Issuu

CHAPTER 1

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

Page 48 1.

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

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

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

WHAT IS ECONOMICS?

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

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

Page 49 1.

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

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

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

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

CHAPTER 1

Answers to the Study Plan Problems and Applications 1.

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

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

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

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

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

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

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

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

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

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

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

WHAT IS ECONOMICS?

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

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

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

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

CHAPTER 1

Answers to Additional Problems and Applications 7.

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

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

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

10.

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

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

11.

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

12.

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

WHAT IS ECONOMICS?

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

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

13.

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

Appendix

GRAPHS IN ECONOMICS

Answers to the Review Quiz Page 66 1.

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

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

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

APPENDIX 1

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

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

GRAPHS IN ECONOMICS

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

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

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

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

10.

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

11.

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

APPENDIX 1

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

1 2 3 4 5 6 7 8 9 10 11

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

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

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

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

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

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

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

GRAPHS IN ECONOMICS

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

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

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

Movie The LEGO Movie About Last Night RoboCop The Monument Men

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

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

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

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

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

APPENDIX 1

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

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

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

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

Price (dollars per ride) 5 10 15

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

GRAPHS IN ECONOMICS

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

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

11.

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

APPENDIX 1

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

12.

1 2 3 4 5 6 7 8 9 10 11

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

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

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

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

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

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

13.

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

GRAPHS IN ECONOMICS

14.

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

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

x y

0 25

1 24

2 22

3 18

4 12

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

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

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

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

16.

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

5 0

17.

APPENDIX 1

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

18.

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

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

20.

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

GRAPHS IN ECONOMICS

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

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

Price (dollars per umbrella) 20 30 40

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

22.

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

23.

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

0 4 2 1

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

8 7 4

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THE ECONOMIC PROBLEM

Answers to the Review Quizzes Page 72 1.

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

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

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

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

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

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

CHAPTER 2

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

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

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

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

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

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

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

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

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

THE ECONOMIC PROBLEM

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

CHAPTER 2

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

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

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

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

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

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

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

THE ECONOMIC PROBLEM

Page 83 1.

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

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

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

CHAPTER 2

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

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

and and and and and and

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

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

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

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

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

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

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

THE ECONOMIC PROBLEM

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

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

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

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

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

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

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

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

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

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

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

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

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

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

10.

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

THE ECONOMIC PROBLEM

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

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DEMAND AND SUPPLY

Answers to the Review Quizzes Page 94 1.

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

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

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

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

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

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

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

CHAPTER 3

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

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

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

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

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

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

DEMAND AND SUPPLY

Economics in the News 27.

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

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

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

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

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

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ELASTICITY

Answers to the Review Quizzes Page 128 1.

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

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

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

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

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

CHAPTER 4

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

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

C h a p t e r

EFFICIENCY AND EQUITY

Answers to the Review Quizzes Page 145 1.

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

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

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

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d. Is the difference in price paid by farmers and urban users fair? According to the “fair results” approach, the difference in price is fair urban users, the difference in price is not fair. The difference in price is not fair according to the “fair rules” approach because the price of water is not determined in competitive markets.

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GOVERNMENT ACTIONS IN MARKETS

Answers to the Review Quizzes Page 168 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.

C h a p t e r

GLOBAL MARKETS IN ACTION

Answers to the Review Quizzes Page 192 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. no-trade 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. no-trade 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.

CHAPTER 7

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.

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 importcompeting 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 increasing employment in the exporting sector of the nation. So, although international trade rearranges jobs—decreasing them in import-competing markets and increasing them in exporting markets—it does not, on net, cost jobs.

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UTILITY AND DEMAND

Answers to the Review Quizzes Page 218 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.

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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.

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.

What are the similarities between utility and temperature? The scales of both utility and temperature are arbitrary. The units used to measure both can be changed without changing their predictive abilities. For instance, the scale used to “measure” utility can be changed without consequence and the scale used to measure temperature (such as Celsius,

UTILITY AND DEMAND

32.

Money Can Buy Happiness A new study by economists Justin Wolfers and Betsey Stevenson has cast doubt on the credibility of the Easterlin paradox, which claims that higher incomes do not necessarily make people happier. The new study states that people do report more happiness and satisfaction as they grow richer. Moving from rich to richer seems to raise happiness just as much as moving from poor to less poor. Source: The Economist, May 2, 2013 According to the news clip, a. How does moving from rich to richer influence total utility? “Utility” and “happiness” aren’t synonymous because they are different measures. Utility is an arbitrary measure that tells how people value different consumption bundles, at a point in time. Happiness, presumably, is a measure that tells how pleased people are with their lives. As they aren’t the same concepts, no conclusion from the news clip can be drawn regarding how becoming richer has an impact on total utility.

b. How do total utility and marginal utility from consumption change over time? For two reasons, the news clip tells us nothing about how total utility has changed over time. First, total utility is an arbitrary measure: its units and scale can be changed with no effect on its predictions, so it does not make sense to try to determine how it has changed over time. Second, even if its units and scale were kept constant, total utility and happiness are not the same thing. Because the article gives us no information about how total utility changed, it also gives no information about how marginal utility changed. A consumer will consume the combination of goods and services that sets their marginal utility divided by their price equal. To know how marginal utilities have changed, we therefore need to know how the prices and quantities consumed have changed.

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POSSIBILITES, PREFERENCES, AND CHOICES

Answers to the Review Quizzes Page 242 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.

