SOLUTIONS MANUAL For Economics 11th Global Edition By Michael Parkin by welldoneassistant

CHAPTER 1

Use headlines from the recent news to illustrate the potential for conflict between selfinterest and the social interest. One example of an issue concerns the size of drinks sold in New York City. Take the June 11, 2012 headline from the Houston Chronicle “NYC Proposes Ban on Large Sodas at Restaurants.” This story discusses Mayor Bloomberg’s intention to pass a law restricting sales in restaurants, movie theaters, and sports arenas from selling sodas in sizes larger than 16 fluid ounces. Mayor Bloomberg believes his action is in the social interest because “The percentage of the population that is obese is skyrocketing.” However soda drinkers, pursuing their self-interest disagree. One analyst said “Folks who want to buy Big Gulps, … a lot of those customers, you’re only going to be able to take it away from them by prying it out of their cold, dead hands.”

Page 11 1.

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

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

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

Explain what it means to choose at the margin and illustrate with three choices at the margin that you have made today.

WHAT IS ECONOMICS?

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

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

Page 12 1.

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

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

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

How is economics used as a policy tool?

CHAPTER 1

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

WHAT IS ECONOMICS?

Answers to the Study Plan Problems and Applications 1.

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

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

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

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

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

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

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

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

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

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

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

CHAPTER 1

Costs Soar for London Olympics The regeneration of East London, the site of the 2012 Olympic Games, is set to add extra £1.5 billion to taxpayers’ bill. Source: The Times, London, July 6, 2006 Is the cost of regenerating East London an opportunity cost of hosting the 2012 Olympic Games? Explain why or why not. The regeneration of East London is an opportunity cost of hosting the 2012 Olympics if East London would not have been regenerated otherwise. However, if there were already plans underway to regenerate East London, then the cost is not an opportunity cost of hosting the Olympics because the cost would have been paid even if London did not host the Olympics.

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

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

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

WHAT IS ECONOMICS?

Answers to Additional Problems and Applications 7.

Hundreds Line up for 5 p.m. Ticket Giveaway By noon, hundreds of Eminem fans had lined up for a chance to score free tickets to the concert. Source: Detroit Free Press, May 18, 2009 When Eminem gave away tickets, what was free and what was scarce? Explain your answer. The seats in the concert are scarce—there are only a limited number (1,500 as it happens) available. Also scarce is the time the enthusiastic fans spent in line to acquire the tickets. In addition, if the fans who scored tickets attended the concert rather than sell their “free” tickets, they incurred the opportunity cost of the foregone ticket price. So the concert was far from “free” for the concert-goers. The publicity that Eminem receives is free to him but the publicity used reporters’ scarce time to report on the lines for the tickets rather than reporting on other news worthy events.

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

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

10.

Before starring in Iron Man, Robert Downey Jr. had appeared in 45 movies that grossed an average of $5 million on the opening weekend. In contrast, Iron Man grossed $102 million. a. How do you expect the success of Iron Man to influence the opportunity cost of hiring Robert Downey Jr.? The salary that must be paid to Robert Downey Jr. to appear in future movies increased because some of the success of Iron Man was attributed to Mr. Downey. As a result the opportunity cost to movie producers of hiring Mr. Downey increased.

b. How have the incentives for a movie producer to hire Robert Downey Jr. changed? There are two effects on the incentives of producers to hire Mr. Downey. First, because the opportunity cost of hiring Mr. Downey increased, the incentive to hire him decreased. However because part of the success of Iron Man was attributed to Mr. Downey’s acting in the title role, producers expect that his acting will lead to increased success for future movies. This belief increases producers’ incentives to hire Mr. Downey.

11.

CHAPTER 1

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

12.

Look at today’s Wall Street Journal. What is the leading economic news story? With which of the big economic questions does it deal and what tradeoffs does it discuss or imply? On July 10, 2012, the top economic news story discussed President Obama’s proposal to extend tax cuts for families earning less than $250,000 and, by not extending tax cuts for families earning more than $250,000, to raise taxes on families earning more than $250,000. This story involved the “for whom?” question because families paying lower taxes will be able to purchase more goods and services. Of course, families paying higher taxes will be able to purchase fewer goods and services. The story implicitly illustrates a tradeoff: If taxes are raised on families earning more than $250,000, these families will have less income to spend on goods and services but the government will collect more tax revenue to spend on goods and services.

13.

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

Appendix

GRAPHS IN ECONOMICS

Answers to the Review Quiz Page 28 1.

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

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

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

APPENDIX 1

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

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

GRAPHS IN ECONOMICS

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

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

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

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

10.

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

11.

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

APPENDIX 1

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

1 2 3 4 5 6 7 8 9 10 11

A 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

B 1.6 2.4 1.9 3.3 3.4 2.5 4.1 0.1 2.7 1.5 3.0

C 3.4 1.6 1.0 1.4 3.2 4.7 4.4 1.5 0.2 0.1 0.1

D 1.1 1.8 2.5 3.5 3.1 2.7 1.9 −0.3 −3.5 3.0 1.7

E 4.7 5.8 6.0 5.5 5.1 4.6 4.6 5.8 9.3 9.6 9.0

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

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

GRAPHS IN ECONOMICS

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

Use the following news clip to work Problems 4 to 6. Avengers Shatters More Records: Source: Boxofficemojo.com, Data for weekend of May 11-12, 2012 4.

Draw a graph of the relationship between the revenue per theater on the y-axis and the number of theaters on the x-axis. Describe the relationship. Figure A1.7 shows the relationship. As the figure shows, there is a positive relationship.

Movie Marvel’s The Avengers Dark Shadows Think Like a Man The Hunger Games

Calculate the slope of the relationship between 3,755 and 2,052 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($7,906 − $2,834)/(3,755 − 2,052) which equals $2.98 per theater.

Calculate the slope of the relationship between 2,052 and 2,531 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($2,834 − $1,780)/(2,052 − 2,531) which equals −$2.20 per theater.

Theater s (numbe r) 4,349

Revenue (dollars per theater)

3,755 2,052 2,531

$7,906 $2,834 $1,780

$23,696

APPENDIX 1

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

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

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

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

GRAPHS IN ECONOMICS

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

Draw a graph to show the relationship between the price and the number of rides, when temperature is 70°F. Describe this relationship.

Price (dollars per ride) 5 10 15

Figure A1.10 shows the relationship between the price and the number of balloon rides when the temperature is 70F. The relationship between the price and the number of rides is inverse; that is, when the price rises, the number of rides decreases.

11.

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

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

APPENDIX 1

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

12.

1 2 3 4 5 6 7 8 9 10 11

A 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

B 26 26 31 42 57 66 72 100 62 79 95

C 146 139 160 190 231 262 284 330 241 284 358

D 5.8 5.7 5.7 5.4 5.2 5.1 5.1 5.0 5.4 5.5 5.7

E 8.6 8.8 8.9 9.1 9.2 9.3 9.3 9.0 9.0 9.0 8.7

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

13.

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

GRAPHS IN ECONOMICS

14.

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

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

0 25

1 24

2 22

3 18

4 12

5 0

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

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

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

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

16.

Calculate the slope of the relationship between x and y when x equals 3. The slope equals −5. The slope of the curve at the point where x is 3 is equal to the slope of the tangent to the curve at that point. Plot the relationship and then draw the tangent line at the point where x is 3 and y is 18. Now calculate the slope of this tangent line by finding another © 2014 Pearson Education, Inc.

APPENDIX 1

point on the tangent. When x equals 5, y equals 10 on the tangent, so another point is x equals 5 and y equals 10. The slope equals the change in x, −8, divided by the change in y, 2, so the slope is −4.

17.

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

18.

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

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

20.

Calculate the slope across the arc AB. The slope across the arc AB is −2. The slope across the arc AB equals the change in y, which is 4 (6 minus 2) divided by the change in x, which equals −2 (1 minus 3). The slope across the arc AB equals 4/−2, which equals −2. © 2014 Pearson Education, Inc.

GRAPHS IN ECONOMICS

Use the following table to work Problems 21 to 23. The table gives information about umbrellas: price, the number purchased, and rainfall in Price inches. (dollars 21. Draw a graph to show the relationship per between the price and the number of umbrella) umbrellas purchased, holding the 20 amount of rainfall constant at 1 inch. 30 Describe this relationship. 40 Figure A1.18 shows the relationship. To draw a graph of the relationship between the price and the number of umbrellas when the rainfall equals 1 inch, keep the rainfall at 1 inch and plot the data in that column against the price. This curve is the relationship between price and number of umbrellas when the rainfall is 1 inches. The relationship between the price and the number of umbrellas is an inverse relationship; as the price rises, the number of umbrellas decreases.

22.

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

23.

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

Umbrellas (numbers per day) 0 1 2 (inches of rainfall) 4 2 1

7 4 2

8 7 4

C h a p t e r

THE ECONOMIC PROBLEM

Answers to the Review Quizzes Page 34 1.

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

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

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

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

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

Why does the PPF bow outward and what does that imply about the relationship between opportunity cost and the quantity produced? Some resources are better suited to produce one type of good or service, like pizza. Other resources are better suited to produce other goods or services, like DVDs. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. Consider a PPF with pizza measured on the x-axis and DVDs measured on the y-axis. A small increase in pizza output when pizza production is relatively low requires only a small increases in the use of those resources still good at making pizza and not good at making DVDs. This yields a small decrease in DVD production for a large increase in pizza production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF over this range of output. However, the same small increase in pizza output when pizza production is relatively large will require society to devote to pizza production those resources that are less suited to making pizza © 2014 Pearson Education, Inc.

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

Page 37 1.

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

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

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

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

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

Page 39 1.

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

How does economic growth influence the production possibilities frontier?

WHAT IS ECONOMICS?

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

What is the opportunity cost of economic growth? When a society devotes more of its scarce resources to research and development of new technologies, or devotes additional resources to produce more capital equipment, both decisions lead to increased consumption opportunities in future periods at the cost of less consumption today. The loss of consumption today is the opportunity cost borne by society for creating economic growth.

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

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

Page 43 1.

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

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

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

What are the gains from specialization and trade? From society’s standpoint, the total output of goods and services available for consumption is greater with specialization and trade. From an individual’s perspective, each person who specializes enjoys being able to consume a larger bundle of goods and services after trading with

others who have also specialized, than would otherwise be possible under self-sufficiency. These increases are the gains from specialization and trade for society and for individuals.

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

Page 45 1.

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

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

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

WHAT IS ECONOMICS?

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

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

and and and and and and

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

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

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

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

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

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

Does Brazil face an increasing opportunity cost of ethanol? What feature of Brazil’s PPF 5

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

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

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

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

WHAT IS ECONOMICS?

Use the following graphs to work Problems 7 to 10. Harry enjoys tennis but wants a high grade in his economics course. The graphs show his PPF for these two “goods” and his MB curve from tennis.

What is Harry’s marginal cost of tennis if he plays for (i) 3 hours a week; (ii) 5 hours a week; and (iii) 7 hours a week? (i) Harry’s marginal cost of an hour of tennis is 1.5 percentage points. When Harry increases the time he plays tennis from 2 hours to 4 hours, his grade in economics falls from 78 percent to 75 percent. His opportunity cost of these 2 additional hours of tennis is 3 percentage points, so his marginal cost of playing tennis for the third hour per week is 1.5 percentage points. (ii) Harry’s marginal cost of an hour of tennis is 2.5 percentage points. When Harry increases the time he plays tennis from 4 hours to 6 hours, his grade in economics falls from 75 percent to 70 percent. His opportunity cost of these 2 additional hours of tennis is 5 percentage points. So his marginal cost of playing tennis for the fifth hour per week is 2.5 percentage points. (iii) Harry’s marginal cost of an hour of tennis is 5 percentage points. When Harry increases the time he plays tennis from 6 hours to 8 hours, his grade in economics falls from 70 percent to 60 percent. His opportunity cost of these 2 additional hours of tennis is 10 percentage points. So his marginal cost of playing tennis for the seventh hour per week is 5 percentage points.

8. a. If Harry uses his time to achieve allocative efficiency, what is his economics grade and how many hours of tennis does he play? Harry’s grade in economics is 66 percent and he plays tennis for 7 hours per week. From the answer to part (a), Harry’s marginal cost of playing the third hour a week of tennis is 1.5 percentage points, his marginal cost of playing tennis the fifth hour a week is 2.5 percentage points and his marginal cost of playing tennis the seventh hour a week is 5 percentage points. Plot these three opportunity costs in Figure 2.3 to create Harry’s marginal cost curve. Harry’s opportunity cost of playing tennis increases as he spends more time playing tennis. Harry uses his time efficiently if he plays tennis for 7 hours a week because when he plays 7 hours a week his marginal benefit from the seventh hour of tennis, 5 percentage points, equals his marginal cost, also 5 percentage points. When Harry plays 7 hours of tennis, the PPF in Figure 2.2 shows that his grade in economics 65 percent.

b. Explain why Harry would be worse off getting a grade higher than your answer to part 7

(a). If Harry studied for enough hours to get a higher grade, he would have fewer hours to play tennis. Harry’s marginal benefit from tennis would be greater than his marginal cost, so he would be more efficient (better off) if he played more hours of tennis and took a lower grade.

If Harry becomes a tennis superstar with big earnings from tennis, what happens to his PPF, MB curve, and his efficient time allocation? If Harry becomes a tennis superstar, his PPF does not change. Harry’s PPF shows the grade he can produce for different hours of playing tennis and these production possibilities are unaffected by Harry’s superstar status. As a result Harry’s MC curve does not change. However Harry’s marginal benefit from playing tennis increases because of his big paydays so his MB curve shifts rightward. As a result, Harry’s efficient allocation of time now allocates more time to tennis (and results in a lower grade).

10.

If Harry suddenly finds high grades in economics easier to attain, what happens to his PPF, his MB curve, and his efficient time allocation? If Harry finds high grades to easier to attain, his PPF shifts outward. In particular for every level of tennis playing his grade in economics is higher. As a result Harry’s marginal cost of earning a high grade in economics is reduced so that Harry’s MC curve shifts downward. Harry’s MB curve does not change because Harry’s marginal benefit from a high grade has not changed. Harry’s efficient time allocation results in Harry increasing the number of hours of tennis he plays.

WHAT IS ECONOMICS?

11.

A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced. a. Make a graph that illustrates the farm’s PPF. The PPF is illustrated in Figure 2.4 as PPF0. Because the marginal cost of both wheat and pork increase as more of the good is produced, the PPF displays increasing opportunity cost so it has the “conventional” bowed-outward shape.

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

c. With the farm using the new technology described in part (b), has the opportunity cost of producing a ton of wheat increased, decreased, or remained the same? Explain and illustrate your answer. The opportunity cost of producing wheat has increased. The opportunity cost of a bushel of wheat is equal to the magnitude of 1/(slope of the PPF). As illustrated in Figure 2.4, for each quantity of wheat the slope of PPF1 has a smaller magnitude than the slope of PPF0 so the opportunity cost of a bushel of wheat is higher along PPF1. For a specific example, the opportunity cost of increasing wheat product from 600 bushels per week to 800 bushels per week along PPF1 is 6,000 pounds of pork but is only 3,000 pounds of pork along PPF0.

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

12.

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

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

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

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

13.

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

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

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

14.

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

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

WHAT IS ECONOMICS?

and to produce the goods and services people want, an incentive sorely lacking in the Cuban economy.

Use the following data to work Problems 15 to 17. Brazil produces ethanol from sugar at a cost of 83 cents per gallon. The United States produces ethanol from corn at a cost of $1.14 per gallon. Sugar grown on one acre of land produces twice the quantity of ethanol as the corn grown on an acre. The United States imports 5 percent of the ethanol it uses and produces the rest itself. Since 2003, U.S. ethanol production has more than doubled and U.S. corn production has increased by 45 percent. 15. a. Does Brazil or the United States have a comparative advantage in producing ethanol? Brazil has a comparative advantage in producing ethanol. In Brazil $0.83 worth of other goods and services must be forgone to produce a gallon of ethanol whereas in the United States $1.14 of other goods and services must be forgone to produce a gallon of ethanol.

b. Sketch the PPF for ethanol and other goods and services for the United States.

Figure 2.5 shows the U.S. PPF. For simplicity and in keeping with Figure 2.6 on p. 42 of the textbook, the PPF is linear. (Ignore until Problem 17 the trade line in the figure.)

c. Sketch the PPF for ethanol and other goods and services for Brazil. Figure 2.6 shows Brazil’s PPF. For simplicity and in keeping with the Figure 2.6 on p. 42 of the textbook, the PPF is linear. (Ignore until Problem 17 the trade line in the figure.)

