (read an article about this price increase here). Using the original estimates in the article below, have students consider the price elasticity of demand for Netflix. In order to keep it simple, it is a good idea to assume other things constant and ignore the fact that many subscribers may have switched to a lower priced option at first. This works well with small groups.

1. If the price increases from $9.99 to $15.98 and subscriptions fall from 25 million to 24 million, what is the price elasticity of demand? Is it elastic or inelastic?

2. Ask students to consider the impact on total revenue.

3. Ask students to next consider the extent to which customers likely switched to lower-priced subscriptions with Netflix. This helps to highlight the other things constant assumption.

Class Discussion: Determinants of Price Elasticity of Demand (LO 4.2) Ask students to consider the price elasticity of demand for cigarettes. The article here discusses a recent proposal to increase the US federal cigarette tax. This is also a nice topic for a small group discussion or in an online environment.

1. How do smokers respond to a change in the price of cigarettes? Are they relatively elastic or relatively inelastic?

2. What are the factors that drive the price elasticity of demand for cigarettes? richard@qwconsultancy.com

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3. Are there any substitutes for cigarettes? It is interesting to consider a federal tax, state tax, or local tax here as the answers are slightly different.

4. Does the other things constant assumption hold when taxes on cigarettes rise?

Writing Assignment: Determinants of Price Elasticity of Demand (LO 4.2) Have students listen to this EconTalk podcast by Russell Roberts featuring Richard McKenzie on prices.

1. Why do prices fall after a major gift-giving season?

2. Why does popcorn at the movie theatre generally seem to be so expensive?

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Solutions to End-of-Chapter Questions and Problems Review Questions 1. You are advising a coffee shop manager who wants to estimate how much sales will change if the price of a coffee rises. Explain why he should measure elasticity in percentage terms rather than in terms of dollars and cups. [LO 4.1] Answer: If the coffee shop manager measures elasticity in percentage changes he will have an understanding of the price sensitivity of demand for coffees that will be consistent regardless of the units of measure. By using percentage changes to calculate elasticity, he will have the same sense of price sensitivity regardless of whether lattes are measured in cups, gallons, or ounces and whether price is measured in dollars or cents.

2. Explain why the coffee shop manager should measure elasticity using the mid-point method in his calculations. [LO 4.1] Answer: Using the mid-point method to calculate elasticity is useful because the coffee shop manager will have a single measure of the price sensitivity of demand over a particular range of prices regardless of the direction price is moving. For example, he would know how sensitive demand is to a price change between $3 and $5 regardless of whether price increases from $3 to $5 or decreases from $5 to $3. Because the mid-point method considers the average of these prices ($4) as the base, he will have the same elasticity measure over that price range, whichever direction price moves.

3. You are working as a private math tutor to raise money for a trip during spring break. First explain why the price elasticity of demand for math tutoring might be elastic. Then explain why the price elasticity of demand for math tutoring might be inelastic. [LO 4.2] Answer: This would depend on the availability of other tutors who might charge prices lower than you and how desperate your students are for tutoring. If your students can easily switch to another tutor and/or think of tutoring as a luxury they can do without if prices rise, the price elasticity of demand would be elastic. If there are no other tutors your students can turn to or if they feel they cannot possibly pass their course without tutoring, the price elasticity of demand could be inelastic. richard@qwconsultancy.com

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4. You are working as a private math tutor to raise money for a trip during spring break. You want to raise as much money as possible. Should you should increase or decrease the price you charge? Explain. [LO 4.2] Answer: Whether you should raise or lower your prices depends on the price elasticity of demand. If demand is elastic, you will increase your revenue by lowering prices. With elastic demand, lower prices mean that people will hire enough additional tutoring hours from you to offset the lower price. If demand is inelastic, you will raise prices by increasing prices. With inelastic demand, people will reduce tutoring hours a bit when you raise prices, but not enough to offset your gain from charging more.

5. You have been hired by the government of Kenya, which produces a lot of coffee, to examine the supply of gourmet coffee beans. Suppose you discover that the price elasticity of supply is 0.85. Explain this figure to the Kenyan government. [LO 4.3] Answer: A price elasticity of supply of .85 would mean that supply of gourmet coffee beans is inelastic, or not very responsive to prices. For example, if the price of gourmet coffee beans rose by 5%, the quantity supplied of gourmet coffee beans would increase by less than 5% in the short run. This could be because it takes a long time to increase supply and/or there may be other constraints like limitations on land. You could advise the Kenyan government to explore the factors that make supply less responsive to price changes.

6. You have noticed that the price of tickets to your university’s basketball games keeps increasing but the supply of tickets remains the same. Why might supply be unresponsive to changes in price? [LO 4.3] Answer: It may not be possible to increase the supply of tickets. The number of tickets is likely fixed in the short run. There are usually a specific number of seats in a sports arena that won’t change as prices fluctuate. In this case, supply is perfectly inelastic and the same number of seats will be supplied, even as prices rise. In a longer term, your university could build a bigger arena.

7. Which will have a more price-elastic supply over six months: real estate in downtown Toronto or real estate in Winnipeg? Explain your reasoning.

[LO 4.4] Answer: Real estate in Winnipeg will be more price-elastic in the short run than real estate in Downtown Toronto. Land is scarce in Downtown Toronto, making it difficult to increase real estate. Higher buildings can richard@qwconsultancy.com

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often replace smaller ones, but this takes more time. Land is more easily available for development in Winnipeg, making this area better able to respond quickly to changes in the price of real estate.

8. Certain skilled labor, such as hair cutting, requires licensing or certification, which is costly and takes a long time to acquire. Explain what would happen to the price elasticity of supply for haircuts if this licensing requirement were removed. [LO 4.4] Answer: The price elasticity of supply would increase (become more elastic). If the requirement for licensing were removed, a hair salon could expand its staff more easily in response to increasing prices because they would not be limited to only hiring licensed haircutters.

9. Although we could describe both the cross-price elasticity of demand between paper coffee cups and plastic coffee lids and the cross-price elasticity of demand between sugar and artificial sweeteners as highly elastic, the first cross-price elasticity is negative and the second is positive. What is the reason for this? [LO 4.5] Answer: Goods that are strong complements like coffee cups and coffee lids will have a more elastic cross-price elasticity. Likewise, goods that are strong substitutes like sugar and artificial sweeteners will also have a more elastic cross-price elasticity. In both cases the goods are closely related so quantity demanded of one good (such as coffee cups) will be more responsive to changes in the price of the other good (coffee lids) than if the two goods were less related. However, complements and substitutes will have different signs. For complements, like coffee cups and coffee lids, the sign will be negative. When the price of coffee lids increases, we buy fewer coffee cups. With substitutes, the sign is positive. As the price of artificial sweeteners increases, quantity demanded of sugar will also increase.

10. Name two related goods you consume which would have a positive cross-price elasticity. What happens to your consumption of the second good if the price of the first good increases? [LO 4.5] Answer: When I am craving something sweet, I like cookies and donuts.

These treats are substitutes for me. If the price of cookies at my local bakery increases, I will choose donuts.

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11. Name two related goods you consume which would have a negative cross-price elasticity. What happens to your consumption of the second good if the price of the first good increases? [LO 4.5] Answer: One of my favorite snacks is chips and guacamole. These goods are complements for me because I consume them together. They have a negative cross-price elasticity for me. If the price of chips increases, I purchase less guacamole.

12. In France, where cheese is an important and traditional part of people’s meals, people eat about six times as much cheese per person as in the United States. In which country do you think the demand for cheese will be more income-elastic? Why? [LO 4.6] Answer: Demand for cheese will be more income-elastic in the United States. While people in the United States also enjoy cheese, it is not as culturally important as it is in France. People in France already prioritize cheese and eat a lot of cheese. If incomes rise, they are unlikely to significantly increase how much cheese they consume. Conversely, if incomes fall, they will try to avoid significantly deceasing consumption of cheese. They may choose to make other sacrifices before they reduce cheese consumption.

13. Name a good you consume for which your income elasticity of demand is positive. What happens when your income increases? [LO 4.6] Answer: Most goods are normal and behave this way. I love dining out at nice restaurants with my friends and family, but eating out at nice restaurants is expensive. When my income increases, I tend to increase the number of meals I eat at nice restaurants. For me, a meal at nice restaurants is a normal good and my income elasticity of demand is positive.

14. Name a good you consume for which your income elasticity of demand is negative. What happens when your income increases? [LO 4.6] Answer: I have always loved to travel. When I was a student, I would stay at youth hostels because they are much less expensive than hotels. I worked part-time as a student and couldn’t afford the luxury of hotels.

These days, I earn more than I did as a student, so I tend to stay in hotels. For me, hostels are an inferior good and my income elasticity of demand is negative. When my income increased, my demand for hostel stays decreased. richard@qwconsultancy.com

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Problems and Applications 1. When the price of a bar of chocolate is $1, demand is 100,000 bars.

When the price rises to $1.50, demand falls to 60,000 bars. Calculate the price elasticity of demand according to the instructions below and express your answer in absolute value. [LO 4.1] a. Suppose price increases from $1 to $1.50. Calculate the price elasticity of demand in terms of percent change. b. Suppose price decreases from $1.50 to $1. Calculate the price elasticity of demand in terms of percent change. c. Suppose the price increases from $1 to $1.50. Calculate the price elasticity of demand using the mid-point method. d. Suppose the price decreases from $1.50 to $1. Calculate the price elasticity of demand using the mid-point method.

Answer: a. [(60,000 − 100,000)/100,000]/[(1.50 − 1.00)/1.00] = 0.8. b. [(100,000 − 60,000)/60,000]/[(1.00 − 1.50)/1.50] = 2.03. Using this method, the price elasticity of demand calculation changes over this range depending on whether price increases or decreases. c. [(60,000 − 100,000)/80,000]/[(1.50 − 1.00)/1.25] = 1.25. d. [(100,000 − 60,000)/80,000]/[(1.00 − 1.50)/1.25] = 1.25. Using this method, the price elasticity of demand calculation is the same whether price increases or decreases.

2. If the price elasticity of demand for used cars priced between $3,000 and $5,000 is −1.2 (using the mid-point method), what will be the percent richard@qwconsultancy.com

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change in quantity demanded when the price of a used car falls from $5,000 to $3,000? [LO 4.1] Answer: −1.2 = % chane in Qd / [(3,000 − 5,000)/4,000] −1.2 = % change in Qd/ −0.5 (−0.5) − 1.2 = % change in Qd -0.6 x 100 = % change in Qd 60 percent = % change in Qd 3. Three points are identified on the graph in Figure 4P-1. [LO 4.2] a. At point A, demand is ____. b. At point B, demand is ____. c. At point C, demand is ____.

Answer: For any linear demand curve, the mid-point represents demand being unit-elastic. At any point on the upper-portion of the curve, demand is price elastic. At any point on the lower-portion of the curve, demand is price inelastic. a. Elastic. b. Unit-elastic. c. Inelastic.

4. Which of the following has a more elastic demand in the short run? [LO 4.2] a. Pomegranate juice or drinking water? b. Cereal or Rice Krispies®? c. Speedboats or gourmet chocolate?

Answer: a. Pomegranate juice. Demand for pomegranate juice would be much more elastic than demand for drinking water (a necessity). b. Rice Krispies. There are more substitutes for a particular type of cereal like Rice Krispies than there are for cereal itself. c. Speedboats. Even though both goods could be considered luxuries, a speedboat is a much higher portion of a household budget than chocolate. Therefore, demand for speedboats will be more sensitive to price changes.

5. In each of the following instances, determine whether demand is elastic, inelastic, or unit-elastic. [LO 4.2] a. If price increases by 10 percent and quantity demanded decreases by 15 percent, demand is _______. richard@qwconsultancy.com

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b. If price decreases by 10 percent and quantity demanded increases by 5 percent, demand is _______.

Answer: a. Elastic. b. Inelastic.

6. In each of the following instances, determine whether quantity demanded will increase or decrease, and by how much. [LO 4.2] a. If price elasticity of demand is -1.3 and price increases by 2 percent, quantity demanded will ______ by ______ percent. b. If price elasticity of demand is -0.3 and price decreases by 2 percent, quantity demanded will ______ by ______ percent.

Answer: a. Quantity demanded will decrease by > 2 percent (i.e. 2.6%). b. Quantity demanded will increase by < 2 percent (i.e. 0.6%).

Problems 7 and 8 refer to the demand schedule shown in Table 4P-1.

For each price change, say whether demand is elastic, unit-elastic, or inelastic, and say whether total revenue increases, decreases, or stays the same.

7. Price increases from $10 to $20. Demand is ______ and total revenue ______. [LO 4.2] Answer: Demand is inelastic: [(300 – 350)/325]/[(20-10)/15] = 0.15/0.67 = -0.22. Total revenue increases from ($10 x 350 = $3,500) to ($20 x 300 = $6,000).

8. Price decreases from $70 to $60. Demand is ______ and total revenue ______. [LO 4.2] Answer: Demand is elastic: [(100 – 50)/75]/[(60-70)/65] = 0.67/-0.15 = -4.44. Total revenue increases from ($70 x 50 = $3,500) to ($60 x 100 = $6,000).

Problems 9–12 refer to Figure 4P-2.

9. Draw the price effect and the quantity effect for a price change from $60 to $50. Which effect is larger? Does total revenue increase or decrease?

No calculation is necessary. [LO 4.2] richard@qwconsultancy.com

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Answer: The quantity effect is larger and total revenue increases.

10. Draw the price effect and the quantity effect for a price change from $30 to $20. Which effect is larger? Does total revenue increase or decrease? No calculation is necessary. [LO 4.2] Answer: The price effect is larger, and total revenue decreases.

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11. Draw the price effect and the quantity effect for a price change from $60 to $70. Which effect is larger? Does total revenue increase or decrease? No calculation is necessary. [LO 4.2] Answer: The quantity effect is larger, and total revenue decreases.

12. Draw the price effect and the quantity effect for a price change from $10 to $20. Which effect is larger? Does total revenue increase or decrease? No calculation is necessary. [LO 4.2] Answer: The price effect is larger, and total revenue increases.

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13. Use the graph in Figure 4P-3 to calculate the price elasticity of supply between points A and B using the mid-point method. [LO 4.3] Answer: The price elasticity of supply between points A and B is [(10 − 8)/9]/[(15 − 12)/13.5] = 1.

14. If the price of a haircut is $15, the number of haircuts provided is 100.

If the price rises to $30 per haircut, barbers will work much longer hours, and the supply of haircuts will increase to 300. What is the price elasticity of supply for haircuts between $15 and $30? [LO 4.3] Answer: The price elasticity of supply for haircuts between $15 and $20 using the mid-point method is [(300 − 100)/200]/[(30 − 15)/22.5] = 1.49.

15. Which of the following has a more elastic supply in the short run? [LO 4.4] a. Hospitals or mobile clinics? b. Purebred dogs or pet rabbits? c. On-campus courses or online courses?

Answer: richard@qwconsultancy.com

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a. Mobile clinics. The supply of mobile clinics can be modified much more easily than the supply of hospitals. Mobile clinics require much less in the way of inputs and infrastructure. b. Pet rabbits. Increasing the quantity of purebred dogs requires other purebred dogs. Pet rabbits are not purebred, so it is much easier to increase their quantity. c. Online courses. Courses online are easier to expand because they have fewer constraints on the availability of classroom space and may also have fewer constraints on instructor availability.

16. In each of the following instances, determine whether supply is elastic, inelastic, or unit‐elastic. [LO 4.4] a. If price increases by 10 percent and quantity supplied increases by 15 percent, supply is ______. b. If price decreases by 10 percent and quantity supplied decreases by 5 percent, supply is ______.

Answer: a. Elastic. b. Inelastic.

17. In each of the following instances, determine whether quantity supplied will increase or decrease, and by how much. [LO 4.4] a. If price elasticity of supply is 1.3 and price increases by 2 percent, quantity supplied will _____ by _____ percent. b. If price elasticity of supply is 0.3 and price decreases by 2 percent, quantity supplied will _____ by _____ percent.

Answer: a. Quantity supplied will increase by > 2% (i.e. 2.6%). b. Quantity supplied will decrease by < 2% (i.e. 0.6%).

18. Suppose that the price of peanut butter rises from $2 to $3 per jar.

[LO 4.5] a. The quantity of jelly purchased falls from 20 million jars to 15 million jars. What is the cross‐price elasticity of demand between peanut butter and jelly? Are they complements or substitutes? b. The quantity of jelly purchased rises from 15 million jars to 20 million jars. What is the cross‐price elasticity of demand between peanut butter and jelly? Are they complements or substitutes? richard@qwconsultancy.com

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Answer: a. The cross-price elasticity of demand between peanut butter and jelly using the mid-point method is [(15 million – 20 million)/17.5 million]/[(3 − 2)/2.5] = −0.725. Peanut butter and jelly are complements. b. The cross-price elasticity of demand between peanut butter and jelly using the mid-point method is [(20 million – 15 million)/17.5 million]/[(3 − 2)/2.5] = 0.725. Peanut butter and jelly are substitutes.

19. For each of the following pairs, predict whether the cross-price elasticity of demand will be positive or negative: [LO 4.5] a. Soap and hand sanitizer. b. CDs and MP3s. c. Sheets and pillowcases.

Answer: a. Positive. Soap and hand sanitizer are substitutes. b. Positive. CDs and MP3s are substitutes. c. Negative. Sheets and pillowcases are complements.

20. Suppose that when the average family income rises from $30,000 per year to $40,000 per year, the average family’s purchases of toilet paper rise from 100 rolls to 105 rolls per year. [LO 4.6] a. Calculate the income-elasticity of demand for toilet paper. b. Is toilet paper a normal or an inferior good? c. Is the demand for toilet paper income-elastic or income-inelastic?

Answer: a. The income-elasticity of demand is [(105 − 100)/102.5]/[(40,000 − 30,000)/35,000] = 0.17. b. Toilet paper is a normal good because the income elasticity is positive. c. Toilet paper is an income-inelastic good because the income elasticity is greater than zero but less than one.

21. In each of the following instances, determine whether the good is normal or inferior, and whether it is income‐elastic or income‐inelastic.

[LO 4.6] a. If income increases by 10 percent and the quantity demanded of a good increases by 5 percent, the good is ______ and ______. richard@qwconsultancy.com

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b. If income increases by 10 percent and the quantity demanded of a good decreases by 20 percent, the good is ______ and ______.

Answer: a. If income increases by 10% and the quantity demanded of a good increases by 5%, the good is normal (income elasticity is positive) and income-inelastic (income elasticity of 5/10 is less than one). b. If income increases by 10% and the quantity demanded of a good decreases by 20%, the good is inferior (income elasticity is negative) and income-elastic (income elasticity of 20/10 is greater than one).

CHAPTER 5 EFFICIENCY Chapter Overview In this chapter we introduce the concepts of willingness to pay and willingness to sell, which help explain when individual buyers and sellers will choose to make a trade. We also discuss what it means to measure consumer and producer surplus and show that the market equilibrium is efficient because it maximizes total surplus.

As we’ll see in the next chapter, surplus and deadweight loss are powerful tools for understanding the implications of business ideas and public policies. Who will benefit from the policy? Who will be harmed by it? What effect will it have on the economy overall? The language of surplus, efficiency, and distribution of benefits is particularly helpful for getting to the bottom of controversial decisions. Later in the book, we will describe important cases where the efficiency rule about market equilibrium does not always hold true, and we’ll see how surplus can also help us understand these cases.

Learning Objectives LO 5.1: Use willingness to pay and willingness to sell to determine supply and demand at a given price.

LO 5.2: Calculate consumer surplus based on a graph or table. richard@qwconsultancy.com

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LO 5.3: Calculate producer surplus based on a graph or table.

LO 5.4: Calculate total surplus based on a graph or table.

LO 5.5: Define efficiency in terms of surplus, and identify efficient and inefficient situations.

LO 5.6: Describe the distribution of benefits that results from a policy decision.

LO 5.7: Define and calculate deadweight loss.

LO 5.8: Explain why correcting a missing market can make everyone better off.

Chapter Outline OPENING STORY: A BROKEN LASER POINTER STARTS AN INTERNET REVOLUTION Willingness to Pay and Sell (LO 5.1) Willingness to Pay and the Demand Curve Willingness to Sell and the Supply Curve BOX FEATURE: REAL LIFE – HAGGLING AND BLUFFING Measuring Surplus BOX FEATURE: FROM ANOTHER ANGLE – HOW MUCH WOULD YOU PAY TO KEEP THE INTERNET FROM DISAPPEARING? Consumer Surplus (LO 5.2) Producer Surplus (LO 5.3) Total Surplus (LO 5.4) BOX FEATURE: REAL LIFE – AIRWAVES THAT COST $2.1 bILLION Using Surplus to Compare Alternatives Market Equilibrium and Efficiency (LO 5.5) Changing the Distribution of Total Surplus (LO 5.6) Deadweight Loss (LO 5.7) Missing Markets (LO 5.8) BOX FEATURE: WHAT DO YOU THINK – KIDNEYS FOR SALE Conclusion

Beyond the Lecture Class Activity: Consumer Surplus and Producer Surplus (LO 5.2, LO 5.3) Class discussions that highlight differences in consumer surplus and producer surplus between different individuals can help students to understand the concepts. It is important to try to get students to consider the maximum that they would pay for something and the minimum that they would accept. There is often a difference between the market price and the price they would pay or accept.

1. Have the class choose a concert for a popular singer or band. Find out who would pay the most in the class to see a concert. Then compare this to the actual price of attending the concert. You can then ask other students how much they would pay for the concert. Some may

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not even be willing to attend for free. See the Pollstar average ticket prices here.

2. Ask students how much they would need to be paid to perform a difficult and potentially dangerous job. Consider Alaskan crab fishing (read an article about it here). How much do students need to be paid relative to actual pay? What would their producer surplus be?

Writing Assignment/Class Discussion: Market Equilibrium and Efficiency (LO 5.5) Have students read Joel Waldfogel’s The Deadweight Loss of Christmas (1993 American Economic Review 83:5, pp. 1328-1336). This may be a slightly difficult read for some students, but most can understand the concept. Have students write a brief essay regarding the potential for deadweight loss with gift-giving, and consider the following questions for class: 1. Why might there be a deadweight loss associated with gift-giving?

2. Who is most likely to give you a gift with a large deadweight loss? Who is most likely to give you a gift that has little or no deadweight loss?

3. Why doesn’t everyone simply give cash as a gift?

Also, you may want to consider a brief clip from the movie Old School (show 12:40-13:30 and 48:20-49:00). In the movie, Will Ferrell tries to give a toaster that he received as a gift to others.

Class Discussion: Missing Markets (LO 5.8) In order to highlight how change and technology can impact missing markets, have students consider the impact of the internet on consumer and producer surplus. Many students likely do not remember the pre-internet age, so this can be a nice small group discussion in class or in an online environment. You can use this article from The Economist to start a discussion. Have students consider the following: 1. What is the impact of the internet on producer and consumer surplus?

What is the impact of overall surplus?

2. What was the impact of the internet on transactions costs associated with trades?

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Bill is a professional photographer. His camera is broken, and he needs a new one within the next hour, or he will miss an important deadline. Lisa is a high-school student who doesn’t have a camera but wants to get one to take pictures at her prom next month. Who do you think would have a higher willingness to pay for a particular camera today? Why? [LO 5.1]

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Answer: Bill will have the higher willingness to pay. He needs a camera for his job and he has no time to spare looking. Meeting his important deadline depends on him finding a camera within the next hour. Bill’s options are limited and his willingness to pay will reflect that. While Lisa would like to have a camera for her prom night, Lisa has time to look for the best deal. And if she never found a camera priced at or below her reservation price, Lisa could rely on friends and Facebook for prom photos. The fact that Lisa has more time and other options for photos will make her willingness to pay less than Bill’s.

2. You are in the market for a new couch and have found two advertisements for the kind of couch you want to buy. One seller notes in her ad that she is selling because she is moving to a smaller apartment, and the couch won’t fit in the new space. The other seller says he is selling because the couch doesn’t match his other furniture. Which seller do you expect to buy from? Why? (Hint: Think who would be the more motivated seller.) [LO 5.1] Answer: You would expect to buy from the seller whose couch won’t fit in the new space.

This seller will probably be willing to sell at a lower price because she does not have the option of keeping the couch if she can’t get a higher price. She needs to sell the couch and has revealed as much to you in her advertisement. The other seller may not like the fact that his couch doesn’t match his other furniture, but he does have the option of keeping the couch if he can’t find a buyer to pay what he thinks it’s worth. You will probably get a better deal from the first seller.

3. Suppose you are at a flea market and are considering buying a box of vintage records. You are trying to bargain down the price, but the seller overhears you telling a friend that you are willing to pay up to $50. Why is your consumer surplus now likely to be lower than it would have been if the seller hadn’t overheard you? [LO 5.2] Answer: Now that the seller knows your highest willingness to pay (how much the records are worth to you), she knows she doesn’t have to accept your lower offers. She will charge you $50, knowing that you are going to purchase at that price. If you pay exactly what something is worth to you, you will have no consumer surplus. Your surplus would be greater if you were able to buy the box for less than $50, but you have unknowingly revealed your willingness to pay more.

4. Consider a market in equilibrium. Suppose supply in this market increases. How will this affect consumer surplus? Explain. [LO 5.2] Answer: If supply increases, equilibrium price will decrease. This is a movement along the demand curve. The lower equilibrium price will mean more consumer surplus. richard@qwconsultancy.com

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5. You currently have a television that you want to sell. You can either pick a price and try to sell it at a yard sale or auction it off on eBay. Which method do you think will yield a higher producer surplus? Why? [LO 5.3] Answer: Auctioning the television on eBay should yield a higher price. eBay will give you access to many more consumers than those who might stop by your yard sale. And auctioning the television will force consumers to compete with each other for your television and reveal their willingness to pay.

6. Consider a market in equilibrium. Suppose demand in this market decreases. How will this affect producer surplus? Explain. [LO 5.3] Answer: If demand decreases, equilibrium price will decrease. This is a movement along the supply curve. The lower equilibrium price will mean less producer surplus.

7. Consider the market for plane tickets to the Caribbean. A bad winter in Eastern and Central Canada increases demand for tropical Caribbean vacations, shifting the demand curve to the right. The supply curve stays constant. Does total surplus increase or decrease? (Hint: Sketch out a generic supply and demand curve and look at what happens to the size of the triangle that represents total surplus when the demand curve shifts right.) [LO 5.4] Answer: Willingness to buy is represented by the demand curve. When demand increases and supply (willingness to sell) stays the same, total surplus increases. You can see this by sketching a graph like the one below and looking at what happens to total surplus when the market demand shifts. When demand = D1, total surplus = Area A. When demand = D2, total surplus = Area A + Area B.

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8. You need to paint your fence but you really hate this task. You decide to hire the kid next door to do it for you. You would be willing to pay him up to $100, but you start by offering $50, expecting to negotiate. To your great surprise, he accepts your $50 offer. When you tell your friend about the great deal you got, she is shocked that you would take advantage of someone. What can you tell your friend to assure her that you did not cheat the kid next door? [LO 5.4] Answer: You can tell your friend that as long as the kid next door was not afraid of you and didn’t feel that he had no choice but to accept your offer, the trade was voluntary. You certainly received surplus from the exchange since you would have been willing to pay more. But just because you hate painting and were willing to pay more does not mean that it was a zero-sum game. The kid next door might like to paint and be outdoors and may have been willing to do the job for even less than $50. By accepting your offer, the kid signaled that $50 was at least equal to his reservation price. If he would have accepted less than $50 to do the job, then he had surplus from the exchange as well.

9. Ontario has rent control for any rental unit built before 1991. Rent control —in essence, is a price ceiling on rent. Is the market for apartments built before 1991 likely to be efficient or inefficient? What does this imply for the size of total surplus? [LO 5.5] Answer: The market for apartments built before 1991 under the maximum price policy is inefficient. Efficiency means maximizing total surplus. If the maximum price policy moves the price away from its equilibrium price (which it does), surplus will not be maximized. Any price other than the equilibrium price will not maximize surplus. It should be noted that the richard@qwconsultancy.com

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goal of placing a maximum price on apartments is not to make the market efficient. It is an attempt to make the market more equitable. We will address the tradeoff between efficiency and equity more as we move forward.

10. Total surplus is maximized at the equilibrium price and quantity. When demand increases, price increases. Explain how total surplus is still maximized if price increases due to an increase in demand. [LO 5.5] Answer: When demand increases, the market moves to a new equilibrium. The price will be higher but surplus will still be maximized because the market is still functioning at its (new) equilibrium price.

11. Atlantic Provinces of Canada have a price ceiling on gasoline to keep it affordable. How does this policy affect producer and consumer surplus? How does this policy affect total surplus?

[LO 5.6]

Answer: A price ceiling (maximum price) below the equilibrium price would reduce producer surplus. There would be fewer trades and the trades that did occur would happen at a lower price. For consumers, the story is a bit more complicated. Some consumers would gain and some would lose surplus. Consumers who were able to trade would do so at a lower price. They would gain surplus. However, because there would be fewer trades, some consumers would no longer be able to trade and would lose surplus. In the end, the losers (producers and some consumers) would lose more than the winners (consumers able to find trades) would gain, and total surplus would decrease.

12. Consider a policy to help struggling farmers by setting a minimum trade price for wheat. Will this be an effective way to increase their surplus? Explain. [LO 5.6] Answer: Minimum prices are also inefficient and cause fewer trades to occur than would occur at the equilibrium price. In the case of a minimum price for wheat, some farmers would gain because they will receive a higher price than the equilibrium price. However, fewer trades will occur and some farmers will be unable to trade. Remember that at a price above equilibrium, quantity supplied exceeds quantity demanded and there is excess supply.

13. If rent control creates deadweight loss for both consumers and suppliers of housing, why are consumers often in favor of this policy?

[LO 5.7]

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Answer: Even though rent control causes fewer trades and deadweight loss, some consumers will benefit by the lower prices. Consumers support the policy if they believe they will be among those who are able to find housing at lower prices.

14. Suppose price is 5 percent above equilibrium in two markets: a market for a necessity and a market for a luxury good. All else equal (including supply conditions), in which market do you expect deadweight loss to be greater? Explain. [LO 5.7] Answer: Deadweight loss would be greater in the market for the luxury good. This is because demand will be more elastic. Consumers will react more (in terms of buying less of a good) to a higher price when demand is elastic.

15. Your grandmother likes old-fashioned yard sales and doesn’t understand why everyone is so excited about eBay. Explain to her why the creation of a market that enables people who don’t live in the same town to buy and sell used goods increases total surplus over the yardsale market. [LO 5.8] Answer: Yard sales are nice because you get to meet people and chat with them face to face, but eBay helps people connect across great distances. If you are looking to buy something in particular and are limited to looking at yard sales in your town, you may not find what you’re looking for. If you do a search on eBay, though, your chances are much greater that you will find somebody selling that item. And if you want to sell something, you will have access to many more buyers on eBay than those that might wander by your yard sale. It’s also possible that more than one person will be interested in what you are selling and their competition for your item will get you a much better price.

16. At Zooey’s elementary school, children are not allowed to trade lunches or components of their lunches with other students. Lunchroom monitors watch closely and strictly enforce this policy. Help Zooey make an argument about the inefficiency of this policy to her principal. [LO 5.8] Answer: The school policy is preventing a market that would generate mutually beneficial trades. A student who likes bologna sandwiches better than tuna sandwiches might trade her tuna sandwich to another student who thinks the bologna sandwich in her lunch pail is gross. Both students are happier after this trade. The ban on lunch trading prevents the surplus that would be generated by allowing lunch items to be allocated according to voluntary trades from being realized. (Of course, the principal might care less about the preferences of the students than those of their parents!) richard@qwconsultancy.com

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Problems and Applications 1. Answer the following questions based on Tables 5P-1 and 5P-2. [LO 5.1] a. What is the quantity demanded at $10? What is the quantity supplied at $10? b. What is the quantity demanded at $25? What is the quantity supplied at $25?

Answer: a. Quantity demanded is 8 units. Consumers B, C, D, E, F, G, H, and I (all but A) are all willing to pay at least $10. Quantity supplied is 2.

Only suppliers B and H are willing to sell at a price of $10. b. Quantity demanded is 3 units. Only consumers B, E, and F are willing to pay $25. Quantity supplied is 7. Suppliers A, B, D, E, F, H, and I (all but C and G) are willing to sell at a price of $25.

2. Use the information below to construct a step-graph of the six consumers’ willingness to pay. [LO 5.1]

Answer:

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3. Use the information below to construct a step-graph of the six sellers’ willingness to sell. [LO 5.1]

Answer:

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4. Based on Table 5P-1, calculate consumer surplus for each consumer when the price is $17. What is the total consumer surplus at this price? [LO 5.2] Answer: Consumer A: $0 (WTP < $17).

Consumer B: $10 ($27 - $17 = $10).

Consumer C: $0 (WTP < $17).

Consumer D: $4 ($21 - $17 = $4).

Consumer E: $16 ($33 - $17 = $16).

Consumer F: $18 ($35 - $17 = $18).

Consumer G: $0 (WTP < $17).

Consumer H: $0 (WTP < $17).

Consumer I: $5 ($22 - $17 = $5).

Total consumer surplus: 0 + 10 + 0 + 4 + 16 + 18 + 0 + 0 + 5 = $53.

5. Use the market represented in Figure 5P-1 to draw the consumer surplus when the market is in equilibrium. What is the value of consumer surplus at the equilibrium price? [LO 5.2] Answer: The consumer surplus is the area under the demand curve and above $7. The value of consumer surplus at this price is 0.5 base × height = 0.5(40)(4) = $80. richard@qwconsultancy.com

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6. Use the market represented in Figure 5P-1 to draw the consumer surplus when the market price is $8. What is the value of consumer surplus at this price? [LO 5.2] Answer: The consumer surplus is the area under the demand curve and above $8. The value of consumer surplus at this price is 0.5 base × height = 0.5(30)(3) = $45.

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7. Based on Figure 5P-1, consumer surplus is $0 when price is greater than or equal to what price? [LO 5.2] Answer: Consumer surplus is $0 when price is ≥ $11.

8. Based on Table 5P-2, calculate producer surplus for each producer when the price is $12. What is total producer surplus at this price? [LO 5.3] Answer: Seller A: $0 (WTS > $12).

Seller B: $8 ($12 — 4 = $8).

Seller C: $0 (WTS > $12).

Seller D: $0 (WTS > $12).

Seller E: $0 (WTS = $12).

Seller F: $0 (WTS > $12).

Seller G: $0 (WTS > $12).

Seller H: $3 ($12 — $9 = $3).

Seller I: $0 (WTS > $12).

Total producer surplus = 0 + 8 + 0 + 0 + 0 + 0 + 0 + 3 + 0 = $11.

9. Use the market represented in Figure 5P-1 to draw the producer surplus when the market is in equilibrium. What is the value of producer surplus at the equilibrium price? [LO 5.3] richard@qwconsultancy.com

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Answer: The producer surplus is the area above the supply curve and below $7. The value of producer surplus at this price is 0.5 base × height = 0.5(40)(4) = $80.

10. Use the market represented in Figure 5P-1 to draw the producer surplus when the market price is $5. What is the value of producer surplus at this price? [LO 5.3] Answer: The producer surplus is the area above the supply curve and below $5. The value of producer surplus at this price is 0.5 base × height = 0.5(20)(2) = $20.

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11. Based on Figure 5P-1, producer surplus is $0 when price is less than or equal to what price? [LO 5.3] Answer: Producer surplus is $0 when price is ≤ $3.

12. What is the value of the existence of the market represented in Figure 5P-2? [LO 5.4] Answer: The value of the existence of a market is given by the total surplus possible in that market. In Figure 5P-2, the total surplus that is possible is 0.5(70)(44 — 2) = $1,470.

13. Consider the market represented in Figure 5P-3. [LO 5.4] a. Calculate total surplus when demand is D1. b. Calculate total surplus when demand decreases to D 2.

Answer: Total surplus when demand is D1: 0.5(100)(22 — 6) = $800. Total surplus when demand decreases to D2: 0.5(50)(16 — 6) = $250.

14. Consider the market represented in Figure 5P-4. [LO 5.4] a. Calculate total surplus when supply is S1. b. Calculate total surplus when supply increases to S2.

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Answer: Total surplus when supply is S1: 0.5(50)(50 — 20) = $750. Total surplus when supply increases to S2: 0.5(75)(50 — 10) = $1,500.

15. Consider the market represented in Figure 5P-5. [LO 5.5] a. Draw the consumer surplus and producer surplus if the market is functioning at the equilibrium price and quantity. Compute the total surplus if the market is functioning at the equilibrium price and quantity. b. Compute the consumer surplus and producer surplus if the price is $30. c. Compute the consumer surplus and producer surplus if the price is $10.

Answer: a. Total surplus = 0.50(40)(4) = $80.

b. Consumer surplus = 0.50(40 - 30)(2) = $10. Producer surplus = (30 10)(2) + 0.50(10)(2) = $50. Total surplus = $60. c. Consumer surplus = 0.50(40 - 30)(2) + (30 - 10)(2) = $50. Producer surplus = 0.50(10)(2) = $10. Total surplus = $60.

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16. Assume the market for wine is functioning at its equilibrium. For each of the following situations, say whether the new market outcome will be efficient or inefficient. [LO 5.5] a. A new report shows that wine is good for heart health. b. The government sets a minimum price for wine, which increases the current price. c. An unexpected late frost ruins large crops of grapes. d. Grape pickers demand higher wages, increasing the price of wine.

Answer: a. Efficient. Demand increases and the market functions at its new equilibrium. b. Inefficient. Setting a minimum price will move the market away from its equilibrium. c. Efficient. Supply decreases and the market functions at its new equilibrium. d. Efficient. Supply decreases and the market functions at its new equilibrium.

17. Based on Figure 5P-6, choose all of the following options that are true.

[LO 5.5, 5.6] a. The market is efficient. b. Total surplus is higher than it would be at market equilibrium. c. Total surplus is lower than it would be at market equilibrium. d. Producer surplus is lower than it would be at market equilibrium. e. Consumer surplus is lower than it would be at market equilibrium.

Answer: C and E. Total surplus is lower than it would be at market equilibrium. Consumer surplus is lower than it would be at market equilibrium.

18. In which of the following situations can you say, without further information, that consumer surplus decreases relative to the market equilibrium level? [LO 5.6] a. Your province passes a law that pushes the interest rate (i.e., the price) for payday loans below the equilibrium rate. b. The federal government enforces a law that raises the price of dairy goods above the equilibrium. c. Your city passes a local property tax, under which buyers of new houses have to pay an additional 5 percent on top of the purchase price.

Answer: B and C. The federal government enforces a law that raises the price of dairy goods above the equilibrium. Your city passes a local property tax, under which buyers of new houses have to pay an additional 5 percent on top of the purchase price.

19. Use the areas labeled in the market represented in Figure 5P-7 to answer the following questions. [LO 5.6] a. What area(s) are consumer surplus at the market equilibrium price? richard@qwconsultancy.com

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b. What area(s) are producer surplus at the market equilibrium price? c. Compared to the equilibrium, what area(s) do consumers lose if price is P2? d. Compared to the equilibrium, what area(s) do producers lose if the price is P2? e. Compared to the equilibrium, what area(s) do producers gain if the price is P2? f. Compared to the equilibrium, total surplus decreases by what area(s) if the price is P2?

Answer: a. A, B, C. b. D, E. c. B, C. d. E. e. B. f. C, E. 20. Figure 5P-8 shows a market for cotton, with the price held at $0.80 per pound. Calculate the dead-weight loss caused by this policy. [LO 5.7] Answer: Deadweight loss = 0.5($.30)(20m) = $3 million 21. Consider the market represented in Figure 5P-9. [LO 5.7] a. Suppose the government sets a minimum price of $25 in the market.

Calculate the deadweight loss. b. Suppose the government sets a maximum price of $25 in the market.

Calculate the deadweight loss.

Answer: a. Deadweight loss = 0.5(10)(12) = $60. b. Deadweight loss = $0. If the maximum price is $25, the market will function at its equilibrium price, which is $20. Since the price ceiling is above the equilibrium it is not binding.

22. We can consider the market for traveling to Mars to be missing, because no technology exists that allows this service to be bought and sold. Suppose that someone has invented space-travel technology that will enable this service to be provided. Figure 5P-10 shows the estimated market for trips to Mars. Calculate the surplus that could be generated by filling in this missing market. [LO 5.8] richard@qwconsultancy.com

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Answer: Since the market does not currently exist, the surplus gained would be the area of total surplus: 0.5(40)(310,000 – 150,000) = $3,200 thousand.

23. Consider the market for travelling to Mars represented in Figure 5P-10.

Assuming consumers knew they would each eventually pay $190,000 for the trip itself, how much would they collectively be willing to invest to support the space program that would make this trip possible? [LO 5.8] Answer: Consumers would be willing to spend up to the amount of their consumer surplus. Consumer surplus is the difference between how much consumers are willing to pay (the value they place on purchasing a good) and the actual price they pay. The consumer surplus in this market represents the value that consumers place on taking a trip to Mars. They would be willing to invest up to this amount to make the trip possible.

The value of consumer surplus is: 0.5(40)(310,000 – 190,000) = $2,400 thousand.

CHAPTER 6 GOVERNMENT INTERVENTION Chapter Overview If you listen to the news, it might seem as if economics is all about business and the stock market. Business matters, but many of the most important, challenging, and useful applications of economic principles involve public policy.

This chapter gives you the basic tools you need to understand government interventions and some of the ways they can affect your everyday life. Of course, the real world is complicated, so this isn’t our last word on the topic. Later, we discuss how to evaluate the benefits of both markets and government policies. We’ll also discuss market failures and whether and when governments can fix them.

Learning Objectives LO 6.1: Calculate the effect of a price ceiling on the equilibrium price and quantity. richard@qwconsultancy.com

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LO 6.2: Calculate the effect of a price floor on the equilibrium price and quantity.

LO 6.3: Calculate the effect of a tax on the equilibrium price and quantity.

LO 6.4: Calculate the effect of a subsidy on the equilibrium price and quantity.

LO 6.5: Explain how elasticity and time period influence the impact of a market intervention.

Chapter Outline OPENING STORY: FEEDING THE WORLD, ONE PRICE CONTROL AT A TIME Why Intervene?

Three Reasons to Intervene Four Real-World Interventions Price Controls Price Ceilings (LO 6.1) BOX FEATURE: HOW ENEFICIAL IS DRUG PRICE CONTROL IN CANADA Price Floors (LO 6.2) Taxes and Subsidies Taxes (LO 6.3) Subsidies (LO 6.4) BOX FEATURE: REAL LIFE – THE UNINTENDED CONSEQUENCES OF BIOFUEL SUBSIDIES Evaluating Government Interventions (LO 6.5) How Big Is the Effect of a Tax or Subsidy?

BOX FEATURE: WHERE CAN IT TAKE YOU? – PUBLIC ECONOMICS Long-Run versus Short-Run Impact BOX FEATURE: WHAT DO YOU THINK? – FARM SUBSIDIES Conclusion

Beyond the Lecture Class Discussion: Price Ceilings (LO 6.1) Have students read Rent-Stabilized Apartments, Ever More Elusive by Mark Santora. The NY Times article highlights the shortage of rent-stabilized apartments in New York City and discusses some of the other issues associated with rent controls. Additionally, consider showing this clip from the TV show Seinfeld (Season 2: The Apartment), where Jerry discusses rent control apartments in New York City.

1. What are the proposed benefits of rent controls? What are the costs?

2. How do rent controls impact price and quantity?

3. How do rent controls impact the market for housing?

Class Discussion: Price Floors (LO 6.2) Discuss the minimum wage with students as an example of a price floor. Students really enjoy this topic. Consider asking students to read The Business of the Minimum Wage by Christina D.

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Romer. This is a nice topic for a small group in the classroom or for students in an online format. The following are great questions to consider with students: 1. What are the proposed benefits and potential problems associated with an increase in the minimum wage?

2. What is the likely impact on price (wage in this case) and quantity?

3. Although economists care deeply about improving the situation of individuals earning low salaries, why might many economists be less likely to support higher minimum wages relative to other policies to help lower-income individuals?

Class Discussion: Taxes (LO 6.3) Carbon pricing is a new federal policy in Canada. The following link present different types of carbon policies across Canada (https://www.c2es.org/document/canadian-provincial-carbonpricing/). Carbon tax is one of the main policy tools of carbon pricing that imposes a tax on gasoline.

1. Have students consider the impact of a carbon tax on price and quantity of gasoline.

2. How does the price elasticity of demand play a role in the impact of a tax?

3. Ask students how they would respond to carbon taxes.

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Class Discussion: Subsidies (LO 6.4) Have students view this short video report by Angel Gonzalez from the Wall Street Journal. It discusses the impact of subsidized gasoline in Venezuela. The report shows the opportunity for arbitrage in neighboring Colombia, where gasoline prices are much higher. Additionally, the attempt of the government to combat gasoline smuggling is discussed.

1. How do gasoline subsidies impact gasoline prices in Venezuela? How does the subsidy impact the quantity demanded?

2. How does the gasoline subsidy in Venezuela create an arbitrage opportunity?

Solutions to End-of-Chapter Questions and Problems Review Questions 1. You are an advisor to the Egyptian government, which has placed a price ceiling on bread. Unfortunately, many families still cannot buy the bread they need. Explain to government officials why the price ceiling has not increased consumption of bread. [LO 6.1] Answer: The price ceiling has not increased the consumption of bread because it reduces the quantity supplied. A price ceiling below the equilibrium price will mean that some families will be able to purchase bread at a lower price, but on the whole fewer families will be able to purchase bread at all because there will be a shortage.

2. Suppose there has been a long-standing price ceiling on housing in your city. Recently, population has declined, and demand for housing has decreased. What will the decrease in demand due to the efficiency of the price ceiling? [LO 6.1] Answer: A binding price ceiling keeps the price below the equilibrium quantity and creates both a shortage and a deadweight loss. If demand decreases, the equilibrium price would fall. This will make the shortage and deadweight loss smaller. If demand decreases enough, the price ceiling could become non-binding and there would be no shortage or deadweight loss.

3. Suppose Canada maintains a price floor for spinach. Why might this policy decrease revenues for spinach farmers? [LO 6.2] Answer: A binding price floor will guarantee a minimum price for spinach above the equilibrium price. Farmers will receive a higher price for the richard@qwconsultancy.com

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spinach that they are able to sell. However, the price floor will create excess supply, as quantity demanded will decrease due to the higher price. If demand for spinach is elastic, revenues would decrease.

4. Suppose Colombia maintains a price floor for coffee beans. What will happen to the size of the deadweight loss if the price floor encourages new growers to enter the market and produce coffee? [LO 6.2] Answer: If additional producers enter the market, the supply curve would shift right and the equilibrium price would fall. That is, the price that would prevail in the absence of the floor would be even lower than the original equilibrium. This means the price floor is even more distortionary than it was before. The size of the deadweight loss would increase.

5. Many provinces tax cigarette purchases. Suppose that smokers are unhappy about paying the extra charge for their cigarettes. Will it help smokers if the province imposes the tax on the stores that sell the cigarettes rather than on smokers? Why or why not? [LO 6.3] Answer: No. The statutory incidence does not matter. If sellers were taxed instead of buyers of cigarettes, the price that consumers pay would remain exactly the same. The tax incidence or burden of the tax is a function of the relative elasticities of supply and demand and is not determined by which side of the market is officially taxed.

