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CHAPTER 1 | Economics: Foundations and Models SOLUTIONS TO END-OF-CHAPTER EXERCISES 1.1

Three Key Economic Ideas Learning Objective: Explain these three key economic ideas: People are rational; people respond to incentives; and optimal decisions are made at the margin.

Review Questions 1.1 “People are rational” is the assumption that decision makers explicitly or implicitly weigh the benefits

and costs of each action and then choose an action only if the benefits are expected to outweigh the costs. “People respond to incentives” means that consumers and firms consistently respond to economic incentives. “Optimal decisions are made at the margin” means that most decisions are not “all or nothing” but involve doing a little more or a little less of an activity. Therefore, the optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost.

1.2 Scarcity is the situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics is the study of the choices consumers, business managers, and government officials make to attain their goals. Scarcity is central to the study of economics because scarcity requires people to make choices about how to use their resources to best fulfill their wants.

Problems and Applications 1.3 As noted in the chapter, the economic incentive to banks is clear—it is less costly to put up with bank

robberies than to take these additional security measures. The marginal cost of adding the additional security is greater than the expected marginal benefit.

1.4 a. Students face scarcity of time, like everyone else, and respond to the incentives of the teacher’s grading system. Students have more incentive to direct their efforts into the parts of the course that have the most weight in the grading system. b. Too little weight on outside readings or the like gives students little incentive to read and master the material. Students will put less effort into the parts of the course that have little effect on their grades. c. Quizzes over assigned readings would give students an incentive to come to class having read the upcoming material. Some teachers give preparation assignments where students have to read and answer questions about the upcoming material, and over the course of the semester students have to successfully complete a certain percentage of the preparation assignments to qualify for an A, or B, or other grade in the course. 1.5 The carbon price and the subsequent increase in the price of gasoline (and other carbon-intensive products) will encourage people to use less gasoline. If people respond to the negative incentive of higher gas prices by using less gas, maybe by taking the bus or buying a more fuel-efficient car, we will emit fewer greenhouse gases and do less damage to the environment. Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models

1.6 a. In deciding whether or not to go to the gym on a specific day, most people aren’t comparing the benefits of an active lifestyle and the cost of the gym membership. They’re comparing what they stand to miss out on and the relatively small benefit any single workout will have on their overall health. By implementing a simple payment system, the researchers increase the benefit of a small number of trips to the gym. Further thought: The benefits of going to the gym tend to materialize over a long time after the decision to go to the gym is made. Some of those benefits will be received years into the future. By offering cash payments in the relatively near term, the researchers offer a benefit that can be received in the same time frame as the costs of going to the gym are paid. b. Those who do not respond to the monetary incentive to go to the gym clearly value their other options more than the health benefits and monetary reward received by going to the gym. Consider a student who is working to pay for their education. The payment received by going to the gym is likely less than the payment received by going to work. In short, the incentive isn’t big enough.

1.7 Jill is correct. The difference between the grade before and after watching an extra episode is exactly the same as knowing the change in the grade.

1.8 Your friend is failing to think at the margin. It doesn’t matter how much time your friend has already

spent studying psychology. What matters is the marginal benefit to be received from studying psychology relative to the marginal cost, where cost is measured as the opportunity cost of lower grades in other subjects. If the course is required to graduate, that may raise the marginal benefit associated with completing the course.

The Economic Problems All Societies Must Solve 1.2 Learning Objective: Discuss how a society answers these three key economic questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

Review Questions 2.1 Scarcity implies that every society and every individual faces trade-offs because wants are unlimited, but the ability to satisfy those wants is limited. Societies and individuals cannot have everything they want, so they have to make choices about what to have and what not to have.

2.2 The three economic questions that every society must answer are: (1) What goods and services will

be produced? (2) How will the goods and services be produced? (3) Who will receive the goods and services produced? In a centrally planned economy, the government makes most of these decisions. In a pure market economy, almost all these decisions are made by the decentralized interaction of households and firms in markets. In a mixed economy, most economic decisions result from the interaction of buyers and sellers in markets, but the government plays a significant role in the allocation of resources.

2.3 Productive efficiency occurs when a good or service is produced at the lowest possible cost. Allocative efficiency means that what is produced reflects consumer preferences—every good or service is produced up to the point at which the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

CHAPTER 1 | Economics: Foundations and Models

2.4 Efficiency is concerned with producing the goods and services that people want at the lowest cost. Equity is “fairness,” a concept that can differ from person to person. Government policymakers often want to make economic outcomes “fairer,” but doing so usually involves redistributing income from one group to another. Redistributing income usually (but not always) hampers efficiency because it reduces incentives to produce and drives up production costs.