16. a. Do you expect the opportunity cost of producing ethanol in the United States to have increased since 2003? Explain why. If there have been no technological changes in the production of ethanol, so that the PPF between ethanol and other goods and services has not shifted, and if there is increasing opportunity cost when producing more of a good along the PPF, then the opportunity cost of producing ethanol in the United States increased as more ethanol was produced.

b. Do you think the United States has achieved production efficiency in its manufacture of ethanol? Explain why or why not. The United States has probably attained production efficiency. In the United States firms have the incentive to produce goods and services, such as ethanol, efficiently because the owners of firms have been given the property right to their firm’s profit.

c. Do you think the United States has achieved allocative efficiency in its manufacture of ethanol? Explain why or why not. The United States does not allow free trade in ethanol, which is why the U.S. price exceeds the Brazilian price. It is likely that the allocatively efficient quantity of U.S.-produced ethanol is less than the quantity produced in the United States. Most likely allocative efficiency requires that the United States should produce less ethanol, more other goods and services, and trade with Brazil because Brazil produces ethanol at lower cost than the United States.

17.

Sketch a figure similar to Fig. 2.6 on p. 42 to show how both the United States and Brazil can gain from specialization and trade. In general, the United States gains from trade with Brazil by importing ethanol from Brazil. Brazil produces ethanol at a lower opportunity cost than the United States, so the opportunity cost to the United States of consuming ethanol is lower if the United States consumes ethanol produced in Brazil. In Figure 2.5 initially the United States produced and consumed 400 billion units of other goods and services and 10 million gallons of ethanol. After specializing in the production of other goods and services and trading with Brazil, the United States produces 800 billion units of other goods and services. By trading 200 billion units of goods and services for 20 million gallons of ethanol, the United States consumes 600 billion units of other goods and services and 20 million gallons of ethanol. The consumption of both other goods and services and ethanol increases in the United States. The story in Brazil is similar. In Figure 2.6 prior to trade Brazil produced and consumed 150 billion units of other goods and services and 20 million gallons of ethanol. After specializing in the production of ethanol (50 million gallons of ethanol) and trading with the United States (20 million gallons of ethanol in exchange for 200 billion units of other goods and services) Brazil consumes 200 billion units of other goods and services and 30 million gallons of ethanol. The consumption of both other goods and services and ethanol increases in Brazil.

WHAT IS ECONOMICS?

Use this news clip to work Problems 18 to 20. Time For Tea Americans are switching to loose-leaf tea for its health benefits. Tea could be grown in the United States, but picking tea leaves would be costly because it can only be done by workers and not by machine. Source: The Economist, July 8, 2005

18. a. Sketch PPFs for the production of tea and other goods and services in India and in the United States. The PPFs might be linear, though more realistic PPFs are bowed out from the origin, as illustrated above. The goods along the two axes are tea and other goods and services. The important point about the two PPFs is that the opportunity cost of producing tea is lower in India. The magnitude of the slope of the PPF is equal to the opportunity cost of producing tea, so the U.S. PPF is steeper than India’s PPF.

b. Sketch marginal cost curves for the production of tea in India and in the United States. The marginal cost curves for producing tea are illustrated in Figure 2.9. The marginal cost curves slope upward. Because tea is less costly to produce in India than in the United States, the U.S. MC curve lies above the Indian MC curve.

19. a. Sketch the marginal benefit curves for tea in the United States before and after Americans began to appreciate the health benefits of loose tea. As Figure 2.10 shows, after more Americans start to appreciate tea the downward sloping marginal benefit curve for tea shifts rightward from the initial marginal benefit curve, MB0 to the new marginal benefit curve, MB1.

b. Explain how the quantity of loose tea that achieves allocative efficiency has changed. The increase in the marginal benefit from tea increases the quantity of tea that achieves allocative efficiency.

c. Does the change in preferences toward tea affect the opportunity cost of producing tea? If the PPF in India between tea and other goods and services is bowed out from the origin, increasing the production of tea raises the opportunity cost of producing tea.

20.

Explain why the United States does not produce tea and instead imports it from India. The United States imports tea from India because it is cheaper for the U.S. to import tea than to produce it in the United States. Fewer other goods and services must be given up to import tea than would be given up if the United States produced tea.

WHAT IS ECONOMICS?

Answers to Additional Problems and Applications Use the table to work Problems 21 to 23. Suppose that Yucatan’s production possibilities are given in the table. 21. a. Draw a graph of Yucatan’s PPF and explain how your graph illustrates a tradeoff. Yucatan’s PPF is illustrated in Figure 2.11. The figure illustrates a tradeoff because moving along Yucatan’s PPF producing more of one good requires producing less of the other good. Yucatan trades off more production of one good for less production of the other.

Food (pounds per month) 300 200 100 0

and and and and

Sunscreen (gallons per month) 0 50 100 150

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

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

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

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

22.

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

23.

In problem 21, what is the marginal cost of a pound of food in Yucatan when the quantity produced is 150 pounds per day? What is special about the marginal cost of food in Yucatan? The marginal cost of a pound of food in Yucatan is constant at all points along Yucatan’s PPF and is equal to 0.5 gallons of sunscreen per pound of food. The special point about Yucatan’s marginal cost is the fact that the marginal cost is constant. This result reflects Yucatan’s linear PPF.

24.

The table describes the preferences in Yucatan. a. What is the marginal benefit from sunscreen and how is it measured? The marginal benefit from sunscreen is the benefit enjoyed by the person who consumes one more gallon of sunscreen. It is equal to the willingness to pay for an additional gallon.

b. Draw a graph of Yucatan’s marginal benefit from sunscreen.

Sunscreen (gallons per month) 25 75 125

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

The table gives the information necessary to calculate the marginal benefit from sunscreen. The marginal benefit is equal to the willingness to pay for an additional gallon of sunscreen. To draw the marginal benefit curve from sunscreen, plot the quantity of sunscreen on the x-axis and the willingness to pay for sunscreen (that is, the number of pounds of food that a person is willing to give up to get a gallon of sunscreen) on the y-axis. Figure 2.12 shows this figure.

Use the following news clip to work Problems 25 and 26. Malaria Eradication Back on the Table In response to the Gates Malaria Forum in October 2007, countries are debating the pros and cons of eradication. Dr. Arata Kochi of the World Health Organization believes that with enough money malaria cases could be cut by 90 percent, but he believes that it would be very expensive to eliminate the remaining10 percent of cases. He concluded that countries should not strive to

WHAT IS ECONOMICS?

eradicate malaria. 25.

Source: The New York Times, March 4, 2008

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

26.

Make a graph with the percentage of malaria cases eliminated on the x-axis and the marginal cost and marginal benefit of driving down malaria cases on the y-axis. On your graph: (i) Draw a marginal cost curve that is consistent with Dr. Kochi’s opinion. (ii) Draw a marginal benefit curve that is consistent with Dr. Kochi’s opinion. (iii) Identify the quantity of malaria eradicated that achieves allocative efficiency. Figure 2.13 shows a marginal cost curve and a marginal benefit curve that are consistent with Dr. Kochi’s views. Dr. Kochi believes that the last 10 percent of malaria would be very expensive to eradicate. The marginal cost curve in the figure reflects this view because the marginal cost curve rises rapidly after 90 percent of malaria is eradicated. The marginal benefit curve is downward sloping, reflecting diminishing marginal benefit from malaria eradication. The allocatively efficient quantity of malaria eradicated is 90 percent because that is the quantity for which the marginal benefit of eradication equals the marginal cost of eradication. This outcome demonstrates Dr. Kochi’s conclusion that countries should not attempt to completely

27.

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

Use the following data to work Problems 28 and 29. Kim can produce 40 pies or 400 cakes an hour. Liam can produce 100 pies or 200 cakes an hour. 28. a. Calculate Kim’s opportunity cost of a pie and Liam’s opportunity cost of a pie. If Kim spends an hour baking pies, she gains 40 pies but forgoes 400 cakes. Kim’s opportunity cost of 1 pie is (400 cakes)/(40 pies), or 10 cakes per pie. If Liam spends an hour baking pies, he 17

gains 100 pies but forgoes 200 cakes. Liam’s opportunity cost of 1 pie is (200 cakes)/(100 pies), or 2 cakes per pie.

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

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

29. a

Draw a graph of Kim’s PPF and Liam’s PPF.

Kim’s PPF is illustrated in Figure 2.14; Liam’s PPF is illustrated in Figure 2.15.

b. On your graph, show the point at which each produces when they spend 30 minutes of each hour producing pies and 30 minutes producing cakes. Point A in both figures shows their production points when each spends 30 minutes making cakes and 30 minutes making pies.

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

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

WHAT IS ECONOMICS?

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

Use the following information to work Problems 30 and 31. Before the Civil War, the South traded with the North and with England. The South sold cotton and bought manufactured goods and food. During the war, one of President Lincoln’s first actions was to blockade the ports and prevent this trade. The South increased its production of munitions and food. 30.

In what did the South have a comparative advantage? Before the war the South had a comparative advantage in producing cotton.

31. a. Draw a graph to illustrate production, consumption, and trade in the South before the Civil War. Figure 2.16 illustrates the South’s situation. The production point is point a. The South produces a great deal of cotton and very little food and manufactured goods; indeed, in the unlikely case that the South completely specialized, the production point could be at the maximum quantity of cotton and zero food and manufactured goods. From the production point a trade line with a negative slope touches the PPF and extends beyond the PPF. The trade line shows that the South traded cotton for manufacturing goods and food and consumed at point b, well beyond its PPF.

b. Was the South consuming inside, on, or outside its PPF ? Explain your answer. The South was consuming at a point beyond its PPF. The South could do so because it was able to trade cotton, which was relatively less expensive for the South to produce, in exchange for manufactured goods and food, which would have been relatively expensive for the South to produce. In other words, the South enjoyed gains from trade.

c. Draw a graph to show the effects of the Civil War on consumption and production in the South. Assuming that the Civil War did not affect the South’s PPF (which is probably true only for the first part of the war) the North’s blockade meant that the South could no longer trade with others. As a result, the South increased its production of manufactured goods (especially munitions) and food, which caused the South to decrease its production of cotton. The blockade forced the South’s consumption point to lie on its PPF, so the South’s consumption of manufactured goods and food decreased. In Figure 2.16, the South changes so that its production and its consumption point become point c.

d. Did the Civil War change any opportunity costs in the South? If so, did the opportunity cost of everything increase? Did the opportunity cost of any items decrease? Illustrate your answer with appropriate graphs. The Civil War increased the opportunity cost of food and manufactured goods. However it decreased the opportunity cost of cotton. 19

Figure 2.16 illustrates the changes. The opportunity cost of cotton decreased because the blockade lead the South to produce less cotton, moving from initial production point a to final production point c. Moving along a PPF, as less of a good is produced, its opportunity cost falls. The opportunity cost of food and manufactured goods increased because the South increased the amount of food and manufactured goods it produced. Moving along a PPF, as more of a good is produced, its opportunity cost rises.

Use the following information to work Problems 32 and 33. He Shoots! He Scores! He Makes Movies! NBA All-star Baron Davis and his school friend, Cash Warren, premiered their first movie Made in America at the Sundance Festival in January 2008. The movie, based on gang activity in South Central Los Angeles, received good reviews. Source: The New York Times, February 24, 2008 32. a. Does Barron Davis have an absolute advantage in basketball and movie directing and is this the reason for his success in both activities? Mr. Davis might have an absolute advantage in both endeavors. His success, however, is the result of his comparative advantage in both.

b. Does Barron Davis have a comparative advantage in basketball or movie directing or both and is this the reason for his success in both activities? Mr. Davis has many activities available, so he might have a comparative advantage in both basketball and directing. Mr. Davis, however, will not have a comparative advantage in all the other activities.

33. a. Sketch a PPF between playing basketball and producing other goods and services for Barron Davis and for yourself. Figure 2.17 shows a typical set of PPFs. Unless the student is a future NBA superstar, the PPF for Mr. Davis will definitely intersect the axis that measures playing basketball much farther away from the origin than the student’s PPF. The intersection of the PPF and the axis that measures the production of other goods might be higher for Mr. Davis or might be higher for the student (depending on the student’s ego). But the student’s PPF will be steeper than Mr. Baron’s PPF, indicating that the opportunity cost of producing units of basketball is lower for Mr. Davis than for the student.

b. How do you (and people like you) and Barron Davis (and people like him) gain from specialization and trade? Mr. Davis will specialize in the activity in which he has a comparative advantage, possibly playing basketball. Other people will specialize in the activities in which they have a comparative advantage. As a result, production of all goods and services takes place at the lowest opportunity cost. Then all these low-cost producers can trade with everyone else, so that everybody can enjoy a larger consumption bundle acquired at lower cost than if the goods and services were produced by the person himself or herself.

WHAT IS ECONOMICS?

34.

Indicate on a graph of the circular flows in the market economy, the real and money flows in which the following items belong: a. You buy an iPad from the Apple Store. Figure 2.18 shows the circular flows in a market economy. Your purchase of an iPad from Apple is the purchase of a good from a firm. This flow is in the black arrow indicated by point a in the figure. When you pay for the iPad, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled a.

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

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

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

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

36.

Lots of Little Screens Inexpensive broadband access has created a generation of television producers for whom the Internet is their native medium. As they redirect the focus from TV to computers, cell phones, and iPods, the video market is developing into an open digital network. Source: The New York Times, December 2, 2007 a. How has inexpensive broadband changed the production possibilities of video entertainment and other goods and services? Inexpensive broadband has increased the production possibilities.b. Sketch a PPF for video entertainment and other goods and services before broadband. The PPF should have video entertainment on one axis and other goods and services on the other as illustrated in Figure 2.19 by PPF0. The PPF is bowed outward as a conventional PPF.

c. Show how the arrival of inexpensive broadband has changed the PPF. The arrival of inexpensive broadband shifts the PPF outward as shown by the change from PPF0 to PPF1 in Figure 2.19. The intersection of the new PPF along the axis measuring video entertainment increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

d. Sketch a marginal benefit curve for video entertainment. The marginal benefit curve should be a conventional downward-sloping marginal benefit curve as shown in Figure 2.20. The marginal benefit from video entertainment is

WHAT IS ECONOMICS?

measured along the vertical axis and the quantity of video entertainment is measured along the horizontal axis.

e. Show how the new generation of TV producers for whom the Internet is their native medium might have changed the marginal benefit from video entertainment. The marginal benefit increases because these new producers will be better able to take advantage of the Internet since it is their native medium. Because they will be able to create entertainment designed for the Internet, the marginal benefit from video entertainment increases. In Figure 2.20, the marginal benefit curve shifts rightward from the initial marginal benefit curve, MB0, to the new marginal benefit curve, MB1. f. Explain how the efficient quantity of video entertainment has changed. The arrival of broadband has decreased the marginal cost of providing video entertainment, so the marginal cost curve shifts rightward. This shift is illustrated in the Figure 2.21 by the rightward shift of the marginal cost curve from MC0 to MC1. As Figure 2.21 shows, the allocatively efficient quantity of video entertainment increases. In Figure 2.21, the allocatively efficient quantity increases from 5 million units per year to 8 million units per year.

C h a p t e r

DEMAND AND SUPPLY

Answers to the Review Quizzes Page 56 1.

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

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

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

Page 61 1.

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

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

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

List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand. Influences that change the demand for a good include: • The prices of related goods. A rise (fall) in the price of a substitute increases (decreases) the demand for the first good. A rise (fall) in the price of a complement decreases (increases) the demand for the first good. © 2014 Pearson Education, Inc.

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•

The expected future price of the good. A rise (fall) in the expected future price of a good increases (decreases) the demand in the current period.

•

Income. An increase (decrease) in income increases (decreases) the demand for a normal good. An increase in income decreases (increases) the demand for an inferior good.

•

Expected future income and credit. An increase (decrease) in expected future income or credit increases (decreases) the demand.

•

The population. An increase (decrease) in population increases (decreases) the demand.

•

People’s preferences. If people’s preferences for a good rise (fall), the demand increases (decreases).

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

Page 65 1.