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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 9.14, with 20books and 300 other goods. For the student who consumes e-books, the best affordable point is point B in Figure 9.15 with 28 e-books and 200 other goods

C h a p t e r

ORGANIZING PRODUCTION

Answers to the Review Quizzes Page 264 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

C h a p t e r

OUTPUT AND COSTS

Answers to the Review Quizzes Page 286 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

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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.

Does the law of diminishing returns apply to capital as well as labor? Explain why or why not. The law of diminishing returns applies to capital as well as labor. The marginal product of capital is the change in the total product resulting from a one-unit increase in capital, holding the quantity of labor constant. As the quantity of capital increases for a given level of labor, the first units of capital will increase output substantially. But as capital continues to increase, eventually the increase in production starts to get smaller and diminishing returns to capital are occurring.

OUTPUT AND COSTS

Source: Vietnam Breaking News, May 30, 2015 30.

Thinking of an airline as a production plant, explain why Thai Airways is making a decision to sell 22 old aircraft? Is Thai Airways’s decision a long-run decision or a short-run decision? Thai Airways is making losses and it is operating where it has diseconomies of scale. By reducing the size of its plant (by selling 22 old aircraft), Thai Airways can slide down its LRAC curve and decrease its average cost. Thai Airways’s decision is a long-run decision because it involves the size of the firm’s plant.

31.

How might Thai Airways take advantage of economies of scale by revising its fleet and slashing its workforce ? At 22 old aircraft and 25,000 employees, Thai Airways was incurring diseconomies of scale. When Thai Airways revises its fleet and slashes its workforce, it will use fewer resources, particularly less capital and less labor. Thai Airways’s costs will be less as a result. Additionally, Thai Airways’s revenue will be less but the proportionate decrease in cost will exceed the decrease in Thai Airways’s revenue. In this case, Thai Airways’s average costs will decrease so that it can reap economies of scale it currently is not enjoying.

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PERFECT COMPETITION

Answers to the Review Quizzes Page 311 1.

Why is a firm in perfect competition a price taker? One firm’s output is a perfect substitute for another firm’s output and each firm is a small part of the market. These points imply that each firm cannot unilaterally influence the market price at which it can sell its good or service. It must accept, or “take” the market equilibrium price—hence the term, price taker.

In perfect competition, what is the relationship between the demand for the firm’s output and the market demand? The market demand curve for the goods and services in a perfectly competitive market is downward sloping. However, no single firm in this market can influence the price at which it sells its output. This point means a firm that is a price taker must take the equilibrium market price as given, and the firm faces a perfectly elastic demand.

In perfect competition, why is a firm’s marginal revenue curve also the demand curve for the firm’s output? A perfectly competitive firm’s demand curve is a horizontal line at the market price. This result means that the price it receives is the same for every unit sold. The marginal revenue received by the firm is the change in total revenue from selling one more unit, which is the constant market price. So a perfectly competitive firm’s demand curve is the same as its marginal revenue curve.

What decisions must a firm make to maximize profit? The firm has three decisions it must make. First it must determine how to produce at the minimum cost. Then it must determine how much to produce. Finally it must decide whether to enter or exit a market.

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Why does a firm in perfect competition produce the quantity at which marginal cost equals price? A firm’s total profit is maximized by producing the level of output at which marginal revenue for the last unit produced equals its marginal cost, or MR = MC. In a perfectly competitive market, MR is equal to the market price P for all levels of output. These points imply that a perfectly competitive firm will maximize profit by producing the quantity at P = MC.

C h a p t e r

MONOPOLY

Answers to the Review Quizzes Page 337 1.

How does monopoly arise? Monopoly arises if a firm is selling a good that has no close substitutes and if the firm is protected from competition by a barrier to entry. As a result, a monopoly is the only firm in its market.

How does a natural monopoly differ from a legal monopoly? The barrier to entry protecting a natural monopoly is the firm’s cost. For a natural monopoly, the costs are such that one firm can supply the entire market at lower cost than could two or more firms. The barrier to entry protecting a legal monopoly is a legal prohibition preventing competitors from entering the market. Copyrights, patents, government licenses, and public franchises are legal barriers to entry.

Distinguish between a price-discriminating monopoly and a single-price monopoly. A single-price monopoly charges every consumer the same price for each unit of the good or service the consumer buys. A price-discriminating monopolist might charge different consumers different prices for the same good or service or charge the same consumer different prices for different units of the good or service. When a firm practices price discrimination, it sells different units of a good or service for different prices.

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What is the relationship between marginal cost and marginal revenue when a single-price monopoly maximizes profit? A single-price monopoly firm maximizes profit by producing an amount of output so that marginal cost equals marginal revenue (MR = MC).

How does a single-price monopoly determine the price it will charge its customers? The market demand curve is the monopolist’s demand curve. The demand curve shows the maximum price at which the monopoly can sell its profit-maximizing level of output. So the monopoly finds the quantity it will produce and then uses its demand curve—the market demand curve—to determine the price it will charge.

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What is the relationship between price, marginal revenue, and marginal cost when a single-price monopoly is maximizing profit? MR < P for every level of output. A profit-maximizing monopoly firm produces the amount of output that sets MR = MC. As a result, MC must be below price: MC = MR < P.

Why can a monopoly make a positive economic profit even in the long run? Barriers to entry prevent the monopoly firm from enduring the pressure of competition, and allow it to choose the quantity of output that is associated with the profit-maximizing market price. This allows a monopoly firm to potentially enjoy positive economic profit, even in the long run.

