SOLUTIONS MANUAL FOR Essential Foundations of Economics 8th Edition By Robin Bade Michael Parkin by digitaldownload87

Part 1 . INTRODUCTION

Draw a time-series graph of quantity of compact discs sold. Say in which year or years the quantity sold (a) was highest, (b) was lowest, (c) increased the most, and (d) decreased the most. If the data show a trend, describe it. Figure A1.2 illustrates the time series of the quantity of compact discs sold using the data from the spreadsheet. a. b. c. d.

The quantity sold was the highest in 2004. The quantity sold was the lowest in 2014. The quantity sold never increased. The quantity sold decreased the most between 2006 and 2008 when it decreased by 235 million. Over the entire time period covered in the figure, there is a downward trend in the quantity of compact discs sold.

The following data shows the relationship between two variables x and y. x

Is the relationship between x and y positive or negative? Calculate the slope of the relationship when x equals 2 and when x equals 4. How does the slope change as the value of x increases? The relationship is negative: When x increases, y decreases. The slope of the relationship equals the change in y divided by the change in x along the tangent line; that is, the slope of the relationship at a point equals the slope of the tangent line at that point. When x equals 2, the slope of the tangent line equals –4, so the slope of the relationship equals –4. When x equals 4, the slope of the tangent line equals –8, so the slope of the relationship equals –8. The slope of the relationship increases in magnitude (the line becomes steeper) as x increases.

Appendix 1 . Making and Using Graphs

The table provides data on the Price price of a balloon ride, the tem(dollars perature, and the number of per ride) rides a day. Draw graphs to 5 show the relationship between 10 • The price and the number of 15 rides, when the temperature 20 is 70°F. Figure A1.3 illustrates the relationship between the price and the number of rides when the temperature is 70°F.

Balloon rides (number per day) 50F

70F

90F

32 27 18 10

50 40 32 27

40 32 27 18

• The number of rides and the temperature, when the price is $15 a ride. Figure A1.4 illustrates the relationship between the number of rides and the temperature, when the price is $15 a ride.

Part 1 . INTRODUCTION

◼ Instructor Assignable Problems Use the information in the table to work Problems 1 and 2. Column A is the year; the other columns are quantities sold in millions per year of compact discs (column B), music videos (column C), and singles downloads (column D). 1.

2004

767

139

2006

620

586

2008

385

1,033

4 Draw a scatter diagram to show the relationship between quantities sold of music 5 videos and singles downloads. Describe the 6 relationship. Figure A1.5 illustrates the relationship of the data from the spreadsheet between the quantities sold of music videos and singles downloads. Over all the period, there appears to be a negative or indirect relationship; that is, when fewer music videos are sold, more singles are downloaded.

2010

226

1,162

2012

211

1,392

2014

144

1,200

Appendix 1 . Making and Using Graphs

Draw a time-series graph of the quantity of music videos sold. Say in which year or years the quantity sold (a) was highest, (b) was lowest, (c) decreased the most, and (d) decreased the least. If the data show a trend, describe it. Figure A1.6 illustrates the time series of music videos sold using the data from the spreadsheet. a. The quantity sold was the highest in 2006. b. The quantity sold was the lowest in 2014. c. The quantity sold decreased the most between 2004 and 2006 and between 2006 and 2008, when it decreased by 10 million per period. d. Setting aside the periods during which the quantity increased, the quantity sold decreased the least between 2008 and 2010. There is a downward trend in the quantity of music videos sold.

Use the following data on the relationship between two variables x and y to work Problems 3 and 4. x

Is the relationship between x and y positive or negative? Explain. The relationship is positive: When x increases, y also increases.

Calculate the slope of the relationship when x equals 2 and x equals 4. How does the slope change as the value of x increases? The slope of the relationship equals the change in y divided by the change in x along the tangent line; that is, the slope of the relationship at a point equals the slope of the tangent line at that point. When x equals 2, the slope of the tangent line equals 4, so the slope of the relationship equals 4. When x equals 4, the slope of the tangent line equals 8, so the slope of the relationship equals 8. The slope of the relationship increases as x increases.

Part 1 . INTRODUCTION

The table provides data on the price of hot chocolate, the Price (dollars temperature, and the cups of per cup) hot chocolate bought. Draw graphs to show the 2.00 relationship between 2.50 3.00 • The price and cups of hot 3.50 chocolate bought, when the temperature is constant. Figure A1.7 illustrates the relationship between the price and the number of cups bought holding constant the temperature. Note that there are three relationships, one for each temperature.

Hot chocolate (cups per week) 50F

70F

90F

40 30 20 10

30 20 10 0

20 10 0 0

• The temperature and cups of hot chocolate bought, when the price is constant. Figure A1.8 illustrates the relationship between the number of cups bought and the temperature, holding constant the price. Note that there are four relationships, one for each price.

The U.S. and Global Economies ANSWERS TO CHAPTER CHECKPOINT

◼ Study Plan Problems and Applications 1.

Which of the following items are not consumption goods and services? Explain why not. • A chocolate bar A chocolate bar is a consumption good. • A ski lift A ski lift is not a consumption good. It is capital that produces a service for skiers. • A golf ball A golf ball is a consumption good. 2. Which of the following items are not capital goods? Explain why not. • An auto assembly line An auto assembly line is a capital good. • A shopping mall A shopping mall is a capital good. • A golf ball A golf ball is not a capital good. It is a consumption good. 3. Which of the following items are not factors of production? Explain why not. • Vans used by a baker to deliver bread Vans used to deliver bread are capital, so they are factors of production. • 1,000 shares of Amazon.com stock 1,000 shares of Amazon.com stock are not a factor of production. The shares represent partial ownership of Amazon.com and therefore are financial capital. • Undiscovered oil in the Arctic Ocean Undiscovered oil is not a factor of production because it is not used to

Chapter

Part 1 . INTRODUCTION

produce goods or services. Once it is discovered, it will become a factor of production. Which factor of production earns the highest percentage of total U.S. income? Define that factor of production. What is the income earned by this factor of production called? Labor earns by far the largest percentage of total U.S. income, 63 percent of total income in 2014. Labor consists of the work time and the work effort that people devote to producing goods and services. The income earned by labor is a wage.

With more job training and more scholarships to poor American students, which special factor of production is likely to grow faster than in the past? As more people go to school and/or receive job training, the nation’s human capital will grow more rapidly. Human capital is the knowledge and skills people obtain from education, on-the-job training, and work experience. With more job training and more scholarships, human capital will grow more rapidly.

Define the factor of production called capital. Give three examples of capital, different from those in the chapter. Distinguish between the factor of production capital and financial capital. Capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that businesses now use to produce goods and services. Capital includes railroad engines and cars, servers, and ATMs. The factor of production “capital” is the actual good itself; “financial capital,” such as stocks and bonds, are the funds that provide businesses with their financial resources which can be used to acquire capital goods.

The pace at which new businesses are created in the U.S. economy and the percentage of U.S. jobs in young firms has fallen. Ryan Decker and others, “The Role of Entrepreneurship in U.S. Job Creation and Economic Dynamism.” Journal of Economic Perspectives, 2014. Explain how you would expect these facts to influence what, how, and for whom goods and services are produced in the United States The answer to the what question changes if, as is probably the case, new and young business produce different goods and services than more established business. For example, new and young firms are more likely to create apps than older and more established firms. If these groups of producers produced their goods and services using different technologies than the rest of the producers, then the question of how goods and services would change. For whom goods and services are produced would

Chapter 2 . The U.S. and Global Economies

change if some groups of consumers prefer the goods and services produced by the new and young firms while other groups do not. 8.

In the circular flow model, explain the real flow and/or the money flow in which each item below belongs. Illustrate your answers on a circular flow diagram. • You buy a coffee at Starbucks. In Figure 2.1 the dark arrows represent money flows and the grey arrows represent flows of goods and services and factors of production. If you buy a coffee at Starbucks, your expenditure is a money flow from households to the goods market, labeled a in the figure. • The government buys some Dell computers. The purchase of computers by the government represents a flow of computers from the goods market to the government, labeled b in the figure. • A student works at a FedEx office. The student working at FedEx is a factor of production, so the flow is a flow of the services of factor of production from households to the factor markets, labeled c in the figure. • Donald Trump rents a Manhattan building to a hotel. Donald Trump’s building in Manhattan is a factor of production, so the flow is the services from this factor of production from households to the factor markets, labeled d in the figure. • You pay your income tax. Your income tax payment is a money flow from households to the government and is labeled e in the figure.

Part 1 . INTRODUCTION

Why you can get a free college education in Germany but not in California Even American students can get a free college degree in Germany, where high taxes pay for colleges. Despite college being free, fewer students in Germany earn college degrees than in the United States and more enter vocational apprenticeships. Source: Los Angeles Times, October 29, 2015 If California adopted the German model of higher education, how would that change for whom goods and services are produced? The students in California who otherwise would not have gone to college but who take advantage of the “free” college education will have higher incomes than otherwise. Consequently, more goods and services will be produced for them. The taxpayers who must pay the taxes necessary to fund these college educations will have less income to spend on goods and services, so fewer goods and services will be produced for them. 10. Read Eye on the Dreamliner on p. 43 and then answer the following questions: • How many firms are involved in the production of the Dreamliner and how many are identified in the figure on p. 43? Over 400 firms are involved in the production of the Dreamliner. Only 15 of them are identified in the figure. • Is the Dreamliner a capital good or a consumption good? Explain why? The Dreamliner is a capital good because it will be used to produce services (airline travel) throughout many future years. • State the factors of production that make the Dreamliner and provide an example of each. All the factors of production—land, labor, capital, and entrepreneurship—are used to make the Dreamliner. The copper used for wiring is an example of the land used; the engineer who helped design the landing gear is an example of labor; the huge cranes that lift the various pieces of the Dreamliner to assemble them is an example of capital; and the creative and imaginative input of Boeing’s top managers who organize the resources used to produce the Dreamliner exemplify entrepreneurship. • Explain how the production of the Dreamliner influences what, how, and for whom, goods and services are produced. Dreamliner influences “what” goods and services are produced by creating a demand for components manufactured around the world. It influences “how: goods are produced because Boeing and the other 400 firms all determine the best way to produce each particular part

Chapter 2 . The U.S. and Global Economies

•

of the Dreamliner. It influences “for whom” because factors of production employed to make the Dreamliner receive income from this production, thereby increasing the quantity of goods and services they can purchase. Use a graph to show where in the circular flow model of the global economy the flows of the components listed on p. 43 appear and where the sales of Dreamliners appear. Except for the components built in the United States, spending on the other components appear in the flow of expenditure on U.S. imports. Sales of Dreamliners appear in the flow of expenditure on U.S. exports.

Part 1 . INTRODUCTION

◼ Instructor Assignable Problems and Applications 1.

Boeing’s Dreamliner has had a rocky start. • Why doesn’t Boeing manufacture all the components of the Dreamliner at its own factory in the United States? Boeing wants to manufacture the Dreamliner at the lowest possible cost. It would be more expensive for Boeing to manufacture Dreamliners at its own factory in the United States because Boeing does not have the expertise possessed by its subcontractors and because the wages Boeing pays U.S. workers exceed the wages its subcontractors pays their workers. • Describe some of the changes in what, how, and for whom, that would occur if Boeing manufactured all the components of the Dreamliner at its own factories in the United States. If Boeing manufactured all the components of the Dreamliner at its own factories in the United States, more components would be produced in the United States and more capital would have been used in their production. U.S. workers and investors would have received higher incomes but the Dreamliner would cost more to produce so Boeing would have earned a lower profit. • State some of the tradeoffs that Boeing faces in making the Dreamliner. Boeing faced a huge number of tradeoffs. For example, when designing the plane, Boeing’s engineers had to make decisions about fuel economy and passenger load. Increasing the passenger load decreased fuel economy, so the engineers traded passenger load for fuel economy. Another example revolves around the construction of the Dreamliner. Boeing could have constructed the plane using just a few companies but instead it used over 400. Boeing was trading off the simplicity of dealing with just a handful of companies for the increased specialization by dealing with many specialized companies. • Why might Boeing’s decisions in making the Dreamliner be in the social interest? Building the Dreamliner itself advances the social interest because it increases the quantity of comfortable, rapid transportation. The amount of high-quality transportation available in the economy increases, which benefits society. The decisions in making the Dreamliner advance the social interest because they were designed to make the Dreamliner at low cost and thereby avoid wasting resources. 2. The global economy has seen a fall in the number of landlines and rapid growth in the number of smartphones. In the United States, 41 percent of

Chapter 2 . The U.S. and Global Economies

households have no landline and 90 percent have a smartphone. In Africa, 33 percent have a smartphone. Describe the changes in what, how, and for whom telecommunication services are produced in the global economy. What: As the number of cell phone users increases, the global economy has been producing more cell phone telecommunication services. More cell phones are produced, fewer land phones are produced, and presumably more cell phone frequencies are used. How: More telecommunication services are being produced using cell phones rather than fixed-line phones. For whom: While the amount of telecommunication services has been rising throughout the world, it has been increasing most rapidly in Africa. So more telecommunication services are being produced for residents of Africa as well as for residents in the rest of the world. 3.

Which of the entries in the list are conList sumption goods and services? Explain your • An interstate highway choice. • An airplane A pack of bubble gum and a movie are • A school teacher consumption goods. They are purchased • A stealth bomber by consumers. • A garbage truck Which of the entries in the list are capital • A pack of bubble gum goods? Explain your choice. • President of the United States An airplane, a garbage truck, and an ATM • A strawberry field are capital goods. All provide services to • A movie produce other goods and services. The in• An ATM terstate highway and the stealth bomber also are capital goods. They also provide services (transportation and defense) that help produce other goods and services.

Which of the entries in the list are factors of production? Explain your choice. An interstate highway, an airplane, a school teacher, a stealth bomber, a garbage truck, the President of the United States, a strawberry field, and an ATM are factors of production. A school teacher and the President are labor; an interstate highway, an airplane, a stealth bomber, a garbage truck, and an ATM are capital; and, a strawberry field is land.

In the African nation of Senegal, to enroll in school a child needs a Birth Certificate that costs $25. This price is several weeks’ income for many families. Explain how this requirement is likely to affect the growth of human capital in Senegal. Human capital growth depends, in part, on the extent of schooling: More schooling means more human capital. Because of Senegal’s hefty fee for a

Part 1 . INTRODUCTION

required Birth Certificate, fewer children will enroll in school, thereby decreasing Senegal’s human capital growth. 7.

China’s income gap widens The income gap has widened in China. In 2014, the pay of workers in the coastal regions increased by 9.7 percent while that of workers in the inland regions grew by 9 percent. Source: South China Morning Post, May 28, 2015 Explain how the distribution of personal income in China can be getting more unequal even though the poorest are getting richer. The distribution of income in China can be getting more unequal even when the poorest are getting richer if the richest are getting richer even faster. If the rich are getting richer faster, the fraction of the nation’s total income received by the poorest 20 percent falls, which makes the personal distribution of income more unequal.

Compare the scale of agricultural production in the advanced and developing economies. In which is the percentage higher? In which is the total amount produced greater? Agricultural is a small part of total production in advanced economies. It is a much larger part in developing economies. Even though advanced economies devote only a small part of their total production to agriculture, they still produce about one third of the world’s total production of food. The remaining two thirds is produced in the developing nations.

Chapter 2 . The U.S. and Global Economies

On a diagram of the circular flow model, indicate in which real or money flow each entry in the list belongs. • General Motors’ pays its workers wages. General Motors wage payment is a money flow that is a payment for use of the services of a factor of production and so flows out of the factor market to households (it flowed into the factor market from General Motors, a firm). In Figure 2.3 the dark arrows represent money flows and the grey arrows represent flows of goods and services and factors. The flow of wage payments to households is labeled a in the figure in Figure 2.3. • IBM pays a dividend to its stockholders. IBM’s dividend payment is a money flow that is a payment for use of the services of a factor of production and so flows out of the factor market to households (it flowed into the factor market from IBM, a firm). The flow to households is labeled b in the figure. • You buy your groceries. Your purchase of groceries represents a money flow from households to the goods market, labeled c in the figure. • Southwest rents some aircraft. The aircraft are factors of production, so the flow is the services from these factors of production from the factor markets to firms, labeled d in the figure. • Nike pays Serena Williams for promoting its sports shoes. Serena Williams is a factor of production, so the flow is a money flow

Part 1 . INTRODUCTION

from the factor markets to households in exchange for Ms. Williams’ services of promoting the sports shoes. The flow is labeled e in the figure. Use the following information to work Problems 10 and 11. Poor India makes millionaires at fastest pace India, with the world’s largest population of poor people, also paradoxically created millionaires at the fastest pace in the world. Millionaires increased by 22.7 percent to 123,000. In contrast, the number of Indians living on less than a dollar a day is 350 million and those living on less than $2 a day is 700 million. In other words, there are 7,000 very poor Indians for every millionaire. Source: The Times of India, June 25, 2008 10. How is the personal distribution of income in India changing? If the number of millionaires is growing more rapidly than the number of other income groups, it will be the case that the personal distribution of income in India is becoming less equally distributed. 11. Why might incomes of $1 a day and $2 a day underestimate the value of the goods and services that these households actually consume? The people living on $1 and $2 a day probably grow a lot of their food and produce a lot of their clothing and shelter. If these goods and services are not taken into account, their share of goods and services is understated. Including them raises the value of the goods and services these households actually consume.

Chapter 2 . The U.S. and Global Economies

◼ Multiple Choice Quiz 1.

Which of the following classifications is correct? A. City streets are consumption goods because they wear out with use. B. Stocks are capital goods because when people buy and sell them they make a profit. C. The coffee maker in the coffee shop at an airport is a consumption good because people buy the coffee it produces. D. White House security is a government service because it is paid for by the government. Answer: D Answer D is correct. 2.

Which of the following statements about U.S. production is correct? A. Construction accounts for a larger percentage of total production than does manufacturing. B. Real estate services account for 14.5 percent of the value of total production, larger than any other item of services or goods. C. Consumption goods and services represent 78.5 percent of U.S. production by value and that percentage doesn’t fluctuate much. D. The manufacture of goods represents more than 50 percent of total production. Answer: C Answer C is correct as the data on page 34 show. 3.

Which of the following items is not a factor of production? A. An oil rig in the Gulf of Mexico B. A ski jump in Utah C. A bank loan to a farmer D. An orange grove in Florida Answer: C Answer C is not a factor of production because it is financial capital; see page 37. 4.

What is human capital? A. A fruit picker B. Unskilled labor C. Your professor’s knowledge of the economy D. An auto assembly line robot Answer: C Answer C uses the definition of human capital on page 37.

Part 1 . INTRODUCTION

Which of the following statements is correct? A. Labor earns wages and entrepreneurship earns bonuses. B. Land earns interest and capital earns rent. C. Entrepreneurship earns interest and capital earns profit. D. Capital earns interest and labor earns wages. Answer: D Page 39 shows that answer D is correct. 6.

How are goods and services produced in the global economy? A. Developing countries use less human capital but just as much physical capital as advanced economies. B. Emerging economies use more capital-intensive technology than do developing economies. C. Human capital in all economies is similar. D. Advanced economies use less capital than developing economies. Answer: B Developing countries have less capital than emerging economies. 7.

In the circular flow model, which of the following items is a real flow? A. The flow of government expenditures to firms for the goods bought B. The flow of income from firms to households for the services of the factors of production hired C. The flow of U.S. borrowing from the rest of the world D. The flow of labor services from households to firms Answer: D Answer D is a real flow because it is a labor service.

The Economic Problem ANSWERS TO CHAPTER CHECKPOINTS

Chapter

◼ Study Plan Problems and Applications 1.

The table shows the quantities of corn and beef that a farm Corn can produce in a year. Draw a graph of the farm’s PPF. Mark (bushels) on the graph: 250 200 • An inefficient combination of corn and beef—label this 100 point A. 0 • An unattainable combination of corn and beef—label this point B. • An efficient combination of corn and beef—label this point C. The production possibilities frontier is illustrated in Figure 3.1. Any production point in the interior of the PPF, such as the point marked A, is an inefficient combination of corn and beef. Any production point beyond the PPF, such as the point marked B, is an unattainable combination of corn and beef. Any production point on the PPF, such as the point marked C is a production efficient combination of corn and beef.

Beef (pounds) and and and and

0 300 500 600

Part 1 . INTRODUCTION

Use the following information to work Problems 2 and 3. The people of Leisure Island have 50 hours of Entertainment labor a day that can be used to produce enterLabor (units) tainment and good food. The table shows the 0 0 or maximum quantity of either entertainment or 10 20 or 20 40 or good food that Leisure Island can produce 30 60 or with different quantities of labor. 40 80 or 2. Is an output of 50 units of entertainment 50 100 or and 50 units of good food attainable and efficient? With a production of 50 units of entertainment and 50 units of good food, do the people of Leisure Island face a tradeoff? Producing 50 units of good food and 50 units of entertainment is attainable. However, at this production point, Leisure Island’s resources are not fully employed or are misallocated. They are producing within their PPF. As a result, the people of Leisure Island do not face a tradeoff—they can produce more entertainment or good food at no opportunity cost. 3.

What is the opportunity cost of producing an additional unit of entertainment? Explain how the opportunity cost of producing a unit of entertainment changes as more entertainment is produced. If production is initially within the PPF, the opportunity cost of an additional unit of entertainment is zero. If production is on the PPF there is an opportunity cost of producing a unit of entertainment because good food must be forgone. At that point, the opportunity cost while moving along the PPF equals the loss in good food produced divided by the gain in entertainment produced. Once on the PPF, as more entertainment is produced, the opportunity cost of an additional unit increases.

Use the following information to work Problems 4 and 5. Malaria can be controlled The World Health Organization’s malaria chief says that it is too costly to try to fully eradicate the disease. He says that by using nets, medicine, and DDT it is possible to eliminate 90 percent of malaria cases. But to eliminate 100 percent of cases would be extremely costly. Source: The New York Times, March 4, 2008 4. Make a graph of the production possibilities frontier with malaria control on the x-axis and other goods and services on the y-axis. Figure 3.2 (on the next page) shows the PPF. 5.

Describe how the opportunity cost of controlling malaria changes as more resources are used to reduce the number of malaria cases. As more resources are used to control malaria, the opportunity cost increases. Indeed, the malaria chief indicated that the opportunity cost of eliminating the last 10 percent of malaria would have an extremely high

Good food (units) 0 30 50 60 65 67

Chapter 3 . The Economic Problem

opportunity cost. This conclusion is shown in the PPF diagram by the very steep PPF between 90 percent elimination and 100 percent elimination.

Explain how the following events influence U.S. production possibilities: • Some retail workers are re-employed building dams and wind farms. When these former retail workers are re-employed at their new occupations, more dams and wind farms are produced and fewer retail services are produced. The opportunity cost of the increased numbers of dams and wind farms is the forgone production of retail services. There is a movement along the PPF. • More people take early retirement. As more people retire, the quantity of labor available in the economy shrinks. As a result, the nation’s PPF shifts inward. • Drought devastates California’s economy. The nation’s PPF shifts inward as a result of the drought. The drought decreases the amount of productive land, thereby decreasing production of agricultural products and shifting the PPF inward.