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

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

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

List all the influences on selling plans, and for each influence, say whether it changes supply. Changes in the price of the good change the quantity supplied. They do not change the supply of the good. Influences that change the supply of a good include: • Prices of factor of production. A rise (fall) in the price of a factor of production increases firms’ costs of production and decreases (increases) the supply of the good. •

Prices of related goods produced. If the price of a substitute in production rises (falls), firms decrease (increase) their sales of the original good and the supply for the original good decreases (increases). A rise (fall) in the price of a complement in production increases (decreases) production of the original good, causing the supply of the original good to increase (decrease).

•

The expected future price of the good. A rise (fall) in the expected future price of the good decreases (increases) the amount suppliers sell today. This change in expectations decreases (increases) the supply in the current period.

DEMAND AND SUPPLY

•

The number of sellers. An increase (decrease) in the number of sellers in a market increases the quantity of the good available at every price, and increases (decreases) the supply.

•

Technology. An advance in technology increases the supply.

•

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

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

Page 67 1.

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

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

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

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

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

Page 72

What is the effect on the price and quantity of MP3 players (such as the iPod) if 1. The price of a PC falls or the price of an MP3 download rises? (Draw the diagrams!) A fall in the price of a PC decreases the demand for MP3 players because a PC is a substitute for an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls and the quantity of MP3 players decreases. You can illustrate this outcome by drawing a diagram like Figure 3.10c on page 73.

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A rise in the price of an MP3 download decreases the demand for MP3 players because an MP3 download is a complement of an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls and the quantity of MP3 players decreases. You can illustrate this outcome by drawing a diagram like Figure 3.10c on page 73.

More firms produce MP3 players or electronics workers’ wages rise? (Draw the diagrams!) An increase in the number of firms that produce MP3 players increases the supply of MP3 players. The supply curve of MP3 players shifts rightward. Demand remains unchanged. The price of an MP3 player falls and the quantity of MP3 players increases. You can illustrate this outcome by drawing a diagram like Figure 3.10d on page 73. A rise in the wages of electronic workers decreases the supply of MP3 players because it increases the cost of producing MP3 players. The supply curve of MP3 players shifts leftward. Demand remains unchanged. The price of an MP3 player rises and the quantity of MP3 players decreases. You can illustrate this outcome by drawing a diagram like Figure 3.10g on page 73.

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

DEMAND AND SUPPLY

Answers to the Study Plan Problems and Applications 1.

William Gregg owned a mill in South Carolina. In December 1862, he placed a notice in the Edgehill Advertiser announcing his willingness to exchange cloth for food and other items. Here is an extract: 1 yard of cloth for 1 pound of bacon 2 yards of cloth for 1 pound of butter 4 yards of cloth for 1 pound of wool 8 yards of cloth for 1 bushel of salt a. What is the relative price of butter in terms of wool? 1 pound of butter exchanged for 2 yards of cloth and 4 yards of cloth exchanged for 1 pound of wool. So pound of butter exchanged for 2 yards of cloth and 2 yards of cloth exchanged for 1/2 pound of wool. So the relative price of butter in terms of wool was 1/2 pound of wool per pound of butter.

b. If the money price of bacon was 20¢ a pound, what do you predict was the money price of butter? 1 pound of bacon exchanged for 1 yard of cloth and 2 yards of cloth exchanged for 1 pound of butter. Hence it took 2 pounds of bacon to exchange for 1 pound of butter. As a result, if the money price of a pound of bacon was 20¢, the money price of 1 pound of butter was 40¢.

c. If the money price of bacon was 20¢ a pound and the money price of salt was $2.00 a bushel, do you think anyone would accept Mr. Gregg’s offer of cloth for salt? If the money price of bacon is 20¢ a pound, Mr. Gregg’s offer to exchange 1 pound of bacon for 1 yard of cloth means that anyone could obtain 1 yard of cloth for a money price of 20¢. Mr. Gregg’s further offer to exchange 8 yards of cloth for 1 bushel of salt means that anyone could acquire 1 bushel of salt for $1.60, the price of 8 yards of cloth. If the money price of salt is $2.00 a bushel, many would accept Mr. Gregg’s offer of cloth for salt because it enables them to obtain salt at a money price of only $1.60 a bushel.

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

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

c. Explain how the income effect influences food purchases and provide some examples of the income effect that might occur when the price of food rises and other things remain the same. Food is a normal good so a rise in the price, which decreases people’s real incomes, decreases the quantity of food demanded. In the United States, restaurants suffer as the negative income effect from a higher price of food leads people to cut back their trips to restaurants. At home, people © 2014 Pearson Education, Inc.

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will buy fewer steaks and instead will buy more noodles. In poor countries (and among the poor in the United States), people literally eat less when the price of food rises and in extremely poor countries starvation increases.

Place the following goods and services into pairs of likely substitutes and pairs of likely complements. (You may use an item in more than one pair.) The goods and services are coal, oil, natural gas, wheat, corn, rye, pasta, pizza, sausage, skateboard, roller blades, video game, laptop, iPod, cell phone, text message, email, phone call, voice mail Substitutes include: coal and oil; coal and natural gas; oil and natural gas; wheat and corn; wheat and rye; corn and rye; pasta and pizza; pasta and sausage; pizza and sausage (they type of sausage that cannot be used as a topping on pizza); skateboard and roller blades; skateboard and video game; roller blades and video game; text message and email; text message and phone call; email and voice mail; and, email and phone call. Complements include: pizza and sausage (the type of sausage that can be used as a topping on pizza); skateboard and iPod; roller blades and iPod; video game (those played on a computer) and laptop; cell phone and text message; cell phone and phone call; cell phone and voice mail; and, phone call and voice mail.

During 2010, the average income in China increased by 10 percent. Compared to 2009, how do you expect the following would change: a. The demand for beef. Explain your answer. Beef is a normal good. The increase in income increases the demand for beef.

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

In January 2010, the price of gasoline was $2.70 a gallon. By spring 2010, the price had increased to $3.00 a gallon. Assume that there were no changes in average income, population, or any other influence on buying plans. Explain how the rise in the price of gasoline would affect a. The demand for gasoline. The rise in the price of gasoline does not change the demand for gasoline. The demand for gasoline changes only when some other relevant factor other than the price of the good changes.

b. The quantity of gasoline demanded. The rise in the price of gasoline decreases the quantity of gasoline demanded. A rise in the price of a good or service decreases the quantity of that good or service demanded.

In 2008, the price of corn increased by 35 percent and some cotton farmers in Texas stopped growing cotton and started to grow corn. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. This fact illustrates the law of supply: the higher price of corn increases the quantity of corn grown.

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

Use the following information to work Problems 7 to 9. Dairies make low-fat milk from full-cream milk. In the process of making low-fat milk, the dairies produce cream, which is made into ice cream. In the market for low-fat milk, the following events occur one at a time: © 2014 Pearson Education, Inc.

DEMAND AND SUPPLY

(i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With the period of low rainfall extending, dairies raise their expected price of low-fat milk next year. (v) With advice from health-care experts, dairy farmers decide to switch from producing full cream milk to growing vegetables. (vi) A new technology lowers the cost of producing ice cream. 7.

Explain the effect of each event on the supply of low-fat milk. (i) Dairy workers are a factor used to produce low-fat milk. The price of a factor of production rises, which decreases the supply of low-fat milk. (ii) Cream and low fat milk are complements in production. The price of a complement in production rises, which increases the supply of low fat milk. (iii) A rise in the price of low-fat milk does not change the supply of low-fat milk. It does, however, increase the quantity of low-fat milk supplied. (iv) The higher expected price of low-fat milk decreases the (current) supply of low-fat milk. (v) Full-cream milk and low-fat milk are substitutes in production. The decrease in the production of full-cream milk increases the supply of low-fat milk. (vi) Ice cream and low-fat milk are complements in production. The lower cost of producing ice cream increases the quantity of ice cream produced, which increases the supply of low-fat milk.

Use a graph to illustrate the effect of each event.

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Figure 3.1 illustrates events (i) and (iv), both of which decrease the supply of low-fat milk. Figure 3.2 illustrates events (ii), (v), and (vi), all of which increase the supply of low-fat milk. Figure 3.3 illustrates event (iii), which increases the quantity of low-fat milk supplied.

Does any event (or events) illustrate the law of supply? Event (iii), the rise in the price of low-fat milk, illustrates the law of supply because it leads to a change in the quantity supplied.

10.

“As more people buy computers, the demand for Internet service increases and the price of Internet service decreases. The fall in the price of Internet service decreases the supply of Internet service.” Explain what is wrong with this statement. The statement is wrong for several reasons. First, if the demand for Internet services increases and nothing else changes, the price of Internet service will rise not fall. Second, if the price of Internet services falls, the supply of Internet services does not change. Rather, there is a decrease in the quantity supplied, that is, a movement along the supply curve rather than a shift of the supply curve.

11.

The demand and supply schedules for gum are in the table. a. Draw a graph of the market for gum and mark in the equilibrium price and quantity.

Price (cents per pack) 20 40 60 80 100

Figure 3.4 shows the demand and supply curves. The equilibrium price is 50 cents a pack, and the equilibrium quantity is 120 million packs a week. The price of a pack adjusts until the quantity demanded equals the quantity supplied. At 50 cents a pack, the quantity demanded is 120 million packs a week and the quantity supplied is 120 million packs a week.

Quantity Quantity demanded supplied (millions of packs a week) 180 60 140 100 100 140 60 180 20 220

DEMAND AND SUPPLY

b. Suppose that the price of gum is 70¢ a pack. Describe the situation in the gum market and explain how the price adjusts. At 70 cents a pack, there is a surplus of gum and the price falls. At 70 cents a pack, the quantity demanded is 80 million packs a week and the quantity supplied is 160 million packs a week. There is a surplus of 80 million packs a week. The price falls until market equilibrium is restored at a price of 50 cents a pack.

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

12.

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

b. The supply of gasoline? (i) changes the supply of gasoline. The supply of gasoline will change if the price of crude oil (a factor of production used in the production of gasoline) changes. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases.

c. The quantity of gasoline demanded? (i) changes the quantity of gasoline demanded. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases. The demand for gasoline does not change. The price of gasoline rises and there is a movement up the demand curve for gasoline. The quantity of gasoline demanded decreases.

d. The quantity of gasoline supplied? (ii) and (iii) and (iv) change the quantity of gasoline supplied. If the price of a car rises, the quantity of cars bought decrease so the demand for gasoline decreases. The supply of gasoline does not change. The price of gasoline falls and there is a movement down the supply curve of gasoline. The quantity of gasoline supplied decreases.

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If all speed limits on highways are abolished, people will drive faster and use more gasoline. The demand for gasoline increases. The supply of gasoline does not change, so the price of gasoline rises and there is a movement up along the supply curve. The quantity of gasoline supplied increases. If robot production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be bought. The demand for gasoline increases. The supply of gasoline does not change, so the price of gasoline rises and the quantity of gasoline supplied increases.

13.

In Problem 11, a fire destroys some factories that produce gum and the quantity of gum supplied decreases by 40 million packs a week at each price. a. Explain what happens in the market for gum and draw a graph to illustrate the changes. As the number of gum-producing factories decreases, the supply of gum decreases. There is a new supply schedule and, in Figure 3.5, the supply curves shifts leftward by 40 million packs at each price to the new supply curve S1. After the fire, the quantity supplied at 50 cents is now only 80 million packs, and there is a shortage of gum. The price rises to 60 cents a pack, at which the new quantity supplied equals the quantity demanded. The new equilibrium price is 60 cents and the new equilibrium quantity is 100 million packs a week.

b. If at the time the fire occurs there is an increase in the teenage population, which increases the quantity of gum demanded by 40 million packs a week at each price, what are the new equilibrium price and quantity of gum? Illustrate these changes on your graph. The new price is 70 cents a pack, and the quantity is 120 million packs a week. The demand for gum increases and the demand curve shifts rightward by 40 million packs at each price. Supply decreases by 40 millions packs a week and the supply curve shifts leftward by 40 million packs at each price. These changes are shown in Figure 3.6 by the shift of the demand curve from D to D1 and the shift of the supply curve from S to S1. At any price below 70 cents a pack there is a shortage of gum. The price of gum rises until the shortage is eliminated.

DEMAND AND SUPPLY

14.

Indian Weddings Boost Gold Price Hopes Indian weddings traditionally take place between late September and December. The predilection for jewelry at this time usually gives a big boost to gold sales, and the record shows the price of gold has generally risen during this period. Source: Financial News, September 9, 2011 a. Describe the changes in demand and supply in the market for gold in India before and during the wedding season. The number of people (couples) demanding gold increases during the wedding season, so the demand for gold increases during the wedding season. This factor, by itself, raises the price of gold during the wedding season. Because this event is predictable, the rise in the price also is predictable, which has further consequences on the demand and supply. The rise in the expected future price during the wedding season increases the demand for gold before wedding season and decreases the supply of gold before the wedding season.

b. Given that the wedding season is a predictable event, how might expectations influence the market for gold in India? The expected rise in price during the wedding season increases the demand before the wedding season and decreases the supply before the wedding season. Before the wedding season, these changes in demand and supply raise the price of gold from what it otherwise would be; the effect on the quantity, however, is ambiguous. Because the demand increased before wedding season, the demand during wedding season will be less than otherwise. Similarly because the supply decreased before the wedding season, the supply during the wedding season will be larger than otherwise. These changes in demand and supply mean that the price during wedding season will be lower than otherwise, though the effect on the quantity is ambiguous.

15.

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Pump Prices on Pace to Top 2009 High by Weekend The cost of filling up the car is rising as the crude oil price soars and pump prices may exceed the peak price of 2009. Source: USA Today, January 7, 2010 a. Does demand for or the supply of gasoline or both change when the price of oil soars? Oil is used to produce gasoline, so when the price of oil rises, the price of a factor used to produce gasoline rises. The higher price of oil decreases the supply of gasoline. The demand for gasoline does not change.

b. Use a demand-supply graph to illustrate what happens to the equilibrium price of gasoline and the equilibrium quantity of gasoline bought when the price of oil soars. Figure 3.7 shows the impact of the higher price of oil. The supply of gasoline decreases so that the supply curve shifts leftward from S0 to S1. The equilibrium price of gasoline rises, in the figure from $3.50 per gallon to $4.25 per gallon, and the equilibrium quantity decreases, in the figure from 100 million gallons per week to 75 million gallons per week.

16.

American to Cut Flights, Charge for Luggage American Airlines announced that it will charge passengers $15 for their first piece of checked luggage and cut domestic flights as it grapples with record-high fuel prices. Source: Boston Herald, May 22, 2008 a. According to the news clip, what is the influence on the supply of American Airlines flights? Fuel prices are a cost of a factor of production. As the cost rises, the supply decreases. American Airlines is decreasing the supply of its flights by cutting domestic flights.

b. Explain how supply changes. An increase in the cost of the factor of production decreases the supply and shifts the supply curve leftward.

DEMAND AND SUPPLY

17.

Frigid Florida Winter is Bad News for Tomato Lovers An unusually cold January in Florida destroyed entire fields of tomatoes. Florida’s growers are shipping only a quarter of their usual 5 million pounds a week. The price has risen from $6.50 for a 25-pound box a year ago to $30 now. Source: USA Today, March 3, 2010 a. Make a graph to illustrate the market for tomatoes in January 2009 and January 2010. Figure 3.8 shows the tomato market in January 2009 and January 2010. In both years the demand curve is labeled D. The supply curve for 2009 is labeled S0 and the supply curve for 2010 is labeled S1. The supply curve for 2010 lies to the left of the supply curve for 2009 because the cold January was a bad state of nature and decreased the supply of tomatoes.

b. On the graph, show how the events in the news clip influence the market for tomatoes. The cold weather shifted the supply curve leftward, from S0 to S1. The equilibrium price of a box of tomatoes rises from $6.25 per box to $30.00 per box and the equilibrium quantity decreases from 5 million pounds of tomatoes per week to 1.25 million pounds of tomatoes per week.

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

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Answers to Additional Problems and Applications 18.

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

19.

The money price of a textbook is $90 and the money price of the Wii game Super Mario Galaxy is $45. a. What is the opportunity cost of a textbook in terms of the Wii game? A textbook costs $90 and a Wii game costs $45. Purchasing 1 textbook forces the buyer to give up 2 Wii games. So the opportunity cost of a textbook in terms of Wii games is 2 Wii games per textbook.

b. What is the relative price of the Wii game in terms of textbooks? The relative price of a Wii game in terms of textbooks equals ($45 per Wii)/($90 per textbook), which is 1/2 of a textbook per Wii game.