6. Consider a tax on cigarettes. Do you expect the tax incidence to fall more heavily on buyers or sellers of cigarettes? Why? [LO 6.3] Answer: The tax incidence will fall more heavily on the side of the market that is less elastic. In the case of cigarettes, demand could be less elastic than supply because smoking is addictive and consumers may have a harder time reducing consumption than producers would have reducing supply.

7. In the Philippines, rice production is lower than rice consumption, resulting in a need to import rice from other countries. In this situation, the Philippine government might consider subsidizing rice farmers. What are the potential benefits of such a policy? What are the costs? [LO 6.4] Answer: Subsidizing rice production will increase both consumer and producer surplus. Consumers will be able to by domestic rice at a lower price and producers will receive a higher price. Therefore, the domestic richard@qwconsultancy.com

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equilibrium quantity will increase. Government will have to pay for the subsidy, however. And this will come at the expense of taxpayers.

8. A subsidy will increase consumer and producer surplus in a market and will increase the quantity of trades. Why, then, might a subsidy (such as a subsidy for poultry farms in Canada) be considered inefficient? [LO 6.4] Answer: A subsidy might be considered inefficient because the prices that consumers pay are artificially low and the prices sellers receive are artificially high. These prices would not occur without the subsidy, which comes at a cost to taxpayers. Looking at the market equilibrium, a subsidy will encourage trades to occur past this point. But for each unit to the right of the market equilibrium quantity, the cost of supplying that unit or exceeds the willingness to pay. This is why these trades don’t occur in the absence of the subsidy. The subsidy encourages the market to move beyond the point where willingness to pay is greater than or equal to willingness to sell. It is always a good idea to ask why we want a market to function beyond its equilibrium. If we think the market equilibrium quantity is too low and we want more trades to occur, the cost of the subsidy might be worth it. If not, the subsidy is inefficient.

9. Suppose the government imposes a price ceiling on gasoline. One month after the price ceiling, there is a shortage of gasoline, but it is much smaller than critics of the policy had warned. Explain why the critics’ estimates might still be correct. [LO 6.5] Answer: Elasticity is greater over a longer time horizon. In the first month, supply and demand are less responsive to a price control than they will be over a longer time horizon. Over time the shortage of gasoline is likely to grow as elasticity in the market increases. The critics’ estimate of a larger shortage than was seen after one month might turn out to be on target if measured over a longer time frame.

10. A province facing a budget shortfall decides to tax soft drinks. You are a budget analyst for the province. Do you expect to collect more revenue in the first year of the tax or in the second year? Why? [LO 6.5] Answer: You would expect to collect more tax revenue in the first year.

You collect taxes only on trades that occur. Taxes will reduce the number of trades. In the first year, the number of trades reduced due to the tax will be smaller than in the second year because elasticity is larger over a longer time frame. richard@qwconsultancy.com

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Problems and Applications 1. Many people are concerned about the rising price of gasoline. Suppose that government officials are thinking of capping the price of gasoline below its current price. Which of the following outcomes do you predict will result from this policy? Check all that apply. [LO 6.1] a. Drivers will purchase more gasoline. b. Quantity demanded for gasoline will increase. c. Long lines will develop at gas stations. d. Oil companies will work to increase their pumping capacity.

Answer: B and C. Quantity demanded for gasoline will increase at a price below the equilibrium price. Drivers will not purchase more gasoline, however, because quantity supplied will be below the equilibrium quantity. As a result, there will be a shortage of gasoline and long lines will develop at gas stations. With a ceiling on price, oil companies will not have an incentive to increase quantity supplied.

2. Figure 6P-1 shows a market in equilibrium. [LO 6.1] a. Draw a price ceiling at $12. What is the amount of shortage at this price? Draw and calculate the deadweight loss. b. Draw a price ceiling at $4. What is the amount of shortage at this price? Draw and calculate the deadweight loss.

Answer: a. The price ceiling is non-binding because it is above the equilibrium quantity. There is no shortage. There is also no deadweight loss. The market will function at its equilibrium. Shortage = 0. DWL = $0.

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b. The shortage due to the price ceiling is Qd-Qs = 8-2 = 6. The deadweight loss is 0.5(6 - 2)(16 - 4) = $24.

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3. Decades of overfishing have dramatically reduced the world supply of cod (a type of whitefish). Farm-raised halibut is considered a close substitute for ocean-fished cod. [LO 6.1] a. On the graph in Figure 6P-2, show the effect of overfishing cod on the market for farmed halibut. b. A fast-food chain purchases whitefish for use in its Fish ’n’ Chips meals. Already hurt by the reduced supply of cod, the fast-food chain has lobbied aggressively for price controls on farmed halibut. As a result, Parliament has considered imposing a price ceiling on halibut at the former equilibrium price—the price that prevailed before overfishing reduced the supply of cod. On your graph, show what will happen in the market for farmed halibut if Parliament adopts the price control policy. Draw and label the price ceiling, quantity demanded, quantity supplied, and deadweight loss.

Answer: a. Due to the reduced supply of cod, the price of cod will rise. Because they are substitutes, if the price of cod goes up, demand for farmed halibut will increase. This will cause the price and quantity of farmed halibut to increase. b. Demand for halibut has increased due to the reduced supply of cod. If the price of halibut is not allowed to increase accordingly, the quantity demanded for halibut will exceed quantity supplied and there will be a shortage of fish. The deadweight loss is shown. c.

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4. The Organization for the Promotion of Brussels Sprouts has convinced the government of Ironia to institute a price floor on the sale of brussels sprouts, at $8 per bushel. Demand is given by P = 9 - Q and supply by P = 2Q, where Q is measured in thousands of bushels. [LO 6.2] a. What will be the price and quantity of brussels sprouts sold at market equilibrium? b. What will be the price and quantity sold with the price floor? c. How big will be the excess supply of brussels sprouts produced with the price floor?

Answer: a. Solve for equilibrium. P = 9 - Q = 2Q; 9 = 3Q; Q = 3 thousand bushels. P = $6. b. The price floor is above the equilibrium price, so it is binding. The price will be P = $8 = 9 - Qd; so Qd = 1 thousand bushels. At this price of $8, quantity supplied is $8 = 2Qs, Qs = 4 thousand bushels, but quantity demanded is only 1 thousand. Therefore, the quantity sold is 1 thousand bushels. c. The amount of excess is supply is Qs - Qd = 4 - 1 = 3 thousand bushels.

5. The traditional diet of the citizens of the nation of Ironia includes a lot of red meat, and ranchers make up a vital part of Ironia’s economy. The richard@qwconsultancy.com

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government of Ironia decides to support its ranchers through a price floor, which it will maintain by buying up excess meat supplies. Table 6P1 shows the supply and demand schedule for red meat; quantities are given in thousands of pounds. [LO 6.2] a. How many thousands of pounds of meat would you recommend that the government purchase to keep the price at $4/pound? b. How much money should the government budget for this program?

Answer: a. At a price of $4, quantity supplied = 60,000 but quantity demanded equals 35,000. So excess supply is 25,000. This is what the government will need to purchase. b. If the government buys 25,000 of excess supply at $4 per unit, it will need to budget $100,000.

6. Suppose you have the information shown in Table 6P-2 about the quantity of a good that is supplied and demanded at various prices. [LO 6.3], [LO 6.5] a. Plot the demand and supply curves on a graph, with price on the yaxis and quantity on the x -axis. b. What are the equilibrium price and quantity? c. Suppose the government imposes a $15 per unit tax on sellers of this good. Draw the new supply curve on your graph. d. What is the new equilibrium quantity? How much will consumers pay?

How much will sellers receive after the tax? e. Calculate the price elasticity of demand over this price change. f. If demand were less elastic (holding sup-ply constant), would the deadweight loss be smaller or larger?

Answer: a. See graph below, curve S1.

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b. The equilibrium price is $20 and the equilibrium quantity is 60. Check this against the table provided. c. See the graph in part a, curve S2. d. The new equilibrium quantity is 40. Consumers will pay $30 and suppliers will receive $15. e. Price elasticity of demand = (% change in Qd)/(% change in Pc). Pc is the price consumers pay. % change in Qd = (60 - 40)/[60 + 40)/2] = -0.4. % change in Pc = (30 - 20)/[(30 + 20)/2] = 0.4. Price elasticity of demand = -0.4/0.4 = -1. f. The DWL would be smaller if demand were less elastic.

7. The weekly supply and demand for fast-food cheeseburgers in your city is shown in Figure 6P-3. In an effort to curb a looming budget deficit, the mayor recently proposed a tax that would be levied on sales at fast-food restaurants. [LO 6.3] a. The mayor’s proposal includes a sales tax of 60 cents on cheeseburgers, to be paid by consumers. What is the new outcome in this market (how many cheeseburgers are sold and at what price)?

Illustrate this outcome on your graph. b. How much of the tax burden is borne by consumers? How much by suppliers? c. What is the deadweight loss associated with the proposed tax? d. How much revenue will the government collect? richard@qwconsultancy.com

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e. What is the loss of consumer surplus from this tax?

Answer:

a. Quantity supplied and demanded with the tax = 30 thousand. Price paid by consumers = $1.40. Price received by sellers =$0.80. b. The pre-tax price is $1.10. Consumers pay $0.30 of the tax ($1.40 $1.10). Suppliers pay $0.30 of the tax ($1.10 - $0.80). The tax burden is therefore shared equally by consumers and producers. c. The efficiency costs of the tax are the mutually beneficial trades between 30,000 and 45,000 cheeseburgers that do not occur. DWL = ½ (45,000 - 30,000) × ($0.60) = $4,500. d. The government will collect $0.60 on each cheeseburger sold.

Therefore, tax revenue will be 0.60(30,000) = $18,000. e. The loss of consumer surplus is the portion of tax revenue that is borne by consumers as well as the portion of deadweight loss that comes from consumers. The consumer potion of the tax burden is $0.30, so 0.30(30,000) = $9,000. This is the consumer surplus that is lost to tax revenue. The consumer portion of the deadweight loss is 0.5(15,000)(0.30) = $2,250. The total amount of surplus consumers lose is $9,000 + $2,250 = $11,250.

8. Demand and supply of laptop computers are given in Figure 6P-4. The quantity of laptops is given in thousands. Suppose the government

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provides a $300 subsidy for every laptop computer that consumers purchase. [LO 6.4] a. What will be the quantity of laptops bought and sold at the new equilibrium? b. What will be the price consumers pay for laptops under the subsidy? c. What will be the price that sellers receive for laptops under the subsidy? d. How much money should the government budget for the subsidy?

Answer: a. The quantity of laptops bought and sold at the new equilibrium is 14,000. b. Consumers will pay $500. c. Sellers will receive $800. d. Government should budget $300 for each computer sold: $300(14,000) = $4,200,000.

9. Suppose the government offers a subsidy to laptop sellers. Say whether each group of people gains or loses from this policy. [LO 6.4] a. Laptop buyers. b. Laptop sellers. c. Desktop computer sellers (assuming that they are different from laptop manufacturers). d. Desktop computer buyers.

Answer: a. Gain: The subsidy will lower the price consumers pay. b. Gain: The subsidy will increase the price sellers receive. c. Lose: If laptops are a substitute for desktops, the subsidy for laptops will reduce demand for desktops and drive the price down. d. Gain: If laptops are a substitute for desktops, the subsidy for laptops will reduce demand for desktops and drive the price down. Those who still wish to purchase a laptop can do so at a lower price.

10. Suppose that for health reasons, the government of the nation of Ironia wants to increase the amount of broccoli citizens consume. Which of the following policies could be used to achieve the goal? [LO 6.1], [LO 6.4] a. A price floor to support broccoli growers. b. A price ceiling to ensure that broccoli remains affordable to consumers. c. A subsidy paid to shoppers who buy broccoli. d. A subsidy paid to farmers who grow broccoli.

Answer: C and D. Price controls will reduce the quantity traded in a market. A price ceiling will mean that quantity demanded is greater than quantity supplied but the number of trades will be lower than the equilibrium quantity. A subsidy, however, will increase consumer purchases by the same amount whether the subsidy is given to consumers or to producers. richard@qwconsultancy.com

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11. The following scenarios describe the price elasticity of supply and demand for a particular good. In which scenario will a subsidy increase consumption the most? Choose only one. [LO 6.5] a. Elastic demand, inelastic supply. b. Inelastic demand, inelastic supply. c. Elastic demand, elastic supply. d. Inelastic demand, elastic supply.

Answer: C. Quantity will change the most when both supply and demand are elastic. With elastic demand, consumers will respond more to price falling. With elastic demand, suppliers will respond more to price rising. Both sides of the market will respond strongly to the favorable price conditions they receive with the subsidy.

12. The following scenarios describe the price elasticity of supply and demand for a particular good. All else equal (equilibrium price, equilibrium quantity, and size of the tax), in which scenario will government revenues be the highest? Choose only one. [LO 6.5] a. Elastic demand, inelastic supply. b. Inelastic demand, inelastic supply. c. Elastic demand, elastic supply. d. Inelastic demand, elastic supply.

Answer: B. All else equal, the government will raise more revenue taxing goods that are inelastically supplied and demanded. Inelastic supply and demand means that neither side of the market is very responsive to price changes. Consumers pay a higher price after the tax but inelastic demand means that quantity demanded does not decline much. Producers receive less after a tax but inelastic supply means that quantity supplied does not decline much. Consumers and producers are stuck paying the tax when supply and demand are inelastic.

CHAPTER 7 CONSUMER BEHAVIOR Chapter Overview richard@qwconsultancy.com

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The ideas in this chapter are at the very heart of economic analysis. Everything in the following chapters (and for that matter, the preceding chapters) is in some way based on the assumption that people attempt to maximize their utility within the limitations of the resources available to them. We’ll enrich this picture in the coming chapters, seeing that individuals have to answer a lot of tough questions when making even commonplace decisions. When will the costs arrive relative to the benefits? What are the risks? Am I fully informed about the situation? Are others competing with me for the same goal?

The idea of utility maximization is remarkably flexible. We’ll see that people often have preferences that extend far beyond a narrow definition of their own benefit. Sometimes they pursue their goals in unexpected or not entirely rational ways. Nonetheless, the essential idea of individuals pursuing the things they want in the face of scarcity drives economic analysis from A to Z.

Learning Objectives LO 7.1: Explain how revealed preferences indicate which goods or activities give a person the most utility.

LO 7.2: Show how the budget constraint affects utility maximization.

LO 7.3: Show how a change in income affects consumption choices.

LO 7.4: Show how a change in price affects consumption choices, and distinguish between the income and substitution effects.

LO 7.5: Outline the ways in which utility is influenced by outside perceptions LO 7.6: Describe how people get utility from altruism and reciprocity.

Chapter Outline OPENING STORY: THE GIFT CARD BUY AND SELL

The Basic Idea of Utility Utility and Decision Making Revealed Preference (LO 7.1) BOX FEATURE: REAL LIFE – THE SCIENCE OF HAPPINESS

Utility Functions Marginal Utility Maximizing Utility within Constraints (LO 7.2) Responding to Changes in Income and Prices Changes in Income (LO 7.3) Changes in Prices (LO 7.4) Utility and Society Utility and Status (LO 7.5) BOX FEATURE: FROM ANOTHER ANGLE – CONSPICUOUS CONSUMPTION AND CONSPICUOUS CHARITY richard@qwconsultancy.com

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Utility and Altruism (LO 7.6) BOX FEATURE: REAL LIFE – WHY WE GIVE

Utility and Reciprocity

Beyond the Lecture Class Discussion: Revealed Preference (LO 7.1) There are two great media clips available to highlight the concept of diminishing marginal utility. These can both be used as a discussion starter. Cool Hand Luke is a perfect example of how too much of something that you like can be a bad thing. The Simpsons Treehouse of Horror IV (Season 5, Episode 5, from 2:30 to 5:00) jokes that Homer never tires of doughnuts, seemingly impervious to the law of diminishing marginal utility.

Class Discussion: Revealed Preference, Maximizing Utility within Constraints, and Changes in Income (LO 7.1, LO 7.2, LO 7.3) Consider showing two brief scenes from the movie Dumb and Dumber. In the movie, Harry and Lloyd discover that they have a suitcase full of money in their possession. They had been barely scraping by throughout the movie, but by the end of the movie they have so much money that they use it to blow their nose. Show 1:10:10 to 102:00:00 and 1:25:15 to 102:00:00.

Class Discussion: Changes in Prices (LO 7.4) Ask students to imagine that they are planning a party with friends. Present this scenario for them: they have $50 to spend on pizza for 20 people, and they estimate that they need five pizzas for everyone to have two pieces. They think that the pizzas are $10 each. However, when they arrive at the restaurant, they find that pizzas are on sale for $5 each.

1. How many pizzas will they buy?

2. What do the income and substitution effects suggest will occur in terms of quantity purchased?

3. How will they spend the savings due to the sale price (if at all)?

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Class Discussion: AltruismUtility and Status (LO 7.65) Show students this brief video from TED x (locally organized TED type talks), which discusses effective altruism (please note there is graphic footage at the beginning of this video)the difference between relative and absolute happiness.

1. Ask students what makes them happy. Do they care more about relative or absolute measureshave they done that could be considered altruistic? Why did they do it and was it effective?

1.2. In the video there is mention of some people who have shown altruism. Who else could be added to the list?

2. Why might people care about relative well-being? How could this influence decisions and feelings?

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Which of the following activities give you positive utility? [LO 7.1] a. Playing sports b. Receiving a prestigious scholarship c. Buying a new TV d. Eating Brussels sprouts e. All of the above Answer: For me, the answer is e, all of the above. Playing sports, receiving a scholarship, and buying a TV would all give me utility—and Brussels sprouts are my favorite vegetable.

Of course, the answer will differ for each individual. Other people may find that any amount of Brussels sprouts makes them very unhappy.

2. Your gym offers two classes at the same time: weightlifting and yoga. Both classes are included in your membership and have space available. Your friend tells you he wants to work on his strength and take the weightlifting class, but you always see him in yoga class.

Which class gives him more utility? How do you know this? [LO 7.1] Answer: Yoga class gives your friend the most utility. You know this because your friend reveals his preference by his actions. The fact that your friend chose to go to yoga class “reveals” that he prefers it to weightlifting class. He may say that he wants to increase his strength by weightlifting, but his choice to go to yoga indicates that he is happier going to this class.

3. Evie has a gift pass for unlimited rollercoaster rides on her birthday. Given the information about Evie’s utility in Table 7P-1, explain why she chooses to ride only three times. [LO 7.1]

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Answer: Evie’s marginal utility is positive for the first three rides. It makes sense for Evie to take these rides. However, Evie’s marginal utility is negative after the third ride (perhaps she starts to feel sick), and a fourth ride will decrease her happiness.

4. Dan likes to spend his allowance on two things: candy and toys. What are the three constraints that determine the possible consumption bundles of toys and candy available to Dan? [LO 7.2] Answer: Dan’s budget constraint is determined by the amount of his allowance, (whatever bundle of toys and candy Dan chooses, it cannot cost more than the money he has to spend), the price of toys, and the price of candy. Together, these three constraints determine the possible consumption bundles available to Dan. 5. Evan has $40 to spend at an amusement park. The roller coaster costs $10 per ride. Given the information about Evan’s utility in Table 7P-2, explain why he chooses to ride only three times. [LO 7.2] Answer: Evan can afford four roller coaster rides, and his marginal utility from the fourth ride is still positive. The fact that Dan does not choose to ride the roller coaster a fourth time must mean that the marginal utility he gets from the fourth ride is less than the utility he would get from spending that $10 on something else.

6. Suppose a wedge of cheese is $10, and a loaf of bread is $5. What is the opportunity cost of purchasing a wedge of cheese (in terms of bread)? Explain what happens to the opportunity cost of purchasing a wedge of cheese (in terms of bread) if your income decreases by 20 percent. [LO 7.3] Answer: The opportunity cost of purchasing a wedge of cheese is two loaves of bread because the $10 you spend on a wedge of cheese could have purchased two loaves of bread.

If your income decreases by 20 percent, your budget constraint shifts in. You are now able to buy less bread and cheese. However, the opportunity cost of purchasing a wedge of cheese has not changed. As long as the price of cheese is still $10 and bread is still $5, the opportunity cost of purchasing a wedge of cheese is still two loaves of bread. A change in your income does not change the relative trade-off between the goods you consume. This trade-off is determined by the prices of the goods.

7. Simone spends $200 a month on voice lessons and dance lessons. She just learned that starting next month her favorite dance instructor is moving out of town and the monthly rent for her apartment is increasing. How will each of these events affect Simone’s budget constraint for voice and dance lessons? [LO 7.3] Answer: The fact that Simone’s favorite instructor is moving may reduce her consumption of dance lessons, but it will not affect her budget constraint. Simone’s increase in rent, however, will probably reduce the amount of money she has available for lessons. If so,

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Simone’s budget constraint will shift in. She will need to reduce the number of voice or dance lessons (or both) she takes.

8. Julian buys plants and flowers every month. Both are normal goods. When the price of flowers fell, Julian purchased fewer plants. Which effect was stronger for Julian, the income effect or the substitution effect? [LO 7.4] Answer: The substitution effect was stronger. When the price of flowers falls, the income effect predicts that Julian will buy more flowers and more plants because both are normal goods. However, the income effect predicts that Julian will substitute toward flowers and away from plants because plants have become more expensive relative to flowers. We don’t know which effect will prevail until we observe Julian’s behavior. Since he purchased fewer plants, the substitution effect was stronger for Julian.

9. Sarah spends her monthly entertainment budget on books and movies. Sarah’s initial utilitymaximizing combination of books and movies is five movies and two books a month.

Assume the price of books falls. Sarah’s new utility-maximizing combination of books and movies is five movies and four books. Given this information, can we say whether movies are a normal good? [LO 7.4] Answer: Yes. We know that the substitution effect will lead Sarah to substitute away from movies and toward books, since books are now cheaper relative to movies. The substitution effect is negative for movies. Since consumption of movies remains constant, this means that the income effect must be positive and lead Sarah to consume more books, offsetting the negative substitution effect. If the income effect is positive when purchasing power increases, the good is normal.

10. Your friend says, “I’d rather be a big fish in a small pond than a small fish in a big pond.”

What concept does this comment illustrate? [LO 7.5] Answer: Your friend has illustrated the concept of frames of reference. Your friend is saying that she would rather be an in a smaller setting if she can be an important player than be in a larger setting if her role is diminished. This is similar to an actor saying she would rather play the lead in her community theater than play a bit part on a Broadway stage.

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An organization that raises money to provide meals for seniors gives tote bags to its donors. Sami thinks it is wasteful to spend donated money on tote bags for donors because the money could be used to provide more meals.

Explain to Sami why giving tote bags could make financial sense for the organization. [LO 7.5]

10.1.

11. Answer: The benefit of giving the bags outweighs the cost of the bags. It is a worthwhile incentive.Suppose that in addition to being a college student, you run your own business and richard@qwconsultancy.com

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earn $35,000 per year. Your friends are all in college, and their average annual income is $10,000 per year. When you graduate from college, you decide to continue running your business. Your friends accept jobs that pay $50,000 per year. Do you expect your utility to increase, decrease, or stay the same after graduation? Why? [LO 7.5LO 7.5] Answer: Even though your own income has not changed, you now make relatively less than your friends instead of relatively more. Your frame of reference has changed, and this may lead to lower utility. Of course, being your own boss may make you happier, and this might outweigh the relative differences in your income compared to your friend.

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12. You come home to discover that your roommate has left their dirty dishes in the sink

(again!). Why might you be likely to leave your own dirty dishes in the sink (which you know annoys your roommate), even though you usually prefer a clean kitchen to a messy kitchen? [LO 7.6LO 7.6]

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13. An organization that raises money to provide meals for seniors gives tote bags to its donors.

Sami thinks it is wasteful to spend donated money on tote bags for donors because the money could be used to provide more meals. Explain to Sami why giving tote bags could make financial sense for the organization. [LO 7.5]6] Answer: The benefit of giving the bags outweighs the cost of the bags. It is a worthwhile incentive.

11. Your friend says, “I’d rather be a big fish in a small pond than a small fish in a big pond.”

What concept does this comment illustrate? [LO 7.5] Answer: Your friend has illustrated the concept of frames of reference. Your friend is saying that she would rather be an in a smaller setting if she can be an important player than be in a larger setting if her role is diminished. This is similar to an actor saying she would rather play the lead in her community theater than play a bit part on a Broadway stage.

Problems and Applications 1. Total utility is maximized when marginal utility becomes (positive, zero, negative). [LO 7.1] Answer: Zero. If marginal utility is positive, total utility will increase if you consume the next unit. If marginal utility is negative, total utility will decrease if you consume the next

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unit. If marginal utility is zero, total utility is maximized, and the next unit will neither increase nor decrease total utility.

2. Table 7P-3 shows the total utility that John gets from ice cream, for each quantity he consumes. Fill in the third column showing the marginal utility he gets from each additional scoop. [LO 7.1] Answer: Quantity of ice cream (scoops) 1 2 3 4 5

Total utility 10 17 21 23 23

Marginal utility of the last scoop eaten 10 7 4 2 0

3. You love going to the movies. For your birthday, your friend offers to take you to a triple feature without popcorn or a double feature with two bags of popcorn. Table 7P-4 shows your utility for movies and popcorn. Which option should you choose? [LO 7.1] Answer: You will be happiest choosing the double feature with popcorn. Even though you get no additional utility from the second bag of popcorn, the first bag of popcorn gives you 5 units of utility, which is more than the marginal utility of the third movie (three units). A double feature with popcorn gives you 20 units of utility, whereas a triple feature gives you 18 units of utility.

4. Refer to the budget constraint for jeans and T-shirts in Figure 7P-1. Which of the following consumption bundles is attainable? [LO 7.2] a. 3 pairs of jeans, 1 T-shirt. b. 2 pairs of jeans, 4 T-shirts. c. 2 pairs of jeans, 3 T-shirts. d. 1 pair of jeans, 4 T-shirts.

Answer: d: 1 pair of jeans, 4 T-shirts. This is the only consumption bundle that falls on the budget constraint. All other bundles are unattainable, given current resources.

5. Petra has $480 to spend on DVDs and books. A book costs $24 and a DVD costs $15. [LO 7.2] a. Write an equation for the budget constraint. Let x = 5 books. Let y = 5 DVDs. b. Use your equation to determine how many books Petra can buy if she buys 8 DVDs. Answer: a. 480 = 24x + 15y b. 480 = 24x + 15(8) richard@qwconsultancy.com

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480 = 24x + 120 360 = 24x 15 = x Petra can buy 15 books if she buys 8 DVDs. 6. Jordan visits her sister several times a year. Jordan’s travel budget is $600, which she uses to buy bus tickets and train tickets. The train costs $120 per trip, and the bus costs $40. [LO 7.2, 7.3] a. Graph Jordan’s budget constraint. b. How many total trips can Jordan take if she takes the train three times? c. Suppose Jordan’s travel budget is cut to $360. Draw her new budget constraint. d. How many train trips can she take if she doesn’t want to reduce the total number of trips she takes each year?

Answer: a, c. See BCa and BCc in the graph below.

b. Taking the train 3 times costs Jordan $360. This leaves her with $240 for bus rides. Since each bus ride costs $40, Jordan can take 6 bus rides. Jordan takes a total of 9 trips each year to see her sister. d. If Jordan wants to continue to take 9 trips a year, she will need to take the bus for all 9 trips. Jordan will take zero train trips each year.

7. Maria has a $300 gift certificate at a spa that she can use on massages or manicures. A massage costs $100, and a manicure costs $30. [LO 7.3, 7.4] richard@qwconsultancy.com

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a. Write the equation for Maria’s budget constraint. Let x = 5 massages. Let y = 5 manicures. b. Suppose Maria decides to split her gift certificate with a friend and transfers half of the value of her gift certificate to her friend. Write the equation for her new budget constraint. c. After giving away half of her gift certificate, suppose the price of a massage increases by 50 percent before Maria can use her gift certificate. Write the equation for her new budget constraint.

Answer: a. 300 = 100x + 30y b. 150 = 100x + 30y c. 150 = 150x + 30y 8. Every year, Heather hosts a holiday party for her friends. Her party budget is $200. Heather spends her budget on food platters that cost $25 each and on entertainment, which costs $50 per hour. [LO 7.4] a. Graph Heather’s budget constraint for food and entertainment. b. To reward her loyal business, the entertainment company Heather hires has offered her a 50 percent discount on entertainment purchases for this year’s party. On your graph, illustrate Heather’s new budget constraint for food and entertainment. c. Assuming that food platters and entertainment are normal goods, what can you say about the quantity of each good that Heather will purchase after the discount? Will the quantity of entertainment increase or decrease, or is the change uncertain? Will the quantity of food increase or decrease, or is the change uncertain?

Answer: a, b. See BCa and BCb in the graph below.

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Heather can purchase up to 8 hours of entertainment, and it will really cost her only $200 after the 50 percent discount. c. The discount for entertainment purchases affects Heather’s spending in two ways. The income effect results because the discount effectively increases Heather’s “purchasing power” for party spending. The income effect of the discount will induce Heather to increase spending on both food and entertainment. The substitution effect arises because the discount makes entertainment cheaper relative to food. The substitution effect predicts that Heather will substitute spending toward entertainment and away from food.

Thus, we know that the quantity of entertainment will increase. For the quantity of food, however the change is uncertain. We cannot be sure if Heather will increase or decrease her food spending as a result of the discount on entertainment. It depends whether, for Heather, the income effect or the substitution effect is stronger.

9. Hideki attends baseball games and goes to movie theaters. Baseball tickets cost $15, and movie tickets cost $10. His entertainment budget is $180. [LO 7.4] a. Graph Hideki’s budget constraint for baseball and movie tickets. b. Suppose the home team is having a good season, and the price of baseball tickets goes up to $20 per game. Graph the new budget constraint. c. Assuming that baseball and movie tickets are normal goods, what can you say about the quantity of each good that Hideki will consume after the price of baseball tickets goes up? Will the quantity of baseball games he attends increase or decrease, or is the change uncertain? Will the quantity of movies he watches increase or decrease, or is the change uncertain?

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a, b. See BCa and BCb in the graph below.

c. The increase in the price of baseball tickets affects Hideki’s spending in two ways. The income effect results because increase in price decreases Hideki’s “purchasing power” for spending on all tickets. The income effect will induce Hideki to decrease spending on both movie and baseball tickets. The substitution effect arises because movie tickets are cheaper relative to baseball tickets than they were before. The substitution effect predicts that Hideki will substitute spending toward movies and away from baseball. Thus, we know that the quantity of baseball tickets will decrease. For the quantity of movie tickets, however the change is uncertain. We cannot be sure if Hideki will increase or decrease his movie spending as a result of the price increase for baseball. It depends whether, for Hideki, the income effect or the substitution effect is stronger.

10. For which of the following goods is the utility you get from consuming them likely to be affected by the opinions of others? [LO 7.5] a. A cell phoneMP3s. b. A new car. c. Running shoes. d. A new laptop for class.

Answer: All of the above (a−d). The utility we get from consuming most goods is affected by the opinions and perceptions of others. We tend to get more enjoyment from the goods we consume if the people around us admire or at least approve of our choices.

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11. Dan spends his money on baseball games and concert tickets. Baseball tickets cost $15, and concert tickets cost $25. His entertainment budget is $150. richard@qwconsultancy.com

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a. Draw Dan’s budget constraint, putting baseball tickets on the x-axis. b. Dan decides to attend three concerts and five baseball games. Plot this point on the budget constraint. c. Dan’s best friend Jay tells Dan that his favorite thing to do is go to concerts. In fact, going to concerts is popular with a lot of Dan’s friends. Will Dan’s budget constraint increase, decrease, or stay the same? Will the quantity of concerts he attends increase, decrease, or stay the same? [LO 7.5LO 7.5]

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Answer:

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a. If Dan buys zero baseball tickets, he can buy $150/$25 = 6 concert tickets. This is the yintercept.

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b. The point (5 baseball tickets, 3 movie tickets) is on the budget constraint. This means that it is a feasible option, and that choosing it would use Dan's entire budget. c. Like most of us, Dan's utility is probably influenced by his friends. Even though his budget constraint doesn't change (neither prices nor income have changed), Dan's chosen consumption bundle will likely change. We expect him to attend more concerts.

12. Samuel’s utility is influenced by reciprocity. He is likely to respond to a surprisingly generous birthday gift from his best friend in what way? [LO 7.6LO 7.6]

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a. Not giving his friend a birthday gift at all. b. Giving his friend the birthday gift he had originally planned to give. richard@qwconsultancy.com

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c. Giving his friend a more thoughtful or more generous gift that he had originally planned to give. d. Returning the birthday gift he received.

Answer: Reciprocity involves doing good things for people who did good things for us.

When Samuel receives a generous birthday gift, he is likely to respond with a generous birthday gift for his friend.

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11.13. Say whether each of the following situations is an example of altruism or reciprocity.

[LO 7.5]6] a. Giving a few canned goods to the local food bank for its annual food drive. b. Helping someone move her couch after she helped you study for an upcoming exam. c. The biological relationship between cleaner fish and large predators in the ocean, in which cleaner fish keep the predator free from parasites and the predator keeps the cleaner fish safe.

Answer: Reciprocity involves doing good things for people who did good things for us.

Altruism involves simply wanting others to be better off. a. Altruism. b. Reciprocity. c. Reciprocity.

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CHAPTER 8 BEHAVIORAL ECONOMICS: A CLOSER LOOK AT DECISION MAKING Chapter Overview While we can go a long way by assuming that people act rationally to maximize their utility, behavioral economics shows us that, in practice, we need a broader understanding of “maximizing utility” in order to build models that predict many of the quirky things people really do. Real people make economic decisions in complicated, unexpected, and sometimes nonoptimal ways. Understanding these human tendencies can help us to avoid common decision-making pitfalls. It can also help us to design products and policies that allow people to make better choices.

Although the behaviors explored in this chapter can be viewed as biases or mistakes, they are also the sort of mistakes that can be corrected. We also discuss some strategies designed to help people reach their intended goals and make better choices. In a later chapter (“Public richard@qwconsultancy.com

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Policy and Choice Architecture”) we’ll return to some of these issues as we think about public policies that help people make good choices and stick to their goals.

Learning Objectives LO 8.1: Define time inconsistency, and explain how it accounts for procrastination and other problems with self-control.

LO 8.2: Explain why sunk costs should not be taken into account in deciding what to do next.

LO 8.3: Identify the types of opportunity cost that people often undervalue, and explain why undervaluing them distorts decision making.

LO 8.4: Define fungibility, and explain why it matters in financial decision making.

Chapter Outline OPENING STORY: WHEN IS $20 NOT QUITE $20?

Dealing with Temptation and Procrastination Time Inconsistency, Competing Selves, and Commitment (LO 8.1) BOX FEATURE: REAL LIFE – GIVE MORE TOMORROW BOX FEATURE: REAL LIFE – TAKE OUT A CONTRACT ON YOURSELF

Thinking Irrationally about Costs The Sunk-Cost Fallacy (LO 8.2) Undervaluing Opportunity Costs (LO 8.3) Forgetting about Fungibility (LO 8.4) Creating Mental Categories for Money BOX FEATURE: WHAT DO YOU THINK? – CREDIT-CARD CATEGORIES: MORE REALISTIC OR MORE CONFUSING? BOX FEATURE: REAL LIFE – THE METHOD-OF-PAYMENT EFFECT

Beyond the Lecture Writing Assignment: Time Inconsistency, Competing Selves, and Commitment (LO 8.1) Ask students to write a brief essay regarding a topic where their short-term and long-term goals conflicted. What advice do they have to help deal with time inconsistency problems? Some suggestions could include longer-term goals like good grades, a successful career, getting healthier, etc. This can also be used for a discussion in class or in an online environment.

Class Discussion: The Sunk-Cost Fallacy (LO 8.2) Have students review this brief article on sunk costs in sports. It specifically discusses the New York Jets player personnel decisions. Ask the students to consider the following: 1. What should a team do if they cannot recover past costs for a player and do not think the player adds to the team going forward?

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2. How can psychological factors play a role in the decision to consider sunk costs in current decisions (even if economists say that this is a bad idea)?

Class Discussion: Undervaluing Opportunity Costs (LO 8.3) Consider showing a scene from the movie Elf that highlights Walter’s decision to seemingly put work ahead of family. Many scenes in the movie will work to highlight the tradeoff between work and family. The opportunity cost of time and the tradeoff between work and family/leisure is important to students.

1. How do people reach a decision on the amount of time to spend working vs. everything else that is important to them?

2. Have students consider how much work is too much.

Class Discussion: Undervaluing Opportunity Costs (LO 8.3) Have students view this short video about the Broken Window Fallacy and discuss the topic of opportunity costs with students.

1. While a natural disaster does lead to increased spending as individuals must fix and replace many items, why does this not add to overall wealth?

2. What is the opportunity cost associated with replacement spending?

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Solutions to End-of-Chapter Questions and Problems Review Questions 1. Describe a situation from your own experience in which you are time inconsistent. What have you done (or might you do) to accomplish the goals of your future-oriented self? [LO 8.1] Answer: I am forever setting (and breaking) fitness goals. My future-oriented self wants to exercise more. I put exercise times in my calendar, but when the day and time rolls around, I often decide that I am too busy working (or would rather do something fun). To combat this problem, I am trying two things. First, I make plans to work out with a friend. I feel pressured to show up when I know my friend is counting on me. I also joined a running club that charges me money only if I RSVP and then don’t show up. Let’s hope these two things work!

2. You have a friend who is always resolving to improve her grades, but who never seems to find time to study. Explain to her how time inconsistency might be affecting her choices, and suggest some steps she might take to meet her goal. [LO 8.1] Answer: Your friend wants to study in order to improve her grades, but not because she enjoys studying. She makes plans to study in the future, but when the time rolls around, she can always think of something she’d rather be doing. Your friend needs to find a reliable way to pre-commit do doing what her future-oriented self wants and study more. She could make a commitment to a study partner. And she could pledge to pay $25 to the study partner each time she fails to show up for their study sessions.

3. You’ve already paid to get into an all-you-can-eat buffet and have enjoyed several plates of food. You’re not really hungry anymore, but feel you ought to eat more to get the full value from the buffet. Does this inclination make sense? Explain why or why not. [LO 8.2] Answer: This decision does not make sense. The money you paid for the buffet is a sunk cost and should not factor in your decision about whether to continue eating. You should continue to eat only if you will increase your utility by doing so. Since you are already full, continuing to eat will likely reduce your utility, because you will probably start to feel sick.

4. Alda is willing to pay $2,000 to visit her favorite cousin over spring break. A month ago, she booked a trip costing $1,200. Spring break has arrived, but Alda needs one day to finish an important paper before she goes. Alda could cancel her trip and get a refund of $800. Or, she could pay an additional $1,000 (on top of the $1,200 she already paid) to rebook the trip for two days later. Explain what Alda should do. [LO 8.2] Answer: The $400 that can’t be refunded is sunk. The opportunity cost of going is now the $800 potential refund that Alda would give up, plus the additional $1,000 cost to rebook the flight = $1,800. Alda is willing to pay $2,000 for the trip, so she should go. richard@qwconsultancy.com

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5. Suppose your art history professor has a small personal art collection, including some works by a famous artist. She bought this artist’s paintings at modest price, before he became well known. One of the paintings is now worth $2 million. When you ask the professor whether she would buy it now for $2 million, she says she wouldn’t. Is the professor’s decision making consistent? Why or why not? [LO 8.3] Answer: Your professor’s decision making is not consistent. Your professor is failing to recognize the implicit cost of ownership. If she would not be willing to pay $2 million for the painting, she should sell it. Holding on to something worth $2 million is the same as paying $2 million for it.

6. Chandra received a gift certificate that covers three salsa dance lessons. After the first lesson, Chandra decided that she doesn’t like salsa, yet she still plans to go the next lesson because it doesn’t cost her anything. Evaluate Chandra’s logic. [LO 8.3] Answer: Chandra is undervaluing the opportunity cost of her time. It is not true that going to the dance lessons doesn’t cost her anything. It costs her time. If Chandra doesn’t like salsa, chances are she could find something else to do with the time that she would have spent going to the classes that would make her happier.

7. You have a friend who runs up a balance on his credit card by buying new furniture to replace the furniture he has. The interest rate on the balance is 15 percent per month. The furniture store offers a layaway plan with monthly payments equivalent to an interest rate of 10 percent per month. Explain to your friend how he could manage his finances more sensibly. [LO 8.4] Answer: The layaway plan costs your friend less than paying for furniture on his credit card.

If your friend doesn’t have the cash upfront for furniture, the layaway plan is a better option for replacing his old furniture. Your friend will be charged 10 percent each month until he pays off an item and can take it home. Since your friend has old furniture, this is a better option than paying for the furniture on credit at a 15 percent interest rate.

8. Dora and Vicki are bartenders. Dora prefers her tips in cash because she can have the money right away. Credit-card tips don’t get paid to bar staff until the payments are processed, which can take a few days. Vicki still prefers for her customers to put her tip on their credit card. Why might Vicki have this preference? [LO 8.4] Answer: Vicki probably prefers her customers to tip her on their credit cards because people have a tendency to spend more when they use credit. They don’t see the actual dollars leaving their hands so they are more likely to be generous tippers when they pay with credit.

Problems and Applications 1. In which of the following cases is time inconsistency likely to be at work? [LO 8.1] richard@qwconsultancy.com

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a. A child plans to become a doctor when he grows up, but a month later reads a book about firefighters and decides to become a firefighter instead. b. A student keeps intending to finish reading War and Peace—next week. c. A parent plans to enroll his child in art class but enrolls her in dance class instead. d. A beginning piano player plans to practice three times a week but frequently practices only once a week.

Answer: Time inconsistency is likely to be at work for b. A student keeps intending to finish reading War and Peace—next week, and d. A beginning piano player plans to practice three times a week but frequently practices only once a week. It is not time-inconsistent to simply change your mind, like in a and c.

2. You would like to save more money. Which of the following strategies will help you overcome time inconsistency? [LO 8.1] a. Deciding how much you need to save. b. Setting up a savings account. c. Putting reminders in your calendar to make deposits. d. Enrolling in an automatic-transfer program that will move a specified amount of money from your checking account to your savings account each month.

Answer: d. While a, b, and c are all good ideas, none of them will override your presentoriented self who prefers spending over savings. d is the only strategy that will help you overcome time-inconsistency. Of course, you can always spend from your savings, but only the automatic transfer will guarantee that money at least enters your savings account.

3. You’re seated at a banquet that is beginning to become boring. Which of the following pieces of information are relevant to your decision to stay or go somewhere else? [LO 8.2] a. Another party is happening at the same time, and you’ve heard that it’s fun. b. The dinner you were served was only so-so. c. You haven’t eaten dessert yet, and it looks delicious. d. You paid $30 to attend the banquet. e. The other party has a cover charge of $10.

Answer: a, c, and e. The only relevant information is current or future costs and benefits.

The fact that the dinner was so-so and you paid $30 for the banquet should not affect your decision. These are sunk costs. If you leave, you have the potential benefit of having more richard@qwconsultancy.com

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fun at the other party. But you will miss out on the chance to have that yummy-looking dessert. And the other party will cost you $10 to get in. If the potential of having more fun outweighs the cost of $10 and the dessert you will miss, you should leave and go to the other party. Your decision should be about weighing those costs and benefits against each other.

4. You just spent $40 on a new movie for your collection. You would have preferred the director’s cut but discovered when you got home that you bought the theatrical version. The store you bought the movie from has an “all sales final” policy, but you could resell the movie online for $30. The director’s cut sells for $50. By how much would you need to value the director’s cut over the theatrical version for it to make sense for you to sell the version you bought and buy the director’s cut? [LO 8.2] Answer: The $40 cost of the theatrical version has already been spent, but you can recoup $30 of that cost, so only $10 is sunk. Therefore, the opportunity cost of the director’s cut is $50 − $30 = $20. You would have to value the director’s cut at least $20 more than the other version.

5. Suppose you’re bowling with friends. You’ve already played one game and are trying to decide whether to play another. Each game costs $6 per person, plus a one-time rental fee of $5 for the bowling shoes. It would take another hour to play the next game, which would make you late for work. Missing an hour of work would mean that you would lose pay at a rate of $12 per hour. Based on this information, how much would you have to enjoy the next bowling game, expressed in terms of dollars, to play another game? [LO 8.3] Answer: You would have to place a value on your enjoyment of the next game of at least $18. This game will cost you $6 (the shoe rental is paid and is now a sunk cost) plus the $12 you will not earn by missing that hour of work.

6. During a holiday party at work, you pay $2 to buy a raffle ticket for a 16-gigabyte iPad. You win the drawing. Based on a little research online, you discover that the going rate for a hardly used 16-gigabyte iPad is $200. [LO 8.3] a. What was the opportunity cost of acquiring the iPad? b. What is the opportunity cost of choosing to keep the iPad? Answer: a. The opportunity cost of acquiring the iPad was $2. b. The opportunity cost of choosing to keep the iPad is $200.

7. Jamie is saving for a trip to Europe. She has an existing savings account that earns 2 percent interest and has a current balance of $4,500. Jamie doesn’t want to use her current savings for vacation, so she decides to borrow the $1,500 she needs for travel expenses. She will repay the loan in exactly one year. The annual interest rate is 5 percent. [LO 8.4]

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a. If Jamie were to withdraw the $1,500 from her savings account to finance the trip, how much interest would she forgo? b. If Jamie borrows the $1,500, how much will she pay in interest? c. How much does the trip cost her if she borrows rather than dips into her savings?

Answer: a. Interest forgone = $1,500 x (0.02) = $30. b. Interest expense = $1,500 x (0.05) = $75. c. Principle plus net interest = $1,500 + $75 - $30 = $1,545.

8. Suppose you have accumulated a credit card balance of $500, at an annual interest rate of 10 percent. You are also planning to open a new savings account that accumulates interest at an annual rate of 3 percent. You just got your paycheck and have $200 that you can use either to pay down your debt or open your savings account. [LO 8.4] a. If you use the full $200 to pay down your debt, what will your credit card balance be in one year? Assume no additional credit card payments during this time. b. If, instead, you put the full $200 into your savings account, what will be the balance in your savings account in one year, assuming you make no additional deposits during this time? What will your credit card balance be, assuming you make no additional payments during this time because your payment requirements have been deferred for one year? c. In one year, how much money will you have lost if you deposit the $200 in your savings account compared to paying down your credit card?

Answer: a. Credit Card balance at the beginning of the year: $500 - $200 = $300. Interest charged: $300 x 0.10 = $30. End of year balance = starting balance + interest = $300 + $30 = $330. Your credit card balance will be $330. b. The balance in your savings account will be $200 x (1 + 0.03) = $206. Your credit card balance will be $500 x (1 +0.1) = $550. c. Interest expense on the original credit card balance = $500 x (0.10) = $50. Interest expense on the revised credit card balance = $300 x (0.10) = $30. Savings in interest expense = $50 - $30 = $20. Loss = Savings in interest expense - forgone interest = $20 $6 = $14.