Part 1 . INTRODUCTION

Use the following information to work Problems 7 and 8. Figure 3.3 (on the next page) shows Tom’s production possibilities and Figure 3.4 (on the next page) shows Abby’s production possibilities. Tom uses all his resources and produces 2 rackets and 20 balls an hour. Abby uses all her resources and produces 2 rackets and 40 balls an hour. 7. What is Tom’s opportunity cost of producing a racket? What is Abby’s opportunity cost of a racket? Who has a comparative advantage in producing rackets? Who has a comparative advantage in producing balls? If Tom increases his production by 1 racket, he forgoes 10 balls. So his opportunity cost of 1 racket is 10 balls  1 racket, or 10 balls per racket.

If Abby increases her production by 1 racket, she forgoes 20 balls. So her opportunity cost of 1 racket is 20 balls  1 racket, or 20 balls per racket. Tom has the comparative advantage in producing rackets. Tom’s opportunity cost of a racket is 10 balls per racket and Abby’s opportunity cost of a racket is 20 balls per racket. Abby has the comparative advantage in producing balls. Tom’s opportunity cost of a ball is 0.10 rackets per ball and Abby’s opportunity cost of a ball is 0.05 rackets per ball. 8.

If Tom and Abby specialize and trade 15 balls for 1 racket, what are the gains from trade? Both Tom and Abby gain from their specialization and trade. Tom could produce 4 rackets and then trade 2 of the rackets for 30 balls. Tom would wind up with 2 rackets and 30 balls, 10 more balls than he had without the specialization and trade. Abby could produce 80 balls and then trade

Chapter 3 . The Economic Problem

30 of them for 2 rackets. Abby would wind up with 2 rackets and 50 balls, also 10 more balls than she had without the specialization and trade. 9.

Read Eye on the Environment on p. 68 and describe a tradeoff faced when deciding how to generate electricity and whether to use wind power. Using wind power to generate electricity requires that the wind turbines be located in areas with wind which often are not near population centers. Long transmission lines are required which means transmissions losses are large. If other sources are used to generate power, long transmission lines are not necessary and smaller generating facilities are required because transmissions losses are less. If wind power is used to generate power, more resources are used and fewer other goods can be produced.

Part 1 . INTRODUCTION

◼ Instructor Assignable Problems and Applications Use the following information to work Problems 1 to 4. Representatives Waxman of California and Markey of Massachusetts proposed a law to limit greenhouse gas emissions from electricity generation and require electricity producers to generate a minimum percentage of power using renewable fuels, with some emission rights to be auctioned. The Congressional Budget Office estimated that the government would receive $846 billion from auctions and would spend $821 billion on incentive programs and compensation for higher energy prices. Electricity producers would spend $208 million a year to comply with the new rules. (Think of these dollar amounts as dollars’ worth of other goods and services.) 1. Would the Waxman-Markey law achieve production efficiency? Production efficiency requires producing on the PPF. Use a PPF showing the tradeoff between electricity and clean air. Production efficiency requires producing on the PPF so that gaining more clean air means giving up some electricity. Before the new law, production might have been on the PPF if the producers had used the most efficient technologies and taken account of the pollution they created. After the law is in place, production might be within the PPF if the law requires more production of energy from renewable sources than is production efficient. 2.

Is the $846 billion that electricity producers would pay for the right to emit greenhouse gasses part of the opportunity cost of producing electricity? To the extent that the $846 billion pays for the cost that greenhouse gasses impose on society (by way of forgone production of other goods and services), the $846 billion is part of the opportunity cost of generating electricity.

Is the $821 billion that the government would spend on incentive programs and compensation for higher energy prices part of the opportunity cost of producing electricity? The incentive programs change what electricity providers buy in order to produce electricity with lower emissions. The goods and services forgone are the opportunity cost of these programs. Compensation for higher energy prices is a transfer payment from taxpayers to consumers. Nothing is forgone and so it is not an opportunity cost.

Is the $208 million that electricity producers will spend to comply with the new rules part of the opportunity cost of producing electricity? The $208 million is part of the opportunity cost of producing electricity because it represents the purchase of goods and services necessary to produce electricity.

Chapter 3 . The Economic Problem

The people of Foodland have 40 Bread hours of labor a day to bake pizza Labor Pizzas (loaves) and bread. The table shows the 0 0 or 0 10 30 or 10 maximum quantity of either pizza 20 50 or 20 or bread that Foodland can bake 30 60 or 30 with different quantities of labor. 40 65 or 40 Can Foodland produce 30 pizzas and 30 loaves of bread a day? If it can, is this output efficient, do the people of Foodland face a tradeoff, and what is the opportunity cost of producing an additional pizza? Producing 30 pizzas and 30 loaves of bread is attainable and efficient. There is a tradeoff because the nation is operating on its production possibilities frontier. As a result, if the production of pizza increases, less bread can be produced and if the production of bread increases, less pizza can be produced. For the nation to produce 20 more pizzas requires 10 more hours of labor devoted to making pizza, which means 10 fewer hours devoted to making bread. Foodland gives up 10 loaves of bread. The opportunity cost of another pizza equals the loaves of bread forgone, 10 loaves, divided by the pizzas obtained, 20 pizzas, or 10 loaves of bread  20 pizzas, or 1/2 of a loaf of bread per pizza. Use the table, which shows a farm’s production Soybean Chicken (bushels (pounds possibilities, to work Problems 6 and 7. per year) per year) 6. If the farm uses its resources efficiently, what 500 and 0 is the opportunity cost of an increase in chicken 400 and 300 production from 300 pounds to 500 pounds a 200 and 500 0 and 550 year? Explain your answer. If the farm expands chicken production from 300 pounds to 500 pounds, soybean production decreases from 400 to 200 bushels. The opportunity cost of the additional 200 pounds of chicken is 200 bushels of soybean, or 1 bushel of soybeans per pound of chicken. 7.

If the farm adopted a new technology, which allows it to use fewer resources to fatten chickens, explain how the farm’s production possibilities will change. Explain how the opportunity cost of producing a bushel of soybean will be affected. The farm’s PPF rotates outward; the maximum quantity of soybeans (500 bushels) does not change but the maximum quantity of chicken increases. The opportunity cost of a bushel of soybeans increases because more chicken must be given up to produce additional soybeans.

In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. Who has a comparative advantage in producing caps? If Sue and Tessa specialize and trade, who will gain?

Part 1 . INTRODUCTION

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 jackets per 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 jackets per cap. Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps. If Tessa specializes in caps and Sue specializes in jackets, both Sue and Tessa gain from trade. For instance, suppose they settle upon a price of 1 jacket for 15 caps. 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. Use the following opinion to work Problems 9 to 11. Free Internet? Everyone should have free Internet access to education, news, jobs, and more. Source: Internet.org by Facebook, May 4, 2015 9. Explain how Internet access has changed the production possibilities and the opportunity cost of producing education and news. Internet access is a technological advance that has increased the production possibilities of all goods and services. The opportunity cost of producing more education and news is the quantity of other goods and services that must be given up to get an additional unit of education and news. With more education and news placed on the Internet, Internet access means that for the same quantity of resources used before widespread Internet access, the production of these services has increased. The opportunity cost of education and news has decreased.

Chapter 3 . The Economic Problem

10. Sketch a PPF with education and news on the x-axis and other goods and services on the y-axis before and after the Internet. The PPFs in Figure 3.5 have the conventional outward bowed shape. The figure shows that the introduction of the Internet shifted the production possibilities frontier outward from the PPF labeled “Initial PPF,” to the PPF labelled “New PPF.” The illustrated PPF assumes that effect on education and news is larger than the effect on other goods and services. 11. Explain why it is not possible for everyone to have free Internet access to education, news, jobs, and more. Providing Internet access is not free because it takes resources. But the opportunity cost of Internet service increases as more people gain access, so the opportunity cost of giving everyone “free” access to the Internet would be extremely high, probably much higher than society is willing to pay.

Part 1 . INTRODUCTION

◼ Multiple Choice Quiz 1.

The table shows the PPF of an island communiFish Berries ty. Choose the best statement. Possibility (pounds) (pounds) A. This community has enough resources to A 0 and 40 produce 2 pounds of fish and 36 pounds of B 1 and 36 C 2 and 30 berries. D 3 and 22 B. This community cannot produce 2 pounds of E 4 and 12 fish and 36 pounds of berries because this F 5 and 0 combination is inefficient. C. This community will waste resources if it produces 2 pounds of fish and 22 pounds of berries. D. This community can produce 2 pounds of fish and 30 pounds of berries but this combination is inefficient. Answer: C The production point is inside the PPF and so is inefficient. 2.

The table above shows the PPF of an island community. Choose the best statement. A. Suppose that this community produces 3 pounds of fish and 20 pounds of berries. If it decides to gather more berries, it faces a tradeoff. B. When this community produces 4 pounds of fish and 12 pounds of berries it faces a tradeoff, but it is inefficient. C. Suppose that this community produces 5 pounds of fish and 0 pounds of berries. If it decides to gather some berries, it will get a free lunch. D. If this community produces 3 pounds of fish and 22 pounds of berries, production is efficient but to produce more fish it faces a tradeoff. Answer: D The production point is on the PPF so production is efficient and there is a tradeoff when more fish are produced. 3.

The table above shows the PPF of an island community. This community’s opportunity cost of producing 1 pound of fish ______. A. is the increase in the quantity of berries gathered as the quantity of fish increases by 1 pound B. increases as the quantity of berries gathered increases C. is 10 pounds of berries if the quantity of fish increases from 2 to 3 pounds D. increases as the quantity of fish caught increases Answer: D Page 68 discusses why opportunity increases as production of the good increases.

Chapter 3 . The Economic Problem

The table above shows the PPF of an island community. Choose the best statement. A. When a drought hits the island, its PPF shifts outward. B. When the islanders discover a better way of catching fish, the island’s PPF shifts outward. C. When islanders reduce the time they spend gathering berries, the PPF shifts inward. D. If the islanders decide to spend more time gathering berries but continue to spend the same amount of time fishing, they face a tradeoff. Answer: B Page 70 shows that technological progress, such as exemplified in answer B, shifts the PPF outward. 5.

Mary makes 10 pies and 20 cakes a day and her opportunity cost of producing a cake is 2 pies. Tim makes 20 pies and 10 cakes a day and his opportunity cost of producing a cake is 4 pies. If Mary and Tim specialize in the good in which they have a comparative advantage ______. A. Mary produces only pies B. Tim produces both pies and cakes C. Mary produces only cakes while Tim produces only pies D. Tim produces only cakes while Mary produces only pies Answer: C Answer C is correct because Mary has the lower opportunity cost of making a cake.

Chapter

Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications 1.

Explain how each of the following events changes the demand for or supply of air travel. • Airfares tumble, while long-distance bus fares don’t change. A change in the price of airfares does not change either the demand for or the supply of air travel. (It changes the quantity demanded and the quantity supplied of air travel.) •

The price of jet fuel rises. The rise in the price of jet fuel decreases the supply of air travel because it raises the cost of producing air travel.

•

Airlines reduce the number of flights each day. The reduction in the number of flights decreases the supply of air travel.

•

People expect airfares to increase next summer. The current demand for air travel increases when people expect airfares to increase next summer because people fly now, when airfares are relatively cheaper, rather than next summer.

•

The price of train travel falls. Train travel is a substitute for air travel. So, a fall in the price of train travel decreases the demand for air travel.

•

The price of a pound of air cargo increases. Transporting cargo by air is a substitute in production for transporting people by air. So, the rise in the price of air cargo decreases the supply of air travel for people.

Use the laws of demand and supply to explain whether the statements in Problems 2 and 3 are true or false. In your explanation, distinguish between a change in demand and a change in the quantity demanded and between a change in supply and a change in the quantity supplied. 2. The United States does not allow oranges from Brazil (the world’s largest

Part 1 . INTRODUCTION

producer of oranges) to enter the United States. If Brazilian oranges were sold in the United States, oranges and orange juice would be cheaper. The statement is true. Allowing Brazilian oranges into the United States increases the supply of oranges and the supply curve shifts rightward. The equilibrium price of an orange falls and the equilibrium quantity increases. The quantity of oranges demanded increases and there is a movement down along the demand curve. Oranges are a resource used in the production of orange juice. When the price of an orange falls, it costs less to produce orange juice and the supply of orange juice increases. The quantity of orange juice demanded increases and there is a movement down along the demand curve. The equilibrium price of orange juice falls and the equilibrium quantity increases. 3.

If the price of frozen yogurt falls, the quantity of ice cream consumed will decrease and the price of ice cream will rise. The statement is false. Frozen yogurt and ice cream are substitutes for consumers. When the price of frozen yogurt falls, people substitute frozen yogurt for ice cream. The demand for ice cream decreases and the demand curve shifts leftward. The equilibrium quantity of ice cream decreases but the equilibrium price of ice cream falls. There is a change in the quantity of ice cream supplied and a movement down along the supply curve.

The table shows the demand and supPrice Quantity Quantity ply schedules for running shoes. What (dollars demanded supplied is the market equilibrium? If the price per pair) (pairs per day) is $70 a pair, describe the situation in 60 1,000 400 70 900 500 the market. Explain how market equi80 800 600 librium is restored. If a rise in income 90 700 700 increases the demand for running 100 600 800 shoes by 100 pairs a day at each price, 110 500 900 explain how the market adjusts to its new equilibrium. The market equilibrium occurs at a price of $90 a pair and 700 pairs of running shoes a day. At the price of $90 a pair, the quantity demanded equals the quantity supplied. If the price is $70 a pair, the quantity demanded is 900 pairs and the quantity supplied is 500 pairs. There is a shortage of 400 pairs a day and the price rises. As the price rises, the quantity demanded decreases, the quantity supplied increases, and the shortage decreases. The price rises until the shortage disappears.

Chapter 4 . Demand and Supply

The table shows the new demand Price New Quantity Quantity schedule after the increase in income (dollars demanded supplied has increased the quantity demanded by per pair) (pairs per day) 100 pairs of shoes at each price. At the 60 1,100 400 70 1,000 500 original equilibrium price of $90 a pair, 80 900 600 there is a shortage and the price rises. 90 800 700 As the price rises, the quantity demand100 700 800 ed decreases, the quantity supplied in110 600 900 creases, and the shortage decreases. The price rises until the shortage disappears. The price rises to $95 a pair and the quantity increases to 750 pairs of running shoes a day. 5.

“As more people buy fuel-efficient hybrid cars, the demand for gasoline will decrease and the price of gasoline will fall. The fall in the price of gasoline will decrease the supply of gasoline.” Is this statement true? Explain. The first statement is correct. As more people buy fuel-efficient cars, the demand for gasoline will decrease. The price of gasoline will fall. The second statement is false. The demand for gasoline decreases and the demand curve shifts leftward. There is a movement along the supply curve and a decrease in the quantity of gasoline supplied but no change in supply.

OPEC deadlocked on oil production hike Oil prices exceeded the $100-a-barrel mark Wednesday after OPEC said it could not reach an agreement about raising crude production. Source: CNN Money, June 8, 2011 Suppose that OPEC members had agreed to increase production. Use a graph of the oil market to show the effect of this decision on the market equilibrium. The market initially is in equilibrium in Figure 4.1 with demand curve D and supply curve S0. The initial equilibrium price is $105 per barrel of oil and the initial equilibrium quantity is 120 million barrels per day. If OPEC agreed to increase the supply, the supply curve shifts rightward, as illustrated in Figure 4.1 by the shift from S0 to S1. In the figure the price of a barrel of oil falls from $105 per barrel to $90 per barrel and the quantity increases from 120 million barrels per day to 150 million barrels per day.

Part 1 . INTRODUCTION

Use the following information to work Problems 7 and 8. Rain delays to U.S. planting lift corn and soybean prices Heavy rain has delayed the planting of corn and soybean and soggy conditions have slowed the winter wheat harvest. Source: Financial Times, June 25, 2015 7. Explain how heavy rain and soggy conditions will change the prices of corn, soybean, and wheat. The heavy rain and soggy conditions decrease the supply of corn and soybean because farmers may not plant some acreage. The soggy conditions have delayed the harvesting of wheat, which decreases the supply of wheat. Consequently, the prices of these crops rise. 8.

Use graphs to show how supply and demand will change in the markets for corn, soybean, and wheat. The effect in all three markets is similar, so Figure 4.2 uses corn as the example. The heavy rains decrease the supply of corn. In Figure 4.2, the supply curves shifts leftward from S0 to S1. The price of corn rises, in the figure from $5.90 per bushel to $6.10 per bushel, and the equilibrium quantity decreases, from 600 million bushels to 400 million bushels.

Read Eye on the Price of Coffee on p. 105 and explain how we know that the price increased in 2014 because the supply of coffee decreased and not because the demand for coffee increased. We know that the supply decreased because the quantity of coffee decreased. If the higher price was the result of an increase in demand, the quantity of coffee would have increased.

Chapter 4 . Demand and Supply

◼ Instructor Assignable Problems and Applications 1.

Why can we be confident that the market for coffee is competitive and that a decrease in supply rather than the greed of coffee growers is the reason for the 2014 rise in price? There are more than 55,000 coffee shops in the United States and probably more than 100,000 growers worldwide. Even if coffee growers were greedy, the fact that there are tens of thousands of other growers with whom they compete keeps their greed from affecting the price they charge. If one greedy grower raised his or her price, a large number of buyers would switch to other growers whose price had not changed.

What is the effect on the equilibrium price and equilibrium quantity of orange juice if the price of apple juice decreases and the wage rate paid to orange grove workers increases? Apple juice and orange juice are substitutes for consumers, so the fall in the price of apple juice decreases the demand for orange juice. The demand curve for orange juice shifts leftward. The increase in the wage rate paid to orange grove workers raises the cost of producing oranges and thereby boosts the cost of producing orange juice. The supply of orange juice decreases and the supply curve of orange juice shifts leftward. The net effect of these events decreases the equilibrium quantity but has an undetermined effect on equilibrium price. If supply decreases by more than the demand decreases, the equilibrium price rises. If demand decreases more than the supply decreases, the equilibrium price falls. And if they decrease by the same amount, the equilibrium price does not change.

What is the effect on the equilibrium in the orange juice market if orange juice becomes more popular and a cheaper robot is used to pick oranges? Because orange juice becomes more popular, demand increases and the demand curve for orange juice shifts rightward. The cheaper picking robot lowers the production costs of orange juice, so the supply of orange juice increases and the supply curve of orange juice shifts rightward. The equilibrium quantity increases. But the effect on the equilibrium price is ambiguous. If the increase in supply is greater than the increase in demand, the equilibrium price falls. If the increase in demand is greater than the increase in supply, the equilibrium price rises. And if the increase is the same size, then the equilibrium price does not change.

Concerns over winter wheat may boost price Concerns about the U.S. winter wheat crop and dry conditions in other wheat-producing nations have increased the price of wheat. Source: Agweb.com, July 6, 2015 Explain how an upcoming harvest influences today’s price of wheat. The upcoming harvest will help determine the future price of wheat. If

Part 1 . INTRODUCTION

the harvest is low, then the supply of wheat will decrease, thereby raising the price of wheat in the future. The higher expected future price of wheat affects the current demand and supply of wheat. In particular, the higher expected future price increases the current demand, so the demand curve shifts rightward, and decreases the current supply, so the supply curve shifts leftward. The current increase in demand and decrease in supply raise the current price of wheat. The table shows the demand and supply Price Quantity Quantity schedules for boxes of chocolates in an av(dollars demanded supplied erage week. Use this information to work per box) (boxes per week) Problems 5 and 6. 13.00 1,600 1,200 14.00 1,500 1,300 5. If the price of chocolates is $17.00 a 15.00 1,400 1,400 box, describe the situation in the mar16.00 1,300 1,500 ket. Explain how market equilibrium 17.00 1,200 1,600 is restored. 18.00 1,100 1,700 At the price of $15.00 a box, the quantity supplied equals the quantity demanded. At a price of $17.00 a box, the Price suppliedQuantity quantity demanded is 1,200 boxes and the quantity is 1,600 box- Quantity (dollars demanded supplied es. There is a surplus of 400 boxes a week and the price falls. As the price per pad) (mouse pads per week) falls, the quantity demanded increases, the quantity supplied decreases, 3 180 120 and the surplus decreases. The price falls until4 the surplus disappears. 170 130 The market equilibrium occurs at a price of $15.00 5 a box and 1,400 160boxes a 140 6 150 150 week so the price falls to $15.00 a box. 7 140 160 6. During Valentine’s week, more people buy 8 130 170 chocolates and chocolatiers offer their chocolates in special red boxes, which cost more to produce than the everyday box. Set out the three-step process of analysis and show on a graph the adjustment process to the new equilibrium. Describe the changes in the equilibrium price and the equilibrium quantity. Starting with the demand side, Valentine’s week increases people’s preferences for boxes of chocolate so the demand for boxes of chocolate increases. The demand curve for chocolates shifts rightward, from D0 to D1 in Figure 4.4. Moving to the supply side, the fancy red box raises the cost of producing boxes of chocolate, which decreases the supply. The rise in the cost of producing boxes of chocolates shifts the supply

Chapter 4 . Demand and Supply

curve leftward, from S0 to S1 in Figure 4.4. After these changes, at the initial price of a box of chocolate, $15.00, in Figure 4.4 there is a shortage of 600 boxes of chocolate per week. The shortage forces the price higher, so the equilibrium price of a box of chocolate rises, to $18.00 in the figure. The problem points out that people buy more boxes of chocolate during Valentine’s week. This result means that the change in demand exceeds the change in the supply, that is, the magnitude of the increase in demand exceeds that of the decrease in supply. Figure 4.4 illustrates this situation and in the figure the equilibrium quantity increases from 1,400 boxes per week to 1,500 boxes per week. 7.

After a severe bout of foreclosures and defaults on home loans, banks made it harder for people to borrow. How does this change influence: • The demand for new homes? The demand for homes decreases. •

The supply of new homes? The supply of new homes does not change.

•

The price of new homes? The price of new homes falls.

Illustrate your answer with a graphical analysis. Figure 4.5 shows the effect of making home loans more difficult to obtain. Before the change in difficulty, the demand curve is D0. In the figure the price of a new home is $350,000. After the increase in difficulty, the demand decreases and the demand curve shifts leftward, in the figure from D0 to D1. The supply curve does not shift. The price of a new home falls, in the figure from $350,000 to $275,000. 8.

Bacon is 25 percent cheaper Bacon is 25 percent cheaper now than a year ago and bacon sales are up 13 percent on the year. At the same time, the bird flu virus is killing millions of chickens, raising egg prices. Source: CNN Money, May 20, 2015 Explain how this news clip illustrates: (a) the law of demand and why the price of bacon fell, and (b) how the markets for bacon and eggs influence each other. Draw a graph to illustrate your explanation. The result that bacon is less expensive and the quantity sold is higher indicate that the supply of bacon increased. The increase in the supply of

Part 1 . INTRODUCTION

bacon lowers the price, creating a movement along the demand curve and thereby demonstrating the law of demand: A lower price increases the quantity demanded. Bacon and eggs are complements for consumers so changes in their price affect the demand for the other good. Consider the market for eggs. The fall in the price of bacon increases the demand for eggs, so, as Figure 4.6 illustrates, the demand curve for eggs shifts rightward. However, bird flu killed millions of chickens and decreased the supply of eggs, which shifts the supply curve leftward. As the figure shows, the price of eggs rises from $1.00 per dozen to $1.75. The effect on the quantity is ambiguous: If the change in demand dominates, the quantity increases; if the change in supply dominates, the quantity decreases; or, if as in the figure, the changes offset each other, the quantity does not change. 9.