20.

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

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

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

21.

Think about the demand for the three game consoles: Xbox, PS3, and Wii. Explain the effect of the following events on the demand for Xbox games and the quantity of Xbox games demanded, other things remaining the same. a. The price of an Xbox falls. An Xbox and an Xbox game are complements. When the price of an Xbox falls, consumers respond by increasing the quantity of Xboxes demanded so the equilibrium quantity of Xboxes increases. Consumers increase their demand for Xbox games because an Xbox console is useless without Xbox games.

b. The prices of a PS3 and a Wii fall. A PS3 and a Wii are substitutes for an Xbox. When these game consoles fall in price, the demand for Xbox consoles decreases and so the equilibrium quantity of Xboxes decreases. Consumers

DEMAND AND SUPPLY

decrease their demand for Xbox games because an Xbox game is useless without an Xbox console.

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

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

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

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

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

22.

Classify the following pairs of goods and services as substitutes in production, complements in production, or neither. a. Bottled water and health club memberships Bottled water and health club memberships are neither substitutes in production nor complements in production. (For consumers, these are complements because people in health clubs drink a lot of bottled water.)

b. French fries and baked potatoes For a restaurant that produces both French fries and baked potatoes, they are substitutes in production. (For a consumer, they are substitutes.)

c. Leather purses and leather shoes Leather purses and leather shoes are substitutes in production.

d. Hybrids and SUVs For an auto company that produces both on the same assembly line, they are substitutes in production. (For a consumer, hybrids and SUVs are substitutes.)

e. Diet coke and regular coke For a soda company that produces both on the same assembly line, they are substitutes in production. (For a consumer, Diet coke and regular coke are substitutes.)

23.

As the prices of homes fell across the United States in 2008, the number of homes offered for sale decreased. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. This fact illustrates the law of supply: As the price falls, the quantity supplied decreases.

b. Why would home owners decide not to sell? Home owners delay selling their homes because they believe the price they would receive is too low and the price they will receive in the future will be higher.

24.

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G.M. Cuts Production for Quarter General Motors cut its fourth-quarter production schedule by 10 percent because Ford Motor, Chrysler, and Toyota sales declined in August. Source: The New York Times, September 5, 2007 Explain whether this news clip illustrates a change in the supply of cars or a change in the quantity supplied of cars. The lower sales of Ford, Chrysler, and Toyota cars probably reflect a decrease in the demand for these cars. G.M. believes that the demand for its cars will decrease, so G.M. is responding to this decrease in demand by decreasing the quantity of its cars supplied.

Use Figure 3.9 to work Problems 25 and 26. 25. a. Label the curves. Which curve shows the willingness to pay for a pizza? The demand curve is the downward sloping curve and the supply curve is the upward sloping curve. The demand curve shows the willingness to pay for a pizza.

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

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

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

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

DEMAND AND SUPPLY

The demand and supply schedules for potato chips are in the table. 27. a. Draw a graph of the potato chip market and mark in the equilibrium price and quantity. Figure 3.10 (on the next page) draws the supply and demand curves for this market. The equilibrium price is 65¢ a bag, and the equilibrium quantity is 145 million bags a week.

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

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

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

28.

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In Problem 27, a new dip increases the quantity of potato chips that people want to buy by 30 million bags per week at each price. a. Does the demand for chips change? Does the supply of chips change? Describe the change. As the new dip comes onto the market, the demand for potato chips increases. Supply does not change. The demand curves shifts rightward.

b. How do the equilibrium price and equilibrium quantity of chips change? Demand increases by 30 million bags a week. The demand curve shifts rightward as shown in Figure 3.11 by the shift from D to D1. The quantity demanded at each price increases by 30 million bags. The quantity demanded at 65¢ is now 175 million bags a week of potato chips. The price rises to 80¢ a bag, at which the quantity supplied equals the quantity demanded (160 million bags a week). The new equilibrium price is 80¢ per bag and the new equilibrium quantity is 160 million bags.

29.

In Problem 27, if a virus destroys potato crops and the quantity of potato chips produced decreases by 40 million bags a week at each price, how does the supply of chips change? The supply of potato chips decreases, and the supply curve shifts leftward by 40 million bags. The price rises to 85¢ a bag and the quantity decreases to 125 million bags a week.

30.

If the virus in Problem 29 hits just as the new dip in Problem 28 comes onto the market, how do the equilibrium price and equilibrium quantity of chips change? The result by itself of the new dip entering the market is a price of 80¢ a bag and a quantity of 160 million bags. But now with the virus affecting the market, at this price there is a shortage of potato chips. The price of potato chips rises until the shortage is eliminated. The new equilibrium price is 100¢ a bag, and the new equilibrium quantity is 140 million bags a week.

31.

Strawberry Prices Drop as Late Harvest Hits Market Shoppers bought strawberries in March for $1.25 a pound rather than the $3.49 a pound they paid last year. With the price so low, some growers plowed over their strawberry plants to make way for spring melons; others froze their harvests and sold them to juice and jam makers. Source: USA Today, April 5, 2010 a. Explain how the market for strawberries would have changed if growers had not plowed © 2014 Pearson Education, Inc.

DEMAND AND SUPPLY

in their plants but offered locals “you pick for free.” If the growers had offered “you pick for free” deals, the supply of strawberries increases. The demand for strawberries at local grocery stores would have decreased as people substituted picking their own berries for buying them in the store. The demand curve for store-bought strawberries would have shifted leftward and the equilibrium price of strawberries purchased in the store would have fallen and the equilibrium quantity would have decreased.

b. Describe the changes in demand and supply in the market for strawberry jam. Growers increased the quantity of strawberries they sold to jam makers. The increased supply of strawberries to made into jam decreases the price of these strawberries. In turn, the lower price of strawberries lowers the cost of producing strawberry jam. In the market for jam, the supply of strawberry jam increased. The demand for strawberry jam did not change.

32.

“Popcorn Movie” Experience Gets Pricier Cinemas are raising the price of popcorn. Demand for field corn, which is used for animal feed, corn syrup, and ethanol, has increased and its price has exploded. That’s caused some farmers to shift from growing popcorn to easier-to-grow field corn. Source: USA Today, May 24, 2008 Explain and illustrate graphically the events described in the news clip in the market for a. Popcorn As illustrated in Figure 3.12, the farmers’ actions decrease the supply of popcorn and the supply curve of popcorn shifts leftward. The demand curve does not shift. The equilibrium price of popcorn rises and the quantity decreases.

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b. Movie tickets In the market for movie tickets—essentially the market for viewing movies in the theater— popcorn and viewing movies are complements. The increase in the price of popcorn decreases the demand for attending movies in the theater. As a result, Figure 3.13 shows the demand curve shifting leftward. The equilibrium price of attending a movie in the theater falls and the equilibrium quantity decreases.

33.

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

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

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

DEMAND AND SUPPLY

Economics in the News 34. After you have studied Reading Between the Lines on pp. 74–75 answer the following questions. a. What happened to the prices of napa cabbage and kimchi in 2010? The prices of both goods rose.

b. What substitutions do you expect might have been made to decrease the quantity of kimchi demanded? Consumers could substitute napa cabbage with Chinese cabbage.

c. What influenced the demand for kimchi in 2010 and what influenced the quantity of kimchi demanded? Not applicable, as the demand did not change here.

d. What influenced the supply of kimchi during 2010 and how did supply change? Rise in the price of napa cabbage(a key ingredient in kimchi) decreased the supply of kimchi.

e. How did the combination of the factors you have noted in parts (d) influence the price and quantity of kimchi? Price of kimchi rises but the quantity falls.

f. Was the change in quantity of kimchi a change in the quantity demanded or a change in the quantity supplied? The change in quantity of kimchi reflects a change in quantity demanded. The decrease in supply of kimchi caused a fall in quantity demanded of kimchi.

C h a p t e r

ELASTICITY

Answers to the Review Quizzes Page 90 1.

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

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

What makes the demand for some goods elastic and the demand for other goods inelastic? The magnitude of the price elasticity of demand for a good depends on three main influences:

•

Closeness of substitutes. The more easily people can substitute other items for a particular good, the larger is the price elasticity of demand for that good.

•

The proportion of income spent on the good. The larger the portion of the consumer’s budget being spent on a good, the greater is the price elasticity of demand for that good.

•

The time elapsed since a price change. Usually, the more time that has passed after a price change, the greater is the price elasticity of demand for a good.

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

What is the total revenue test? The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue, given a change in price, holding all other things constant. The total revenue test shows that a price cut increases total revenue if demand is elastic, decreases total revenue if demand is inelastic, and does not change total revenue if demand is unit elastic.

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Page 94 1.

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

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

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

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

Page 96 1.

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

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

What are the main influences on the elasticity of supply that make the supply of some goods elastic and the supply of other goods inelastic? The main influences on the elasticity of supply are: •

Resource substitution possibilities: the greater the suppliers’ ability to substitute resources, the greater will be their ability to react to price changes and the greater the elasticity of supply.

•

Time frame for the supply decision: the greater the amount of time available after the price change, the greater is the suppliers’ ability to adjust quantity supplied, and the greater the elasticity of supply.

ELASTICITY

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

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

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

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

How does the time frame over which a supply decision is made influence the elasticity of supply? Explain your answer. The momentary supply, short-run supply, and long-run supply all illustrate the response of suppliers to changes in the price, but they differ according to how much time has elapsed after the price change. •

The momentary supply is frequently the least elastic and shows how suppliers cannot easily respond to a price change immediately after the price change occurs. Changing the quantity produced means changing the inputs into the production process, which takes time to complete. Sometimes the momentary supply is perfectly inelastic.

•

The short-run supply shows suppliers’ response after enough time has elapsed for some, but not all, of the possible technological adjustments have occurred. Short-run supply generally is intermediate in elasticity between the momentary supply and the long-run supply.

•

The long-run supply shows how suppliers react after enough time has passed that all possible adjustments to factors of production have been made to accommodate the price change. It usually is the most elastic of the three supplies.

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Answers to the Study Plan Problems and Applications 1.

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

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

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

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

Price (dollars per night) 200

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

When the price is $400, the total revenue is equal 250 to $400 × 50 million rooms, or $20 billion. When 400 the price is $250, the total revenue is equal to $250 500 × 80 million rooms, or $20 billion. So the total 800 revenue does not change when the price falls from $400 to $250 a night. When the price is $250, the total revenue is equal to $250 × 80 million rooms, or $20 billion. When the price is $200, the total revenue is equal to $200 × 100 million rooms, or $20 billion. So the total revenue does not change when the price falls from $400 to $250 a night.

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

ELASTICITY

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

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

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

The demand for illegal drugs is inelastic. Much of the expenditure on illegal drugs comes from crime. Assuming these statements to be correct, a. How will a successful campaign that decreases the supply of drugs influence the price of illegal drugs and the amount spent on them? By decreasing the supply, the price of illegal drugs will rise. Because the demand is inelastic, the total amount spent on them will increase. © 2014 Pearson Education, Inc.

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b. What will happen to the amount of crime? On the one hand, purchasing illegal drugs is a criminal activity so decreasing the amount of illegal drugs bought and sold decreases crime. On the other hand, many consumers of illegal drugs turn to criminal activities to raise the funds necessary to purchase the drugs. Because the total expenditure on these drugs would increase, the total amount of crime necessary to raise these funds would increase.

c. What is the most effective way of decreasing the quantity of illegal drugs bought and decreasing the amount of drug-related crime? If drug users are penalized, then the demand for illegal drugs decreases, so that both the price and quantity of illegal drugs falls. The total expenditure on illegal drugs also falls. The decrease in the quantity of illegal drugs purchased directly reduces the crime rate. Because the total expenditure spent on illegal drugs falls, less crime would be necessary to raise these funds, so the crime rate also falls, albeit indirectly.

The Grip of Gas U.S. drivers are ranked as the least sensitive to changes in the price of gasoline. For example, if the price rose from $3 to $4 per gallon and stayed there for a year U.S. purchases of gasoline would fall only about 5 percent. Source: Slate, September 27, 2005 a. Calculate the price elasticity of demand for gasoline. Is the demand for gasoline elastic, unit elastic, or inelastic? The price rises by $1.00 and the average price is $3.50. So the percentage change in the price is ($1.00/$3.50) × 100, which equals 28.6 percent. The news story says that the change in the quantity demanded is 5 percent. So the price elasticity of demand is (5 percent)/(28.6 percent), or 0.17. Because the elasticity of demand is less than 1, the demand for gasoline is inelastic.

b. Explain how the price rise from $3 to $4 a gallon changes the total revenue from gasoline sales. If the price of gasoline rises, because the demand is inelastic the total revenue test concludes that the total revenue from gasoline will increase.

Spam Sales Rise as Food Costs Soar Sales of Spam are rising as consumers realize that Spam and other lower-cost foods can be substituted for costlier cuts of meat as a way of controlling their already stretched food budgets. Source: AOL Money & Finance, May 28, 2008 a. Is Spam a normal good or an inferior good? Explain. Based on the story, Spam is probably an inferior good. The idea of “stretched food budgets” implies that consumers’ incomes have fallen. And, as a result, the demand for Spam increased. The demand for Spam increased when income decreased, so Spam is an inferior good.

b. Would the income elasticity of demand for Spam be negative or positive? Explain. If Spam is an inferior good, its income elasticity of demand is negative. When income increases, the demand decreases so the income elasticity of demand divides a negative number (the decrease in demand) by a positive number (the increase in income) thereby resulting in a negative value for the income elasticity of demand.

ELASTICITY

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

a. b. 10.

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

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

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

11.

If a 5 percent rise in the price of sushi increases the quantity of soy sauce demanded by 2 percent and decreases the quantity of sushi demanded by 1 percent, calculate the a. Price elasticity of demand for sushi. The price elasticity of demand for sushi equals 1/5, which is 0.2.

b. Cross elasticity of demand for soy sauce with respect to the price of sushi. The cross elasticity of demand for soy sauce with respect to the price of sushi equals 2/5, which is 0.4.

12.

Swelling Textbook Costs Have College Students Saying ‘Pass’ Textbook prices have doubled and risen faster than average prices for the past two decades. Sixty percent of students do not buy textbooks. Some students hunt for used copies and sell them back at the end of the semester; some buy online, which is often cheaper than the campus store; some use the library copy and wait till it’s free; some share the book with a classmate. Source: Washington Post, January 23, 2006 Explain what this news clip implies about a. The price elasticity of demand for college textbooks. The news clip discusses ways students decrease the quantity of textbooks demanded when the price of a textbook rises. It is not possible to determine the precise elasticity of demand for textbooks, but there are substitutes for textbooks listed. In particular, a number of substitutes listed (borrowing, copying, using a library copy) enable students to completely avoid buying © 2014 Pearson Education, Inc.

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textbooks. Additionally other substitutes listed (buying used books, selling books, buying on the Internet) enable students to pay less for their textbooks. The fairly long list of good substitutes indicates that the demand for textbooks might be elastic.

b. The income elasticity of demand for college textbooks. The income elasticity of demand measures how the quantity demanded changes when income changes. The news clip does not directly give any information about changes in income, so the news clip fives no information about the income elasticity of demand for college textbooks.

c. The cross elasticity of demand for college textbooks from the campus bookstore with respect to the online price of a textbook. The cross elasticity of demand for textbooks from campus bookstores with respect to the online price of books is positive: the lower the price of online books, the lower the quantity of textbooks demanded from campus bookstores. This sign makes sense because textbooks from campus bookstores are substitutes for textbooks from online stores.

Use the following information to work Problems 13 to 15. As Gas Costs Soar, Buyers Flock to Small Cars Faced with high gas prices, Americans are substituting smaller cars for SUVs. In April 2008, Toyota Yaris sales increased 46 percent and Ford Focus sales increased 32 percent from a year earlier. SUVs sales decreased 25 percent in 2008 and Chevrolet Tahoe sales fell 35 percent. Fullsize pickup sales decreased 15 percent in 2008 and Ford F-Series pickup sales decreased by 27 percent in April 2008. The effect of a downsized vehicle fleet on fuel consumption is unknown. In California in January 2008, gasoline consumption was 4 percent lower and the price of gasoline 30 percent higher than in January 2007. Source: The New York Times, May 2, 2009 13.