CHAPTER 9 GAME THEORY AND STRATEGIC THINKING richard@qwconsultancy.com

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Chapter Overview This chapter introduces the concept of strategic games. Many real-life situations can be analyzed as if they were strategic games, with associated rules, strategies, and potential payoffs. Game theory can explain the logic behind outcomes that might not seem intuitive at first. Sometimes, for example, both players in a simultaneous game may choose to behave in a way that makes both worse off. When games are played in turns rather than simultaneously, the first mover’s decision can dictate the outcome of the entire game. With repeated play, however, the first mover’s advantage weakens. Players who can communicate with each other and agree on a strategy can often secure a better outcome than if they acted alone. Such agreements may break down if one side tries to get ahead by defecting. Backward induction is another useful analytical tool; it allows you to break down your decisions and predict how they will affect others’ decisions and shape the final payoff. When trying to solve a real-life problem, whether societal, personal or business, it helps to think through these strategic issues. Doing so can help you see how to “play” the game given the rules and constraints. It also can help you see how to change the rules and constraints, if possible, to help get to a better outcome.

Much of the analysis in this chapter involves one player guessing what the other will do and acting accordingly. In the next chapter, we’ll see that knowing what one player is planning to do isn’t always easy, and that a lack of information can have real economic consequences.

Learning Objectives LO 9.1: Understand strategic behavior and describe the components of a strategic game.

LO 9.2: Explain why noncooperation is always the outcome in the prisoners’ dilemma.

LO 9.3: Identify whether or not a player has a dominant strategy in a one-time game.

LO 9.4: Identify whether or not a Nash equilibrium will be reached in a one-time game.

LO 9.5: Explain how a commitment strategy can be used to achieve cooperation in a one-time game.

LO 9.6: Explain how repeated play can enable cooperation.

LO 9.7: Explain how backward induction can be used to make decisions.

LO 9.8: Use a decision tree to solve a sequential game.

LO 9.9: Define first-mover advantage and identify it in practice.

LO 9.10: Explain why patient players have more bargaining power in repeated games.

LO 9.11: Explain how a commitment strategy can allow players to achieve their goals by limiting their options.

LO 9.1: Define strategic behavior and describe the components of a strategic game.

LO 9.2: Explain why noncooperation is a dominant strategy in the prisoners’ dilemma.

LO 9.3: Explain how repeated play can enable cooperation.

LO 9.4: Explain how backward induction can be used to make decisions.

LO 9.5: Use a decision tree to solve a sequential game.

LO 9.6: Define first-mover advantage and identify it in practice. richard@qwconsultancy.com

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LO 9.7: Explain why patient players have more bargaining power in repeated games.

LO 9.8: Explain how a commitment strategy can allow players to achieve their goals by limiting their options.

Chapter Outline OPENING STORY: LITTERBUGS BEWARE OPENING STORY: LITTERBUGS BEWARE

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Games and Strategic Behavior (LO 9.1) Rules, Strategies, and Payoffs One-Time Games and the Prisoner’s Dilemma Prisoner's Dilemma (LO 9.2) Finding the Dominant Strategy (LO 9.3) Reaching Equilibrium (LO 9.4) Avoiding Competition through Commitment (LO 9.5) Promoting Competition in the Public Interest Repeated Play in the Prisoners’ Dilemma (LO 9.6) The Tit-for-Tat Strategy BOX FEATURE: REAL LIFE – WHAT DO PRICE-MATCHING GUARANTEES GUARANTEE? BOX FEATURE: FROM ANOTHER ANGLE – TIT-FOR-TAT AND HUMAN EMOTIONS

Sequential Games Think Forward, Work Backward (LO 9.7) Deterring Market Entry: A Sequential Game (LO 9.8) BOX FEATURE: WHAT DO YOU THINK? – SURVIVING WITH STRATEGIC THINKING

First-Mover Advantage in Sequential Games (LO 9.9) Repeated Sequential Games (LO 9.10) Commitment in Sequential Games (LO 9.11) BOX FEATURE: REAL LIFE – DR. STRANGELOVE, OR HOW WE LEARNED TO LOVE THE COMMITMENT DEVICE

Games and Strategic Behavior (LO 9.1) Rules, Strategies, and Payoffs One-Time Games and the Prisoner’s Dilemma (LO 9.2) Finding the Dominant Strategy Reaching Equilibrium Avoiding Competition through Commitment Promoting Competition in the Public Interest Repeated Play in the Prisoners’ Dilemma (LO 9.3) The Tit-for-Tat Strategy BOX FEATURE: REAL LIFE – WHAT DO PRICE-MATCHING GUARANTEES GUARANTEE BOX FEATURE: FROM ANOTHER ANGLE – TIT-FOR-TAT AND HUMAN EMOTIONS

Sequential Games Think Forward, Work Backward (LO 9.4) richard@qwconsultancy.com

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Deterring Market Entry: A Sequential Game (LO 9.5) First-Mover Advantage in Sequential Games (LO 9.6) Repeated Sequential Games (LO 9.7) Commitment in Sequential Games (LO 9.8) BOX FEATURE: REAL LIFE – DR. STRANGELOVE OR: HOW WE LEARNED TO STOP WORRYING AND LOVE THE COMMITMENT DEVICE Formatted: Indent: First line: 0.5"

Beyond the Lecture Class Discussion: Games and Strategic Behavior (LO 9.1) Consider showing students this brief interview with Vanessa Rousso, a professional poker player briefly discussing the use of game theory in poker.

9. What strategic behavior occurs in poker (or similar games)?

10. How can game theory be applied in poker?

11. Can game theory give someone an advantage in poker?

Class Activity: Games, Strategic Behavior, and the Prisoner’s Dilemma (LO 9.1, LO 9.2) Consider placing students in groups and having them work through a game theory problem. A simple prisoner’s dilemma works well with the class. You can set up a number of scenarios for students to discuss. Additionally, consider having students attempt one of the free game theory applets available here.

Class Discussion: One-Time Games and the Prisoner’s Dilemma (LO 9.2) Consider showing students a clip from the movie Kingpin to highlight a noncooperation strategy in a strategic game. In the movie, Roy and Big Ern are trying to win money gambling on bowling.

You can show the clip from 8:00 to 10:30 & 12:13 to 13:28 (skipping the middle due to some bad language). Pause at 13:28, where they both decide whether to drive away from some angry bowlers or stay and “face the music.” You can then show the next minute or so to see the result. Big Ern leaves by tricking Roy into staying, where Roy ends up losing an arm. You can construct a decision matrix for this scenario.

Class Discussion: Commitment in Sequential Games (LO 9.8) In order to highlight the potential for commitment strategy to help players achieve their goals, consider showing this brief clip from the British game show Golden Balls. The players must simply decide to split or steal. If they both choose split, they split a sum of money. If one person splits and one steals, the person who steals gets all of the money. If they both steal, they get nothing. In this clip, one player guarantees the other player that he will steal, but promises to split the money after the game ends if the other player chooses split (although there is no legal requirement to do so). This effectively forces the player to choose split or get nothing. In the end, they both split. It is a great example of game theory strategy.

Solutions to End-of-Chapter Questions and Problems richard@qwconsultancy.com

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Review Questions 1. Taking an exam can be considered a game. Describe a rule, a strategy, and payoff for this game. [LO 9.1] Answer: Rule: The exam might have a time limit, such as one hour. Another rule could be that you have to show your work when solving a problem in order to get full credit. Strategy: Instead of taking the exam in order, you might decide to start with the questions that are worth the most points, to make sure you allocate your time for the greatest payoff. Payoff: The score/grade you receive on the exam is your payoff.

2. Why is strategic behavior required to win a presidentialfederal election? Describe some of

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the rules, strategies, and payoffs that define this game in the real world. [LO 9.1LO 9.1]

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Answer: Strategic behavior is about thinking about what your opponent is likely to do and letting this inform your own choices. Elections involve a lot of strategic behavior; candidates pay attention to the messages and actions of their opponents and decide the best way to respond. Some rules of this game include guidelines for how votes are counted and limits on sources of fundraising. Some of the strategies involve choosing where to campaign and when, choosing what message to emphasize to certain voters, and whether to run negative ads about your opponent. Payoffs include campaign contributions, endorsements, and votes.

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2.3.Felix and Sam are roommates. They both want the dishes to be washed, but each would prefer that the other person do it. Use the decision matrix in Figure 9Q-1 to explain why Felix and Sam are likely to end up with a sink full of dirty dishes. Their preferences are ranked from 1 (lowest) to 4 (highest). [LO 9.2] Answer: If Sam does dishes, Felix prefers not do the dishes (4) rather than to help Sam (2).

If Sam does not do dishes, Felix prefers not to do dishes either (3) rather than do all the dishes himself (1). No matter what Sam does, Felix prefers not to do dishes. Sam has the same preferences as Felix. If Felix does dishes, Sam prefers not do the dishes (4) rather than to help Felix (2). If Felix does not do dishes, Sam prefers not to do dishes either (3) rather than do all the dishes himself (1). No matter what Felix does, Sam prefers not to do dishes.

Alas, Felix and Sam will wind up with dirty dishes.

3.4.Two neighbours share a pond they have stocked with catfish. They have agreed upon the amount of fishing each can do in order for the stock of catfish to replenish itself. If one neighbor increases the amount he fishes a little bit, the catfish stock could still replenish itself. If both neighbours increase their fishing, the stock will not be sustainable. Both neighbours would like to cheat and increase the amount they fish, but want the other neighbor to stick to the agreement. [LO 9.2] a. What is the non-cooperative outcome, and why does it occur? b. What is the cooperative outcome, and how could the neighbours achieve this outcome?

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a. The non-cooperative outcome is for both neighbours to increase fishing, which will make them both worse off. This outcome occurs because they both have an incentive to cheat if the other neighbor sticks to the agreement. They both know they can be better off by cheating if the other neighbor doesn’t, so both wind up cheating. b. The cooperative outcome is to stick to the original agreement about the amount of fishing that is sustainable without having to restock the pond. The neighbours could achieve this outcome if they can agree to a commitment strategy, such as sole financial responsibility to restock the pond if one of the neighbours cheats. a) You have been texting with your friends trying to make plans for this evening. Your best friend Jocelyn is not sure if she will finish her homework in time to come out, but if she does, she wants to go to a new restaurant on the north end of town that you’ve both been wanting to try. Another group of friends is going to a restaurant on the south end of town, but you’ve already been to this restaurant and it was only okay. No one is returning your calls, but you need to get on the subway and head into town if you want to do anything this evening. You have to decide whether to head north or south. Do you have a dominant strategy? Explain why or why not. [LO 9.3LO 9.3] 5.

Answer: Something can only be a dominant strategy if you want to choose it no matter what the other players are doing. It's true that you would prefer to head north if you knew Jocelyn is coming out, but if you knew Jocelyn was staying home, you would prefer to head south.

Thus, you do not have a dominant strategy in this case.

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6. You have just played rock, paper, scissors with your friend. You chose scissors and he chose paper, so you won. Is this a Nash equilibrium? Explain why or why not. [LO 9.4LO 9.4]

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Answer: Even though you don't regret your choice, your friend regrets his choice. A Nash equilibrium is reached when all players choose the best strategy they can, given the choices of all other players. In other words, this is a point in a game when no player has an incentive to change his or her strategy, given what the other players are doing. Because your friend regrets his choice, this is not a Nash equilibrium.

7. Two firms each have the option of polluting during production or cleaning up their production process such that they don’t pollute. Of course, polluting is cheaper than not polluting. The payoffs for each of the choice combinations are shown in the decision matrix in Figure 9Q-2Figure 9Q-2. The government would like to stop pollution by making it illegal and charging a fine if a firm is found polluting. How large does the fine need to be to keep a firm from polluting? [LO 9.54] Answer: The government would like to have the companies operating in the bottom right quadrant where both are not polluting and the payoff is $25,000 each. However there is an incentive for both firms to pollute since there is a higher payoff. If one of the two firms pollutes and the other continues to not pollute, they would make $90,000 and the other would continue to make $25,000. To stop this, the government would have to tax the companies enough such that is not advantageous to pollute. In this question the tax would have to be at least $65,000 ($90,000- $25,000). richard@qwconsultancy.com

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4.8.Explain how you could use a tit-for-tat strategy to motivate your roommate to do his share of the cleaning. [LO 9.53] Answer: Tit-for-tat involves taking the same action (or inaction) as the other player. If your roommate does not pull his weight on cleaning, tit-for-tat would mean you stop doing your portion of the cleaning as well. Of course, this may be difficult for you if your roommate has a higher tolerance for a mess than you do. If that is the case, you could find some other chore of importance to your roommate, such as taking turns buying snacks, and refuse to cooperate.

5.9.Toni and Kala are new coworkers. They make a plan to go out together every Thursday night. On their first Thursday night out, Toni buys a pitcher of beer and shares it with Kala.

Kala is excited to discover that her Thursday night outings will include free beer as well as a way to have fun with her new co-worker. Explain why Kala is likely to be disappointed.

[LO 9.63] Answer: It is unlikely that Toni was signaling that she will always buy the drinks when they go out on Thursdays. Customarily, people take turns buying rounds. If Kala does not respond with tit-for-tat buy buying the next pitcher, Toni will likely respond with tit-for-tat by not buying more pitchers either.

6.10. Suppose your goal is to be promoted at your job. Use backward induction to determine what you should do to work toward that goal right now, and describe each step in your logic.

[LO 9.74] Answer: If your goal is to be promoted, you would start by finding out the requirements and preferred qualifications of the job you want. Next, you would assess your own skills, experience, and education to determine how they match up with the job requirements and preferences. As of today, you would work on obtaining or enhancing skills, experience, and knowledge in alignment with the necessary qualifications for the job you want. Perhaps you sign up for an advanced economics course!

7.11. You are playing a game with a friend. It’s your move but you don’t have a dominant strategy. Your payoff depends on what your friend does after your move. You consider flipping a coin to decide what to do. You are about to reach for a coin, but then you realize that your friend has a dominant strategy. Explain how using backward induction (rather than a coin toss) will now determine your next move. [LO 9.74] Answer: If you don’t have a dominant strategy because your payoff depends on what your friend does after your move, it’s unclear how you should decide. However, if you reason that your friend has a dominant strategy, you can use your expectation of what they will do to work backward. Knowing that your friend has a dominant strategy takes the guesswork out of what they will do next. You can now choose your own move based on confidence that your friend will follow his dominant strategy.

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8.12. Melissa let Jill cheat off of her during a history exam last week. Now Melissa is threatening to tell on Jill unless Jill pays her $50. Use the decision tree in Figure 9Q-2 to explain whether Jill will pay Melissa to keep her quiet. [LO 9.85] Answer: Jill will not pay Melissa. Jill knows that Melissa will also be expelled if she reveals that she let Jill cheat. Jill knows Melissa will not want to get expelled for $50 and will call Jill’s bluff.

9.13. Nicolas has asked for a raise. His boss must decide whether to approve his request. If Nicolas doesn’t get the raise, he will have to decide whether to stay at his job or quit.

Construct a decision tree for these sequential decisions, and choose a payoff structure where Nicolas has a dominant strategy to stay at his job even without getting the raise. [LO 9.85] Answer: Numbers are arbitrary, but students should choose a payoff structure such that Nicolas has a dominant strategy to stay even if he is not offered the raise. If Nicolas’s boss knows his payoff structure, he will not offer the raise.

10.14. Job offers could be considered a one-round bargaining game with a first-mover advantage: The company offers you a job at a certain salary, and you can take it or leave it.

Explain why the company might not capture all the surplus in this game, even if you can’t make a counteroffer. [LO 9.96] Answer: Even if you cannot make a counteroffer, you do still have options. Presumably, you have applied to more than one place. At least the company who plans to hire you should assume that you are looking into other options and may even have other offers on the table.

Therefore, they would want to make you an offer attractive enough that you accept it over some other offer you may have.

11.15. Muriel likes her job, but her boss gives lousy bonuses. Muriel was recently offered a new job with better rewards, and her friend wants to know if she intends to take it. “It depends on whether the bonus this year is generous. Let’s wait and see. We’ll find out next week.”

Explain why Muriel is likely to be accepting the new job. How could she improve her strategy if she wants to stay at her cur-rent job and be better rewarded? [LO 9.96] Answer: Waiting to see what her bonus is this year is not a good strategy. There is no reason she should expect her boss to behave differently than usual. Her boss would have no reason in increase the size of bonus unless Muriel moves first and tells him that she has another offer she is prepared to take if her bonus structure does not increase by a certain amount.

12.16. Suppose you are moving out of the country and need to sell your car fast. Explain why you are likely to get lower offers from used-car dealers if they find out that you are moving away soon. [LO 9.107]

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Answer: If dealers know you are moving soon, they know that you do not have time to be patient and wait for a good offer. Due to the limits on your time, dealers will have the upper hand in negotiating a price. They have other cars to sell and can be more patient.

13.17. Hal is negotiating his salary for a job offer. Hal’s potential employer moves first by making an offer. Hal knows he will accept the offer but asks for a couple of weeks to think it over. If the offer was acceptable to Hal, why did he do this? [LO 9.107] Answer: If Hal is not desperate to get paid right away, asking for more time may increase his offer. Hal is hoping that by asking for time the employer will see this as a sign that he is considering other options. Hal is also hoping that the employer is less patient for the work to begin and will increase the offer in order to get a quicker decision.

14.18. Many warrior cultures have codes of conduct that make retreat from battle and other cowardly behaviors extremely dishonorable. Warriors are expected to die bravely in battle rather than surrender; if they do retreat, they face an enormous social stigma. Paradoxically, these codes could help warriors to win their battles. Explain. [LO 9.118] Answer: The cultural pressure and stigma essentially remove the option for retreat. If a warrior knows that retreat is never going to be an acceptable option, his only choice is to fight. Knowing that he must win his battles or die trying, he will fight harder.

15.19. A town’s two gas stations are each considering lowering prices to attract more sales. How this affects the profits for each gas station depends on whether the other station also lowers prices. The decision matrix in Figure 9Q-3 shows the payoffs, depending on what each player decides to do. Suppose both gas stations lower their prices, and they find themselves in the worst-case scenario in which both have also lowered their profits. Now suppose gas station A announces in an advertisement that it is committed to keeping the new low prices. Why would gas station A do this? What outcome would you expect? [LO 9.118] Answer: Answer: Gas station A is using a commitment strategy to signal to gas station B that it won’t be returning to higher prices. Gas station A is best off if it has low prices while gas station B has high prices. However, gas station B might keep prices low in hopes that gas station A is the one to retreat (switch back to higher prices). With the public announcement, gas station A has “burned its bridges,” and gas station B knows that it will have higher profits ($30,000 rather than $15,000) if it returns to higher prices. This will leave gas station A with the higher profits at $60,000.

Gas station A does not announce its commitment to low prices because it is fine with low profits. Rather, gas station A is using a commitment strategy to signal to gas station B that it won’t be returning to higher prices. Gas station A is best off if it has low prices while gas station B has high prices. However, gas station B might keep prices low in hopes that gas station A is the one to retreat (switch back to higher prices). With the public announcement, gas station A has “burned its bridges,” and gas station B knows that it will have higher profits

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($65,000 rather than $35,000) if it returns to higher prices. This will leave gas station A with the higher profits at $125,000.

Problems and Applications 1. Say whether each of the following is a rule, a strategy, or a payoff. [LO 9.1] a. In chess, when you capture your opponent’s king, you win the game. b. In Monopoly, players frequently mortgage their existing properties to raise cash to buy new ones. c. In chess, the rook piece can move any number of spaces directly forward, back-ward, or to either side, but it cannot move diagonally. d. In rock-paper-scissors, you might always play rock.

Answer: Rules define the actions that are allowed in a game. Strategies are the plans of action that players follow to achieve their goals. Payoffs are the rewards that come from particular actions. a. Payoff. b. Strategy. c. Rule. d. Strategy.

2. Sharon is going to an auction. Say whether each of the following is a rule, a strategy, or a payoff. [LO 9.1] a. Bids must increase in increments of $20. b. The highest bid wins the item being auctioned. c. Sharon waits until the bidding is just about to close before she enters a bid. d. The money raised from the auction goes to charity.

Answer: Rules define the actions that are allowed in a game. Strategies are the plans of action that players follow to achieve their goals. Payoffs are the rewards that come from particular actions. a. Rule. b. Payoff. c. Strategy. d. Rule.

3. Two families are trying to decide whether to donate to a fund to build a public park. The payoffs are shown in Figure 9P-1. [LO 9.2]

a. What is the mutually beneficial outcome? b. Acting in their best interests, what strategy will each family choose? c. Explain why this game is or is not an example of a prisoners' dilemma.

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Answer: In the prisoners' dilemma, noncooperation is the outcome. If Family B donates, Family A is best off not donating. If Family B does not donate, Family A is best off not donating. The same is true for Family B: If Family A donates, Family B is best off not richard@qwconsultancy.com

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donating. If Family A does not donate, Family B is best off not donating. Thus, both families choose not to donate. But it is clear that they could be better off by cooperating at donating.

However, acting in their best interests yields a less-than-optimal outcome. Thus, this is an example of the prisoners' dilemma.

3.

4. In Figure 9P-1 , what is the dominant strategy for Player A? What is the dominant strategy for Player B? [LO 9.32] Answer: A dominant strategy is a strategy that is the best one for a player to follow no matter what strategy other players choose. If Player B chooses Strategy 1, Player A should choose Strategy 1 (-2 vs. -3). If Player B chooses Strategy 2, Player A should choose Strategy 1 (1 vs. 0). Thus, Player A has a dominant strategy to choose Strategy 1. If Player A chooses Strategy 1, Player B should choose Strategy 1 (-2 vs. -3). If Player A chooses Strategy 2, Player B should choose Strategy 1 (1 vs. 0). Player B has a dominant strategy to choose Strategy 1.

5. A town’s two gas stations are each considering lowering prices to attract more sales. How this affects the profits for each gas station depends on whether the other also lowers prices.

The decision matrix in Figure 9P-2 shows the payoffs, depending on what each player decides to do. Identify any Nash equilibria. [LO 9.42] Answer: A Nash equilibrium is an outcome in a game that is reached when all players choose the best strategy they can, given the choices of all other players. There are two Nash equilibria: (1) Both gas stations charge a higher price and (2) both gas stations charge a lower price. In these two quadrants, neither player can unilaterally improve its position by changing its strategy unless the other player also changes its strategy.

9.6.Consider again the two families trying to decide whether to donate to a fund to build a public park. The payoffs are shown in Figure 9P-1Figure 9P-1. [LO 9.4LO 9.4, LO 9.5LO 9.5] 10.a. What is the Nash equilibrium? b. Suppose Family A agrees to match the donation of Family B. Under these new circumstances, what strategy will each family choose?

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Answer: Each family has a dominant strategy to not donate. Thus, the Nash equilibrium is where neither family donates. When both players have a dominant strategy, playing the dominant strategy will always result in a Nash equilibrium. Remember that a Nash equilibrium is reached when all players choose the best strategy they can, given the choices of all other players. In other words, this is a point in a game when no player has an incentive to change his or her strategy, given what the other players are doing.

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When Family A agrees to match Family B's donation, Family B knows that they don't have to worry about Family A not donating. They will choose to donate, and Family A will also donate.

11.

6.7.In which of the following situations, a or b, is a tit-for-tat strategy more likely to be successful at maintaining cooperation? [LO 9.63] a. An agreement of mutual support between players on a reality television show, in which the relatively worst-off player is eliminated every episode. b. A peace treaty between neighboring countries.

Answer: A tit-for-tat strategy is one in which a player in a repeated game takes the same action that his or her opponent did in the preceding round. Thus, a peace treaty between neighboring countries would likely be more successful at maintaining a cooperative equilibrium.

7.8.Which of the following are examples of tit-for-tat strategies? [LO 9.63] a. A friend forgets to send you a birthday card this year, so you decide not to send one to her on her next birthday. b. Your friend let you borrow her class notes last week, so you decide to skip class again this week. c. You and your roommate take turns buying toilet paper, milk, and other shared items. d. Your book club chooses a book you don’t want to read, so you decide to not to go this month.

Answer: a and c. A tit-for-tat strategy is one in which a player in a repeated game takes the same action that his or her opponent did in the preceding round.

8.9.Using backward induction in Figure 9P-3, decide which class a hypothetical university student should take in her first year, assuming that she wants to be an economics major. [LO 9.74] Answer: Backward induction is the process of analyzing a problem in reverse, starting with the last choice, then the second-to-last choice, and so on, to determine the optimal strategy.

To be an economics major in her third junior year, she needs to take Intro Statistics in her secondsophomore year. To take Intro Statistics in her secondsophomore year, she needs to take Algebra in her first year.

9.10. You need to travel from Edmonton to Copenhagen; it’s now Tuesday morning. You know you need to arrive in Copenhagen no later than 4 pm on Wednesday. Using backward induction in Table 9P-1, choose your travel itinerary. Enter the flight numbers for each leg of your trip. [LO 9.74] Answer: First leg: Flight 1252. Second leg: Flight 2004. Third leg: Flight 803

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10.11. In the sequential game shown in Figure 9P-4, what choice should Player A make now to achieve the highest payoff at the end of the game? [LO 9.85] Answer: Player A should choose Strategy 2. Even though the highest payoff for Player A is if Player A chooses Strategy 1 and Player B chooses Strategy 4, Player B will not choose Strategy 4 if Player A chooses Strategy 1. If Player A chooses Strategy 1, Player B is better off choosing Strategy 3, which leaves Player A with a payoff of only 5. However, if Player A chooses Strategy 2, Player B is better off to choose Strategy 4, which leaves Player A with a payoff of 8.

11.12. Company A is considering whether to invest in infrastructure that will allow it to expand into a new market. Company B is considering whether to enter the market. Assume the companies know each other’s payoffs. Using Figure 9P-5, choose the outcome that will occur from the list below. [LO 9.85] a. A invest, B enter. b. A invest, B don’t enter. c. A don’t invest, B enter. d. A don’t invest, B don’t enter.

Answer: a. Company B has a dominant strategy to enter. Given this, Company A is better off to invest.

12.13. In the sequential game shown in Figure 9P-6, does Player A have a first-mover advantage? [LO 9.96] Answer: Yes. If Player A chooses Strategy 1, Player B is better off to choose Strategy 1.

This will leave player A with a payoff of 4 while Player B has a payoff of 9. However, if Player A chooses Strategy 2, Player B is better off to choose Strategy 2. This will leave Player A with a payoff of 9 and Player B with a payoff of 8. Player A has the first-mover advantage and will choose Strategy 2.

13.14. Which of the following are examples of first-mover advantage? [LO 9.96] a. You make an offer on a house. The seller can only accept or reject the offer. b. You and your roommate are dividing chores. The chores are written on slips of paper and drawn from a hat. You get to draw first. c. You are first in line to buy a raffle ticket. d. You can take vacation whenever you like, as long as no other employees are also scheduled to take vacation. You submit your vacation requests first this year.

Answer: a and d.

14.15. Which player is likely to have higher bargaining power: a city government responding to angry citizens’ demands that the trash be collected regularly, or the sanitation workers’ union? Explain your answer. [LO 9.107]

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Answer: The sanitation workers’ union has higher bargaining power because the union can be more patient than a government under pressure from angry citizens.

15.16. Which player is likely to have higher bargaining power: a large, established company shopping around for a new parts supplier, or a start-up company trying to sell its parts?

Explain your answer. [LO 9.107] Answer: The large, established company shopping around for a new parts supplier is in a better position to be patient for a good deal than a start-up company that needs to build business.

16.17. Figure 9P-7 shows a sequential game in which one player decides whether to cause damage to the property of (injure) another player. The injured player can then choose whether to sue, which involves costly legal fees. [LO 9.108] a. What is the predicted outcome in this “game”? b. What is the predicted outcome if the injured party has made a binding commitment always to sue when injured?

Answer: a. The injurer gets the highest payout if he does harm and does not get sued, which is what will happen because the injured party is worse of if he sues than if he doesn’t when the injurer does harm. b. The injurer is worse off if he gets sued than if he does no harm. He will choose not to do harm.

17.18. Two companies are considering whether to enter a new market. The decision matrix in Figure 9P-8 shows each company’s payoff, depending on whether one, both, or neither enter the market. Company A is in Costa Rica. Company B is in Nicaragua. [LO 9.118] a. If Company A enters, what should Company B do? b. If Company B enters, what should Company A do? c. Suppose the Nicaraguan government releases a press statement that it will cover any profit losses for Company B. How much will this policy cost the Nicaraguan government? (Hint: Think carefully about what Company A’s best choice would be.)

Answer: a. Company B should enter, to earn $3 million. b. Company A should enter, to avoid losing $1 million. c. If the Nicaraguan government releases a press statement that it will cover any profit losses for Company B, Company B will enter, since there is no risk of loss. Knowing this, Company A will also enter, because if they do not enter when Company B does they will lose $1 million. So, with both companies entering, Company B will earn $3 million, and thus there are no profit losses that the Nicaraguan government needs to cover.

CHAPTER 10 richard@qwconsultancy.com

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INFORMATION Chapter Overview People make decisions based on what they know, but sometimes they don’t have enough information to make good decisions. One of the key assumptions behind perfect markets is that individuals have perfect information. When this is not true, individuals are not necessarily able to make decisions that set marginal benefits equal to marginal costs. We see in this chapter that in many situations information asymmetry can allow one person to take advantage of another. In other cases, markets may fall apart because people are afraid to trade with one another. Problems like adverse selection and moral hazard can derail what appear to be clever programs or business models.

Screening and signaling, if used correctly, can help to correct these inefficiencies and increase surplus. Statistical discrimination can also be helpful, but it can have unintended downsides.

Sometimes government may step in to correct information problems that affect large numbers of people. The success of government regulation, however, depends on whether or not people understand and are motivated to use the information made available to them.

Learning Objectives LO 10.1: Define information asymmetry and explain why it matters for economic decision making.

LO 10.2: Define adverse selection and explain how it is caused by asymmetric information.

LO 10.3: Define moral hazard and explain how it is caused by asymmetric information.

LO 10.4: Differentiate between screening and signaling and describe some applications of each.

LO 10.5: Explain how reputations can help to solve information problems.

LO 10.6: Explain how statistical discrimination might be used to solve information problems.

LO 10.7: Discuss the uses and limitations of education and regulation in overcoming information asymmetry problems.

Chapter Outline OPENING STORY: USE OF GENETIC INFORMATION FOR HEALTH INSURANCE

Information: Knowledge Is Power Information Asymmetry (LO 10.1) Adverse Selection and the Lemons Problem (LO 10.2) Principal-Agent Problems and Moral Hazard (LO 10.3) BOX FEATURE: REAL LIFE – THE WEATHER CAN’T CHEAT

Moral Hazard and Adverse Selection—Avoiding Confusion Solving Information Problems richard@qwconsultancy.com

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Screening (LO 10.4) BOX FEATURE: WHERE CAN IT TAKE YOU? – RISK MANAGEMENT

Signaling BOX FEATURE: REAL LIFE – DRESS FOR SUCCESS

Reputation (LO 10.5) Statistical Discrimination (LO 10.6) BOX FEATURE: WHAT DO YOU THINK? – FROM SPRAY PAINT TO AUTO INSURANCE

Regulation and Education (LO 10.7) BOX FEATURE: REAL LIFE – GOT ADVERSE SELECTION? BRANDING AND REGULATING MILK BOX FEATURE: WHAT DO YOU THINK? – HOW MUCH INFORMATION IS TOO MUCH?

Beyond the Lecture Class Discussion: Information Asymmetry (LO 10.1) In order to highlight the importance of information asymmetry, consider discussing Chapter 2 of Freakonomics. The chapter provides an overview of how prior to the internet real estate agents were able to control information about the housing market, in particular comparable sales. You can also show students this brief video by the authors of Freakonomics that discusses the chapter and explains the incentives of real estate agents.

1. What information do real estate agents have that buyers and sellers may not have, especially prior to the internet?

2. Prior to the internet, how could some real estate agents possibly use information asymmetry, along with the control of information, to their advantage?

Class Discussion: Information Asymmetry and Reputation (LO 10.1, LO 10.5) Consider showing and discussing this brief clip from the TV show Seinfeld.

1. Why is there asymmetric information between automobile mechanics and the owners of the cars?

2. What is the potential impact of asymmetric information on the owner of the car?

3. How can reputation help to mitigate asymmetric information?

Class Discussion: Adverse Selection, Principal-Agent Problems, and Moral Hazard (LO 10.2, LO 10.3) Consider showing a brief scene (part or all of scene 17) from the movie I Love You Man. In the scene, Sidney asks Peter for a loan for an unspecified reason. This can be used to start a discussion about adverse selection and moral hazard.

1. What is the information asymmetry in this situation?

2. How could this be a problem for the lender? Can the lender do anything to screen the borrower?

3. What will the borrower do after he gets the loan?

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4. Is there anything that can be done to help mitigate the potential for misuse of the loan?

Class Media: Reputation (LO 10.5) Use two clips from the movie American Gangster (51:44–54:03 and 1:31:56–1:34:17) to highlight the possibility of using branding and reputation to convey information to consumers.

In the clips, Denzel Washington’s character actually brands the higher quality drugs that he sells. Watch 51:44-54:03 and1:31:56-1:34:17.

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Return to the description of the genetic screening program that opened the chapter. Suppose that all individuals are perfectly altruistic and share the insurance companies’ goal of pricing according to health status. Would information asymmetry cause a problem in this situation?

Why or why not?[LO 10.1] Answer: If all individuals are perfectly altruistic and share the insurance companies’ goal of pricing according to health status, information asymmetry would not be a problem.

Asymmetric information is a problem only when the two sides of the market (or of a transaction) have different goals. If individuals have different goals, the side of the market with more information (in this case, the insurance companies) can use their information advantage strategically. But if all individuals and the insurance company share the same goal, having the advantage of more information is not important.

2. Suppose you are in the market to purchase your first home. You found a house you like in your price range and are buying directly from the previous owner. Describe an information asymmetry in this situation. Explain who is likely to benefit from this information imbalance.

[LO 10.1] Answer: The previous owner of the home will have more information than you will have about any issues with the house, such as problems with the pipes, wiring, or foundation. This information asymmetry will matter because you and the seller of the home have different goals. The seller wants to get as high a price for the house as she can. She will benefit from the information asymmetry of your knowing less than she does about any potential problems that would affect the price of the house.

3. A club charges a flat fee for an open bar (all-you-can-drink). Describe the adverse-selection problem. [LO 10.2] Answer: A flat fee for an open bar is appealing to people who intend to drink a lot. A person who wants only one or two drinks will not benefit from a flat fee that allows attendees to richard@qwconsultancy.com

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have as many drinks as they want. The fee will likely be too expensive for anyone who doesn’t plan to drink very much. Rather than attracting a balance of light and heavy drinkers, the flat fee attracts mostly heavy drinkers.

4. A course description posted during the registration period notes that homework is graded complete or incomplete rather than being corrected by the instructor. Describe the adverseselection problem. [LO 10.2] Answer: A course advertising that homework will receive credit if it is complete, regardless of whether it is actually correct, will disproportionately attract students who don’t typically perform well on graded assignments. A strong student who doesn’t mind doing homework and usually performs well will be less likely to be persuaded to take this course just because homework is not corrected.

5. A club charges a flat fee for an open bar (all-you-can-drink). Describe the moral-hazard problem. [LO 10.3] Answer: Once you have paid a flat fee for an open bar, you may be tempted to drink more than you would have if you were paying by the glass. People like to feel like they “got their money’s worth.” Once you pay the flat fee, the marginal cost of another drink (at least monetarily) is zero. People will tend to consume until the marginal benefit is also zero. If you were paying by the glass, the marginal cost of another drink would not be zero, and you would likely stop sooner.

6. Imagine that you own a bagel shop, which you visit once a day. According to company policy, employees are supposed to pay for all the bagels they eat. Why is moral hazard likely to be a problem in this situation, and what could you do to prevent it? [LO 10.3] Answer: Moral hazard is likely to be a problem because there is very little monitoring if the owner stops by only once a day. Employees have an incentive to eat bagels without paying if there is no system to monitor their consumption. The owner could spend more time in the shop, be less predictable about when he stops by, or keep track of the bagel supply versus receipts. He could also install surveillance if he thinks the cost of employees taking bagels justifies this expense. There is a cost to monitoring, and the bagel owner should weigh this against his projected losses from employee bagel theft.

7. The university admissions process involves both screening and signaling. Give an example of each. Who is doing the screening? Who is doing the signaling? [LO 10.4] Answer: An example of screening would be the admissions committee checking high school grades and test scores for minimum standards. An example of signaling would be an applicant highlighting her participation on the high school debate team and her awards in track. She wants to signal to the admissions committee that she is smart, disciplined, and achievement-oriented, qualities that should make her a good student. In university richard@qwconsultancy.com

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admissions, the admissions committee is doing the screening, and the applicant is doing the signaling.

8. Explain why joining a fraternity or sorority might include elaborate or difficult rituals. [LO 10.4] Answer: A person’s willingness to participate in elaborate or difficult rituals effectively signals their commitment to the group they are joining. It is hard to know how committed someone is to group membership if there are no hurdles to join.

9. Walter wants to signal his devotion to Emily. He has $75 and is considering a bracelet for Emily or a tattoo for himself of her name. Which is the more effective signal? [LO 10.4] Answer: The tattoo is a more effective signal of devotion. The most effective signals are costly to fake. If Walter isn’t serious about Emily, he might still buy her a bracelet, but he certainly wouldn’t tattoo her name to his body!

10. Advertising often features testimonials from satisfied customers, who happily describe the characteristics of the goods or services they received. Why do advertisers use this technique rather than a direct description of the goods or services? [LO 10.5] Answer: People assume that the opinions of other customers are more reliable than what the seller would say about the product himself. If we don’t yet know about the quality of a good or service from our own experience, we look to the reputation the good or service (or seller) has with other customers. Other customers, we assume, have no incentive to say that a product or service is great if it isn’t. The reputation of the seller with other customers is important information to inform our willingness to buy a good or service.

11. Two instructors are offering elective courses this semester. One instructor has been teaching at the university for several years. The other instructor is new. For which instructor will teaching evaluations be the most important this semester? Explain why. [LO 10.5] Answer: Think about how you sign up for elective classes. Do you ever ask your peers, “What’s the instructor like?” The reputation of the professor is an important and valid consideration when you have a choice among classes. For this reason, the new professor is likely to care more about her teaching evaluations. As a new instructor, she needs to establish a positive reputation if she wants students to continue to sign up for her elective class.

Students already know the reputation of the other instructor. Of course, the established instructor should care about maintaining a good reputation and will not ignore her evaluations, but they are less critical for her than for the first-time teacher.

12. Consider the market for life insurance. Give an example of statistical discrimination an insurer might use to set premiums. [LO 10.6]

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Answer: An insurer might charge a higher premium for men than for women because life expectancy is shorter for men.

13. Consider the market for auto insurance. Explain why insurers ask student drivers about their grades. [LO 10.6] Answer: Insurers ask about grades because being a good student is correlated with being a less-risky driver. The insurer can’t predict the risk level of the individual driver, but on average, students with good grades are less risky behind the wheel.

14. Suppose the government is thinking of requiring pharmaceutical companies to print the exact chemical formulas of medications on the label, so consumers will know exactly what they are ingesting. Is the new disclosure rule likely to benefit the average consumer? Explain your reasoning. [LO 10.7] Answer: The new disclosure rule would not be likely to benefit the average consumer.

Consumers do need information that helps them assess the risk of a product, such as what side-effects they may experience. However, the average consumer will not understand chemical formulas printed on a label. This will provide no useful information to help them gauge risk or make better decisions about taking medications.

15. Some people have argued that charging the citizens for health insurance could reduce healthcare costs for the government. Explain this argument. What problem would mandatory premiums not solve that could undermine cost savings? [LO 10.7] Answer: Mandatory insurance would address the problem of adverse selection. By preventing people from opting out, the pool of people paying premiums will increase. Part of the assumption people are making with this argument is that there are people who are lowrisk in terms of health insurance payouts who currently choose to forgo insurance because premiums are too high to reflect their low risk. Making health insurance mandatory would mean that these low-risk people are also paying premiums, which would reduce overall costs.

However, mandatory health insurance would not address the problem of moral hazard. This effect comes into play because once people pay their premium (a sunk cost), they are more likely to over-consume health care because they are not paying the full cost of an office visit.

Problems and Applications 1. In which of the following situations is an information asymmetry likely to cause problems?

[LO 10.1] a. Cab drivers know the shortest route to any destination better than their passengers do. b. Managers can’t always supervise members of their sales staff, who work on commission.

(That is, staff members receive a percentage of the total value of the sales they make.)

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Answer: a. Cab drivers know the shortest route to any destination better than their passengers do. Information asymmetry is a condition in which one person knows more than another. The incentives of the cab driver and the passenger are not aligned: cab drivers want the fare to be as high as possible.

2. In which of the following situations is an information asymmetry likely to cause problems?

[LO 10.1] a. Parents know more than their children about how to write a good university application. b. People who book hotel rooms online know less about the quality of the room they are reserving than the hotel’s management.

Answer: b. People who book hotel rooms online know less about the quality of the room they are reserving than the hotel’s management. Information asymmetry is a condition in which one person knows more than another. For any given reservation, the guest has limited knowledge of what they are getting. Their reservation is based on a standard description and a couple of photos meant to represent the typical room. The hotel can also charge the same amount for rooms of varying quality and the average guest is usually none the wiser.

3. Which of the following situations are likely to involve adverse selection? [LO 10.2] a. After receiving an emergency call during class, a professor leaves students unsupervised for the rest of the period. b. A course has a reputation for being an easy A, even though after the term begins, students realize that it isn’t. c. A course is a requirement for physics majors but an elective for biology majors.

Answer: b. A course has a reputation for being an easy A, even though after the term begins, students realize that it isn’t. Adverse selection is a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation. It results in failure to complete transactions that would have been possible if both sides had the same information.

4. In which of the following situations is adverse selection not a concern? [LO 10.2] a. A company offers employees the opportunity to purchase group health insurance. b. A company requires employees to purchase group health insurance. c. The health insurance plan does not include dental care.

Answer: b. A company requires employees to purchase group health insurance. Adverse selection is a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation. It results in failure to complete transactions that would have been possible if both sides had the same information.

5. Which of the following situations are likely to involve moral hazard? [LO 10.3]

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a. After receiving an emergency call during class, a professor leaves students unsupervised for the rest of the period. b. A course has a reputation for being an easy A, even though after the term begins, students realize that it isn’t. c. A course is a requirement for physics majors but an elective for biology majors.

Answer: a. After receiving an emergency call during class, a professor leaves students unsupervised for the rest of the period. With moral hazard, people engage in behavior that is considered undesirable by the person who bears the cost of the behavior.

6. In which of the following government policies is moral hazard not a concern? [LO 10.3] a. Government provides disaster relief for homeowners who lose their homes in a flood. b. Government provides unemployment insurance when workers are laid off. c. Government raises taxes to pay for social services.

Answer: c. Government raises taxes to pay for social services. With moral hazard, people engage in behavior that is considered undesirable by the person who bears the cost of the behavior.

7. Say whether each of the following situations involves screening or signaling. [LO 10.4] a. Auto shops and motels advertise that they are CAA-approved. b. Employers check interviewees’ Facebook or Instagram profiles before hiring one of them. c. Applicants must pass an exam before becoming eligible for a civil service position. d. People wear expensive clothing with large brand names or logos.

Answer: When people take action to reveal their own private information, they are signaling.

Screening involves taking action to make someone reveal private information. a. Signaling. b. Screening. c. Screening. d. Signaling.

8. Jane uses an online dating service. For each of the following activities say whether Jane is screening or signaling. [LO 10.4] a. Jane views profiles of only non-smokers. b. Jane describes her volunteer activities in her profile. c. Jane lists museums and foreign films among her interests. d. Jane looks for matches who live within 25 kilometers of her address.

Answer: When people take action to reveal their own private information, they are signaling.

Screening involves taking action to make someone reveal private information. a. Screening. b. Signaling. c. Signaling. richard@qwconsultancy.com

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d. Screening.

9. Consider the effect of reputation and say whether you are likely to be treated better in scenario a or scenario b. [LO 10.5] a. You tell an auto mechanic that you have just moved to town. b. You tell an auto mechanic that you are moving out of town.

Answer: a. You tell an auto mechanic that you have just moved to town. Reputation can overcome the problem of asymmetric information. A good reputation can be viewed as a special form of signaling.

10. Consider the effect of reputation and say whether you are likely to be treated better in scenario a or scenario b. [LO 10.5] a. You are purchasing your car from an individual who advertised it on Craigslist. b. You are purchasing your car from a local dealership.

Answer: b. You are purchasing your car from a local dealership. Reputation can overcome the problem of asymmetric information. A good reputation can be viewed as a special form of signaling.

11. In university admissions, which of the following are examples of statistical discrimination?

Choose all that apply. [LO 10.6] a. A university has minimum required scores on standardized tests. b. A university is an all-women’s school. c. A university uses high-school marks to rank students for scholarship offers. d. A university requires three letters of recommendation.

Answer: a and c. Statistical discrimination is the process of distinguishing between choices by generalizing based on observable characteristics in order to fill in missing information.

12. In a market for car insurance, which of the following are examples of statistical discrimination? Choose all that apply. [LO 10.6] a. Premiums are adjusted based on the postal code of the insured. b. Premiums are adjusted based on the colour of the car. c. Premiums are adjusted based on the driving record of the insured. d. Premiums are adjusted based on the model of the car.

Answer: All are examples of statistical discrimination. Statistical discrimination is the process of distinguishing between choices by generalizing based on observable characteristics in order to fill in missing information.

13. Say which public regulation approach is likely to be more effective in providing information to consumers of pharmaceuticals. [LO 10.7] a. Requiring pharmaceutical companies to list major side effects of their medications in television advertisements. richard@qwconsultancy.com

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b. Requiring pharmaceutical companies to post online the full text of research results from medical testing done during the development of new drugs.

Answer: a. Requiring pharmaceutical companies to list major side effects of their medications in television advertisements. When an information problem is pervasive and has a pronounced negative effect on society, government will sometimes step in to provide the missing information or require that others reveal private information. The effectiveness of these interventions depends on how well the government’s requirements are enforced, and how well people understand the information they receive.

14. Say which public regulation approach is likely to be more effective in providing information to consumers of restaurant meals. [LO 10.7] a. Filing a notice at city hall when a restaurant fails a health and sanitation inspection. b. Posting a public notice on the door of a restaurant that fails a health and sanitation inspection.

Answer: b. Posting a public notice on the door of a restaurant that fails a health and sanitation inspection. When an information problem is pervasive and has a pronounced negative effect on society, government will sometimes step in to provide the missing information or require that others reveal private information. The effectiveness of these interventions depends on how well the government’s requirements are enforced, and how well people understand the information they receive.

CHAPTER 11

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TIME AND UNCERTAINTY Chapter Overview Some of life’s most important decisions involve weighing uncertain future costs and benefits against costs and benefits today. In this chapter, we look at tools that can help with these decisions. Interest rates enable you to compare apples to apples when you think about costs and benefits that occur at different times. Expected value can help you think about what is the best option given uncertainty. Managing risk through pooling or diversification can allow you to avoid bearing the full cost of a worst-case scenario if it happens.

Learning Objectives LO 11.1: Explain why money is worth more now than in the future, and how the interest rate represents this relationship.

LO 11.2: Calculate compounding over time with a given interest rate.

LO 11.3: Calculate the present value of a future sum. richard@qwconsultancy.com

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LO 11.4: Evaluate the costs and benefits of a choice using expected value.

LO 11.5: Explain the behavior of individuals who are risk-averse or risk-seeking.

LO 11.6: Explain how risk aversion makes a market for insurance possible.

LO 11.7: Explain the importance of pooling and diversification for managing risk.

LO 11.8: Describe the challenges that adverse selection and moral hazard pose for insurance.

LO 11.1: Explain why money is worth more now than in the future, and how the interest rate represents this relationship.