“As more people buy smartphones, the demand for smartphone service increases and the price of smartphone service falls, which decreases the supply of smartphone service.” Is this statement true or false? Explain. The assertion that the demand for smartphone service increases as more people buy smartphones is true. However, the claim that the increase in demand reduces the price of smartphone service is false; the increase in demand raises the price of smartphone services. The second sentence is false. Regardless of whether the price of smartphone service rises or falls, the supply of smartphone service does not change. Rather the change in price changes the quantity of smartphone service supplied.

10. China slowdown could bring good news China’s economic slowdown could help reduce the cost of steel used by U.S. auto makers. Source: The Wall Street Journal, September 8, 2015 Explain how an economic slowdown in China influences the global steel market. What happens to the equilibrium price of steel? The economic slowdown in China reduces the demand for steel in China. The demand curve for steel shifts leftward. The slowdown does not change the supply of steel, so the supply curve of steel does not shift. As the demand curve shifts leftward, there is a movement down along the supply curve of steel and a decrease in the price of steel.

Chapter 4 . Demand and Supply

◼ Multiple Choice Quiz 1.

Which of the following events illustrates the law of demand: Other things remaining the same, a rise in the price of a good will ________ . A. decrease the quantity demanded of that good B. increase the demand for a substitute of that good C. decrease the demand for the good D. increase the demand for a complement of that good Answer: A The law of demand is the inverse relationship between the price of a good and the quantity demanded. 2.

In the market for jeans, which of the following events increases the demand for a pair of jeans? A. The wage rate paid to garment workers rises. B. The price of a denim skirt (a substitute for jeans) rises. C. The price of denim cloth falls. D. New technology reduces the time it takes to make a pair of jeans. Answer: B The other factors listed change the supply; only answer B increases the demand. 3.

Other things remaining the same, a fall in the price of peanuts will ________. A. increase the supply of peanuts B. decrease the supply of peanut butter C. decrease the quantity supplied of peanuts D. decrease the supply of peanuts Answer: C A fall in the price of the good creates a movement along the supply curve and decreases the quantity supplied. 4.

In the market for smartphones, which of the following events increases the supply of smartphones? A. New technology lowers the cost of making a smartphone B. Rise in the price of an e-book reader (a substitute in production) C. An increase in people’s incomes D. A rise in the wage rate paid to electronics workers Answer: A Answers B and D decrease the supply of smartphones; answer C affects the demand for smartphones.

Part 1 . INTRODUCTION

When floods wiped out the banana crop in Central America, the equilibrium price of bananas ________ and the equilibrium quantity of bananas ________. A. rose; increased B. rose; decreased C. fell; increased D. fell; decreased Answer: B Figure 4.12(b) on page 104 illustrates this case of a decrease in supply. 6.

A decrease in the demand for chocolate with no change in supply will create a ________ of chocolate at today’s price, but gradually the price will ________. A. surplus; fall B. shortage; fall C. surplus; rise D. shortage; rise Answer: A Figure 4.11(b) on page 102 illustrates this case of a decrease in demand. 7.

Many Americans are selling their used cars and buying new fuel-efficient hybrids. Other things remaining the same, in the market for used cars, ________ and in the market for hybrids ________. A. supply increases and the price falls; demand increases and the price rises B. demand decreases and the price rises; supply increases and the price falls C. both demand and supply decrease and the price might rise, fall, or not change; demand increases and the price rises D. demand decreases, supply increases, and the price falls; supply increases and the price falls Answer: A Selling their used cars increases the supply of used cars. Buying new hybrids increases the demand for hybrids.

Chapter

Elasticities of Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications When the price of home heating oil increased by 20 percent, the quantity demanded decreased by 2 percent and the quantity of wool sweaters demanded increased by 10 percent. Use this information to work Problems 1 and 2. 1. Use the total revenue test to determine whether the demand for home heating oil is elastic or inelastic. When the price of home heating oil increased by 20 percent, the total revenue collected by sellers of home heating oil increased because the quantity demanded decreased by only 2 percent. Because the total revenue increased when the price rose, the total revenue test tells us that the demand for home heating oil is inelastic. (To check, the elasticity of demand is (2 percent)  (20 percent), which is 0.10. Recall that when calculating the price elasticity of demand, we use absolute values or magnitudes and ignore the minus sign.) 2.

If the price of a wool sweater did not change, calculate the cross elasticity of demand for wool sweaters with respect to the price of home heating oil. Are home heating oil and wool sweaters substitutes or complements? Why? The cross elasticity of demand for wool sweaters with respect to home heating oil is:

 Percentage change in quantity of sweaters demanded   10 percent   =     20 percent  = 0.50. Percentage change in price of heating oil     Home heating oil and sweaters are substitutes because as the price of home heating oil rises, you can stay warm by using less home heating oil and putting on a sweater. The cross elasticity of demand for a substitute is positive.

Part 2 . A CLOSER LOOK AT MARKETS

The figure shows the demand for movie tickets. Is the demand for movie tickets elastic or inelastic over the price range $7 to $9 a ticket? If the price falls from $9 to $7 a ticket, explain how the total revenue from the sale of movie tickets will change. Calculate the price elasticity of demand for movie tickets when the price is $8 a ticket. The percentage change in the quantity of movie tickets demanded equals

 300 tickets − 100 tickets     100 , or 100  (100 tickets + 300 tickets)  2 )  percent. The percentage change in the price of a movie ticket equals  $9 a ticket − $7 a ticket     100 , or 25  ($9 a ticket + $7 a ticket)  2 )  percent. So, the demand for movie tickets is elastic because the percentage change in the quantity demanded is larger than the percentage change in price. Because the demand is elastic, the fall in the price of a movie ticket increases the total revenue from the sale of movie tickets. When the price is $9 a ticket, the total revenue is $9 a ticket  100 tickets, which is $900. When the price is $7 a ticket, the total revenue is $7 a ticket  300 tickets, which is $2,100. So, the total revenue increases by $1,200. The price elasticity of demand for movie tickets is the percentage change in the quantity of movie tickets demanded divided by the percentage change in the price of a movie ticket. The percentage change in the quantity of movie tickets

 300 tickets − 100 tickets    100 , which is 100 perdemanded equals   (100 tickets + 300 tickets)  2 )  cent. The percentage change in the price of a movie ticket equals  $9 a ticket − $7 a ticket     100 , which is 25 percent. So, the price  ($9 a ticket + $7 a ticket)  2 )  elasticity of demand for movie tickets at the price of $8 is 100 percent  25 percent, or 4.00. 4.

The price elasticity of demand for Pete’s chocolate chip cookies is 1.5. Pete wants to increase his total revenue. Would you recommend that Pete raise or lower his price of cookies? Explain your answer. Because the price elasticity of demand for cookies is 1.5, Pete should lower the price of cookies to raise his total revenue. Because demand is elastic a decrease in the price of cookies will bring about a larger percentage increase in the quantity demanded than the percentage fall in price.

Chapter 5 . Elasticities of Demand and Supply

Use the following information to work Problems 5 and 6. The price of a plane ride rises by 10 percent. The price elasticity of demand for plane rides is 0.5 and the price elasticity of demand for train rides is 0.2. The cross elasticity of demand for train rides with respect to the price of a plane ride is 0.4. 5. Calculate the percentage changes in the quantity demanded of plane rides and train rides. The percentage change in the quantity demanded of plane rides equals the price elasticity of demand for plane rides multiplied by the percentage change in the price of a plane ride, which is (0.5)  (10 percent) = 5 percent. The percentage change in the quantity demanded of train rides equals the cross elasticity of demand for train rides with respect to the price of a plane ride multiplied by the percentage change in the price of a plane ride, which is (0.4)  (10 percent) = 4 percent increase. 6.

Given the rise in the price of a plane ride, what percentage change in the price of a train ride will leave the quantity demanded of train rides unchanged? From the previous answer, when the price of a plane ride rises 10 percent, the quantity of train rides demanded increases 4 percent. The price rise of a train ride necessary to decrease the quantity demanded by 4 percent is 20 percent because a 20 percent increase in the price of train ride decreases the quantity demanded by (0.2)  (20 percent) = 4 percent.

A survey found that when incomes increased by 10 percent, the following changes in the quantities demanded occurred: spring water up by 5 percent; sports drinks down by 2 percent; cruises up by 15 percent. For which good is demand income elastic? For which good is income inelastic? Which goods are normal goods? Because the percentage change in the quantity of cruises demanded increased by more than the percentage change in income, the demand for cruises is income elastic. Because the percentage change in the quantity of spring water demanded increased by less than the percentage change in income, the demand for spring water is income inelastic. The demand for cruises increases with income, so cruises are a normal good. The demand for spring water increases with income, so it is a normal good. The demand for sports drinks decreases with income, so it is an inferior good.

Use the following information to work Problems 8 and 9. Record U.S. corn crop, up 24%, is forecast The USDA reported that world corn production will be 9.9 percent greater than last year’s, while U.S. corn production will be 24 percent larger. The price of corn is expected to be 46 percent higher than last year’s price. Source: Bloomberg News, August 11, 2007

Part 2 . A CLOSER LOOK AT MARKETS

Did Starbucks start a pumpkin boom? Ever since Starbucks introduced its famed pumpkin spice latte about a Decade ago, pumpkin sales have skyrocketed. Source: CNNMoney, October 1, 2014 The price of pumpkin increased from $286 per ton in 2000 to $732 per ton in 2014 (both prices in 2014 dollars) and the quantity produced increased from 423,000 tons in 2000 to 657,150 in 2014. Calculate the U.S. price elasticity of supply of pumpkin: Is its supply elastic? The price elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in the price. The change in the quantity supplied is: [(657,150 tons – 423,000)/540,075] × 100 = 43.4 percent, where 540,075 is the midpoint between the two quantities. The percentage change in the price is: [($732 − $286)/$509] × 100 = 87.6 percent, where $509 is the midpoint between the two prices. So, the price elasticity of supply equals 43.4 percent  87.6 percent, which is 0.5. The supply of pumpkins corn is not elastic; it is inelastic.

Read Eye on Elasticity at the Coffee Shop on p. 123 and then explain why the demand for latte is inelastic while the demand for a Starbucks latte is elastic. Which demand is likely to be more inelastic: the demand for latte or the demand for coffee? The demand for latte is inelastic because there are not many substitutes for a latte. Most of the substitutes, such as tea or water, are poor substitutes, which also makes the demand for latte inelastic. The demand for Starbucks latte, however, is elastic because there are good substitutes for Starbucks latte. As the Eye on Elasticity at the Coffee Shop explained, Dunkin’ Donuts latte is a substitute. So, too, are lattes from independent coffee shops. With more good substitutes, the demand for Starbucks latte is elastic. The demand for a latte is probably more elastic than the demand for coffee because a latte is a more narrowly defined good than coffee, which is a more broadly defined good. Anything that substitutes for coffee also substitutes for a latte and all other coffee-based drinks are also substitutes for a latte. Because a latte has more substitutes than does coffee, its demand is more elastic than the demand for coffee.

Chapter 5 . Elasticities of Demand and Supply

◼ Instructor Assignable Problems and Applications Use the following information to work Problems 1 and 2. When Elle’s Espresso Bar increased its prices by 10 percent, the quantity of coffee that Elle sold decreased by 40 percent. When Elle and all her competitors cut their prices by 10 percent, the quantity of coffee sold by Elle increased by only 4 percent. 1. Calculate the price elasticity of demand for Elle’s Espresso Bar coffee and the price elasticity of demand for coffee. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in price. When Elle alone increased the price by 10 percent, the quantity of coffee demanded decreased by 40 percent, so the price elasticity of demand for Ellie’s coffee is (40 percent)/(10 percent) = 4.0. When all the stores lowered their prices by 10 percent, the quantity demanded increased by 4 percent, so the price elasticity of demand for coffee equals (4 percent)/(10 percent) = 0.4. 2.

Explain the difference between the responses to Elle’s price hike and price cut. Why did the price increase bring a large response in the quantity sold while the price cut had only a small effect? The demand for Elle’s coffee is elastic (4.0) because there are many good substitutes for Elle’s coffee, such as the coffees sold by all of Elle’s competitors. So, in this case the quantity of Elle’s coffee demanded decreased quite substantially. When all stores lowered their prices, customers can buy at Ellie’s store and at all the competitors’ stores also. So, in this case, because the demand for coffee is inelastic (0.4), the (small) increase in the quantity demanded is spread over all Ellie’s store and all the other coffee stores.

When rain ruined the banana crop in Central America, the price of bananas rose from $1 to $2 a pound. Growers sold fewer bananas, but their total revenue was unchanged. By what percentage did the quantity demanded of bananas change? Is the demand for bananas elastic, unit elastic, or inelastic? Because the total revenue did not change, the percentage change in bananas demanded equals the percentage increase in price. Using the midpoint method, the percentage increase in the price equals ($1.00  $1.50) = 66.67 percent. So, the quantity of bananas demanded decreased by 66.67 percent. The demand for bananas is neither elastic nor inelastic; it is unit elastic because the percentage increase in the price equals the percentage decrease in the quantity of bananas demanded.

Part 2 . A CLOSER LOOK AT MARKETS

The income elasticity of demand for haircuts is 1.5, and the income elasticity of demand for food is 0.14. You take a weekend job, and the income you have to spend on food and haircuts doubles. If the prices of food and haircuts remain the same, will you double your expenditure on haircuts and double your expenditure on food? Explain why or why not. Your expenditure on haircuts will more than double because the income elasticity of demand exceeds 1.0. Your expenditure on food will not double because the income elasticity of demand is less than 1.0. Only if the income elasticity of demand equals 1.0 will the expenditure on a good or service change proportionally with income.

Drought cuts the quantity of wheat grown by 2 percent. If the price elasticity of demand for wheat is 0.5, by how much will the price of wheat rise? If pasta makers estimate that this change in the price of wheat will increase the price of pasta by 25 percent and decrease the quantity demanded of pasta by 8 percent, what is the pasta makers’ estimate of the price elasticity of demand for pasta? If pasta sauce makers estimate that, with the change in the price of pasta, the quantity of pasta sauce demanded will decrease by 5 percent, what is the pasta sauce makers’ estimate of the cross elasticity of demand for pasta sauce with respect to the price of pasta? Rearranging the price elasticity of demand formula shows that the percentage change in the price of wheat equals the percentage change in the quantity demanded divided by the price elasticity of demand. The percentage change in the price of wheat is (2 percent)  (0.5), or 4 percent. The estimated price elasticity of demand for pasta is equal to the percentage change in the quantity demanded of pasta divided by the estimated change in the price of pasta. So, the estimated price elasticity of demand for pasta is (8 percent)  (25 percent), which is 0.32. The estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is equal to the percentage change in the quantity demanded of pasta sauce divided by the estimated change in the price of pasta. So, the estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is −(5 percent)  (25 percent), which is −0.2.

“In a market in which demand is price inelastic, producers can gouge consumers and the government must set high standards of conduct for producers to ensure that consumers get a fair deal.” Do you agree or disagree with each part of this statement? Explain how you might go about testing the positive part. Most of this statement is normative in nature. The terms “gouge,” “high standards of conduct,” and “fair deal” are all normative. To the extent

Chapter 5 . Elasticities of Demand and Supply

that the statement can be interpreted as a positive statement, the first part might mean “in a market in which demand is price inelastic, producers can set a higher price than otherwise.” If this is the meaning of the first part, then it is testable by determining the extent to which the price elasticity of demand affects the equilibrium price in markets. Use the following information to work Problems 7 and 8. Valentine roses On Valentine’s Day 2015, 257 million roses were sold for about double the normal price. On a normal day, 3 million roses are sold. Source: aboutflowers.com, 2015 7. Does the information about the market for roses enable us to estimate an elasticity, and if so, which one: the price elasticity of demand, the price elasticity of supply, an income elasticity, or a cross elasticity? Explain your answer. The information does not allow us to estimate an income elasticity of demand nor a cross elasticity of demand because there is no data about a change in income nor a change in the price of a related good. The price elasticity of demand is measured along an unchanging demand curve but on Valentine ’s Day the demand for roses increases and the demand curve shifts to the right. Consequently, we cannot estimate the price elasticity of demand. If we assume that the supply of roses did not change, so that the supply curve did not shift, then we can sue the data to estimate the price elasticity of supply. 8.

What is the magnitude of the elasticity that you can estimate using the information provided? Explain your answer. Presuming the supply curve did not shift, the price elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in the price. The percentage change in the quantity supplied is given as 100 percent (“double the normal price”) and the percentage change in the quantity supplied is equal to: [(257 million – 3 million)/130 million] × 100 = 195 percent, where 130 million is the midpoint (the average) between 257 million and 3 million. So, the price elasticity of supply equals (195 percent)/(100 percent) = 1.95.

Part 2 . A CLOSER LOOK AT MARKETS

◼ Multiple Choice Quiz 1.

When the price of ice cream rises from $3 to $5 a scoop, the quantity of ice cream bought decreases by 10 percent. The price elasticity of demand for ice cream is _______. A. 5 B. 0.2 C. 50 D. 2.5 Answer: B The percentage change in the price is equal to ($2/$4) × 100, which is 50 percent. The price elasticity of demand is equal to (10 percent) ÷ (50 percent), which is 0.2. 2.

In Pioneer Ville, the price elasticity of demand for bus rides is 0.5. When the price of a bus ticket rises by 5 percent, _______. A. the demand for bus rides increases by 10 percent B. the quantity of bus rides demanded increases by 2.5 percent C. the demand for bus rides decreases by 2.5 percent D. the quantity of bus rides demanded decreases by 2.5 percent Answer: D The quantity of bus rides demanded decreases by (0.5) × (5 percent), which is 2.5 percent. 3.

The price elasticity of demand for a good is 0.2. A 10 percent rise in the price will _______ the total revenue from sales of the good. A. decrease B. increase C. decrease the quantity sold with no change in D. not change Answer: B The total revenue test on page 123 shows that a rise in the price increases the total revenue if demand is inelastic. 4.

If the price of a good falls and expenditure on the good rises, the demand for the good is _______. A. elastic B. perfectly elastic C. inelastic D. unit elastic Answer: A The total revenue test on page 123 shows that demand is elastic.

Chapter 5 . Elasticities of Demand and Supply

When the price of a good rises from $5 to $7 a unit, the quantity supplied increases from 110 to 130 units a day. The price elasticity of supply is _______. The supply of the good is _______. A. 60; elastic B. 10; elastic C. 0.5; inelastic D. 2; inelastic Answer: C The price elasticity of supply equals (20/120)÷($2/$6), which is 0.5; the price elasticity of supply is less than 1.0, so the supply is inelastic. 6.

The cross elasticity of demand for good A with respect to good B is 0.2. A 10 percent change in the price of good B will lead to a ____ percent change in the quantity of good A demanded. Goods A and B are _______. A. 2; substitutes B. 0.5; complements C. −2; complements D. −0.5; substitutes Answer: A The change in the quantity of good A demanded is computed as (0.2) × (10 percent), which is 2 percent; the cross price elasticity is positive, so the goods are substitutes. 7.

A 2 percent increase in income increases the quantity demanded of a good by 1 percent. The income elasticity of demand for this good is _______. The good is a _______ good. A. 2; normal B. –2; inferior C. 1/2; normal D. 2; inferior Answer: C The income elasticity of demand equals (1 percent) ÷ (2 percent); it is positive so the good is a normal good.

Chapter

Efficiency and Fairness of Markets ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications At McDonald’s, no reservations are accepted; at the St. Louis Art Museum Restaurant, reservations are accepted; at Le Bernardin in New York, reservations are essential. Use this information to work Problems 1 to 3. 1. Describe the method of allocating table resources in these three restaurants. All these restaurants use a first-come, first-serve system. McDonald’s uses this system directly. Le Bernardin uses a first-come, first-serve because the first person to call to make a reservation at a particular time is allocated the table at that time. The St. Louis Art Museum Restaurant uses a combination of the immediate first-come, first serve system and the reservation based first-come, first-serve system. 2.

Why do you think restaurants have different reservation policies, and why might each restaurant be using an efficient allocation method? The speed with which tables turn over at the different restaurants probably is quite different and the customers probably have quite different values of time. Le Bernardin has a low turnover rate—only 1 or 2 groups of customers can use a table each night—and its customers have a high value of time. If Le Bernardin refused to take reservations, its customers would need to wait an inefficiently long time and would go elsewhere so that Le Bernardin’s profits would be lower. At McDonald’s, the tables have a high turnover rate (indeed, many customers do not use the tables at all, buying their food to go) and the customers have a lower value of time. Allowing reservations would be costly for McDonald’s and would spare its customers only a slight wait at most so that allowing reservations would decrease McDonald’s profits. At the St. Louis Art Museum Restaurant, the turnover rate of the tables is between that at Le Bernardin and McDonald’s, so it uses a combination of phone reservation first-come, first-serve and appear in person first-come, first serve. Each restaurant is using a different allocation method because of the rela-

Part 2 . A CLOSER LOOK AT MARKETS

tive costs. Each uses the method that has the lowest cost for the restaurant. 3.

Why don’t all restaurants use the market price to allocate their tables? Market allocation requires that customers pay for a table and the price would fluctuate from one hour to the next depending on the number of customers who arrive. Customers would be highly uncertain about the price they would need to pay and such uncertainty decreases the demand for meals from the restaurant. The decreased demand lowers the restaurant’s profit. Price Quantity Quantity The table shows the demand and supply (dollars per demanded supplied schedules for sandwiches. Use the table to sandwich) (sandwiches per week) work Problems 4 to 7. 0 400 0 4. Calculate the equilibrium price of a 1 350 50 sandwich, the consumer surplus, and 2 300 100 the producer surplus. What is the effi3 250 150 4 200 200 cient quantity of sandwiches? 5 150 250 The equilibrium quantity is 200 6 100 300 sandwiches and the equilibrium price 7 50 350 is $4 a sandwich. Figure 6.1 can be 8 0 400 used to calculate the consumer surplus. The consumer surplus equals the area of the light gray triangle above the price and below the demand curve. The area of the triangle is 1/2  base  height, so the consumer surplus is 1/2  (200 sandwiches)  ($4 a sandwich), which is $400. Figure 6.1 also can be used to calculate the producer surplus. The producer surplus equals the area of the dark gray triangle below the price and above the supply curve. This area is 1/2  (200 sandwiches)  ($4 a sandwich), which is $400. The efficient quantity is 200 sandwiches. 5.

If the quantity demanded decreases by 100 sandwiches an hour at each price, what is the equilibrium price and what is the change in total surplus? If the quantity demanded of sandwiches decreases by 100 per hour at each price, the new equilibrium price of a sandwich is $3 and the new equilibrium quantity is 150. This consumer surplus equals the area of the

Chapter 6 . Efficiency and Fairness of Markets

triangle above the price and below the demand curve and so is equal to 1/2  (150 sandwiches)  ($3 a sandwich), which is $225. The producer surplus equals the area of the triangle below the price and above the supply curve and so is equal to is 1/2  (150 sandwiches)  ($3 a sandwich), which is $225. The total surplus equals the sum of the consumer surplus plus producer surplus. Before the change the total surplus is $400 + $400 = $800 and after the change the total surplus is $225 + $225 = $450, for a change of −$350. 6.