Calculate the price elasticity of demand for gasoline in California. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price of the good. Based on the data in the problem and assuming that the demand curve for gasoline in California did not change, then the price elasticity of demand for gasoline in California equals (4 percent/30 percent), which equals 0.13. If the downsized fleet shifted the demand curve for gasoline leftward, then the price elasticity of demand just calculated is too large because it includes the decrease in the quantity demanded from the higher price of gasoline plus the decrease in the quantity from the more fuel efficient fleet.

14.

Calculate the cross elasticity of demand for a. Toyota Yaris with respect to the price of gasoline. The cross elasticity of demand for a Toyota Yaris with respect to the price of gasoline equals the percentage change in the quantity demanded of Toyotas divided by the percentage change in the price of gasoline. Based on the data in the problem and assuming that the demand curve for these cars did not change, then the cross elasticity of demand equals (46 percent/30 percent), which equals 1.53.

b. Ford Focus with respect to the price of gasoline. The cross elasticity of demand for a Ford Focus with respect to the price of gasoline equals the percentage change in the quantity demanded of Fords divided by the percentage change in the price of gasoline. Based on the data in the problem and assuming that the demand curve for these cars did not change, then the cross elasticity of demand equals (32 percent/30 percent), which equals 1.07.

ELASTICITY

15.

Calculate the cross elasticity of demand for a. Chevrolet Tahoe with respect to the price of gasoline. The cross elasticity of demand for a Chevrolet Tahoe with respect to the price of gasoline equals the percentage change in the quantity demanded of Chevrolets divided by the percentage change in the price of gasoline. Based on the data in the problem and assuming that the demand curve for these cars did not change, then the cross elasticity of demand equals (−35 percent/30 percent), which equals 1.17.

b. A full-size pickup with respect to the price of gasoline. The cross elasticity of demand for a full-size pickup with respect to the price of gasoline equals the percentage change in the quantity demanded of these trucks divided by the percentage change in the price of gasoline. Based on the data in the problem and assuming that the demand curve for these trucks did not change, then the cross elasticity of demand equals (−15 percent/30 percent), which equals 0.50.

16.

Home Depot Earnings Hammered As gas and food prices increased and home prices slumped, people had less extra income to spend on home improvements. And the improvements that they made were on small inexpensive types of repairs and not major big-ticket items. Source: CNN, May 20, 2008 a. What does this news clip imply about the income elasticity of demand for big-ticket homeimprovement items? The news clip implies that the income elasticity of demand for big-ticket home-improvement items is positive. In particular “people have less extra income to spend” and, as a result, “fewer people are spending money to renovate their homes.”

b. Would the income elasticity of demand be greater or less than 1? Explain. The income elasticity of demand is probably greater than 1. Home remodeling is not a necessity; it is more of a luxury. The income elasticity of demand for luxuries is greater than 1.

17.

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

Price (dollars per pair) 120 125 130 135

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

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

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

18.

Study Ranks Honolulu Third Highest for “Unaffordable Housing” A study ranks Honolulu number 3 in the world for the most unaffordable housing market in urban locations, behind Los Angeles and San Diego and is deemed “severely unaffordable.” © 2014 Pearson Education, Inc.

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With significant constraints on the supply of land for residential development, housing inflation has resulted. Source: Hawaii Reporter, September 11, 2007 a. Would the supply of housing in Honolulu be elastic or inelastic? The supply of housing is probably inelastic because it is limited by the amount of land, which is inelastically supplied. Indeed, the elasticity of supply for housing is probably close to 0.

b. Explain how the elasticity of supply plays an important role in influencing how rapidly housing prices in Honolulu rise. The less elastic the supply, the more an increase in demand raises the price. Because the supply of housing is quite inelastic in Honolulu, increases in demand for housing have lead to large increases in the price of housing, that is, severe “housing inflation.”

ELASTICITY

Answers to Additional Problems and Applications 19.

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

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

20.

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

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

Use the following table to work 23. The demand schedule for computer table. 21. a. What happens to total price falls from $400 to $350 a

Price (dollars per chip) 200 250 300 350 400

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

Problems 21 to chips is in the revenue if the chip and from

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$350 to $300 a chip? When the price of a chip is $400, 30 million chips are sold and total revenue equals $12,000 million. When the price of a chip falls to $350, 35 million chips are sold and total revenue is $12,250 million. The total revenue increases when the price falls. When the price is $350 a chip, 35 million chips are sold and total revenue is $12,250 million. When the price of a chip is $300, 40 million chips are sold and total revenue decreases to $12,000 million. The total revenue decreases as the price falls.

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

22.

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

23.

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

24.

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

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

25.

As Gasoline Prices Soar, Americans Slowly Adapt As gas prices rose in March 2008, Americans drove 11 billion fewer miles than in March 2007. Realizing that prices are not going down, Americans are adapting to higher energy costs. Americans spend 3.7 percent of their disposable income on transportation fuels. How much we spend on gasoline depends on the choices we make: what car we drive, where we live, how much time we spend driving, and where we choose to go. For many people, higher energy costs mean fewer restaurant meals, deferred weekend outings with the kids, less air © 2014 Pearson Education, Inc.

ELASTICITY

travel, and more time closer to home.

Source: International Herald Tribune, May 23, 2008 a. List and explain the elasticities of demand that are implicitly referred to in the news clip. The elasticities to which the clip refers are the income elasticity of demand, the price elasticity of demand, and the cross elasticity of demand. The income elasticity of demand is reflected in the news clip’s discussion of the fraction of income spent on transportation fuels. More references are made to the factors that influence the price elasticity of demand. The article lists many substitutions households can make in response to higher fuel prices. In particular the type of car a family can drive, where the family lives, and where the family chooses to go reflect substitution methods that households can use to decrease the quantity of gasoline demanded. In addition, discussion of “fewer restaurant meals, deferred weekend outings with the kids, less air travel and more time closer to home” suggest that higher gasoline prices have an income effect that decreases the quantity demanded. It is the strength of these factors that determines the magnitude of the price elasticity of demand for fuel. Additionally these activities, such as smaller cars, more time closer to home, are also the substitutes that people use in place of gasoline. The news clips suggests that these activities increase in response to the higher price of gasoline, indicating that they are substitutes for gasoline so that their cross elasticity of demand with respect to the price of gasoline is positive.

b. Why, according to the news clip, is the demand for gasoline inelastic? One factor listed that helps make the demand for gasoline inelastic is the point that gasoline accounts for only a relatively small fraction of people’s incomes. Another factor is more qualitative: none of the substitutions listed for gasoline—the type of car the family drives and so forth—are particularly close substitutes for gasoline. The absence of close substitutes combined with the relatively small fraction of income spent on gasoline combine to make the demand for gasoline inelastic.

Use this information to work Problems 26 and 27. Economy Forces Many to Shorten Summer Vacation Plans This year Americans are taking fewer exotic holidays by air and instead are visiting local scenic places by car. The global financial crisis has encouraged many Americans to cut their holiday budgets. Source: USA Today, May 22, 2009 26.

Given the prices of the two holidays, is the income elasticity of demand for exotic holidays positive or negative? Are exotic holidays a normal good or an inferior good? Are local holidays a normal good or an inferior good? The income elasticity of demand for exotic holidays is positive so exotic holidays are a normal good. The income elasticity of demand for local holidays is negative so local holidays are an inferior good.

27.

Are exotic holidays and local holidays substitutes? Explain your answer. Exotic holidays and local holidays are substitutes. The article points out that in 2009 Americans were visiting local scenic places rather than visiting exotic locations. So Americans were substituting local holidays for exotic holidays.

28.

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When Alex’s income was $3,000, he bought 4 bagels and 12 donuts a month. Now his income is $5,000 and he buys 8 bagels and 6 donuts a month. Calculate Alex’s income elasticity of demand for a. Bagels. The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $2,000 and the average income is $4,000, so the percentage change in income equals 50 percent. The change in the quantity demanded is 4 bagels and the average quantity demanded is 6 bagels, so the percentage change in the quantity demanded equals 66.67 percent. The income elasticity of demand for bagels equals (66.67 percent)/(50 percent), which is 1.33.

b. Donuts. From part (a), the percentage change in income is 50 percent. The change in the quantity demanded is −6 donuts and the average quantity demanded is 9 donuts, so the percentage change in the quantity demanded is −66.67 percent. The income elasticity of demand for donuts equals (−66.67 percent)/(50 percent), which is −1.33.

29.

Wal-Mart’s Recession-Time Pet Project During the recession, Wal-Mart moved its pet food and supplies to in front of its other fast growing business, baby products. Retail experts point out that kids and pets tend to be fairly recession-resistant businesses—even in a recession, dogs will be fed and kids will get their toys. Source: CNN, May 13, 2008 a. What does this news clip imply about the income elasticity of demand for pet food and baby products? The news clip implies that both pet food and baby food are necessities. Their income elasticities of demand are positive but very small (since they “tend to be fairly recession resistant businesses”).

b. Would the income elasticity of demand be greater or less than 1? Explain. The income elasticities of demand are less than 1 because they are necessities.

30.

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

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

ELASTICITY

31.

Netflix to Offer Online Movie Viewing Online movie rental service Netflix has introduced a new feature to allow customers to watch movies and television series on their personal computers. Netflix competes with video rental retailer Blockbuster, which added an online rental service to the in-store rental service. Source: CNN, January 16, 2007 a. How will online movie viewing influence the price elasticity of demand for in-store movie rentals? The price elasticity of demand for store rental movies will increase because online movie viewing is a substitute for renting movies.

b. Would the cross elasticity of demand for online movies and in-store movie rentals be negative or positive? Explain. Online movies and in-store rental movies are substitutes, so their cross elasticity of demand is positive.

c. Would the cross elasticity of demand for online movies with respect to high-speed Internet service be negative or positive? Explain. Online movies and high-speed Internet service are complements, so their cross elasticity of demand is negative.

32.

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

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

33.

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

Price (cents per minute) 10 20 30 40

Quantity supplied (millions of minutes per day) 200 400 600 800

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

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

34.

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

Economics in the News 35. After you have studied Reading Between the Lines on pp. 98–99, answer the following questions. a. Besides the factors mentioned in the analysis, what is another factor affecting price elasticity of demand? How is the application of this factor different from theory?

Time elapsed since the price change. In theory, demand is initially price inelastic but more price elastic in the longer term. In this news article, demand was initially price elastic but became price inelastic in the longer term.

b. Using the price elasticity value calculated, find the change in price if quantity demanded for cab travel rises by 15 per cent. In this case, will total revenue increase, decrease or remain constant?

15 ÷ 1.5 = 10%. Price falls by 10 per cent. Total revenue will rise as the rise in quantity demanded more than offset the fall in price.

c. What could be a supply factor that can cause a rise in cab fare?

Rise in production cost, for example, diesel price or rental fee for cabs..

d. Why may a rise in cabbies’ earnings not translate to good news to for cabbies?

Earnings represent total revenue but not profits. If operating costs increase, cabbies’ profits will fall.

C h a p t e r

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Answers to the Review Quizzes Page 107 1.

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

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

Provide an example of each allocation method that illustrates when it works well. Below are examples of when each allocation scheme works well: • Market price: Generally works well in competitive markets and for most goods and services. An example is the allocation of cat food. • Command: Generally works well in organizations where lines of authority are clear and it is easy to monitor subordinates. An example is in a fast food restaurant when the supervisor tells a worker to clean the tables. • Majority rule: Generally works well when large numbers of people are affected by the allocation. An example is an election in which people vote whether or not to support a tax to build more parks. • Contest: Generally works well when the efforts of the participates are hard to monitor. An example is the contest run by Pfizer in which three top managers competed to see who would be appointed CEO. • First-come, first-served: Generally works well when a resource can be used by only one user at a time. An example is a line at a movie ticket booth. • Lottery: Generally works well when there is no way to easily distinguish which user of a resource would use it most effectively. An example is the lottery used to allocate cell phone frequencies. • Personal characteristics: Generally works well when resource use is such that different people consume the same resources. An example is the decision whom to marry. • Force: Generally works well when used to uphold the rule of law. An example is the state imprisoning thieves and thereby preventing resource allocation by the thief stealing the resource. © 2014 Pearson Education, Inc.

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Provide an example of each allocation method that illustrates when it works badly. Below are examples of when each allocation scheme would work poorly: • Market price: Deciding court cases on the basis of who will pay the most for the decision. • Command: Running an economy. • Majority rule: Deciding how many acres of wheat to plant. • Contest: Allocating food in a winner-take-all contest. • First-come, first-served: Admitting students to college based on who applied first. • Lottery: Assigning grades based on random chance. • Personal characteristics: Renting only to married couples. • Force: Stealing by threat of physical harm.

Page 111 1.

What is the relationship between the marginal benefit, value, and demand? The value of one more unit of a good is its marginal benefit. The marginal benefit of a good or service is measured by the maximum amount that consumers are willing to pay for one more unit of a good or service. The demand curve shows the maximum consumers are willing to pay for each additional unit, so the demand curve is the same as the marginal benefit curve.

What is the relationship between individual demand and market demand? The market demand equals the sum of the individual quantities demanded by all the demanders at each price. Therefore the market demand curve equals the horizontal sum of the individual demand curves.

What is consumer surplus? How is it measured? Consumer surplus is the excess of the benefit received from a good over the amount paid for it. The total consumer surplus is the sum of the consumer surpluses on all the units purchased. It is measured as the area under the demand curve and above the price.

What is the relationship between the marginal cost, minimum supply-price, and supply? The marginal cost is the cost of producing an additional unit of a good. The marginal cost is the minimum price that producers must receive to induce them to offer one more unit of a good or service for sale. This minimum supply-price determines the supply of the good, so the supply curve is the same as the marginal cost curve.

What is the relationship between individual supply and market supply? The market supply equals the sum of the individual quantities supplied by all the producers at each price. The market supply curve is equal to the horizontal sum of all the individual supply curves.

What is producer surplus? How is it measured? Producer surplus is the excess of the amount received from the sale of a good or service over the cost of producing it. The producer surplus is measured as the area under the price and above the supply curve over the entire quantity sold.

Page 115 1.

Do competitive markets use resources efficiently? Explain why or why not. In the absence of the obstacles mentioned earlier in the chapter, competitive markets use society’s resources efficiently. For resources to be used efficiently they must be allocated to produce the quantity of a good or service where the marginal cost of the last unit produced in the market is equal to the marginal benefit. This condition will be met in a competitive market © 2014 Pearson Education, Inc.

EFFICIENCY AND EQUITY

because the quantity occurs where the demand curve (which equals the marginal social benefit curve) intersects the supply curve (which equals the marginal social cost curve).

What is deadweight loss and under what conditions does it occur? The deadweight loss is the decrease in total surplus that results from an inefficient level of production. This is the decrease in consumer surplus plus the decrease in producer surplus that occurs when the market either overproduces or underproduces relative to the efficient quantity.

What are the obstacles to achieving an efficient allocation of resources in the market economy? Markets with price or quantity regulations, taxes or subsidies, externalities, public goods or common resources, monopoly power, or high transactions costs will not produce the efficient quantity of a good or service. In each of these situations, the market prices charged or quantities produced and sold will not result in the efficient allocation of resources. Efficiency requires that the marginal social benefit of the last unit produced be equal to the marginal social cost. The equilibrium at the intersection of the demand and supply curves in the competitive market creates this result. When the market price or quantity is pulled away from the market equilibrium, the marginal social benefit of the last unit produced does not equal its marginal social cost.

Page 119 1.

What are the two big approaches to thinking about fairness? The two big approaches to thinking about fairness are: • “It’s not fair if the result isn’t fair,” or utilitarianism. • “It’s not fair if the rules aren’t fair,” or equality of opportunity.

What is the utilitarian idea of fairness and what is wrong with it? The utilitarian idea of fairness implies that equality of incomes is necessary for the allocation of resources to be “fair.” There should be income transfers from the rich to the poor until equality is achieved, because the marginal benefit of the last dollar of income is the same for everybody. There are two problem with utilitarianism: • It ignores the cost of implementing the income transfers, which will decrease the total goods and services that the finite resources of society can produce. The size of the economic pie will be smaller. • It ignores the Big Tradeoff, the tradeoff between efficiency and fairness. Taxing people’s incomes makes them work less, which decreases the size of the economic pie and thereby diminishes the total amount that can be transferred to the poor.