LO 11.2: Calculate compounding over time with a given interest rate.

LO 11.3: Calculate the present value of a future sum.

LO 11.4: Evaluate the costs and benefits of a choice using expected value.

LO 11.5: Explain how risk aversion makes a market for insurance possible.

LO 11.6: Explain the importance of pooling and diversification for managing risk.

LO 11.7: Describe the challenges that adverse selection and moral hazard pose for insurance.

Chapter Outline OPENING STORY: IS COLLEGE WORTH IT?

Value over Time Timing Matters (LO 11.1) Interest Rates Compounding (LO 11.2) BOX FEATURE: REAL LIFE – THE RULE OF 70

Present Value (LO 11.3) Risk and Uncertainty What Is Risk?

Expected Value (LO 11.4) Propensity for Risk (LO 11.5) Insurance and Managing Risk The Market for Insurance (LO 11.6)

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BOX FEATURE: FROM ANOTHER ANGLE – HOLE-IN-ONE INSURANCE?

Pooling and Diversifying Risk (LO 11.76) BOX FEATURE: WHAT DO YOU THINK? – WHO SHOULD BEAR THE RISK THAT A COLLEGE DEGREE DOESN’T PAY OFF? BOX FEATURE: FROM ANOTHER ANGLE – HINDSIGHT IS 20/20

Problems with Insurance (LO 11.87) BOX FEATURE: WHAT DO YOU THINK? – SHOULD HEALTH INSURANCE INCLUDE PREVENTIVE CARE?

Beyond the Lecture Class Discussion: Timing Matters and Expected Value (LO 11.1, LO 11.4) Consider showing a brief clip (scene 17, or part of it) from the movie I Love You Man. In the scene, Sidney asks Peter for a loan for an unspecified reason. This can be used to discuss why richard@qwconsultancy.com

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money is worth more in the present than the future and interest rates. If you chose to show this movie clip for Chapter 10, you could simply discuss the clip instead of showing it again.

1. Why would you rather have money now than in the future?

2. How much interest would you have to earn in this situation?

3. What determines how much interest is charged on a loan?

4. What are the costs and benefits of making this loan?

Class Activity: Present Value (LO 11.3) Ask students to consider whether an individual who wins the lottery should take a lump sum payment or take annual payments over time. To engage students, have them indicate (perhaps using www.polleverywhere.com) which option they would take if they won, and display the aggregate results for the class. (Do this before reading the article or engaging in the below activity.) You can also have students read this article about that very question. You can make up numbers or use the numbers in the article.

1. Ask students to calculate the present value of taking the annual payments, using either the numbers in the article or your own numbers. Ask them how this compares to the lump-sum payment.

2. What factors should an individual consider when deciding between the lump-sum payment and annual future payments?

3. Ask students to revisit their answer to the question of which option they would take: Did their answer change?

Class Activity: Expected Value (LO 11.4) Have students play Deal or No Deal to highlight the concept of expected value. You can find a computerized version of the game here and instructions for a handwritten version (created by John Sloman) here. While going through this activity, students must choose whether to keep the banker’s offer or continue with the game. You can even have students calculate expected value along the way, to help them make their decisions. This activity also provides insight into risk tolerance.

Class Discussion: Expected Value (LO 11.4) Consider showing a brief clip from the television show Storage Wars (just about any clip will do; there are plenty on this YouTube channel). Have students consider the following: 1. How do the buyers estimate the expected value of the units purchased?

2. How risky is it to purchase the units?

3. What is the opportunity cost?

Class Discussion: Pooling and Diversifying Risk (LO 11.6) In order to highlight the importance of diversification, have students examine changes in the price of one stock relative to the entire stock market. It is often entertaining for students to discuss the Wall Street Journal’s investment dartboard contest, where reader’s pick a stock that they think will do well (six readers are chosen) and darts are thrown to pick six random stocks. richard@qwconsultancy.com

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This can be compared to the overall performance of the stock market. You can find an article about the 2012 WSJ contest here.

Solutions to End-of-Chapter Questions and Problems Review Questions

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10.1. Anna is indifferent between receiving $200 today or $230 in a month. What does this imply about her opportunity cost in the coming month? How much interest would Anna need to charge to lend $200 for the month in order to break even? [LO 11.1]

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Answer: If Anna is indifferent between receiving $200 today or $230 in a month, it means that her opportunity cost in the coming month is $30. Anna’s opportunity cost is the value of whatever she could have done with the money that month. Perhaps Anna could invest her money in another opportunity next month that would earn her $30. She would need to do at least this well to be willing to loan the money instead. Anna would need to charge $30 in interest in order to break even.

11.2. Colton has a choice between $100 today and $150 in three months. Farah has a choice between $100 today and $125 in three months. Colton chooses $100 today. Farah chooses $125 in three months. Explain why Farah is the one who delays payment even though Colton stands to earn more by waiting. [LO 11.1]

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Answer: Colton and Farah differ in their opportunity costs. Colton has a stronger preference for cash in hand. He would require more than $50 to get him to postpone payment. Farah has a lower opportunity cost for waiting. Even though she does not have the opportunity to earn as much as Colton by waiting for her money, Farah is more patient and less in need of immediate cash in hand.

12.3. Suppose your aunt invests $2,000 for you. You are not allowed to have the money until the original amount doubles. Your aunt’s investment earns 10 percent, compounded annually.

Give a rough estimate of how long it will take before you can access the money your aunt invested for you. [LO 11.2]

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Answer: Using the rule of 70 as a rough estimate, your aunt’s investment will double in 70 ÷ 10 = 7 years.

13.4. You are considering taking out a two-year loan of $1,000 from a bank, on which you can pay either compound yearly interest of 1 percent or a flat rate of 2 percent for the whole twoyear period. Which option is a better deal, and why? [LO 11.2] Answer: The flat rate of 2 percent is the better deal. If you pay the flat rate of 2 percent, you will wind up paying $20 in interest on your loan. 1,000(1.02) = 1,020. If you pay 1 percent interest compounded annually, you will wind up paying $20.10 in interest. richard@qwconsultancy.com

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V = 1,000(1.01)2 V = 1,000(1.0201) V = 1,020.1 14.5. Suppose you know that an investment will earn a positive return in the future. Why is it important to know the present value of the investment? [LO 11.3] Answer: It’s important to know the present value of the investment so that you can compare the costs and benefits of the investment in today’s money. Calculating the present value of future benefits will help you understand if the investment today is worth the future reward.

Just because you expect to gain something in the future does not mean that the future gain enough to make up for the cost today.

15.6. Suppose you are selling a piece of furniture to a friend who can’t afford to pay you upfront but offers to pay you in monthly installments for the next year. What information do you need to calculate the present value of this offer? (Hint: Think about the formula for present value.) [LO 11.3]

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Answer: The formula for present value is given as PV = FV / (1 + r)n. Thus, to calculate present value, you need the future value, the time period and the interest rate. You know the time period, so you would need the future value and the interest rate to assess your friend’s offer.

16.7. A pharmaceutical company is considering investing in the development of a new drug.

The company stands to make a lot of profit if the drug is successful. However, there is some risk that the drug will not be approved by government regulators. If this happens, the company will lose its entire investment. Advise the company how to take this risk into account as managers evaluate whether to invest. [LO 11.4]

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Answer: The pharmaceutical company could use expected value to assess the investment.

Expected value takes risk into account. To evaluate the investment using expected value, the company would need to project the possible profit if the drug is successful and assign a probability of that outcome versus the probability that the drug will not be approved and the investment will be lost. Taking both possibilities and their relative probabilities into account will tell the company the expected value of the investment.

17.8. You have a big exam tomorrow. You were planning to study tonight, but your friend has tickets to a concert and has invited you to join her. You would be willing to accept a B on the exam in order to go to the concert. You estimate that if you don’t study you have a 35 percent chance of scoring a 90, a 35 percent chance of scoring an 80 (the score required to earn a B), a 25 percent chance of earning a 75, and a 5 percent chance of earning a 60. Will you go to the concert? Explain why or why not. [LO 11.4]

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Answer: The expected value of your score if you don’t study is 81.25, which is enough for a B. If you make your decision based on expected value, you will go to the concert. Of course, richard@qwconsultancy.com

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this outcome is not certain. It is based on your estimates of the probability for various outcomes. There is still risk involved, and you may decide to stay home and study even though you expect to earn a B without studying.

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9. Many individuals prefer to have insurance (health insurance, car insurance, etc.) rather than not, even if the expected value of their wealth is higher without insurance. What does this imply about their willingness to take on risk? [LO 11.5LO 11.5] Answer: Not having insurance can be very risky. There is a chance that you might face very high costs if you have a car accident, need surgery, etc. Many people are willing to pay extra for insurance because they are risk-averse. They would rather lose a little money for sure than face the possibility of losing a lot of money.

10. Lenders tend to offer lower interest rates to borrowers with high credit scores and higher interest rates to borrowers with low credit scores. What does this imply about lenders’ willingness to take on risk? [LO 11.5LO 11.5]

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Answer: Just like individual people, businesses are also typically risk-averse. In order to take on more risk (through lending to higher-risk borrowers), the lenders must raise the expected value of the return by raising the interest rate.

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18.11. Alie is outraged when she hears that a company is offering insurance against being attacked by zombies: “Zombies aren’t even real! This company is just taking advantage of people.” Without acknowledging the possible existence of zombies, provide an alternative perspective on the insurance company’s ethics. [LO 11.65] Answer: Some people are afraid of zombies and believe in the possibility of a zombie attack.

The insurance company may not be selling protection against something real, but it is definitely selling something that people value: peace of mind. People who are willing to pay for insurance against a zombie attack are doing so because owning the policy reduces their anxiety.

19.12. Julia pays $500 for an insurance policy with an expected value of $120. Explain why this is a rational choice for Julia. [LO 11.65] Answer: Paying more for insurance than its expected value is a rational choice. Julia isn’t paying just to cover the probability of a payout. She is also paying for the sense of security richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

that comes from knowing that she is covered in the event of an accident. If Julia is riskaverse, this sense of security is worth the extra price.

20.13. Suppose that the crop yield of corn farmers in Alberta depends solely on rainfall levels.

Also, suppose that every part of the state gets approximately the same amount of rain as every other part in any given year. Will the corn farmers of Alberta Iowa be able to effectively use pooling to reduce their exposure to risk? Why or why not? [LO 11.76] Answer: The farmers will not be able to effectively pool their risk. Risk pooling works only if everyone in the pool is paying premiums but not everyone is making claims. Assuming all parts of the province getprovince get the same amount of rain in a given year, if one area suffers a drought (or flood), all areas will experience the same conditions and everyone will make claims.

21.14. An insurance company that faces fierce competition from other providers is considering a strategy to sell more policies by simplifying its portfolio and becoming the expert in flood insurance for the state. The company managers reason, “Everyone buys flood insurance in this state, so let’s focus our efforts on becoming the preferred provider.” Evaluate this strategy. [LO 11.76]

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Answer: This strategy is risky for the insurance company. If everyone in the state is buying flood insurance, it is likely that flooding is common. If the company does not diversify its risk, it will be faced with too many claims at once.

22.15. Suppose the economy is suffering and many people are afraid they will be laid off from their jobs. Workers would like to protect against this risk with insurance. Identify and explain two problems that prevent insurance companies from offering layoff insurance. [LO 11.87] Answer: Adverse selection: Individuals probably have more knowledge about their own risk of layoff than does the insurance company. Those more likely to be laid-off are more likely to buy insurance. This means that insurance companies have to charge higher prices for the insurance. This drives out more of the lower risk people. Moral hazard: Once people have layoff insurance, they are more likely to slack off at work and get themselves laid-off because the cost of being laid-off is lower than it would have been without insurance.

23.16. BackPedal is a bike-rental shop that rents bicycles, helmets, and other gear by the day.

[LO 11.87] a. a. BackPedal offers an optional helmet rental for $10/day with the rental of a bicycle.

To his surprise, the store manager has noticed that cycling accidents are higher among customers who rent helmets than those who do not. Explain this phenomenon using economic concepts. Assume that customers who do not rent helmets also do not own helmets. b. b. BackPedal is considering offering helmets for free with a bike rental. Explain how this new policy will affect the issues you identified in part a.

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Answer: a. a. Both moral hazard and adverse selection may be at play. In terms of moral hazard, because cyclists feel safer when they are wearing a helmet, they may tend to ride less cautiously and are therefore more likely to get into accidents. As for adverse selection, cyclists who tend to ride less safely or take more risks than other cyclists may be more likely to rent helmets, knowing that they are at higher risk for accidents. b. b. Adverse selection will be reduced. Offering helmets without charge will cause many of the less-risky riders who may not have been willing to pay $10 for a helmet to use one if it is free. Moral hazard is still a concern. Offering helmets for free should cause more people to wear helmets but does not change the incentive to ride less cautiously once the rider feels more protected.

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Problems and Applications 1. Your bank offers 3 percent annual interest on savings deposits. If you deposit $560 today,

how much interest will you have earned at the end of one year? [LO 11.1] 1.

Answer: If you invest $560 for one year at 3 percent interest, you will have $576.80 at the end of the year, so you earned $16.80 in interest. 560(1.03) = 576.80.

2. You have $350, which a friend would like to borrow. If you don’t lend it to your friend, you

could invest it in an opportunity that would pay out $392 at the end of the year. What annual interest rate should your friend offer you to make you indifferent between these two options?

[LO 11.1]

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Answer: In order to break even, you will need to receive $42 in interest. This corresponds with a 12 percent interest rate.

350(1 + r) = 392 350 + 350r = 392 350r = 42 r = 0.12 = 12% 3. If you deposit $500 in a savings account that offers 3 percent interest, compounded annually,

and you don’t withdraw any money, how much money should you expect to have in the account at the end of three years? [LO 11.2]

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3

Answer: 500 x (1.03) x (1.03) x (1.03) = $500 x (1.03) = $546.36.

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4. Suppose you run up a debt of $300 on a credit card that charges an annual rate of 12 percent,

compounded annually. How much will you owe at the end of two years? Assume no additional charges or payments are made. [LO 11.2] Answer: If you run up a debt of $300 on a credit card that charges 12 percent annual interest compounded annually, you will owe $376.32 at the end of two years. $300 x (1.12) x (1.12) = $300 x (1.12)2 = $376.32. richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

5. Your savings account currently has a balance of $32,300. You opened the savings account

two years ago and have not added to the initial amount you deposited. If your savings have been earning an annual interest rate of 2 percent, compounded annually, what was the amount of your original deposit? [LO 11.3]

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Answer: If your savings account has a balance of $32,300 and has been earning 2 percent annual interest for two years, your original deposit was $31,045.75. $32,300 / [(1.02) x (1.02)] = $32,300 / (1.02)2 = $31,045.75.

6. You run a business and are considering offering a new service. If you offer the new service,

you expect it to generate $60,000 in profits each year for your business over the next two years. In order to offer the new service, you will need to take out a loan for new equipment.

What would be the maximum amount you would borrow in order to offer this new service?

Assume a 5 percent annual interest rate. [LO 11.3]

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Answer: The present value of the profits is: ($60,000 / 1.05) + ($60,000 / [(1.05) x (1.05)] = $111,564.63. Your loan should be less than this amount in order for your future benefits to exceed present costs.

7. You are driving home from work, and get stuck in a traffic jam. You are considering turning off from your usual route home and taking a longer route that might have less traffic.

However, you know that there is some chance that the traffic on your usual, shorter route will clear up. Based on Table 11P-1, calculate the expected value (in minutes until you arrive home) of each option. [LO 11.4]

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Answer: The expected value of Route 1 is 39 minutes. The expected value of Route 2 is 30 minutes. You should take Rroute 2.

Route 1 Expected Value: EV = 0.30(10) + 0.20(30) + 0.50(60) EV = 3 + 6 + 30 EV = 39 minutes Route 2 Expected Value: EV = 0.50(20) + 0.50(40) + 0(80) EV = 10 + 20 + 0 EV = 30 minutes 8. Books for Kids is a not-for-profit organization that runs after-school reading programs in four school districts. Books for Kids is planning a fundraiser to buy new books. Last time it held a fundraiser, donors were allowed to specify which district program they wanted to receive their donation. Table 11P-2 shows the average donations and the percent of all donations that went to each district. Using the last fundraiser as a projection, what is the expected value of the average donation across all four programs? [LO 11.4]

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

Answer: The expected value of the average donation across all four districts is $25.95.

EV = 0.15(25) + 0.30(50) + 0.20(15) + 0.35(12) EV = 3.75 + 15 + 3 + 4.20 EV = 25.95 9. Cora had two options when buying car insurance. Option A had a higher expected value, but Cora chose option B. From the list below, what can we assume about these policies and Cora’s willingness to take on risk? Check all that apply. [LO 11.5] a. Option B was riskier. b. Option A was risker. c. Cora is risk-seeking. d. Cora is risk-averse.

Answer: b and d. If option A had a higher expected value but Cora chose option B, then option A must be riskier and the higher expected value is not enough for Cora to choose the riskier option. Cora chose the less risky option. She is risk-averse.

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10. Consider the following scenarios. For each scenario, determine whether a risk averse person will definitely choose Option A, definitely choose Option B, be indifferent between Options A and B, or might choose either Option A or B, [LO 11.5LO 11.5] a. Option A: There is a 50% chance of winning $1,000 and a 50% chance of winning $0. Option B: There is a 100% chance of receiving $500.

b. Option A: There is a 40% chance of winning $90 and a 60% chance of winning $110.

Option B: There is a 100% chance of winning $90. c. Option A: There is a 50% chance of winning $0 and a 50% chance of winning $100.

Option B: There is a 50% chance of winning $20 and a 50% chance of winning $60.

Answer: a. Though the two options have the same expected value, option B has no risk, so a riskaverse person will choose option B. b. Though option C involves risk, it will not yield a lower payoff than option D. A riskaverse person has no reason to choose option D. Option C is at least as good or better. c. Thought option E is riskier, it has a higher expected value. It's unclear what a risk-averse person will prefer.

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11. Suppose you own a beach house on a coast that has a small chance of encountering a hurricane each year. There is a 1% chance that there will be a hurricane this year that would completely destroy your $350,000 home. (Assume that this home is the only store of wealth that you have.) An insurance company has offered you insurance that would reimburse you the entire value of your home in the event of a hurricane. The premium for this insurance is $4,000. [LO 11.6LO 11.6]

a. What is the expected value of your wealth if you do not purchase insurance?

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b. What is the expected value of your wealth if you purchase the insurance at a $4,000 premium? c. Will a risk-averse person choose to purchase insurance? d. Will a risk-seeking person choose to purchase insurance? e. What would the premium have to be to make a risk-neutral person indifferent between buying the insurance and not buying the insurance? f. If the insurance company offered the premium you found in part (e), would a risk-averse person purchase insurance?

10.12. You are considering buying one of two types of extended health insurance. You guess that in the next year there is a 1 percent chance of serious illness that will cost you $67,500 in health care; a 9 percent chance of a moderate illness that will cost you $2,500; and a 90 percent chance of regular health care needs that will cost you $500. One type of health insurance is emergency-only coverage; it will cover your expenses for serious illness but not other types of care. The other type covers extended expenses for moderate illness, but its payout is capped, so it will not cover the cost of a serious illness. [LO 11.65] a. What is the expected value of payouts from the emergency-only insurance? b. What is the expected value of payouts from the capped-coverage insurance? c. Which is the more risk-averse option?

Answer: a. a. EV = 0.01(67,500) = $675. b. b. EV = 0.09(2,500) + 0.9(500) = $675. c. c. The emergency-only coverage is the more risk-averse option. Even though there is only a 1 percent chance of this outcome, if the serious illness did occur it would be the most financially damaging.

11.13. For each of the following scenarios, say whether pooling or diversification is a more promising risk-mitigation strategy. [LO 11.76] a. a. Employees of a company who receive their salaries and health insurance from their employer and also invest their savings in that company’s stocks. b. b. Families who are worried about losing their possessions if their houses burn down. c. c. Neighbouring farmers who grow the same crop, which is prone to failure in dry years.

Answer: Risk pooling organizes people into a group to collectively absorb the risk faced by each individual. Risk diversification means avoiding large risks by replacing them with smaller ones that are unrelated. a. Diversification. b. Pooling. c. Diversification.

12.14. You have two possessions you would like to insure against theft or damage: your new bicycle, which cost you $800, and a painting you inherited, which has been appraised at $55,000. The painting is more valuable, but your bicycle must be kept outdoors and is in richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

much greater danger of being stolen or damaged. You can afford to insure only one item.

Which should you choose? Why? [LO 11.76] Answer: If you have to choose, you should insure the painting. Even though there is less risk of it being stolen or damaged, the painting is of far greater value than the bike. It would be much less catastrophic to lose your bike.

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15. Farmer Tom is trying to decide what to produce on his farm in the upcoming season. In the past, he has usually grown Crop A. If he grows Crop A, there is a 70% chance that his crop will yield $15,000 in profit and a 30% chance that he will earn zero profit. [LO 11.7LO 11.7] a. What is the expected value of his profit if he grows only Crop A? b. Now Farmer Tom considers dividing his land between two crops: Crop A and Crop B. There is a 5% chance that both crops will fail, and Tom will earn zero profit. The is a 25% chance that only one crop will grow, and Tom will earn $6,000 in profit. There is a 60% chance that both crops will grow, and Tom will earn $15,000 in profit. What is the expected value of his profit if he grows both crops? c. Which option would a risk-averse farmer choose? d. Which option would a risk-seeking farmer choose? e. Which option would a risk-neutral farmer choose?

Answer:

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a.

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c - e. Though both options have the same expected value, growing both crops is less risky.

There is only a 15% chance of earning zero profit versus a 30% chance if he grows only Crop A. A risk-averse individual would prefer the lower risk and choose to grow both crops. On the other hand, a risk-loving person would choose to grow only Crop A. If a person is riskneutral, only the expected value matters. Because the expected value is the same for each option, a risk-neutral individuals will be indifferent between the two options.

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13.16. Say whether each of the following scenarios describes an insurance problem caused by adverse selection or by moral hazard. [LO 11.87] a. a. People who have homeowners insurance are less likely than others to replace the batteries in their smoke detectors.

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

b. b. People who enjoy dangerous hobbies are more likely than others to buy life insurance. c. c. People whose parents died young are more likely than others to enroll in health insurance. d. d. People who have liability coverage on their car insurance take less care than others to avoid accidents.

Answer: Adverse selection occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation. With moral hazard, people engage in behavior that is considered undesirable by the person who bears the cost of the behavior. a. Moral hazard. b. Adverse selection. c. Adverse selection. d. Moral hazard.

14.17. Canada has universal health care. Does universal health care reduce adverse selection, moral hazard, both, or neither? [LO 11.87] Answer: This policy would reduce adverse selection by removing the opt-out option. If everyone has health insurance, the selection bias is removed. The policy does nothing to help with moral hazard. People are more likely to behave in risky ways when they are insured.

CHAPTER 12 THE COSTS OF PRODUCTION Chapter Overview In this chapter, we explore the costs that all firms face when they produce goods or services.

Understanding the relationship between inputs, outputs, and costs is crucial because costs, along with the firm’s revenues, determine profits. The pursuit of profits, of course, drives every firm’s decision-making process, including how much to produce and whether to stay in business. Over the next few chapters, we’ll continue to dig into the details of firm behavior that determine the market supply curve.

Learning Objectives LO 12.1: Define total revenue, total cost, and profit.

LO 12.2: Explain the difference between fixed and variable costs, and give examples of each.

LO 12.3: Explain the difference between explicit and implicit costs, and give examples of each.

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

LO 12.4: Calculate economic and accounting profit, and explain the importance of the difference.

LO 12.5: Define marginal product, and show why there is diminishing marginal product.

LO 12.6: Define and graph total cost, average costs, and marginal cost.

LO 12.7: Explain why firms face different costs in the long run than in the short run.

LO 12.8: Define returns to scale and its implications for production decisions.

Chapter Outline OPENING STORY: WHAT ARE YOU PAYING FOR IN THAT PRESCRIPTION?

The Building Blocks of Business: Revenues, Costs, and Profits Profit Is Revenue Minus Costs (LO 12.1) Fixed and Variable Costs (LO 12.2) BOX FEATURE: FROM ANOTHER ANGLE – THE “PRODUCTION” OF KIDS

Explicit and Implicit Costs (LO 12.3) Economic and Accounting Profit (LO 12.4) BOX FEATURE: FROM ANOTHER ANGLE – BEYOND THE BOTTOM LINE

Production Functions Marginal Product (LO 12.5) Cost Curves Total, Average, and Marginal Costs (LO 12.6) Production in the Short Run and the Long Run Costs in the Long Run (LO 12.7) Returns to Scale (LO 12.8) BOX FEATURE: REAL LIFE – WALMART AND ECONOMIES OF SCALE BOX FEATURE: WHAT DO YOU THINK? – THE PROFIT MOTIVE AND “ORPHAN” DRUGS

Beyond the Lecture Class Activity/ Discussion: Profit Is Revenue Minus Costs, Fixed and Variable Costs (LO 12.1, LO 12.2) Have students get into small groups and consider the cost of opening a restaurant. Ask them to list all of the primary costs that they would incur as a new startup and then the ongoing costs of operating a restaurant. This article provides examples of the costs associated with opening a restaurant. This activity can serve as an introduction to the topic of costs.

1. What costs are associated with starting and operating a restaurant?

2. Which of these are fixed and which are variable?

3. What is the opportunity cost involved?

Class Media: Profit Is Revenue Minus Costs, Fixed and Variable Costs (LO 12.1, LO 12.2) Have students view this brief clip from the TV show Seinfeld, where Kramer and Newman try to drive bottles from New York (where the bottle deposit is $0.05) to Michigan (where the bottle richard@qwconsultancy.com

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deposit is $0.10). This scene highlights both fixed and opportunity costs. A link below to The Economics of Seinfeld discusses the clip while the second link shows the Seinfeld episode.

Class Activity/Assignment: Fixed and Variable Costs; Marginal Product; and Total, Average, and Marginal Costs (LO 12.2, LO 12.5, LO 12.6) In order to highlight fixed versus variable costs, marginal product, diminishing marginal return, marginal cost, and average cost, consider a simple class activity where students ‘produce’ something. Have students pick a four letter word to produce (a clean one). Draw a square on the board to represent the production facility. This is the fixed resource; you can designate a price for it. Students will be the variable resource; you can designate a wage for them. Then have one student write the four letter word as many times as possible in 15 seconds. Record the writings as quantity. Continue to add students one by one who will write simultaneously until you reach a point of diminishing returns in your output. You can use the quantity to calculate all of the important costs. It is a good idea to give students a handout with all of the costs that you would like to calculate in a table form.

Class Activity: Explicit and Implicit Costs, Economic and Accounting Profit (LO 12.3, LO 12.4) Show this brief clip from the movie Ferris Bueller’s Day Off, in which Ferris is racing to beat his parents home to avoid getting into trouble. This can be used to start a discussion on explicit and implicit costs and economic and accounting profits. Any movie scenario where a crime is committed for money is a nice introduction for this topic as well.

1. What are the explicit costs associated with skipping high school?

2. What are the implicit costs associated with skipping high school?

3. What is the difference between accounting and economic costs in this scenario?

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Review Questions

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b)1. Economists assume that firms have a goal to maximize profits. Is this a reasonable assumption for not-for-profit organizations? [LO 12.1] Answer: Yes. Although a not-for-profit organization uses its profits to achieve the goals outlined in its mission rather than distributing profits to owners and investors, it is reasonable to assume that such organizations want to get as much as they can from their resources. The more profit they earn, the more funds they have available to achieve the goals outlined by their mission. Furthermore, even if the organization is willing to sacrifice some profit, unless losses are subsidized by the government or wealthy philanthropists, not-for-profits do still need to make a profit in order to function.

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

c)2. Suppose you were are evaluating the profit earned by a pharmaceutical company that produces three different medicines. What information would you need to know to calculate profit? [LO 12.1]

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Answer: Profit is calculated as total revenue minus total cost. The company would need to know the price and quantity sold for each medicine as well as the total costs (fixed costs plus variable costs) associated with producing all three medicines. d)3. Suppose that a pharmaceutical company’s costs include factory workers’ wages, researchers’ salaries, chemicals, warehouses, and paper and plastic packaging. Which of these costs do you expect to be fixed in the short run, and which variable? [LO 12.2]

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Answer: You would expect researchers’ salaries and warehouses to be fixed in the short run.

These costs likely involve contracts that make the costs fixed for the length of the contract.

Factory workers’ wages, chemicals, and packaging could be variable in the short run. e)4. Dustin is planning to open a catering business. Give examples of a one-time fixed cost, an ongoing fixed cost, and a variable cost his new catering business might incur. [LO 12.2]

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Answer: A one-time fixed cost for Dustin’s catering business might be a van he purchases to transport food and equipment to catering jobs. An ongoing fixed cost might be a kitchen space he rents to prep meals. A variable cost would be the groceries he purchases for the meals he makes. f)5. A shopkeeper explains to you that she keeps down the cost of running her business because her husband and sister work in the shop for free. Are her workers really free?

Explain why or why not. [LO 12.3]

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Answer: Her workers are not really free because there is an opportunity cost to their time.

Presumably the shopkeeper’s husband and sister could be earning paychecks elsewhere if they were not working in her shop. The shopkeeper should take into account this implicit cost. g)6. Dustin is planning to open a catering business. Give examples of an explicit cost and an implicit cost his new catering business might incur. [LO 12.3]

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Answer: An explicit cost would be the wages Dustin pays his employees. An implicit cost would be the forgone interest Dustin could have earned on the savings he used to invest in starting his business. h)7. Imagine you’re in a meeting with the owner of a restaurant, who is trying to decide whether to keep his restaurant open or to invest his time and money in another way. Explain to him the difference between accounting and economic profit, and why it should matter for his decision. [LO 12.4] richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

Answer: Accounting profit and economic profit both calculate revenues the same way.

However, accounting profit considers only explicit costs, while economic profit considers both explicit and implicit costs. It is important to consider the profitability of an enterprise using economic profit. The owner of the restaurant should consider not just whether his restaurant is turning an accounting profit; he also should consider the opportunity cost of using his resources of time and money in his restaurant. If there is another opportunity that would earn him more profit, he should consider this alternate opportunity part of the cost of keeping his restaurant open. i)8.Explain why self-employed business owners frequently overestimate their profit levels. [LO 12.4] Answer: Self-employed business owners often overestimate their profit levels because they calculate accounting profits and do not always take into consideration the implicit costs of their time and resources. If a person is self-employed, there is an implicit opportunity cost in the forgone wages he or she would have earned working elsewhere. j)9. Imagine a restaurant in which tables are spread over a large area, and there is only one wait-person. Explain to the manager why there might be increasing marginal product of laborlabour associated with hiring a second waitperson. [LO 12.5]

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Answer: Hiring only one wait-person means that she or he has to cover a lot of ground in a large restaurant. Working along, the one wait-person will be much slower to take orders, deliver food, get refills, drop checks, and deliver change than if she or he were covering a section of the dining room, rather than the entire floor. Hiring another wait-person could increase marginal product if the two divide the room into sections: they should be able to sell more meals and turn more tables in an hour than the one wait-person could do alone. k)10. If a firm experiences diminishing marginal product, does this mean that total output decreases? Explain. [LO 12.5] Answer: No. Diminishing marginal product means that the increase in total output is getting smaller. Each additional input adds less to the total output than the previous unit of input added. l)11. A firm is trying to decide whether it could earn higher profits by increasing its output.

Explain to the firm’s manager why the cost that is relevant to this decision is the marginal cost of the next unit of output, and not the average total cost. [LO 12.6] Answer: Looking at average total cost will tell the manager the cost of a typical unit, spreading out costs equally over all units. Deciding whether to increase production, however, the manager should look at the marginal cost. What the manager really needs to know is what the cost of the next unit will so she can compare this to the marginal revenue from the next. If

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

the marginal cost of producing the next unit is less than the marginal revenue from that unit, it makes sense to increase production by another unit. m)12. A firm’s output and total costs are given in Table 12Q-1. Going from a quantity of 3 to a quantity of 4, is marginal product increasing or decreasing? How can you tell? [LO 12.6]

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Answer: Marginal product is decreasing. We can see this by calculating marginal cost and noting that marginal cost is increasing when production increases from 3 units to 4 units. If marginal cost is increasing, marginal product is decreasing.

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Quantity 0 1 2 3 4 5

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Total Cost ($) Marginal Cost ($) 0 40 1 64 24 2 86 22 3 111 25 4 139 28 5 169 30

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n)13. Explain the statement, “In the long run, there are no fixed costs.” [LO 12.7] Answer: The statement, “In the long run, there are no fixed costs,” refers to the fact that any kind of cost can be changed over a long enough timeframe. A cost we would consider fixed in the short run, such as a lease on space, can be adjusted once the period of the lease is over.

The long run specifically refers to the timeframe over which all costs can be changed. o)14. Suppose that a pharmaceutical company wants to grow in size, but is constrained in the short run by its production capacity. Describe some steps that it can take in the long run to overcome these constraints. [LO 12.7] Answer: In the long run, the pharmaceutical company can increase its production capacity by expanding the size of current factories or building more factories. Really, almost anything that is limiting production capacity in the short run can simply be increased in the long run to achieve greater capacity. p)15. Explain why an industry experiencing constant returns to scale is “just the right size.”

[LO 12.8] Answer: An industry experiencing constant returns to scale is just the right size because it is has grown large enough that it has exhausted any economies of scale it could gain by expanding, but it has not expanded so large as to create diseconomies of scale. An industry experiencing constant returns to scale will not decrease average total costs by either expanding or shrinking. q)16. Explain why the pharmaceutical industry is characterized by large economies of scale.

[LO 12.8] Answer: The pharmaceutical industry is characterized by large economies of scale because there are high fixed costs in producing pharmaceuticals. Industries with high fixed costs will see their average total costs fall over a wide range of production as those fixed costs are spread out over units of output.

Problems and Applications richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual 1. 1. A hair salon offers three services: haircuts, colour treatments, and styling. The salon

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charges $40 for a cut, $65 for a color treatment, and $30 for styling. Last month, the salon sold 68 haircuts, 34 color treatments, and 22 styling sessions. If the salon’s costs for the month totaled $2,843, what was its profit? [LO 12.1]

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Answer: Total revenue = (Q1 x P1) + (Q2 x P2) + … + (Qn x Pn). Profit = Total revenue – Total cost. For the hair salon, then: Profit = [(68 x $40) + (34 x $65) + (22 x $30)] – $2,843 Profit = [$2,720 + $2,210 + $660] – $2,843 Profit = $5,590 – $2,843 Profit = $2,747

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2. 2. Lisa is a self-employed physical therapist who works from a rented space. Lisa charges

$250 for a therapy session. She incurred the following costs last month: space and equipment rental, $1,200; wages, $3,500; materials, $1,800. If Lisa’s profit last month was $2,000, how many clients did she see? [LO 12.1]

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Answer: Lisa saw 34 clients. Profit = Total revenue – Total cost. $2,000 = [250 x Q] – $6,500 $8,500 = 250Q 34 = Q 3. 3. Kat runs a cake shop. Her monthly expenses are listed below. For each cost, indicate

whether the cost is a fixed cost or a variable cost of producing cakes in the short run. [LO 12.2] a. Ingredients (flour, butter, sugar). b. Bakers (cooks). c. Rent. d. Payments for equipment (ovens). e. Interest payments for borrowed capital.

Answer: Variable costs depend on the quantity of output produced. Fixed costs do not depend on the quantity of output produced. a. Variable cost. b. Variable cost. c. Fixed cost. d. Fixed cost. e. Fixed cost.

24.

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4. 4. An auto-repair shop faces the following weekly costs: rent, $500; laborlabour, $400 per

worker; parts and supplies, $30 per repair. Each worker can repair three cars per week. [LO 12.2] richard@qwconsultancy.com

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a. Fill in the costs in Table 12P-1. b. What are the total costs if the shop repairs 15 cars in a week? c. What are the total costs if the shop repairs 0 cars in a week?

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Answer: a.

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b. $2,950. c. $500.

5. 5. Paola is thinking of opening her own business. For each of the production inputs listed

below, indicate whether the input incurs an implicit cost, explicit cost, or no cost. [LO 12.3] a. Rent. b. Wages. c. Owned equipment.

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Answer: Explicit costs require a firm to spend money. Implicit costs do not require a firm to spend money or take on obligations. a. Explicit cost. b. Explicit cost. c. Implicit cost.

6. 6. Paola is thinking of opening her own business. For each of the production inputs listed

below, indicate whether the input incurs an implicit cost, explicit cost, or no cost. [LO 12.3] a. Borrowed capital. b. Investment from savings. c. Donated supplies.

Answer: Explicit costs require a firm to spend money. Implicit costs do not require a firm to spend money or take on obligations. a. Explicit cost. b. Implicit cost. c. Implicit cost. richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual 7. 7. Keri owns a landscaping business. For each of Keri’s inputs given in the list below,

indicate whether the associated cost is fixed or variable, explicit or implicit, and whether the cost affects accounting profit only, economic profit only, or both. [LO 12.2, 12.3, 12.4] a. Landscapers. b. Plants taken from her home garden. c. Truck rental. d. Owned lawn mowers.

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8. 8. Last year, Jarod left a job that pays $60,000 to run his own bike-repair shop. Jarod’s shop

charges $65 for a repair, and last year the shop performed 3,000 repairs. Jarod’s production costs for the year included rent, wages, and equipment. Jarod spent $50,000 on rent and $100,000 on wages for his employees. Jarod keeps whatever profit the shop earns, but does not pay himself an official wage. Jarod borrowed $20,000 for the shop’s equipment at an annual interest rate of 5 percent. [LO 12.4] a. What is Jarod’s accounting profit? b. What is Jarod’s economic profit?

Answer: 16.a. Accounting profit = Total revenue – Explicit costs.

Accounting profit = [$65 x 3,000] – [$50,000 + $100,000 + Interest on borrowed capital].

Accounting profit = [$65 x 3,000] – [$50,000 + $100,000 + $1,000].

Accounting profit = $195,000 – $151,000 .151,000.

Accounting profit = $44,000.

17.b. Economic profit = Total revenue – [Explicit costs + Implicit costs].

Economic profit = [$65 x 3,000] – [$50,000 + $100,000 + Interest on borrowed capital + Forgone wages].

Economic profit = [$65 x 3,000] – [$50,000 + $100,000 + $1,000 + $60,000].

Economic profit = $195,000 – $211,000.

Economic profit (loss) = − $16,000.

9. 9. If adding an additional input does not produce additional output, what is the slope of the

production function at this point? [LO 12.5] Answer: The production function is a ratio of inputs to outputs. If adding an additional input does not produce additional output, the slope of the production function is zero. richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual 10. 10. Webby Inc. is a web development company. Webby’s monthly production function for

developing websites is given in Table 12P-2. [LO 12.5] a. Fill in the marginal product column. b. After which programmer does marginal product diminish?

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Answer: a. a.

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b.

b. Marginal product decreases from 8 with 3 programmers to 6 with 4 programmers, so marginal product diminishes after the third programmer.

11. 11. Webby Inc. is a web development company. Webby’s monthly production function for

developing websites is given in Table 12P-3. Webby pays $4,000 a month in rent for office space and equipment. It pays each programmer $2,000 a month. There are no other production costs. Fill in the table of production costs. [LO 12.6]

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12. 12. A firm’s output, variable costs, and total costs are given in Table 12P-4. [LO 12.6] a. a. Calculate marginal cost using the formula given in the chapter: change in total

cost divided by change in quantity. b. b. Calculate change in variable cost divided by change in quantity.

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Answer: a.

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b.

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13. 13. The dean of a college university faces the following costs: graders, faculty, classroom

space, and chalk. Of these costs, which are likely to be variable in the long run? [LO 12.7] Answer: The long run is a period of time in which a firm can vary all of its costs, if it wants to. For example, in the short run classroom space is limited to the facilities that exist on campus. It will not change depending on the number of courses offered. Thus, it is a fixed cost in the short run. But in the long run the dean can choose to build more classrooms depending on the quantity of output produced, making it a variable cost. Likewise the dean richard@qwconsultancy.com

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Microeconomics 2CE Karlan/Morduch/Alam/Wong Instructor’s Manual

could always buy more chalk or hire more graders or faculty. Thus, all costs are variable in the long run.

14. 14. In the pet industry, would you expect the long run to be longer for a pet store or a

veterinary clinic? [LO 12.7] Answer: You would expect the long run to be longer for a veterinary clinic than for a pet store. A veterinary clinic has specialized laborlabour (veterinarians) and specialized equipment, which would mean that it would take longer to increase (or decrease) the inputs than it would for a pet store.

15. 15. Consider a firm that increases its inputs by 15 percent. For each scenario, state whether

the firm experiences economies of scale, diseconomies of scale, or constant returns to scale.

[LO 12.8] a. Outputs increase 15 percent. b. Outputs increase by less than 15 percent. c. Outputs increase by greater than 15 percent.

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Answer: a. Constant returns to scale. b. Diseconomies of scale. c. Economies of scale.

16. 16. A firm’s long-run total costs are given in Table 12P-5. [LO 12.8]

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a. Over what production range does this firm experience economies of scale? b. Over what production range does this firm experience constant returns to scale? c. Over what production range does this firm experience diseconomies of scale?

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Answer: a. 0−5 units. b. 5−6 units. c. 6−8 units.

CHAPTER 13 PERFECT COMPETITION Chapter Overview In this chapter, we dig into the wants and constraints that drive firm behavior in competitive markets. Firms will choose to produce a quantity that maximizes their profits. In the short run, they will shut down if their revenues don’t cover their variable costs of production. In the long run, they will exit the market if their revenues don’t cover their total costs of production. This analysis leads to some surprising conclusions about long-run supply in competitive markets: richard@qwconsultancy.com

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Firms earn zero economic profit; they operate at their efficient scale; and long-run supply is, in theory, perfectly elastic. Firms are able to enter and exit the market freely to adjust the quantity supplied at a given price. These choices by firms benefit consumers by keeping prices low and ensuring that supply is responsive to needs. However, real-world markets are not guaranteed to be perfectly competitive. Firms may wield market power, or offer products that are not perfectly standardized. There may be barriers that prevent firms from freely entering or exiting the market. Understanding what perfect competition looks like, we can now spend the next few chapters looking at how firms behave when we relax the assumptions of perfect competition.

Learning Objectives LO 13.1: Describe the characteristics of a perfectly competitive market.

LO 13.2: Calculate average, marginal, and total revenue.

LO 13.3: Find a firm’s optimal quantity of output.

LO 13.4: Describe a firm’s decision to shut down and when to exit the market, and explain the difference between these choices.

LO 13.5: Draw a short-run supply curve for a competitive market with identical firms.

LO 13.6: Draw a long-run supply curve for a competitive market with identical firms, and describe its implications for profit-seeking firms.

LO 13.7: Explain why a long-run supply curve might slope upward.

LO 13.8: Calculate the effect of a shift in demand on a market in long-run equilibrium.

Chapter Outline OPENING STORY: TRAINSIDE VARIETY

A Competitive Market Characteristics of a Competitive Market (LO 13.1) BOX FEATURE: REAL LIFE – BAZAAR COMPETITION

Revenues in a Perfectly Competitive Market (LO 13.2) Profits and Production Decisions Deciding How Much to Produce (LO 13.3) Deciding When to Operate (LO 13.4) Behind the Supply Curve Short-Run Supply (LO 13.5) Long-Run Supply (LO 13.6) Why the Long-Run Market Supply Curve Shouldn’t Slope Upward, But Does (LO 13.7) BOX FEATURE: REAL LIFE – HOW TIM HORTON’S MAKE COFFEE CHEAPER AND ‘ALWAYS FRESH’

Responding to Shifts in Demand (LO 13.7)

Beyond the Lecture richard@qwconsultancy.com

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Class Discussion: Characteristics of a Competitive Market (LO 13.1) Show students this brief episode preview of the TV show The Office. In this episode, “Heavy Competition”, Dwight meets with Michael and provides him with information about Michael Scott Paper Company’s main rival.

1. Why would the customer be willing to pay more for their paper (which is presumably very similar to the competitors)?

2. Can you think of products for which you prefer a specific brand and will pay more for it?

3. Can you think of products for which you do not care about brand and decide solely on price?

Writing Assignment/Class Discussion: Characteristics of a Competitive Market and Deciding How Much to Produce (LO 13.1, LO 13.3) Have students read this brief Associated Press article about the relatively low price of lobster in 2012. Consider having students write a short essay about the why the lobstermen generally have to accept the market price. In class, you can have a discussion.

1. What would happen if an individual seller of lobster increased price?

2. What does the demand curve for an individual lobsterman look like?

3. How does a lobsterman decide on price and output?

Class Activity: Deciding When to Operate (LO 13.4) Consider breaking students into several small groups and having them work on a problem about shut-down decisions. Create a few different simple examples, providing the students with marginal revenue, marginal cost, average variable cost, average fixed cost, and average total costs. Have the students pick the optimal quantity. Then have students decide if the firm should continue to operate in the current time period. You can make some data suggesting that the firm should keep operating as-is, temporarily shut-down, or close permanently.

Solutions to End-of-Chapter Questions and Problems Review Questions 1. You stop by a craft fair and you notice consumers haggling with vendors over prices. What does this tell you about the competitiveness of this market? Suppose you plan to go to a farmers’ market next. Do you expect to find more or less haggling at this market than you did at the crafts fair? Why? [LO 13.1] Answer: Consumers and sellers haggling over prices is a sign that the market is not perfectly competitive. If the market were perfectly competitive, consumers and sellers would be price takers, and both would accept a given market price. One reason a crafts fair is not perfectly competitive is that vendors are not selling standardized goods. The farmers’ market is likely to be more competitive because the goods will be more standardized; consumers will be

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fairly indifferent between tomatoes from one farmer versus another. Prices are likely to be more stable, and you would expect to see less haggling at the farmers’ market.

2. In the market for gold jewelry (unlike the market for gold ore), products come in a range of designs, styles, and levels of quality. Which of the characteristics of a competitive market is violated in the jewelry market? What does this imply for consumers’ willingness to buy from different producers? [LO 13.1] Answer: The characteristic of competitive markets that is violated in the jewelry industry is that the goods are not standardized. This will mean that consumers are not indifferent between producers and will have preferences based on style and quality. Consumers do not perceive sellers as all being the same and will be willing to shop around.

3. Suppose that the manager of a donut shop tells you that he sold 220 donuts today, for a total revenue of $220 and average revenue of $0.90. What’s wrong with this story? [LO 13.2] Answer: Average revenue is total revenue divided by quantity. If the manager sold 220 donuts and received total revenue of $220, then the average revenue would be $1, not $0.90.

4. Suppose a firm’s output is small relative to the size of its market. Explain why this means the firm’s marginal revenue will be equal to the market price. [LO 13.2] Answer: If a firm’s output is small relative to the size of the market, the firm’s output decision does not affect the market price. The firm will be a price taker, which means that its revenue on each unit (marginal revenue) will be equal to the market price.

5. The manager of the donut shop tells you that he sells donuts for $1 each, and that if he were to make additional donuts, based on his current level of output, it would cost him $0.80 per donut. Do you recommend that the manager increase or decrease the number of donuts he makes? [LO 13.3] Answer: The manager should increase his production of donuts as long as the marginal revenue is greater than or equal to the marginal cost. The marginal revenue in a competitive market is the market price. In this case, $1 is greater than the marginal cost of $.0.80, so the manager should increase production.