If the quantity supplied decreases by 100 sandwiches an hour at each price, what is the equilibrium price and what is the change in total surplus? If the quantity supplied of sandwiches decreases by 100 per hour at each price, the new equilibrium price of a sandwich is $5 and the new equilibrium quantity is 150. This consumer surplus equals the area of the triangle above the price and below the demand curve and so is equal to 1/2  (150 sandwiches)  ($3 a sandwich), which is $225. The producer surplus equals the area of the triangle below the price and above the supply curve and so is equal to is 1/2  (150 sandwiches)  ($3 a sandwich), or $225. Before the change the total surplus is $400 + $400 = $800 and after the change the total surplus is $225 + $225 = $450, for a change of −$350.

If Sandwiches To Go, Inc., buys all the sandwich producers and cuts production to 100 sandwiches an hour, what is the deadweight loss that is created? If Sandwiches To Go, Inc. rations sandwiches to two per person, by what view of fairness would the allocation be unfair? If only 100 sandwiches are produced, the deadweight loss equals the area of the darkened triangle in Figure 6.2. This area is 1/2  (100 sandwiches)  ($4 a sandwich), which is $200. Rationing sandwiches might be fair based on the “fair results” principle because everyone has an equal number of sandwiches. However, because Sandwiches To Go, Inc. is restricting the number of sandwiches it produces, some customers might go without. If the “fair results” view incorporates these consumers into the picture, then the rationing is unfair because not every consumer has a sandwich. The “fair rules” approach is likely to consider the rationing fair, because all exchanges are voluntary. But, it is worth noting

Part 2 . A CLOSER LOOK AT MARKETS

that Sandwiches To Go, Inc. is restricting its production and so is creating a deadweight loss. Use the following information to work Problems 8 and 9. The table shows the deQuantity Quantity demanded demanded mand and supply schedules Price before during Quantity for sandbags before and (dollars per flood flood supplied during a major flood. Durbag) (thousands of bags) ing the flood, suppose that 0 40 70 0 the government gave all 1 35 65 5 families an equal quantity 2 30 60 10 of sandbags. Resale of 3 25 55 15 4 20 50 20 sandbags is not permitted. 5 15 45 25 8. How would total sur6 10 40 30 plus and the price of a 7 5 35 35 sandbag change? 8 0 30 40 The effect on the producer surplus of the companies selling sandbags depends on the price the government paid. If the government paid the higher, post-flood price, the firms’ producer surplus is unchanged. If the government required the companies to sell the sandbags to the government at the lower, pre-flood price, the firms’ producer surplus decreased. If the government hands out the sandbags for “free,” so that everyone gets an equal share, the effect on the consumer surplus is ambiguous. The consumer surplus increases because the bags are available at a price of $0. But there are two factors that offset the increase in the consumer surplus: First, if the government buys only 20,000 bags—the equilibrium quantity before the flood—the consumer surplus will be reduced because fewer sandbags will be distributed. Second, even if the government buys 35,000 bags—the equilibrium quantity during the flood—the consumer surplus will be reduced because the government will distribute some bags to people with low marginal benefit (those who live on high ground) rather than concentrating on people with high marginal benefit (those who live on low ground). The effect on the price depends on whether the government pays the higher, during-flood price, or the lower, pre-flood price. 9.

Would the outcome be more efficient than if the government took no action? Explain. If the government took no action and the market was free to reach its equilibrium, then the outcome is efficient. If the government allows no resales, then the allocation is almost assuredly inefficient unless the government precisely duplicates the competitive market allocation.

Chapter 6 . Efficiency and Fairness of Markets

10. The winner of the men’s or women’s tennis singles at the U.S. Open is paid twice as much as the runner-up, but it takes two to have a singles final. Is this compensation arrangement efficient? Is it fair? Explain why it might illustrate the big tradeoff. The compensation arrangement is efficient because all the participants play their hardest in an attempt to win the prize. As a result, the quality of play is extremely high and the “amount” of tennis produced is large. The fair results approach to fairness asserts that the compensation scheme is unfair because income is not equally distributed. The fair rules approach asserts that the scheme is fair because the players voluntarily enter the tournament and the symmetry principle is not violated. This arrangement might illustrate the big tradeoff because if the winner was paid less and the loser was paid more, both the ultimate winner and the ultimate loser have an incentive to play less hard, that is, they may decrease the amount of tennis they produce. Use the following information to work Problems 11 and 12. eBay saves billions for bidders On eBay, the bidder who places the highest bid wins the auction and pays only what the second highest bidder offered. Researchers Wolfgang Jank and Galit Shmueli reported that purchasers on eBay in 2003 paid $7 billion less than their winning bids. Because each bid shows the buyer’s willingness to pay, the winner receives an estimated consumer surplus of $4 or more. Source: InformationWeek, January 28, 2008 11. What method is used to allocate goods on eBay? How does an eBay auction influence consumer surplus from the good? eBay is using market price to allocate the goods. The market price is the price established in the auction. If someone is willing and able to pay that price, the person will get the item. For the vast majority of auctions the winning bidder will enjoy a consumer surplus so eBay increases consumer surplus. For instance, if there are bidders on a unique item, the winning bidder—who sets the price for the good—will pay a price that is equal to the value of the item to the bidder with the second-highest valuation plus the minimum bid increment. The winning bidder has some consumer surplus as long as his or her value of the good exceeds the price that must be paid, which will almost always be the case. Indeed, a person chooses to buy on eBay rather than elsewhere if the person believes that his or her consumer surplus is largest by purchasing on eBay. 12. Read Eye on Price Gouging on p. 162 and explain why it was inefficient to stop Mr. Shepperson from selling his generators. After the hurricane the marginal benefit from a generator skyrocketed

Part 2 . A CLOSER LOOK AT MARKETS

and the demand for generators drastically increased. Potential consumers were willing to pay the price Mr. Shepperson was charging, which means that their marginal benefit from the generators equaled or exceeded the price Mr. Shepperson was setting. Additionally, Mr. Shepperson’s price exceeded his marginal cost. Consequently, the marginal benefit from Mr. Shepperson’s generators exceeded their marginal cost. Confiscating the generators prevented their sales. Forbidding the sales created a deadweight loss because the marginal benefit of these generators exceeded their marginal cost, which means that preventing the sales was inefficient.

Chapter 6 . Efficiency and Fairness of Markets

◼ Instructor Assignable Problems and Applications 1.

Mets World Series ticket prices spike after NLCS win Now that the New York Mets are in baseball’s World Series for the first time in 15 years, fans who don’t have a ticket will pay a hefty $1,667.82 to get one. That’s the average asking price for a resold ticket, which is the highest since World Series price-tracking started in 2010. Source: CNBC.com, October 22, 2015 Why is a $1,667.82 ticket price similar to “price gouging”? Is the high price an example of the market price method of allocating scarce resources? Is the market for tickets efficient? Is it fair? Usually price gouging occurs after a natural disaster. The Mets have not been in a World Series for 15 years. Their appearance in the World Series is not a natural disaster (except for fans of other teams) but is unusual. The $1,667.82 can be considered “price gouging” because it reflects a markedly higher price that results from a large, unusual increase in demand. If $1,667.82 is the equilibrium price at which the quantity demanded of seats equaled the quantity supplied, then it is an example of resources being allocated by the market price. Presuming once again that the price is the equilibrium price, the market for tickets is efficient. The price is fair under the “fair rules” view of fairness. Because wealthy fans will be the fans who see the game, it’s unfair under the “fair results” view of fairness.

Part 2 . A CLOSER LOOK AT MARKETS

The table shows the demand schedule for haircuts and the supply schedule for haircuts. Use the table to work Problems 2 and 3. 2. What is the quantity of haircuts bought, the value of a haircut, and the total surplus from haircuts? The equilibrium quantity of haircuts is 40 per day. The value of the 40th

Price (dollars per haircut) 0 10 20 30 40 50

haircut is $30. The total surplus is equal to the sum of the consumer surplus plus the producer surplus. Figure 6.3 helps in calculating the consumer surplus and producer surplus. The consumer surplus is equal to the area of the dark grey triangle. The consumer surplus equals 1/2  40 haircuts  $20 per haircut), or $400. The producer surplus is equal to the lighter grey area which is also $400 so total surplus is $400 + $400 = $800.

Suppose that all salons agree to charge $40 a haircut. How do consumer surplus and producer surplus change? What is the deadweight loss created? If the price is $40 a haircut, the quantity of haircuts is 20. The consumer surplus in Figure 6.4 is the dark triangle and is $100, so the consumer surplus has decreased by $300. The producer surplus in Figure 6.4 is the light grey area and is $500, so the producer surplus has increased by $100. The deadweight loss is $200. Note that the deadweight loss is equal to the gain in producer surplus minus the loss in consumer surplus.

Quantity Quantity demanded supplied (haircuts per day) 100 0 80 0 60 20 40 40 20 60 0 80

Chapter 6 . Efficiency and Fairness of Markets

In California, farmers pay a lower price for water than do city residents. Use this information to work Problems 4 to 6. 4. What is this method of allocation of water resources? Is this allocation of water efficient? Is this use of scarce water fair? Why or why not? This method of allocation is based on personal characteristics. Two otherwise identical people pay different prices for water if one is a farmer and the other is not. Water use is probably not efficient. Because farmers face a lower price, the quantity of water they consume is greater than the quantity of water consumed by otherwise identical non-farmers. As a result, the marginal benefit of farmers is less than the marginal benefit of otherwise identical nonfarmers. Presumably, however, the marginal cost of supplying water to the two groups is the same. So, there is overuse of water in farm uses and underuse of water in other uses. By the “fair results” approach, the question of fairness depends on relative incomes of farmers and city dwellers. If farmers have lower incomes, the lower price for water is fair. If farmers have higher incomes, then the lower price of water is not fair. Under the “fair rules” approach, the different prices are fair because transactions are voluntary 5.

If farmers were charged the same price as city residents pay, how would the price of agricultural produce, the quantity of produce grown, consumer surplus, and producer surplus change? If farmers are charged the same price for water as city residents, farmers’ costs increase. The increase in costs decreases the supply of agricultural products, so the price of agricultural produce rises and the quantity decreases. Consumer surplus decreases and producer surplus also decreases.

If all water in California is sold for the market equilibrium price, would the allocation of water be more efficient? Why or why not? Water use would be more efficient. Prior to the change, farmers were paying less than the marginal cost and so there was overuse of water in farm uses. After the change farmers pay the marginal cost and so the marginal benefit equals the marginal cost.

Use the following information to work Problems 7 and 8. The world’s largest tulip and flower market Every day over 19 million tulips and flowers are auctioned at the Dutch market called “The Bloemenveiling.” These Dutch auctions match buyers and sellers. Source: Tulip-Bulbs.com In a Dutch auction, the auctioneer announces the highest price. If no one offers to buy the flowers, the auctioneer lowers the price until a buyer is found.

Part 2 . A CLOSER LOOK AT MARKETS

What method is used to allocate flowers at the Bloemenveiling? The auction uses the market price (as established by the auction) to allocate the flowers.

How does a Dutch flower auction influence consumer surplus and producer surplus? Are the flower auctions at the Bloemenveiling efficient? A Dutch auction means there is little or no consumer surplus. If the buyers bid the moment the price reaches their value for the flower, then the successful buyers have no consumer surplus. The producers, however, likely have substantial producer surplus. As long as the price exceeds the marginal cost of producing the flowers, the producers have some producer surplus. The flower auctions are efficient because there are no obstacles (taxes, subsidies, monopoly, and so on) that prevent the market price from reaching allocative efficiency. The buyers pay a price equal to their marginal benefit and the sellers receive a price equal to their marginal cost.

Take pride in U.S. forests U.S. forestland has been a constant 755 million acres for the past century, but the number of trees has increased by 20 percent since 1970, the volume of wood has doubled since 1953, and the United States is the world’s largest supplier of forest products. Decisions by millions of private forest-land owners are responsible for this remarkable performance. Source: Frank Beidler letter, Chicago Tribune, October 23, 2015 Is the U.S. timber industry efficient and do forest-land owners operate in the social interest or self-interest? What effect does private ownership have on the efficiency of the timber industry? It is probable that the timber industry has operated efficiently. The private forest owners have the incentive to limit the extent of logging so that the owner can sell logging rights throughout the future. Indeed, the clip points out that the acres devoted to forestland has remained constant for a century. With this institutional set up, timber companies have operated in their self-interest which has been the same as the social interest.

Chapter 6 . Efficiency and Fairness of Markets

◼ Multiple Choice Quiz 1.

The method of allocation that most stores use during Thanksgiving sales is: A. a combination of market price and lottery B. first-come, first-served C. a combination of contest and command D. a combination of market price and first-come, first-served Answer: D Market price is used until the store runs out the good, so the first to come who are willing to pay the price get the good. 2.

All of the following statements are correct except ______. A. the value of an additional unit of the good equals the marginal benefit from the good B. marginal benefit is the excess of value over the price paid, summed over the quantity consumed C. the maximum price willingly paid for a unit of a good is the marginal benefit from it D. price is what we pay for a good but value is what we get from it Answer: B Answer B defines consumer surplus not marginal benefit. 3.

Choose the best statement. A. An increase in the demand for a good increases producer surplus. B. If producers decrease the supply of the good, their producer surplus will increase. C. Producer surplus equals the total revenue from selling the good. D. Producer surplus is the excess of the value of the good over the market price, summed over the quantity produced. Answer: A The increase in demand raises the price and increases the quantity, both of which raise the producer surplus. 4.

The market for a good is efficient if ______. A. the marginal cost of producing the good is minimized B. the marginal benefit from the good is maximized C. the consumer surplus is maximized D. the total surplus is maximized Answer: D Figure 6.8 in the textbook shows that an efficient allocation of resources maximizes the total surplus.

Part 2 . A CLOSER LOOK AT MARKETS

When the marginal benefit from a good exceeds its marginal cost, ______. A. there is overproduction of the good B. a deadweight loss, which is the excess of marginal benefit over marginal cost, arises C. producer surplus decreases and consumer surplus increases D. total production increases and efficiency increases Answer: B Figure 6.9(a) on page 157 shows the deadweight loss when the marginal benefit exceeds the marginal cost. 6.

Market failure arises if ______. A. there is overproduction of the good but not if there is underproduction B. the deadweight loss is zero C. producer surplus exceeds consumer surplus D. total surplus is not maximized Answer: D When the total surplus is maximized, resource allocation is efficient; if it is not maximized, then resource allocation is inefficient and market failure occurs. 7.

The allocation of resources is fair ______. A. in the fair-rules view if everyone has equal opportunity B. in the fair-results view if most resources are distributed to the poorest people C. in the fair-rules view if owners of the resources are protected by property rights and all transfers of resources are voluntary D. in the fair-results view if resources are transferred voluntarily so that everyone has the same quantity Answer: C Page 161 discusses the rules view of fairness.

Chapter

Government Actions in Markets

ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications 1.

In Florida, sunscreen and sunglasses are vital items. If the tax on sellers of these items is doubled from 5.5 percent to 11 percent, who will pay most of the tax increase: the buyer or the seller? Will the tax increase halve the quantity of sunscreen and sunglasses bought? Because sunscreen and sunglasses are necessities, the demand for them is inelastic. So, most of a tax imposed on them will be paid by the buyer. Even though the tax doubles, the quantity purchased is not halved because the demand is inelastic.

Suppose that the government imposes a $2 a cup tax on coffee. What determines by how much Starbucks will raise its price? How will the quantity of coffee bought in coffee shops change? Will this tax raise much revenue? The price elasticities of demand and supply determine how much more Starbucks charges for a coffee. The smaller the price elasticity of demand and the larger the price elasticity of supply, the more Starbucks will raise the price of a coffee. The quantity of coffee bought will decrease. The amount of revenue the government raises depends on the size of the tax and the size of the decrease in the quantity of coffee purchased. For a given tax, the government collects more revenue the smaller the price elasticities of demand and supply because the smaller these elasticities, the smaller the decrease in the quantity purchased.

3. The table illustrates the market for Internet service. What is the market price of Internet service? If the government taxes Internet service $15 a month, what is the price the buyer pays? What is the price the sell-

Price (dollars per month)

0 10 20 30 40

Quantity Quantity demanded supplied (units per month)

30 25 20 15 10

0 10 20 30 40

Part 2 . A CLOSER LOOK AT MARKETS

er receives? Does the buyer or seller pay more of the tax? The market price of an Internet service is $20 a month because that is the price at which the quantity demanded equals the quantity supplied. A figure is helpful to answer the questions about the tax incidence. If the government imposes a tax of $15 a month on Internet services, Figure 7.1 shows that the buyer pays $30 a month for Internet services. If the government imposes a tax of $15 a month on Internet services, the seller receives $15 a month for Internet services. The buyers pay more of the tax.

Use Figure 7.2, which shows the demand for oncampus housing, to work Problems 4 to 6. The college has 200 rooms to rent. 4. If the college puts a rent ceiling on rooms of $650 a month, what is the rent, how many rooms are rented, and is the on-campus housing market efficient? The equilibrium rent is $600 a month and the equilibrium quantity of rooms is 2,000 rooms. The rent ceiling of $650 a month is above the equilibrium rent and does not change the market equilibrium. The rent remains the equilibrium rent of $600 a month, the quantity of rooms rented remains 2,000 rooms, and the market remains efficient. 5.

If the college puts a strictly enforced rent ceiling on rooms of $550 a month, what is the rent, how many rooms are rented, and is the on-campus housing market efficient? Explain why or why not. The rent ceiling of $550 a month is below the equilibrium rent, so the rent is $550 a month. At this rent 2,250 rooms are demanded and the quantity supplied is only 2,000 rooms, so 2,000 rooms are rented. The on-campus

Chapter 7 . Government Actions in Markets

housing market is efficient because the supply is perfectly inelastic so the quantity remains equal to the efficient quantity. However, there is a shortage of rooms and students spend additional time searching for housing. 6.

Suppose that with a strictly enforced rent ceiling on rooms of $550 a month, a black market develops. How high could the black market rent be and would the on-campus housing market be fair? Explain your answer. The black market rent could be as high as $600 a month, which is the maximum rent someone is willing to pay for the 2,000th room. If a black market develops, using the “fair results” approach, the market is not fair because the poorest students cannot afford the higher black market rent. Using the “fair rules” approach, the market is not fair because the rent ceiling blocks some voluntary exchanges unless the buyers and sellers are willing to participate in the black market.

The table shows the demand and supWage rate Quantity Quantity ply schedules for student workers at (dollars per demanded supplied on-campus venues. If the college inhour) (student workers) troduces a strictly enforced minimum 10.00 600 300 10.50 500 350 wage of $11.50 an hour, who gains and 11.00 400 400 who loses from the minimum wage, 11.50 300 450 and is the campus labor market effi12.00 200 500 cient or fair? 12.50 100 550 The workers who retain their jobs and are paid the higher wage rate gain from the minimum wage. The employer, the workers who lose their job, and workers who must undertake extensive search for a job lose from the minimum wage. The minimum wage of $11.50 an hour is not efficient. There is a surplus of workers and the marginal benefit to firms exceeds the marginal cost to workers. A deadweight loss is created. The minimum wage is unfair under the “fair results” approach because some student workers lose their jobs. The minimum wage is unfair under the “fair rules” approach because it blocks voluntary exchange.

Part 2 . A CLOSER LOOK AT MARKETS

The table shows the demand and Price supply schedules for mushrooms. (dollars per pound) Suppose that the government 1.00 introduces a price support for 2.00 mushrooms and sets the support price 3.00 at $6 per pound. Who gains and who 4.00 loses? What are the quantity of mush5.00 rooms produced, the surplus, and the 6.00 deadweight loss? If the government introduces a price support of $6 per pound, production rises to 4,500 pounds per week. Mushroom producers gain from the price support. Mushroom consumers and taxpayers lose from the price support. There is a surplus of 2,000 pounds per week. Figure 7.3 can be used to calculate the deadweight loss. The deadweight loss is the area of the darkened triangle. The area of a triangle is equal to 1/2  base  height, so the deadweight loss is 1/2  (1,000 pounds)  ($4 a pound), which is $2,000.

Quantity Quantity demanded supplied (pounds per week) 5,000 2,000 4,500 2,500 4,000 3,000 3,500 3,500 3,000 4,000 2,500 4,500

Use the following news clip to work Problems 9 and 10. Venezuelans organize to overcome food shortages The government of Venezuela controls the price of food and there are shortages of milk, rice, coffee, pasta, sugar, corn flour, and cooking oil. Eggs have disappeared from store shelves. While people stand in line for milk, cheese and yogurt are abundant. People who buy milk at the low price either sell it for a profit or exchange it for food items that other families stand in line to buy. Source: www.teleSURtv.net/english, November 27, 2015 9. Are Venezuela’s price controls price floors or price ceilings? Draw a graph to illustrate the shortages of food created by the price controls. Venezuela’s price controls are price ceilings. In the face of increased demand, Venezuela’s price controls have kept the price from rising to its equilibrium. As a result the quantity demanded exceeds the quantity supplied and shortages have resulted. Figure 7.4 illustrates the situation in the market for food. In Figure 7.4 at the controled price of $5.50 per unit, the quantity of food demanded is 100 million units per week, the

Chapter 7 . Government Actions in Markets

quantity of food supplied is only 97.5 million units per week so there is a shortage of 2.5 million units per week. 10. Explain how Venezuela’s price controls have changed consumer surplus, producer surplus, total surplus, and the deadweight loss in the markets for milk and cheese. Draw a graph to illustrate your answer. Venezuela’s price controls aim to keep the price from rising to the equilibrium level so they are examples of a price ceiling. A price ceiling decreases the quantity available to the quantity supplied at the price ceiling. Figure 7.5 shows the market for cheese; the market for milk is similar. In Figure 7.5, the quantity with the price control is 97,500 kg of cheese per week. The price ceiling also increases the willingness to pay for the quantity available (to $2.25 per kg in Figure 7.5) and creates an incentive to incur search costs and trade illegally in a black market. Because the price and quantity decrease, producer surplus decreases. Since the quantity decreases and search costs are incurred, consumer surplus decreases. Because the quantity decreases and marginal benefit exceeds marginal cost, a deadweight loss arises. Figure 7.5 shows the changes in consumer surplus, producer surplus, and deadweight loss. With no price ceiling the consumer surplus is equal to area A + area B + area C. With the price ceiling consumer surplus is equal to area A. Search costs are area B + area E. The producer surplus without the price ceiling is equal to area E + area F + area G. With the price ceiling the producer surplus is equal to area G. Without the price ceiling there is no deadweight loss. With the price ceiling there is a deadweight loss equal to area C + area F and area B + area E are resources lost to search activity.

Part 2 . A CLOSER LOOK AT MARKETS

11. Read Eye on Price Regulation on p. 185 and explain why a mismatch between intention and outcome is inevitable if a price regulation seeks to block the laws of supply and demand. Price regulations have as their purpose the goal of changing the market outcome. For example, minimum wage laws raise the wage rate paid lower-skilled workers and rent controls lower the rent paid for apartments. In both instances, the law is designed to change the equilibrium price (the wage for the minimum wage and the rent for rent controls) determined by supply and demand. Because the equilibrium price is the only price at which there is neither a shortage nor a surplus, a law that changes the price automatically creates either a shortage or a surplus. In the Eye on Price Regulation, the cap on executive pay would create a shortage of executives.

Chapter 7 . Government Actions in Markets

◼ Instructor Assignable Problems and Applications 1.