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Why does a single-price monopoly produce a smaller output and charge more than the price that would prevail if the market were perfectly competitive? The market supply curve for a competitive market is the horizontal sum of the individual firm’s marginal cost curves. Equilibrium output in this competitive market is determined where the market supply curve intersects the market demand curve, and at this point price equals marginal cost, that is P = MC. Equilibrium output for a single-price monopoly is determined at the intersection of its marginal cost curve and its marginal revenue curve. Marginal revenue is less than price, which means that MR = MC at less output than that for which P=MC, so the monopoly produces less than a perfectly completive market. For a monopoly price exceeds marginal revenue which, in turn, equals marginal cost. Therefore for a monopoly, P > MC which means the monopoly price exceeds the price in a perfectly competitive market.

How does a monopoly transfer consumer surplus to itself? The monopoly raises price by lowering the quantity offered for sale. This raises the price consumers must pay for the good compared to the competitive market price. This difference in price multiplied by the quantity the monopolist sells represents the amount of consumer surplus that is transferred to producer surplus.

Why is a single-price monopoly inefficient? In a competitive market, the supply curve is the marginal social cost curve for society, and the demand curve is the marginal social benefit curve to society. The perfectly competitive market is efficient because production occurs where the quantity supplied equals the quantity demanded so that MSB = MSC. The monopolist is inefficient because price exceeds marginal cost at the quantity of output the monopoly produces. When the monopoly equates MC = MR to choose the profit-maximizing level of output, it charges a price from the demand curve that is greater than marginal cost, which means MSB > MSC. Consumer and producer surplus are not maximized and society suffers a deadweight loss.

What is rent seeking and how does it influence the inefficiency of monopoly? Rent seeking is the pursuit of wealth by capturing economic rent. Any surplus—consumer surplus, producer surplus, or economic profit—is called economic rent. There are two forms of rent seeking activity to pursue a monopoly status: i) Buying a monopoly, where a person expends resources seeking to purchase monopoly rights for a price slightly less than the monopoly profit, or ii) Creating a monopoly, where a person expends resources seeking political influence, such as lobbying legislators to provide preferential market status by restricting domestic or international competition. The resources expended in rent seeking can be equal to the economic profit that a monopoly status would create for the owner.

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What is price discrimination and how is it used to increase a monopoly’s profit? Price discrimination is the practice of selling different units of a good or service for different prices. To practice price discrimination, a monopoly must be able to: i) identify and separate different buyer types, and ii) sell a product that cannot be resold. The key idea to price discrimination is to charge different

MONOPOLY

24.

Hong Kong Electric Joins Chorus against a Cut in Permitted Return Rate HK Electric Investments, the sole power supplier to Hong Kong Island and Lamma Island, has joined its larger rival CLP Holdings, which supplies power to 80 percent of Hong Kong’s population, in opposing the Hong Kong government’s proposal to cut their permitted return and bring in competition to their regional electricity supply monopolies in the long term. Source: South China Morning Post, May 14, 2015 a. What barriers to entry exist in the electricity supply market in Hong Kong Island and Lamma Island? The major barrier to entry is that the electricity supply market in Hong Kong Island and Lamma Island is a natural monopoly. Firms entering the market will have higher average total costs if the amount they produce and sell is less than that of the existing firm.

b. Are high power tariffs evidence of monopoly power? High prices are not necessarily evidence of monopoly. Prices can be high in competitive markets if the costs are high. For instance, the luxury car market is competitive but these cars are quite expensive.

c. Draw a graph to illustrate the effects of introducing new competitors in the electricity supply market in Hong Kong Island and Lamma Island on the price, quantity, total surplus, and deadweight loss. Presuming that the power industry was an unregulated monopoly before introducing new competitors and that the market becomes competitive after the actions, Figure 13.11 shows what would happen. With the power industry a monopoly, 30 billion kilowatts electricity is provided and the price is $0.9 a kilowatt. The consumer surplus is equal to area a, the producer surplus is equal to area b+ area e, and the deadweight loss is equal to area c+ area f. Once the market is competitive, 35billion kilowatts electricity is provided and the price is $0.8 a kilowatt. Consumer surplus increases to area a+ area b+ area c. Producer surplus decreases to area e+ area f. There is no deadweight loss because the market is allocatively efficient.

25.

Break Up of State Oil Monopoly? Experts have suggested that China should establish an independent company to operate the oil wholesale business and manage the supply to retailers, to break up the de facto monopoly of the three State-owned oil companies, especially the two onshore oil giants. Source: China Daily, September 26, 2013 a. Is China’s oil industry a monopoly? China’s oil industry is not a monopoly because there are three competitors in the market. If the industry was a monopoly it would have no competitors.

b. Will introducing competition decrease the oil price in China? In the short term, the oil price in China will decrease with the introduction of competitors, since the supply will increase. However, in the long term, the price of oil will depend on the fluctuating global demand and supply of oil.

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MONOPOLISTIC COMPETITION

Answers to the Review Quizzes Page 363 1.

What are the distinguishing characteristics of monopolistic competition? The distinguishing characteristics of monopolistic competition are: i) a large number of firms, each producing a differentiated product than its competitors, ii) firms compete on quality, price, and marketing, and iii) there are no barriers to entry into the industry.

How do firms in monopolistic competition compete? Firms in monopolistic competition compete in three areas: Quality—the physical attributes of a product, including the product’s design and reliability, the service provided with the product, and the ease of access to the product; price—because the firms produce differentiated products, each firm faces a downward-sloping demand curve for its own product; and marketing—firms must make consumers aware of the quality of their differentiated products through advertising and packaging.