6. Suppose a firm is operating in a competitive market and is maximizing profit by producing at the point where marginal revenue equals marginal cost. Now suppose that consumer wealth decreases in this market (and the good is a normal good). What might you expect to happen to the profit-maximizing output quantity for the firm? [LO 13.3]

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Answer: If consumer wealth decreases, demand for a normal good decreases (shifts left).

This will cause the price in the market to decrease. Price equals marginal revenue for a firm in a competitive industry. Therefore, if price decreases, marginal revenue decreases, and the firm will decrease its output if the new marginal revenue is less than the marginal cost of increasing output.

7. A restaurant owner is trying to decide whether to stay open at lunchtime. She has far fewer customers at lunch than at dinner, and the revenue she brings in barely covers her expenses to buy food and pay the staff. What do you recommend that she do? Explain your reasoning to her. [LO 13.4] Answer: As long as the revenue from staying open at lunch does cover the variable costs of doing a lunchtime service, the restaurant owner will maximize profits (or minimize losses) by staying open at lunch. Only if the variable costs involved in the lunch service were greater than the associated revenue should the owner consider closing during lunch.

8. In what ways are profit-maximizing and loss-minimizing the same? In what ways are they different? [LO 13.4] Answer: Profit-maximizing and loss-minimizing are the same in that they both mean increasing production until marginal revenue equals marginal cost. Producing by this decision rule will mean that profits are highest or losses are minimized. The difference between the two is that loss-minimizing involves a caveat to the rule of producing where MR = MC. That is, if price is below AVC, the firm should not produce where MR = MC but should shut down to minimize losses instead.

9. Suppose that the profit-maximizing quantity of output for a firm in the competitive textile industry is 1 million yards of cloth. If this firm is representative of others in the industry, how can you describe total supply in the market, with respect to the number of firms? [LO 13.5] Answer: If the firm is representative, then all firms will maximize profit by producing a quantity of one million yards of cloth. Total supply in the market would simply be one million times the number of firms.

10. What would you expect to happen to market supply if variable costs decreased for individual firms in the market? [LO 13.5] Answer: If variable costs decreased for individual firms, the individual firms would maximize profit by producing more because MR would equal MC at a higher quantity for each firm. Total market supply would increase.

11. Suppose that the airline industry is in long-run equilibrium when the price of gasoline increases, raising the cost of operating airplanes. In the long run, what do you expect to happen to the number of airlines in business? Why? [LO 13.6]

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Answer: If the airline industry is in long-run equilibrium, economic profit for airlines is zero (at least for the marginal airline). Therefore, if the cost of operating airplanes increases, profits will become negative. Airlines will continue to operate in the short run if the price still covers their AVC. In the long run, assuming the higher costs for gasoline persist, airlines will begin to exit the industry.

12. The firm in Figure 13Q-1 represents the cost structure for all firms in the industry. Describe the steps that will lead to long-run equilibrium in this market. [LO 13.6] Answer: If the firm represented in Figure 13Q-1 is representative of all firms, firms in this market are making positive economic profit. We can see this because price is above ATC. In the long run, other firms will enter this industry to chase these profits. As other firms enter and the supply curve shifts to the right, the price in the market will fall. This process will continue until price falls to the point where there is no further incentive for firms to enter.

This happens when economic profit is zero and price is equal to the minimum of ATC. 13. Corn farmers in Ontario are producers in a highly competitive global market for corn. They also have some of the most fertile, productive land in the entire world. Could Ontario’s farmers be earning a positive economic profit in the long run? Why or why not? [LO 13.7] Answer: Yes. A producer can be earning economic profit in the long run if firms differ in cost structure. Long-run equilibrium means that there is no incentive for entry or exit. As long as the marginal firm earns zero economic profit, the industry is in long-run equilibrium and individual producers who may face lower costs than the marginal firm can be earning positive profits.

14. Suppose that firms in an industry have identical cost structures and the industry is in long-run equilibrium. Explain how the profit motive could lead to lower market prices. [LO 13.7] Answer: If a market is in long-run equilibrium and firms have identical cost structures, firms are making zero economic profit. Producers in a competitive market can’t affect the price by changing their output level, but they can attempt to gain positive profits by reducing their costs. Firms will be motivated to find innovative ways to reduce costs so that they can enjoy positive profits at the current market price. If they are successful, however, other firms will enter and adopt the cost-saving innovation. The entry of new firms will continue and will shift the supply curve to the right until economic profits are zero again, even with the new, lower cost structure.

15. A market is in long-run equilibrium and firms in this market have identical cost structures.

Suppose demand in this market decreases. Describe what happens to the profit-maximizing output quantity for individual firms as the market leaves and then returns to long-run equilibrium. [LO 13.8] Answer: When demand decreases, the market price will decrease. For the individual firm, this means that the profit-maximizing output, where MR = MC, will be at a lower quantity. richard@qwconsultancy.com

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In the short run, the individual firm will produce less (and may even shut down if the price falls below AVC). In the long run, firms will begin to exit, because they are facing negative profits. As firms exit, the supply curve shifts to the left, causing price to rise. This will continue until price returns to the minimum of ATC. Because price will return to its original level before demand decreased, each individual firm that remains in the market will increase output to the original level.

16. A market is in long-run equilibrium and firms in this market have identical cost structures.

Suppose demand in this market decreases. Describe what happens to the market quantity as the market leaves and then returns to long-run equilibrium. [LO 13.8] Answer: When demand decreases, the market price will decrease. At the market level, this is a movement along the short-run supply curve, and the market quantity will also decrease. As firms begin to exit due to negative profits, the short-run supply curve shifts to the left, further decreasing the quantity supplied in the market until there is no more incentive for exit. Even though the individual firm that remains in the market will return to its previous output levels when the price returns to its original level, there will now be fewer firms, and the new equilibrium market quantity will be less than it was before the decrease in demand.

Problems and Applications 1. Suppose the market for bottled water and the market for soft drinks both have large numbers of buyers and sellers. Which of these markets is likely to be more competitive? [LO 13.1] Answer: If both markets meet the characteristic of large numbers of buyers and sellers, the market for bottled water would more competitive than the market for soft drinks because bottled water is more of a standardized good.

2. Suppose the market for steel and the market for cars both have large numbers of buyers and sellers. Which market is likely to be affected by information asymmetries? [LO 13.1] Answer: Markets for goods that are not standardized are more susceptible to information asymmetries. Steel is much more standardized than cars. Therefore, information asymmetries are more likely in the market for cars.

3. Check all that apply. In a perfectly competitive market, MR = [LO 13.2] a. Price b. Average revenue c. Total revenue d. Δ in total revenue / Δ in quantity Answer: a, b, and d.

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4. Darla sells roses in a competitive market where the price of a rose is $5. Use this information to fill out the revenue columns in Table 13P-1. [LO 13.2] Answer:

5. Paulina sells beef in a competitive market where the price is $5 per kilogram. Her total revenue and total costs are given in Table 13P-2. [LO 13.3] a. Fill out the table. b. At what quantity does marginal revenue equal marginal cost?

Answer: a.

b. Marginal revenue equals marginal cost at a quantity of 3 kilograms.

6. On Figure 13P-1, show the profit-maximizing quantity when price is P1. Label this point Qmax1. Show the profit-maximizing quantity when price is P2. Label this point Qmax2. [LO 13.3] Answer:

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7. The data in Table 13P-3 are the monthly average variable costs (AVC), average total costs (ATC), and marginal costs (MC) for Alpacky, a typical alpaca wool-manufacturing firm in Peru. The alpaca wool industry is competitive. For each market price given below, give the profit-maximizing output quantity and state whether Alpacky’s profits are positive, negative, or zero. Also state whether Alpacky should produce or shut down in the short run. [LO 13.4] a. $16.00 b. $18.00 c. $22.00 Answer: Market Price Qmax a. $16.00 b. $18.00 c. $22.00

0 4 5

Produce in SR? Why? (Y/N) negative No There is loss. Price is less than AVC. negative Yes There is a short run loss. Price exceeds AVC. positive Yes Price exceeds ATC. Profit (+,−, 0)

8. The marginal costs, average variable costs (AVC), and average total costs (ATC) for a firm are shown in Figure 13P-2. In the figure, mark the quantity the firm will choose to produce in the short run given this cost structure and the market price. Does the firm earn positive or negative profits? Graph the area that defines the firm’s profit (or loss). [LO 13.4] Answer:

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9. The cost curves for an individual firm are given in Figure 13P-3. [LO 13.4, 13.6] a. In Figure 13P-3 (A), highlight the firm’s short-run supply curve. b. In Figure 13P-3 (B), highlight the firm’s long-run supply curve.

Answer: a. The firm's short run supply curve is given by marginal costs equal-to or greater-than the minimum AVC (orange part of MC curve). b. The firm's long run supply curve is perfectly elastic at the price = min ATC curve (orange curve).

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10. Suppose the quantity of apples supplied in your market is 2,400. If there are 60 apple producers, each with identical cost structures, how many apples does each producer supply to the market? [LO 13.5] Answer: If producers have the same cost structure, they are all profit maximizing at the same output level. Therefore, you can divide the total market supply by the number of firms to get the quantity supplied by each firm: 2,400 ÷ 60 = 40. Each producer supplies 40 apples to the market.

11. Suppose an industry consists of many firms with identical cost structures, represented by the “typical individual firm” in panel A of Figure 13P-4. Price is P1. With the aid of panel A, draw the short-run market supply curve in panel B, and show the firm and market output quantities at the equilibrium price in each panel. [LO 13.5]

Answer:

12. The monthly average variable costs, average total costs, and marginal costs for Alpacky, a typical alpaca wool manufacturing firm in Peru, are shown in Table 13P-3. All firms in the industry share the same costs as Alpacky, and the industry is in long-run equilibrium. What is the market price? [LO 13.6] Answer: If the firms all share the same cost structure and the industry is in long-run equilibrium, the market price must be $19.50. That amount is equal to the minimum ATC, richard@qwconsultancy.com

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which corresponds with zero economic profit for the firms and no incentive for entry or exit by other firms.

13. The industry in Figure 13P-5 consists of many firms with identical cost structures, and the industry experiences constant returns to scale. [LO 13.6] a. Draw the short-run market supply curve. b. Draw the long-run market supply curve.

Answer: The short-run market supply curve begins at the minimum of the average variable cost. The quantity for every price above this minimum value is the firm output level times 100 firms. The long-run industry supply curve is horizontal at the minimum of the average total cost since the industry experiences constant returns to scale

14. A firm’s costs are represented in Table 13P-4. Suppose the price in the market is $110. Is the market in long-run equilibrium—yes, no, or can’t determine? [LO 13.7] Answer: Can’t determine. If all firms in this market have the same cost structure, then the market would not be in long-run equilibrium, because the firms would all be making positive economic profit and there would be an incentive for entry. However, if firms do not share the same cost structure, this firm could be making positive profit, while the marginal firm may be making zero economic profit. We are not told whether the data for the firm’s costs is representative of other firms, so we cannot determine.

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15. Curling is a popular sport in Canada. The Winter Olympics has generated a lot of excitement about the fascinating sport of curling. As a result, demand for curling stones has increased.

Curling stones are made from blue Trefor granite. There are limited deposits of blue Trefor, and other types of granite are poor substitutes. If the increase in demand for curling stones persists, do you expect the long-run equilibrium price to increase, decrease, or stay the same?

[LO 13.7] Answer: The long-run equilibrium price would increase. Because a key input in the production of curling stones (blue Trefor granite) is inelastically supplied, the cost of this input will increase as more of it is demanded. As a result, the minimum of ATC will be higher than it was before, and therefore the long-run equilibrium price will be higher.

16. The industry in Figure 13P-6 consists of many firms with identical cost structures, and the industry experiences constant returns to scale. Consider a change in demand from D1 to D2 which increases price from P1 to P2 in the short run. [LO 13.8] a. Draw the new short-run supply curve after the market adjusts and returns to long-run equilibrium. b. Draw the long-run supply curve.

Answer: a. See S2 in the graph below. b. See LRS in the graph below.

17. Suppose the market for gourmet chocolate is in long-run equilibrium, and an economic downturn has reduced consumer discretionary incomes. Assume chocolate is a normal good, and the chocolate producers have identical cost structures. [LO 13.8] richard@qwconsultancy.com

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a. What will happen to demand—shift right, shift left, no shift? b. What will happen to profits for chocolate producers in the short run—increase, decrease, or no change? c. What will happen to the short-run supply curve—increase, decrease, or no change? d. What will happen to the long-run supply curve—increase, decrease, or no change?

Answer: a. Demand will shift left since income fell. b. Profits for chocolate producers in the short run will decrease since the price will fall. c. The short-run supply curve will shift left because as profits fall exit will occur. d. The long-run supply curve will not change because the firms have identical cost structures so the price that results in a normal profit will not change.

CHAPTER 14 MONOPOLY Chapter Overview Monopolies can use their market power to hold price above the level that would prevail in a competitive market, turning consumer surplus into positive economic profits and reducing total social welfare. This poses a tricky problem for policy-makers, who want to regulate or break up monopolies to increase welfare. Practically speaking, it can be difficult to accomplish this goal without causing more inefficiency. Policies designed to address the problems associated with monopolies run the risk of setting prices at the wrong level or raising costs by breaking up a natural monopoly. This difficult situation is complicated further by the fact that few firms are truly perfect monopolies. Instead, many markets include firms with some degree of market power, ranging on the spectrum from perfect monopoly to perfect competition. We can call markets in this range “imperfectly competitive.” It turns out that small differences in the structure of imperfectly competitive markets can make big differences in how firms behave; those differences can give policy-makers headaches.

In the next chapter, we’ll take a close look at two specific varieties of imperfect competition.

Learning Objectives LO 14.1: List several reasons that monopolies exist, and explain how each causes barriers to entry.

LO 14.2: Explain why a monopolist is constrained by demand.

LO 14.3: Calculate the profit-maximizing production price and quantity for a monopolist. richard@qwconsultancy.com

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LO 14.4: Calculate the loss in total social welfare associated with a monopoly.

LO 14.5: Describe the pros and cons of common public policy responses to monopoly.

LO 14.6: Explain why a firm has an incentive to use price discrimination when possible.

Chapter Outline DIAMONDS WEREN’T ALWAYS FOREVER

Why Do Monopolies Exist?

Barriers to Entry (LO 14.1) BOX FEATURE: REAL LIFE – CHINA’S RARE EARTH

How Monopolies Work Monopolists and the Demand Curve (LO 14.2) Monopoly Revenue (LO 14.3) Problems with Monopoly and Public Policy Solutions The Welfare Costs of Monopoly (LO 14.4) BOX FEATURE: FROM ANOTHER ANGLE – POOR MONOPOLISTS

Public Policy Responses (LO 14.5) BOX FEATURE: REAL LIFE – ROCKERS VS. TICKETMASTER

Market Power and Price Discrimination What Is Price Discrimination? (LO 14.6) BOX FEATURE: FROM ANOTHER ANGLE – RICKSHAW RIDES: PRICE DISCRIMINATION AND ASYMMETRIC INFORMATION

Beyond the Lecture Class Discussion: Barriers to Entry (LO 14.1) In order to highlight monopoly behavior and entry barriers, consider showing a clip from the TV show The Simpsons. Show students the segment 10:20-14:30 of the episode Who Shot Mr. Burns? Part I. In this episode, Mr. Burns is trying to monopolize the power industry by blocking the sun.

12. Are there any substitutes for electricity?

13. What are the entry barriers to supplying electricity?

Class Discussion: Barriers to Entry (LO 14.1) Consider discussing Toronto taxis. To limit the number of drivers, the city requires the purchase of a very expensive license (details here), which acts as a barrier to entry into the cab market.

However, the firms Uber and Lyft continue to expand and take market share away from traditional cabs. Taxi cab unions are fighting Uber and Lyft, often trying to get the programs removed from the city. See this article for some more information about taxi drivers suing the city of Toronto over the loss of value in taxi license plates. A news video about a 2019 Toronto City council meeting shows some of the animosity between the two sides.

1. Why would the taxi system require a license? How does it create an entry barrier?

2. Why would cab drivers want to eliminate Uber and Lyft from the city? richard@qwconsultancy.com

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Writing Assignment/Class Discussion: The Welfare Costs of Monopoly and Public Policy Responses (LO 14.4, LO 14.5) Consider discussing the sale of beer and liquor in corner stores in Ontario. A lot has been written about this in the news recently including an opinion piece from the Globe and Mail and an article about a report from the Ontario Chamber of Commerce by the CBC. The policy is interesting since it is pitting the Beer Store and the LCBO against grocery and convenience stores. This change in regulations has been met with mixed reactions in the realm of public opinion. Students can be asked to write a short essay either supporting or disagreeing with the decision to use public policy in this case.

Class Discussion: What Is Price Discrimination? (LO 14.6) Have students view a brief clip from the movie Tommy Boy to start a discussion on price discrimination. Show scene 21 on the DVD; in the clip, Richard is trying to book a last minute flight to Chicago, but nothing is available.

1. How do airlines use price discrimination?

2. What generally happens to the price of flights as the flight date approaches?

3. What are the conditions necessary for price discrimination to occur?

Solutions to End-of-Chapter Questions and Problems Review Questions 1. If competition places discipline on costs, motivating firms to innovate and find more costeffective ways to produce, explain why in some markets a single firm without competitors will produce at a lower cost than if the firm faced competition. [LO 14.1] Answer: If a firm faces economies of scale, the more output it produces, the more it lowers its average total costs. Sometimes, economies of scale are so large that they exist for the entire range of the demand curve. If this is the case, a single producer will be able to achieve lower costs than would be possible if production were split among several producers.

2. Suppose a city has a chain of fitness centers (gyms) all owned by the same company, Fit Fun. A new company is considering opening a gym in the city. Give an example of an aggressive tactic Fit Fun might take to maintain its monopoly. [LO 14.1] Answer: Fit Fun could slash membership prices low enough to make it impossible for a new gym to compete. Large firms and chains will sometimes accept temporary losses to fend off entry by smaller competitors.

3. Suppose that De Beers and the local water utility are both monopolists, in the markets for diamond jewelry and water, respectively. If both monopolies decided to raise prices 15 richard@qwconsultancy.com

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percent, which monopoly would be more likely to see its total revenue decrease? Why? [LO 14.2] Answer: De Beers would be more likely to see total revenue decrease as a result of increasing prices. Diamonds are a luxury good, whereas water is a necessity. Recall that when a good is elastically demanded, raising prices will cause total revenues to fall.

4. Suppose that a producer in a previously competitive market is granted the sole right to produce in the market. Given that demand in the market is unchanged but now all consumers must purchase from the same producer, why might the new monopolist produce less than the quantity that was produced when the market was competitive? [LO 14.2] Answer: When the market was competitive, producers were price takers. For each producer, the profit-maximizing choice was to produce all output for which the market price was greater than or equal to his marginal costs. As a monopolist, however, the producer will raise his profit by reducing output below the efficient level. The monopolist will still choose the output quantity where MR = MC, but this will occur at a lower output than the quantity that would be produced in perfect competition.

5. Suppose that an inventor discovers a new chemical compound that can change the color of people’s eyes with no negative side effects. Since she holds a patent on this chemical, she has a monopoly over the sale of the new eye-color treatment. However, she’s an inventor, not a businessperson. Explain to her how she should set the price for the eye-color treatment in order to maximize her profits. [LO 14.3] Answer: The inventor will need to know the demand for her product at different prices. Once she has estimated the demand curve, she should produce all units for which the marginal revenue she would receive on the unit is greater than or equal to the marginal cost to produce that unit. This will be her profit-maximizing quantity. Once she knows the quantity that will maximize her profits, she should sell this quantity for the highest price that demand will bear.

She can get this price from her estimated demand curve.

6. Suppose a monopolist has to purchase new equipment and his fixed costs increase. Explain what will happen to the monopolist’s profit-maximizing output quantity and the monopolist’s profits. [LO 14.3] Answer: The profit-maximizing output quantity will not change. The profit-maximizing quantity is where MR = MC. A change in fixed costs will not affect MR or MC. The increase in fixed cost, however, will decrease the monopolist’s profit, as profit is determined by TR − TC and TC includes fixed costs.

7. Until the 1980s, AT&T held a monopoly over the national market for phone services in the US. Suppose that AT&T argued that it was a natural monopoly, because the fixed cost of creating a nationwide phone network generated huge economies of scale, and that there was

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therefore no welfare loss associated with its monopoly. Counter this argument by explaining how even a natural monopoly causes deadweight loss. [LO 14.4] Answer: If AT&T is a natural monopoly, it does make sense for it to be the sole provider of phone services due to its large economies of scale. However, if AT&T is not regulated, it will maximize its profits by producing a quantity that is less than the efficient quantity and by charging a price that is less than the efficient price. There is no reason to believe that AT&T will choose an efficient outcome rather than a profit-maximizing outcome.

8. Suppose you are advising a mayoral candidate in your town. The candidate’s platform includes strong opposition to monopoly suppliers because consumer welfare is compromised by monopoly pricing. Present your candidate with an alternative view about why it may make sense to tolerate the existence of some monopoly firms. [LO 14.4] Answer: Monopolies do reduce consumer surplus by producing less and charging more than the outcomes that would occur in a competitive market, but at times it makes sense to sacrifice some efficiency. For example, there are some goods that may not exist if it were not for the monopoly profits that a patent ensures to create incentives for research and development. And for some goods, it may even make more sense for a good to be provided by a monopolist rather than by multiple producers, as when there are very large fixed costs in production.

9. Suppose that your province is considering a law that would force all monopolies to charge no more than their average total costs of production. Explain to your legislator the pros and cons of this approach. [LO 14.5] Answer: Under this pricing regulation, the monopolist would make a normal rate of return (zero economic profit) and could stay in business. Compared to monopoly pricing, charging a price equal to ATC will reduce deadweight loss. On the downside, it is very difficult for government to know the true costs of production such that it can accurately regulate price.

Regulating price to equal ATC also removes the incentive for the firm to find innovative ways to reduce costs. If the firm reduces its ATC, the government will just lower the price to match the new ATC. This is great for consumers, but the firm has no incentive to invest in cost-saving innovation.

10. Suppose that your province is considering a law that would force all monopolies to charge the efficient price that would prevail if the market were competitive. Explain to your MPP why the province will have to subsidize natural monopolies if this law goes into effect. [LO 14.5] Answer: The defining characteristic of a natural monopoly is that economies of scale are so large that ATC is falling for the entire range of demand. Recall that if ATC is falling, MC must be below it. (MC crosses ATC at the minimum of ATC.) If price is set at the efficient level, price will equal MC. Given that MC is necessarily below ATC for a natural monopoly, richard@qwconsultancy.com

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this will mean negative profit. Therefore, if a natural monopolist is forced to charge the efficient price, it will go out of business without a subsidy.

11. Suppose a small town has one theater for live performances and one Indian restaurant. Will it be easier for the theater or for the Indian restaurant to price discriminate? [LO 14.6] Answer: It will be easier for the theater to price-discriminate than for the restaurant to do so.

Price discrimination is more successful when there is more market power. There may be no or few good substitutes for the only live theater venue in town. Although there may only be one Indian restaurant, there are likely substitutes in the form of other restaurants. It would also be harder for the Indian restaurant to prevent side trades and resale to other customers, especially if the restaurant has a take-out service. Customers who had access to a discount could purchase food for those who do not have access to the discount.

12. Suppose a museum charges different entrance fees for children, students, adults, and seniors, but these groups all pay the same amount for souvenirs at the gift shop. Explain why the museum price discriminates on admission but not souvenirs. [LO 14.6] Answer: It is easy to distinguish between children, students, adults, and seniors when collecting entrance fees. However, price discrimination would be undermined at the souvenir shop. If children are given a discount and adults are not, adults can get children to buy their souvenirs for them.

Problems and Applications 1. Canada Post maintains a monopoly on mail delivery in part through its exclusive right to access customer mailboxes. Which barrier to entry best describes this situation—scarce resources, economies of scale, government intervention, or aggressive tactics? [LO 14.1] Answer: The entry barrier that best describes the situation is government intervention: Canada Post is granted exclusive access to mailboxes by Parliament.

2. Which (if any) of the following scenarios is the result of a natural monopoly? [LO 14.1] a. Patent holders of genetically modified seeds are permitted to sue farmers who save seeds from one planting season to the next. b. Doctors in Canada are prohibited from practising without a medical license. c. There is one train operator with service from Ottawa to Montréal. d. Coal is used as the primary energy in a country with abundant coal deposits.

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Answer: c. Railroads have large fixed costs. Economies of scale suggest that it does not make sense to lay multiple track routes to the same destination.

3. Due to arduous certification requirements, Nature’s Crunch is currently the only certified organic produce grower in a region that produces lots of non-organic produce alternatives.

From a profit-maximizing perspective, would it be better for Nature’s Crunch to lobby the government to relax organic certification requirements or to require grocery stores to clearly label its produce as organic? [LO 14.2] Answer: Nature’s Crunch would not want the government to relax organic certification requirements because doing so would create competition. As the only certified organic grower, Nature’s Crunch has a regional monopoly on selling organic produce. Nature’s Crunch would be better off lobbying the government to require that certified organic produce be clearly labeled in grocery stores so that consumers can easily identify it.

4. Nature’s Crunch is currently the only certified organic produce grower in a region that produces lots of non-organic produce alternatives. Which of the following scenarios would increase Nature’s Crunch’s profits? Check all that apply. [LO 14.2] a. A tomato blight affecting chemically treated plants. b. An increase in the cost of chemical pesticides. c. A new report about the environmental dangers of chemically treated plants. d. Income tax cuts for all consumers. e. A new report showing that there is no nutritional difference between organic and nonorganic produce.

Answer: a, b, c, and d. A tomato blight affecting chemically treated plants: Supply of nonorganic produce decreases, raising its price, demand for organic produce increases. An increase in the cost of chemical pesticides: Due to an increase in production costs, supply of nonorganic produce decreases, raising its price, and demand for organic produce increases. A new report about the environmental dangers of chemically treated plants: Demand for nonorganic substitute decreases, and demand for organic produce increases. Income tax cuts for all consumers: Incomes increase, and demand for normal goods (organic produce) increases.

5. Table 14P-1 presents the demand schedule and marginal costs facing a monopolist producer.

[LO 14.3] a. Fill in the total revenue and marginal revenue columns. b. What is the profit-maximizing level of output? c. What price will the monopolist charge for the quantity in part b?

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Answer: a.

Q

P ($)

TR ($)

MR ($)

MC ($)

0 1 2 3 4 5 6 7 8 9 10

10 9 8 7 6 5 4 3 2 1 0

0 9 16 21 24 25 24 21 16 9 0

9 7 5 3 1 -1 -3 -5 -7 -9

— 2 2 2 2 2 2 2 2 2 2

b. The profit-maximizing decision rule is to increase production as long as MR is > or = MC. This monopolist should produce 4 units. The marginal revenue of increasing production to 4 units is $3, while the marginal cost is $2, so it makes sense to produce the fourth unit. However, the marginal revenue of increasing to 5 units is $1, while the marginal cost is $2. The monopolist should not increase to 5 units. c. The monopolist will charge the highest price consumers are willing to pay for 4 units, which is $6 per unit.

6. Table 14P-2 presents the demand schedule and marginal costs facing a monopolist producer.

[LO 14.3] a. Fill in the total revenue and marginal revenue columns. b. What is the profit-maximizing level of output? c. What price will the monopolist charge for the quantity in part b?

Answer: a.

Q 0 1 2 3 4 5 6 7 8

richard@qwconsultancy.com

P ($) 8 7 6 5 4 3 2 1 0

TR ($) 0 7 12 15 16 15 12 7 0

MR ($) — 7 5 3 1 -1 -3 -5 -7

MC ($) — 1 2 3 4 5 6 7 8

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b. The profit-maximizing decision rule is to increase production as long as MR is > or = MC. This monopolist should produce 3 units. The marginal revenue of increasing production to 3 units is $3, and the marginal cost is $3, so it makes sense to produce the third unit. However, the marginal revenue of increasing to 4 units is $1, while the marginal cost is $4. The monopolist should not increase to 4 units. c. The monopolist will charge the highest price that consumers are willing to pay for 3 units, which is $5 per unit.

7. Figure 14P-1 presents the demand curve, marginal revenue, and marginal costs facing a monopolist producer. [LO 14.3, 14.4] a. What is the profit-maximizing level of output? b. What price will the monopolist charge for the quantity in part a? c. What are the efficiency costs (deadweight loss) of monopoly output/pricing? Provide a numerical answer and illustrate this area on the graph. d. What is consumer surplus under monopoly output/pricing? Illustrate this area on the graph. e. What is the loss of consumer surplus under monopoly outcomes versus efficient outcomes? Provide a numerical answer.

Answer:

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a. The profit-maximizing level of output is 4, because this is where MR = MC. b. The monopolist will charge $30, because the demand curve shows this is the highest willing to pay for a quantity of 4. c. DWL = 0.5(8 − 4)(30 − 10) = $40 and represents the lost surplus from the monopolist producing less than the efficient quantity and charging more than the efficient price. d. Consumer surplus is ($50 - $30) × 0.5 × 4 = $40. e. In this example, the efficient price is $10, which is equal to MC. Under efficient outcomes, consumer surplus is the entire area under the demand curve and above $10.

This is equal to 0.5(8 − 0)(50 − 10) = $160. Under monopoly outcomes, consumer surplus the area under the demand curve and above the monopoly price of $30, which is equal to 0.5(4 − 0)(50 − 30) = $40. Therefore, the loss of consumer surplus under monopoly outcomes versus efficient outcomes is $160 − $40 = $120.

8. Figure 14P-2 presents the demand curve, marginal revenue, and marginal costs facing a monopolist producer. [LO 14.3, 14.4] a. What is the profit-maximizing level of output? b. What price will the monopolist charge for the quantity in part a? c. What are the efficiency costs (deadweight loss) of monopoly output/pricing? Provide a numerical answer and illustrate this area on the graph. d. What is consumer surplus under monopoly output/pricing? Illustrate this area on the graph. e. What is the loss of consumer surplus under monopoly outcomes versus efficient outcomes? Provide a numerical answer.

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a. The profit-maximizing level of output is 3, because this is where MR = MC. b. The monopolist will charge $35, because the demand curve shows this is the highest willingness to pay for a quantity of 4. c. DWL = 0.5(4.5 − 3)(35 − 20) = $11.25 and represents the lost surplus from the monopolist producing less than the efficient quantity and charging more than the efficient price. d. Consumer surplus is ($50 - $35) × 0.5 × 3 = $22.50. e. In this example, the efficient price is $27.50, which is the price at which supply (MC) and demand intersect. Under efficient outcomes, consumer surplus is the area under the demand curve and above $27.50. This is equal to 0.5(4.5 − 0)(50 − 27.5) = $50.63. Under monopoly outcomes, consumer surplus the area under the demand curve and above the monopoly price of $35, which is equal to 0.5(3 − 0)(50 − 35) = $22.50. Therefore, the loss of consumer surplus under monopoly outcomes versus efficient outcomes is $50.63 − $22.5 = $28.13.

9. Use Figure 14P-3 to answer the following questions. [LO 14.5] a. Under monopoly pricing, are profits positive, negative, or zero? b. If government regulates average total cost pricing (P = ATC), are profits positive, negative, or zero? c. If government regulates efficient pricing, are profits positive, negative, or zero? d. Is this a natural monopoly?

Answer: a. Positive: Price exceeds average total cost. b. Zero: When price equals average total cost, there is a zero economic profit. c. Negative: MC is everywhere < ATC for the range of demand, so at the efficient price where P = MC, profits are negative. d. Yes: There are economies of scale, and ATC is falling for the entire range of the demand curve.

10. Use Figure 14P-4 to answer the following questions. [LO 14.5] a. If this monopolist were regulated, would it prefer average total cost pricing (P = ATC) or efficient pricing? b. Is this a natural monopoly?

Answer: a. This monopolist would prefer the efficient price. The efficient price (where supply MC = demand) is higher than ATC, so profits would still be positive. b. No. The defining characteristic of a natural monopoly is that it has economies of scale so large that ATC is falling for the entire range of the demand curve.

11. Suppose a monopolist discovers a way to perfectly price discriminate. What is consumer surplus under this scenario? What are the efficiency costs? [LO 14.6]

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Answer: If a monopolist discovers a way to perfectly price-discriminate, consumer surplus is zero because each consumer is paying exactly her willingness to pay. There are no efficiency costs. The monopolist will make all trades for which the consumer willingness to pay is greater than or equal to its marginal costs. Therefore, all efficient trades will occur.

12. Suppose there are three types of consumers who attend concerts at your university’s performing arts center: students, staff, and faculty. Each of these groups has a different willingness to pay for tickets; within each group, willingness to pay is identical. There is a fixed cost of $1,000 to put on a concert, but there are essentially no variable costs. For each concert there are 140 students willing to pay $20, 200 staff members willing to pay $35, and 100 faculty members willing to pay $50. [LO 14.6] a. If the performing arts center can charge only one price, what price should it charge? b. What are profits at this price? c. If the performing arts center can price discriminate and charge two prices, one for students and another for faculty/staff, what are its profits? d. If the performing arts center can perfectly price discriminate and charge students, staff, and faculty three separate prices, what are its profits?

Answer: a. If the performing arts center can charge only one price, it should charge $35. At this price, both staff and faculty will purchase. Total revenue will be highest at 300($35) = $10,500. If the performing arts center charged $50, only faculty would purchase for a total revenue of 100($50) = $5,000. If the performing arts center charged $20, everyone (students, staff, and faculty) would purchase, but total revenue would be 440($20) = $8,800. Revenues are highest when the price is $35. b. Profit = TR – TC. Profit = 300 (35) − $1,000.

Profit = $10,500 − $1,000.

Profit = $9,500. c. Students: 140 ($20) = $2,800.

Faculty/Staff: 300 ($35) = $10,500.

TR: $2,800 + $10,500 = $13,300.

Profit = $13,300 − $1,000 = $12,300. d. Students: 140 ($20) = $2,800.

Staff: 200($35) = $7,000.

Faculty: 100($50) = $5,000.

TR: $2,800 + $7,000 + $5,000.

Profit: $14,800 − $1,000 = $13,800.

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CHAPTER 15 MONOPOLISTIC COMPETITION AND OLIGOPOLY Chapter Overview In previous chapters, we’ve explored two opposite ends of the spectrum of market structures: perfect competition and monopoly. In this chapter, we move to the gray area in between, learning about imperfect competition and the characteristics of industries that fall into the categories of monopolistic competition and oligopoly. Knowing about these market structures helps business owners make optimal decisions about production and pricing. Such knowledge also helps consumers make sense of firms’ behavior and the abundance of advertising they see in the real world. Market structure can tell us a lot about how firms make decisions, but there are still a number of other factors that we haven’t explored yet.

Up until now, we’ve focused on the amount of any given good that firms choose to produce. In the next chapter, we’ll see how markets for the factors of production play an important role in how firms choose to produce goods.

Learning Objectives LO 15.1: Name the defining features of oligopoly and monopolistic competition LO 15.2: Calculate the profit-maximizing price and quantity for a monopolistically competitive firm in the short run.

LO 15.3: Describe a monopolistically competitive market in the long run.

LO 15.4: Analyze the welfare costs of monopolistic competition.

LO 15.5: Explain how product differentiation motivates advertising and branding.

LO 15.6: Describe the strategic production decision of firms in an oligopoly.

LO 15.7: Explain why firms in an oligopoly have an incentive to collude, and why they might fail to do so.

LO 15.8: Compare the welfare of producers, consumers, and society as a whole in an oligopoly to monopoly and perfect competition.

Chapter Outline WHICH ONE OF THESE IS JUST LIKE THE OTHERS?

What Sort of Market?

Oligopoly and Monopolistic Competition (LO 15.1) Monopolistic Competition Monopolistic Competition in the Short Run (LO 15.2) richard@qwconsultancy.com

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Monopolistic Competition in the Long Run (LO 15.3) The Welfare Costs of Monopolistic Competition (LO 15.4) Product Differentiation, Advertising, and Branding (LO 15.5) BOX FEATURE: WHERE CAN IT TAKE YOU? – THE ADVERTISING AGE BOX FEATURE: REAL LIFE – WHAT REALLY SELLS LOANS? BOX FEATURE: FROM ANOTHER ANGLE – COKE, PEPSI, AND THE NOT-SO-SECRET FORMULA

Oligopoly Oligopolies in Competition (LO 15.6) Compete or Collude? (LO 15.7) Oligopoly and Public Policy (LO 15.8)

Beyond the Lecture Class Activity/ Writing Assignment: Oligopoly, Monopolistic Competition in the Long Run, and Product Differentiation, Advertising, and Branding (LO 15.1, LO 15.3, LO 15.5) Place students in groups and ask them to think of a product or firm that was once popular but is either no longer popular or no longer exists at all. Ask students to consider what happened that cause the product or firm to cease being popular. This can be used to generate a discussion on competition and why monopolistic competition tends to result in zero economic profits in the long run.

Class Discussion: Product Differentiation, Advertising, and Branding (LO 15.5) Consider showing a brief clip (scene 3 on the DVD) from the movie Zoolander. In the movie, an award for male model of the year is being given at an awards show. Have students consider the following: 14. How could a famous person help differentiate (or try to differentiate) a good or service?

15. Why do firms advertise?

16. What are the pros and cons for consumers?

Class Discussion: Oligopolies in Competition (LO 15.6) Discuss the telecom industry in Canada, which students can read about here. Consider the following: 1. Are the high mobile phone bills justified?

2. What can be done to make the telecomm industry more competitive?

Is phone bill populism the solution?

Writing Assignment: Oligopolies in Competition and Public Policy (LO 15.6, LO 15.7) Ask students to consider the collective bargaining agreements negotiated between professional sports leagues and their associated player associations. Have them read CBCs coverage of the 2019 NHL labor negotiations first, found here. Ask them to write a few paragraphs about what this has to do with oligopolies. You can choose to discuss the best essays in class. This discussion highlights strategic behavior. richard@qwconsultancy.com

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Solutions to End-of-Chapter Questions and Problems Review Questions 1. Explain why an oligopolist (with few competitors) pays more attention to what its competitors are doing than a producer in a competitive market (with many competitors) does.

[LO 15.1] Answer: Even though a firm in an oligopoly has fewer competitors than a firm in a perfect competition, the behavior of the other firms matters more to the oligopolist. This is because an oligopolist is not a price taker. The oligopolist faces the downward-sloping market demand curve, so he must pay attention to what his competitors are doing. If a competitor is offering an enhanced service or running a sale, for example, this will affect the oligopolist’s revenues.

2. If a market has few barriers to entry and many firms, how might firms still have positive economic profit? Describe a strategy a firm in this type of market might use to maintain economic profits. [LO 15.1] Answer: If a market has few barriers to entry and many firms, a firm in this market could still have positive economic profit if it is offering a good for which its competitors are imperfect substitutes. In this case, the firm will do its best to convince consumers that its goods or services are different enough from its competitors (and more desirable) that it can maintain a price differential.

3. McDonald’s, Harvey’s, and Wendy’s all produce hamburgers, among other things. However, if you prefer burgers from McDonald’s, you might consider other burgers an imperfect substitute. With this in mind, how would you expect McDonald’s to set its prices in the short run? Describe the relationship between price, marginal revenue, and marginal cost. [LO 15.2] Answer: In the short run, McDonald’s will set its prices like a monopolist. McDonald’s will maximize profits by producing where marginal revenue equals marginal cost and charging the highest price that demand will bear. If this price happens to be more than Harvey’s and Wendy’s, consumers will pay the price differential as long as it is not greater than the value they place on their preference for McDonald’s burgers over its competitors.

4. Consider Jimmy Choo designer shoes. In what way does Jimmy Choo face many competitors? In what way does Jimmy Choo face no competitors? [LO 15.2] Answer: Jimmy Choo is a small player in the market for shoes and faces many competitors.

However, Jimmy Choo is a monopolist for Jimmy Choo designer shoes. How much Jimmy richard@qwconsultancy.com

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Choo can charge for shoes bearing its label will depend on how substitutable consumers think other shoes are as a substitute for Jimmy Choo shoes.

5. Restaurants offer related but differentiated products to their consumers. In the long run, new restaurants enter the market and imitate the cuisine and atmosphere of successful competitors. How would you expect a restaurant to set its prices in the long run? Describe the relationship between price and average total cost. Does a restaurant earn economic profits?

[LO 15.3] Answer: In the long run, restaurants will enter the market as long as there are positive profits. As more competitors and substitutes enter, the demand curve for a particular restaurant will shift to the left. This will continue until there are no longer economic profits.

Price will be equal to ATC in the long run for firms in a monopolistically competitive market.

6. In both perfectly competitive and monopolistically competitive markets, when firms are making positive economic profits, other firms will enter until price equals ATC and profits are zero. Despite these similarities, in a perfectly competitive market total surplus is maximized, while in a monopolistically competitive market surplus is not maximized.

Explain this difference. [LO 15.3] Answer: In monopolistically competitive markets, firms face downward-sloping demand curves, which means price equals ATC on the decreasing section of the ATC curve, rather than the minimum of ATC (as in perfect competition). Operating where ATC is minimized is the efficient scale of production. Because a monopolistically competitive firm operates on the decreasing section of the ATC curve, it produces less than the efficient quantity and surplus is not maximized.

7. Suppose a perfectly competitive market for hot-dog stands in downtown Toronto becomes monopolistically competitive when gourmet, discount, and ethnic hot-dog retailers show up, making each cart slightly different. If hot dogs from different stands are now imperfect substitutes and there are numerous carts in the city, compare the producer and consumer surplus and total social welfare before and after the change. [LO 15.4] Answer: In the short run, moving from perfect competition to a monopolistically competitive market will reduce social welfare because the monopolistically competitive firms will maximize profits by producing less than the efficient quantity. This will create a deadweight loss. Consumer surplus will decrease because the monopolistically competitive firms will be able to charge a higher price than the competitive firms could charge. Producer surplus should increase compared to perfect competition because vendors are selling versions of hot dogs for which other types are imperfect substitutes. Consumers will have preferences between types of hot dogs, which will allow for price differentials.

8. Given that the market for smartphones is inefficient, explain why consumers of smartphones might not want the price to be regulated. [LO 15.4] richard@qwconsultancy.com

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Answer: Consumers like lower prices, but they also like product variety. Regulating the price of smart phones would reduce product variety if there are firms in the market that cannot operate at a lower cost and would face negative profits at the regulated price.

Consumers may prefer more product variety even if they pay a bit more for smart phones.

9. Imagine that you have an app on your cell phone that allows you to walk up to any item in the supermarket and have your phone recognize it and display all the necessary information about the product. The app tells you where and how it is made, and when it is predicted to go on sale next. Does a firm selling goods in this setting need to advertise? Why or why not?

[LO 15.5] Answer: Yes; despite the neat cell phone app, the firm still needs to advertise. The purpose of advertising is not just to inform consumers about product details and sales. Advertising is important to create consumer preference for a particular brand. Presented with options, consumers will gravitate toward goods they recognize and with which they have positive associations. Advertising also helps producers create the impression (true or not) that their product is distinct from competitors’ products.

10. Why might the cost of advertising be relevant to a consumer’s decision about which brand of a product to purchase? [LO 15.5] Answer: The cost of advertising acts as a credible (costly to fake) signal of product quality.

Presumably, a producer will not spend a lot of money on expensive advertising for a product it does not believe consumers will like and continue to purchase. If a consumer sees expensive advertising, then, she can assume that the advertising investment means that the producer believes in the quality of the good.

11. Suppose that the market for e-readers is an oligopoly controlled by Amazon.ca, Indigo Books & Music, Sony, and Apple. Indigo is considering increasing its output. How would this affect the market price? How would it affect the profits of each company? [LO 15.6] Answer: If one producer in an oligopoly increases output, the price will fall for all producers. The oligopolist that increased quantity will increase profits as long as the quantity effect outweighs the price effect (that is, as long as the increase in sales outweighs the decrease in price). Profit will decrease for the other oligopolists who did not increase quantity because they will be selling the same quantity as before, but at a lower price.

12. Compare the efficiency of perfectly competitive markets, monopoly markets, and oligopoly markets. Explain why the same profit-maximizing behavior for the individual firm leads to different levels of efficiency in these three types of markets. [LO 15.6] Answer: In all three types of markets, producers maximize profit by producing where MR = MC. The efficient outcome is to produce where P = MC. For competitive firms, MR is the same as the market price, so the profit-maximizing production level is also efficient. For richard@qwconsultancy.com

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monopolies and oligopolies, MR is less than price, so the production level will be less than the efficient level. For monopolies, this inefficient production level is sustainable in the long run as long as there are barriers to entry. Oligopolies will produce at the same level as monopolies (and will be equally inefficient) if they collude. If they compete, oligopolies will produce more than monopolies but less than the efficient level of perfect competition.

13. The Organization of the Petroleum Exporting Countries (OPEC) is a cartel of 12 countries that controls roughly two-thirds of the world’s oil production. The cartel gives countries quotas for production. Why might a country be tempted to produce above quota for a year?

How do you think other OPEC countries might respond if it did so? [LO 15.7] Answer: A country might be tempted to produce above its quota because it will increase its profits by doing so. If everyone else holds to their quotas, the country that cheats and overproduces will enjoy all of the benefits of selling extra quantity but will share the cost with all of the other countries in terms of the lower price that will result. Other OPEC countries might respond by increasing production as well. If enough countries increase production, profits will fall enough to outweigh the temporary gain the country that originally overproduced received by cheating. In the end, all member countries are better off sticking to their quotas.

14. Isabella runs an IT solutions business for her university peers and has only one competitor, Franco. Isabella and Franco have decided to collude and provide monopoly-level output.

Given that they are both freshmen and intend to run their businesses for the next three years, is this agreement sustainable? Would your answer change if Franco knew he planned to transfer to another university next year? [LO 15.7] Answer: If Isabella and Franco’s agreement to collude were sure to be a repeat game (every semester for three years), it could be sustainable. If one cheats, the other will retaliate.

However, if Franco plans to transfer to another university next year, he will have an incentive to cheat because he knows he will not be around for retaliation if he does. Collusion is unlikely to hold in a one-time game.

15. Canada Post has a government monopoly on home mail delivery, but several private companies, such as FedEx, UPS, and DHL, compete with Canada Post for other types of delivery service. Describe the differences in producer and consumer surplus, and in overall social welfare, that would occur in each of the following scenarios. [LO 15.8] a. Canada Post has a monopoly on every type of mail or package. b. Consumers are allowed to choose between Canada Post , UPS, FedEx, and DHL for home mail delivery. c. There are an infinite number of local and national mail providers.

Answer: a. Consumer surplus is lowest in this scenario. Monopoly pricing is the highest of the three scenarios. Zero competition is the least beneficial to consumers.

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b. Consumers are better off in this scenario. The introduction of some competition will move price and quantity closer to efficient outcomes. The price will be lower (and quantity higher) than under a monopoly producer. c. Consumer surplus is highest in this scenario. Under perfect competition, price is the lowest (and quantity) highest. Total surplus is maximized (including consumer surplus) under perfect competition.

16. Explain why government is usually more concerned about regulating an oligopoly than a monopolistically competitive market. [LO 15.8] Answer: From an efficiency standpoint, an oligopoly will be more problematic than a monopolistically competitive market. If an oligopoly is successfully colluding, it will be as inefficient as a monopoly. Even if an oligopoly is not colluding, it will still be inefficient in the long run. A monopolistically competitive market will be equally inefficient initially but will eventually come closer to efficient outcomes as more firms enter the market and produce similar substitutes. A monopolistically competitive market will compete away its profits without government intervention.