Explain the big tradeoff. What idea of fairness has been developed to deal with it? The big tradeoff is the tradeoff between efficiency and fairness. Redistributing incomes changes the incentives facing producers and consumers. Taxing income decreases producer surplus and taxing purchases decreases consumer surplus. Producers produce less and consumers consume less, and total economic activity declines, such that the size of the economic pie decreases. The big tradeoff has led to the idea that the fairest distribution is that which makes the poorest person as well off as possible.

What is the idea of fairness based on fair rules? The fair rules idea of fairness is that of providing equality of opportunity is necessary for the allocation of resources to be “fair.” This is the economic application of the symmetry principle,

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that people in similar situations be treated similarly. Equality of opportunity can be achieved if two rules are obeyed: • The government must enforce laws that establish and protect rights to private property that are held by individuals in society, and • Private property may be transferred from one person to another only by voluntary exchange and without fraudulent representation.

EFFICIENCY AND EQUITY

Answers to the Study Plan Problems and Applications Use the following information to work Problems 1 and 2. At Chez Panisse, the restaurant in Berkeley that is credited with having created California cuisine, reservations are essential. At Mandarin Dynasty, a restaurant near the University of California San Diego, reservations are recommended. At Eli Cannon’s, a restaurant in Middletown, Connecticut, reservations are not accepted. 1. a. Describe the method of allocating scarce table resources at these three restaurants. All these restaurants use a first-come, first-serve system. Eli Cannon’s uses this system directly. Chez Panisse uses a first-come, first-serve system because the first person to call to make a reservation at a particular time is allocated the table at that time. Mandarin Dynasty uses a combination of the immediate first-come, first-serve system and the reservation based first-come, first-serve system.

b. Why do you think restaurants have different reservations policies? The speed with which tables turn over at the different restaurants probably is quite different and the customers probably have quite different values of time. Chez Panisse has a low turnover rate—only 1 or 2 groups of customers can use a table each night—and its customers have a high value of time. If Chez Panisse refused to take reservations, its customers would need to wait an inefficiently long time and would go elsewhere so that Chez Panisse’s profits would be lower. At Eli Cannon’s, the tables have a high turnover rate and the customers have a lower value of time. Allowing reservations would be costly for Eli Cannon’s and would spare its customers only a slight wait at most so that allowing reservations would decrease Eli Cannon’s profits. At Mandarin Dynasty, the turnover rate of the tables is between that at Chez Panisse and Eli Cannon’s, so it uses a combination of phone reservation first-come, first-serve and appear in person first-come, first-serve.

Why do you think restaurants don’t use the market price to allocate their tables? Market allocation requires that customers pay for a table and the price would fluctuate from one hour to the next depending on the number of customers who arrive. Customers would be highly uncertain about the price they would need to pay and such uncertainty decreases the demand for meals from the restaurant. The decreased demand lowers the restaurant’s profit.

Use the following table to work Problems 3 to 5. The table gives Price Quantity demanded schedules for (dollars (miles) the only per mile) Ann Beth market, Ann, 3 30 25 3. a. 4 25 20 the 5 20 15 The

6 7 8 9

15 10 5 0

10 5 0 0

Cy 20 15 10 5 0 0 0

the demand train travel for buyers in the Beth, and Cy. Construct market demand schedule.

market demand schedule shows the sum of the quantities demanded by Ann, Beth, and Cy at each price. When the price is $3 per mile, the market quantity demanded is 75 miles; when the price is $4 per mile, the market quantity demanded is 60 miles; when the price is $5 per mile, the marker quantity demanded is 45 miles; when the price is $6 per mile, the market quantity demanded is 30 miles; when the price is $7 per mile, the market quantity demanded is 15 miles; when the price is $8 per mile, the market quantity © 2014 Pearson Education, Inc.

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demanded is 5 miles; and when the price is $9 per mile, the market quantity demanded is 0 miles.

b. What is the maximum price that each traveler, Ann, Beth, and Cy, is willing to pay to travel 20 miles? Why? Each person’s demand schedule shows the maximum price that person is willing to pay to travel 20 miles. The maximum price Ann is willing to pay to travel 20 miles is $5 per mile, the maximum price Beth is willing to pay is $4 per mile, and the maximum price Cy is willing to pay is $3 per mile.

4. a. What is the marginal social benefit when the total distance travelled is 60 miles? The marginal social benefit when the quantity is 60 miles is $4 per mile. The marginal social benefit is determined from the consumers’ demand schedules and equals the maximum price that consumers will pay for the quantity. The demand schedule shows that the maximum price consumers will pay for 60 miles is $4 per mile and this price equals the marginal social benefit.

b. When the three people travel a total of 60 miles, how many miles does each travel and what is the marginal private benefit of each traveler? The three travel a total distance of 60 miles when the price is $4 a mile. Each person’s marginal benefit is $4 per mile. At this price Ann travels 25 miles, Beth travels 20 miles, and Cy travels 15 miles.

5. a. What is each traveler’s consumer surplus when the price is $4 a mile? Ann’s consumer surplus is $62.50; Beth’s consumer surplus is $40.00; and, Cy’s consumer surplus is $22.50. When the price is $4 per mile, Ann buys 25 miles. Ann’s consumer surplus is the triangular area under her demand curve and above the price. The demand curve is linear, so Ann’s consumer surplus is 1/2  ($9 − $4)  25, which equals $62.50. When the price is $4 per mile, Beth buys 20 miles. Beth’s consumer surplus is the triangular area under her demand curve and above the price. The demand curve is linear, so Beth’s consumer surplus is 1/2  ($8 − $4)  20, which equals $40.00 When the price is $4 per mile, Cy buys 15 miles. Cy’s consumer surplus is the triangular area under his demand curve and above the price. The demand curve is linear, so Cy’s consumer surplus is 1/2  ($7 − $4)  15, which equals $22.50.

b. What is the market consumer surplus when the price is $4 a mile? The market consumer surplus is the sum of Ann’s consumer surplus, Beth’s consumer surplus, and Cy’s consumer surplus, or $125.00.

Use the following table to work Problems 6 to 8. The table gives the supply Price schedules of hot air balloon rides (dollars for the only sellers in the market, per ride) Xavier, Yasmin, and Zack. 100 6. a. Construct the market 90 supply schedule. 80 The market supply 70 schedule shows the sum of 60 the quantities supplied by 50 Xavier, Yasmin, and Zack at 40 each price. When the price

Quantity supplied (rides per week) Xavier Yasmin 30 25 25 20 20 15 15 10 10 5 5 0 0 0

Zack 20 15 10 5 0 0 0

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supplied is 60 rides; when the price is $80 per ride, the market quantity supplied is 45 rides; when the price is $70 per ride, the market quantity supplied is 30 rides; when the price is $60 per ride, the market quantity supplied is 15 rides; when the price is $50 per ride, the market quantity supplied is 5 rides; and when the price is $40 per ride, the market quantity supplied is 0 rides.

b. What are the minimum prices that Xavier, Yasmin, and Zack are willing to accept to supply 20 rides? Why? The minimum supply-price equals the lowest price at which a producer is willing to produce the given quantity. The supply schedule tells us the minimum supply-price. Xavier’s minimum supply-price for 20 rides is $80; Yasmin’s minimum supply-price is $90; and, Zack’s minimum supply-price is $100.

7. a. What is the marginal social cost when the total number of rides is 30? The quantity of rides supplied is 30 when the price is $70 per ride. The marginal social cost of any quantity is equal to the price for which that quantity will be supplied, so when the total number of rides is 30, the marginal social cost equals $70 per ride.

b. What is the marginal cost for each supplier when the total number of rides is 30 and how many rides does each of the firms supply? When the total number of rides is 30, Xavier supplies 15 rides, Yasmin supplies 10 rides, and Zack supplies 5 rides. The marginal cost for each firm is $70.

When the price is $70 a ride, what is each firm’s producer surplus? What is the market producer surplus? Xavier’s producer surplus is $225; Yasmin’s producer surplus is $100; and, Zack’s producer surplus is $25. When the price is $70 per ride, Xavier supplies 15 rides. Xavier’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Xavier’s producer surplus is 1/2  ($70 − $40)  15, which equals $225. When the price is $70 per ride, Yasmin supplies 10 rides. Yasmin’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Yasmin’s producer surplus is 1/2  ($70 − $50)  10, which equals $100. When the price is $70 per ride, Zack supplies 5 rides. Zack’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Zack’s producer surplus is 1/2  ($70 − $60)  5, which equals $25. The market producer surplus is equal to the sum of Xavier’s producer surplus, Yasmin’s producer surplus, and Zack’s producer surplus, which is $225 + $100 + $25 or $350.

Use the following news clip to work Problems 9 and 10. eBay Saves Billions for Bidders If you think you would save money by bidding on eBay auctions, you would likely be right. Two Maryland researchers calculated the difference between the actual purchase price paid for auction items and the top price bidders stated they were willing to pay. They found that the difference averaged at least $4 per auction. Source: InformationWeek, January 28, 2008 9.

What method is used to allocate goods on eBay? How does the allocation method used by eBay auctions influence consumer surplus? eBay is using market price to allocate the goods. The market price is the price established in the auction. If someone is willing and able to pay that price, the person will get the item. For the vast majority of auctions the winning bidder will enjoy a consumer surplus so eBay increases consumer surplus. For instance, if there are bidders on a unique item, the winning © 2014 Pearson Education, Inc.

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bidder—who sets the price for the good—will pay a price that is equal to the value of the item to the bidder with the second-highest valuation plus the minimum bid increment. The winning bidder has some consumer surplus as long as his or her value of the good exceeds the price that must be paid, which will almost always be the case. Indeed, a person chooses to buy on eBay rather than elsewhere if the person believes that his or her consumer surplus is larger by purchasing on eBay.

10. a. Can an eBay auction give the seller a surplus? Yes, an eBay auction can give a seller a surplus. The seller has a minimum supply-price for which the item will be sold. If the price established in the auction exceeds that minimum supply-price, the seller has a surplus.

b. On a graph show the consumer surplus and producer surplus from an eBay auction. Figure 5.1 illustrates an eBay auction. The figure assumes that there are many suppliers of this good, each with a different minimum supply-price so that the supply curve is upward sloping. The consumer surplus is area A, the area under the demand curve and above the (auction-determined) market price. The producer surplus is area B, the area under the market price and above the supply curve.

11.

The figure illustrates the competitive market for cell phones. a. What are the equilibrium price and equilibrium quantity of cell phones? The equilibrium price is $30 per cell phone and the equilibrium quantity is 100 cell phones per month.

b. Shade in and label the consumer surplus at the competitive equilibrium. In Figure 5.3 (on the next page) the consumer surplus is the shaded area A.

c. Shade in and label the producer surplus at the competitive equilibrium. In Figure 5.3 (on the next page) the producer surplus is the shaded area B.

EFFICIENCY AND EQUITY

d. Calculate total surplus at the competitive equilibrium. The total surplus is equal to the sum of the consumer surplus plus the producer surplus, or the triangle with area A + area B. The amount of the total surplus equals ½ × ($60 per cell phone − $15 per cell phone) × 100 cell phones, which is $2,250.

e. Is the competitive market for cell phones efficient? The equilibrium quantity of cell phones is 100 cell phones per month because this is the quantity at which the demand and supply curves intersect. The demand curve is the marginal social benefit curve and the supply curve is the marginal social cost curve. Therefore the efficient quantity of cell phones is 100 cell phones per month because this is the quantity at which these two curves intersect. This competitive market is efficient because the equilibrium quantity equals the efficient quantity.

12.

The table gives the demand and supply schedules for sunscreen. Sunscreen factories are required to limit production to 100 bottles a day. a. What is the maximum price that consumers are willing to pay for the 100th bottle?

Price (dollars per bottle) 0 5 10 15 20

Quantity Quantity demanded supplied (bottles per day) 400 300 200 100 0

0 100 200 300 400

Consumers are willing to pay a maximum price of $15 for the 100th bottle of sunscreen. The demand schedule shows the maximum price that consumers will pay for each bottle of sunscreen. The maximum price that consumers will pay for the 100th bottle is $15.

b. What is the minimum price that producers are willing to accept for the 100th bottle? Producers are willing to accept a minimum price of $5 for the 100th bottle of sunscreen. The supply schedule shows the minimum price that producers will accept for each bottle of sunscreen. The minimum price that produces will accept for the 100th bottle is $5. © 2014 Pearson Education, Inc.

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c. Describe the situation in this market. There is less than the efficient quantity being produced. The efficient quantity is the equilibrium quantity, 200 bottles.

13.

Explain why each restaurant in Problem 1 might be using an efficient allocation method. Each restaurant is using the same allocation method because of the costs. Each uses the method that has the lowest cost for the restaurant. With the costs being lowest, the allocation scheme used is efficient.

14.

Explain why the allocation method used by each restaurant in Problem 1 is fair or not fair. According to the “fair rules” approach, all of the methods are fair because everyone faces the same rules and therefore the same chance of obtaining a table. According to the “fair results” approach, none of the methods are fair because in each case some people get a table and others do not.

15.

In Problem 12, how can the 100 bottles available be allocated to beach-goers? Which possible methods would be fair and which would be unfair? The bottles can be allocated using a contest (a raffle for the bottles, perhaps), first-come, firstserved (a line until all 100 bottles are distributed), personal characteristics (perhaps all fairhaired people are allocated the sun screen), or force (a fight). Using the “fair results” criteria, none of the allocation schemes are necessarily fair because there is no guarantee that poorer people will receive the sun screen. Using the “fair rules” criteria, the force method is definitely unfair and the others are fair.

16.

The World’s Largest Tulip and Flower Market Every day 20 million tulips, roses, and other cut flowers are auctioned at the Dutch market called The Bloemenveiling. Each day 55,000 Dutch auctions take place, matching buyers and sellers. Source: Tulip-Bulbs.com A Dutch auction is one in which the auctioneer starts by announcing the highest price. If no one offers to buy the flowers, the auctioneer lowers the price until a buyer is found. a. What method is used to allocate flowers at the Bloemenveiling? The auction uses the market price (as established by the auction) to allocate the flowers.

b. How does a Dutch flower auction influence consumer surplus and producer surplus? A Dutch auction means there is little or no consumer surplus. If the buyers bid the moment the price reaches their value for the flower, then the successful buyers have no consumer surplus. The producers, however, likely have substantial producer surplus. As long as the price exceeds the marginal cost of producing the flowers, the producers have some producer surplus.

c. Are the flower auctions at the Bloemenveiling efficient? The flower auctions are efficient because there are no obstacles (taxes, subsidies, monopoly, and so on) that prevent the market price from reaching allocative efficiency. In the equilibrium, the buyers pay a price equal to their marginal benefit and the sellers receive a price equal to their marginal cost.

EFFICIENCY AND EQUITY

17.

Wii Sells Out Across Japan After a two-month TV-ad blitz for Wii in Japan, demand was expected to exceed supply. Yodobashi Camera was selling Wii games on a first-come, first-served basis. Eager customers showed up early and those who tried to join the line after 6 or 7 a.m. were turned away—many rushed off to the smaller stores that were holding raffles to decide who got a Wii. Source: Gamespot News, December 1, 2006 a. Why was the quantity demanded of Wii expected to exceed the quantity supplied? The price of a Wii was set by Nintendo not by market supply and demand. At that price retailers forecast that the quantity demanded would exceed the quantity supplied. Stores could run surveys to determine how many customers were likely to buy a Wii from the store. The survey could be as informal as clerks reporting how many people asked about a Wii during the clerk’s shift to more formal surveys, such as asking customers to sign up in advance to buy a Wii. Given these surveys, the quantity demanded was expected to exceed the quantity Nintendo released for sale.

b. Did Nintendo produce the efficient quantity of Wii? Explain. At the price Nintendo set, Nintendo did not produce the efficient quantity of Wii. There was a shortage of Wii consoles. The MSB of a Wii exceeds the MSC so the market is inefficient.

c. Can you think of reasons why Nintendo might want to underproduce and leave the market with fewer Wii than people want to buy? Nintendo might have wanted to create a shortage to gain more publicity for its Wii. If news reporters had story after story about the shortage, then Nintendo would gain free publicity. Additionally, given the very high initial demand for a Wii, if the price was set so that the quantity supplied equaled the initial (very high) quantity demanded, then the price would be high. After the initial adopters were satisfied, the price would then fall and Nintendo would get a reputation for price gouging.

d. What are the two methods of resource allocation described in the news clip? Is either method of allocating Wii efficient? The first store was using a first-come, first-serve method of allocation. The second, smaller stores were allocating Wii using a lottery so that winners would obtain a Wii. Neither method is likely efficient. But given that the price was not going to change to allocate the Wii, some other method or methods had to be used to allocate the Wii.

e. What do you think some of the people who managed to buy a Wii did with it? Some of the people who acquired a Wii resold it to other people.