Problems and Applications 2.5 Yes, even Bill Gates faces scarcity because his wants exceed his resources. First, Gates has established a foundation with billions of dollars to spend on worthy causes like eradicating malaria and reducing homelessness. However, there are an unlimited number of worthy causes that Gates can fund, so even he faces scarcity. Second, even Gates has only 24 hours in a day, so he must make choices about how to spend his scarce time. Everyone faces scarcity, because human desires are virtually unlimited. Because the world’s resources are limited, the only way not to face scarcity would be to reduce your wants to be fewer than what your resources can accomplish.

2.6 a. It is doubtful that centrally planned economies have been less efficient purely by chance. The

underlying reason seems to be that centrally planned economies don’t provide as strong incentives for hard work and innovation as market economies do. In addition, the people running centrally planned economies cannot make the most efficient decisions because they don’t have the information that is in the minds of all the decentralized decision makers in a market economy.

b. You might still prefer having a centrally planned economy if you considered it to be more equitable. (Also, you might prefer a centrally planned economy if you were in charge.)

2.7 A complete explanation for the connection between majoring in economics and succeeding in business

or government leadership would involve many factors. But we can say that economics teaches us how to look at the trade-offs involved in every decision we make. Those who cannot understand the costs of an action and weigh them against its benefits are unlikely to make good decisions. Climbing the corporate or governmental ladder requires making a wider and wider array of such decisions.

2.8 a. The groups of students most likely to try to get the tickets will be those for whom the expected marginal benefit of going to the athletic department’s office on Monday morning is greater than the expected marginal cost. These would include students who have a relatively low opportunity cost of their time, such as those who have no Monday-morning classes. Other students who are likely to stand in line are those who would have a large benefit from getting the tickets: those who love hockey and those who hope to sell their tickets (“scalpers”). b. The major opportunity cost of distributing the tickets this way is the cost to those students who attempt to get the tickets: the costs of missing out on the activities that cannot be done while standing in line, and the costs to those people who try to get tickets but don’t arrive soon enough to do so. There’s also the cost of the lost revenue to the college from giving away the tickets instead of selling them. c. This isn’t an efficient way to distribute the tickets because it wastes a lot of time. It would be more efficient to sell the tickets to those willing to pay the highest prices. d. Equity is hard to define. Some people will see this way of distributing tickets as equitable because students with low incomes can still get tickets, provided they are willing to pay the opportunity cost of waiting in line. Some people will see this way of distributing the tickets as equitable because only those with the greatest desire to watch the game in person will put up with the hassle of getting the tickets. Some people might argue that this system is equitable because students are more deserving than non-student recipients of the tickets. Others may disagree, saying that people with a strong desire to obtain the tickets, but who are unable to be at the athletic Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models department’s office at the designated time, would have no chance to get the tickets. Still others could argue that the system is not equitable because no revenue is received for the tickets— revenue that could be used to cover some of the costs of administering the university’s athletic programs.

1.3

Economic Models Learning Objective: Understand what economic models are and aren’t, and why they are a good idea.

Review Questions 3.1 Economists use models for the same reason that any other scientist (and indeed everyone else) does— to make a complicated world simple enough that it can be understood and analyzed, so that questions about it can be usefully answered. Useful models will generate testable predictions. If these predictions are consistent with economic data, then the model isn’t rejected and can be used to understand the economy. Testing models with data can be very difficult, however, because the economy is always changing, and it is difficult to conduct controlled economic experiments. 3.2 In arriving at a useful economic model, these five steps are followed: (1) decide the assumptions to be used; (2) formulate a testable hypothesis; (3) use economic data to test the hypothesis; (4) revise the model if it fails to explain the economic data; and (5) retain the revised model to help answer similar economic questions in the future. 3.3 Positive economic analysis concerns what is; that is, it deals with how the economy actually behaves. Normative economic analysis concerns what ought to be. Economics is mainly concerned with positive analysis—conceptualizing and measuring the costs and benefits of different courses of action. Decision makers (including voters and government officials) can use the trade-offs and costs and benefits identified by positive economic analysis in normatively deciding what course of action should be taken.

Problems and Applications 3.4 The economist should revise the model in light of its failure to explain or predict real-world events. 3.5 The problem with Dr. Strangelove’s theory is that it cannot be tested unless we can devise a way to measure the emission of these subatomic particles, which seems to be impossible because they don’t exist in our universe. Because we cannot test the model’s predictions, it is not very useful to us; even though it might be true, we have no way of knowing. 3.6 The positive elements of debate would be the costs of the policy (people who were harmed and how much they were harmed) and the benefits of the policy (people who were made better off and how much better off they were). The economic data that would be most useful would be to identify those who are unemployed due (largely) to the increase in the minimum wage and to identify those who are able to enjoy the improved income resulting from increased wages. Understanding the number and nature of those who lose and those who gain can help us understand the positive side of the issue. Unfortunately, this data will not resolve the normative side of the data debate, as the normative side of the debate requires people to make an assessment of which group is more important.