Problems and Applications 1. Identify whether each of the following markets has few or many producers, and uniform or differentiated products. Which market is an oligopoly? Which market is monopolistically competitive? [LO 15.1] a. University education. b. Retail gas market.

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Answer: a. The market for university degrees has many producers and differentiated products. This market is monopolistically competition. b. The retail gas market has few producers and a uniform product. This market is an oligopoly.

2. Match the statement about goods sold in a market with the market type. [LO 15.1] a. There are imperfect substitutes for the goods. b. There are no substitutes for the goods. c. The goods may or may not be standardized.

Answer: a. Monopolistic competition. b. Monopoly. c. Oligopoly.

3. Spotify sells the music of Drake, who is very popular among young listeners. Suppose the current period’s supply and demand for Drake song downloads from Spotify is given in Figure 15P-1. [LO 15.2, 15.3] a. What are the profit-maximizing price and quantity for Drake song downloads in the short run? b. In the long run, what happens to the demand curve? c. In the long run, what happens to the profit-maximizing price?

Answer: a. In the short run, Spotify will maximize profits by producing where MR = MC and charging the highest price demand will bear. This approach corresponds with a quantity of 50,000 song downloads and a price of $1. b. In the long run, the demand curve for Drake songs shifts to the left as other firms with similar artists enter the market. c. In the long run, the profit-maximizing price decreases.

4. Figure 15P-2 shows the monopolistically competitive market for smartphones. [LO 15.3] a. Is this producer earning positive or negative profits in the short run? b. In the long run, will economic profits increase or decrease for this producer?

Answer: a. This producer is earning negative profits. The producer is producing where MR = MC, which is 25 phones, and charging the highest price demand will bear, which is $200.

Because $200 is lower than ATC of $240, profits are negative ($200 - $240 = -$40). b. In the long run, profits will increase. Because there are negative economic profits in the short run, other firms will exit the market. These exits will drive up demand for the existing firms, driving up the price until price equals ATC and there is no further incentive for exit. richard@qwconsultancy.com

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5. Figure 15P-3 shows a monopolistically competitive market for a fictional brand of shampoo called SqueakyKleen. [LO 15.4] a. What is the price and quantity of SqueakyKleen in the short run? b. What is the efficient price and quantity of SqueakyKleen? c. Draw the deadweight loss.

Answer: a. In the short run, SqueakyKleen behaves like a monopolist and sells 30 bottles of shampoo at a price of $2 per bottle. b. The efficient quantity is where MC intersects demand. This occurs at a quantity of 45 bottles of shampoo and a price of $1.50. c. See graph below:

6. The marginal costs (MC), average variable costs (AVC), and average total costs (ATC) for a monopolistically competitive firm are shown in Figure 15P-4. [LO 15.4] Answer: a. The profit-maximizing output occurs where MC = MR or Q = 20 units. The firm charges a price according to the demand curve.

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b. Because P = ATC, we know profits are zero. c. When profits are zero, a monopolistically competitive firm is in a long-run equilibrium.

7. For which good would you expect deadweight loss to be smaller relative to the total surplus in its market: Harvey's hamburgers or Drake downloads? Explain your answer. [LO 15.4] Answer: The less differentiated products are, the more difficult it is to sustain inefficient prices and the smaller the deadweight loss. Harvey's hamburgers are less differentiated from their competitors than Drake songs are from his competitors, so deadweight loss should be smaller for Harvey's hamburgers.

8. For which product would you expect producers to have a stronger reaction to a ban on advertising: music artists or fast-food burgers? Explain your answer. [LO 15.5] Answer: You would expect a stronger reaction to a ban on advertising fast-food burgers.

Fast-food burgers are not very differentiated. Consumers are likely to be more indifferent about fast-food burger options than they are about music options. Burger producers have a greater need to advertise to convince consumers that they should have a preference for one fast-food burger over another.

9. Suppose you manage a firm in a monopolistically competitive market. Which of the following strategies will do a better job of helping you maintain economic profits: obtaining a celebrity endorsement for your product or supporting the entry of firms that will compete directly with your biggest rival? Explain your answer. [LO 15.5] richard@qwconsultancy.com

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Answer: Obtaining a celebrity endorsement: Consumers may have positive feelings about a good that is endorsed by a celebrity they like or trust. Entry of firms that compete with your biggest rival will hurt your profits as well. If your biggest rival is forced to cut prices due to the competition it is facing, it ultimately becomes competition for you as well. If your rival is forced into lower prices, demand for your good will decrease.

10. Table 15P-1 shows the monthly demand schedule for a good in a duopoly market. The two producers in this market each face $5,000 of fixed costs per month. There are no marginal costs. [LO 15.6] a. What is the monthly profit for each duopolist if they evenly split the quantity a monopolist would produce? b. What is the monthly profit for duopolist A and duopolist B if duopolist A decides to increase production by 200 units?

Answer: a. The monopoly outcome is to produce a quantity of 800 and charge a price of $20. If the duopolists split production, each produces 400 and charges $20 per unit for a total revenue of $8,000. Each firm faces a fixed cost of $5,000, so profit is $8,000 − $5,000 = $3,000 for each duopolist. b. If dupolist A increases production by 200 units, price will fall to $15 for all units.

Duopolist A will be producing 600 at a price of $15 for a total revenue of $9,000. Profit for dupopolist A will be $9,000 − $5,000 = $4,000. Duopolist B is still producing 400, so his total revenue will be 400 x 15 = $6,000. Duopolist B will have a profit of $6,000 − $5,000 = $1,000.

11. Figure 15P-5 shows the monthly demand curve for a good in a duopoly market. There are no fixed costs. [LO 15.6] a. What is the monthly profit for each duopolist if they evenly split the quantity a monopolist would produce? b. What is the deadweight loss if the duopolists evenly split the quantity a monopolist would produce? c. What is the monthly profit for duopolist A and duopolist B if duopolist A decides to increase production by 10 units? d. What is the deadweight loss if duopolist A increases production by 10 units?

Answer: a. The monopoly outcome is to produce a quantity of 50 and charge a price of $70. If the duopolists evenly split production, each will produce 25 and charge $70 for a total revenue of $1,750. Marginal costs are $20 per unit, so the cost of producing 25 units would be $500. Profit for each duopolist would therefore be $1,750 − $500 = $1,250. b. DWL = 0.5(100 − 50)(70 − 20) = $1,250. c. If duopolist A increases production by 10, price for all units will fall to $60. Dupolist A will charge $60 for 35 units (his original 25 + 10 extra units) for a total revenue of $2,100. Marginal costs are $20 per unit so $20 x 35 = $700. Profit for duopolist A will be $2,100 − $700 = $1,400. Duopolist B’s total revenue will be $60 x 25 = $1,500. richard@qwconsultancy.com

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Duopolist B’s profit will be $1,500 − $500 = $1,000. Therefore, if duopolist A increases production by 10 units, profits increase for duopolist A but decrease for duopolist B. d. If Dupolist A increases production by 10 units, DWL decreases to 0.5(100 − 60)(60 − 20) = $800.

12. Oil Giant and Local Oil are the only two producers in a market, as shown in Figure 15P-6.

They have an agreement to restrict oil output in order to keep prices high. [LO 15.7] a. What is the dominant strategy for each player? b. If this game is played once, what is the Nash equilibrium? c. Now suppose that both players know that the game will be played multiple times. What outcome would we expect?

Answer: a. The dominant strategy for Oil Giant is to compete. The dominant strategy for Local Oil is to compete. b. If this game is played once, the Nash equilibrium is for both firms to compete. They are both better off if they collude, but each has an incentive to cheat and a one-time game will lead to this outcome. c. If the game is played multiple times, we would expect collusion to be possible. Both firms know they are better off if they collude, and this outcome is more likely when a game is repeated multiple times.

13. Suppose Warner Music and Universal Music are in a duopoly and currently limit themselves to 10 new artists per year. One artist sells 2 million songs at $1.25 per song. However, each label is capable of signing 20 artists per year. If one label increases the number of artists to 20 and the other stays the same, the price per song drops to $0.75, and each artist sells 3 million songs. If both labels increase the number of artists to 20, the price per song drops to $0.30, and each artist sells 4 million songs. [LO 15.7] a. Fill in the revenue payoffs for each scenario in Figure 15P-7. b. If this game is played once, how many artists will each producer sign, and what will be the price of a song? c. If this game is played every year, how many artists will each producer sign, and what will be the price of a song?

Answer: a. See figure below.

b. If this game is played once, each producer will sign 20 artists, and the price of a song will be $0.30/song. richard@qwconsultancy.com

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c. If this game is played multiple times, each producer will sign 10 artists, and the price of a song will be $1.25.

14. Suppose a new product is developed and is supplied by a monopolist with a patent.

Compared with the monopoly outcome, indicate whether consumer surplus, producer surplus, and total surplus increase, decrease, or remain the same under the following scenarios. [LO 15.8] a. Another producer creates a similar product and colludes with the original producer. b. Another producer creates a similar product and competes with the original producer. c. The patent expires.

Answer: a. Consumer surplus, producer surplus, and total surplus all stay the same. A colluding duopoly has the same outcomes as a monopoly. b. Consumer surplus increases, producer surplus decreases, and total surplus increases. c. Consumer surplus increases, producer surplus decreases, and total surplus increases.

15. For which of the following markets would there be a greater increase in total welfare if government were able to intervene and regulate prices: OPEC or the music industry? Explain your answer. [LO 15.8] Answer: OPEC; it is a colluding oligopoly and is more inefficient than the music industry, where producers have market power but are competing against each other.

CHAPTER 16 THE FACTORS OF PRODUCTION Chapter Overview Why do some people earn more money than others? That is one of the most fundamental questions in economics and politics. When markets are competitive, everyone earns income in proportion to the productivity of the factors of production they control. For most people, that means their income is based on their own productivity as workers. That’s usually closely tied to the skills, education, and other talents that determine our “human capital.” For farmers, the productivity of land matters as well. For investors, income is determined by the productivity of their financial capital. Competitive markets have the remarkable ability to reward work according to what is contributed to the economy. We’ll see that we can use the familiar tools of supply and demand to put prices on the factors of production, and examine how business owners decide how much of each factor to use in producing goods and services. Their choice is driven by both the marginal productivity and the price of each factor.

In future chapters we’ll return to the markets for land, labour, and capital, to see what happens when we add public policy and collective decision making to the picture.

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Learning Objectives LO 16.1: Define factors of production and describe how they contribute to output.

LO 16.2: Graph the demand curve for a factor of production, and explain its relationship to marginal productivity.

LO 16.3: Graph the supply curve for a factor of production, and explain what determines the supply of labour.

LO 16.4: Explain how to find the equilibrium price and quantity for a factor of production.

LO 16.5: Use graphs to demonstrate the effect of a shift in supply or demand and describe what causes these curves to shift.

LO 16.6: Define human capital, and justify its importance in the labour market.

LO 16.7: Describe the similarities and differences between the markets for land and capital and the market for labour.

LO 16.8: Identify two reasons why a wage might rise above the market equilibrium, and describe their effect on the labour market.

LO 16.9: Describe several causes of imperfectly competitive labour markets and their effect on workers and employers.

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Chapter Outline THE FIELDS OF CALIFORNIA

The Factors of Production: Land, Labour, and Capital (LO 16.1) Derived Demand Marginal Productivity Picking the Right Combination of Inputs Labour Markets ad Wages Demand for Labour (LO 16.2) Supply of Labour (LO 16.3) BOX FEATURE: FROM ANOTHER ANGLE – THE BEST JOB IN THE WORLD

Reaching Equilibrium (LO 16.4) Shifts in Supply and Demand (LO 16.5) Determinants of Labour Demand and Supply BOX FEATURE: WHAT DO YOU THINK? – SHOULD THE UNITED STATES BE A COUNTRY OF IMMIGRANTS?

What’s Missing? Human Capital (LO 16.6) Land and Capital Capitalists: Who Are They?

Markets for Land and Capital (LO 16.7) The Factor Distribution of Income BOX FEATURE: WHAT DO YOU THINK? – WORK, WAGES, AND SOCIAL VALUE

Real-World Labour Markets Minimum Wages and Efficiency Wages (LO 16.8) Company Towns, Unions, and Labour Laws (LO 16.9) BOX FEATURE: REAL LIFE – MONOPSONY AND COMPETITION IN PROFESSIONAL BASEBALL

Changing Demographics BOX FEATURE: WHAT DO YOU THINK? – POPULATION POLICY AND THE WEALTH OF NATIONS

Beyond the Lecture Class Discussion: Shifts in Supply and Demand (LO 16.5) Have students consider the relationship between Apple and their primary supplier; Apple primarily relied on one supplier (Foxconn) before splitting production with a second supplier (Pagatron) in 2013. Students can read about this issue in the Wall Street Journal article here.

17. Ask students to think about how changes in the demand for or supply of a product would impact the market.

18. Have students consider the potential supply chain issues that can impact a firm.

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Class Discussion: Minimum Wages and Efficiency Wages (LO 16.8) Show student a brief series of clips from The Simpsons episode Homer’s Enemy (show 6:006:53, 7:10-8:42, 11:30-13:02, and 15:00-16:03). In the episode, Homer does numerous stupid things while a new employee Frank is constantly professional. However, Homer tends to do better in terms of salary.

1. What factors other than productivity can impact wage in reality?

Class Discussion: Company Towns, Unions, and Labour Laws (LO 16.9) Have students view this brief clip from the TV show Seinfeld, where Kramer finds out that a strike has ended at his former place of employment. This can be used to start a discussion of imperfectly competitive labour markets. A link to the discussion of the clip at The Economics of Seinfeld is included along with a link to the episode.

1. What effect does collective bargaining have on labour markets?

2. Can labour unions work to enact changes in a market or at a particular company?

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Consider the factors of production that go into a fast-food restaurant. Give an example of land, labour, and capital. [LO 16.1] Answer: Land: The plot of land on which the restaurant is built as well as the parking lot is a factor of production that has value as well as alternate uses. Labour: The workers who make the food, clean the restaurant, and manage the other employees are all part of the labour input to a fast-food restaurant. Capital: The stoves and other cooking equipment as well as the tables and chairs for customers are part of the physical capital.

2. Suppose an auto manufacturer has one factory in Canada and one in Mexico. The auto manufacturer produces the same number of cars and the same models in each factory but hires more workers in Mexico than in Canada. Give an explanation for the discrepancy in the amount of labour hired in each location. [LO 16.1] Answer: One reason for hiring more workers at the factory in Mexico is that labour is cheaper in Mexico than it is in Canada. In Canada, the auto manufacturer would have an incentive to substitute capital (machinery) for labour because cost of labour is high.

3. Suppose you run a flower-delivery business and employ college students to drive the vans and make deliveries. You are considering hiring an additional worker. What information would you need to know to decide whether doing so would increase or decrease your profit?

[LO 16.2] richard@qwconsultancy.com

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Answer: You would need to know the value of the marginal product for that worker. That is, you would need to know how many additional deliveries you could make if you hired another worker, and you’d need to know the value of those additional deliveries. If the value of the additional deliveries is greater than the cost of hiring the additional worker, your profits would increase. If you have to pay the additional worker more than the value of the additional deliveries, your profits would decrease.

4. Christina runs an IT consulting firm in a competitive market. She recently determined that hiring an additional consultant would mean that she would be able to serve five more clients per week. Assuming her goal is to maximize her profits, explain why Christina did not hire another consultant. [LO 16.2] Answer: It must be the case that the wage for hiring an additional consultant is greater than the value of serving five additional clients. If Christina is operating in competitive input and output markets, she must accept the market price for consultations as well as the going rate for hiring consultants. It would make sense for Christina to hire an additional consultant only if the marginal revenue she would receive for five consultations covered her marginal cost of hiring the consultant.

5. Suppose your retired grandmother has complained of boredom and is considering taking a part-time job. Use the concept of opportunity cost to advise your grandmother how to decide whether to take the job. [LO 16.3] Answer: You should speak to your grandmother about the opportunity cost of her time.

Supplying a factor of production, such as labour, is a function of the other opportunities for using that resource. Your grandmother has time to take a part-time job, but that time could be used doing other stimulating things as well, like traveling. Your grandmother should take the job only if it pays well enough to compensate for the opportunity costs she faces by using her time to work.

6. Jackie and Samia are both nurses at the same hospital. Jackie and Samia have the same duties, experience, and performance reviews. Give an example that explains why Samia makes more than Jackie for the same job. [LO 16.3] Answer: Samia could make more than Jackie if she works the overnight shift and Jackie works the day shift. Most people prefer to work during the day, and the hospital may have to pay a compensating differential as an incentive for people to accept a less-desirable shift in an otherwise-equivalent job.

7. Suppose BMW runs a great ad campaign that increases demand and drives up the price of BMWs. What do you expect will happen to the demand for the labour in auto-manufacturing plants? Explain how the equilibrium price and quantity of labour will change. [LO 16.4] Answer: If the price of BMWs increases, the value of the labour that creates BMWs will increase. The labour demand curve is equivalent to the value of the marginal product of richard@qwconsultancy.com

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labour. Therefore, if the price of the output created by labour increases, demand for that labour also increases. The demand curve for labour will shift to the right, and the equilibrium price (wage) and quantity of labour will both increase in this market.

8. Suppose a cafe owner wants to switch to automatic espresso machines instead of paying baristas to pack the coffee grounds by hand. The machines are twice as effective as a human; the fixed cost per machine equals the yearly wage of one employee. Explain how the equilibrium price and quantity of labour will change. [LO 16.4] Answer: If demand for labour decreases because a cheaper, more-productive alternative is discovered, the price (wage) and quantity of labour will decrease. Substituting capital for labour represents a shift to the left in the demand curve for labour.

9. Leo runs a bicycle repair shop. He recently examined information on wage and employment levels and noted that he employs the same number of workers in 2019 that he employed in 2016. However, wages (controlling for inflation) increased quite substantially between 2016 and 2019. Assume the supply of labour remained constant over this time period. Give two possible explanations for why Leo’s workers are paid more in 2019. [LO 16.5] Answer: Leo hires labour up until the point where the value of the marginal product equals the wage. If the wage increased between 2016 and 2019, the value of the marginal product must have also increased. Since VMPL = MPL x price of the output, one or both of the following must have occurred. Either marginal product increased during this time (workers are more productive today than they were in 2016), or the price of a bicycle repair was less in 2016 than it is today.

10. Consider a labour market that traditionally discriminates against hiring women. Suppose a new law effectively prohibits this practice. What would you expect to happen to the wages of men in this industry? [LO 16.5] Answer: If women newly have access to a job market, the supply curve in that market will shift to the right. Wages will decrease due to the increase in labour supply.

11. Suppose your friend wants to become a doctor. Describe some of the human capital required to achieve this goal. [LO 16.6] Answer: Becoming a doctor requires many years of education and training. Your friend will first need to go to medical school. In addition to the classroom education she receives, your friend will also need to train under the supervision of other doctors for several years.

Eventually, your friend will have to demonstrate that she has obtained the necessary human capital in order to become certified to practice medicine.

12. Madison has a full-time job, but she is considering going back to school for a master’s degree. Describe how Madison might decide whether or not to continue her education. [LO 16.6] richard@qwconsultancy.com

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Answer: She should consider the costs and benefits of additional education. First, there is the direct cost of tuition to consider. If she plans to leave her job to go back to school, there will also be forgone wages to factor in the costs of her education as well. She should weigh these costs against the benefits of furthering her education. Getting an advanced degree will open additional job opportunities and usually results in promotion and higher pay.

13. Ariel is shopping for a space to open a new restaurant. She has two options in her target neighborhood. One space is available for lease and the other for purchase. How would you advise Ariel to think through her choice of restaurant location? What factors should she consider? [LO 16.7] Answer: Renting allows Ariel to use the space she needs to run her restaurant but does not lead to ownership of this factor of production. If she rents, Ariel needs to consider the other current opportunities in the rental market, but the long-run value of the space is not important. If she chooses to purchase, however, the long-run value of the space is a very important consideration. Before purchasing, Ariel will need to project her expectation of the future value of the space so that she can decide whether the purchase price is worth the investment.

14. Suppose you have inherited a few acres of land from a relative and you are considering what to do with your inheritance. A farmer with land next to yours offers to buy your acres so he can expand his grazing area. How will you decide whether to sell your land to the farmer?

What factors should you consider? [LO 16.7] Answer: Your decision about whether to sell a factor of production should be a function of the other opportunities for the asset you own. What are the opportunity costs of selling the land to the farmer? You could use the land yourself, sell it to someone else, or sell it in the future if you expect prices to rise. You should consider these opportunity costs before you sell to the farmer.

15. Large telecom companies like Telus routinely send repair technicians to customers’ homes.

Although they are skilled labourers, they must usually train on the job, so it takes some time for them to reach a high standard of quality. In addition, their work cannot be constantly supervised. Explain why an efficiency wage could help telecom companies to increase the productivity of repair techs. [LO 16.8] Answer: Efficiency wages are wages that are above the equilibrium wage. Because these wages are better than the going rate, people who have jobs paying efficiency wages have a greater incentive to work hard. Knowing that they are paid better than the market standard, employees receiving an efficiency wage will want to keep their job and will work hard to do so. Less supervision is needed if an employee’s other options in the labour market are less desirable.

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16. The Coalition of Immokalee Workers (CIW) claims that the going wage for farm labour is exploitative. The CIW supports a minimum wage for farm workers. Explain how the minimum wage would affect a farm’s hiring decision. Are farm workers better off under this policy? [LO 16.8] Answer: Due to the higher wage, production costs would increase and farms will hire fewer workers. The workers who are hired are better off, but fewer workers will be employed.

17. Suppose a new law passes requiring farms to provide health benefits to farm labour. Assume that workers value having health benefits. When the new law goes into effect, what will happen to the wage for farm labour at equilibrium? Now suppose farm workers place no value on health benefits. How does this affect your answer? [LO 16.9] Answer: If the workers value the benefits, they will be willing to work for a lower wage. The wage in the market will fall by the amount that the workers value the benefits. If workers do not value the health benefits, they are not willing to work for a lower wage to receive these benefits. The going wage remains the same, but the labour costs in wages + benefits are higher. Fewer workers will be hired.

18. Suppose a group of high school friends work at the same fast-food restaurant. They all dislike the manager because she doesn’t allow them to swap shifts with one another whenever someone has a big exam to study for or a date. One of the friends suggests that they all agree to walk out if the manager doesn’t change her policy. Explain whether the manager will change her policy to avoid a walkout. [LO 16.9] Answer: The group of friends is not likely to succeed in changing the manager’s policy.

There are plenty of workers who can take the place of a few friends doing a low-skill job.

The friends do not have enough market power for a walkout to be effective. The manager has too many other hiring options for this strategy to work.

Problems and Applications 1. Recently, some college alumni started a moving service for students living on campus. They have three employees and are debating hiring a fourth. The hourly wage for an employee is $18 per hour. An average moving job takes three hours. The company currently does three moving jobs per week, but with one more employee, the company could manage five jobs per week. The company charges $80 for a moving job. [LO 16.1, 16.2] a. What would be the new employee’s marginal product of labour? b. What is the value of that marginal product? richard@qwconsultancy.com

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c. Should the moving service hire a fourth worker?

Answer: a. 2 moving jobs. b. $80 x 2 = $160. c. Yes. The worker will cost $18/hour times six hours (one job takes 3 hours and the new worker can do two jobs). $18 x 6 = $108, which is less than the value of the worker’s marginal product.

2. Fresh Veggie is one of many small farms in Florida operating in a perfectly competitive market. Farm labour is also perfectly competitive, and Fresh Veggie can hire as many workers as it wants for $20 a day. The daily productivity of a tomato picker is given in Table 16P-1. If a bushel of tomatoes sells for $5, how many workers will Fresh Veggie hire?

[LO 16.1, 16.2] Answer: Fresh Veggie maximizes profit by hiring all units of labour for which the value of the marginal product is greater than or equal to the wage. Fresh Veggie will hire 4 workers.

3. Dustin’s labour supply curve is graphed in Figure 16P-1. [LO 16.3] a. Consider a wage increase from $5 to $6. For Dustin, does the price effect or income effect dominate his labour supply decision? b. Consider a wage increase from $7 to $8. For Dustin, does the price effect or income effect dominate his labour supply decision?

Answer: a. The price effect dominates. As the wage increases, Dustin works more hours. b. The income effect dominates. As the wage increases, Dustin works fewer hours. richard@qwconsultancy.com

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4. Sasha has 60 hours a week she can work or have leisure. Wages are $8/hour. [LO 16.3] a. Graph Sasha’s budget constraint for income and leisure. b. Suppose wages increase to $10/hour. Graph Sasha’s new budget constraint. c. When wages increase from $8/hour to $10/hour, Sasha’s leisure time decreases from 20 hours to 15 hours. Does her labour supply curve slope upward or downward over this wage increase?

Answer: a and b. See graph below.

c. If leisure time decreases, hours worked increases. Sasha’s labour supply curve slopes upward over this wage increase.

5. Suppose you run a business that specializes in producing graphic T-shirts, using labour as an input. Based on Table 16P-2, graph the labour supply and demand curves and identify the market equilibrium wage and quantity. [LO 16.4]

Answer:

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6. Based on Table 16P-3, indicate what would happen in this labour market at various wage rates by selecting one of the three choices shown for each item. [LO 16.4] a. At $8/hour: excess quantity labour supplied; excess quantity labour demanded; or equilibrium. b. At $3/hour: excess quantity labour supplied; excess quantity labour demanded; or equilibrium. c. At $5/hour: excess quantity labour supplied; excess quantity labour demanded; or equilibrium.

Answer: a. Excess quantity labour supplied. b. Excess quantity labour demanded. c. Equilibrium.

7. Identify which way the labour supply curve would shift under the following scenarios. [LO 16.5] a. A country experiences a huge influx of immigrants who are skilled in the textile industry. b. Wages increase in an industry that requires similar job skills. c. New machines require additional maintenance over time, so that the marginal productivity of labour rises.

Answer: a. Immigration increases labour supply. The labour supply curve would shift to the right. b. Better opportunities in a related job market would shift the supply curve to the left in the industry with lower wages (and to the right in the industry where wages increased).

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c. An increase in the marginal productivity of labour will cause an increase in demand for labour. Wages will rise and there will be a movement along the labour supply curve (no shift).

8. Figure 16P-2 shows the supply and demand for labour in the textile industry. In each of the following scenarios, graph any shift in the supply or demand curve and state whether the resulting equilibrium wage and quantity increase or decrease. [LO 16.5] a. What is the original equilibrium wage and quantity? b. Immigration and layoffs from other jobs increase the population of textile workers. c. A new technology for making self-printed T-shirts reduces the marginal product of labour for textile workers.

Answer: a. The equilibrium occurs where supply intersects demand. This is at 75,000 textile workers paid $50,000. b. At every wage, the quantity of workers willing to supply labor is higher. Thus, the supply increases. The new equilibrium occurs where the new supply curve intersects the demand curve. The wage decreases, and the quantity of workers increases.

c. When the marginal product of labor decreases, the value of the marginal product of labor also decreases. (VMPL = MPL*Price.) Thus, the demand for labor (which is measured by the value of the marginal product of labor) decreases. The new equilibrium occurs where the new richard@qwconsultancy.com

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demand curve intersects the supply curve. The wage decreases, and the quantity of workers decreases.

9. Suppose that fast-food chains start using healthier ingredients, increasing the demand for fast food and therefore for food-service workers, as shown in Figure 16P-3. [LO 16.6] a. What are the new equilibrium wage and quantity of labour in the fast-food industry? b. Assume that the skills required of a sales clerk at a retail store are similar to those required of workers at a fast-food restaurant. If workers are completely indifferent between fast-food jobs and retail-sales jobs, what will be the wages for sales clerks?

Answer: a. The new equilibrium wage is $30 and the new equilibrium quantity of labour is 400 thousand workers in the fast-food industry. b. The wages of sales clerks would go up. As workers leave their jobs as sales clerks to work at fast-food restaurants where wages have already increased, the supply curve for sales clerks will shift left, causing the wage to go up.

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10. Suppose a town’s largest employers are its auto manufacturing plant and its airplane manufacturing plant. Airplane manufacturing jobs require familiarity with a technology that is not currently used in auto manufacturing. Assume workers are indifferent between the two types of manufacturing work. [LO 16.6] a. All else equal, which plant will pay its workers more? b. Suppose the auto industry adopts the same technology used by airplane manufacturers and trains its current workers in this technology. What will happen to the pay differential between auto manufacturing and airplane manufacturing work?

Answer: a. The airplane-manufacturing plant will pay more because it requires additional skills. All else equal, workers at the airplane plant must possess an additional skill that is not required for auto manufacturing. If workers are indifferent between the jobs, there is no incentive for them to obtain the added skill needed to work at the airplane plant unless they are compensated by additional pay. b. If the auto industry requires the same skills as the airplane manufacturing and workers are indifferent between the jobs, a pay differential will no longer be sustainable, and the wages for the two jobs will have to equalize.

11. Figure 16P-4 shows a local labour market for landscapers. What is the value of economic rent in this labour market? [LO 16.7] Answer: Economic rent is the difference between the price at which the owner of a factor of production is willing to supply that factor and the rental price that the owner receives. In the local labour market for landscapers, the value of economic rent is 0.5(400 − 0)(30 − 15) = $3,000.

12. Match the following aspects of factor markets with the corresponding characteristics. [LO 16.7] a. b. c. d. e.

analogous to producer surplus affected by an asset’s long run productivity interest pain on loans determined by ownership of factors of production determined by the value of marginal product

1 Demand for factors of production 2 Economic rent 3 Purchase markets for factors of production 4 Rental price of capital 5 Income

Answer: a. b. c. d. e.

Analogous to producer surplus: economic rent.

Affected by an asset’s long-run productivity: purchase markets for factors of production.

Interest paid on loans: rental price per capital.

Determined by ownership of factors of production: income.

Determined by the value of marginal product: demand for factors of production.

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13. Figure 16P-5 shows a local labour market. What is the quantity supplied and quantity demanded when the minimum wage is: [LO 16.8] a. At equilibrium? b. $15,000? c. $60,000?

Answer: a. If the minimum wage is set at equilibrium, the quantity demanded will equal the quantity supplied at 10 mechanics. b. If the minimum wage is set below equilibrium it is not effective and the equilibrium wage will prevail. The quantity demanded and the quantity supplied will occur at the equilibrium level of 10 mechanics. c. If the minimum wage is $60,000, the quantity supplied is 14 mechanics, but the quantity demanded is 8 mechanics.

14. The market for grocery-store baggers is a competitive labour market, as shown in Figure 16P-6. Suppose a new federal law raises the minimum wage to $10 per hour. [LO 16.8] a. What is the equilibrium wage rate prior to the law being enacted? b. What are total labour earnings at the equilibrium wage? c. How much labour is being hired at the minimum wage? d. What are total labour earnings with enactment of the minimum wage?

Answer: As seen in Figure 16P-6, the equilibrium wage rate is $8 per hour with equilibrium hours at 40 per week. Labour earnings are calculated as the wage rate multiplied by the hours worked, which in this case is $320. With imposition of a binding minimum wage (greater than $8 per hour), the quantity of hours demanded falls to 30 per week–this is the amount of labour business firms will hire even though workers are willing to supply up to 60 hours per week at this $10 minimum. Labour earnings fall to $300 per week. a. $8.00. b. $320 per week. c. 30 hours per week. d. $300 per week.

15. Imagine that, faced with budget shortfalls, a government changes its current policy of granting tax credits based on family size to a flat rate tax credit for a family with one or more children. [LO 16.9] a. Over time, what will happen to the average age in the population? b. Over time, what will happen to the size of the workforce?

Answer:

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a. A flat rate tax credit means the tax credit is the same whether a family has one child or many. The marginal cost of each subsequent child will rise, leading to smaller family sizes. Over time, average age in the population will increase. b. The workforce is proportional to the population. As the average age in the population increases, the average age in the labour force will also increase. Over time, as there are fewer new workers to replace retirees, the size of the workforce will decrease.

16. In each scenario, will wages rise above the market equilibrium or fall below it? [LO 16.9] a. All but one of the factories in a town go out of business. b. All the software engineers in Silicon Valley organize into a union and go on strike. c. A major grocery store chain buys out all the other stores in the city.

Answer: a. Wages will fall below equilibrium. The employer will have market power. b. Wages will rise above equilibrium. The workers will have market power. c. Wages will fall below equilibrium. The employer will have market power.

CHAPTER 17 INTERNATIONAL TRADE Chapter Overview The chapter takes a close look at one of the most powerful economic insights: There can be big gains from specialization and exchange. This is true for countries as well as individual people and companies. Even though the total gains from trade are usually positive on a national level, the distribution of those gains to different people and industries matters a lot in the real world.

There are usually winners and losers from trade, especially in the short run. The hope is that opening up to trade eventually makes everyone better off, but getting to that point requires responsive political solutions. Trade restrictions such as tariffs and quotas are used in varying degrees by every country in the world to protect some groups and industries from international competition. Some domestic policies, such as environmental and labour standards, can also affect trade. Because trade takes place across countries, the role of public policy in shaping international trade is more obvious than in most of the domestic topics we’ve covered so far.

In upcoming chapters, we’ll tackle other ways that public policy drives the economy, on both the domestic and international levels.

Learning Objectives LO 17.1: Define comparative advantage and list some root causes of comparative advantage on a national level. richard@qwconsultancy.com

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LO 17.2: Determine whether a country will become a net-importer or net-exporter of a good when it moves from autarky to free trade.

LO 17.3: Calculate the change in surplus and the distribution of benefits within a market when a country opens up to trade.

LO 17.4: Identify when and how an economy’s trade policies affect world supply of and world demand for a good.

LO 17.5: Explain the effect of a tariff on quantity, price, and the distribution of surplus.

LO 17.6: Explain the effect of an import quota on quantity, price, and the distribution of surplus.

LO 17.7: Describe the effects of trade on the factor distribution of income.

LO 17.8: Discuss the challenges of establishing environmental or labour standards in international markets.

Chapter Outline MADE IN LESOTHO

Why Trade? A Review Comparative Advantage (LO 17.1) Gains from Trade The Roots of Comparative Advantage Incomplete Specialization From Autarky to Free Trade Becoming a Net-Importer (LO 17.2) (LO 17.3) Becoming a Net-Exporter Big Economy, Small Economy (LO 17.4) Restrictions on Trade Why Restrict Trade?

Tariffs (LO 17.4) Quotas (LO 17.5) Trade Agreements International Labour and Capital (LO 17.6) The WTO and Trade Mediation Labour and Environmental Standards (LO 17.7) BOX FEATURE: FROM ANOTHER ANGLE – ARE ENVIRONMENTAL REGULATIONS BAD FOR THE ENVIRONMENT?

Embargoes: Trade as Foreign Policy BOX FEATURE: WHAT DO YOU THINK? – LIFT THE EMBARGO ON CUBA?

Beyond the Lecture richard@qwconsultancy.com

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Writing Assignment/Class Activity: Comparative Advantage (LO 17.1) Split the class into teams and have each team choose a country. Then have the each team research what their country produces and why the country produces it. Also, have the teams try to determine which goods and services their countries will trade with one another. You can show students this data from Statistics Canada to see which countries Canada trades with the most.

Class Discussion: Becoming a Net-Importer (LO 17.3) Have students view this brief clip of Don Boudreaux discussing the benefits of free trade.

1. What parties will gain if a country opens up to free trade?

2. What parties could be harmed if a country opens up to free trade?

3. Why do so many people both defend and critique free trade?

Class Discussion: Tariffs (LO 17.5) Show students Figure 11.4 from the World Trade Organization paper by Richard Baldwin (https://www.wto.org/english/res_e/reser_e/ersd201108_e.pdf).

1. What is the impact of tariffs on price and quantity sold in general?

2. What factors contributed to the drop in the average tariff rate over time?

Class Discussion: Tariffs (LO 17.5) Have students read this brief article from USA Today regarding the imposition of tariffs by the European Union on solar panels from China.

1. Why do countries impose tariffs?

2. What are the problems associated with the use of tariffs?

3. Do you think that tariffs are justified?

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Why might a country that is more productive in producing wheat than its trading partners end up importing wheat? [LO 17.1] Answer: A country trading on world markets will export goods for which it has a comparative advantage and import goods for which it does not have a comparative advantage. Comparative advantage is based on opportunity cost, not productivity. For example, Canada might be more productive than China at making clothes, but if China can produce clothes at a lower opportunity cost (perhaps through cheaper labour), Canada will import clothes from China.

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2. Imagine two nations with similar landmasses and levels of wealth that do not specialize in the same industries. What characteristics might drive differences in their comparative advantages? [LO 17.1] Answer: The two countries may differ in their relative access to labour or capital. If one of the countries has access to abundant labour, that country may specialize in labour-intensive goods. If the other country has wealth but a smaller labour pool, it may invest in capitalintensive goods. The two countries may differ in climate and natural resources as well, which will affect their relative comparative advantages. For example, if one country has more arable land and favorable climate, it will have the comparative advantage in agricultural production.

3. Producing socks is labour-intensive, while producing satellites is capital-intensive. If India has abundant labour, and Canada has abundant capital, which good will Canada export? Is trade beneficial to textile labourers in Canada? [LO 17.2] Answer: If India has abundant labour, and Canada has abundant capital, Canada will export satellites. If Canada is importing socks (textiles), it means that the world price for textiles is lower than the domestic price that would prevail under autarky. Domestic suppliers of textiles in Canada will supply less at the world price, which will not be beneficial to Canadian textile labourers.

4. Suppose Egypt wants to open its trade borders to the world market for natural gas. What will determine whether Egypt becomes a net-exporter or net-importer of natural gas? If Egypt becomes a net-exporter, will domestic supply be equal to, less than, or greater than domestic demand? [LO 17.2] Answer: Whether Egypt becomes a net exporter or net importer will depend on whether the domestic price of natural gas in Egypt is greater or less than the world price of natural gas. If the world price of natural gas is higher than the domestic price, Egypt has a comparative advantage and will export natural gas. Conversely, if the world price of natural gas is lower than the domestic price, Egypt will import natural gas. If Egypt exports, domestic supply will be greater than domestic demand. The excess supply of natural gas is what will be exported.

5. If Argentina becomes a net-exporter of beef after trade barriers are removed, how does total welfare in Argentina change compared with autarky? Are Argentine cattle ranchers better or worse off? What about Argentine consumers? [LO 17.3] Answer: If Argentina becomes a net exporter of beef after trade barriers are removed, total welfare in Argentina increases compared with autarky. Exports represent a new area of surplus that did not exist before Argentina traded on the world market. Argentine cattle ranchers are better off because they can sell more beef at higher prices. Argentine consumers are worse off because they have to pay the higher world price for their beef. On balance, the Argentine cattle ranchers gain more surplus than the Argentine consumers lose, so total surplus increases. richard@qwconsultancy.com

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6. Suppose a country opens its trade borders and becomes a net-exporter of beef. Is it better for domestic consumers of beef if the country is a large player on the world market or a small player? [LO 17.3] Answer: If a country becomes an exporter of beef, this is because the world price of beef is higher than the domestic price, which is bad for domestic consumers. If the exporting country is a small player on the world market, the addition of that country’s exports to the world market does not affect the world price. However, if the exporting country is large relative to the market for beef, the addition of that country’s exports to the world market will cause the world price to fall. Therefore, if a country becomes an exporter of a good, it is better for consumers if the country is a large player relative to the size of the world market.

7. Suppose Canada wants to open its trade borders to the world market for milk. What will determine whether the world price for milk is affected? [LO 17.4] Answer: For Canada to be a price taker in the global market for some good, the quantity it produces and consumes must be very small relative to the total amount of that good bought and sold worldwide. To determine whether or not Canada will influence the world price, we need to know how many producers and consumers of milk there are in Canada relative to the rest of the world.

8. Suppose that Japan is a net exporter of automobiles. If a large country like the United States moves from autarky to free trade in automobiles, how will the price of automobiles sold in Japan change? How will the amount of automobiles exported change? [LO 17.4] Answer: Because the United States both produces and consumes a lot of cars, when it enters the world market, it will likely influence the world price. However, without knowing whether the shift in the demand curve or the shift in the supply curve is greater, it's impossible to know if the world price will increase or decrease. Similarly, we cannot know if Japan will export more cars or fewer cars, as this depends on the change in world price.

9. Suppose Canada wants to protect its domestic poultry industry from US competition. How will a tariff on imported poultry products help it to accomplish this task? How does the tariff affect domestic producer and consumer surplus? [LO 17.5] Answer: A tariff is a tax on imports. By taxing imports, the price of poultry products rises from the world price to the world price plus the tariff. The higher price is good for domestic suppliers who cannot afford to supply at the lower world price. Domestic producer surplus increases but domestic consumer surplus decreases, as consumers now have to pay more for poultry products than they would if imports were not taxed.

10. Refer to Figure 17-9. Explain why area D is a dead-weight loss. What about area F? [LO 17.5]

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Answer: At the world price, domestic consumers demanded 30 million solar panels. After the tariff raises the price of solar panels, domestic consumers demand only 25 million. Area F represents the loss of surplus on the trades between 25 million and 30 million solar panels that no longer occur. The other area of deadweight loss (area D) represents the fact that domestic suppliers are unable to supply more than 8 million solar panels at the world price but are willing to supply 14 million after the tariff. Because the tariff raises the price, domestic suppliers who face higher opportunity costs for producing solar panels than importing countries wind up producing units that could be more efficiently supplied by countries with lower opportunity costs. Area D represents this inefficiency.

11. Imagine Mexico is considering using an import quota rather than a tariff to protect its domestic automobile industry. How does the outcome differ from that of a tariff? [LO 17.6] Answer: A quota is a cap on the quantity of imports rather than a tax on imports. Both policies will reduce the number of imports and raise the price above the world price. As with a tariff, domestic producers gain surplus, domestic consumers lose surplus, and there is deadweight loss. The main difference is that instead of tax revenue being collected by the government imposing the tariff, a quota transfers benefits to whoever holds the right to import (foreign firms or governments). The right to import is a resource that can be sold or traded for profits (quota rents).

12. Explain how lifting an import quota on other countries will affect an exporting country that had been exempted from the quota restriction. [LO 17.6] Answer: Lifting an import quota will lower the price back to the world price. If a country that was exempted from the import quota has a higher opportunity cost of producing than countries that can supply at the lower world price, the exempted country will not be able to compete once the quota is lifted.

13. Labour is relatively abundant in Mexico compared with arable land. Explain who wins and who loses in Mexico as a result of the newly signed (but not yet ratified) Canada–United States–Mexico Agreement (CUSMA), intended to liberalize trade between the Canada, the U.S., and Mexico.[LO 17.7] Answer: Liberalizing trade benefits owners of domestically abundant factors of production, in this case labourers in Mexico, because increased demand for the abundant factor increases its price. Conversely, liberalizing trade increases the supply of domestically scarce resources and lowers their price. Land owners would be the losers as a result of CUSMA. 14. If capital is domestically scarce in a country, do you expect owners of capital in that country to be free-traders or protectionists? Why? [LO 17.7] Answer: If capital is domestically scarce in a country, owners of capital in that country would likely be protectionists. The price of domestically scarce factors of production tends to

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decrease when trade is liberalized, so owners of that factor would see their incomes decline under free trade.

15. Suppose Great Britain wants to take a stance on labour standards for imports. The prime minister imposes a blanket standard that requires all imports to meet certain labour standards.

Who will benefit from this policy? What are the drawbacks for Great Britain and countries that export to Great Britain? [LO 17.8] Answer: Domestic producers in Great Britain competing with imports could benefit if they are already held to higher labour standards. Importing countries will no longer have a cost advantage based on lower labour standards. The main drawback for both Great Britain and the countries that export to Great Britain is that improving labour standards usually increases labour costs to suppliers. Suppliers to Great Britain will face higher production costs, which will mean consumers in Great Britain will have to pay more for goods that are produced and imported according to improved labour standards.

16. Suppose Canada imposes a trade embargo on North Korea in order to exert political pressure on the government. Consider how the embargo will affect Canadian producers. Under what conditions would they support the embargo? Why might they oppose it? [LO 17.8] Answer: Canadian producers will support the embargo if they are producing goods for which North Korea has a comparative advantage and can compete with cheaper imports. If Canadian producers have a comparative advantage and are exporting goods to North Korea, they will be harmed by the inability to trade with North Korea and may oppose the embargo.

Problems and Applications 1. If a country has relatively abundant unskilled labour, with scarce land and capital, it is more likely to have a comparative advantage in which of the following industries? Check all that apply. [LO 17.1] a. Food service. b. Textiles. c. Agriculture. d. Financial services.

Answer: Since the country has relatively abundant unskilled labour, with scarce land and capital, it will have a comparative advantage in sectors where large amounts of unskilled labour can be used: food service (a) and textiles (b).

2. Suppose Ghana discovers it has lost its comparative advantage in the production of maize.

Which of the following could explain the loss of comparative advantage? Check all that apply. [LO 17.1] a. Maize-processing technology developed in Ghana spreads to other maize-producing countries. richard@qwconsultancy.com

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b. Decline in global demand for maize. c. Immigration of cheap labour into Ghana. d. Growth of low-skill service jobs in Ghana.

Answer: Maize processing technology developed in Ghana spreads to other maize producing countries (a) and growth of low-skill service jobs in Ghana (d) could both explain the loss of comparative advantage.

3. Calculate the following values using Figure 17P-1, which shows domestic supply and demand for steel in the United States under autarky. [LO 17.2] a. What is the equilibrium price and quantity of steel under autarky? b. Suppose the post-trade domestic quantity supplied is 150 million. What is the domestic quantity demanded and the new world price? c. Is the U.S. a net-exporter or net-importer of steel? d. What quantity of steel is imported/exported?

Answer: a. The equilibrium price of steel is $300 per ton and the equilibrium quantity is 200,000 tons under autarky. b. If the post-trade domestic quantity supplied is 150 million, the world price must be $250 per ton. At $250 per ton, the domestic quantity demanded is 250,000 tons. c. The domestic quantity supplied is less than the domestic quantity demanded (the world price is less than the domestic equilibrium price), so the U.S. is a net-importer of steel. d. Domestic quantity supplied is 150,000 tons and domestic quantity demanded is 250,000 so the difference (100,000 tons) is imported.

4. Table 17P-1 shows the domestic supply and demand schedule for rice in Thailand. [LO 17.2] a. In autarky, what is the domestic quantity supplied and price? b. The world price of rice is $1.25 per kilogram. If Thailand opens up to trade in rice, what will be the new domestic price of rice? (Hint: You can assume Thailand is a small producer of rice relative to the world market.) c. What quantity of rice will be supplied by domestic producers? d. What quantity of rice will be demanded by domestic consumers? e. How much rice will Thailand import or export?

Answer: a. In autarky, the domestic quantity supplied is 2,500 million kilograms, and the price is $0.50/kg. b. If Thailand opens up to trade in rice and the world price is $1.25 per kilogram, the new domestic price of rice will be the same as the world price of $1.25 per kilogram. c. 2,800 million kilograms of rice will be supplied by domestic producers. d. 2,350 million kilograms of rice will be demanded by domestic consumers. e. Thailand will export 2,800m – 2,350m = 450 million kilograms of rice.