Explain which is the fairer method of allocating the Wii: the market price or the two methods described in the news clip. Allocating Wii according to the market price is not necessarily fair using the “fair results” approach but is fair using the “fair rules” approach. The other two methods of allocation are fair according to either of fairness measures only by random chance.

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Answers to Additional Problems and Applications 18.

At McDonald’s, no reservations are accepted; at Puck’s at St. Louis Art Museum, reservations are accepted; at the Bissell Mansion restaurant, reservations are essential. Describe the method of allocating table resources in these three restaurants. Why do you think restaurants have different reservations policies? All these restaurants use a first-come, first-serve system. McDonald’s uses this system directly. Bissell Mansion uses a first-come, first-serve because the first person to call to make a reservation at a particular time is allocated the table at that time. Puck’s uses a combination of the immediate first-come, first-serve system and the reservation based first-come, first-serve system. The speed with which tables turn over at the different restaurants probably is quite different and the customers probably have quite different values of time. Bissell Mansion has a low turnover rate—only 1 or 2 groups of customers can use a table each night—and its customers have a high value of time. If Bissell Mansion refused to take reservations, its customers would need to wait an inefficiently long time and would go elsewhere so that Bissell Mansion profits would be lower. At McDonald’s, the tables have a high turnover rate (indeed, many customers do not use the tables at all, buying their food to go) and the customers have a lower value of time. Allowing reservations would be costly for McDonald’s and would spare its customers only a slight wait at most so that allowing reservations would decrease McDonald’s profits. At Puck’s, the turnover rate of the tables is between that at Bissell Mansion and McDonald’s, so it uses a combination of phone reservation first-come, first-serve and appear in person firstcome, first-serve.

Use the following table to work Problems 19 to 22. The table gives the supply schedules Price for jet-ski rides by the only suppliers: (dollars Rick, Sam, and Tom. per ride) 19. What is each owner’s minimum 10.00 supply-price of 10 rides a day? 12.50 Rick’s minimum supply- price 15.00 for 10 rides is $15.00, Sam’s 17.50 minimum supply-price is 20.00 $17.50, and Tom’s minimum

Rick 0 5 10 15 20

Quantity supplied (rides per week) Sam 0 0 5 10 15

Tom 0 0 0 5 10

supply-price is $20.00.

20.

Which owner has the largest producer surplus when the price of a ride is $17.50? Explain. Rick has the largest producer surplus when the price is $17.50. Rick’s producer surplus is largest because he produces the largest quantity and his costs are lower than those of the other producers. More formally, each supplier’s producer surplus is equal to the area under the price and above that producer’s supply curve. Calculating these areas of producer surplus, Rick’s producer surplus is $56.25, Sam’s producer surplus is $25.00, and Tom’s producer surplus is $6.25.

21.

What is the marginal social cost of 45 rides a day? 45 rides are produced when the price is $20.00, so the marginal social cost of producing 45 rides a day is $20.00.

22.

Construct the market supply schedule of jet-ski rides. When the price is $10.00, the quantity of rides supplied is 0; when the price is $12.50, the quantity supplied is 5 rides; when the price is $15.00, the quantity supplied is 15; when the © 2014 Pearson Education, Inc.

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price is $17.50, the quantity supplied is 30; and, when the price is $20, the quantity supplied is 45.

23.

The table gives the demand and supply schedules for sandwiches. a. What is the maximum price that consumers are willing to pay for the 200th sandwich? The demand schedule shows the maximum price that consumers will pay for each sandwich. The maximum price consumers will pay for the 200th sandwich is $2.

b. What is the minimum price that producers are willing to accept for the 200th sandwich?

Price (dollars per sandwich) 0 1 2 3 4 5 6

Quantity Quantity demanded supplied (sandwiches per hour) 300 250 200 150 100 50 0

0 50 100 150 200 250 300

The supply schedule shows the minimum price that producers will accept for each sandwich. The minimum price that producers are willing to accept for the 200th sandwich is $4.

c. If 200 sandwiches a day are available, what is the total surplus? 200 sandwiches a day are more than the efficient quantity because the marginal social benefit (the maximum price consumers will pay) is less than the marginal social cost (the minimum price suppliers will accept). Because production is inefficient, there is a deadweight loss, equal to the sum of the consumer surplus and producer surplus lost because the quantity produced is not the efficient quantity. The deadweight loss equals the quantity (200 − 150) multiplied by ($4 − $2)/2, which is $50. This deadweight loss must be subtracted from the surplus that would be obtained if the market was efficient to calculate the total surplus when 200 sandwiches are produced. When the market produces the efficient quantity, 150 sandwiches are produced. The total surplus at this efficient quantity equals the area of the triangle under the demand curve and above the supply curve to the quantity of 150. This area is ½  ($6 − $0)  150, which is $450. So the total surplus when 200 sandwiches are produced equals $450 − $50, which is $400.

24.

“Two Buck Chuck” Wine Cult “Two Buck Chuck” is a cheap, good wine. After a year flooding the West Coast market, it is still being sold by the case to wine lovers. An overabundance of grapes has made the wine cheap to bottle—about 5 million cases so far. Source: CBS, June 2, 2003 How has “Two Buck Chuck” influenced the consumer surplus from wine, the producer surplus for its producer, and for the producers of other wines? “Two Buck Chuck” increased the consumer surplus from wine. Consumers are flocking to this cheaper wine in place of more expensive wines. The consumer surplus increased because the price of “Two Buck Chuck” is lower than other wines and because the quantity of wine consumed increased. “Two Buck Chuck” increased the producer surplus of its producer. Because “Two Buck Chuck” is a substitute for other wines, the quantity and price of other wines sold has decreased and so the producer surplus from these wines decreased.

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surplus, and what is the total surplus? 150 sandwiches is the efficient quantity and the equilibrium price is $3. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the consumer surplus triangle is ½  ($6 − $3)  150, which is $225. The producer surplus is the area of the triangle above the supply curve below the price. The price is $3 and the quantity is 150. The area of the triangle is 1/2  ($3 − $0)  150, which is $225. The total surplus is the sum of the consumer surplus plus the producer surplus, which is $450.

b. If the demand for sandwiches increases and sandwich makers produce the efficient quantity, what happens to producer surplus and deadweight loss? If the demand for sandwiches increases, the price and quantity of sandwiches both rise. The producer surplus definitely increases. There is no deadweight loss because sandwich makers are producing the efficient quantity.

Use the following news clip to work Problems 26 to 28. The Right Price for Digital Music Apple’s $1.29-for-the-latest-songs model isn’t perfect and isn’t it too much to pay for music that appeals to just a few people? What we need is a system that will be profitable but fair to music lovers. The solution: Price song downloads according to demand. The more people who download a particular song, the higher will be the price of that song; the fewer people who buy a particular song, the lower will be the price of that song. That is a free-market solution—the market would determine the price. Source: Slate, December 5, 2005 Assume that the marginal social cost of downloading a song from the iTunes Store is zero. (This assumption means that the cost of operating the iTunes Store doesn’t change if people download more songs.) 26. a. Draw a graph of the market for downloadable music with a price of $1.29 for all the latest songs. On your graph, show consumer surplus and producer surplus. Figure 5.4 shows this market. The marginal social cost curve runs along the horizontal axis. The consumer surplus is area A and the producer surplus is area B.

b. With a price of $1.29 for all the latest songs, is the market efficient or inefficient? If it is inefficient, show the deadweight loss on your graph. The market is inefficient. Efficiency requires that the amount be the quantity for which the marginal social benefit equals the marginal social cost, which in this case is the quantity at which the marginal social benefit curve intersects the horizontal axis. The deadweight loss is area C in Figure 5.4.

C h a p t e r

GOVERNMENT ACTIONS IN MARKETS

Answers to the Review Quizzes Page 130 1.

What is a rent ceiling and what are its effects if it is set above the equilibrium rent? A rent ceiling is a specific example of a price ceiling. A rent ceiling is a government imposed regulation that makes it illegal to charge a rent higher than a specified level. If a rent ceiling is set above the equilibrium rent, it has no effect because it does not make the equilibrium rent illegal.

What are the effects of a rent ceiling that is set below the equilibrium rent? If the rent ceiling is set below the equilibrium rent, the quantity of housing units demanded by renters exceeds the quantity supplied by landlords. Since landlords are not forced to supply more units than the supply curve would indicate for the rent ceiling price, the quantity of housing units actually rented equals the quantity supplied, rather than the quantity demanded. This causes a shortage in the rental housing market.

How are scarce housing resources allocated when a rent ceiling is in place? With an effective rent ceiling, some means for allocation of housing units (other than by price) becomes necessary. Some housing is allocated by first-come, first-serve. Other housing is allocated by discrimination. Black markets also develop, where housing units are allocated at a rent higher than the regulated rent.

Why does a rent ceiling create an inefficient and unfair outcome in the housing market? A rent ceiling creates inefficiency because at the quantity of apartments that are rented, the marginal social benefit exceeds the marginal social cost. Rent ceilings are unfair under the “fair rules” approach because rent ceilings prevent voluntary transactions. Rent ceilings are unfair under the “fair results” approach because there is no assurance that apartments go to those with lower incomes. Indeed, rent ceilings lead to discrimination, which is perhaps the antithesis to fairness.

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What is a minimum wage and what are its effects if it is set above the equilibrium wage? A minimum wage is a price floor applied to the labor market. A minimum wage is a government imposed regulation that makes it illegal to charge (or pay) a wage rate lower than a specified level. If the minimum wage is set above the equilibrium wage, it creates a surplus of labor— unemployment—and decreases workers’ and firms’ surplus.

What are the effects of a minimum wage set below the equilibrium wage? If the minimum wage is set below the equilibrium wage, then the law has no impact on the labor market equilibrium wage and quantity.

Explain how scarce jobs are allocated when a minimum wage is in place. If a minimum wage is set above the equilibrium wage, the ability of the competitive market to allocate resources is thwarted and other means must be used. Sometimes the method used is © 2014 Pearson Education, Inc.

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first-come, first-served so that those who are first in line to apply for openings are given the jobs. Other times discrimination is used so that those from favored groups are allocated the jobs.

Explain why a minimum wage creates an inefficient allocation of labor resources. A competitive labor market allowed to reach its equilibrium creates an efficient allocation of resources. At the equilibrium, the amount of employment is such that the marginal social cost of labor to workers equals the marginal social benefit from labor to firms. A minimum wage set above the equilibrium wage rate creates a surplus of labor—the quantity of labor supplied exceeds the quantity of labor demanded. The minimum wage reduces employment so that it is less than the efficient amount.

Explain why a minimum wage is unfair. Workers who receive wage hikes and retain their jobs gain from the minimum wage but workers who lose their jobs and workers who must extensively search for a job lose. Those who keep (or find) jobs are not necessarily the least well off, so the minimum wage fails the fair results approach to fairness. And the minimum wage also fails the fair rules approach to fairness because the minimum wage blocks voluntary transactions that otherwise would occur.

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How does the elasticity of demand influence the incidence of a tax, the tax revenue, and the deadweight loss? The more elastic the demand for a given supply, the smaller the increase in the price paid by the buyers and the greater the decrease in the price received by the sellers, which means that the incidence on buyers is smaller. Additionally, the more elastic the demand, the smaller the quantity bought so the smaller the tax revenue; and the larger the deadweight loss.

How does the elasticity of supply influence the incidence of a tax, the quantity bought, the tax revenue, and the deadweight loss? The more elastic the supply for a given demand the larger the increase in the price paid by the buyers and the smaller the decrease in the price received by the sellers, which means that the incidence on buyers is larger. Additionally, the more elastic the supply, the smaller the quantity bought so the smaller the tax revenue and the larger the deadweight loss.

Why is a tax inefficient? The imposition of a tax on a market causes a wedge to be driven between the price received by the seller and the price paid by the buyer. This causes the marginal social benefit from the last unit sold to be higher than its marginal social cost, and the market will under-produce the good or service being taxed. If more of the good or service were produced, the marginal social benefit gained would be greater than the marginal social cost incurred, and the net benefit to society would increase.

When would a tax be efficient? A tax is efficient, that is, creates no deadweight loss, when demand is perfectly inelastic or supply is perfectly inelastic. In both these cases a tax does not change the quantity produced and so creates no deadweight loss.

What are the two principles of fairness that are applied to tax systems? The two principles of fairness are the benefits principle and the ability-to-pay principle. The benefits principle asserts that people should pay taxes equal to the benefits they receive from the government provided services. The ability-to-pay principle asserts that people should pay taxes according to how easily they can bear the burden of the tax. © 2014 Pearson Education, Inc.

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GLOBAL MARKETS IN ACTION

Answers to the Review Quizzes Page 154 1.

Describe the situation in the market for a good or service that the United States imports. The goods and services the United States will import are those in which the United States has a higher opportunity cost of production relative to other countries. In those markets the U.S. notrade price is higher than the world price. With trade the quantity produced in the United States is less than the quantity consumed and the difference is imported.

Describe the situation in the market for a good or service that the United States exports. The goods and services the United States will export are those in which the United States has a lower opportunity cost of production relative to other countries. In those markets the U.S. notrade price is lower than the world price. With trade the quantity produced in the United States exceeds the quantity consumed and the excess is exported.

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How is the gain from imports distributed between consumers and domestic producers? Consumers gain consumer surplus from imports and domestic producers lose producer surplus from imports.

How is the gain from exports distributed between consumers and domestic producers? Consumers lose consumer surplus from exports and domestic producers gain producer surplus from exports.

Why is the net gain from international trade positive? The net gain from international trade is positive because the gain to the winners exceeds the losses to the losers. For instance, in the case of an imported good, all the loss of producer surplus is transferred to consumers as consumer surplus. In addition, however, consumers also gain additional consumer surplus from the units imported. The total gain of consumer surplus exceeds the loss of producer surplus so that the net surplus increases. The situation is similar for exports: The total gain of producer surplus exceeds the loss of consumer surplus.

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What are the tools that a country can use to restrict international trade? A country can use tariffs, import quotas, other import barriers such as health, safety, and regulation barriers, and voluntary export restraints to restrict international trade. Export subsidies given by a nation decrease other countries’ exports and thereby restrict their international trade.

Explain the effects of a tariff on domestic production, the quantity bought, and the price. A tariff raises the domestic price of the product. The higher price increases domestic production and decreases the domestic quantity purchased.

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Explain who gains and who loses from a tariff and why the losses exceed the gains. Domestic consumers lose consumer surplus from the tariff. Domestic producers gain producer surplus from the tariff. The government also gains revenue from the tariff. But the gain in producer surplus plus the gain in government revenue is less than the loss of consumer surplus, so on net a tariff creates a deadweight loss.

Explain the effects of an import quota on domestic production, consumption, and price. An import quota raises the domestic price of the product. The higher price increases domestic production and decreases domestic purchases.

Explain who gains and who loses from an import quota and why the losses exceed the gains. Domestic consumers lose consumer surplus from the import quota. Domestic producers gain producer surplus from the import quota. The importers also gain additional profit from the import quota. But the gain in producer surplus plus the importers’ profits is less than the loss of consumer surplus, so on net an import quota creates a deadweight loss.

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What are the infant industry and dumping arguments for protection? Are they correct? The attempt to stimulate the growth of new industries is the infant-industry argument for protection, which states that it is necessary to protect a new industry from import competition to facilitate the growth of that industry, making it competitive in the world markets. This argument is based on the idea that as firms mature they become more productive. However this argument for protection only works if the benefits also spill over into other industries and other parts of the economy. This is rarely the case, as the entrepreneurs of infant industries and their financial supporters take this risk into account and all returns usually accrue only to them, not to other industries. And it is more efficient to subsidize the infant industry needing protection than it is to protect it by restricting trade. The dumping argument for protection states that a foreign firm is selling its exports at a lower price than its cost of production. Foreign firms trying to monopolize the international market may use this practice. Once the competition is gone, the foreign firm will raise prices and reap profits. This argument fails for several reasons. First, it is virtually impossible to detect the occurrence of dumping since it is impossible to verify a firm’s production costs. The test most commonly used is if the firm’s price when it exports is lower than its domestic price. This test only examines the supply side of the two markets and ignores the demand side. If the domestic market is inelastic and the export market is elastic (which is almost always the case) then it is natural for a firm to price the domestic goods higher than the exports. Second, it is difficult to see how a global firm could have a monopoly for the goods or services it exports. There are too many foreign suppliers (and potential suppliers), making global competition too extensive for a monopoly to exist in the global market. And, even if there is global monopoly it is more efficient to regulate it than to impose trade restrictions on its products.