CHAPTER 1 | Economics: Foundations and Models

3.7 a. Tim Hortons and other coffee shops will likely respond to the reduction in the amount of coffee available by increasing the price they charge their customers. b. Centrally planned economies tend to deal with shortages in two different ways. First, when goods are scarce in centrally planned economies, the central planning committee rations the scarce resource by either issuing a small share to each person or restricting the amount any one person is allowed to buy at a time. Second, consumers are often required to wait in long lines to get the scarce goods. By requiring that someone wait in line for hours in order to receive their ration of coffee, central planners are effectively raising the cost of coffee to consumers—some consumers will choose to give up their coffee rather than wait in line. 3.8. a. and c. are positive statements; b. and d. are normative statements.

1.4

Microeconomics and Macroeconomics Learning Objective: Distinguish between microeconomics and macroeconomics.

Review Questions 4.1 Microeconomics is the study of how households and firms make choices, how they interact in specific markets, and how the government influences their choices. Micro means small, and microeconomics deals with individual decision makers. Macroeconomics is the study of the economy as a whole. Macro means large, and macroeconomics deals with economy-wide outcomes, such as the inflation rate, the unemployment rate, and the economic growth rate. 4.2 No, because many economic situations have both a microeconomic and a macroeconomic aspect. For example, the level of total consumption spending by households helps to determine how fast the economy grows—which is a macroeconomic issue. But to understand the amount of consumption spending by households, we have to analyze the incentives and constraints individual households face—which is a microeconomic issue.

Problems and Applications 4.3 a. and d. are microeconomic issues; b. and c. are macroeconomic issues. 4.4 You should disagree with the assertion. Microeconomics deals with individual decision makers, while macroeconomics deals with economy-wide outcomes. Because the unemployment rate in any one city would be an issue for the economy of the entire city and not an individual, it is a macroeconomic issue rather than a microeconomic issue. The effect of an increase in the taxes on alcohol on underage drinking concerns underage individuals who drink alcohol, so it is a microeconomic issue rather than a macroeconomic issue.

Suggestions for Critical Thinking Exercises CT1.1 Clearly, answers to this question will vary substantially and will depend on the background of the student. The main point is not correctness but to help students connect the chapter to their prior knowledge. This is difficult for an instructor to evaluate. By connecting to their prior knowledge, students should be able to learn this topic more deeply. Copyright © 2024 Pearson Canada Inc.

CHAPTER 1 | Economics: Foundations and Models

CT1.2 The key here is what incentive(s) you need to put in place to encourage yourself and your team to train harder or more often. Also, keep in mind that this article suggests that the training is already in progress, so it is also about additional training, or marginal analysis. Simply put, what can you do to make sure you train for an extra hour or session, or to make sure you work a little bit harder in your next previously scheduled training session?

SOLUTIONS TO CHAPTER 1 APPENDIX A-1

Using Graphs and Formulas Learning Objective: Review the use of graphs and formulas

Problems and Applications 1A.1 a. The relationship is negative because as price decreases, the quantity of pies purchased increases. b.

The slope = ∆y/∆x = rise/run = −1/1 = –1.

CHAPTER 1 | Economics: Foundations and Models

1A.2

1A.3

Answers will vary somewhat depending on the values determined from the time-series graph. The calculations below use Ford sales rounded to the nearest million as shown in the table below. Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Ford’s Auto Sales (in millions of dollars) 6.8 6.6 6.6 5.4 4.9 5.5 5.7 5.7 6.3 6.3 6.6 6.7 Percentage Change [(6.6 – 6.8)/6.8] × 100 = −2.9% [(6.6 – 6.6)/6.6] × 100 = 0.0% [(5.4 – 6.6)/6.6] × 100 = −18.2% [(4.9 – 5.4)/5.4] × 100 = −9.3% [(5.5 – 4.9)/4.9] × 100 = 12.2% [(5.7 – 5.5)/5.5] × 100 = 3.6% [(5.7 – 5.7)/5.7] × 100 = 0.0% [(6.3 – 5.7)/5.7] × 100 = 10.5% [(6.3 – 6.3)/6.3] × 100 = 0.0% [(6.6 – 6.3)/6.3] × 100 = 4.8% [(6.7 – 6.6)/6.6] × 100 = 1.5%

We can conclude that sales fell at the highest rate in 2008.

CHAPTER 1 | Economics: Foundations and Models

1A.4

Percentage change in real GDP: [($16 397 billion − $15 982 billion)/$15 982 billion] × 100 = 2.6% The percentage change in real GDP from one year to the next is the economy’s growth rate.

1A.5 a.

b. At $2.50 per bottle, the total revenue equals rectangles A + B = $250 000 (because $2.50 × 100 000 = $250 000). At $1.25 per bottle, the total revenue equals rectangles B + C = $250 000 (because $1.25 × 200 000 = $250 000). 1A.6

The triangle’s area = 0.5 × 60 000 × $0.75 = $22 500.