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5. Guatemala represents a small part of the world poultry market. Based on Figure 17P-2, answer the following. [LO 17.3] a. Calculate producer and consumer surplus in autarky. b. Assume that the world price of poultry is $0.30/kg. If Guatemala opens to trade, what is the domestic quantity consumed and produced? What is the quantity of imports? c. Calculate the post-trade producer and consumer surplus. Who is better off after trade?

Answer: a. Producer surplus: 0.5(100,000 − 0)(0.6 − 0.1) = $25,000. Consumer surplus: 0.5(100,000 − 0)(1.1 − 0.6) = $25,000. b. Domestic quantity consumed is 160,000 kilograms. Domestic quantity produced is 40,000 kilograms. The quantity of imports is 160,000 − 40,000 = 120,000 kilograms. c. The post-trade consumer surplus is 0.5(160,000 − 0)(1.1 − 0.3) = $64,000. Post-trade producer surplus is 0.5(40,000 − 0)(0.3 − 0.1) = $4,000. Consumers are better off after trade.

6. Guatemala represents a small part of the world poultry market, and is fully open to trade.

Suppose a $0.10/kg tariff is imposed on poultry imports. Based on Figure 17P-2, answer the following. [LO 17.3, 17.4] a. What is the quantity of poultry consumed and produced in Guatemala under the tariff?

What is the quantity of imports? b. Now suppose the tariff is eliminated and instead the world price of chicken feed increases significantly. This causes the world price of poultry to rise from $0.30/kg to $0.40kg.

What is the quantity of poultry now bought and sold in Guatemala? What is the quantity of imports? c. Compare the efficiency of the two situations. Calculate the deadweight loss under the tariff. Calculate the deadweight loss resulting from the higher price of chicken feed.

Answer: a. Domestic quantity consumed is 140,000 kilograms. Domestic quantity produced is 60,000 kilograms. The quantity of imports is 140,000 − 60,000 = 80,000. b. Domestic quantity consumed is 140,000 kilograms. Domestic quantity produced is 60,000 kilograms. The quantity of imports is 140,000 − 60,000 = 80,000. c. Deadweight loss under the tariff is 0.5(60,000 − 40,000)(0.4 − 0.3) + 0.5(160,000 − 140,000)(0.4 − 0.3) = 1,000 + 1,000 = $2,000. Deadweight loss resulting from the higher price for chicken feed = $0.

7. The world wheat market is shown in Figure 17P-3. [LO 17.4] a. What is the initial world price? b. Suppose a large wheat producer country like Canada has been an autarky but is now going to allow free trade. Draw the effect - the entrance of Canada into the world market has on the world supply and world demand curves. c. How will the world price be affected by the entrance of Canada into the world market?

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a. The world price is initially $5.50 b.

c. When a large economy enters a world market, both the world supply and the world demand increase. The magnitude of these increases will determine whether the world price increases or decreases. If the increase in world demand is larger than the increase in world supply, the world price will increase. If the increase in world supply is larger than the increase in world demand, the world price will decrease.

8. Canadian wheat market is shown in Figure 17P-4. Suppose Canada wants to protect its wheat industry by imposing a tariff of $1/bushel on foreign wheat, which currently sells at world price $4/bushel. [LO 17.5] a. Graph consumer and producer surplus after the $1/bushel tariff is imposed. b. How much revenue does the Canadian government collect from the tariff? c. Graph the deadweight loss associated with the tariff.

Answer: a and c. See the areas for consumer surplus (CS) and producer surplus (PS) on the graph below.

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b. The government collects $1 on each import. After the tariff, there are 20 million imports, so the import revenue is $20 million.

9. The Canadian wheat market is shown in Figure 17P-4. [LO 17.5] a. How many bushels of wheat should be allowed under an import quota in order to increase the world price from $4 to $5 per bushel? b. Graph the domestic producer surplus increase as a result of this quota? c. Graph the deadweight loss that results from this quota.

Answer: a. 20 million bushels of wheat should be allowed under an import quota in order to increase the world price from $4 to $5 per bushel. b and c. See the producer surplus (PS) and deadweight loss (DWL) in the graph below.

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10. Suppose a country imposes a tariff on coffee imports. Using the diagram of supply and demand in Figure 17P-5, identify the correct shaded areas as follows. [LO 17.3, 17.5, 17.6] a. In autarky, which area(s) comprise domestic consumer surplus? Which area(s) comprise domestic producer surplus? b. When the country opens up to trade, which area(s) do consumers gain as surplus? Which area(s) do producers lose? c. After trade, if an import tariff is imposed, which area(s) do domestic producers gain as surplus? Which do domestic consumers lose? d. With the tariff, which area is government revenue? e. Which area(s) represent deadweight loss as a result of the tariff? f. If the country uses an import quota instead of a tariff, what is the quota quantity if the quota price is $7?

Answer: a. Consumer surplus: A. Producer surplus: B, D, H. b. Consumers gain: B, C, D, E, F, G. Producers lose: B, D c. Producers gain: D. Consumers lose: D, E, F, G d. Government revenue: F. e. Deadweight loss as a result of the tariff: E, G. f. 60 million kilograms of coffee 11. Imagine a country where capital is scarce and most of industry is labour-intensive with lowskilled labour moves from autarky to free trade. Which of the following do you expect to happen? Check all that apply. [LO 17.7] richard@qwconsultancy.com

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a. Owners of capital become wealthier. b. Wages for labour increase. c. The returns to capital (surplus) decrease.

Answer: Wages for labor increase (b) and he returns to capital (surplus) decrease (c).

12. Suppose two countries are considering a new agricultural trade agreement with each other.

Country A has abundant low-skill labour and scarce land. Country B has abundant arable land but little population. In which country do land owners support a trade agreement? In which country do workers support a trade agreement? [LO 17.7] Answer: International trade equalizes the supply and demand of factors of production across countries. The price of domestically abundant factors increases due to increased global demand, and owners will gain surplus. Thus, land owners support a trade agreement in Country B. Workers support a trade agreement in Country A. 13. Suppose a country has abundant capital but scarce labour. Which group would be more harmed by a trade embargo: owners of capital or labourers? [LO 17.7, 17.8] Answer: Owners of capital would be more harmed by an embargo. If capital is domestically abundant, owners of capital have more to gain from international trade and will be harmed more by an embargo.

14. Which of the following policies is likely to cause more pollution displacement: imposing environmental standards on domestic production or a blanket environmental standard on all imports? [LO 17.8] Answer: Imposing environmental standards on domestic production will cause more pollution displacement because domestic producers will have an incentive to move production to countries where environmental standards are lower. A blanket environmental standard on all imports will reduce the incentive for suppliers to compete by locating production in places with lower environmental standards.

CHAPTER 18 EXTERNALITIES Chapter Overview Typically, we rely on the invisible hand of markets to maximize total surplus by allocating the right quantity of goods to the right people. But what happens when one person’s choices impose costs or benefits on others? Free-market outcomes can be less than ideal, and result in too much or too little of the good or activity in question. As the examples in this chapter show, richard@qwconsultancy.com

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positive or negative externalities are a common part of economic life. They’re the context for discussions of issues like climate change, pollution, blighted neighbourhoods, and education policy. Sometimes, individuals can find private solutions, by paying others to do, or to not do, things that affect them. However, the difficulty of coordinating or enforcing these private agreements often overwhelms the benefits. In these cases, we’ve seen that government policies like taxes and subsidies can actually increase efficiency, even though we typically think of them as creating distortions. This is because taxes and subsidies can counterbalance an externality by forcing buyers or sellers to take the value of the external cost or benefit into account. At first glance, quotas look like a simple way to counter the “too much” problem of negative externalities, but they fail to maximize surplus unless people are allowed to buy and sell the quotas.

In the “Public Goods and Common Resources” chapter, we’ll examine other challenges that are closely related to the idea of externalities. When goods are collectively owned, individuals have limited incentive to take into account the impact of their actions on the publicly held resources.

The resulting market failures and corresponding policy solutions look very similar to those we discuss in this chapter.

Learning Objectives LO 18.1: Explain how external costs and benefits affect the trade-offs faced by economic decision makers.

LO 18.2: Calculate the effect of a negative externality on market price and quantity, and measure the resulting change in surplus.

LO 18.3: Calculate the effect of a positive externality on market price and quantity, and measure the resulting change in surplus.

LO 18.4: Describe how individuals could reach a private solution to an externality, and explain why this doesn’t always occur.

LO 18.5: Show how a tax or subsidy can be used to counteract an externality, and discuss the pros and cons of such a solution.

LO 18.6: Show how quantity regulations and tradable allowances can be used to counteract an externality, and discuss the pros and cons of such a solution.

Chapter Outline THE COSTS OF CAR CULTURE

What Are Externalities?

External Costs and Benefits (LO 18.1) Negative Externalities and the Problem of “Too Much” (LO 18.2) Negative Production Externality Negative Consumption externality Positive Externalities and the Problem of “Too Little” (LO 18.3) richard@qwconsultancy.com

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Negative Consumption Externality Negative Production externality Private Solutions to Externality (LO 18.4) BOX FEATURE: FROM ANOTHER ANGLE – DOES NO-FAULT DIVORCE LAW INCREASE THE DIVORCE RATE?

Public Solutions to Externality (LO 18.5 and LO 18.6) Taxes and Subsidies (LO 18.5) Countering negative externality with a tax Capturing a positive externality with subsidy Quotas and Regulations (LO 18.6) Tradable Allowances (LO 18.6) BOX FEATURE: REAL LIFE – THE FIGHT OVER CAP-AND-TRADE LEGISLATION

Targeting Externalities with Public Policy

Beyond the Lecture Class Media: External Costs and Benefits (LO 18.1) In 2010, Frito-Lay decided that their environmentally-friendly Sun Chips bags would be discontinued due to “noise pollution.” The brief clip from the CBS Early show discusses this and is a great introduction to negative externalities.

Class Discussion: Negative Externalities (LO 18.2) Show students this brief clip from the TV show Seinfeld, from the Season 8 episode “The Chicken Roaster.” In the episode, Kramer is bothered by light from a local restaurant.

1. Does a resident have a right to darkness, or does a restaurant have the right to display a bright light?

2. How are disputes like these resolved?

3. How do negative externalities impact price and quantity?

Class Activity: Tradable Allowances (LO 18.6) Consider conducting this class activity designed by John Sloman about tradable pollution permits. (Note: After clicking the URL, open the “seven games that can be used to increase student motivation” PowerPoint to obtain handouts and worksheets. This activity is Game 7.) In the game, students are placed in teams and assigned a production schedule, marginal cost abatement curve, and the omissions allocation. Teams first have to determine optimal production without trading. Then ask the students to trade allocations to lower cost.

Solutions to End-of-Chapter Questions and Problems Review Questions

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1. Describe an externality not listed in the chapter. Is it positive or negative? Who is the economic decision maker, and who bears the external cost or benefit? [LO 18.1] Answer: Having a loud party in your apartment will create an externality because the noise will affect your neighbours. Some neighbours may see this as a positive externality if they like your music, but most people think negatively of noisy parties to which they are not invited. The person who hosts the party is the economic decision-maker and the external costs are born by the neighbours.

2. Consider the decision to adopt a dog. Describe a private cost, a private benefit, an external cost, and an external benefit that result from your decision to adopt a dog. [LO 18.1] Answer: A private cost of adopting a dog could be the adoption fees or food for the dog. A private benefit is the enjoyment you get from your new companion. An external cost could be that your dog barks a lot and this annoys your neighbours. An external benefit could be that your barking dog discourages intruders and trespassers from your neighbours’ property as well as yours.

3. What are the private costs and benefits associated with smoking cigarettes? What are the external costs? If smokers paid the social cost of cigarettes, what would happen to demand?

[LO 18.2] Answer: The private costs to cigarette smoking include the price of the cigarettes and damage to the smoker’s lungs. Private benefits include the pleasure of smoking and any desirable effects from nicotine. The external costs include the smell and the negative effects of second-hand smoke. If smokers paid the social cost of cigarettes, demand for cigarettes would decrease to reflect that smokers had internalized the external cost.

4. Manufacturing by U.S. factories and coal power plants in the northeastern states causes acid rain that falls on Canadian soil. This acid rain has put Canadian forests and lakes in danger.

Explain why this situation constitutes a negative externality, how it leads to too much air pollution in northeastern US states, and what it would mean for US power plants to internalize the externality. [LO 18.2] Answer: U.S. power plants are not considering the external costs of their operations, only their private costs. When there are relevant costs not taken into account by decision-makers, the result is that they produce or consume too much. If external costs were internalized by U.S. power plants, it would mean that these external costs would become part of U.S power plant’s decision-making when they consider how much to produce. Internalizing the externality would increase the total costs to U.S. power plants and less production may occur.

5. If education has private benefits to an individual as well as external benefits to society, explain why a less-than-optimal amount of education occurs. [LO 18.3]

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Answer: People take into account only their own costs and benefits of education when they decide how much to obtain. An individual will obtain more education only if the private benefits he or she expects are greater or equal to the private costs. External benefits typically do not affect a private decision-maker.

6. Hand washing has external health benefits, helping prevent the spread of communicable diseases. If a program were somehow devised so that people got paid a small reward every time they washed their hands, how would it affect the number of people who are sick at any given time? [LO 18.3] Answer: If a program were somehow devised so that people got paid a small reward every time they washed their hands, the social benefits of hand-washing would be internalized and people would wash their hands more. This would reduce the number of people who are sick at any given time.

7. Jimi loves turning up his electric guitar amp all the way, but his next-door neighbour hates listening to him. How might Jimi and his neighbour reach a private solution to their problem?

Describe potential problems that might make it hard for a private solution to occur. [LO 18.4] Answer: One way Jimi and his neighbour could work out a private solution is if the neighbour offers to pay Jimi to keep the noise down. This solution could be problematic if it is difficult to enforce. Suppose the neighbour pays Jimi, but Jimi continues to keep his amp too loud. The police might fine Jimi separately if they agree he is disturbing the peace, but would not enforce the private agreement between Jimi and his neighbour.

8. Felix and Oscar are roommates. Oscar is messy, and Felix is planning to move out unless they can come to an agreement. For the roommates to reach a private solution, does it matter whether Oscar compensates Felix for being messy or Felix pays Oscar to clean up? [LO 18.4] Answer: It does not matter whether Oscar compensates Felix for being messy or Felix pays Oscar to clean up. Either approach could resolve the problem as long as it is enforceable.

9. Suppose that you are an economic-policy advisor. Environmental groups are pressuring you to implement the highest-possible carbon tax, while industry groups are pressuring you to implement no carbon tax at all. Both argue that their position makes more sense economically. Explain to them what the most-efficient tax level will be, and why there are costs to setting the tax too high or too low. [LO 18.5] Answer: Both positions would lead to inefficiency. No tax at all would mean that industry groups would continue to overproduce by not internalizing the pollution externality they are creating. A tax that is too high, though, is also inefficient and leads to underproduction. The correct level of tax is one that is equal to the external cost.

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10. In what circumstances will a tax make a market less efficient? In what circumstances will a tax make a market more efficient? [LO 18.5] Answer: A tax will be distortionary and create a deadweight loss if the market is functioning efficiently (there are no externalities or other market failures). However, if a market is inefficient to begin with, such as when decision-makers do not account for a negative externality in their consumption or production decisions, a tax can be corrective rather than distortionary. A tax is a neutral policy instrument that shrinks a market (reduces the number of trades). Therefore, a tax can be efficiency-enhancing if the market is overproducing, as with a negative externality.

11. The city of Kingston, Ontario, limits garbage collection for each household to one standard bag of garbage per week. There are fees for any extra garbage collected from the curb. Is this policy the most efficient way of reducing waste? Why or why not? [LO 18.6] Answer: A quota is not the most efficient policy, because allowing everyone the same quantity does not account for the differences in marginal benefits between households. With a tax, everyone is charged the same amount per bag of garbage, so each household can decide how many bags to set out based on the price and their marginal benefits. This will create variety among households in terms of how many bags they have collected, but if the tax level is set correctly, the same overall quantity of bags can be achieved as under the quota policy.

12. Suppose an environmental impact study shows that the coral reef near Port Douglas, Australia, can sustain 20 scuba diving tours per week. Discuss the pros and cons of setting a quota of 20 dive tours per week. [LO 18.6] Answer: The benefit of using a quota is that because the critical amount of tours that the reef can sustain is known, the quota will ensure that the sustainable amount occurs. Using a tax is more efficient, but knowing the correct level to set the tax in order to ensure that the critical quantity is not exceeded can take some tinkering and is subject to change (for example, due to increased incomes and an increase in demand). Quotas are sometimes used when getting the quantity right is very important.

13.

The city of Kingston, Ontario limits each household to one bag of free garbage collection per week. Citizens have to pay a fee and buy a tag for extra garbage bags to be collected from the curb. Suppose that a neighbourhood group in Kingston organizes a group of families so that those who plan to go over their one-bag garbage quota can find households that are under their quota and pay them to put out the extra trash. Does this change the efficiency of the policy? [LO 18.6] Answer: Yes. If the families can trade or compensate each other for garbage collection rights, an efficient outcome can occur. As long as the families who are under-capacity on garbage collection do not charge the other families more than the fee for going over the allowance, being able to trade in this way will improve efficiency.

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14. Suppose the government is considering two policies to limit factory air pollution: taxing producers, or providing each producer with an allotment of permits they may trade with other producers. If both policies lead to the same amount of pollution reduction, why might producers prefer the tradable-permit option? [LO 18.6] Answer: Producers might prefer the tradable permit option because rather than extracting money from the industry in the forms of tax revenues, the tradable permit systems allows suppliers in the industry to compensate each other. For example, a producer might go out of business if taxes are too high; but the same producer might go out of business because they value the permits the least and decided to sell off their allotment of permits to a producer who values them more. Either way, the producer goes out of business, but under the permit system she is compensated in the form of the revenue she receives on the sale of her permits.

Problems and Applications 1. State whether each of the following primarily causes an external cost or an external benefit.

[LO 18.1] a. Fishing at a popular lakeside vacation spot. b. Buying a fax machine. c. Conducting research to find an AIDS vaccine. d. Occupying a seat on a bench in a crowded park. e. Littering. f. Spaying or neutering your pet.

Answer: An external cost is a cost imposed without compensation on someone other than the person who caused it. An external benefit is a benefit that accrues without compensation to someone other than the person who caused it. a. External cost. b. External benefit. c. External benefit. d. External cost. e. External cost. f. External benefit.

2. You are considering whether to enter a holiday lights display contest that pays $1,000 to the winner. State whether each of the following constitutes private costs, private benefits, external costs, or external benefits. Check all that apply. [LO 18.1] a. Increased traffic congestion and difficulty parking on your street. b. Increased electric bill from the holiday lights. c. Winning the holiday lights display contest.

Answer: A private benefit is a benefit that accrues directly to the decision-maker. A private cost is a cost that falls directly on an economic decision-maker. An external cost is a cost imposed without compensation on someone other than the person who caused it. An external

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benefit is a benefit that accrues without compensation to someone other than the person who caused it. a. Private cost and external cost. b. Private cost. c. Private benefit.

3.

The weekly supply and demand for packs of cigarettes in Carcinia is given in Figure 18P-1.

[LO 18.2] a. Suppose cigarette smoking causes a $6/pack external cost on non-smokers. Draw the demand curve that would exist if the externality associated with smoking were internalized by consumers. b. How many packs of cigarettes are consumed per week? c. What is the efficient number of cigarette packs? d. What would be the total gain in surplus if this externality could be internalized?

Answer: a. See the graph below.

b. c. 14 million packs of cigarettes are consumed per week. d. 10 million is the efficient number of cigarette packs. e. The total gain in surplus if this externality could be internalized is 0.5(14M - 10M)($20 $14) = $12 million.

4. Figure 18P-2 shows the marginal private benefit to a Canadian farmer in Ontario for irrigating his land. It costs $100 per acre to irrigate the land. Each acre of land irrigation generates a litre of salty runoff that winds up in the Great Lakes. It costs $50 per litre to

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desalinate the river water so other U.S. and Canadian farmers can irrigate their crops. [LO 18.2] a. Draw the marginal private cost of irrigation on the graph. b. Draw the marginal social cost of irrigation on the graph. c. How many acres will the Canadian farmer irrigate? d. What is the efficient level of irrigation? e. What would be the total gain in surplus if this externality could be internalized?

Answer: a and b. See graph below.

c. The Canadian farmer will irrigate as long as the marginal benefits are greater than or equal to the marginal private costs. The private costs to irrigate are $100/acre, so the farmer will irrigate 60 acres. d. The efficient level of irrigation is 40 acres. e. The total gain in surplus if this externality could be internalized would be: 0.5(60 40)($150 - $100)=$500.

5. Figure 18P-3 shows supply and demand for planting trees, based on private costs and benefits. Trees sequester carbon, meaning that they help counter-act pollutants that contribute to climate change. [LO 18.3] a. Suppose that the carbon sequestration that results from planting a tree is worth $4. Graph the supply curve for tree planting based on the social benefits of trees. b. How many trees will be planted? c. What is the socially optimal quantity? richard@qwconsultancy.com

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d. How much surplus is lost when suppliers are unable to capture the $4 external benefit they provide from planting trees?

Answer: a. See graph below.

b. 30 trees will be planted. c. The socially optimal quantity of trees is 40. d. 0.5(40 − 30)($10 − $6) = $20 in surplus is lost when suppliers are unable to capture the $4 external benefit they provide from planting trees.

6. Figure 18P-4 shows supply and demand for first-aid training, based on private costs and benefits. [LO 18.3] a. Suppose that the external benefit from first-aid training is worth $6. Graph the demand curve for first-aid training based on the social benefits. b. How many hours of first-aid training will occur? c. What is the socially optimal quantity of first-aid training? d. How much surplus is lost when consumers are unable to capture the $6 external benefit they provide from first-aid training?

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Answer: a. See graph below.

b. 10 hours of first aid training will occur. c. The socially optimal quantity of first aid training is 14 hours. d. 0.5(14 − 10)($20 − $14) = $12 in surplus is lost when consumers are unable to capture the $6 external benefit they provide from first aid training.

7. Your neighbour never mows her lawn. You don’t have any legal right to force her to mow, but the mess in her front yard is making your neighbourhood unsightly and reducing the value of your house. The reduction in the value of your house is $5,000, and the value of her time to mow the lawn once a week is $1,000. Suppose you offer her a deal in which you pay her $3,000 to mow. How does this deal affect surplus? [LO 18.4] a. The deal increases only your surplus. b. The deal increases only your neighbour’s surplus. c. The deal increases both your surplus and your neighbour’s. d. The deal increases your surplus but decreases your neighbour’s. e. The deal increases your neighbour’s surplus but decreases yours. f. The deal does not affect surplus.

Answer: c. The deal increases both your surplus and your neighbour’s. richard@qwconsultancy.com

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8. The local government has decided that because children’s health has large external benefits, it will offer a subsidy to help families pay for visits to the pediatrician. However, the government isn’t sure at what level to set the subsidy. Figure 18P-5 shows the current demand curve for pediatricians’ visits (D1), and three alternative subsidies, represented by curves D2, D3, and D4. [LO 18.5] a. Assume that the correct level of subsidy is D3. Compared to the efficient outcome, graph the loss in total surplus that would result from subsidies D2 and D4. b. What is the socially optimal level of pediatrician visits?

Answer: a. See graph below.

b. The socially optimal level of pediatrician visits is 350 visits.

9. Figure 18P-6 shows the daily market for water-skiing permits on Shuswap Lake, BC. Suppose each skier (each permit) causes $4 of damage to the lake. [LO 18.5] a. Calculate the loss of surplus if there is no government intervention in this market. b. Suppose the government imposes a $12 tax on suppliers of ski permits. Compared to no intervention, what is the net surplus gain or loss from this tax? c. What is the socially optimal level of water skiing?

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Answer: a. The loss of surplus if there is no government intervention in this market is 0.5(40 − 30)($4 − $0) = $20. b. The tax corrects the $20 surplus loss from over-skiing but the tax is $8 too large (the correct tax should be $4, not $12), which creates a surplus loss of 0.5(30 − 10)($12 − $4) = $80. Therefore, the tax creates a surplus gain of $20 and a surplus loss of $80 so, on net, a surplus loss of $60. c. The socially optimal level of permits is 30 permits.

10. Suppose certain fireworks are legal in a residential area on Canada Day. The fireworks have been approved for safety, but they do cause noise pollution so their use must be limited.

Jenny and Salo like to purchase fireworks for their families; Table 18P-1 shows the net marginal benefit that Jenny and Salo gain from each firework they purchase. [LO 18.6] a. If a quota of 30 fireworks per person is imposed, what is the marginal benefit of the last firework for each? b. What is the amount of tax that will achieve the same total number of fireworks to be purchased between Jenny and Salo? How many fireworks will each purchase under this tax? c. Under a tax, what is the net marginal benefit of the last firework for each after the tax is subtracted?

Answer: a. For Jenny, the marginal benefit of the 30th firework is $7. For Salo, the marginal benefit of the 30th firework is $4. b. A $6 tax will achieve the same total number of fireworks to be purchased between Jenny and Salo. Jenny will purchase 40 fireworks and Salo will purchase 20 fireworks. c. Under the tax, the net marginal benefit of the last firework for both Jenny and Salo is $0.

11. Table 18P-2 shows current carbon emissions and the cost of reducing carbon emissions for three industrial firms. The government introduces a cap-and-trade policy to regulate carbon emissions. The total cap on emissions is 180 tons of carbon, and each firm receives an initial allocation of tradable permits for 60 tons of carbon emissions. [LO 18.6] a. Which firm(s) will buy emissions permits? How many will they buy and from whom? b. What is the minimum amount the selling firm must receive to break even?

Answer: a. Firm A will buy 20 permits from firm C. Firm B will buy 40 permits from Firm C. b. If Firm C does not sell permits, it will need to reduce emissions by 10 tons at a cost of $50(10) = $500. If Firm C sells all of its permits, it will have to reduce its emissions by 70 tons at a cost of $50(70) = $3,500. Therefore, Firm C needs to receive at least $3,000 (the difference in the reduction costs with and without permits).

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12. There are three major ferry lines operating in Vancouver, each generating 100 units of pollution per year. The ferry lines face the costs of reducing pollution that are shown in Table 18P-3. [LO 18.6] a. The BC government has decided it wants to reduce pollution levels by 50 percent and requires each ferry line to cut its pollution in half. What is the cost of pollution reduction for each ferry line, and what is the total cost of pollution reduction? b. Suppose the government decides to give each ferry line 50 tradable permits. Each permit allows a ferry line to produce one unit of pollution. Which ferry line will buy permits?

How many permits will it buy and from whom? c. What is the total cost of pollution reduction under this system of tradable permits?

Answer: a. Each ferry line must reduce pollution by 50 units. For ferry line A, this will cost $1,500(50) = $75,000. For ferry line B, this will cost $2,500(50) = $125,000. For ferry line C, this will cost $1,800(50) = $90,000. The total cost of the pollution reduction is therefore $290,000. b. Ferry line B will buy 50 permits from ferry line A. The ferry lines face different costs in pollution reduction, so there is room for trade. Ferry line B faces the highest costs to reduce pollution, so this ferry line values the permits the most. It is willing to pay up to $2,500 for each permit. Ferry line B will buy 50 permits from ferry line A. Ferry line B will buy from ferry line A instead of ferry line C because ferry line A values the permits least (its costs of reducing pollution are the lowest), and it will sell at a lower price than ferry line C would sell. Also, ferry line A sells to ferry line B instead of to ferry line C because ferry line B values the permits the most, and it will offer a price higher than ferry line C would offer. c. Ferry line A will reduce pollution by 100 units (because it now has zero permits) at a cost of $1,500(100) = $150,000. Ferry line B will face no abatement costs because it has 100 permits. Ferry line C will reduce pollution by 50 units at a cost of $1,800(50) = $90,000.

The total cost of pollution reduction under this system is $240,000.

CHAPTER 19 PUBLIC GOODS AND COMMON RESOURCES Chapter Overview Public goods and common resources are an important source of market failure. Generally speaking, unregulated public goods will encounter the free-rider problem, in which nonexcludability leads to undersupply. On the other hand, unregulated common-resource goods will fall prey to the tragedy of the commons, which occurs when non-excludability and rivalry combine to cause overconsumption and depletion of the resource. These challenges can be overcome through a variety of solutions. In some cases, strong social norms or local organizations can improve excludability and increase the cost of free riding or overconsumption enough to avoid market failure. In other cases, government can step in, enforcing bans or richard@qwconsultancy.com

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quotas to limit the use of a common resource. Sometimes, it makes sense for government to simply provide a public good to counteract undersupply. In general, limits on use work only when they are backed by sufficiently strong monitoring and enforcement. In places where this is not the case, privatization or combined public-private solutions can harness individual incentives to manage use and improve excludability. In the next chapter, we’ll look into the practical details of how governments fund the provision of public goods and other services.

Learning Objectives LO 19.1 Define different types of goods in terms of rivalry and excludability.

LO 19.2 Describe the free-rider problem and its consequences.

LO 19.3 Explain how and when problems with public goods can be effectively solved by social norms, government provision, and expansion of property rights.

LO 19.4 Describe the tragedy of the commons and its consequences.

LO 19.5 Explain how and when problems with common resources can be effectively solved by social norms, government regulation, and expansion of property rights.

Chapter Outline A NEW TRAGEDY OF THE COMMONS

Characteristics of Goods (LO 19.1) Excludable Goods Rival-in-Consumption Goods Four Categories of Goods Public Goods The Free-Rider Problem (LO 19.2) BOX FEATURE: FROM ANOTHER ANGLE – WHY DOES WIKIPEDIA WORK?

Solutions to the Free-Rider Problem (LO 19.3) Common Resources The Tragedy of the Commons (LO 19.4) Solutions to the Tragedy of the Commons (LO 19.5) BOX FEATURE: WHAT DO YOU THINK? – SHOULD CONSERVATIONISTS BE PRINCIPLED OR PRAGMATIC? BOX FEATURE: REAL LIFE – CANADIAN FISHERIES LEARN FROM FAILURE

Beyond the Lecture Class Media: Characteristics of Goods, The Free-Rider Problem, and The Tragedy of the Commons (LO 19.1, LO 19.2, LO 19.3) Have students watch the episode Canvassing from Season 1 of the TV show Parks and Recreation. Much of this episode is relevant to these topics, although you can choose scenes to suit your preference. The episode is centered on a town hall meeting to discuss turning an richard@qwconsultancy.com

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abandoned construction site into a park. This media can be used to start a conversation about public goods, the free-rider problem, and the tragedy of the commons.

Class Media: Characteristics of Goods, The Free-Rider Problem, and The Tragedy of the Commons (LO 19.1, LO 19.2, LO 19.3) Show students this clip from the episode The Pledge Drive from the TV show Seinfield. In the episode, Jerry hosts a fundraiser for a television station. This clip can be used to highlight public goods and the free-rider problem.

Class Activity: The Free-Rider Problem (LO 19.2) An interesting activity to highlight the potential for a free-rider problem is to pretend to ‘sell’ a course grade to the entire class. Tell students that they will all receive the same grade regardless of their cash contribution. You can set the prices for various grades. Discuss the following: 1. Who in the class would be willing to pay? How much would you pay? Remind them that it is just a game.

2. How would they come to a consensus as a class regarding the choice of grades?

3. What will students who already expect a good grade do?

4. Can the students think of any ways to address the free-rider problem?

You can then discuss how students deal with the free-rider problem in their own lives through issues with roommates, group members in a team for a class project, etc.

Writing Assignment/Class Discussion: Bans, Quotas, and Government Provision (LO 19.5) Have students read this brief article from the Wall Street Journal on crab fishing regulations. In the article, the author discusses the regulations that are set in place to limit the number of crab caught to avoid overfishing. Previous regulations set a quota for the entire industry, and firms raced to catch crab before the quota was filled. The article discusses the new regulations.

1. How could regulation be used to protect against overfishing?

2. What was the problem with the old quota system? How is the new system an improvement?

3. What are some problems with the use of regulation to address a public goods problem?

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Popular software can cost thousands of dollars even though the marginal cost of producing another copy on CD or via download is near zero. What kind of good are these programs?

[LO 19.1] Answer: Copies of software are excludable--it is possible to restrict people from accessing software unless they purchase a license. Because the cost of reproducing copies of software richard@qwconsultancy.com

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is practically zero, and one person purchasing a copy or license does not deplete the supply for others to purchase, copies of software are non-rival. Goods that are excludable and nonrival are artificially scarce goods.

2. Suppose a popular band decides to hold a free concert in its hometown. Admission is available on a first-come, first-served basis. Is the concert a public good? [LO 19.1] Answer: No. A good offered for free is not necessarily a public good. Concerts are excludable. It is possible to charge an entrance fee. And because a limited number of people can attend the concert, it is rival. A good that is both excludable and rival is a private good.

The band has offered a private good for free to those who arrive early enough to get seats.

3. A talented musician plays for tips on the street, but never seems to make very much money.

Explain why his tip jar is never very full. [LO 19.2] Answer: The musician does not make a lot of tips because of the free-rider problem. The street musician cannot exclude people who do not tip from stopping to listen. People can listen to and enjoy his music for free and hope that others will tip him so he returns and continues to entertain them.

4. Suppose a community garden in your neighborhood has both individually owned plots and a large, common plot. If soil and sunlight conditions are the same everywhere in the garden, explain why tomatoes grown in individually owned plots are so much better than tomatoes grown in the common plot. [LO 19.2] Answer: All else equal in terms of growing conditions, tomatoes from the commonly held plot will be lower quality than tomatoes from private plots because gardeners will have an incentive to spend their time and effort on their private plots and free ride on the effort needed to maintain the common plot. After working on her own plot, a gardener may decide to go home and hope someone else will water and weed the common plot.

5. Why is it difficult for private markets to provide the optimal quantity of a public good? Why is it difficult for government to provide the optimal quantity of a public good? [LO 19.3] Answer: It is difficult for private markets to provide the optimal quantity of a public good because, by definition, a nonrival good has zero marginal cost of providing the good to another user. If efficient pricing is P = MC, the efficient price of a public good is zero (free).

Private markets are not interested in providing goods for free. It is difficult for government to provide the optimal quantity of a public good because even though government can provide goods without direct user fees via taxation, it is difficult to know the efficient quantity. The efficient quantity of a public good is the quantity where the marginal social benefit equals the cost, but understanding the marginal social benefit requires knowing the marginal benefit to each individual user. This information is difficult to obtain, and beneficiaries of public goods have an incentive to overstate benefits when government provision is expected. As a result,

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government generally relies on a best guess to choose the quantity of a public good to provide.

6. Consider a fund-raising campaign for your school’s library. What is the free-rider problem in this situation? How might publicly listing the names of donors to the library fund affect this problem? [LO 19.3] Answer: The free-rider problem is that people will be tempted to let others contribute to the library fund-raiser even though all members of the school community will benefit from improvement to the library. Publicly listing the names of donors to the library fund exerts extra pressure to donate because everyone will be aware of who has contributed and who has not.

7. Aquifers are underground sources of clean water that stretch over thousands of square miles.

People who own land over the aquifer are free to take as much as they want. What is likely to happen to water supplies in an aquifer? Is this efficient? [LO 19.4] Answer: Water supplies in an aquifer would be expected to fall from overuse. If people do not have to pay for the resources they use, overuse is usually the result. This is not efficient.

The efficient amount of water use would involve imposing costs on people for what they use.

8. Which do you expect to be more sustainable: grazing on public land or grazing on privately owned pastures? Why? [LO 19.4] Answer: Grazing on privately owned pastures should be more sustainable than grazing on public land because private land owners have an incentive to allow only the amount of grazing that will keep the resource of their pasture sustainable for future grazing. In public land, ranchers would lack the individual incentive to keep grazing to a sustainable level.

9. Even though many school zones don’t have much traffic and aren’t regularly monitored by the police for speed, most drivers are very careful to drive at or below speed limits when near schools. Why might this be the case even in the absence of strong government intervention?

[LO 19.3] Answer: Most people are likely to respect the importance of looking out for the safety of children. People might drive cautiously not because they fear getting a ticket but because being mindful of the safety of children is the right thing to do. This understanding is reinforced through a strong social norm that children are to be protected by all members of the community.

10. Consider a proposal to privatize street lighting. Would this be feasible? Why or why not?

Does street lighting suffer from a tragedy of the commons problem? [LO 19.3, 19.5]

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Answer: It would not be feasible to privatize street lighting because it is not possible to exclude users who do not pay. However, street lighting does not suffer from a commons problem because it is not rival. One person benefiting from street lighting does not diminish its benefits for others.

11. The government of India has made killing Bengal tigers illegal, but poaching of the endangered animal continues. List some possible reasons that the ban hasn’t been very successful, and suggest an alternative approach. [LO 19.5] Answer: Making something illegal is not effective if the punishment is weak or if there is not strong monitoring and enforcement. If poachers know that enforcement is weak, they may reason that the potential profit from illegal poaching outweighs the risk of being caught.

Another approach might be to create private incentives for protecting the tigers by allowing people to earn money from controlled use of the tigers, such as through eco-tourism.

12. The Canadian government is concerned about the huge numbers of people converging on Banff and Jasper National Parks every year. Government officials are worried that the parks might be getting overused and the natural beauty will be ruined as a result. Suppose someone suggests dividing the parks into private lots and selling it to individuals. How might this solution address the tragedy of the commons that is occurring? [LO 19.5] Answer: Dividing the parks into private lots and selling it to individuals would address the tragedy of the commons problem because each land owner would have to bear all of the costs and benefits of her choices about how many people to allow on the land each year. By assigning property rights over a common resource, each owner has the potential for commercial benefit and has an incentive to keep the land well-preserved so that they can enjoy current and future profits.

Problems and Applications 1. Identify whether each of the following goods is usually excludable or non-excludable. [LO 19.1] a. AM/FM radio. b. A round of golf on a course. c. Street art. d. A museum exhibition. e. Toll roads.

Answer: When a good is excludable, it is possible for sellers to prevent its use by those who have not paid for it. a. Non-excludable. b. Excludable. c. Non-excludable. d. Excludable. richard@qwconsultancy.com

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e. Excludable.

2. Identify whether each of the following goods is rival or non-rival. [LO 19.1] a. Cable TV. b. A pair of jeans. c. Street signs. d. Attending a baseball game.

Answer: When a good is rival in consumption (or just rival), one person’s consumption prevents or decreases others’ ability to consume it. a. Non-rival. b. Rival. c. Non-rival. d. Rival.

3. Consider community safety or defense, meaning freedom from crime and threats, to answer the following questions. [LO 19.2] a. What sort of good is community safety? b. If you lived in a place with no government-funded police force, would you expect community safety to be oversupplied or undersupplied? c. Suppose that some neighbors get together and organize a block watch group. What term do economists use to describe someone who lives in the neighborhood but chooses not to volunteer as part of the block watch?

Answer: The free-rider problem occurs when the non-excludability of a public good leads to undersupply. A public good is a good that is neither excludable nor rival. a. Public good. b. Undersupplied. c. A free rider.

4. From the list below, which of the following do you expect to suffer from a free-rider problem? Check all that apply. [LO 19.2] a. Pay-what-you-can yoga classes. b. Unlimited yoga classes with monthly membership dues. c. Fundraiser for public television. d. Neighborhood park cleanup day. e. Housecleaning business operating in your neighborhood. f. Suggested museum-admission donation.

Answer: a, c, d, and f. The free-rider problem occurs when the non-excludability of a public good leads to undersupply.

5. Which of the following subway announcements are attempts to establish or enforce a social norm? [LO 19.3] richard@qwconsultancy.com

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a. “Loud music and phone conversations are discourteous to fellow riders. Please keep the noise down.” b. “If you see something, say something.” c. “Please watch your step as you exit. Be careful of the gap between the train and the platform edge.” d. “Please be patient and allow others to exit the train before you attempt to enter.” e. “The train is being held at the station due to traffic ahead. We apologize for the inconvenience.”

Answer: a, b, and d.

6. Would you expect tourists or locals to be more likely to give up their seat on a bus to an elderly person? [LO 19.3] Answer: Locals would be more likely to give up their seat on a bus to an elderly person.

Locals are more likely to feel invested in their community. And they are more likely to fear being judged by people who might recognize or know them if they do not give up their seat.

7. Consider the following government-provided goods. Which of these goods necessarily require funding via general taxation (as opposed to direct user fees)? [LO 19.3] a. b. c. d. e.

Street lights.

A park.

A fireworks display.

Public radio.

A library.

Answer: a, c, and d. Each of these require general taxation instead of user fees because they are non-excludable. Parks and libraries are excludable and could include user fees.

8. In much of Canada and the United States, logging takes place in both privately owned and government-owned forests. [LO 19.4] a. Are privately owned forests excludable? Are they rival? What type of good are they? b. Suppose that anyone is legally allowed to enter a government-owned forest and start logging. What type of good are these forests? c. Do you expect the rate of logging in government-owned forests to be faster, slower, or equal to the efficient level?

Answer: a. Privately owned forests are excludable and rival. They are a private good. b. These forests are common resources. c. The rate of logging in a government-owned forest would be faster than the efficient level. richard@qwconsultancy.com

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9. Suppose that the government decides to start regulating use of its forests, charging anyone who wants to log. Which of the following ways of calculating the price to charge for each acre will lead to an efficient quantity of logging? [LO 19.4] a. The sum of the marginal social value of each acre to all logging companies. b. The average price citizens say they would be willing to pay for an acre. c. The external cost that logging an acre imposes on all citizens.

Answer: c. The external cost that logging an acre imposes on all citizens.

10. Determine whether each of the following policy interventions is designed to increase supply or decrease demand for a public good or common resource. [LO 19.3, 19.5] a. A city government increases the frequency of street sweeping. b. London begins charging a toll to all vehicles that drive within the city limits. c. A gated community passes a bylaw requiring all homeowners to mow their lawns once a week during the summer. d. Parks Canada increases the cost of a pass to enter the Jasper national park.

Answer: a. Increase supply. b. Decrease demand. c. Increase supply. d. Decrease demand.

11. Public-opinion polls in a small city have revealed that citizens want more resources spent on public safety, an annual fireworks display, and more community swimming pools. Which of these three citizen requests could be privatized by assigning property rights? [LO 19.5] Answer: Swimming pools could be privatized by assigning property rights because they are excludable and it is possible to charge entrance fees.

12. For each of the following examples, state which of these approaches is being taken to manage a common resource or supply a public good: social norms, quota, tradable allowance, government provision, or property rights. [LO 19.3, 19.5] a. A nonprofit organization spray-paints signs on storm drains reminding everyone that it “drains to the ocean” with a picture of a fish. b. A city starts a free program that collects recyclable glass, paper, and plastic from residents’ doorsteps. c. In England, municipal-waste authorities are given a percentage of an overall limit that can be put in the landfill each year. These percentages can be traded among municipalities. d. American bison, which once roamed freely across the Great Plains, are now raised on ranches for commercial purposes.

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a. b. c. d.

Social norms.

Government provision.

Tradable allowance.

Property rights.

13. There is a road between the suburbs and downtown. The road becomes congested at rush hour. As long as fewer than 100 people use the road at rush hour, the trip takes 30 minutes.

When the 101st person enters the road, everyone has to slow down and the trip now takes 31 minutes. People value their time at $6 per hour (i.e., $0.10 per minute) and so a 30 minute trip costs $3. [LO 19.5] a. What is the private cost of one of the 100 individuals using the road? What is the total private cost of 100 people using the road? What is the total social cost of 100 people using the road? b. What is the total social cost of 101 people using the road? What is the private cost of using the road for the 101st individual? What is the external social cost of the 101st person using the road?

Answer: a. Private cost of one individual = 30 minutes × $0.10 = $3.

Because the driving time is the same with 1 person or 100 people, there are no externalities and total social cost = total private cost. Since there are 100 drivers, each driving 30 minutes on the congested highway, we multiply 30 min × $0.10 per minute cost × 100 people = $300 in total. b. Total social cost = 101 people × 31 minutes × $0.10 = $313.10.

Private cost of driving for the 101st individual = 31 minutes × $0.10 = $3.10.

The 101st driver brings the social cost from $300 to $313.10. The difference is $13.10.

Subtract out the driver's private cost to get the external social cost = $13.10 - $3.10 = $10.00.

CHAPTER 20 TAXATION AND THE PUBLIC BUDGET Chapter Overview The fine points of tax law are complex, but the basics are fairly straightforward. The ideas and evidence in this chapter show what’s at stake in political debates. Understanding the implications of taxes can also help you make better personal financial choices. When it comes to taxes, economists focus on trade-offs between revenue, efficiency, and incidence. In other words, we’re concerned with how much money is raised, how costly it is to raise it, and who ultimately shoulders the burden. We see why governments need to balance revenues and expenditures in the long run, but also why they might not want to do so in the short run. Public support for taxation depends on whether citizens like how governments spend their tax dollars. richard@qwconsultancy.com

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If voters think that governments misuse money or spend too much, they’ll want to reduce taxes. When voters think that governments are helping to create stronger communities and better opportunities for citizens, they won’t mind the tax bite as much. We’ll dig deeper into some of these questions in the next chapter, as we address issues around poverty, inequality, and the uses of public funds.

Learning Objectives LO 20.1: Describe the major public policy goals of taxation.

LO 20.2: Explain how deadweight loss and administrative costs contribute to the inefficiency of a tax.

LO 20.3: Calculate the effect of a tax increase on revenue, taking into account price and quantity effects.

LO 20.4: Identify proportional, progressive, and regressive taxes.

LO 20.5: Describe the sources of tax revenue in the United States, and discuss the role played by different types of taxes.

LO 20.6: Discuss the important features of the public budget and the relationship between revenues and expenditures.

Chapter Outline HAPPY TO PAY TAXES?

Why Tax? (LO 20.1) BOX FEATURE: FROM ANOTHER ANGLE – LOVE THE SINNER, LOVE THE SIN TAX

Principles of Taxation Efficiency: How Much (Extra) Will the Tax Cost? (LO 20.2) Deadweight Loss Administrative Burden Revenue: How Much Money Will the Tax Raise? (LO 20.3) Incidence: Who Ultimately Pays the Tax? (LO 20.4) A Taxonomy of Taxes (LO 20.5) Personal Income Tax Payroll Tax Corporate Income Tax Other Taxes BOX FEATURE: WHAT DO YOU THINK? – DEATH, TAXES, AND “DEATH TAXES”

The Public Budget (LO 20.6) Expenditures Balancing the Budget BOX FEATURE: REAL LIFE – THE INSECURE FUTURE OF OLD AGE SECURITY richard@qwconsultancy.com

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Beyond the Lecture Class Media: Why Tax? (LO 20.1) Consider playing the song Taxman by The Beatles for students before class. While George Harrison wrote the song about what he perceived to be excessive tax rates, it is a nice way to start a discussion regarding the impact of taxes on the supply of labour (or any other tax related issue).

Class Activity: Why Tax and Tax Incidence (LO20.1, LO 20.4) Depending on where you teach, students may or may not have a lot of experience with income taxes. One way to drive the idea home is to have students calculate the income tax for a family of four. Place students in groups (aka, families) and provide them with household incomes, giving different incomes to different groups. You can provide as many details as you like about each family, but you may want to keep it simple and have students take the standard deduction according to the 2019 tax rates located http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html.

You could also ask students to figure out provincial and local taxes for their family.