Provide some examples of industries near your school that operate in monopolistic competition (excluding those given on the text page in the figure). Hamburger restaurants, coffee shops, and juice bars are examples of firms competing in their own respective industry, each industry being a market described by monopolistic competition.

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How does a firm in monopolistic competition decide how much to produce and at what price to offer its product for sale? A firm that has already decided the quality of its product and its marketing program produces the output at which its marginal revenue equals its marginal cost (MR = MC) because this output maximizes profit. The price is determined from the demand curve for the firm’s product and is the highest price the firm can charge for the profit-maximizing quantity.

Why can a firm in monopolistic competition make an economic profit only in the short run? A firm in monopolistic competition can make an economic profit only in the short-run because economic profit induces entry, which decreases the demand for the firm’s product, lowers its profitmaximizing output, price, and economic profit. In long-run equilibrium, when entry ends, each firm makes zero economic profit.

Why do firms in monopolistic competition operate with excess capacity? A firm’s capacity output is the output at which average total cost is at its minimum. In monopolistic competition in the long run, MR = MC and P = ATC. At the long run equilibrium, it is the case that MC < ATC, which means that ATC is falling in this range and so production occurs at an output level that is less than capacity output.

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Economics in the News 29.

After you have studied Economics in the News on pp. 372–373, answer the following questions. a. Why do you think Babolat worked with the firm that helped Nintendo develop the Wii remote? Babolat’s designers have expertise in designing tennis rackets, not remote sensors. The company that helped develop the Wii remote has expertise in remote sensing and therefore is able to design and produce the remote sensors at lower cost than could Babolat. Consequently Babolat worked with that company so that each company concentrated on its competitive advantage.

b. How would Babolat’s cost curves (MC and ATC) have been different if they had not worked with the Wii developer? Babolat’s average total cost and marginal cost would have been higher if it had attempted to create the smart racquet by itself. Consequently, its ATC and MC curves would have been above the ATC and MC curves when it partners with the other company.

c. How do you think the launch of Babolat’s new-technology racquet has influenced the demand for other firms’ racquets? The creation of the smart racquet decreases the demand for older generation racquets.

d. Explain the effects of the introduction of the new-technology racquet on Prince and other firms in the market for tennis racquets. The introduction of the smart racquet decreased the demand for existing racquets made by Prince and other companies. This change lowered the price and quantity of their racquets and decreased the firms’ profit.

e. Draw a graph to illustrate your answer to part (c). Explain your answer. Figure 14.5 shows how the smart racquet affected the demand for other firm’s racquets. The demand for existing, say, Prince racquets decreased and the demand curve shifted leftward from D0 to D1. The price of a Prince racquet falls (in the figure from $225 per racquet to $100 per racquet) and the quantity decreased (in the figure from 400,000 racquets per year to 200,000 per year). Prince’s economic profit decreases. In the figure, after Babolat’s introduction of its smart racquet, Prince is incurring an economic loss because Prince’s price is less than its average total cost.

What do you predict will happen to the markup in the market for smart racquets? In the long run, there will be entry into the market for smart racquets. As more firms enter, the demand for the incumbent firms’ smart racquets decreases. As the demand decreases, the markup between marginal cost and price also decreases.

g. What do you predict will happen to excess capacity in the market for smart racquets? Explain your answer. In the long run, similar to all firms in monopolistic competition, the producers of smart racquets will have excess capacity. In the short run, however, the firms might not have excess capacity. Indeed, in the short run it is possible for the manufacturers to produce at a point beyond their capacity output.

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OLIGOPOLY

Answers to the Review Quizzes Page 381 1.

What are the two distinguishing characteristics of oligopoly? Oligopoly has two distinguishing characteristics: Natural or legal barriers prevent the entry of new firms, and a small number of firms compete in the industry.

Why are firms in oligopoly interdependent? Firms in oligopoly are interdependent because each firm has a large market share and so each firm’s decisions have a major influence on its competitors’ profits.

Why do firms in oligopoly face a temptation to collude? Firms in oligopoly face the temptation to collude because if they can successfully collude, they can boost their economic profit.

Can you think of some examples of oligopolies that you buy from? The market for graphic accelerator cards is close to an oligopoly; the market for long-distance landbased telephone service is close to an oligopoly; the market for soft drinks is an oligopoly; and, the market for beer is an oligopoly.

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What are the common features of all games? All games share four common features: rules, strategies, payoffs, and outcome.

Describe the prisoners’ dilemma game and explain why the Nash equilibrium delivers a bad outcome for both players. In the prisoners’ dilemma game, each prisoner faces two strategies: confess or deny. There are four outcomes: i) Both prisoners confess and each receives more years in prison than if they both did not confess, ii) both prisoners deny, iii) prisoner A confesses and prisoner B denies, and iv) prisoner B confesses and prisoner A denies. In these last two outcomes, the confessing prisoner gets a lower sentence than if both confessed and lower than if they both denied. The dominant strategy for both prisoners is to confess. Regardless of what the other prisoner does, the best strategy for each prisoner is to confess, and both prisoners confess. This outcome is worse for both prisoners than if they each denied the crime, which creates the dilemma.

Why does a collusive agreement to restrict output and raise price create a game like the prisoners’ dilemma? Each firm has the possibility of sharing monopoly profits with other members of the cartel if each firm complies with the agreement. But each firm has an incentive to cheat on the collusive agreement in a cartel. If they all cheat, the outcome for each firm is worse than if they had all held to the agreement.