Suppose that Congress caps executive pay at a level below the equilibrium. • Explain how the quantity of executives demanded, the quantity supplied, and executive pay will change, and explain why the outcome is inefficient. Because the price cap is below the equilibrium salary, the executive pay falls. The quantity of executives demanded increases and the quantity of executives supplied decreases. There is a shortage of executives. The outcome is inefficient because the marginal benefit (to firms) exceeds the marginal cost (to executives). •

Draw a graph of the market for corporate executives. On your graph, show the market equilibrium, a pay cap, the quantity of executives supplied and the quantity demanded at the pay cap, and the deadweight loss created. Also show the highest pay that an executive might be offered in a black market. Figure 7.6 shows the market for executives. In the absence of a price cap, the equilibrium salary is $600,000 a year and the equilibrium quantity of executives is 60,000. With a price cap (which is the same as a price ceiling) of $550,000, the salary falls to $550,000 per year. At this salary, the quantity of executives demanded is increases to 65,000 per year and the quantity supplied decreases to 55,000 per year. There is a shortage of 15,000 executives. The price ceiling is inefficient. The deadweight loss is the darkened triangle. If a black market develops, the figure shows that firms are willing to pay $700,000 per year to hire an executive, so executives who participate in the black market can be paid as much $700,000 per year.

Use the following information to work Problems 2 and 3. The supply of luxury boats is perfectly elastic, the demand for luxury boats is unit elastic, and with no tax on luxury boats, the price is $1 million and 240 luxury boats a week are bought. Now luxury boats are taxed at 20 percent. 2. What is the price that buyers pay? How is the tax split between the buyer and the seller? What is the government’s tax revenue? Because the supply is perfectly elastic, the buyers pay all the tax: the price rises by the full amount of the tax and buyers pay $1.2 million per boat.

Part 2 . A CLOSER LOOK AT MARKETS

Because the supply is perfectly elastic, the buyers pay all the tax and the sellers pay none of the tax. Demand is unit elastic, which means as the price rises the total revenue (total expenditure) remains constant at 240 boats x 1 million per boat = $240 million. The price rises to by 20 percent to $1.2 million because supply is perfectly elastic. So, $240 million / $1.2 million = 200 boats are produced. The tax decreases the number of boats by 40 per year. Consequently, tax revenue = 200 boats x $200,000 per boat = $40 million. 3.

On a graph, show the excess burden of this tax. Is this tax efficient? The shaded area in Figure 7.7 is the excess burden of the tax. The tax is not efficient because a deadweight loss is created.

Chapter 7 . Government Actions in Markets

Figure 7.8 shows the demand for and supply of chocolate bars. Suppose that the government levies a $1.50 tax on a chocolate bar. What is the change in the quantity of chocolate bars bought, who pays most of the tax, and what is the deadweight loss? The initial price of a chocolate bar is $3.00 per bar and the initial quantity of chocolate bars is 6 million bars per year. Figure 7.9 shows the situation after the tax is imposed. As Figure 7.9 shows, the tax shifts the supply curve upward by $1.50 to the S + tax curve. Once the tax is imposed, including the tax consumers pay $4.00 a bar. Manufacturers must send $1.50 to the government as the tax, so after the tax is imposed, the suppliers receive $2.50. The equilibrium quantity of chocolate bars is 4 million bars per year. The quantity of chocolate bars decreases by 2 million bars per year. The amount that the consumer pays rises by $1.00 and the amount that the supplier receives falls by $0.50. Hence the consumers pay most of the tax. The deadweight loss is shown in Figure 7.9 as the area of the grey triangle. The area of a triangle is 1/2  base  height. Hence the deadweight loss is equal to 1/2  2 million bars  $1.50 per bar, which is $1.5 million.

Use the following information to work Problems 5 and 6. Concerned about the political fallout from rising gas prices, suppose that the U.S. government imposes a price ceiling of $3.00 a gallon on gasoline. 5. Explain how the market for gasoline would react to this price ceiling if the oil-producing nations increased production and drove the equilibrium price of gasoline to $2.50 a gallon. Would the U.S. gasoline market be efficient? If the equilibrium price of gasoline is $2.50 a gallon, then a price ceiling of $3.00 a gallon has no effect on the market because it does not change the

Part 2 . A CLOSER LOOK AT MARKETS

equilibrium price. The market is efficient because at the equilibrium the marginal benefit equals the marginal cost. 6.

Explain how the market for gasoline would react to this price ceiling if a global shortage of oil sent the equilibrium price of gasoline to $3.50 a gallon. Would the U.S. gasoline market be efficient? If the equilibrium price of gasoline is $3.50 a gallon, then a price ceiling of $3.00 a gallon results in a shortage. The quantity of gasoline demanded at $3.00 a gallon exceeds the quantity supplied. A black market is likely to develop, in which consumers buy gasoline at prices higher than the price ceiling. In addition, a great deal of additional search activity arises as drivers look for gas stations that are open and willing to sell gasoline. The market is inefficient because the marginal benefit of a gallon of gasoline exceeds the marginal cost and so there is a deadweight loss.

Suppose the government introduced a ceiling on lawyers’ fees. How would the amount of work done by lawyers, the consumer surplus of people who hire lawyers, and the producer surplus of law firms change? Would this fee ceiling result in an efficient and fair use of resources? Why or why not? If the ceiling is set above the equilibrium fee, the ceiling has no effect on the amount of work, consumer surplus, or producer surplus. The market remains efficient. If the ceiling is set below the equilibrium fee, the quantity of work supplied decreases. There is a shortage and increased search. The consumer surplus decreases and the law firms’ producer surplus decreases. This ceiling results in an inefficient use of resources. The marginal benefit exceeds the marginal cost and a deadweight loss arises. Additionally, added resources are used as people increase their search activity to find an attorney. It also is unfair, by the “fair rules” view because it blocks voluntary exchange and by the “fair results” view unless the allocation mechanism allocates more law firm resources to poorer people, which is unlikely.

Use the following information to work Problems 8 and 9. Canada’s dairy industry is a rich, closed club If you want to be a dairy farmer, you buy a plot of land and some cows and start to sell your milk. Not in Canada. There, farmers must buy a quota to produce a set amount of milk. The situation is similar in the markets for chicken and eggs. Source: The Globe and Mail, June 25, 2015 8. Draw a graph to illustrate the Canadian market for milk. With a production quota, show the quantity of milk produced, the price, consumer surplus, producer surplus, and the deadweight loss created. Figure 7.10 (on the next page) illustrates the market for milk. In the absence of the production quota, the equilibrium price is $3.00 per gallon

Chapter 7 . Government Actions in Markets

and 3.0 million gallons are produced. With a production quota of 2.8 million gallons, the price rises to $4.00 per gallon. The producer surplus is equal to the area of the light grey shape. The consumer surplus is equal to the area of the dark grey triangle. The deadweight loss is equal to the area of the medium grey triangle. The production quota increases the producer surplus, decreases the consumer surplus, and creates a deadweight loss. 9.

In the Canadian market for milk with a production quota, explain what happens if a drought decreases supply. If a drought decreases the supply but the equilibrium quantity remains more than 2.8 million gallons of milk (the quota amount) the price does not change nor does the quantity. The producer surplus and deadweight loss both decrease; the consumer surplus, however, does not change. If a drought decreases the supply so much that the equilibrium quantity become less than 2.8 million gallons, the equilibrium quantity decreases and the equilibrium price rises. The consumer surplus decreases and the deadweight loss disappears.

Part 2 . A CLOSER LOOK AT MARKETS

◼ Multiple Choice Quiz 1.

If a tax of $1 a can is imposed on the buyers of sugary drinks, the demand for sugary drinks ______ and the price that buyers pay ______. A. doesn’t change; doesn’t change B. doesn’t change; rises by $1 a can C. decreases; rises by more than $1 a can D. decreases; rises by less than $1 a can Answer: D Figure 7.1(a) illustrates this result. 2.

A tax on candy will be paid by ______. A. only buyers if the demand for candy is inelastic B. only sellers if the supply for candy is inelastic C. buyers and sellers if the demand for candy is elastic D. only buyers if the supply of candy is elastic Answer: C While sellers pay more of the tax if demand is elastic, both buyers and sellers part of the tax. 3.

A price ceiling imposed below the equilibrium price ______. A. creates a black market in which the price might equal or exceed the equilibrium price B. creates a black market in which the price equals the price ceiling C. leads to increased search activity, which reduces the shortage of the good D. increases the demand for the good, which makes the shortage even larger Answer: A The price in black markets lies between the ceiling price and the maximum price demanders will pay for the quantity produced. 4.

A price ceiling is ______ if it is set _____ the market equilibrium price. A. efficient and fair; below B. unfair but efficient; equal to C. efficient and unfair; above D. inefficient and unfair; below Answer: D A price ceiling set below the equilibrium price creates inefficiency and is unfair by both measures of fairness.

Chapter 7 . Government Actions in Markets

A price floor influences the outcome of a market if it is ______. A. set below the equilibrium price B. set above the equilibrium price C. an incentive for buyers to increase demand for the good D. an incentive for sellers to decrease supply of the good Answer: B If the price floor is set above the equilibrium price, it makes the equilibrium price illegal. 6.

A minimum wage set above the market equilibrium wage rate ______. A. increases both employment and the quantity of labor supplied B. decreases unemployment and raises the wage rate of those employed C. raises the wage rate of those employed and increases the supply of jobs D. increases unemployment and decreases employment Answer: D By raising the wage rate above the equilibrium wage rate, a minimum wage creates unemployment and decreases employment. 7.

A support price set above the equilibrium price ______. A. creates a shortage, increases farmers’ total revenue, and is efficient B. creates a surplus, which the government buys and dumps on the rest of the world to keep the U.S. market price equal to the price support C. is inefficient because farmers’ marginal cost exceeds U.S consumers’ marginal benefit D. is efficient because farmers’ marginal cost equals U.S. consumers’ marginal benefit Answer: B Price supports set above the equilibrium price require the government to purchase the surplus to maintain the price. 8.

Choose the best statement. A. A subsidy to peanut growers lowers peanut growers’ costs, lowers the market price of peanuts, and increases the demand for peanuts. B. A price support for peanut growers is a guaranteed price for peanuts, which increases the quantity of peanuts produced. C. A price support and a subsidy to peanut growers will make the peanut market more efficient if the support price is below the market price. D. For a support price set above the equilibrium price to increase peanut growers’ incomes, they must also receive a subsidy. Answer: B By guaranteeing a higher price, a price support increases the quantity producers supply.

Global Markets in Action ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications Use Figures 8.1 and 8.2 to work Problems 1 to 4. Figure 8.1 and Figure 8.2 show the markets for shoes if there is no trade between the United States and Brazil.

Which country has a comparative advantage in producing shoes? With international trade, explain which country would export shoes and how the price of shoes in the importing country and the quantity produced by the importing country would change. Explain which country gains from this trade. Brazil has the comparative advantage in producing shoes because, with no international trade, the price in Brazil is less than the price in the Unit-

Chapter

Part 3 . A CLOSER LOOK AT MARKETS

ed States. With international trade, Brazil will export shoes to the United States. The price of a pair of shoes in the United States will fall and the quantity of shoes produced in the United States will decrease. Both countries will gain from this trade. In Brazil producers of shoes gain (consumers of shoes lose, but the gain to the producers exceeds the loss to consumers) and in the United States consumers of shoes gain (producers of shoes lose, but the gain to the consumers exceeds the loss to producers). 2.

The world price of a pair of shoes is $20. Explain how consumer surplus and producer surplus in the United States changes as a result of international trade. On the graph, show the change in U.S. consumer surplus (label it A) and the change in U.S. producer surplus (label it B). The consumer surplus of U.S. consumers increases because the price U.S. consumers pay for a pair of shoes falls. As a result of the fall in price, U.S. consumers increase the number of shoes they buy. Consumer surplus increases because the price falls and because the quantity of shoes purchased increases. The producer surplus of U.S. producers decreases because of the fall in the price of a pair of shoes. As a result of the fall in price, U.S. producers decrease the quantity of shoes they produce. Producer surplus decreases both because the price falls and because the quantity of shoes produced decreases. Figure 8.3 shows the change in consumer surplus and the change in producer surplus. The increase in consumer surplus equals the area A + B (the part of the light colored gain that lies beneath area B is not visible). The loss of producer surplus equals the dark gray area B.

The world price of shoes is $20. Explain how consumer surplus and producer surplus in Brazil change as a result of international trade. Show the change in Brazil’s consumer surplus (label it C) and the change in Brazil’s producer surplus (label it D). The consumer surplus of Brazilian consumers decreases because the price Brazilian consumers pay for a pair of shoes rises. As a result of the rise in price, Brazilian consumers decrease the number of shoes they buy. Consumer surplus decreases both because the price rises and because the quantity of shoes purchased decreases. The producer surplus of Brazilian producers increases because of the rise in the price of a pair of shoes. As a result of the rise in price, Brazilian producers increase the quantity of shoes they produce. Producer surplus increases both because the price

Chapter 8 . Global Markets in Action

rises and because the quantity of shoes produced increases. Figure 8.4 shows the change in consumer surplus and the change in producer surplus. The decrease in consumer surplus equals the dark gray area C. The increase in producer surplus equals the area C + D (the part of the light colored gain that lies beneath area C is not visible). 4.

Who in the United States loses from free trade in shoes with Brazil? Explain. In the United States the losers from the trade in shoes are U.S. shoe producers. U.S. shoe producers lose because the price of a pair of shoes falls, so producers decrease the quantity of shoes they produce. The producer surplus of U.S. shoe producers decreases.

Use the following information to work Problems 5 to 7. 5. The supply of roses in the United States is made up of U.S. grown roses and imported roses. Draw a graph to illustrate the U.S. rose market with free international trade. On your graph, mark the price of roses and the quantities of roses bought, produced, and imported into the United States. Figure 8.5 shows a graph of the rose market. In the figure, the world price of roses is $10 per dozen and this is the price in the United States. In the United States, the demand curve shows that 400,000 dozen roses are purchased and sold per month. The supply curve shows that 100,000 dozen roses per month are produced in the United States. The difference, or 300,000 dozen roses per month, is imported into the United States. 6.

Who in the United States loses from this trade in roses and would lobby for a restriction on the quantity of imported roses? If the U.S. government put a tariff on rose imports, show on your graph the U.S. consumer surplus that is redistributed to U.S. producers and also the government’s tariff revenue. U.S. producers of roses lose from the international trade in roses and so they would lobby for a tariff on imported roses. If the government puts a

Part 3 . A CLOSER LOOK AT MARKETS

$10 per dozen tariff on rises, Figure 8.6 shows the consequences. The $10 per dozen tariff equals the length of the two-headed gray arrow. The price in the United States rises to $20 per dozen. The number of roses purchased in the United States decreases to 300,000 per month and the number of roses produced in the United States increases to 200,000 per month. The quantity of roses imported falls to 100,000 per month. The government’s tariff revenue is equal to the area of dark rectangle, $10 per dozen multiplied by 100,000 dozen imported, or $1,000,000 per month. The increase in producer surplus from the tariff equals the area of the medium grey trapezoid.

Suppose that the U.S. government puts an import quota on roses. Show on your graph the consumer surplus that is redistributed to producers and importers and also the deadweight loss created by the import quota. In Figure 8.7, the import quota is equal to the length of the light grey arrow, 100,000 dozen roses per month. With the import quota in place, the supply curve becomes S1 so that the equilibrium price in the United States is $20 per dozen and equilibrium quantity becomes 300,000 dozen. The consumer surplus is redistributed to producers (the area of the light grey trapezoid) and to importers (the area of the light grey rectangle). The deadweight loss is equal to the area of the two dark grey triangles.

Use the following information to work Problems 8 to 10. U.S. steelmakers seek antidumping action Steelmakers want the United States to put restrictions on imports from five nations, alleging unfair pricing of steel for the automobile and construction industries. Source: Wall Street Journal, June 3, 2015 8. Explain who in the United States gains and who loses from restrictions

Chapter 8 . Global Markets in Action

on steel imports. How do you expect the prices of automobiles and office towers to be affected? The U.S. producers of steel will gain. If the restriction is a tariff, the U.S. government will gain because it will receive additional tariff revenue. If the restriction is an import quota, than the importers of the steel gain. U.S. consumers of steel will lose. The higher price of steel increases the costs of building automobiles and constructing office towers. The cost of producing automobiles and office towers increases, which decreases their supply and thereby raises their prices. 9.

What is dumping? Who in the United States loses from China’s dumping of steel? Dumping occurs when a foreign firm sells its exports at a lower price than the cost of production. U.S. producers of steel lose from China’s dumping of steel.

10. Explain what an antidumping tariff is. What argument might U.S. steelmakers use to get the government to raise the tariff on steel imports? Dumping is illegal under the rules of international trade, so dumping is regarded as a justifiable reason for a temporary tariff. U.S. steelmakers might argue that Chinese exporters of steel were charging a price that was less than the cost of production. A tariff could be imposed that would raise the price to the (alleged) cost of production.

Part 3 . A CLOSER LOOK AT MARKETS

11. Read Eye on Globalization on p. 203 and draw two graphs to show how U.S. consumers gain from iPads manufactured in China and why Chinese workers also gain. Figure 9.8 shows the market for iPads in the United States. As the figure illustrates, U.S. consumers gain because they pay a lower price and consequently buy more iPads. In the figure the price falls from $300 per iPad with no trade to $200 per iPad with trade. The lower price means that consumers increase the quantity of iPads they buy, in the figure from 75 million iPads per year to 100 million per year. Figure 9.9 (on the next page) shows that Chinese workers also gain. As the figure illustrates, Chinese workers gain because more iPads will be produced in China. Consequently, more workers are employed and potentially their wage rate also rises. In the figure the price rises from $100 per iPad with no trade to $200 per iPad with trade. The quantity of iPads produced in China increases from 75 million with no trade to 100 million with trade.

Chapter 8 . Global Markets in Action

◼ Instructor Assignable Problems and Applications Use the following information to work Problems 1 and 2. The future of U.S.–India relations In May 2009, Secretary of State Hillary Clinton gave a major speech covering all the issues in U.S.–India relations. On economic and trade relations she noted that India maintains significant barriers to U.S. trade. The United States also maintains barriers against Indian imports such as textiles. Mrs. Clinton, President Obama, and Anand Sharma, the Indian Minister of Commerce and Industry, say they want to dismantle these trade barriers. Source: www.state.gov 1. Explain who in the United States would gain and who might lose from dismantling trade barriers between the United States and India. Winners from increased trade are U.S. producers and Indian consumers from U.S. exports and U.S. consumers and Indian producers from Indian exports. Losers from increased trade are U.S. consumers and Indian producers from U.S. exports and U.S. producers and Indian consumers from Indian exports 2.

Draw a graph of the U.S. market for textiles and show how removing a tariff would change producer surplus, consumer surplus, and the deadweight loss from the tariff. Figure 8.10 shows the market for textiles. With the tariff the price of a unit of clothing in the United States is $20 while the world price is $10. When the tariff is removed, producers lose producer surplus equal to area A. This area is converted into consumer surplus. The deadweight loss with the tariff is equal to the sum of areas B. When the tariff is removed, the deadweight loss disappears—it becomes part of the consumer surplus. When the tariff is removed, consumer surplus increases by an amount equal to the sum of area A (which had been producer surplus with the tariff) plus both areas B (which had been the deadweight loss with the tariff) and area C (which was the amount of the tariff revenue).

Part 3 . A CLOSER LOOK AT MARKETS

The United States exports wheat. Draw a graph to illustrate the U.S. wheat market if there is free international trade in wheat. On your graph, mark the price of wheat and the quantities bought, produced, and exported by the United States. Figure 8.11 illustrates the situation. In the figure, without international trade, the price of a bushel of wheat in the United States is $2 per bushel and 20 billion bushels are grown and consumed. With international trade the price of a bushel of wheat in the United States rises to $6 per bushel. At this higher price, 10 billion bushels are consumed and 40 billion are produced. The difference between the quantity produced and the quantity consumed, which is 30 billion bushels, is exported by the United States.

Suppose that the world price of sugar is 20 cents a pound, Brazil does not trade internationally, and the equilibrium price of sugar in Brazil is 10 cents a pound. Brazil then begins to trade internationally. • How does the price of sugar in Brazil change? Do Brazilians buy more or less sugar? Do Brazilian sugar growers produce more or less sugar? With international trade, the price of sugar rises in Brazil. Brazilian consumers buy less sugar. Brazilian sugar growers produce more sugar. • Does Brazil export or import sugar and why? Brazil exports sugar. The world price of sugar is higher than the Brazilian price of sugar, so sugar will be exported from Brazil.

The United States exports services and imports coffee. Why does the United States gain from exporting services and importing coffee? How do economists measure the net gain from this international trade? The United States gains from exporting services because the United States receives a higher price for the services it produces than would otherwise be the case. For exports, producers gain increased producer surplus while consumers lose consumer surplus. But the increase in producer surplus is larger than the loss in consumer surplus. The United States gains from importing coffee because the United States pays a lower price for the cof-

Chapter 8 . Global Markets in Action

fee it consumes than would otherwise be the case. For imports, consumers gain increased consumer surplus while producers lose producer surplus. But the increase in consumer surplus is larger than the loss in producer surplus. Economists measure the net gain from international trade as the increase in the total surplus. 6.

In the 1950s, Ford and General Motors established a small car-producing industry in Australia and argued for a high tariff on car imports. The tariff has remained through the years. Until 2000, the tariff was 22.5 percent. What might have been Ford’s and General Motor’s argument for the high tariff? Is the tariff the best way to achieve the goals of the argument? Most likely the argument in favor of the tariff was the infant-industry argument. According to proponents of this argument, protection is necessary to a new industry to enable it to grow into a mature industry that can compete in world markets. Alternatively, Ford and General Motors might also have argued that a high tariff was necessary to protect Australian jobs. Protection is not the best way to achieve these goals. A more efficient way to protect infant industries is to subsidize the firms in the industry. And the jobs lost in the auto sector will be regained in other sectors devoted to exporting Australian goods.

Use Figure 8.12 and the following information to work Problems 7 to 9. Figure 8.12 shows the car market in Mexico when Mexico places no restriction on the quantity of cars imported. The world price of a car is $10,000. 7. If the government of Mexico introduces a $2,000 tariff on car imports, what will be the price of a car in Mexico, the quantity of cars produced in Mexico, the quantity imported into Mexico, and the government’s tariff revenue? If the Mexican government imposes a $2,000 per car tariff on cars imported into Mexico, the price of a car in Mexico rises from $10,000 to $12,000. At this price, 10 million cars per year will be purchased in Mexico and 6 million cars per year will be produced in Mexico. The difference, 4 million cars per year, will be imported. The Mexican government’s tariff revenue is $2,000 per car multiplied by 4 million cars imported, which is $8 billion per year. 8.

If the government of Mexico introduces an import quota of 4 million cars

Part 3 . A CLOSER LOOK AT MARKETS

a year, what will be the price of a car in Mexico, the quantity of cars produced in Mexico, and the quantity imported? If the Mexican government imposes an import quota of 4 million cars a year, the price of a car in Mexico will rise from $10,000 to $12,000. At this new, higher price, the quantity of cars demanded in Mexico is 10 million; the quantity of cars produced in Mexico is 6 million. The difference between Mexican consumption and Mexican production, 4 million, is equal to the amount of the import quota and so is imported from abroad. 9.