Writing Assignment/Class Discussion: Tax Efficiency and Revenue (LO 20.2, LO 20.3) Ask students to consider whether income taxes impact the decision to work and the decision regarding where to live. Included here are two articles that are great conversation starts. This article (http://www.cbc.ca/news/business/taxes/tax-season-2015-where-in-canada-do-youpay-the-most-tax-1.2507059) discusses the tax differences across Canada. And this article https://business.financialpost.com/personal-finance/taxes/canadas-income-tax-rates-havebecome-uncompetitive-and-the-economy-will-pay-the-price looks at the relationship between tax rates and the ability for our economy to be productive and competitive.

19. How do changes in income tax rates impact labour decisions?

20. Do individuals consider taxes when choosing a place to work and reside?

21. Are there any differences between local, provincial, and federal income taxes in terms of their impact on individual’s decisions?

Class Assignment: A Taxonomy of Taxes and the Public Budget (LO 20.5, LO 20.6) Have students explore the official Canadian revenue and expenditure numbers. They should especially consider the following: • Examine government receipts, outlays, and surplus/deficit Examine the sources of government revenue.

• Examine federal government spending by category.

• Examine government debt over time.

Solutions to End-of-Chapter Questions and Problems Review Questions

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1. Both a payroll tax and an excise tax on alcohol raise revenue and, respectively, shrink the markets for labour and alcohol. Although both have some functions in common, governments may have different goals when levying them. What goals do you think motivate a payroll tax? What goals motivate an alcohol tax? [LO 20.1] Answer: Since a payroll tax is levied on income from many different types of incomegenerating activities, it doesn’t target one specific economic behaviour. Therefore, its primary purpose is to raise revenue for public expenditures. On the other hand, an excise tax on alcohol is often levied to reduce consumption for one specific good—alcohol. Hence, the goals of raising revenue and changing behaviour likely motivate it.

2. The demand for cigarettes, which create negative externalities through secondhand smoke, is often relatively inelastic. That is, when the price of cigarettes changes, the quantity demanded changes by a smaller portion. Using this fact, explain to what extent you think a tax on cigarettes would fulfill each of the goals of taxation. [LO 20.1] Answer: The demand curve for inelastic goods is more vertical relative to elastic goods.

When a tax is raised on cigarettes, therefore, the new equilibrium will be only slightly to the left of the old equilibrium, implying that the quantity of cigarettes consumed is only slightly reduced by the tax. Therefore, the major effect of the tax is to raise revenue, while minimally reducing smoking.

3. Which would you expect to be less efficient, a flat tax on all income or a property tax (charged based on the assessed value of real estate)? Explain why, in terms of both deadweight loss and administrative costs. [LO 20.2] Answer: Implementing a flat tax on income entails less administrative cost than a property tax, which requires assessors to calculate the value of the real estate each year. A flat tax, on the other hand, is calculated simply by applying a fixed percentage to reported income. From a deadweight loss perspective, however, a flat tax is less efficient: By taxing income, it reduces income-generating activities, whereas a tax on property will reduce property ownership. The price elasticity of income is higher than the price elasticity of property ownership.

4. A local government is considering ways to raise taxes to pay for making sidewalks. One prominent citizen suggests taxing people based on how much they walk on the sidewalk, measured in yards each day. Explain why, despite its apparent fairness, this tax is likely very inefficient. [LO 20.2] Answer: Levying this tax would entail a large amount of administrative burden. Absent a very innovative and efficient method of tracking how much people walk on sidewalks, administering this tax would require paying people to measure how often others walk in certain areas of the city each day.

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5. In an election debate, two candidates for governor are debating about whether to raise the general sales tax from 5 to 7 percent. One argues that this would increase tax revenues, enabling the state to maintain essential services. The other argues that the tax would hurt retailers and consumers, and would actually slow down the economy so much that it would decrease tax revenues too. Restate these candidates’ positions in economic terminology, and explain what assumptions they must be making in order to justify their different positions, in terms of price and quantity effects. [LO 20.3] Answer: The two candidates disagree about the relative sizes of the price and quantity effects of the sales tax. The first candidate believes revenues would increase, i.e., that the price effect would be larger than the quantity effect. The second candidate believes the opposite: The quantity effect would dominate the price effect. To determine which candidate is correct, we would need to know more about the price elasticity of demand in the market. If consumers would reduce their consumption at a greater rate than the increase in price, the quantity effect would dominate, and the second candidate would be correct. On the other hand, if the increase in prices is higher than the decrease in consumption, the price effect would dominate.

6. Explain, with reference to the price and quantity effects, why all else equal, taxing several goods at a modest rate is better than taxing one good at a very high rate. [LO 20.3] Answer: All else equal, taxing one good instead of many to receive the same level of government revenue would require a very high tax rate on the good. This would highly distort the market for that good, resulting in relatively large deadweight loss. The deadweight loss associated with taxing several goods at a lower rate to create the same level of revenue would be relatively smaller in comparison.

7. People with low income spend more, as a share of their overall income, on food and clothing than wealthier people. As a result, they tend to spend a higher proportion of their income relative to people with high income. Given this trend, explain how a general sales tax of 8 percent could be regressive. Now, suppose that food and children’s clothing are exempted from the sales tax. Is this likely to make the tax more or less regressive? [LO 20.4] Answer: The general sales tax would add 8 percent to all of the money spent by each person.

Since people with lower income spend a greater fraction of their income, the proportion of their income they pay in taxes would be higher than the proportion paid by people with higher incomes. One reason why people with low income spend a greater fraction of their income is that there’s a set of goods every person needs to survive, such as food and clothing.

If people bought only these goods, people with higher incomes would have much more money left over than people with low incomes. However, people with high incomes also buy luxury goods that people with low income can’t afford. If the sales tax didn’t cover the more basic goods like food and clothing, but still covered luxury goods, then the overall tax system would be less regressive.

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8. Suppose you turn on the television to find an ad by a local politician accusing car dealers of making too much money off consumers. As a remedy for this abuse, the official proposes to tax the dealers at a higher rate and reward car buyers with the proceeds of the tax. Drawing on the idea of economic incidence and administrative cost, explain why this tax may not benefit consumers after all. [LO 20.4] Answer: There are two reasons this tax might not help consumers. As we learned, statutory incidence is not the same as economic incidence: Even if the government taxes car dealers, the dealers might pass the tax on to the consumers, resulting in higher car prices. Moreover, the government may consume some of the tax revenues in administering it—lowering the amount it could pass on to consumers. Thus, consumers might end up paying higher car prices and receiving a fraction of those higher prices back from the government.

9. Your friend Edgar has just finished his first year working full-time, and comes home beaming with an envelope from the CRA, which has sent him a check for $650 after he sent in his tax forms. Explain to Edgar why this does not mean that he didn’t pay taxes. [LO 20.5] Answer: Throughout the year, the government automatically takes a fraction of every paycheque for taxes. When it comes time to report taxes, each person calculates how much he needs to pay and compares that to the amount the government has already taken from his paychecks in the last year. In most cases, this difference is positive, so people receive a check for the difference from the government. This is the point Edgar misses: The money he gets from the government is just the excess money it “took” from him throughout the year.

10. Explain why most people’s marginal tax rate is higher than their average tax rate. Is a system in which average tax rates are higher than marginal tax rates regressive, proportional, or progressive? [LO 20.5] Answer: In a progressive tax system, the higher the tax bracket, the higher the marginal tax rate. For example, the government might tax income from 0 to $10,000 at a 10 percent rate, and income from $10,000 to $20,000 at a 15 percent rate. Someone who earns $20,000 is said to have a marginal tax rate of 15 percent. The average rate is the overall proportion of income that person pays in taxes, which will be smaller than the marginal rate because each marginal rate below the highest marginal rate is smaller than it. If average tax rates are higher than marginal tax rates, the system would be regressive: The more income someone receives, the smaller the proportion of it she has to pay in taxes.

11. A prime ministerial candidate vows to cut social spending by 20 percent in the first few weeks that he is in office. Why is it unlikely the candidate could achieve this reduction? [LO 20.6] Answer: The majority of social spending is non-discretionary, meaning that it’s mandated by law to occur automatically. Although the prime minister could work with Parliament to reform social welfare programs, it’s unlikely he or she could make a dramatic 20 percent cut richard@qwconsultancy.com

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within the first few weeks in office given the budgetary process and time it would take to reform these programs.

12. When the federal government borrows money, it can fund higher expenditures in the short term, but incurs a debt that accrues interest and has to be paid off in the long term. What does this imply about the trade-off between current and future taxes? How might this trade-off change if the overall size of the economy grows over time? [LO 20.6] Answer: Borrowing money in the short term requires the government to pay it back at some point in the long term. All else equal, this borrowing would require much higher taxes in the future—or lower spending. The size of the tax increase depends on the growth rate of GDP. The higher the growth rate, the greater the amount of revenue the government will be able to receive from any given tax rate.

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Problems and Applications 1. Consider each of the following tax policies. Decide for each whether the primary public policy goal is most likely raising revenue or changing behaviour (with or without a market failure). [LO 20.1] a. Income tax. b. Cigarette tax. c. Gas tax. d. Payroll tax. e. Toll road. f. Income tax exemption for charity donations.

Answer: a. Income taxes target a wide array of income-generating activities, so it is unlikely that this would be implemented to change a specific behaviour (apart from earning income). Hence, the goal is most likely raising revenue. b. Cigarette taxes target negative externalities—second-hand smoke and other public health costs associated with people smoking. The taxes thus work to change behaviour (even though cigarettes are price inelastic, so behaviour doesn’t change a lot) as well as to raise revenue. c. Gas taxes also target a market failure, the negative externality of pollution. They change driving behaviour and raise revenue to reduce the environmental cost of driving. d. Like income taxes, payroll taxes target a variety of activities, making it unlikely the government would levy them to change a specific behaviour (apart from providing labour); for the same reason, such taxes raise substantial revenue, covering such a multitude of activities. e. Toll road taxes are often collected to raise revenue to fund the maintenance of the roads. However, they can also be used to reduce traffic such that those with the highest willingness to pay have access to the roads. f. Tax exemptions result in lowered revenue for the government for the benefit of charitable organizations. They are meant to change behaviour by rewarding individuals for donating to such groups.

2. Governments throughout history have levied some very interesting taxes (https://listverse.com/2010/08/19/top-10-truly-bizarre-taxes/). Each of the following taxes changed citizens’ behaviour. Determine whether it’s likely that the tax also addressed a market failure. [LO 20.1] a. The Hat Tax: Adopted by the British Government, requiring every hat to bear a stamp on the inside showing it was legal. richard@qwconsultancy.com

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b. The “Flatulence Tax”: Proposed, but ultimately not adopted, in New Zealand to help reduce methane emissions from livestock. c. The Window Tax: Levied by English King William III on the number of windows in a house, which tended to be more numerous in wealthier homes. d. The Cowardice Tax: Introduced in medieval England and applied to people who refused to defend the country at request of the king.

Answer: a. Unless the hats in question caused a great style scandal (causing a negative externality), the hat tax would not have addressed a market failure, as wearing a hat does not substantially affect others’ utility. b. Methane emissions contribute to global warming, which reduces utility of people across the globe, making them a negative externality. The flatulence tax proposal attempted to correct this externality by raising the cost of livestock. c. Like hats, windows do not typically affect the utility of non-users.

Instead, the tax was levied to gather more revenue from wealthy households. d. Depending upon the military goal in question, the cowardice tax could have made it more costly for people to shirk the duty of protecting their country, a public good. By taxing “cowards,” the king would have corrected the incentive to free ride on a strong national defense by making individuals pay for enjoying peace.

3. Suppose the government wants to levy a new excise tax. For each of the following goods, determine whether you would expect an excise tax to result in high or low deadweight loss. [LO 20.2] a. Alcohol. b. Milk. c. Diamonds. d. Tropical vacations. e. Socks.

Answer: The size of the deadweight loss of an excise tax depends upon the price elasticity of the good taxed. Taxes on elastic goods entail more deadweight loss than taxes on inelastic goods. Recall that the quantity demanded for elastic goods falls more than the price increase. And the quantity demanded for inelastic goods falls less than the price increase. a. Alcohol is relatively inelastic (there are few substitutes and many people—alcoholics—find it addicting). Deadweight loss would be relatively small. richard@qwconsultancy.com

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b. Milk is inelastic because there are few substitutes. Deadweight loss would be relatively small. c. Diamonds are a luxury good. Deadweight loss would be relatively large. d. Tropical vacations are highly substitutable and therefore price elastic.

Deadweight loss is relatively large. e. Socks are a basic necessity with few substitutes, so they are price inelastic and deadweight loss is relatively small.

4. Table 20P-1 shows supply and demand in the market for sub sandwiches in Wheretown, where the local government wants to raise revenue via a $1 tax on all sandwiches, collected from sandwich shops. [LO 20.2] a. Graph supply and demand. Before and after the tax: What is the equilibrium quantity? What price is paid by consumers? What price is received by suppliers? b. Calculate consumer and producer surplus before and after the tax. c. How much tax revenue does Wheretown receive? d. How much deadweight loss is caused by the tax? e. Suppose it costs Wheretown $35 to collect the tax revenue from sub shops. In the end, how much revenue from the sub tax is actually available to spend on public services?

Answer: a. As the figure below shows, the equilibrium price and quantity occurs with 50 sandwiches at a price of $5.50 per sandwich. Without the tax, consumers and producers each pay $5.50 per sandwich. With the tax, equilibrium occurs at 40 sandwiches; consumers pay $6 and producers receive $5.

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b. Before the tax, consumer surplus is 0.5 × $2.50 × 50 = $62.50, and producer surplus is 0.5 × $2.50 × 50 = $62.50. After the tax, consumer surplus is 0.5 × $2 × 40 = $40, and producer surplus is 0.5 × $2 × 40 = $40. c. Wheretown receives $1 × 40 in revenues, or $40. d. Deadweight loss is equal to the total surplus before the tax minus the total surplus after the tax, or $5 ($125 − $120). e. The amount of available revenue is only $5, the difference between the revenue from the tax ($40) and the cost of collecting the tax ($35).

5. Figure 20P-1 shows a hypothetical market for gasoline. [LO 20.3] a. Suppose an excise tax of $0.15 per litre is levied on gasoline. What price will consumers pay? What price will sellers receive? b. How much government revenue will result from the tax? c. Suppose the tax is raised to $0.3 per litre. How much additional revenue will this raise compared to the $0.15 tax? d. Would raising the tax further to $0.45 per litre increase or decrease tax revenue?

Answer: a. An excise tax of $0.15 per litre can be represented with a new supply curve located $0.15 above the old one. With this new curve, the equilibrium price occurs at 4 million litres at a price of $0.40 per litre. richard@qwconsultancy.com

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Consumers will pay $0.40 per litre, and sellers will receive $0.25 per litre.

b. With 4 million litres of gasoline being sold, the tax will generate $600,000 in revenue ($0.15 × 4 million). c. An excise tax of $0.30 per litre can be represented by a new supply curve $0.30 above the old one. With this new curve, the equilibrium price occurs at 3 million litres trading at a price of $0.50 per litre.

Revenue is thus $900,000 ($300,000 higher than under a $0.15 tax).

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d. Under a tax of $0.45 per litre, the equilibrium price and quantity is $0.60 per litre and 2 million litres. Revenue is still $900,000.

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6. In each of the following examples, determine whether the price effect or the quantity effect dominates when the tax is applied. [LO 20.3] a. The government raises taxes on the 10 million iPods sold each year from $10 per iPod to $20 per iPod. The new equilibrium quantity is 9 million iPods. b. In response to concerns about chewing gum in schools, the government raises the tax on packs of gum from 20 cents per pack to 30 cents per pack. Before the tax increase, 50 million packs were sold each year. After the tax increase, 40 million packs are sold each year. c. Worried that Canadians are addicted to coffee, the government raises the 5-cent tax on a cup of coffee to 10 cents. Before the tax increase, 10 billion cups were sold each year. Afterward, 5 billion cups are sold each year.

Answer: a. Revenue before the tax increase was $100 million; after the tax it is $180 million. Because revenue is higher, the price effect dominated. b. Revenue before the tax increase was $10 million; after the increase it is $12 million. The price effect dominated. c. Before the tax increase, revenue was $500 million; after it is $500 million. The price and quantity effects were the same.

7. Determine whether each of the following taxes is proportional, regressive, or progressive. [LO 20.4] a. An income tax of 25 percent on income from all sources. b. An income tax with three brackets and corresponding marginal tax rates: 10 percent for income up to $50,000; 20 percent for income up to $100,000; and 30 percent for income over $100,000. c. A fee of $500 per year for municipal services, charged to everyone who lives within the city limits. d. A capital gains tax that charges a flat rate of 40 percent, but only on capital gains over $1 million. e. A payroll tax of 10 percent on income under $200,000.

Answer: a. Proportional: Everyone is taxed at the same rate for all sources of income. b. Progressive: People with higher incomes pay a higher proportion of their taxes than people with lower incomes c. Regressive: $500 represents a greater share of total income for people with low incomes relative to people with high incomes. d. Progressive: People who earn more than $1 million in capital gains pay more taxes than people who earn less than $1 million. richard@qwconsultancy.com

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e. Regressive: Anyone who earns over $200,000 pays a smaller proportion of income to taxes than people who earn under $200,000.

8. Table 20P-2 shows an income tax schedule for the imaginary country of Independence. Connor is a citizen of Independence who earns $95,000 per year at his job. Assume Connor is not eligible for any deductions or exemptions. [LO 20.4, 20.5] a. How much does Connor pay in income tax? b. What is Connor’s marginal tax rate? What is his overall tax rate? c. Connor isn’t crazy about his job and wants to move to a job in a related industry that pays $100,000. How much will Connor have to pay in taxes in the new job? d. Is the income tax in Independence regressive, proportional, or progressive?

Answer: a. Connor earns $95,000. According to the table, he will pay 5% for the first $5,000 ($250); 7% for the next $10,000 ($700); 9% for the next $15,000 ($1,350); 11% for the next $20,000 ($2,200); 13% for the next $25,000 ($3,250); and 15% on the final $20,000 ($3,000). In total he pays $10,750. b. His marginal tax rate is 15%, and his overall tax rate is 11.3% ($10,750 ÷ $95,000). c. Connor now earns $5,000 more, but stays within the tax bracket with a marginal tax rate of 15%. He thus pays $750 more in taxes, for a total of $11,500. d. The tax is progressive because people with higher incomes pay a higher proportion of their income in taxes than people with lower incomes.

9. Evangeline is a citizen of Independence, whose income and expenditures are shown in Table 20P-3. Table 20P-2 shows Independence’s personal income tax schedule. In answering the following questions, you may assume the following. [LO 20.5] (1) All income other than capital gains falls under the personal income tax.

(2) Deductible expenses are subtracted from income before income tax is calculated.

(3) Charitable donations and money paid in pay-roll taxes are tax-deductible.

(4) Payroll tax is 5 percent of earned income up to $50,000.

(5) Capital gains tax is 3 percent on capital gains over $10,000.

(6) Sales tax is 6 percent.

a. How much does Evangeline pay in payroll taxes? richard@qwconsultancy.com

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b. How much does Evangeline pay in capital gains taxes? c. What is Evangeline’s adjusted income subject to the personal income tax? How much does she pay in personal income tax? d. How much does Evangeline pay in sales taxes? e. How much does Evangeline pay in taxes, in total? What percentage of her income does this represent?

Answer: a. Evangeline pays 5% of $50,000 in income in payroll taxes, or $2,500. b. Evangeline pays 3% on $10,000 worth of capital gains, or $300. c. Evangeline’s adjusted income is equal to her total income ($90,000) minus her deductible income ($3,000 for charitable donations) and the amount she pays in payroll taxes ($2,500). Her adjusted income is therefore $90,000 − $5,500 = $84,500. We can calculate her total income taxes as follows: Evangeline earns $84,500 in adjusted income. According to the table, she will pay 5% for the first $5,000 ($250); 7% for the next $10,000 ($700); 9% for the next $15,000 ($1,350); 11% for the next $20,000 ($2,200); 13% for the next $25,000 ($3,250); and 15% on the final $15,000 ($1,425). In total she pays $9,175. d. Evangeline pays 6% of the $10,000 she spent subject to sales tax, or $600. e. In total, Evangeline pays $12,575 ($2,500 + $300 + $9,175 + $600), which represents 11.4% of her income ($12,575 ÷ $110,000) 10. Table 20P-4 shows an economy’s GDP, current expenditures, and tax revenue for 2013–2016. [LO 20.6] a. Complete the table by filling in the prior-year debt for each year listed. b. For each year, is this economy experiencing a budget surplus or budget deficit? c. Debt is what percentage of GDP in 2013? d. Between 2013 and 2016, by what percentage has GDP changed? By what percentage has the debt changed? Is debt as a percentage of GDP growing, constant, or shrinking between 2013 and 2016?

Answer: a. The prior year debt for each successive year is calculated by adding the difference between expenditure and revenue to the existing debt.

The prior year debt for 2013 is $5,100; for 2014 is $5,350; for 2015 is $5,225; and for 2016 is $5,525. b. An economy experiences a deficit when expenditures are greater than revenue and a surplus when expenditures are less than revenue. In richard@qwconsultancy.com

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2013, the economy is experiencing a budget deficit; in 2014, a budget surplus; in 2015, a budget deficit; and in 2016, a budget deficit. c. The debt-GDP ratio is calculated by dividing the level of debt by GDP; in 2013, it is 60 percent. d. Between 2013 and 2016, both GDP and the debt have changed by 8 percent. The debt-GDP ratio is unchanged, or constant, between 2013 and 2016.

11. Table 20P-5 shows an economy’s GDP, population, debt, and GDP per capita for 2013 and 2014. [LO 20.6] a. Complete the table by filling in the debt per capita for both years. b. What is the percentage change from 2013 to 2014 in each of the following? (i) GDP. (ii) Population. (iii) Debt. (iv) GDP per capita. (v) Debt per capita. c. Which is growing faster—GDP per capita or debt per capita? Why? Answer: a. Debt per capita is calculated as total debt divided by population. Thus, for 2013 debt per capita is 7,472,500 ÷ 305 = $24,500. For 2014 debt per capita is 7,920,850 ÷ 311.1 = $25,461 (rounded up). b. Percentage changes are calculated as (new value – previous value) ÷ (previous value). The percentage change from 2013 to 2014 for (i) GDP is 3 percent, (ii) population is 2 percent, (iii) debt is 6 percent, (iv) GDP per capita is 1 percent, and (v) debt per capita is 3.9 percent. c. Debt per capita is growing faster, because debt is growing at a faster rate than GDP.

CHAPTER 21 POVERTY, INEQUALITY, AND DISCRIMINATION Chapter Overview Understanding the roots of poverty, inequality, and discrimination matters for economists and policy-makers alike. From an intellectual perspective, these topics push us to understand how markets and institutions really work. They also take us below the surface of statistics such as average income and GDP to understand who gets how much and why. From the perspective of a policy-maker or a concerned citizen, they may raise challenging economic and social issues.

What does a fair society look like? How much poverty is acceptable? Does equality of opportunity matter more than the distribution of income itself? We see in this chapter that even the measurement of poverty, inequality, mobility, and discrimination can be tricky. We richard@qwconsultancy.com

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have to decide whether we care more about absolute or relative measures, adjust for differences across regions, and pick out the causal factors we care about.

Learning Objectives LO 21.1: Discuss the difference between relative and absolute measures of poverty.

LO 21.2: Explain and interpret different methods of measuring income inequality.

LO 21.3: Describe how income mobility differs from income equality.

LO 21.4: Identify the public policies that are used to reduce poverty and inequality.

LO 21.5: Explain the trade-off between equity and efficiency in poverty-reduction policy.

LO 21.6: Explain why demographic differences in income or wages do not necessarily imply discrimination.

Chapter Outline STRIKING IT RICHER

Poverty Measuring Poverty (LO 21.1) BOX FEATURE: REAL LIFE – WHAT IF YOUR $2 A DAY DOESN’T COME EVERY DAY?

Why are People Poor?

Inequality Measuring Inequality (LO 21.2) Inequality in Canada and around the World Inequality versus Mobility (LO 21.3) Policies to Reduce Poverty and Inequality Public Policy Goals The Welfare State (LO 21.4) BOX FEATURE: FROM ANOTHER ANGLE – PAYING PEOPLE TO HELP THEMSELVES

Trade-offs between Equity and Efficiency (LO 21.5) Discrimination Measuring Discrimination in the Labor Market (LO 21.6) BOX FEATURE: REAL LIFE – ARE EMILY AND GREG MORE EMPLOYABLE THAN LAKISHA AND JARNAL?

Do Free Markets Reduce Discrimination?

Long-Term Effects of Discrimination BOX FEATURE: WHAT DO YOU THINK? – AFFIRMATIVE ACTION IN PUBLIC SERVICE

Beyond the Lecture Class Discussion: Measuring Poverty (LO 21.1) This Globe and Mail article (http://www.theglobeandmail.com/news/british-columbia/genderpay-gap-in-canada-more-than-twice-global-average-study-shows/article24274586/) provides a richard@qwconsultancy.com

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nice introduction to the topic of the wage gap between male and females. Have students read this, or go over in class, then discuss the following: 1. Is the entire difference in wages between male and female workers due directly to discrimination?

2. What other factors could influence the difference in wages between male and female workers?

Class Activity: Measuring Poverty and Inequality (LO 21.1, LO 21.2) Ask students to guess the income necessary to be included in various percentiles in terms of wealth. Many students do not have a great sense of income distribution and inequality in general. This provides a starting point for the chapter. You can then put the incomes into a calculator and show them what the actual income percentiles are. You can find an income percentile calculator for Canada (http://www.macleans.ca/economy/economicanalysis/rankyour-income-where-do-you-stand-compared-to-the-rest-of-canada/ )and for the rest of the world here.

Class Discussion: Measuring Poverty and Inequality (LO 21.1, LO 21.2) Consider showing students a brief clip from this episode of the TV show No Reservations, where host Anthony Bourdain visits Haiti. Any of these clips will provide a visual of the poverty that many Haitians face on a daily basis and will provide good insight for students. You could also ask students to watch all of the clips on their own time. Then discuss in class: 1. What is the difference between poverty in Haiti and anada?

2. What is the difference between relative and absolute poverty?

3. What do you think can be done to assist with poverty in developing countries?

Reading Assignment/Class Discussion/Writing Assignment: Inequality versus Mobility and the Welfare State (LO 21.3, LO 21.4) Assign students to read – (http://www.conferenceboard.ca/hcp/details/society/intergenerational-income-mobility.aspx) on Canadian income mobility and international comparison. Then, either discuss the following in class or assign as a writing exercise: 1. How much income mobility exists in Canada and how do we compare with other developed countries according to this study?

2. Do you think that this is a good or bad sign?

3. What, if anything, should be done to improve income mobility?

Solutions to End-of-Chapter Questions and Problems Review Questions 1. Suppose Statistics Canada considers redefining the national poverty measure in a way that would classify an additional 0.25 million people as poor. The prime minister worries that his administration will be criticized for leading the country into greater poverty. Explain whether richard@qwconsultancy.com

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this change would have reflected a shift in an absolute measure of poverty, a relative measure of poverty, or whether it cannot be known. Finally, explain why all else equal, the prime minister is not responsible for causing greater poverty. [LO 21.1] Answer: The poverty measure in question could be relative or absolute—so the correct answer is that we cannot know. Under either type of measure, shifting the poverty level could classify an additional quarter million people as poor. In the public statement, the prime minister should highlight the fact that the additional quarter million people are exactly the same as they were before the measurement change, so it’s not as if the prime minister’s policies changed their circumstances in this case. The only difference is how the government defines poverty.

2. Poverty in Decilia is measured relatively, with people in the bottom 10 percent of the income distribution being defined as poor. Suppose a politician in Decilia promises to halve the poverty rate in five years. Explain why this could never be achieved given the poverty statistic Decilia uses. Propose an alternative measure of poverty that would allow the politician to achieve that goal. [LO 21.1] Answer: Because Decilia defines poverty as being in the bottom 10 percent of the income distribution, there will always be some individuals classified as poor. Even if everyone in the bottom 10 percent made $10 billion a year, they would still be poor by definition if everyone else earned more. An alternative measure Decilia could use would be an absolute measure of poverty, like having an income of more than $10,000 per year. Using that metric, it’s possible that the politicians’ policies could cut poverty in half.

3. Explain why it might be difficult for low income individuals to receive a college education and why the government may need to subsidize student loans for a college education. [LO 21.2] Answer: For most loans, an individual offers up collateral against the loan. (For example, to get a car loan, you agree that if you can't pay the loan, the bank will take the car.) For education, there often isn't any obvious collateral to offer. Education is risky and doesn't yield a tangible result for sure. Even if other collateral would be accepted, for low-income individuals, there may not be any collateral at all to offer. High-income families could potentially offer up other items as collateral.

Additionally, students from higher-income families may be able to borrow from their parents or other family members. Low-income students do not have this option. Thus, the government may want to subsidize student loans.

4. Some people argue that unpaid internships should be illegal. In what ways is an unpaid internship part of a poverty trap? [LO 21.2]

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Answer: Increasing one's human capital is one way to get out of poverty. However, it can be costly to increase one's human capital. An unpaid internship is often not feasible for a student who does not have savings. Many students from low-income families might like to take an unpaid internship in order to increase their likelihood of a higher future income. However, this can be difficult without a second job or savings. Thus, it is easiest for rich students to take on an unpaid internship. This means that the students who accept unpaid internships (and thus increase their human capital) might be disproportionately from high-income families.

5. Is it possible for two countries to have the same Gini coefficient but different distributions of income? Explain how you came to your conclusion. [LO 21.3] Answer: Yes, it is possible for two countries to have the same Gini coefficient but different distributions of income. The Gini coefficient looks only at the area under the Lorenz curve, not the shape of the area, so it does not provide any information about the distribution of income.

6. Explain why it’s possible for income inequality to decrease globally while increasing in every country at the same time. [LO 21.3] Answer: Imagine that in rich countries the incomes of the poor do not increase, but the incomes of the rich increase slowly. In poor countries, both the poor and rich are gaining income at a high rate, but the rich are doing so slightly faster. In both groups of countries income inequality rises, but in the world overall, poor countries will close the income gap with high rates of growth.

7. In which of the following countries is income mobility likely higher? Explain your answer.

[LO 21.4] a. A country with a poverty rate of 25 percent, of which 80 percent represents chronic poverty. b. A country with a poverty rate of 30 percent, of which 20 percent represents chronic poverty.

Answer: b. Chronic poverty rates reflect the number of people who stay under the poverty line for longer than three years. Hence, knowing nothing else about these two countries, we can say that people in the second country—a country with a poverty rate of 30 percent, of which 20 percent represents chronic poverty—have higher income mobility since there’s a lower rate of chronic poverty.

8. Suppose there is an economy where 80 percent of people earn more than their parents and 40 percent end up in a different income quintile than their parents. What measure of the income distribution does the first statistic tell you about? What about the second? [LO 21.4]

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Answer: When there is income mobility, people are moving up the income distribution as well as down the distribution. So, it would be tough to identify a stable set of people who always represent the 99 percent of the income distribution—depending upon the rate of mobility, a significant fraction of people will move between the bottom 99 percent and top 1 percent.

9. If unconditional cash transfers have the same effect as conditional cash transfers, which one allows the government to alleviate poverty more effectively? In answering the question, draw on your knowledge of administrative costs. [LO 21.5] Answer: If unconditional cash transfers have the same effect as conditional cash transfers, unconditional cash transfers will allow the government to alleviate poverty more effectively.

Since unconditional cash transfers cost less to administer, the government would be able to give more in benefits, rather than paying the overhead costs that are required to make sure that recipients are following the rules imposed in conditional programs.

10. John Rawls is a philosopher famous for his “maximin” principle, which states that society should maximize the position of the people with the minimum amount of goods, and not focus only on the level of inequality. For instance, Rawls would favor a society in which the bottom 10 percent earn $30,000 per year and the top 10 percent earn $2 million over a society in which the bottom 10 percent earn $28,000 per year and the top 10 percent earn $40,000 per year. Drawing on the trade-off between equity and efficiency, explain whether Rawls would favor (a) redistribution that limits growth but creates equality or (b) economic development that encourages growth but creates inequality. [LO 21.6] Answer: In general, it’s likely that Rawls would favor economic development (choice b) over redistribution, because the position of people at the lowest end of society is likely to improve over time when the economy is growing. It might be the case that in the very short run, people at the bottom of the income distribution will be better off with redistribution. But over time, if this redistribution limits economic growth those people will not be as well off as they could have been. This argument reduces back to the competing idea of equity and efficiency. Rawls believed that any system that was not rigorously focused on improving the situation of the poorest in society would not be equitable. It may not be very efficient to aggressively redistribute throughout the economy, though, which could hurt economic growth in the long run.

11. Your professor has decided that, from now on, students who receive less than a 60 percent grade on any exam will be eligible to go to a review session. If they attend the session, they will receive an extra 10 percent on their grade. You see a problem with this policy, and instead propose to your professor that people who go to the review session should receive 50 percent of the difference between their grade and 60 percent. Explain why this situation represents a trade-off between equity and efficiency. [LO 21.6] Answer: The original policy is more efficient than the one you proposed: by simply adding 10 percent to the grades of people who went to the review session, the professor avoids the richard@qwconsultancy.com

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hassle of having to recalculate all of the grades in the way you proposed. On the other hand, the original policy is less equitable: People who received a 65 percent on the test, for instance, would have a lower grade relative to people who received a 59 percent and could go to the review session.

12. Is it possible that even though men make more than women in a particular industry, there could be gender discrimination against men in that industry? If no, explain why not. If yes, explain why and give an example. [LO 21.7] Answer: Yes, it’s possible that in a certain industry men could make more than women but still be discriminated against. For example, consider nursing. If people discriminate against men when hiring nurses, it could be the case that a male nurse who has 10 years of experience gets paid more than a female nurse who has one year of experience, but if the female nurse had 10 years of experience she would be paid more than the male nurse.

13. For each of the scenarios below, determine whether you think it is likely that an employer could be discriminating against a person because of his or her age. Explain why or why not.

[LO 21.7] a. A young lawyer who just finished work on a multimillion-dollar development deal downtown is hired by an economic development firm in lieu of an older lawyer who works on litigation. b. A large retail outlet hires an 80-year-old woman to greet customers instead of a 30-yearold woman who has been greeting customers in other stores for a decade. c. The owner of a local, hip smoothie bar in a university town just fired a graduate student who had worked at the bar for three years and instead hired a college sophomore.

Answer: a. Discrimination is unlikely. Although the other lawyer has been working longer, the younger lawyer has more relevant experience. b. Discrimination is likely. There’s nothing in the prompt that indicates that the younger person has more experience or qualifications than the older person, who has more experience in customer service. c. Discrimination is likely. The prompt gives us no reason to believe that the sophomore had more qualifications than the older graduate student.

14. Jackie Robinson broke baseball’s colour barrier in 1947, which precipitated integration in all major league teams after 12 years. Explain why the market might have acted to eliminate discrimination in this example. [LO 21.7] Answer: Teams that wouldn’t allow African-American players artificially limited the pool of talent. Those teams were thus at a disadvantage relative to teams that did have AfricanAmerican players, and so they would begin to lose games and money for their owners.

Consequently, the market would push those teams out of the league unless they allowed African-Americans to play. richard@qwconsultancy.com

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15. Some economists have studied the effects of “lookism,” or discrimination based on how attractive a person is. Give an example of a case in which the market might encourage lookism and an example of a case in which the market might combat lookism. [LO 21.7] Answer: Any service in which the physical attractiveness of a person adds to the experience may encourage lookism. Most often this would occur in service industries. On the other hand, whenever a good or service does not involve personal interaction with the customer, looks may not influence customer decisions. Engineering is one example.

Problems and Applications 1. Table 21P-1 shows a data set that contains the income of 20 households, each with a household size of four people. [LO 21.1] a. What percent of these households are below the national poverty line of $18,250 for a household of four people? b. What is the average income of the bottom 20 percent of the households? c. Which poverty measurement (the national one, or the bottom quintile) gives a higher poverty rate?

Answer: a. 4 out of the 20 households have income below $18,250, so the answer is 20 percent. b. The average income of the bottom 20 percent is $12,750. c. The national poverty line gives a higher poverty rate, as only 10 percent of households fall below the average of the bottom quintile.

2. Table 21P-2 shows the incomes of 10 households in two different years, 2020 and 2021.

Assume that the government is considering two different measures of poverty, an absolute level of below $10,000 and a relative measure of being in the bottom 40 percent of income earners. [LO 21.1] a. What is the poverty rate using the absolute measure of poverty in 2020? In 2021? Does it go up, down, or stay the same between the two years? b. What is the poverty rate using the relative measure of poverty in 2020? In 2021? Does it go up, down, or stay the same between the two years? c. Which yields a higher rate, the absolute measure of poverty or the relative measure of poverty in 2020? In 2021? d. Now assume that the government decides to index the poverty rate to inflation. Suppose inflation was 5 percent from 2020 to 2021. Now what is the poverty rate according to the absolute measure in 2021? Is it higher than the relative rate in 2021?

Answer: a. Using the absolute measure of poverty, there is a 50 percent poverty rate in 2020 and a 40 percent rate in 2021, so the poverty rate goes down between the years. b. The poverty rate stays the same at 40 percent for both years. richard@qwconsultancy.com

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c. In 2020, the absolute poverty measurement yields a higher rate; in 2021, the measurements yield the same rate. d. The absolute poverty line is now $10,500. With this line, there’s a 50 percent poverty rate in 2021, which is higher than the relative rate in 2021.

3. Using the data for income distribution found in Table 21-2, determine the following. [LO 21.3] a. Does Sweden or Brazil have a higher Gini coefficient? b. From the bottom quintile to the middle quintile, is the Lorenz curve for Brazil above or below Sweden’s?

Answer: If everyone earned the same amount and income distribution were perfectly equal, the Gini coefficient would be zero: The Lorenz curve would be the line of perfect equality, and so the area between them would be 0. If one person earned all of the income and no one else earned anything, the Gini coefficient would be 1. In reality, the distribution is always somewhere between these opposites. Thus, the Gini coefficient is between 0 and 1. The higher it is, the more unequal the income distribution. a. Table 21-2 shows that Brazil has a more unequal distribution of income: People at the top have a higher percentage of income, and people at the bottom have a lower percentage of income relative to the same people in Sweden. b. The Lorenz curve plots percentiles on the horizontal axis and percent of income on the vertical axis. Hence, from the bottom quintile to the middle quintile, Brazil’s Lorenz curve would be below Sweden’s.

4. Look at the various measures of poverty in 2009 for several countries in Table 21P-3. (The data are provided by the World Bank.) [LO 21.3] a. Rank the countries from the country with the highest inequality to the lowest using the Gini coefficient. (Higher Gini coefficients represent higher inequality.) b. Rank the countries from the country with the highest inequality to the lowest using the ratio of the top decile to the bottom decile. c. Rank the countries from the country with the highest inequality to the lowest inequality using the share of total income held by the top 10 percent.

Answer: a. Countries from highest to lowest, using the Gini index: Honduras, Chile, Panama, Paraguay, El Salvador, Argentina, and Uganda. b. Countries from the highest inequality to the lowest, using the ratio of the top decile to the bottom decile: Honduras, Paraguay, El Salvador, Argentina, Panama, Chile, Uganda. c. Countries from the highest inequality to the lowest inequality, using the share of total income held by the top 10 percent: Chile, Honduras, Panama, Paraguay, El Salvador, Uganda, Argentina.

5. Determine whether each of the scenarios is possible. [LO 21.4] a. A poverty rate based on a relative measure is high, income mobility is low, and there is perfect income equality. richard@qwconsultancy.com

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b. A poverty rate based on an absolute measure is high, income mobility is zero, and there is perfect income equality. c. A poverty rate based on an absolute measure is high, income mobility is high, and there is high income equality. d. There is no poverty based on a relative measure, income mobility is high, and there is perfect income equality.

Answer: a. Impossible. If there is perfect income equality there can be no income mobility and no poverty that is based on a relative measure. b. Possible. Even though there is perfect income equality, which implies no income mobility, there can be poverty measured absolutely. For example, 100 percent of the United States is poor if the poverty rate is an income of $100 trillion per year. c. Possible. With high income equality, there can still be some income mobility and poverty measured in an absolute way. d. Impossible. There can be no income mobility if there is perfect income equality.

6. The left column of Table 21P-4 shows the income data for 10 people at age 40. The right column shows the income for one of their children at the same age (adjusted for inflation).

[LO 21.4] a. How many people in the second generation are in a higher income quintile than their parents? b. How many people in the second generation are in a lower income quintile than their parents? c. How many people are in the highest income quintile who had parents who were in the lowest quintile?

Answer: a. Four people are in a higher income quintile than their parents. b. Four people are in a lower income quintile than their parents. c. Zero people are in the highest quintile who had parents in the lowest.

7. Classify the following social policies based on the approach taken to alleviating poverty: economic development, safety nets, or redistribution. [LO 21.5] a. The government of Zimbabwe reorganizes property rights, giving traditionally marginalized black Zimbabweans access to land owned by white Zimbabweans. b. As part of a package called the GI Bill, the United States offered to pay the college tuition of newly returned veterans of World War II. c. The government of Chile privatizes its social security system. The new system sets up private accounts that require contributions of at least 10 percent of income. This money is invested by private actors and then returned to each person at retirement.

Answer: The goal of economic development is not only the immediate effect of the policy on poverty but also the growth it will produce for the entire economy in the future. Common examples of such policies include education, job training, infrastructure, and urban planning. richard@qwconsultancy.com

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Many policies are designed to protect against the temporary hard times that can lead to transient poverty. Important approaches include safety nets, such as private retirement savings programs and social insurance programs. Some policies may redistribute resources with the explicit purpose of reducing chronic poverty or lessening income inequality. a. The social policy is one of redistribution. b. The social policy is one of economic development. c. The social policy provides safety nets.

8. Imagine a person who makes $400 per week working 40 hours per week for 50 weeks of the year. She is currently eligible for a welfare program, available to people with income below $21,000, which gives her $800 a year. No such program is available to people with income above $21,000 per year. Her boss offers her a promotion that would increase her wage by 25 cents per hour. [LO 21.5] a. What is her total income before the promotion? b. What is her total income if she accepts the promotion? c. Should she accept the promotion if she wants to have higher income?

Answer: a. Before the promotion her total income is $20,800 a year ($20,000 + $800). b. If she accepts the promotion she will receive $10.25 per hour for an annual salary of $20,500. c. No, she should not accept the promotion if she wants to have higher income.

9. President Joe Nositall just published a report for his country, laying out various scenarios for the economy in the next year. Table 21P-5 shows his report, with various levels of GDP growth, income equality, and tax rates. [LO 21.6] a. Rank the scenarios from the most equal to the most unequal income distribution (defined as the average income of the top decile of earners divided by the average income of the bot-tom decile of earners). b. Rank each scenario in terms of the level of GDP growth between 2010 and 2011. c. Between which scenarios is there no trade-off between GDP growth and income equality?

Answer: a. Scenarios from the most equal to the most unequal income distribution: B, D, C, A b. Scenarios in terms of the level of GDP growth between 2018 and 2019: C, A, B, D c. There is no trade-off between GDP growth and income equality between B and D and between C and A. 10. Which of the following are means-tested programs? [LO 21.6] a. A local public university starts to give financial aid to individuals who score above 98% in high school diploma exams. b. The United Kingdom decides to start giving out pension benefits based on individuals’ prior amount of savings.

richard@qwconsultancy.com

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c. A government decides to give tax credits to anyone who purchases computers made domestically. d. USA begins to pay half of the cost of public transportation for people who do not own a car.

Answer: Many programs are means-tested: They define eligibility for benefits based on recipients’ income. a. This is not means-tested; it is a merit-based program. b. Yes, the means-test criterion is based on savings. c. This is not means-tested; this is an example of a simple incentive program. d. Yes, owning a car is the criterion for the means test.

11. Table 21P-6 shows hypothetical salaries for four pairs of men and women who share the same position. It also shows the average increase in income associated with having certain qualities as a worker; assume these represent the only qualities that are relevant for doing the job well. Using these averages, determine for each pair whether there is gender discrimination. If so, say who it is against and how large the gap is in dollar terms. [LO 21.7] Answer: Economists think about discrimination as the practice of making choices using generalizations based on observable characteristics to fill in missing information. Most commonly we hear about discrimination based on race or gender.

a. There is no gender discrimination. b. There is gender discrimination against the male, with a gap of $4,000. c. There is gender discrimination against the female, with a gap of $4,000.

richard@qwconsultancy.com

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12. Working women in Canada earn only half of what men earn. Consider each of the following explanations for this statistic, and say whether each could be true or must not be true in order to explain this fact. [LO 21.7] a. Women choose lower-paying professions (e.g., becoming a nurse rather than a doctor). b. Women are discriminated against when being considered for promotions or raises. c. Women are more educated and have more work experience than men, on average. d. Women are discriminated against in the hiring process. e. Women benefit from affirmative action in the hiring process.

Answer: Average income for adults still varies widely across gender and racial groups. It’s possible that these differences are due to discrimination in the labour market. There are also plenty of other explanations: For instance, on average, white men have higher educational qualifications than people in other groups. To the extent that being more educated is a signal or a cause of higher productivity as a worker, this could explain higher wages. Similarly, women are more likely than men to choose to leave the labour force when they have children, and therefore have less work experience on average. a. Could be true. b. Could be true. c. Must not be true; more education and experience would confer higher wages, not lower ones. d. Could be true e. Must not be true; affirmative action would help women get jobs with higher pay if they are getting discriminated against.

13. Are the workings of the free market likely to encourage or discourage discrimination in the following examples? [LO 21.7] a. The musical director of a symphony orchestra that records but never performs in front of an audience refuses to hire female musicians. b. In apartheid-era South Africa (where racial discrimination was legal and popular among white voters for many decades), a white business owner refuses to hire black candidates to work in management positions dealing with white customers. c. In a Martian culture in which blue hair is considered the most beautiful, a Martian modeling agency preferentially hires blue-haired models.

Answer: Under some conditions, markets may help to eliminate discrimination. When consumer preferences are not in agreement with the discrimination (or when the discrimination is irrelevant to consumers’ preferences), markets will cause those who discriminate to lose profitable opportunities. However, when consumer preferences support discrimination, discrimination and efficient markets can co-exist. a. Discourage: The talent should win out, as no one can see the members of the orchestra in making a decision in buying a CD. b. Encourage: Prejudiced customers may not support a business that hires black candidates for upper-level positions. c. Encourage: Blue-haired candidates have a natural advantage in hiring as long as that is the standard for beauty in Martian culture. richard@qwconsultancy.com

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14. Consider Table 21P-7, which shows several different types of goods sold in a hypothetical town. Imagine a new competitor enters who refuses to discriminate between locals and foreigners in hiring employees. Determine whether the new competitor will do well in the town, given market conditions, for each market (pajama pants, bow ties, and yo-yos). [LO 21.7] Answer: Under some conditions, markets may help to eliminate discrimination. When consumer preferences are not in agreement with the discrimination (or when the discrimination is irrelevant to consumers’ preferences), markets will cause those who discriminate to lose profitable opportunities. However, when consumer preferences support discrimination, discrimination and efficient markets can co-exist. The competitor will likely do well in the pajama pants market, since half the customers will buy from a company that hires only locals, and 70 percent of the stores hire only locals. It is unlikely that the competitor will do well in the bow tie market, since 70 percent of the customers will buy from a company that hires only locals, and half of the stores hire only locals. It is also unlikely that the competitor will do well in the yo-yo market, since 10 percent of the customers will buy from a company that hires only locals, and only 5 percent of the stores hire only locals.

richard@qwconsultancy.com

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