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PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

Answers to the Review Quizzes Page 411 1.

List the economic functions of governments. Governments exist to establish and maintain property rights, to provide nonmarket ways of allocating resources, and to create methods that redistribute income and wealth.

Describe the political marketplace. Who are the participants, what do they do, and what is a political equilibrium? Voters, firms, politicians, and bureaucrats interact in the political marketplace. Voters and firms demand policies. Voters provide votes and/or funds while firms supply funds and other help to politicians or political parties that supply the policies they want. Politicians and political parties supply the policies and in exchange receive votes and/or contributions from voters and firms. Politicians attempt to supply proposals that attract enough votes to be elected and then reelected. Bureaucrats are in charge of implementing the policies. The political equilibrium is a situation in which no one has the incentive to change their efforts or their policies.

Distinguish among public goods, private goods, common resources, and natural monopoly goods. Public goods are nonexcludable and nonrival. As a result, anyone can consume the good whether or not he or she paid for it and one person’s use of the good does not decrease the amount available for other people. Private goods are excludable and rival. As a result, only the person who pays for the good can consume it and one person’s use decreases the amount available for others. Common resources are nonexcludable and rival. As a result, anyone can consume the good whether or not he or she paid for it and one person’s consumption decreases the amount available for other people’s consumption. Natural monopoly goods are nonrival and excludable. Potential users of the good can be excluded if they do not pay but once having paid their use of the good is nonrival.

Why are healthcare and education not public goods and why do governments play a large role in the markets for these services? Healthcare and education are not public goods because they are rival and excludable. But governments play a major role in the market for these services because a majority of voters want these goods provided to people regardless of the people’s ability to pay for them. Because of this view, public choices are used to determine the quantity of healthcare and education services provided.

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Page 415 1.

What is the free-rider problem? Why do free riders make the private provision of a public good inefficient? If a firm were to provide a public good, it would suffer from the free-rider problem, which arises when non-paying consumers consume the public good without paying, enjoying a “free ride.” Public goods are, in part, characterized by inability to exclude nonpaying consumers. A private firm would not receive a sufficient level of revenue to provide the efficient level of the public good.

Under what conditions will competition among politicians for votes result in an efficient provision of a public good? Competition in the political marketplace will provide the efficient quantity of a public good only if the voters are well informed and are motivated to carefully evaluate the alternative policies that the politicians propose.

How do rationally ignorant voters and budget maximizing bureaucrats prevent the political marketplace from delivering the efficient quantity of a public good? If the marginal benefit to the voter of becoming well informed about a particular policy issue is much smaller than the marginal cost of becoming well informed, the voter is likely to remain rationally ignorant about the policy and the level of any related public goods provision. The marginal benefit of providing public goods is very high to both bureaucrats and the contractors who are employed to produce and distribute the public goods. So they have a concentrated interest in lobbying politicians to direct the bureaucrats to provide more than the efficient quantity of the public good, even to where the net benefit to the economy is zero.

Explain why public choices might lead to the overprovision rather than the underprovision of a public good. Rational ignorance of voters, combined with lobbying by public goods contractors and bureaucrats, causes the political equilibrium to provide public goods at a higher level than is economically efficient. In this case, it is in the self-interest of the politicians to provide more than the efficient quantity of the public good because they reap benefits from the lobbyists and bureaucrats while suffering little or no loss from voters.

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What is special about healthcare that makes it a good provided by the government? The government provides healthcare services because the marginal social benefit of healthcare exceeds the marginal benefit perceived by its consumers, Consumers underestimate the benefit of healthcare because they underestimate the health risks they face. They also underestimate their future needs for healthcare. And some people cannot afford the healthcare they need. For these reasons the majority of voters want healthcare to be available on need rather than on the ability and willingness to pay

Why would the market economy produce too little healthcare? The markets for healthcare will produce less than the efficient quantity because consumers of healthcare take account of only the benefits that accrue to them. They ignore the marginal social benefit that exceeds their perceived marginal benefit. Therefore the consumers’ demand for healthcare is less than the marginal social benefit from healthcare so the quantity of healthcare services produced is less than the efficient quantity.

How do Canada and the United Kingdom deliver healthcare and what is the problem left unresolved? Canada and the United Kingdom provide healthcare using a universal coverage, single payer system. Everyone is covered by health insurance and the government pays for all healthcare services. The government’s public choice determines the quantity of healthcare services provided. Consumers pay little or nothing for any healthcare service. Consequently the quantity of healthcare services demanded exceeds the quantity provided by the government which creates a problem: There often is a long waiting period until a patient receives services.

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EXTERNALITIES

Answers to the Review Quizzes Page 430 1.

What are the four types of externality? Externalities can be: a negative production externality, a positive production externality, a negative consumption externality, or a positive consumption externality.

Provide an example of each type of externality that is different from the ones described above. Dumping dangerous chemicals in river while producing paper is an example of a negative production externality. Baking bread and the resulting odor enjoyed by by-passers is an example of a positive production externality. Littering while hiking is an example of a negative consumption externality. Planting a beautiful bamboo garden that by-passers enjoy is an example of a positive consumption externality.

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What is the distinction between private cost and social cost? A private cost of production is the cost of producing a good or service that is borne only by the producer. A social cost of production includes the private costs of production as well as the external costs of production borne by people other than the producer.