Can protection save jobs and the environment and prevent workers in developing countries from being exploited? There are many myths about trade restrictions. The problem mentions three of them, all false reasons often offered as reasons to restrict international trade. These arguments are: •

Trade restrictions save domestic jobs: Free international trade does, indeed, cost jobs in the import-competing markets. But this argument ignores the fact that, under free trade, consumers in the exporting country will have greater disposable income. These consumers will use part of their higher income to buy goods and services from other countries, thereby © 2014 Pearson Education, Inc.

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UTILITY AND DEMAND

Answers to the Review Quizzes Page 180 1.

Explain how a consumer’s income and the prices of goods limit consumption possibilities. A consumer’s consumption possibilities are limited by the consumer’s income and the prices of the goods. The consumer is unable to consume limitless quantities of goods and services because the consumer must pay a price for each good or service consumed and the consumer’s income is limited. If the consumer’s income increases and/or the prices of the goods and services fall, the quantity of goods and services the consumer can afford increases, thereby increasing the consumer’s consumption possibilities.

What is utility and how do we use the concept of utility to describe a consumer’s preferences? Utility is the benefit a person gets from the consumption of goods and services. We use total utility to describe a consumer’s preferences by looking at the (total) utility from the consumption of all the goods and services. We use marginal utility to measure the gain in utility from consuming another unit of a good or service.

What is the distinction between total utility and marginal utility? Total utility is the entire amount of satisfaction an individual obtains from the total amount of goods and services consumed. Marginal utility is the change in total utility from a one-unit increase in the consumption of a good or service.

What is the key assumption about marginal utility? Generally, more consumption gives more utility. A key assumption about marginal utility is that it generally declines as more units of the good are consumed. This assumption is the principle of diminishing marginal utility.

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Why does a consumer spend the entire budget? The more goods and services a person consumes, the higher the person’s utility. By spending his or her entire budget, the person is consuming the maximum quantity of goods and services, which means the utility can be at its maximum.

What is the marginal utility per dollar and how is it calculated? The marginal utility per dollar equals the marginal utility of the good or service divided by its price. The marginal utility per dollar tells the additional utility gained from spending one more dollar on a good or service.

What two conditions are met when a consumer is maximizing utility? The two conditions that must be met to ensure that a consumer is maximizing his or her utility are: i) all available income is spent, and ii) the marginal utility per dollar spent is equal for all goods and services consumed.

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Explain why equalizing the marginal utility per dollar for all goods maximizes utility. Equating the ratio of marginal utility per dollar for each good and service consumed maximizes utility because it measures the utility gained when an additional dollar of a good or service is consumed. This allows the consumer to weigh the utility gained from additional consumption of a dollar’s worth of one good against the utility lost from the forgone consumption of a dollar’s worth of another good. When the marginal utility per dollar for each good and service is equalized, there is no additional utility available from any other consumption combination.

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When the price of a good falls and the prices of other goods and a consumer’s income remain the same, explain what happens to the consumption of the good whose price has fallen and to the consumption of other goods. When the price of a good falls, the marginal utility per dollar for that good increases. The marginal utility per dollar for other goods does not change. To maximize total utility, a consumer makes marginal utility per dollar equal for all goods, so the consumer buys more of the good that has experienced the fall in price and less of the goods whose marginal utilities per dollar have not changed.

Elaborate on your answer to the previous question by using demand curves. For which good does demand change and for which good does the quantity demanded change? After the price of a good falls, the consumer increases consumption of the good to lower the marginal utility per dollar. This action means that more of the good is consumed at the lower price, which implies that the demand curve for the good is downward sloping. The consumer increases the quantity demanded of this good. Additionally, the consumer decreases the quantity of the other goods and services consumed, despite the price of other goods and services remaining unchanged. This change implies that the demand curves for each of the other goods and services shift leftward.

If a consumer’s income increases and if all goods are normal goods, explain how the quantity bought of each good changes. If the consumer’s income increases and all the goods consumed are normal goods, then the consumption of all goods increase. With the increase in income, the initial consumption possibility is now affordable with money left over. If the consumer’s utility for all goods increases with consumption, because the consumer seeks to maximize utility subject to prices and available income, he or she will use the money left over from the initial bundle to increase the quantity consumed for all goods and services. By doing so the consumer increases his or her total utility. This increase occurs while the price of these goods and services remained unchanged, which indicates there is a rightward shift of the demand curve for all goods and services.

What is the paradox of value and how is the paradox resolved? The paradox of value asks: “Why is water, which is essential to life, far cheaper than diamonds, which are not essential?” Consumers have diminishing marginal utility for water. The marginal utility of the last unit of water consumed is low because water is readily available and so the quantity consumed is very high. Consumers also have diminishing marginal utility for diamonds. The marginal utility of the last diamond consumed is high because diamonds are very scarce and so the quantity consumed is very low. Consumers maximize utility by equating the marginal utility per dollar for both goods. The scarcity of diamonds (high marginal utility) and the abundance of water (low marginal utility) indicate people are willing to pay a higher price for an additional unit of diamonds than for an additional unit of water.

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POSSIBILITES, PREFERENCES, AND CHOICES

Answers to the Review Quizzes Page 204 1.

What does a household’s budget line show? The budget line plots combinations of goods that require all a household’s income and describes the limits to its consumption choices.

How does the relative price and a household’s real income influence its budget line? The magnitude of the slope of the budget line equals the relative price of the good or service measured on the horizontal axis. A fall in the price of the good measured on the horizontal (vertical) axis decreases that good’s relative price and decreases (increases) the slope of the budget line. A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. An increase (decrease) in household income causes a parallel shift of the budget line rightward (leftward). The slope of the budget line does not change when income changes.

If a household has an income of $40 and buys only bus rides at $2 each and magazines at $4 each, what is the equation of the household’s budget line? The budget equation states that a household’s spending must equal its income. The budget equation is derived for two goods, bus rides and magazines. The amount spent on bus rides is (Pbus ride)×(Qbus ride), the amount spent on magazines is (Pmagazine)×(Qmagazine), and the consumer’s income is y. We know that (Pmagazine)×(Qmagazine) + (Pbus ride)×(Qbus ride) = y. Rearrange this equality by subtracting the amount spent on bus rides from both sides to give (Pmagazine)×(Qmagazine) = y – (Pbus ride)×(Qbus ride). Finally, divide both sides by the price of magazine to give the budget equation Qmagazine = y/Pmagazine – (Pbus ride /Pmagazine)×(Qbus ride). Substituting in our values, y = $40, P bus ride = $2 and P magazine = $4, gives Qmagazine = $40/$4 – ($2/$4)×(Qbus ride) which is equal to Qmagazine = 10 – 0.5 Qbus ride

If the price of one good changes, what happens to the relative price and the slope of the household’s budget line? A relative price is the price of one good divided by the price of another good. For example, the magnitude of the slope of the budget line (Pmovie/Psoda) is the relative price of a movie in terms of soda. This relative price shows how many sodas must be forgone to see an additional movie. A fall in the price of the good on the horizontal (vertical) axis increases the total affordable quantity of that good, decreases its relative price, and decreases (increases) the magnitude of the slope of the budget line.

If a household’s money income changes and prices do not change, what happens to the household’s real income and budget line? A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. For example, the vertical intercept for a budget line measuring soda on the vertical axis is (y/Psoda), which is the consumer’s real income in terms of sodas. A change © 2014 Pearson Education, Inc.

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in a household’s money income changes the household’s real income in terms of both goods and causes a parallel shift of the budget line. If a household’s money income increases, its budget line shifts rightward and if a household’s money income decreases, its budget line shifts leftward.

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What is an indifference curve and how does a preference map show preferences? An indifference curve shows those combinations of goods for which a consumer is indifferent. The consumer has the same level of satisfaction for any combination on a given indifference curve. The family of indifference curves is the preference map. This map shows the person’s preferences because it shows how the person ranks each combination of goods. In particular, the person prefers combinations on higher indifference curves to combinations on lower indifference curves.

Why does an indifference curve slope downward and why is it bowed toward the origin? The downward slope of an indifference curve illustrates the tradeoff between two goods while maintaining the same level of total satisfaction. Since the consumer is indifferent among all points on an indifference curve, when moving along it any increase in satisfaction from gaining one good must be matched by an equal decrease in satisfaction from a loss in the other good. An indifference curve is bowed toward the origin because the more of good x that is consumed the less you are willing to give up of good y to get more of good x and remain indifferent.

What do we call the magnitude of the slope of an indifference curve? The magnitude of the slope of an indifference curve is called the marginal rate of substitution (MRS). The MRS measures the rate at which the consumer gives up one good to get more of another good, while remaining on the same indifference curve (keeping the consumer indifferent about the changes). The bowed-in shape of the indifference curve is due to the assumption of diminishing MRS.

What is the key assumption about a consumer’s marginal rate of substitution? The key assumption about the marginal rate of substitution is that it is diminishing as a consumer moves down an indifference curve, creating the bowed-in shape.

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When a consumer chooses the combination of goods and services to buy, what is she or he trying to achieve? The consumer is trying to achieve the highest level of well being possible.

Explain the conditions that are met when a consumer has found the best affordable combination of goods to buy. (Use the terms budget line, marginal rate of substitution, and relative price in your explanation.) At the optimal consumption choice, the consumer’s consumption bundle is 1) on the budget line, 2) on the highest attainable indifference curve, 3) such that the slope of the budget line, which is the relative price of the two goods, equals the slope of the indifference curve, which is the MRS.

If the price of a normal good falls, what happens to the quantity demanded of that good? If the price of a normal good falls, the quantity demanded of that good increases because the substitution effect and the income effect both bring an increase in the quantity demanded. © 2014 Pearson Education, Inc.

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d. Identify your best affordable point. For the student who consumes print books, the best affordable point is point A in Figure 9.19, with 20-books and 300 other goods. For the student who consumes e-books, the best affordable point is point B in Figure 9.20 with 28 e-books and 200 other goods

C h a p t e r

ORGANIZING PRODUCTION

Answers to the Review Quizzes Page 226 1.

What is a firm’s fundamental goal and what happens if the firm doesn’t pursue this goal? A firm’s fundamental goal is to maximize its profit. If the firm fails to maximize profit it is either eliminated or bought out by other firms maximizing profit.

Why do accountants and economists calculate a firm’s cost and profit in different ways? Accountants and economists have different reasons for computing a firm’s costs. An accountant calculates a firm’s cost and profit to ensure that the firm pays the correct amount of income tax and to show its investors how their funds are being used. An economist calculates a firm’s cost and profit in a way that enables him or her to predict the firm's decisions.

What are the items that make opportunity cost differ from the accountant’s measure of cost? A firm’s opportunity cost includes the cost of using resources bought in the market, owned by the firm and supplied by the firm's owner. Economists and accountants both include the price of resources bought in the market as costs. But accountants omit costs included by economists. For instance, use of a building the owner has already purchased has an opportunity cost that accountants do not include. Additionally the normal profit, interest foregone, and economic depreciation are other opportunity costs not recorded by an accountant.

Why is normal profit an opportunity cost? Normal profit is the return to a firm’s owner for the owner’s supply of entrepreneurial ability and labor to the firm’s production process. Using the owner’s ability to run the business implies that the owner could have received a return for using it in another capacity, such as running another firm. This cost is an opportunity cost for the firm because it is the cost of a forgone alternative, which is running another firm, and must be included in calculating the firm’s opportunity cost of production.

What are the constraints that a firm faces? How does each constraint limit the firm’s profit? The three types of constraints a firm faces are technology constraints, information constraints, and market constraints. Technology is any specific method of producing a good or service and it advances over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output. Information is never complete, for the future or the present. A firm is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information itself limits profit. Market constraints mean that what each firm can sell and the price it can obtain are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms. The resources that a firm can buy and the prices it must pay for them are limited by the willingness of people to work for and invest in the firm. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make. © 2014 Pearson Education, Inc.

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OUTPUT AND COSTS

Answers to the Review Quizzes Page 248 1.

Distinguish between the short run and the long run. The short run is a period of time during which the quantity of at least one factor of production is fixed and cannot be changed. The long run is a period of time long enough so that the quantities of all factors of production can be varied.

Why is a sunk cost irrelevant to a firm’s current decisions? Sunk cost is irrelevant because it cannot be changed by any decision. It is already incurred and so must be paid. The only costs that concern the firm are costs that the firm can change with its current decisions.

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Explain how the marginal product and average product of labor change as the labor employed increases (a) initially and (b) eventually. Initially, as the quantity of labor is increases, the firm experiences increasing marginal returns, which means that the marginal product increases as more labor is employed. Increasing marginal returns occur because hiring additional workers allows the workers to specialize and become more productive. Eventually, the firm will experience diminishing marginal returns which means that the marginal product decreases as more labor is employed. Decreasing marginal returns occur because eventually the gains from specialization diminish and because more and more workers are working with the same fixed amount of capital. The average product of labor follows the marginal product of labor. Initially, when the marginal product of labor is increasing, the average product also increases. As long as the marginal product of labor exceeds the average product of labor, the average product continues to increase. Eventually when the marginal product is falling it falls enough so that it is less than the average product, at which point the average product of labor decreases.

What is the law of diminishing returns? Why does marginal product eventually diminish? The law of diminishing returns states that as a firm uses more of a variable factor of production with a given quantity of fixed factors of production, the marginal product of the variable factor eventually diminishes. Diminishing marginal returns arises from the fact that ever more workers are using the same capital and working in the same space.

Explain the relationship between marginal product and average product. As the quantity of labor initially increases the firm experiences increasing marginal returns and the marginal product of labor increases. The marginal product of labor is greater than the average product over this range of labor, so the average product of labor increases when the quantity of labor increases. Eventually, diminishing marginal returns causes the marginal product of labor to fall. When the marginal product of labor falls below the average product, the average product decreases as the quantity of labor increases.

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What relationships do a firm’s short-run cost curves show? The marginal cost (MC), average total cost (ATC) and average variable cost (AVC) curves are all related in the short run: • When the MC curve lies above (lies below) the AVC curve, the AVC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the AVC curve at its lowest point. • When the MC curve lies above (lies below) the ATC curve, the ATC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the ATC curve at its lowest point. • As output increases, the ATC curve becomes vertically closer to the AVC curve.

How does marginal cost change as output increases (a) initially and (b) eventually? At small outputs, marginal cost decreases as output increases because of greater specialization and the division of labor, but as output increases further, marginal cost eventually increases because of the law of diminishing returns.

What does the law of diminishing returns imply for the shape of the marginal cost curve? The law of diminishing returns states: As a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes. The law of diminishing returns means that each additional worker produces a successively smaller addition to output. So to get an additional unit of output, ever more workers are required. The cost of an additional unit of output—marginal cost—is increasing, so the marginal cost curve eventually slopes upward.

What is the shape of the AFC curve and why does it have this shape? Average fixed cost (AFC) equals total fixed cost divided by total product. As the quantity produced increases, the fixed costs are spread over a larger and larger quantity of output so average fixed cost decreases. So the AFC curve slopes downward as the quantity produced increases.

What are the shapes of the AVC curve and the ATC curve and why do they have these shapes? The average variable cost (AVC), and average total cost (ATC) curves are both U-shaped. • The marginal cost (MC) curve shows how total cost changes when output increases by one unit. If the MC curve lies below the AVC curve, AVC is falling. Diminishing marginal returns means that eventually the MC curve slopes upward. At some point the MC curve lies above the AVC curve, and the AVC curve is upward sloping. • ATC is the sum of average fixed cost (AFC) and AVC. Initially the ATC curve falls as the quantity produced increases because the AFC is initially quite large, but drops rapidly as total fixed costs are spread over greater levels of output. However, eventually diminishing returns cause marginal product to fall below average product, and average product decreases. As a result AVC increases as the quantity produced increases. If AVC rises more quickly than AFC falls, then the ATC curve is upward sloping.

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What does a firm’s production function show and how is it related to a total product curve? A firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labor. The total product curve shows the maximum output that a given quantity of labor can produce for a given quantity of capital.