1A.7

The slope is calculated using the formula: Slope =

Change in value on the vertical axis ∆ y Rise = = . Change in value on the horizontal axis ∆ x Run

At point A: rise = 300 − 175 = 125, run = 7 − 5 = 2. Therefore, the slope = 125/2 = 62.5. At point B: rise = 900 − 700 = 200, run = 14 – 12 = 2. Therefore, the slope = 200/2 = 100.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System SOLUTIONS TO END-OF-CHAPTER EXERCISES Production Possibilities Frontiers and Opportunity Costs 2.1 Learning Objective: Use a production possibilities frontier to analyze opportunity costs and trade-offs.

Review Questions 1.1 Scarcity is the situation in which wants exceed the limited resources available to fulfill those wants. There are some things that are available in such abundance that they exceed our wants. For example, for most people there is enough oxygen in the atmosphere that the amount they want to inhale would not exceed the available amount—so oxygen isn’t scarce for them. Another example might be something undesirable, such as weeds in your garden—unlike tomato plants, the number of weeds available exceeds the number you desire. 1.2 The production possibilities frontier (PPF) is a curve showing all the attainable combinations of two products that may be produced with available resources and existing technology. Combinations of goods that are on the frontier are efficient because all available resources are being fully utilized, and the fewest possible resources are being used to produce a given amount of output. Points inside the production possibilities frontier are inefficient, because the maximum output is not being obtained from the available resources. A production possibilities frontier will shift outward (to the right) if more resources become available for making the products or if technology improves so that firms can produce more output with the same amount of inputs. 1.3 Increasing marginal opportunity costs means that as more and more of a product is made, the opportunity cost of making each additional unit rises. It occurs because the first units of a good are made with the resources that are best suited for making that good, but as more and more of the product is made, resources must be used that are better suited for producing something else. Increasing marginal opportunity costs implies that the production possibilities frontier is bowed out—the slope gets steeper and steeper as you move down the production possibilities frontier.

Problems and Applications 1.4 a. The production possibilities frontiers in the figure are bowed to the right from the origin because of increasing marginal opportunity costs. The drought causes the production possibilities frontier to shift to the left (see the graph part (b)). b. The genetic modifications would shift the maximum soybean production to the right (doubling it), but not the maximum cotton production.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

1.5 Increasing the number of cells will decrease range, as shown in the figure below. Trade-offs can be between physical goods, such as cotton and soybeans in Problem 1.4, or between less tangible features, such as range or cells, or time to charge battery and cells.

1.6 You would still have an opportunity cost represented by the next best use of your time.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 11 1.7 a.

If you spend all five hours studying for your economics exam, you will score a 95 on the exam; therefore, your production possibilities frontier will intersect the vertical axis at 95. If you devote all five hours to studying for your chemistry exam, you will score a 91 on the exam; therefore, your production possibilities frontier will intersect the horizontal axis at 91. b. The points for choices C and D can be plotted using information from the table. Moving from choice C to choice D increases your chemistry score by four points but lowers your economics score by four points. Therefore, the opportunity cost of increasing your chemistry score by four points is the four-point decline in your economics score. c. Choice A might be sensible if the marginal benefits of doing well on the chemistry exam are low relative to the marginal benefits of doing well on the economics exam—for example, if the chemistry exam is only a small portion of your grade but the economics exam is a large portion of your grade; or if you are majoring in economics and don’t care much about chemistry; or if you have already achieved an A in chemistry but want the economics professor to replace your low exam grade in economics with this exam grade. 1.8 Your report should focus on the opportunity costs of spending more money on research to find a cure for heart disease. While heart disease kills thousands of Canadians every year, you need to consider what else could be done with the government resources your minister is considering spending. These same resources could be spent on preventative programs, promotion of the arts, road maintenance, or other things. You also need to consider the impact the additional spending is likely to have on heart disease treatments. These factors make many government decisions very difficult to make. 1.9 The government should consider whether the costs involved in either of the two programs exceed the benefits received from the programs. If the government decides that the costs of Sport A exceed its benefits, it may decide that the funds would be better spent on Sport B. Sport A will allow four more students to participate than Sport B, but at an extra cost of $812.5 per participant. Although this would be a difficult trade-off to consider, spending less—even though four fewer students can participate— would save resources that could be used for other purposes.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System

Comparative Advantage and Trade 2.2 Learning Objective: Understand comparative advantage and explain how it is the basis for trade.

Review Questions 2.1 Absolute advantage is the ability to produce more of a good or service than competitors using the same amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than competitors. It is possible to have a comparative advantage in producing a good even if someone else has an absolute advantage in producing that good (and every other good). Unless the two producers have exactly the same opportunity costs of producing two goods—that is, the same trade-off between the two goods—one producer will have a comparative advantage in making one of the goods and the other producer will have a comparative advantage in making the other good. 2.2 The basis for trade is comparative advantage. If each party specializes in making the product for which it has the comparative advantage, they can arrange a trade that makes both of them better off. Each party will be able to obtain the product made by its trading partner at a lower opportunity cost than without trade.