How do external costs prevent a competitive market from allocating resources efficiently? External costs create a marginal social cost (MSC) that exceeds the marginal private cost (MC) for producing or consuming a good or service. That is, with an external cost, MSC > MC. When the firm produces a good or service with an external cost, it chooses to produce the quantity at which marginal cost equals marginal benefit, MC = MB. Marginal benefit equals marginal social benefit, MSB. In this case, the firm produces the quantity at which MC = MSB. This level of production exceeds the level at which MSC = MSB. Too much of the good or service is produced, resulting in an inefficient allocation of resources.

How can external costs be eliminated by assigning property rights? The existence of a negative externality means some group must bear some of the costs of a production or consumption activity for which they are not involved. The Coase theorem implies that assigning a property right to either the group generating the externality or the group bearing the externality costs will eliminate the inefficient allocation of resources. The Coase theorem applies if the number of parties involved is small and if transactions costs are low.

How do taxes, pollution charges, and cap-and-trade work to reduce emissions? An emissions tax or pollution charge on the producers of the activities that generate pollution or other negative externality will force these producers, when deciding about their level of production, to take account of the external costs they impose on society. Producers' costs increase and, in response, they decrease their production, which decreases pollution emissions. For cap-and-trade, the regulating agency first determines the total amount of pollution to be allowed. Each firm that might potentially pollute is then assigned a permitted amount of pollution to be emitted per period and is allocated

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sufficient permits to allow this amount of pollution. For any firm to exceed this amount, it must buy permits held by another firm. Each firm faces an opportunity cost for selling its emissions permits, namely the cost of cleaning up its pollution. The price of buying an extra permit will reflect the opportunity cost of the firm that sells the permits. Those firms with lower costs of cleaning pollution will sell their permits to those firms with higher costs. The total amount of pollution emitted will equal the total amount allowed.

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What is the tragedy of the commons? Give two examples, including one from your state. The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. The private market place will not produce the efficient quantity of a common resource. Some examples include the congestion of traffic during rush hour, the congestion near a college football stadium whenever a major game is played, or the free Internet access computer at the local library.

Describe the conditions under which a common resource is used efficiently. A common resource is used efficiently when the marginal social benefit equals the marginal social cost at the quantity produced.

Review three methods that might achieve the efficient use of a common resource and explain the obstacles to efficiency. There are three different methods that government can use to obtain the efficient allocation of resources in the event of a common resource: •

Property Rights are assigned to private property, which is a resource that someone owns and has an incentive to use in a way that maximizes its value. However, assigning property rights to resources is not always feasible, such as with the fish that migrate over the vast depths of the oceans.

•

Production Quotas can be set for total catch and divided among harvesting consumers so that the marginal social benefit from harvesting equals the marginal social cost of harvesting. However, it is in every harvester’s best interest to cheat on the quota, because marginal private benefit from exceeding the quota allotment is greater than the marginal cost of harvesting.

•

An Individual Transferable Quotas (ITQ) is a production limit that is assigned to an individual harvester who is free to transfer the quota to someone else.

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Why would the market economy produce too little education? The markets for education will produce less than the efficient quantity because consumers of education take account of only the benefits that accrue to them. They ignore the marginal external benefit that others gain. Therefore the consumers’ demand for education is less than the marginal social benefit from education.

How might governments achieve an efficient provision of education? Governments could use public provision, private subsidies, or vouchers to achieve efficiency in the market for education. Public provision: The government could determine the efficient amount of education and create public colleges. This method is the primary method used for K-12 education. Private subsidies: The government could offer subsidies to private colleges. Vouchers: The government would give vouchers to students. Pell grants are an example of vouchers.

EXTERNALITIES

b. What are the marginal social costs of and marginal social benefits from using gas rather than coal to generate electricity? The marginal social cost of using gas is the marginal private cost of the fuel (the price paid by the utilities for the fuel) plus the marginal external cost from the (smaller amount of) carbon dioxide emitted. The marginal social cost of using fuel from coal is the marginal private cost of the fuel (the price paid by the utilities for the fuel) plus the marginal external cost from the (larger amount of) carbon dioxide emitted. The marginal social benefit from using gas is the same as that from using coal, namely the marginal social benefits from electricity.

c. How will the EPA’s plan for power utilities to switch from coal to gas change the price that households pay for electricity? The price of electricity will rise as utilities switch from the lower-cost fuel, coal, to the higher cost fuel, natural gas.

d. How will the EPA’s plan for utilities to switch from coal to gas change the efficiency of electricity production? The efficiency will increase because utilities will use less coal, which generates a larger external cost, and more natural gas, which creates a smaller external cost.

30.

Traffic: Why It’s Time to Get Serious About the Bloody Illegal Wildlife Trade Wildlife trafficking and poaching are on the rise. According to CITES, an estimated 25,000 elephants were poached across Africa in 2011, and in South Africa alone 668 rhinos were killed by poachers in 2012. The resurgence of poaching is driven by the tremendous increase in the demand for ivory and other animal products and economic growth, which means more money in the hands of consumers who are willing to pay for ivory and other animal products. Source: Time, March 05, 2013 a. How are wildlife trafficking and poaching related to property rights? The wild animals that are poached roam across land that no one owns and no one owns the animals either; that is, the property rights to the land and animals were not established.

b. Can the tragedy of the wildlife trafficking be curtailed by establishing property rights to the land and animals? Once the property rights to the land and the animals are established, then the marginal private benefit will become the same as the marginal social benefit and the tragedy of the commons will be averted. However, it must be possible to establish property rights to the land where the wild animals roam and also to restrict the animals to certain areas so that they can be “owned.” It is not clear how this can be done.

c. How can ‘bag limits’ change the short-term outlook of hunters to a long-term outlook? A bag limit is a law imposed on hunters. ‘Bag limits’ can change hunters’ incentives by limiting the number of animals within a specific species that are hunted. Bag limits may also place restrictions on the size of those animals and the time of the year the animals may be killed. In this case, once the hunter hits the prescribed ‘bag limit’, he or she cannot continue to hunt but a bag limit means that he or she can harvest the specified quantity of animals within a specific species indefinitely, that is, day after day. But poaching and wildlife trafficking are illegal and poachers violate the bag limit and other hunting laws.