What argument might be used to encourage the government of Mexico to introduce a $2,000 tariff on car imports from the United States? Who will gain and who will lose as a result of Mexico’s tariff? The tariff might be imposed because the government gains revenue from the tariffs it imposes. It might also be imposed because of rent seeking, in particular, auto producers who profit from the tariff might lobby intensively to impose the tariff. They likely will suggest that the Mexican auto industry is new (an infant) and therefore needs protection until it matures and can compete with the rest of the world. They might also argue that a tariff will save (actually, gain) jobs in Mexico because of the expansion of Mexican auto production. Mexican auto producers and the Mexican government gain from the tariff. The auto producers have more producer surplus and the Mexican government gains tariff revenue. Mexican consumers lose from the tariff. The consumers have less consumer surplus with the tariff.

Chapter 8 . Global Markets in Action

◼ Multiple Choice Quiz 1.

The fundamental force driving international trade is comparative _______. A. advantage: a country exports those goods that have high prices B. abundance: the country that produces more than it needs exports the good C. advantage: the country with the lower opportunity cost of production exports the good D. cost: a country trades with other countries that produce cheaper goods Answer: C Trade according to comparative advantage maximizes the gains from trade. 2.

A country will export wheat if, with no international trade, ______. A. it produces a surplus of wheat B. its opportunity cost of producing wheat is below the world price C. its domestic price of wheat exceeds the world price D. other countries have a shortage of wheat Answer: B If the opportunity cost of producing wheat is below the world price, the country has a comparative advantage in wheat production. 3.

With free trade between the United States and Canada, the United States exports tomatoes and Canada exports maple syrup. U.S. consumers ______. A. of tomatoes gain and Canadian consumers of maple syrup lose B. of both tomatoes and maple syrup gain more than either producer C. of maple syrup gain more than U.S. producers of maple syrup lose D. of tomatoes gain more than U.S. producers of tomatoes lose Answer: C Figure 8.3 in the text shows that imports create a net gain in total surplus.

Part 3 . A CLOSER LOOK AT MARKETS

With free trade between China and the United States, the winners are ___________ and the losers are _______. A. U.S. consumers of U.S. imports; U.S. producers of the U.S. import good B. China’s consumers of China’s imports; China’s producers of its export good C. U.S. producers of the U.S. export good; U.S. consumers of U.S. imports D. China’s consumers of China’s export good; China’s producers of its imported good Answer: A Figure 8.3 in the text shows that the U.S. price of the imported good falls, so that U.S. consumers win and U.S. producers lose. 5.

The U.S. tariff on paper ____ the U.S. price of paper, _____ U.S. production of paper and _______the U.S. gains from trade. A. raises; increases; increases B. doesn’t change; increases; increases C. doesn’t change; doesn’t change; decreases D. raises; increases; decreases Answer: D Figure 8.6 in the textbook illustrates these results. 6.

If Korea imposes an import quota on U.S. oranges, losers include Korean _______ of oranges and U.S. ______ of oranges. A. consumers; consumers B. consumers; producers C. producers; consumers D. producers; producers Answer: B The import quote decreases U.S. exports of oranges to Korea, thereby harming U.S. producers, and raises the price of oranges in Korea, thereby harming Korean consumers. 7.

The people who support restricted international trade say that ______. A. protection saves jobs, in both the U.S. and foreign economies B. U.S. firms won’t be able to compete with low-wage foreign labor if trade is free C. outsourcing sends jobs abroad, which brings diversification and makes our economy more stable D. protection is needed to enable U.S. firms to produce the things at which they have a comparative advantage Answer: B This commonly encountered argument is flawed, because U.S. firms can compete when U.S. productivity is high.

Externalities: Pollution, Education, and Healthcare ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications

Chapter

Price Quantity The first table shows the demand schedule for electricity (cents per demanded from a coal-burning utility. The second table shows the utilikilowatt) (kilowatts per day) ty’s cost of producing electricity and the external cost of the 4 500 pollution created. Use this information to work Problems 1 8 400 to 3. 12 300 1. With no pollution control, calculate the quantity of elec16 200 20 100 tricity produced, the price of electricity, and the margin24 0 al external cost of the pollution generated. With no pollution control, the quantity of elecQuantity Marginal Marginal tricity produced is the amount at which the (kilowatts cost external cost quantity demanded equals the quantity supper day) (cents per kilowatt) plied as determined by the marginal private cost 0 0 0 of producing electricity. In this case, the quanti100 2 2 200 4 4 ty is 400 kilowatts per day and the price is 8¢ per 300 6 6 kilowatt. At this quantity, the marginal external 400 8 8 cost is (also) 8¢ per kilowatt. 500 10 10 2. With no pollution control, calculate the quantity of electricity produced, the marginal social cost of the electricity generated, and the deadweight loss. With no pollution control, the quantity of electricity produced is the amount at which the quantity demanded equals the quantity supplied as determined by the marginal private cost of producing electricity. In this case, the quantity is 400 kilowatts per day. At this quantity, the marginal external cost is (also) 8¢ per kilowatt so the marginal social cost is 16¢ per kilowatt. The deadweight loss equal to the area of the triangle whose height is the marginal external cost at the equilibrium quantity and whose base is the difference between the efficient quantity and the privatemarket equilibrium quantity. The efficient quantity is 300 kilowatts and at

Part 2 . A CLOSER LOOK AT MARKETS

the equilibrium quantity the marginal external cost is 8¢ per kilowatt. The difference between the efficient quantity and the equilibrium quantity is 100 kilowatts. So, the deadweight loss equals 1/2  100 kilowatts  8¢ per kilowatt, or $4.00. 3.

If the government levies a pollution tax such that the utility generates the efficient quantity of electricity, calculate the quantity of electricity generated, the price of electricity, the size of the pollution tax, and the tax revenue. The efficient quantity of electricity is the amount at which the quantity demanded (which reflects the marginal social benefit) equals the marginal social cost. The marginal social cost is the sum of the marginal cost and the marginal external cost. The efficient quantity is 300 kilowatts because at this quantity the marginal social cost, 12¢ per kilowatt, equals the price, also 12¢ per kilowatt. The pollution tax must equal the marginal external cost, 6¢ per kilowatt. The tax revenue equals 6¢ per kilowatt  300 kilowatts, which is $18.00.

Use the following information to work Problems 4 and 5. Tom and Larry must spend a day working together. Tom likes to smoke cigars and the price of a cigar is $2. Larry likes a smoke-free environment. 4. If Tom’s marginal benefit from a cigar a day is $20 and Larry’s marginal benefit from a smoke-free environment is $25 a day, what is the outcome if they meet at Tom’s home? What is the outcome if they meet at Larry’s home? Larry is willing to pay Tom up to $25 to not smoke. Tom’s net benefit from smoking is $18 (the marginal benefit minus the price of the cigar). The Coase theorem says that in this case, with Tom and Larry meeting at Tom’s home, Larry pays Tom some amount between $18 to $25 not to smoke and Tom does not smoke. If Tom and Larry meet at Larry’s house, Tom is willing to pay up to $18 to be allowed to smoke. But Larry will accept nothing less than $25 to allow Tom to smoke. Tom cannot offer enough to Larry, so Tom does not smoke. In both questions, the efficient outcome, Tom not smoking, is attained regardless of who is given the property right, that is, regardless of who owns the house in which the meeting occurs. 5.

If Tom’s marginal benefit from a cigar a day is $25 and Larry’s marginal benefit from a smoke-free environment is $20 a day, what is the outcome if they meet at Tom’s home? What is the outcome if they meet at Larry’s home? Larry is willing to pay Tom up to $20 to not smoke. Tom’s net benefit from smoking is $23 (the marginal benefit minus the price of the cigar). When Tom and Larry meet at Tom’s house, Larry cannot offer enough to Tom to make Tom quit smoking, so Tom smokes. If Tom and Larry meet

Chapter 9 . Externalities: Pollution, Education, and Health Care

at Larry’s house, Tom is willing to pay up to $23 to be allowed to smoke. And Larry will accept anything more than $20 to allow Tom to smoke. So, Tom can offer Larry some amount between $20 and $23 and Tom smokes. As in Exercise 4, the efficient outcome (in this case, Tom smoking) is attained regardless of who is given the property right, that is, regardless of who owns the house in which the meeting occurs. Use the table and the following information to work Problems 6 to 8. The marginal cost of educating a college student is $5,000 a year. The table shows the marginal benefit schedule from a college education. The marginal external benefit from a college education is a constant at $2,000 per student per year. There are no public colleges. 6. With no government involvement in college education, how many students enroll, what is the tuition, and what is the deadweight loss created? Figure 9.1 illustrates the market for college education.

Students (millions per year) 1 2 3 4 5 6 7 8

Marginal private benefit (dollars per student per year) 5,000 3,000 2,000 1,500 1,200 1,000 800 500

With no public college and no government involvement, 1 million students enroll in college and the tuition is $5,000 a year. The efficient number of students is 2 million because this is the quantity that sets the marginal social benefit equal to the marginal cost. The deadweight loss is the grey area in Figure 9.1 and equals the area of a triangle with a height equal to the marginal external benefit at the unregulated equilibrium and a length equal to the difference between the efficient quantity and the equilibrium quantity. In this case the deadweight loss equals ½  $2,000 per student  1 million students, which is $1 billion. 7.

If the government subsidizes colleges and sets the subsidy so that the efficient number of students enroll, what is the subsidy per student, how many students enroll, and what is the cost to taxpayers? The efficient number of students is 2 million. The required subsidy is $2,000 a student, which leads to 2 million students enrolling. The cost to the taxpayers is $2,000 per student  2 million students, which is $4 billion

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If the government offers vouchers to students, what is the value of the voucher that will encourage the efficient number of students to enroll? If the government offers a $2,000 voucher, which is equal to the marginal external benefit, the efficient number of students, 2 million, enrolls.

Two Philadelphia highways waste a million hours A study of highway use says that on two short stretches of expressway in Philadelphia, delays of 1 million hours a year cost $22 million in lost time and waste 375,700 gallons of fuel. Source: Bob McGovern, PhillyVoice, November 23, 2015 What is the externality described in the news clip? How could road tolls and high parking levies reduce congestion on Philadelphia roads? If road tolls and parking charges cut commute times, would the Philadelphia road system be more efficient? Explain your answers. Driving on the expressway imposes an external cost on other drivers because each additional car slows all the other cars. Creating a toll road or imposing parking levies will make the drivers face the external cost they create by increasing the cost to each individual driver of driving on the expressway. The higher cost will decrease the number of drivers, thereby increasing the efficiency of Philadelphia road system by reducing the congestion.

10. Read Eye on Climate Change on p. 236-237 and then describe the government actions that could decrease carbon emissions. Explain why the government is not using them more aggressively. Governments could decrease carbon emissions by imposing carbon taxes, using a cap-and-trade policy, or by subsidizing green alternatives. A carbon tax increases the cost of carbon emitting activities, and decreases the amount of these activities. A cap-and-trade policy decreases carbon emissions because it sets a limit on the quantity of greenhouse gases that can be emitted. Governments have not moved aggressively to impose these policies. First, developing nations want to use low-cost energy, such as coal, to grow their economies. Second, it is hard to get agreement on the policies. Third, the costs of limiting the emissions are incurred now but the benefits, if any, would come sometime in the future. And, fourth, technology is lowering the cost of cleaner energy so there is the temptation to rely on further technological advances.

Chapter 9 . Externalities: Pollution, Education, and Health Care

◼ Instructor Assignable Problems and Applications 1.

The price of gasoline in Europe is about three times that in the United States, mainly because the European gas tax is higher than the U.S. gas tax. How would an increase in the gas tax in the United States to the European level change carbon emissions? Would this tax increase bring greater efficiency or would it increase deadweight loss? Burning gasoline while driving creates carbon emissions. The increase in the gas tax increases the cost of driving, which leads to less driving. Consequently, raising the gasoline tax leads to less carbon emissions. The case for raising the gasoline tax asserts that the carbon emissions from driving contribute to global warming. These emissions are an external cost, so the marginal social cost of the carbon emissions from driving exceeds the marginal social benefit. The efficient amount of driving automobiles is the amount such that the marginal (social) benefit equals the marginal social cost. Increasing the tax makes the marginal private cost closer to (or, in an ideal world, equal to) the marginal social cost and decreases (potentially eliminates) the deadweight loss.

The warming Arctic affects us all Arctic temperatures are rising twice as fast as the global average and receding sea ice threatens polar bears, walruses, and seals that exist nowhere else on earth and face an increased risk of extinction. Source: Truthout, December 4, 2015 What is the externality described in the news clip? How could property rights influence the amount of damage done to the Arctic Sea and its wildlife? The externality described in the news clip is the potential extinction of polar bears, walruses, and seals. If property rights to these animals were given to individuals and were enforced, their owners would have the incentive to ensure that the animals were not driven to extinction, perhaps by transporting their animals to areas with conditions more in keeping with what they need. Use the following information to work Problems 3 and 4. City ponders ban on plastic bags Most plastic shopping bags end up in the landfill or as litter. Tacoma city officials are considering banning them or allowing them for a fee of 5 or 10 cents. Source: Tacoma Weekly, December 8, 2015 3. Explain how a Tacoma charge will change the use of plastic bags and how the deadweight loss created by plastic bags will change. The charge increases the marginal cost of using plastic bags so the quantity of plastic bags used will decrease. Figure 9.2 illustrates the market for

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plastic bags. In the absence of any government intervention, the unregulated market equilibrium quantity of plastic bags is 300,000 per week. Because use of plastic bags creates pollution, the equilibrium quantity exceeds the efficient quantity, which in the figure is 200,000 per week. Hence a deadweight loss—equal to the area of the grey triangle in the figure—is created. A tax of 10¢ a bag shifts the supply (and marginal private cost, S = MC) curve so that it becomes the same as the marginal social cost curve, MSC. The deadweight loss is eliminated because the tax decreases the production of plastic bags to 200,000 per week, the efficient quantity. Explain why a Tacoma ban on plastic bags would be inefficient. As Figure 9.2 illustrates, there is a marginal social benefit from use of plastic bags. If plastic bags were banned, the quantity of plastic bags would equal 0, which is less than the efficient quantity (200,000 per week in the figure). Because the quantity differs from the efficient quantity, there is a deadweight loss since the marginal social benefit exceeds the marginal social cost.

Use the following information to work Problems 5 to 7. The marginal cost of educating a college student online Marginal is $3,000 a year. The table shows the marginal private Students private benefit (millions (dollars per benefit schedule from a college education. The marginal per year) student per year) external benefit is 50 percent of the marginal private 1 6,000 benefit. 2 5,000 5. With no government involvement in college educa3 4,000 tion, how many students enroll and what is the tui4 3,000 tion? Calculate the deadweight loss created. 5 2,000 6 1,000 With no government involvement, 4 million students enroll in college and the tuition is $3,000 a year. The efficient number of students is 5 million because this is the quantity that sets the marginal social benefit equal to the marginal cost. The deadweight loss equals the area of a triangle with a height equal to the marginal external benefit at the unregulated equilibrium and a length equal to the difference between the efficient quantity and the equilibrium quantity. In this case the deadweight loss equals ½  $1,500 per student  1 million students, which is $750 million.

Chapter 9 . Externalities: Pollution, Education, and Health Care

If the government subsidizes colleges so that the efficient number of students will enroll, what is the cost to taxpayers? The efficient number of students is 5 million. The required subsidy is $1,000 a student, which leads to 5 million students enrolling. Therefore, the cost to taxpayers is $1,000 per student  5 million students, which is $5 billion

If the government offers vouchers to students and values them so that the efficient number of students will enroll, what is the value of the voucher? If the government offers a $1,000 voucher, which is equal to the marginal external benefit, the efficient number of students, 5 million, enrolls.

Worse than useless Europe’s Emissions Trading Scheme (ETS) has too many carbon emission permits trading at too low a price. Source: The Economist, January 25, 2014 Explain the conditions under which the ETS, a cap-and-trade system, would reduce the amount of carbon emissions to the efficient quantity. Use a graph of the European market for electricity to illustrate your explanation. On your graph, show the effects of having too many emission permits. A cap-and-trade system can reduce the amount of carbon emissions to the efficient quantity if (1) the government can correctly determine the efficient quantity, and (2) then issues the correct of number of emission permits to reach the efficient quantity. In this case, the price of a permit is equal to the marginal external cost. Figure 9.3 illustrates the situation in the European market for electricity. In the absence of any government action, the quantity of electricity, 400 megawatts per week, is determined by supply curve (labeled S = MC) and demand curve (labeled D = MB). The efficient quantity, 200 megawatts, is determined by the marginal social cost curve (labeled MSC) and the marginal benefit curve (labeled D = MB). To achieve the efficient quantity, the price of a permit must be 15¢, the difference between the marginal social cost of 20¢ at the efficient quantity and the private cost marginal cost, 5¢ at the efficient quantity. The European governments, however, have issued too many emission permits, so their price is only 7.5¢. The supply curve after taking account of the cost of the

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permits is labeled S + Permit Cost. At each quantity, this curve lies above the supply curve by 7.5¢. Consequently, the equilibrium quantity of electricity 300 megawatts is determined by the supply curve with the permit cost, S + Permit Cost, and the demand curve, D = MB. The equilibrium quantity exceeds the efficient quantity. 9.

Carbon tax debate heats up in Montpelier, VT Vermonters are debating the pros and cons of a state carbon tax—a new tax on gasoline, heating oil, and other fossil fuels sold in the state. Backers say the tax revenue would be used to cut other taxes and increase energy efficiency. Source: Watchdog.org, December 3, 2015 Draw a graph of the market for gasoline in Vermont to show the effects of a state carbon tax. Figure 9.4 shows the market for gasoline. There is an external cost because the marginal social cost, MSC, is greater than the marginal private cost, MC. The equilibrium quantity with no intervention is 300,000 gallons per day but the efficient quantity is 200,000 gallons. There is a deadweight loss, equal to the area of the grey triangle. A carbon tax of $1.00 per gallon shifts the supply and marginal cost curve so it becomes the same as the marginal social cost curve. In this case the equilibrium quantity is the same as the efficient quantity so there is no deadweight loss.

Chapter 9 . Externalities: Pollution, Education, and Health Care

◼ Multiple Choice Quiz 1.

Electricity has a negative production externality because _____. A. its marginal benefit decreases as more of it is consumed B. the marginal private cost of producing it increases as more of it is produced C. the marginal social cost of producing it exceeds the marginal private cost of producing it D. a marginal external cost lowers the marginal benefit from consuming it Answer: C MSC = MC + marginal external cost, so with an external cost present, MSC > MC. 2.

A steelmaking plant pollutes the air and water so __________ . A. the marginal social cost of producing steel exceeds the marginal private cost by the amount of the marginal external cost B. the marginal social cost of producing steel is less than the marginal private cost by the amount of the marginal external cost C. the marginal private cost of producing steel equals the marginal external cost plus the marginal social cost D. the marginal private cost of producing steel minus the marginal social cost equals the marginal external cost Answer: A MSC = MC + marginal external cost, so MSC − MC = marginal external cost. 3.

An unregulated paint factory that pollutes a river results in ______ and _____ . A. overproduction; a price that exceeds the marginal benefit from the good B. underproduction; a price that equals the marginal benefit from the good C. the efficient quantity produced; a marginal benefit equal to the marginal social cost D. an inefficient quantity produced; a marginal benefit below the marginal social cost Answer: D Figure 9.2 in the textbook shows that answer D is correct.

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Steel production creates pollution. If a tax is imposed on steel production equal to the marginal external cost of the pollution it creates, ______. A. steel producers will cut pollution to zero B. the deadweight loss created by steel producers will be cut to zero C. the market price of steel will rise by the amount of the tax D. steel producers will continue to produce the inefficient quantity of steel Answer: B This tax makes the producers’ marginal cost equal to the marginal social cost and eliminates the deadweight loss. 5.

A good or service with a positive externality is one which ______. A. everyone wants to have access to B. is produced in the social interest C. the marginal social benefit exceeds the marginal private benefit D. the marginal external benefit exceeds the marginal private benefit Answer: C The definition of marginal social benefit shows that answer C is correct. 6.

Because education generates a positive externality, ______. A. everyone who wants a college education should get one B. graduates’ marginal benefit exceeds the society’s value of the education C. the quantity of education undertaken will achieve the social interest if it is free D. subsidies to colleges or vouchers to students are means of achieving the efficient number of graduates Answer: D Figures 9.9 and 9.10 show how subsidies and vouchers increase the number of students to be equal to the efficient number.

Chapter

Production and Cost

ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications 1.

Joe runs a shoe shine stand at the airport. Joe has no skills, no job experience, and no alternative job. Entrepreneurs in the shoe shine business earn $10,000 a year. Joe pays the rent of $2,000 a year, and his total revenue is $15,000 a year. He borrowed $1,000 at 20 percent a year to buy equipment. At the end of one year, Joe was offered $500 for his business and all its equipment. Calculate Joe’s annual explicit costs, implicit costs, and economic profit. Joe’s explicit costs are the $2,000 rent and $200 in interest (the amount of interest equals the loan, $2,000, multiplied by the interest rate, 0.10), so the total explicit costs are $2,200. Joe’s implicit costs are $10,000 of normal profit and $500 depreciation for his capital equipment, the chair, polishes, and brushes. Joe’s total implicit costs are $10,500. Joe’s economic profit equals his total revenue minus his total opportunity costs. Joe’s total revenue is $15,000. His total opportunity costs are the sum of his explicit costs, $2,200, and his implicit costs, $10,500. Joe’s total opLabor Total product portunity costs are $12,700 so his economic profit is $15,000 (workers (body boards minus $12,700, or $2,300. per day) per day) Len’s body board factory rents equipment for shaping 0 0 boards and hires students. The table sets out Len’s total 1 20 product schedule. Construct Len’s marginal product and average product schedules. Over what range of workers do marginal returns increase? The table on the next page has Len’s total product, marginal product, and average product schedules. As the table there shows, marginal returns increase for the 1st and 2nd work

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ers. After the second worker is hired, marginal returns decrease.

Labor 0

Total product 0

Average product xx

Use the following information to work Problems 3 to 6. Len’s body board factory pays $60 a day for equipment and $200 a day to each student it hires. The table sets out Len’s total product schedule. 3. Construct Len’s total variable cost and total cost schedules. What does the difference between total cost and total variable cost at each output equal? The variable costs are the costs of labor; the fixed costs are the costs of the equipment. The total cost schedules per day are in the second table to right. Total cost equals the total variable cost plus the total fixed cost so the difference between total variable cost and total cost is total fixed cost. This difference, $60 for this problem, is the same at each level of output. 4.

Marginal product 20 24 16 12

Labor Total product (workers (body boards per day) per day) 0 0 1

Total Total Total Total product fixed cost variable cost cost Labor (body boards) (dollars) (dollars) (dollars) 0 0 60 0 60 1 20 60 200 260 2 44 60 400 460 3 60 60 600 660 4 72 60 800 860

Construct the average fixed cost, average variable cost, and average total cost schedules and the marginal cost schedule. Labor 0

Total Average Average varproduct fixed cost iable cost (body boards) (dollars) (dollars) 0 xx xx

Average total cost (dollars) xx

3.00

10.00

13.00

1.36

9.09

10.45

1.00

10.00

11.00

.83

11.11

11.94

Marginal cost (dollars) 10.00 8.33 12.50 16.67

Chapter 10 . Production and Cost

The average cost schedules and marginal cost schedule are in the table above. 5.