Problems and Applications 2.3 In Figure 2.4 the opportunity cost of 1 kilogram of apples is 1 kilogram of cherries to you and 2 kilograms of cherries to your neighbour. Any price of apples between 1 and 2 kilograms of cherries will be a fair trading price, and because 10 kilograms of apples for 15 kilograms of cherries is the same as 1 kilogram of apples for 1.5 kilograms of cherries, it falls within this range. We could take any other value in this range to complete the table. Let’s take, for example, 1.25 kilograms of cherries per kilogram of apples. We will keep the kilograms of apples traded as before at 10. The completed table will now be as follows: Summary of the Gains from Trade

Production and consumption without trade Production with trade Consumption with trade Gains from trade (increased consumption)

Apples (kilograms) 8 20 10 2

You

Neighbours

Cherries (kilograms)

Apples (kilograms)

Cherries (kilograms)

12 0 10 × 1.25 = 12.5 12.5 − 12 = 0.5

9 0 10

42 60 60 − 12.5 = 47.5

47.5 − 42 = 5.5

Note: Both you and your neighbour are better off after trade than before trade. Also, this rate of trading cherries for apples is better for your neighbour than the original rate of trading and worse for you.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 13 2.4 a. Canada has a comparative advantage in making lumberjack boots. Canada’s opportunity cost of making one boot is giving up one shirt. In the United States, the opportunity cost of making one boot is giving up three shirts. The United States has a comparative advantage in making shirts. In the United States, the opportunity cost of making one shirt is giving up one-third boot, but Canada’s opportunity cost of making one shirt is one boot. b. Neither country has an absolute advantage in making both goods. The United States has an absolute advantage in making shirts, but Canada has an absolute advantage in making boots. Remember, both countries have the same amount of resources. If each country puts all of its resources into making shirts, then the United States makes 12 shirts, but Canada makes only 6 shirts. If each country puts all of its resources into making boots, then Canada makes 6 boots, but the United States makes only 4 boots. c. If each country specializes in the production of the good in which it has a comparative advantage and then trades with the other country, both will be better off. Let’s use the case in which each country trades half of what it makes for half of what the other makes. The United States will specialize by making 12 shirts and Canada will specialize by making 6 boots. Because each gets half of the other’s production, they both end up with 6 shirts and 3 boots. They are better off than before trading because they end up with the same number of boots but twice as many shirts. Other trades will also make them better off. 2.5 Yes, Canada can still benefit from trade with developing countries like Vietnam, despite Canada having an absolute advantage in all goods. Vietnam will still have a comparative advantage in some goods, typically goods that are labour-intensive to produce (such as clothes), so Canada can specialize in goods in which it has a comparative advantage and Vietnam can do the same. After trade, both Canada and Vietnam will both be better off. 2.6 a. When France produces one more bottle of wine, it produces two fewer kilograms of schnitzel. When Germany produces one more bottle of wine, it produces three fewer kilograms of schnitzel. Therefore, France’s opportunity cost of producing wine—two kilograms of schnitzel—is lower than Germany’s—three kilograms of schnitzel. When Germany produces one more kilogram of schnitzel, it produces 0.33 fewer bottles of wine. When France produces one more kilogram of schnitzel, it produces 0.50 fewer bottles of wine. Therefore, Germany’s opportunity cost of producing schnitzel —0.33 bottles of wine—is lower than that of France—0.50 bottles of wine. We can conclude that France has the comparative advantage in making wine and that Germany has the comparative advantage in making schnitzel. b. We know that France should specialize where it has a comparative advantage and Germany should specialize where it has a comparative advantage. If both countries specialize, France will make four bottles of wine and zero kilograms of schnitzel, and Germany will make zero bottles of wine and fifteen kilograms of schnitzel. After both countries specialize, France could then trade three bottles of wine to Germany in exchange for seven kilograms of schnitzel. This will give France the same amount of wine as they initially had but an extra one kilogram of schnitzel. Germany will have three bottles of wine and eight kilograms of schnitzel—that is, the same amount of wine but more schnitzel. Other mutually beneficial trades are possible as well. 2.7 An individual or a country cannot produce beyond its production possibilities frontier. The production possibilities frontier shows the most that an individual or country can produce for a given amount of resources and technology. Without trade, an individual or country cannot consume beyond its production possibilities frontier, but with specialization and trade, an individual or country can consume beyond its production possibilities frontier. In Figure 2.5, both you and your neighbour were

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System able to consume beyond your production possibilities frontiers, and in Solved Problem 2.2, both Canada and the United States were able to consume beyond their production possibilities frontiers.

2.8 Colombia could have a comparative advantage in producing coffee if Nicaragua has an even larger absolute advantage relative to Colombia at producing another product. Say Nicaragua can produce four times more cashews than Colombia can using the same resources. Then Colombia will have a comparative advantage in producing coffee. 2.9 Specialization and trade are about standard of living, not jobs. In both cases, individuals and countries have jobs. You have a job if you produce everything yourself and do not trade with others, and you have a job if you specialize and trade with others. But your standard of living will be higher if you specialize and trade. 2.10 Importing only products that cannot be produced here would result in Canada producing—rather than importing—many goods for which it does not have a comparative advantage. These products would be produced at a higher opportunity cost than if they had been imported.