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MARKETS FOR FACTORS OF PRODUCTION

Answers to the Review Quizzes Page 458 1.

What are the factors of production and their prices? The factors of production and their prices are: labor, which is paid a wage rate for labor services; capital, which is paid a rental rate for capital services; land, which is paid a rental rate for land services; and entrepreneurship, which receives a profit or bears a loss that results from business decisions.

What is the distinction between capital and the services of capital? Capital is the actual tools, instruments, machines, buildings, and constructions that have been produced in the past and that businesses now use to produce goods and services. Capital services are the services of the unit of capital. For example, a copy machine at a local Quik Print is capital but the copying performed by the machine is the service of that particular unit of capital.

What is the distinction between the price of capital equipment and the rental rate of capital? The price of a unit of capital is how much must be paid to acquire the piece of capital equipment. The rental rate of capital is the amount that must be paid to use the unit of capital equipment. For instance, the copy machine at the local Quik Print has a price of $10,000 but its services can be rented from the Quik Print for $50 per hour.

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What is the value of marginal product of labor? The value of marginal product of labor is the value to the firm of hiring one more unit of labor. The value of marginal product of labor, VMP, is the change in total revenue from employing an additional unit of labor.

What is the relationship between the value of marginal product of labor and the marginal product of labor? VMP is equal to the price of a unit of the output, P, multiplied by the marginal product of labor, MP. So VMP = P  MP.

How is the demand for labor derived from the value of marginal product of labor? The demand for labor is determined by the value of marginal product of labor. To maximize its profit a firm hires the number of workers that sets the wage rate equal to the value of marginal product of labor. When the wage rate changes, the firm changes the quantity of labor it demands so that the (new) wage rate equals the value of marginal product. So when the wage rate changes, the firm moves along its value of marginal product of labor curve to determine the quantity of labor demanded, thereby making its value of marginal product of labor curve its demand for labor curve.

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ECONOMIC INEQUALITY

Answers to the Review Quizzes Page 490 1.

Which is distributed more unequally, income or wealth? Why? Which is the better measure? The distribution of wealth is more unequally distributed than income. Wealth is distributed more unequally than income because wealth data do not include the value of human capital, while the income data measure income from all wealth, including human capital. That is why income is a better measure for economic inequality than wealth.

How has the distribution of income changed in the past few decades? From 1970 economic inequality in the United States has increased. The share of income received by the richest quintile (20 percent) of the population has increased and this is the major change in the distribution of income.

What are the main characteristics of high-income and low-income households? There are four major characteristics that influence the amount of income earned by an individual: i) Education: The more education attained by a person the higher the human capital that person has, and the more income that person enjoys; ii) Type of household: Married couples earn more, on average, than single people living alone, especially females living alone; iii) The age of householder: The oldest and youngest households have lower incomes than middle age households; and iv) Race: Individuals living in households headed by an Asian person have the highest incomes, followed by white households, Hispanic households, and then black households.

What is poverty and how does its incidence vary across the races? Poverty is a situation in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. Poverty is a relative concept. Minorities have historically been over-represented among those households living in poverty in the United States. In particular, 13 percent of white households live in poverty while 26 percent of Hispanic-origin households and 27 percent of black households lived in poverty.

How much mobility has there been through the income quintiles since 2007? There is some mobility but not a vast amount, particularly in the lowest and highest quintiles. In both these quintiles, about 70 percent of households remained in the same quintile. In the other three quintiles, somewhere between 45 percent and 50 percent of households remained in the same quintile. But there was some mobility. In the bottom four quintiles, about 25 percent of household moved up a quintile. (It is impossible for a household in the top quintile to move up.) Similarly, in the top four quintiles, about 25 percent of household moved down a quintile. (It is impossible for a household in the bottom quintile to move down.) A few household also moved up and down by more than one quintile.

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Page 492 1.

In which countries are incomes distributed most unequally and least unequally? Brazil and South Africa have the most unequally distributed incomes. Finland and Sweden and some other European nations have the most equally distributed incomes.

Which income distribution is more unequal and why: the income distribution in the United States or in the entire world? The world Gini ratio is larger than the U.S. Gini ratio which means that the distribution of world income is less equally distributed than in the United States. The world income distribution ranges from extremely poor individuals living on less than $2.50 per day to the very wealthy living in the United States and other advanced countries.

How can incomes become more unequally distributed within countries and less unequally distributed across countries? Income within nations generally has become distributed less equally. However because the average income within the poorest nations has been rising more rapidly than average income within richer nations, the world distribution of income has become more equally distributed.