At what output is Len’s average total cost at a minimum? At what output is Len’s average variable cost at a minimum? For the output levels given in the table, Len’s average total cost is at a minimum at 44 body boards a day and Len’s average variable cost is at a minimum at 44 body boards a day. If more production levels were given, though, the average variable cost would occur at a lower level of output than would the average total cost.

Explain why the output at which average variable cost is at a minimum is smaller than the output at which average total cost is at a minimum. Though the output at which the minimum average total cost and average variable cost occur is the same in the table, we know that the average variable cost equals its minimum at a lower level of output than the average total cost. The average total cost equals the average variable cost plus the average fixed cost. The average fixed cost constantly falls as output increases. So, as output increases after the average variable cost reaches a minimum and starts to rise, the average total cost continues to fall for a while because the average fixed cost falls and this fall dominates the rise in the average variable cost. Eventually the rise in the average variable cost is greater than the fall in the average fixed cost and at that level of output, the average total cost begins to rise as output increases.

The table shows the costs incurred at Pete’s peanut farm. Complete the table.

L 0

TP 0

TVC 0

TC 100

AFC

AVC

ATC

105

140

L 0

TP 0

TVC 0

TC 100

AFC xx

AVC xx

ATC xx

135

10.00

3.50

13.50

170

4.17

2.91

7.08

105

205

2.63

2.76

5.39

140

240

2.27

3.18

5.45

The completed table is above. Recall that when output (total product) equals zero, then the total cost (TC) equals the total fixed cost.

13.50 2.50 2.50 5.83

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Gap to close 175 stores in North America Gap announced that it will close 175 (nearly 26 percent) of its North American stores. It will terminate an unknown number of workers and cut 250 headquarters jobs. Source: The Washington Post, June 15, 2015 Thinking of a Gap store as a unit of capital, explain why Gap is reducing the number of stores and workers. Is Gap making a long-run decision or a short-run decision? Is Gap taking advantage of economies of scale? Gap believes that its capital stock (the number of its stores) is too large and that it is operating where it has diseconomies of scale. By reducing the size of its capital stock (its stores) Gap will move to a new (short run) average total cost curve and decrease its average cost. Gap’s decision is a long-run decision because it involves the amount of the firm’s capital. Economies of scale are features of a firm's technology that make average total cost decrease as output increases. Gap’s goal is to move onto its long-run average cost curve and produce less output. At its initial number of stores, Gap’s capital was too large and Gap was incurring diseconomies of scale. When Gap decreases its capital, Gap is not taking advantage of economies of scale but is instead avoiding diseconomies of scale.

Read Eye on Retailers’ Costs on p. 273 and draw a graph to show how the retailers’ cost curves would change if they introduced cost-saving selfcheckouts. The substitution of capital—self-serve checkouts—for labor—clerks—increases 711’s and Wal-Mart’s average total costs at low levels of output. The substitution, however, decreases these costs at higher levels of output. These changes are illustrated in Figure 10.1. The initial average total cost curves for 7-11 and Wal-Mart are in grey; the curves after the substitution has been made are in black.

Chapter 10 . Production and Cost

◼ Instructor Assignable Problems and Applications 1.

If the ATC curves of a Walmart store and a 7–Eleven store are like those in Eye on Retailers’ Costs on p. 273, and if each type of store operates at its minimum ATC, which store has the lower total cost? How can you be sure? Which has the lower marginal cost? How can you be sure? Sketch each firm’s marginal cost curve. The total cost equals ATC × q. For Walmart, the total cost equals $1.00 × 30,000 = $30,000 and for 7-11 the total cost equals $2.00 × 5,000 = $10,000. The MC equals the ATC at the minimum ATC. Because each store is operating at its minimum ATC, Wal-Mart’s MC is $1.00 per customer and 7-11’s MC is $2.00 per customer. Figure 10.2 shows the marginal cost curves. Sonya used to earn $25,000 a year selling real estate, but she now sells greeting cards. The return to entrepreneurship in the greeting cards industry is $14,000 a year. Over the year, Sonya bought $10,000 worth of cards from manufacturers and sold them for $58,000. Sonya rents a shop for $5,000 a year and spends $1,000 on utilities and office expenses. Sonya owns a cash register, which she bought for $2,000 with funds from her savings account. Her bank pays 3 percent a year on savings accounts. At the end of the year, Sonya was offered $1,600 for her cash register. Calculate Sonya’s explicit costs, implicit costs, and economic profit. Sonya’s explicit costs are $10,000 for cards, $5,000 for rent, and $1,000 for utilities. So, Sonya’s explicit costs are $16,000. Sonya’s implicit costs are $25,000 in forgone income as a real estate agent, $14,000 normal profit, $60 in forgone interest, and $400 in economic depreciation on the cash register, for a total of $39,460. Sonya’s economic profit equals her total revenue, $58,000, minus her total opportunity costs or $55,460, which is the sum of her explicit and implicit costs. Sonya’s economic profit is $58,000 − $55,460, which equals $2,540.

Use the following information to work Problems 3 to 5. Yolanda runs a bullfrog farm. When she employs 1 person, she produces 1,000 bullfrogs a week. When she hires a second worker, her total product doubles. Her total product doubles again when she hires a third worker. When she hires a fourth worker, her total product increases but by only 1,000

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bullfrogs. Yolanda pays $1,000 a week for equipment and $500 a week to each worker she hires. 3. Construct Yolanda’s marginal product and average product schedules. Over what range of workers does Yolanda’s experience increasing marginal returns? The marginal product and average Total Average product schedules are in the table to Labor product product 0 0 xx the right. Marginal returns increase for rd the 3 worker. 1 1,000 1,000

2,000

1,000

4,000

1,333

5,000

1,250

Marginal product 1,000 1,000 2,000 1,000

Construct Yolanda’s total variable cost and total cost schedules. Calculate Yolanda’s total fixed cost. The variable costs are the Total Total costs of labor; the fixed Labor Output fixed cost variable cost costs are the costs of the 0 0 1,000 0 equipment. The total cost 1 1,000 1,000 500 2 2,000 1,000 1,000 schedules are in the table 3 4,000 1,000 1,500 to right. Total fixed cost 4 5,000 1,000 2,000 always equals $1,000. At what output is Yolanda’s average total cost at a minimum? Though not necessary to Average Average answer the question, the Labor Output fixed cost variable cost table to the right has the 0 0 xx xx 1 1,000 1.00 .50 average cost schedules. 2 2,000 .50 .50 From the numbers in the 3 4,000 .25 .38 average cost table, 4 5,000 .20 .40 Yolanda’s average total cost is at a minimum when she produces 5,000 bullfrogs a week. The table shows some of the costs incurred at Bill’s Bakery. Calculate the values of A, B, C, D, and E. Show your work. A = $1,050. Calculate A using TVC = TC − TFC. Total cost is given in the row. For total fixed

L 1

TP 100

TVC 350

TC 850

AFC C

AVC 3.50

ATC D

240

700

2.08

2.92

5.00

380

1,550

1.32

2.76

4.08

440

1,400

1,900

1.14

3.18

4.32

470

1,750

2,250

1.06

3.72

4.79

Total cost 1,000 1,500 2,000 2,500 3,000

Average total cost xx 1.50 1.00 .63 .60

MC 2.50 E 5.83 11.67

Chapter 10 . Production and Cost

cost, TFC, note that TFC = TC − TVC. Use the information in the top row to get TFC = $500. So, A = $1,550 − $500, which equals $1,050. B = $1,200. Calculate B by adding TVC + TFC, with TFC from the previous answer as $500. Then B = $700 + $500, which equals $1,200. C = $5. Calculate C by calculating TFC  TP, which is $500  100 = $5. D = $8.50. Calculate D by calculating TC  TP, which is $850  100= $8.50. E = $2.50. Calculate E as the change in TC divided by the change in TP, which is ($1,550 − $1,200)  (380 − 240) = $2.50. 7.

Solar and wind got so cheap, so fast Solar panels and wind turbines are more efficient than they used to be and they cost less to produce. Source: The Atlantic, December 2, 2015 Explain how the facts reported in the news clip affect the short-run and long-run average total cost of producing electricity. How do the facts affect the marginal cost of producing electricity? When producing electricity, solar panels and wind turbines are fixed factors of production in the short run so their cost is a fixed cost in the short run. The news clip said that solar panels and winds turbines cost less to produce, so the average fixed cost of using them to produce electricity has fallen. The short-run average total cost is the sum of the average fixed cost and average variable cost, so the fall in the average fixed cost lowers the short-run average total cost. The long-run average total cost is the lowest average total cost when the firm has enough time to change all its inputs. Because the average total cost has decreased, the long-run average total cost also decreases. Marginal cost is the change in total cost that results from a one-unit change in output. Prior to the efficient gain of solar panels and wind turbines, the marginal cost of producing electricity was almost zero. The increase in efficiency probably means that the marginal cost of producing electricity using solar panels and wind turbines has decreased.

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◼ Multiple Choice Quiz 1.

A firm’s cost of production equals ________. A. all the costs paid with money, called explicit costs B. the implicit costs of using all the firm’s own resources C. all explicit costs and implicit costs, excluding normal profit D. the costs of all resources used by the firm whether bought in the marketplace or owned by the firm Answer: D A firm’s costs include the opportunity costs of all the resources it uses. 2.

The average product of labor increases as output increases if _______. A. marginal product exceeds average product B. average product exceeds marginal product C. total product increases D. marginal product increases Answer: A The relationship between average and marginal product implies that the average product of labor increases when the marginal product of labor exceeds the average product of labor. 3.

Marginal returns start to decrease when more and more workers _______. A. have to share the same equipment and workspace B. produce less and less output C. require jobs to be too specialized D. produce less and less average product Answer: A With no more equipment or workspace, eventually as additional workers are employed, less additional output is produced. 4.

Average variable cost is at a minimum when ______. A. marginal cost equals average variable cost B. average total cost is at a minimum C. marginal cost exceeds average fixed cost D. average total cost exceeds average variable cost Answer: A Figure 10.6 in the textbook shows that A is the correct answer.

Chapter 10 . Production and Cost

An increase in the rent that a firm pays for its factory does not increase ______. A. total cost B. fixed cost C. marginal cost D. average fixed cost Answer: C Rent is a fixed cost, so an increase in the rent increases fixed cost, total cost, and average fixed cost. But it does not change the marginal cost because fixed costs have no influence on the marginal cost. 6.

An increase in the wage rate ______. A. shifts the average total cost curve and the marginal cost curve upward B. shifts the average fixed cost and average variable cost curve upward C. increases average variable cost but does not change marginal cost D. does not change average variable cost but increases average total cost Answer: A Wages are a variable cost, so an increase in the wage rate increases the average total cost and the marginal cost. 7.

When average variable cost is at its minimum level, marginal product _________. A. equals average product B. exceeds average product C. is less than average product D. is at its maximum level Answer: D Figure 10.7 in the textbook shows that D is the correct answer. 8.

In the long run, with an increase in the plant size, _____ . A. the short-run average total cost curve shifts downward B. the long-run average cost curve slopes downward C. the short-run average total cost curve shifts downward if economies of scale exist D. the average total cost of production rises Answer: C The fall in the short-run average total cost means that the long-run average total cost decrease, which is the case when there are economies of scale.

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Perfect Competition ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications 1.

In what type of market is each good or service in the following list sold? Explain your answers. • Wheat Wheat is sold in a perfectly competitive market because there are many producers, an identical product, and no barriers to entry or exit. • Jeans Jeans are sold in a monopolistically competitive market. There are many firms, no barriers to entry, and each firm produces a similar but slightly different type of jean. • Printer cartridges The printer cartridge market is likely an oligopoly. There are four major firms: Hewlett Packard, Cannon, Epson, and Lexmark. • Toothpaste The toothpaste market is monopolistically competitive with a large number of similar but not identical brands. • Gym membership in a town with one gym The membership is provided by a monopoly because there is only one firm in the market. 2. Explain why in a perfectly competitive market, the firm is a price taker. Why can’t the firm choose the price at which it sells its good? The firm cannot choose its price because it produces only a small portion of the entire market output and its good has perfect substitutes. If the firm increases its production, it has no impact on the market price. If the firm raises the price of its good above the market price, no one buys from it, switching instead to cheaper, perfect substitutes. And, if the firm lowers its price below the market price, the firm does not maximize its profit because it does not pick up any sales beyond what it could have gained

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even if it did not lower its price. The firm’s horizontal demand curve shows it can sell as much output as it wants at the market price. The table to the right shows the demand schedule for Lin’s Fortune Cookies. Calculate Lin’s marginal revenue for each quantity demanded. Compare Lin’s marginal revenue and price. In what type of market does Lin’s Fortune Cookies operate? Lin’s marginal revenue equals the price, $50 a batch. Lin’s Fortunate Cookies operates in a perfectly competitive market because Lin can sell all the fortune cookies he produces at a price of $50 a batch.

Price Quantity (dollars per demanded batch) (batches per day) 50 0 50 1 50 2 50 3 50 4 50 5 50 6

The first table to the right shows the demand schedule for Lin’s Fortune Cookies. The second table to the right shows some cost data for Lin’s. Use this information to work Problems 4 to 7. (Hint: Make a sketch of Lin’s short-run cost curves.) 4. At a market price of $50 a batch, what quantity does Lin’s produce and what is the firm’s economic profit in the short run? For reference, Lin’s cost curves are in Figure 11.2 (on the

Price Quantity (dollars per demanded batch) (batches per day) 50 0 50 1 50 2 50 3 50 4 50 5 50 6

next page). Lin produces the quantity at which marginal revenue equals marginal cost. The marginal revenue is $50.00 a batch of cookies. So, Lin produces 6.0 batches a day. Lin’s firm makes zero economic profit. 5.

Quantity (batches per day) 1

AFC

AVC ATC (dollars per batch)

84.0

51.00

135

42.0

44.00

28.0

39.00

At a market price of $35.20 a batch, 4 21.0 36.00 57 what quantity does Lin’s produce 5 16.8 35.20 52 and what is the firm’s economic profit in the short run? 6 14.0 36.00 50 Lin produces the quantity at which 7 12.0 39.00 51 marginal revenue equals marginal cost. The marginal revenue is 8 10.5 44.50 55 $35.20 a batch of cookies. So Lin produces 5 or 0 batches a day. Lin’s average total cost is $52, so Lin incurs an economic loss of $16.80 per batch of cookies, which means she incurs a total economic loss of $84.00.

37 29 27 32 40 57 83

Chapter 11 . Perfect Competition

Create Lin’s short-run supply schedule and make a graph of Lin’s shortrun supply curve. Explain why only part of Lin’s short-run supply curve is the same as its marginal cost curve. At a price of $35.20 a batch of cookies, Lin’s produces 5.0 batches; at a price of $40 a batch of cookies, Lin’s produces 5.5 batches; at a price of $57 a batch of cookies, Lin’s produces 6.5 batches; and, at a price of $83 a batch, Lin’s produces 7.5 batches. At any price less than $35.20 a batch, Lin’s produces no cookies because her minimum average variable cost is $35.20. Figure 11.1 shows Lin’s supply curve. Lin’s supply curve is the part of the marginal cost curve that is above minimum average variable cost. At prices below minimum average variable cost, Lin’s produces no cookies. For prices less than minimum average variable cost, $35.20 a batch, Lin’s incurs a smaller economic loss by shutting down and producing nothing than by remaining open. So, at these low prices, the firm’s supply curve runs along the vertical axis and the firm produces zero cookies.

At a market price of $83 a batch, what quantity does Lin’s produce and what is the firm’s economic profit in the short run? Do firms enter or exit the market and what is Lin’s economic profit in the long run? Lin produces the quantity at which marginal revenue equals marginal cost. The marginal revenue is $83 a batch of cookies. As Figure 11.2 shows, at this price Lin produces 7.5 batches a day. Lin makes an economic profit of $225. Firms enter the market. In the long run, Lin’s makes zero economic profit.

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Use the following information to work Problems 8 to 10. Quebec losing hold over maple syrup industry to U.S. competition The Federation of Quebec Maple Syrup Producers tries to limit production and stockpiles a “strategic reserve” to keep the price of syrup high. But Quebec producers are feeling increased competition from Vermont, New York, and Maine, where market share has increased and is expected to increase further in 2017 and 2018. Source: The Globe and Mail, April 6, 2015 8. Draw a graph to describe the maple syrup market and the cost and revenue of one maple syrup producer in 2016, assuming that all producers are making a positive economic profit because of the actions of the Federation of Quebec Maple Syrup Producers.

Figure 11.3 shows the market for maple syrup. The demand curve in 2016 is D0 and the initial supply curve is S0. The equilibrium price is $35 a gallon and the equilibrium (market) quantity is 4 million gallons of maple syrup a year. Figure 11.4 shows the situation for an individual producer. The firm’s marginal revenue curve is MR and the firm produces 5,000 gallons of maple syrup a year. The firm makes an economic profit, equal to the area of the grey rectangle in Figure 11.4 or $25,000, because the price of $35 per gallon exceeds the average total cost of $30 per gallon.

Chapter 11 . Perfect Competition

Starting with the industry making a positive economic profit, explain how the maple syrup market and the profit of an individual producer will change in the long run. Because the firms are making an economic profit, new maple syrup producers will enter the market. As the new producers enter, the supply of maple syrup increases, which drives the price lower. As the price falls, the economic profit decreases. Eventually enough new firms enter so that the price is so low that firms no longer make an economic profit. At that point entry ceases. Compared to the initial price and quantity, in the long-run the price is lower and the market quantity is greater.

10. If the demand for maple syrup increases, what will happen to price, quantity, and the economic profit of a producer in the short run and in the long run? The increase in demand raises the market price of maple syrup and increases the (market) quantity. The rise in price increases an individual producer’s marginal revenue (so that the producer’s MR curve shifts upward). In response to the higher marginal revenue, the producer increases the quantity of maple syrup produced. Because the price rises, the price exceeds the average total cost so the producer makes an economic profit in the short run. 11. Read Eye on Record Stores on pp. 298-299 and explain how Internet retailing of recorded music changed the constraints faced by small traditional record stores. Why did many record stores exit rather than shut down temporarily? The rise of Internet retailing drastically changed the market faced by small traditional record stores. Amazon entered the market for recorded music using a new technology, Internet marketing, which had much lower costs than the older, traditional format. Amazon made an economic profit and accordingly other firms entered the online music industry. The entry of the new firms increased the supply of pre-recorded music, so the market price of music fell. The small, traditional stores are price takers; the price is a constraint that they cannot change. As the price fell, it dropped below the traditional record stores’ minimum average variable cost. The stores’ owners realized that the price was never going to rise (and likely might drop still more!). Consequently, the owners understood that whenever their store was open, it would incur an economic loss. Faced with the prospect of permanent economic losses, the owners permanently exited the business rather than temporarily closing down.

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◼ Instructor Assignable Problems and Applications 1.

Why did Amazon enter the market for recorded music and why did independent record stores exit? Amazon entered because the entrepreneurs running Amazon realized that with their new, low-cost Internet technology, they could make an economic profit by selling recorded music. The entry of Amazon into the market lowered the price of recorded music. The independent record stores, using the old retail-store technology had higher average costs than did Amazon. The fall in the price of recorded music inflicted an economic loss on the traditional firms and so they exited the market.

How does competition among online music retailers influence economic profit? Competition among online music retailers lowers the price of recorded music. The fall in the price decreases the firms’ economic profit. Ultimately the price falls enough so that the firms make zero economic profit.

In what type of market is each of the following goods and services sold? Explain your answers. • Breakfast cereals The breakfast cereal market is an oligopoly because it is dominated by 4 large firms: Kellogg’s, General Mills, The Quaker Oats Company, and Post Cereals. • Cell phones The cell phone market is monopolistically competitive. There are many firms (LF, Apple, Nokia, Motorola, Panasonic, Sony Ericsson, Sanyo, and others) each making a differentiated cell phone. There are no barriers to entry into the market. • The only restaurant in a small town The only restaurant in a small town is a monopoly because it is the only firm in the market. • Oranges Oranges are a perfectly competitive market. There are many orange growers, with no barriers to entry into the market, and each orange grower produces an identical product—oranges. • Air travel in a town serviced by one airline The company is a monopoly because it is the only firm in the market. 4. Suppose that the restaurant industry is perfectly competitive. Joe’s Diner is always packed in the evening but rarely has a customer at lunchtime. Why doesn’t Joe’s Diner close—temporarily shut down—at lunchtime? Joe’s Diner doesn’t shut down because the price of a meal is greater than average variable cost. By staying open, even though Joe does not have

Chapter 11 . Perfect Competition

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many customers, he can pay all of the variable costs of remaining open and some of his fixed cost. Use the following information to work Problems 5 to 7. Figure 11.5 shows the short-run cost curves of a toy producer. The market has 1,000 identical producers and the table shows the market demand schedule for toys. 5. At a market price of $21 a toy, what quantity does the firm produce in the short run and does the firm make a positive economic profit, a zero economic profit, or an economic loss? At a market price of $21 the firm will produce 2,000 toys per week because this is the quantity of toys for which the marginal revenue, $21, equals the marginal cost. At this price the firm makes a positive economic profit because the price exceeds the average total cost. 6.

At a market price of $12 a toy, how many toys does the Quantity firm produce and what is its economic profit in the Price demanded short run? How will the number of firms in the market (dollars per (thousands of toy) toys per week) change in the long run? 24 1,000 At a market price of $12 the firm will produce either 21 1,500 1,000 toys or 0 toys per week because this price equals 18 2,000 the firm’s shutdown point, the minimum of its average 15 2,500 variable cost. At this price the firm incurs an economic 12 3,000 loss because the price is less than the average total cost. The economic loss is equal to the firm’s fixed cost. Firms will exit the market so in the long run the number of firms decreases.

At what market prices would the firm shut down temporarily? What is the market price of a toy in long-run equilibrium? How many firms will be in the toy market in the long run? Explain your answer. At any market prices less than $12 per toy, the firm would shut down. The long-run price of a toy is $15. This price equals the firms’ minimum average total cost, so at this price there is no longer any incentive to enter or exit the market. When the price is $15 per toy, each firm produces 1,500 toys and the market quantity demanded is 2,500, 000 toys. To meet the market demand, there must be 2,500,000 toys  1,500 toys per firm, or 1,667 firms.

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Use the following information to work Problems 8 and 9. California plans to crack down on the use of fumigants by growers of strawberries. The biggest burden will fall on Ventura County’s growers, who produce about 90 percent of the nation’s crop. 8. Draw graphs of the U.S. strawberry market in long-run equilibrium before the pollution crackdown: one of the U.S. market and one of a California grower. Now show the short-run effects of the pollution crack down.

Figure 11.6 and Figure 11.7 show the initial U.S. market and a typical California grower. In Figure 11.6, the demand curve is D and the initial supply curve is S0. The initial (assumed) equilibrium price is $1 per pound and the initial equilibrium quantity is 600 tons per year. Figure 11.7 shows an individual producer of strawberries. The initial marginal cost curve is MC0, the initial average total cost curve is ATC0, and the initial marginal revenue curve is labeled MR0. The firm initially produces 5 tons per year and makes zero economic profit because the price, $1 per pound, equals the average total cost. The rise in costs shifts the firm’s average total cost and marginal cost curve upward, as shown in Figure 11.7 by the shift from ATC0 to ATC1 and from MC0 to MC1. In the market, Figure 11.6 shows that the market supply decreases and the market supply curve shifts leftward to S1. The new equilibrium price is $1.50 per pound. At this price, Figure 11.7 shows that the firm decreases its production to 2.5 tons per year, where the (new) marginal cost curve, MC1, intersects the new

Chapter 11 . Perfect Competition

marginal revenue curve, MR1. The firm incurs an economic loss because the price, $1.50 per pound, is less than its average total cost. 9.