2.3

The Market System Learning Objective: Explain the basic idea of how a market system works.

Review Questions 3.1 A circular-flow diagram illustrates how participants in markets are linked. It shows that in factor markets, households supply labour and other factors of production in exchange for wages and other payments from firms. In product markets, households use the payments they earn in factor markets to purchase the goods and services produced by firms. 3.2 The two main categories of market participants are households and firms. Households as consumers are of greatest importance in determining what goods and services are produced. Firms make a profit only when they produce goods and services valued by consumers. Therefore, only the goods and services that consumers are willing and able to purchase are produced. 3.3 A free market is one with few government restrictions on how goods or services can be produced or sold, or on how factors of production can be employed. Economic decisions are made by buyers and sellers in the market. In a centrally planned economy, the government—rather than households and firms—makes almost all the economic decisions. Free market economies have a much better track record of providing people with rising standards of living. 3.4 Private property rights are the rights that individuals or firms have to the exclusive use of their property, including the right to buy or sell it. If individuals and firms believe that property rights are not well enforced, they will be reluctant to risk their wealth by opening new businesses. Therefore, the enforcement of property rights and contracts is vital for the functioning of the economy. Independent courts are crucial because property rights and contracts will be enforced only if judges make impartial decisions based on the law rather than decisions that favour powerful or politically connected individuals.

CHAPTER 2 | Trade-offs, Comparative Advantage, and the Market System 15

Problems and Applications 3.5 a. An auto purchase takes place in the product market. The household (George) demands the good and the firm (Toyota) supplies the good. b. The labour market is a factor market. Households supply labour and the firm demands labour. c. The labour market is a factor market. The household (George) supplies the factor of production (labour), while the firm (McDonald’s) demands it. d. The land market is a factor market. The household (George) supplies the factor of production (land) and the firm (McDonald’s) demands it. 3.6 Adam Smith was making the “invisible hand” argument that, in pursuing their self-interest, business people end up producing the goods and services most desired by consumers. 3.7 Adam Smith realized—as economists today realize—that people’s motives can be complex. But in analyzing people in the act of buying and selling, economists have concluded that in most instances, the motivation of financial reward provides the best explanation for the actions people take. Moreover, being self-interested—looking out for your own well-being and happiness—and being selfish—caring only about yourself—are not exactly the same thing. Many successful business people are, in fact, generous: donating to charity, volunteering for activities, and otherwise acting in a generous way. This is not inconsistent with making business decisions that maximize profits for their companies. 3.8 a. “Psychic rewards” refers to the psychological benefits of, in this case, buying lottery tickets, which provide the excitement of playing the lottery and the chance of winning big. b. An entrepreneur might receive the psychic rewards of creating and running their own business along with the chance of making large profits. c. Answers will vary here. Elements of being an entrepreneur do appear to be similar to buying a lottery ticket, with the psychic rewards of playing the game along with the possibility of large returns. Other elements may differ, such as the probability of success. 3.9 Weak property rights force resource owners to spend additional resources defending their property and/or reduce the incentive to invest in ways to make their property more productive and valuable. Finally, weak property rights make it very difficult for someone to use the property as collateral for a loan to start or expand a business.

Suggestions for Critical Thinking Exercises CT2.1

There are very few (if any) companies that make things without purchasing inputs from others. We couldn’t think of any. This is a great illustration of comparative advantage. Companies are able to specialize in what they do well (have a comparative advantage) and make gains from trade.

CT2.2. Most economists would consider this method of production highly inefficient. This person is not exploiting any specialization that would increase their productivity. Even adding just one more person would create opportunities for specialization and the large gains that accompany it. Such gains are one of the advantages a group has over individuals.

CHAPTER 3 | Where Prices Come From: The Interaction of Supply and Demand SOLUTIONS TO END-OF-CHAPTER EXERCISES 3.1

The Demand Side of the Market Learning Objective: Discuss the variables that influence demand.