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What role does human capital play in accounting for income inequality? In general acquiring human capital is a costly endeavor so the supply of workers with a lot of human capital is less than the supply of workers with little human capital. The difference in supply means that the more human capital an individual attains, the more income that individual will likely earn, other things remaining the same. Greater variation in human capital across the population of households increases the degree of income inequality among households. While the level of human capital attained varies across households, this factor alone does not completely explain the observed variation in income across households in the United States

What role might discrimination play in accounting for income inequality? If the levels of VMP of labor for a racial group or one sex are perceived to be higher than that of another racial group or the other sex, then the equilibrium wages earned will vary across these groups, despite the fact that the two groups have equal ability. Economists disagree to the extent that discrimination pervades the labor market. One line of reasoning states that those firms that practice race or sex discrimination in the labor market face higher production costs (pay higher wages for the same value of marginal product) than those firms that do not. If this line of reasoning is correct, the profit margins for the firms practicing discrimination will be lower and the market price of their goods and services would be higher than non-discriminating firms. Either way, the market pressures increase the opportunity cost to firms (and the consumers who buy their goods) for practicing race or sex discrimination, eventually eliminating these practices.

What role might contests among superstars play in accounting for income inequality? Contests can explain why the super-rich have incomes that have increased greatly over the years. With increased globalization, the pool of “contestants” has increased dramatically. With the larger number of conspiracy, each contestant’s probability of winning has shrunk. So contests need to have larger differences in payouts for the winners versus the losers so as to induce larger efforts to win the contest. The result is that the contest winners—be they sports stars, entertainment stars, of CEOs— nowadays have much larger incomes than the vast number of losers.

How might technological change and globalization explain trends in the distribution of income? Technological change and globalization have both changed the distribution of income so that the “rich get richer and the poor get poorer.” More specifically, technological change has increased the demand for high-skilled workers and increased their wage rates and incomes. It also has decreased the demand for low-skilled workers and decreased their wage rates and their income. Globalization also has increased the demand for high-skilled workers and decreased the demand for low-skilled workers in the United States. Globalization has made contests worldwide, so the prizes for the best superstars— be they athletes or business managers—have increased with the increase in the size of the market.

ECONOMIC INEQUALITY

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The Best and Worst College Degrees by Salary Business administration is always a strong contender for honors as the most popular college major. This is no surprise since students think business is the way to making big bucks. But is business administration really as lucrative as students and their parents believe? Nope. In a new survey by PayScale, Inc. of salaries by college degree, business administration didn’t even break into the list of the top 10 or 20 most lucrative college degrees. A variety of engineering majors claim eight of the top 10 salary spots with chemical engineering ($65,700) winning best for starting salaries. Out of 75 undergrad college majors, business administration ($42,900) came in 35th, behind such degrees as occupational therapy ($61,300), information technology ($49,400), and economics ($48,800). Source: moneywatch.com, July 21, 2009 a. Why do college graduates with different majors have drastically different starting salaries? The differences in starting salaries are the result of differences in the demand for and supply of the different majors. Different majors require different skill sets and different amounts of human capital. These differences mean that the value of marginal product and therefore the demand for different majors can be substantially different. In addition different numbers of students major in the different subjects because some majors are high-cost majors (in terms of time and/or effort) while other majors are lower cost. This difference means that the supply of the different majors can be substantially different.

b. Draw a graph of the labor markets for economics majors and business administration majors to illustrate your explanation of the differences in the starting salaries of these two groups. Economics majors likely have more human capital and more marketable skills than do business administration majors, so the demand for economics majors is greater than the demand for business administration majors. There are probably more business administration majors than economics majors, so the supply of business administration majors exceeds the supply of economics majors. Both these differences are illustrated in Figure 19.9. In the figure the demand curve for economics majors is labeled DE and lies to the right of the demand curve for of business administration majors, labeled DBA. Also in the figure the supply curve of business administration majors, labeled SBA, lies to the right of the supply curve of economics majors, labeled SE. These different demand and supply curves result in a starting salary for economics majors of $48,800 and for of business administration majors of $42,900.

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UNCERTAINTY AND INFORMATION

Answers to the Review Quizzes Page 510 1.

What is the distinction between expected wealth and expected utility? Expected wealth is the money value of what a person expects to own at a point in time. Expected utility is the utility value of what a person expects to own at a point in time. These concepts both measure the value of what a person expects to own at a point in time but they differ because expected wealth is the money value and expected utility is the utility value.

How does the concept of utility of wealth capture the idea that pain of loss exceeds the pleasure of gain? The utility of wealth has diminishing marginal utility. Diminishing marginal utility means that the decrease in utility from a dollar decrease in wealth, that is, the pain of loss, is greater than the increase in utility from a dollar increase in wealth, that is, the pleasure of gain.

What do people try to achieve when they make a decision under uncertainty?

How is the cost of risk calculated when making a decision with an uncertain outcome?

When making decisions under uncertainty people maximize their expected utility. A decision made with uncertainty has an expected wealth and an expected utility that depend on the probability, wealth, and utility associated with the different outcomes. Because people are risk averse, the amount of certain wealth that creates the utility equal to the expected utility in the uncertain case is less than the expected wealth in the uncertain case. The difference between the expected wealth in the uncertain case and the certain wealth that creates the same level of utility is the cost of risk.

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How does insurance reduce risk? Insurance reduces the risk any individual faces because insurance pools risks. Everyone pays into the pool but only the small fraction of people who suffer a loss are paid from the pool. Essentially people reduce the risk of a large adverse financial outcome in exchange for the small, certain payment to the insurance company.

How do we determine the value (willingness to pay) for insurance? The amount that someone would be willing to pay to avoid risk is measured using the person’s utility of wealth schedule or curve. The important feature of the curve is that the marginal utility of wealth diminishes as wealth increases. The rate at which the marginal utility of wealth declines determines the degree of the individual’s risk aversion, that is, how much he or she is willing to pay to avoid risk.