On the graph, show the long-run effects of the pollution crackdown.

Figures 11.8 and 11.9 show what happens in the long run. In the short run the higher costs mean that the firms incur economic losses. These economic losses lead to some firms exiting the market. As firms exit, the market supply decreases. Eventually the market supply decreases so that the market supply curve becomes S2 in Figure 11.8. (In the long run, the market supply decreases so that the supply curve S0 shifts to the supply curve S2.) The price rises to $2 per pound. In Figure 11.9, which shows a firm in the market, the higher market price of $2 per pound shifts the firm’s marginal revenue curve upward to MR2. The firm produces where its marginal cost curve, MC1, intersects its (new) marginal revenue curve, MR2. In Figure 11.9, this firm produces 3 tons of strawberries in the long run. At this new equilibrium, the firm makes zero economic profit so there is no longer an incentive for firms to exit the market. Use the following information to work Problems 10 and 11. Grain, soybean prices fall Grain and soybean prices tumbled on news that production would be greater than previously expected. The bigger-than-expected production forecasts come as grain farmers are wrestling with a decrease in overseas demand for grain. Source: The Wall Street Journal, November 10, 2015

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10. Why did soybean prices fall in 2015? Draw graphs to show the soybean market and the cost and revenue curves of a soybean farmer at the start and end of 2015. Show the change in the soybean farmer’s economic profit.

Soybean prices fell in 2015 because the supply of soybeans increased. As Figure 11.10 shows, the increase in the supply of soybeans drives the prices of soybeans lower. Figure 11.11 shows the effect of the lower price on the economic profit of an individual farmer. The price of a bushel of soybeans falls from $10 per bushel to $9 per bushel. The firm’s marginal revenue curve therefore falls from MR0 to MR1. When the price was $10 per bushel, the firm produced 60,000 bushels per year and made an economic profit (because P > ATC). After the price falls to $9 per bushel, the firm produces fewer bushels per year and makes a smaller economic profit. The firm’s economic profit was initially equal to the area of the light grey rectangle; after the fall in price, the firm’s economic profit is equal to the area of the smaller dark grey rectangle.

Chapter 11 . Perfect Competition

11. Why did grain prices fall in 2015? Draw graphs to show the grain market and the cost and revenue curves of an individual grain farmer at the start and end of 2015. Show the change in the grain farmer’s economic profit.

Grain prices fell in 2015 because the supply of grain increased while simultaneously overseas demand for grain decreased. As Figure 11.12 shows, both of these changes lower the price of grain. Figure 11.13 shows the effect of the lower price on the economic profit of an individual farmer. The price of a bushel of grain falls from $10 per bushel to $8 per bushel. The firm’s marginal revenue curve therefore falls from MR0 to MR1. When the price was $10 per bushel, the firm produced 60,000 bushels per year and made an economic profit (because P > ATC). After the price falls to $8 per bushel, the firm produces fewer bushels per year and makes a smaller economic profit. The firm’s economic profit was initially equal to the area of the light grey rectangle; after the fall in price, the firm’s economic profit is equal to the area of the much smaller dark grey rectangle.

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◼ Multiple Choice Quiz 1.

In perfect competition, all the following situations arise except ________. A. firms produce an identical good or service B. each firm chooses the price at which to sell the good it produces C. firms can sell any quantity they choose to produce at the market price D. buyers know each seller’s price Answer: B Firms in perfect competition are price takers so they “take” the price determined in the market. 2.

A firm that is producing the quantity at which marginal cost exceeds both average total cost and the market price will increase its economic profit by _______. A. producing a larger quantity B. raising the price to equal marginal cost C. producing a smaller quantity D. producing the quantity that minimizes average total cost Answer: C The market price equals the firm’s marginal revenue. When a firm’s marginal cost exceeds its marginal revenue, the firm’s profit increases if it decreases its production. 3.

A firm will shut down in the short run if at the profit-maximizing quantity, ___________. A. total revenue is less than total cost B. marginal revenue is less than average fixed cost C. average total cost exceeds the market price D. marginal revenue is less than average variable cost Answer: D The firm’s shutdown point is when price equals the minimum average variable cost. 4.

At the shutdown point, the firm ________. A. incurs an economic loss equal to total variable cost B. makes zero economic profit C. incurs a loss equal to total fixed cost D. stops production to decrease its economic loss Answer: C At the shutdown point, the firm’s economic loss is the same if it remains open or closes. If it closes, the economic loss is equal to the fixed cost, so the fixed cost is the economic loss at the shutdown point.

Chapter 11 . Perfect Competition

In the short run, the profit-maximizing firm will ________. A. break even if marginal revenue equals marginal cost B. make an economic profit if marginal cost is less than average total cost C. incur an economic loss if average fixed cost exceeds marginal revenue D. incur an economic loss if average total cost exceeds marginal revenue Answer: D Because the firm’s marginal revenue equals the price, if the average total cost exceeds marginal revenue, then average total cost exceeds price, which is the signal that the firm incurs an economic loss. 6.

A firm’s short-run supply curve is the same as _____ if it produces the good. A. its marginal revenue curve B. the upward-sloping part of its marginal cost curve C. its marginal cost curve above minimum average variable cost D. its marginal cost curve above minimum average total cost Answer: C Figure 11.5 in the text illustrates that answer C is correct. 7.

A permanent increase in demand ______ economic profit in the short run and some firms will ____ in the long run. A. does not change; exit the market B. increases; enter the market C. increases; raise their price D. does not change; advertise their good Answer: B The increase in demand leads to a higher price, which increases the firms’ economic profit. The economic profit influences other firms to enter the market. 8.

Perfect competition is efficient because all the following conditions hold except ________. A. total product is maximized B. firms maximize profit and produce on their supply curves C. consumers get a real bargain and pay a price below the value of the good D. firms minimize their average total cost of producing the good Answer: A Although perfectly competitive firms produce at the minimum average total cost, that result does not mean that the firm’s total product is at its maximum. Each firm could produce more, albeit at a higher average total cost.

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Monopoly ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications Use the following information to work Problems 1 to 3. Elixir Spring produces a unique and highly prized mineral water. The firm’s total fixed cost is $5,000 a day, and its marginal cost is zero. The table shows the demand schedule for Elixir water. 1. On a graph, show the demand for Elixir water and Elixir Spring’s marginal revenue curve. What are Elixir’s profit-maximizing price, output, and economic profit? Elixir Spring’s marginal revenue curve and demand curve are illustrated in Figure 12.1. Also in the figure is Elixir’s marginal cost curve. The marginal cost curve runs along the horizontal axis because the marginal cost is zero. Elixir produces the quantity where the marginal cost curve intersects the marginal revenue curve, so Elixir produces 5,000 bottles a day. Elixir sets a price of $5 a bottle because that is the price at which 5,000 bottles a day is the quantity demanded. Elixir’s economic profit equals its revenue, which is $5 a bottle  5,000, = $25,000 a day, minus its cost, which is its fixed cost of $5,000 a day. Elixir’s economic profit is $25,000 − $5,000, which is $20,000 a day. 2.

Price (dollars per bottle) 10 8 6 4 2 0

Compare Elixir’s profit maximizing price with the marginal cost of producing the profit-maximizing output. At the profit-maximizing price, is the demand for Elixir water inelastic or elastic? Elixir’s profit-maximizing price is $5 per bottle and Elixir’s profit-

Quantity (bottles per day) 0 2,000 4,000 6,000 8,000 10,000

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maximizing output is 5,000 bottles per day. The price, $5, is well above the marginal cost, $0. At this price and quantity, the demand for Elixir water is unit elastic because the marginal revenue equals zero. 3.

Suppose that there are 1,000 springs, all able to produce this water at zero marginal cost and with zero fixed costs. Compare the equilibrium price and quantity produced with the price and quantity produced by Elixir water. In this (extreme) situation, the competitive outcome has price equal to marginal cost, $0. The quantity demanded at this price is 10,000 bottles a day, so the equilibrium quantity will be 10,000 bottles a day.

Blue Rose Inc. is the only flower grower to have cracked the secret of making a blue rose. Figure 16.2 shows the demand for blue roses and the marginal cost of producing a blue rose. What is Blue Rose’s profit-maximizing output? What price does Blue Rose charge and is it efficient? To work the question, it is handy to use Figure 12.3 which shows Blue Rose’s marginal cost curve as well as its demand curve, and marginal revenue curve. To maximize profit, Blue Rose produces the quantity where the marginal cost curve intersects the marginal revenue curve. Figure 16.3 shows that Blue Rose produces 2 roses a day, determined by the intersection of its marginal revenue and marginal cost curves. The demand curve shows that the price is $40 a (blue) rose because that is the price at which 2 roses per day is the quantity demanded. Blue Rose is not using its resources efficiently because Blue Rose is creating a deadweight loss.

Chapter 12 . Monopoly

Hawaii Cable Television is a natural monopoly. Sketch a market demand curve and the firm’s cost curves. Use your graph to work Problems 5 to 8. 5. If Hawaii Cable is unregulated and maximizes profit, show in your graph the price, quantity, economic profit, consumer surplus, and deadweight loss. Figure 12.4 illustrates the case of Hawaii Cable when it is unregulated. Hawaii Cable produces the quantity at which marginal revenue equals marginal cost, so it serves 20,000 households. The price is $60 a month. The economic profit, consumer surplus, and deadweight loss are illustrated in the figure.

If Hawaii Cable is unregulated and it gives householders a 50 percent discount for second and third connections, describe how its economic profit, consumer surplus, and deadweight loss would change. Hawaii Cable is price discriminating. Its economic profit increases because it will gain additional sales and, presumably, will charge a higher price for the first connection. Consumer surplus decreases as Hawaii Cable charges a higher price. The deadweight loss decreases because the quantity of cable connections increases.

If Hawaii Cable is regulated in the social interest, show in your graph the price, quantity, economic profit, consumer surplus, and deadweight loss. Figure 12.5 illustrates the situation when Hawaii Cable is regulated in the public interest. Hawaii Cable produces the quantity at which the marginal cost curve intersects the demand curve, so it serves 40,000 households. The price is $20 a month. The consumer surplus is the area under the demand curve and above the price, $20 a month. It is equal to the light grey triangle plus the part of the dark rectangle that lies under the demand curve. There is no deadweight loss. There also is no economic

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profit. Instead, Hawaii Cable incurs an economic loss, shown by the dark grey rectangle. 8.

If Hawaii Cable is subject to a price cap regulation that enables it to break even, show in your graph the price, quantity, economic profit, consumer surplus, and deadweight loss. The price cap will be set at $40 per month. Figure 12.6 shows that with this price cap, Hawaii Cable serves 30,000 households and the price is $40 per month, the same as Hawaii Cable’s average total cost. There is no economic profit. The consumer surplus is equal to the area of the light grey triangle. The deadweight loss is equal to the area of the dark grey triangle.

Use the following information to work Problems 9 and 10. Unfair postal competition With the rise of e-mail, the volume of snail mail has fallen precipitously, and the U.S. Postal Service has been losing billions of dollars. It is an unjustified legal monopoly that is heavily subsidized and Congress should end it. Source: The Cato Institute, January 8, 2016 9. Why is the U.S. Postal Service not a natural monopoly? Explain why it could be efficient to keep it in operation with a subsidy. If the U.S. Postal System was a natural monopoly, then other firms would find it difficult or impossible to compete with it because the other firms would have higher average total costs if the amount they produce and sell is less than that of the U.S. Postal System. But, in reality other companies, such as FedEx and UPS, can successfully compete with the U.S. Postal System. That fact indicates that the U.S. Postal System is not a natural monopoly.

Chapter 12 . Monopoly

10. Draw a graph to illustrate the U.S. Postal Service’s price, quantity produced, consumer surplus, producer surplus, and deadweight loss. Figure 12.7 shows the U.S. Postal System as a monopoly. The firm delivers 200 million items a week because that the quantity sets MR equal to MC. The price per item is $0.75. The consumer surplus is equal to the light grey area labeled A; the producer surplus is equal to the medium grey area labeled B; and, the deadweight loss is equal to the dark grey area labeled C. 11. Read Eye on Microsoft on p. 331 and explain how Window’s price, quantity bought, consumer surplus, producer surplus, and deadweight loss would change if Microsoft was able to sell ads that appear every time a user opens a program. Illustrate your answer with a graph. If Microsoft was able to sell ads, the situation will be similar to Google, which sells ads as people search. Microsoft’s ads would lead to a lower price for Windows, an increased quantity, and an increased consumer surplus. If the price falls to equal the marginal cost, zero, the deadweight loss is eliminated. Microsoft’s producer surplus increases. Figure 16.8 shows the market for ads. Presuming Microsoft can perfectly price discriminate, Microsoft’s producer surplus is equal to the area of the entire grey triangle.

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◼ Instructor Assignable Problems and Applications Use the following information to work Problems 1 and 2. Microsoft: We're not gouging Europe on Windows 7 pricing Regulators in the European Union have charged Microsoft with illegally tying Internet Explorer (IE) to Windows and mandated that a version of Windows be offered stripped of IE. A news report suggested that when Microsoft launches Windows 7, it will charge a higher price for the IEstripped version than the price for a full version that includes IE. Microsoft denied this report but announced that it would offer the full version of Windows 7 at a lower upgrade price. Source: computerworld.com 1. How does Microsoft set the price of Windows and would it be in the firm’s self-interest to set a different price for a version stripped of IE? Microsoft sets the price of Windows at the amount that maximizes its profit. Stripping IE increases Microsoft’s fixed costs but has no effect on its variable cost or its marginal cost. Microsoft will set different prices if the marginal revenue of the two Windows versions are different. 2.

Why might Microsoft offer the full version of Windows 7 to European customers at a lower upgrade price? Stripping IE increases Microsoft’s costs. Microsoft might set a lower price—the upgrade price—for the full version of Windows 7 than for the stripped version because Microsoft’s cost of the full version is less than its cost for the stripped version.

Use the following information to work Problems 3 and 4. Bobbie’s Hair Care is a natural monopoly. The Price Quantity Marginal cost (dollars per (haircuts (dollars per table shows the demand schedule (the first two haircut) per hour) hour) columns) and Bobbie’s marginal cost schedule 20 0 (the middle and third columns). Bobbie has 18 1 1 done a survey and discovered that she has four 16 2 4 types of customers each hour: one woman who is 14 3 8 willing to pay $18, one senior who is willing to 12 4 12 pay $16, one student who is willing to pay $14, 10 5 18 and one boy who is willing to pay $12. Suppose that Bobbie’s fixed costs are $20 an hour and Bobbie’s price discriminates. 3. What is the price each type of customer is charged and how many haircuts an hour does Bobbie’s sell? What is the increase in Bobbie’s economic profit that results from price discrimination? If Bobbie price discriminates, she charges the woman $18, the senior citizen $16, the student $14, and the boy $12. If Bobbie price discriminates, she sells 4 haircuts an hour. Bobbie’s economic profit is her total revenue minus her total cost. If she does not price discriminate, she produces the

Chapter 12 . Monopoly

quantity such that marginal revenue equals marginal cost. Bobbie’s marginal revenue when she produces 3 haircuts is equal to her marginal cost when she produces 3 haircuts. (Both are equal to $8.) So without price discrimination, Bobbie’s produces 3 haircuts an hour at a price of $14. In this case, her economic profit is her total revenue, $42, minus her total cost, $33 (the sum of the fixed cost plus the marginal costs), which is $9. If she price discriminates, her total revenue is $18 + $16 +$14 + $12, which is $60. Her total cost to produce 4 haircuts is $45, so her economic profit is $60 − $45, which is $15. So, her economic profit increases by $6. Who benefits from Bobbie’s price discrimination? Is the quantity of haircuts efficient? When Bobbie price discriminates, Bobbie benefits because her economic profit is higher. Because Bobbie is perfectly price discriminating, Bobbie is producing the efficient quantity of haircuts. With price discrimination, the boy willing to pay $12 benefits because he now gets a haircut. Society benefits because the deadweight loss is eliminated.

Use the following information to work Problems 5 through 10. Big Top is the only circus in the nation. The Price table sets out the demand schedule for circus (dollars per tickets and the cost schedule for producing ticket) the circus. 20 18 5. Calculate Big Top’s profit-maximizing 16 price, output, and economic profit if it 14 charges a single price for all tickets. 12 Big Top’s total revenue and marginal 10 revenue schedules are in the second table 8 6 (on the next page), which is useful to an4 swer these questions. Big Top’s marginal

Quantity (tickets per show) 0 100 200 300 400 500 600 700 800

cost is constant and equal to $6 per ticket. Big Top’s marginal revenue equals its marginal cost when the quantity of tickets is 350 tickets per show and the price is $13 per ticket. The total revenue is 350 tickets  $13, which is $4,550. The total cost of 350 tickets is $3,100. So the economic profit equals $4,550 − $3,100, which is $1, 450. 6.

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When Big Top maximizes profit, what is the consumer surplus and producer surplus and is the circus efficient? Explain why or why not. The consumer surplus equals the triangular area under the demand curve and above the price. The height of this triangle is the price at which the quantity demanded is zero ($20) minus the equilibrium price and the base of the triangle is the equilibrium quantity. The consumer surplus equals

Total cost (dollars per show) 1,000 1,600 2,200 2,800 3,400 4,000 4,600 5,200 5,800

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1/2  ($20 − $13)  350, which is $1,225. The producer surplus is the area above the marginal cost curve and below the price. Because the marginal cost curve is horizontal, this area is a rectangle equal to ($13 − $6)  350, which is $2,450. When Big Top maximizes its profit, the circus is not efficient. At 350 tickets, the marginal cost of another ticket is $6 and the marginal benefit from another ticket (which is equal to the maximum a consumer is willing to pay) is $13. Marginal benefit is greater than marginal cost, so a deadweight loss exists.

Total Marginal Price Quantity revenue revenue (dollars per (tickets per (dollars (dollars per ticket) show) per show) show) 20

100

1800

200

3200

300

4200

400

4800

500

5000

600

4800

700

4200

800

3200

At the market equilibrium, no children under 10 years old attend the circus. Big Top offers children under 10 a discount of 50 percent. How will this discount change the consumer surplus and producer surplus? Will Big Top be more efficient by offering the discount to children? If Big Top offers a child discount, the consumer surplus increases because more children attend. Presumably the producer surplus increases (as Big Top’s production increases) because Big Top would be unwilling to offer a discount otherwise. Big Top sells more tickets and so it operates closer to the efficient level of output but it is unlikely to produce the efficient quantity.

If Big Top is regulated to produce the efficient output, what is the quantity of tickets sold, what is the price of a ticket, and what would be the consumer surplus? Big Top’s marginal cost is constant at $6 per ticket. To operate efficiently Big Top’s marginal cost must equal the price, so the price of a ticket is $6. At this price, the quantity of tickets sold will be 700 tickets per show. The consumer surplus equals 1/2  ($20 − $6)  700, which is $4,900.

If Big Top is regulated to charge a price equal to average total cost, what is the quantity of tickets sold, the price of a ticket, and economic profit? The quantity will be a bit more than 600 and the price will somewhat less than $8. Because the price equals the average total cost, the economic profit is zero. (Interpolation of the total cost and demand schedules shows that the “precise” quantity is 619 tickets and the “precise” price is $7.62. At this quantity, interpolation of the total cost schedule is $4,716 and so the average total cost is $7.62, equal to the price).

18 14 10 6 2 −2 −6 −10

Chapter 12 . Monopoly

10. Draw a graph to illustrate the circus market if regulators set a price cap that enables Big Top to break even. Show the deadweight loss in your graph. Figure 12.9 shows the situation if regulators set a price cap that allows Big Cap to break even. The price cap is a touch under $8 because this is the price at which the average total cost curve intersects the demand curve. The quantity of tickets sold is a bit more than 600. The deadweight loss is equal to the area of the grey triangle.

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◼ Multiple Choice Quiz 1.

A firm is a natural monopoly if ________. A. it can produce the good at a price below its competitor’s price B. it can produce a larger quantity of the good than other firms could C. the government grants it a public franchise or patent D. it can satisfy the market demand at a lower average total cost than other firms can Answer: D Answer D is the definition of a natural monopoly. 2.

A monopoly ________. A. can choose its price and output and always has the option of price discriminating B. is a price taker and by offering a range of discounts can price discriminate C. that produces a good that cannot be resold might choose to price discriminate D. book store that offers a discount on Tuesdays is price discriminating Answer: C The monopoly has the potential of price discriminating only when the good cannot be resold. 3.

A single-price monopoly maximizes profit by producing the quantity at which _____. A. its total revenue will be as large as possible B. marginal revenue equals marginal cost and setting the price equal to marginal revenue C. marginal revenue equals marginal cost and setting the price equal to marginal cost D. marginal revenue equals marginal cost and setting the price equal to the most people are willing to pay for that quantity Answer: D Figure 12.4(b) illustrates that answer D is correct. 4.

A monopoly sets its price such that demand for the good produced is ______. A. unit elastic B. inelastic C. elastic D. either elastic or inelastic, but never unit elastic Answer: C To maximize profit, marginal cost must equal marginal revenue. Marginal cost is positive, so to maximize profit marginal revenue must also be positive. Only when the demand is elastic is marginal revenue positive.

Chapter 12 . Monopoly

A single-price monopoly is ______. A. inefficient because it converts consumer surplus to producer surplus B. inefficient because it produces too small an output and creates a deadweight loss C. efficient because buyers are paying a price equal to their willingness to pay D. efficient because it is the only producer of the good Answer: B The monopoly creates inefficiency by producing less than a competitive market to raise its price. 6.

A monopoly that price discriminates ______. A. benefits buyers because it offers the good at a variety of prices B. gains because it converts consumer surplus to economic profit C. uses resources more efficiently than would a competitive market D. enables buyers to maximize their consumer surplus Answer: B Price discrimination converts consumer surplus to economic profit. 7.

Governments regulate natural monopoly by capping the price at _____. A. marginal revenue and allowing the monopoly to maximize profit B. marginal cost so that the monopoly is efficient and makes zero economic profit C. average total cost, which allows the monopoly to be inefficient but make zero economic profit D. the buyers’ willingness to pay, which makes the monopoly operate efficiently Answer: C Figure 12.12 illustrates the effects of using an average cost pricing rule to regulate the natural monopoly.

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Monopolistic Competition and Oligopoly ANSWERS TO CHAPTER CHECKPOINTS

◼ Study Plan Problems and Applications 1.

Chapter

Which of the following items are sold by firms in monopolistic competition? Explain your selections. • Cable TV service The cable television market is not an example of monopolistic competition because at any locale, there are not a lot of firms competing. •

Wheat The wheat market is not an example of monopolistic competition because the many competing firms each produce an identical product.

•

Athletic shoes The athletic shoe market is an example of monopolistic competition. There are several producers of athletic shoes, with extensive product differentiation and competition on quality, price, and marketing.

•

Soda The soda market is not an example of monopolistic competition because there are only two producers who together have a very large market share.

•

Toothbrushes The toothbrush market is an example of monopolistic competition. There are many producers of toothbrushes, with extensive product differentiation and competition on quality, price, and marketing.

•

Ready-mix concrete The ready-mix concrete market is not an example of monopolistic competition.