Review Questions 1.1 A demand schedule is a table showing the relationship between the price of a product and the quantity of the product demanded. A demand curve is a curve that shows the relationship between the price of a product and the quantity of the product demanded. 1.2 Ceteris paribus means “all else equal”—that is, holding everything else constant when examining the relationship between two variables. 1.3 A “change in demand” refers to a shift of the demand curve, while a “change in quantity demanded” refers to a movement along the demand curve as a result of a change in the product’s price. 1.4 The law of demand states that, holding all else constant, when the price of a product falls, the quantity demanded of the product will increase (and when the price of a product rises, the quantity demanded of the product will decrease). An increase in the price of a product raises the price of the product relative to other products, causing consumers to substitute away from the higher-priced product. The increase in the price of the product also causes a decrease in the real incomes of consumers and, assuming that the product is a normal good, leads consumers to buy less of the product. 1.5 The main variables that will cause a demand curve to shift include (1) changes in the prices of related goods—substitutes or complements, (2) changes in income, (3) changes in tastes, (4) changes in population or demographics, and (5) changes in expected future prices. Examples of substitute goods are Coca-Cola and Pepsi, and examples of complementary goods are hot dogs and hot dog buns. The impact of a change in income depends on the nature of the good: normal or inferior. An example of a normal good may be a name brand product, like Coca-Cola. An example of an inferior good may be a store brand product, like PC Cola. An example of a change in tastes would be the increasing popularity of organic produce. An example of a change in population or demographics would be an increase in the number of people over the age of 65 leading to an increase in the demand for health care services. An example of a change in expected future prices would be the prices of hybrid vehicles expected to come down in the future, causing today’s demand to decrease.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 17

Problems and Applications 1.6 a. Substitutes b. Complements c. Probably unrelated d. Substitutes 1.7 Assuming that premium bottled water and carbonated soft drinks are substitutes, then a tax on soft drinks will increase the price of soft drinks and increase the demand for premium bottled water. 1.8 a. Because the price of a substitute good has declined, the demand curve for Quarter Pounders will shift to the left from D1 to D2 in the following graph.

b. The coupon results in a cut in the price of Quarter Pounders, so there will be a movement down the demand curve for Quarter Pounders in the following graph.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply c. Because for many people Quarter Pounders and french fries are complements, an increase in the price of french fries will shift the demand curve for Quarter Pounders to the left from D1 to D2 in the following graph.

d. If McDonald’s made this switch, it would expect there to be an increase in the demand for Quarter Pounders (demand would shift from D1 to D3 in the following graph), but until the switch is made the effect on the demand for Quarter Pounders is uncertain.

e. The demand curve for Quarter Pounders will shift. If Quarter Pounders are an inferior good, the demand curve will shift to the left from D1 to D2 in the following graph. If Quarter Pounders are a normal good, the demand curve will shift to the right from D1 to D3.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 19

1.9 The demand for Allbirds shoes decreased from 2019 to 2020, which could be caused by the following: a decrease in the price of leather shoes, which are a complementary good (Allbirds shoes are made from wool and other plant materials); a decrease in national income assuming Allbirds shoes are normal goods; a decrease in the taste (preference) for Allbirds shoes as a result of a campaign against using wool; or any other factors decreasing demand. 1.10 The student’s reasoning is flawed. Whether a good is normal or inferior depends on how your demand changes when your income changes. If this person were to buy less lobster when their income increased, then they’d be correct. Just because you don’t like something doesn’t make it an inferior good. 1.11 a. Music downloads, SAT test prep services, text messaging services b. Diapers, developmental toys, child-care services c. English language courses, prepaid phone cards, foreign-language newspapers 1.12 The data does not indicate that the demand curve for Priuses is upward sloping. It is likely that factors such as income, fuel prices, and the prices of other hybrid vehicles have changed during these three years. Therefore, the data is likely to represent points from three different demand curves. 1.13 As given by the reporter, Posner’s statement confuses a change in demand and a change in quantity demanded. The reduction in the cost of books—the price of books—will increase the quantity demanded of books. It will not cause the demand curve to shift outward. 1.14 a. Factors that have caused a decline in sales of carbonated beverages include the following: increases in demand for substitutes, such as bottled water; health concerns among consumers regarding sugar and other ingredients found in carbonated beverages; and increases in taxes on sugary drinks. It is likely that these factors will continue to affect demand for carbonated beverages in the future. b. Sales of bottled water might decline during a recession because consumers can use tap water as a substitute for bottled water. Because the price of premium bottled water is higher than the price of regular bottled water, sales of premium bottled water are likely to decline more than regular bottled water during a recession.

3.2

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

The Supply Side of the Market Learning Objective: Discuss the variables that influence supply.

Review Questions 2.1 A supply schedule is a table that shows the relationship between the price of a product and the quantity of the product supplied. A supply curve is a curve that shows the relationship between the price of a product and the quantity of the product supplied. 2.2. A “change in supply” refers to a shift of the supply curve, while a “change in quantity supplied” refers to a movement along the supply curve as a result of a change in the product’s price. 2.3 The law of supply states that, holding everything else constant, an increase in price causes an increase in the quantity supplied (and a decrease in price causes a decrease in the quantity supplied). The main variables that will cause a supply curve to shift include (1) changes in the prices of inputs used to make the product, (2) technological change, (3) changes in the prices of substitutes in production (other things that the producers could be making), (4) changes in expected future prices, and (5) changes in the number of firms. An example of a change in price of input used would be if the price of hybrid engines increases, the supply of hybrid cars will decrease. An example of technological change would be an improvement in the technology of producing iPhones leading to an increase in the supply of iPhones. An example of changes in the prices of substitutes in production would be if Sony is producing both plasma and LED flat-screen televisions, and the price of LED televisions increases, the supply of plasma televisions will decrease. An example of changes in expected future prices would be if Toyota believes that the price of the Prius hybrid will increase in the future, it will decrease supply today and increase it in the future. An example of changes in the number of firms would be as more firms enter the flat-screen television market, the supply of flat-screen televisions will increase.

Problems and Applications 2.4

a. Change in quantity supplied: A movement up the supply curve. b. Change in supply: The supply curve shifts to the right. c. Change in demand: The demand curve shifts to the left.

2.5 The supply of Allbirds shoes decreased from 2021 to 2022. The supply decrease could be caused by an increase in the price of wool (or any other material used in the production of these shoes) or an increase in the price of the machines used to assemble the shoes, an increase in the price of other types of shoes that the makers of Allbirds could produce, or any of the other factors identified in the text. 2.6 Not necessarily. Firms may have different costs of producing tablet computers and, therefore, supply different quantities at the same price. 2.7 The increase in the quantity supplied is likely to be larger the longer the time period being considered. Over time, new firms can enter the market and existing firms can better adjust their mix of products by increasing the quantity they supply of the good whose price has increased.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 21

3.3

Market Equilibrium: Putting Buyers and Sellers Together Learning Objective: Use a graph to illustrate market equilibrium.

Review Questions 3.1 Market equilibrium is the situation in which the quantity demanded equals the quantity supplied. 3.2 A shortage is a situation in which the quantity demanded is greater than the quantity supplied, and a surplus is a situation in which the quantity demanded is less than the quantity supplied. 3.3 If the current price is above equilibrium, the quantity supplied will be greater than the quantity demanded, and there will be a surplus. A surplus causes the market price to fall toward equilibrium. If the current price is below equilibrium, the quantity demanded will be greater than the quantity supplied, and there will be a shortage. A shortage causes the market price to rise toward equilibrium.

Problems and Applications 3.4 You should disagree. If there is a shortage, firms will raise the prices they charge. The quantity supplied will increase, the quantity demanded will decrease, and equilibrium will be reached at a higher price. 3.5 Begin by drawing two demand curves. Label one “Demand for diamonds” and the other “Demand for water.” Make sure that the water demand curve is much farther to the right than the diamond demand curve. Based on the demand curves you have just drawn, think about how it might be possible for the market price of water to be lower than the market price of diamonds. The only way this can be true is if the supply of water is much greater than the supply of diamonds. Draw on your graph a supply curve for water and a supply curve for diamonds that will result in an equilibrium price of diamonds that is much higher than the equilibrium price of water.

3.6 No. It only means that those willing to pay the equilibrium price received the goods. They would have been happier paying less. And there are likely to be consumers who want the good but are not willing (or able) to pay the market price. Similarly, on the supply side, sellers would be happier to receive a higher price than the equilibrium price, and there may be sellers who are only willing to sell at a higher price and, therefore, do not participate in the market.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

3.7 a. A supply chain is a series of processes or steps in a production process involved in the production and distribution of good, often involving several different firms. A breakdown in the supply chain suggests reduction in supply at every given price so that at the prior equilibrium price quantity demanded will exceed quantity supplied. b. The reduced supply will put upward pressure on prices, causing the equilibrium price to rise. c. The rising prices will make empty shelves less likely. As prices rise, all else equal, quantity demanded will fall until the price has risen sufficiently to cause quantity demanded to be equal to quantity supplied.

The Effect of Demand and Supply Shifts on Equilibrium 3.4 Learning Objective: Use demand and supply graphs to predict changes in prices and quantities.

Review Questions 4.1 When the demand curve shifts to the right, the equilibrium price and equilibrium quantity both rise. The first graph that follows illustrates this case. When the supply curve shifts to the left, the equilibrium price rises, but the equilibrium quantity falls. The second graph that follows illustrates this case.

4.2 If the demand curve shifts to the right more than the supply curve does, the equilibrium price will rise. Figure 3.11(a) illustrates this case. If the supply curve shifts to the right more than the demand curve, the equilibrium price will fall. Figure 3.11(b) illustrates this case.

Problems and Applications 4.3 You should agree. The increase in demand for athletic shoes would cause the demand curve to shift to the right along an unchanged supply curve. By itself, this shift in the demand curve would result in an increase in the price of athletic shoes. But an increase in the number of firms producing athletic shoes would result in an increase in supply—the supply curve will shift to the right—and a lower price—if demand remained unchanged. The relative size of the shift of the demand curve and the supply curve will determine whether the equilibrium price rises or falls. The following graph illustrates this

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 23 uncertainty. For a given increase in demand—from D1 to D2—an increase in supply from S1 to S2 results in an increase in the equilibrium price from P1 to P2, but an increase in supply from S1 to S3 results in a decrease in the equilibrium price from P1 to P3.

4.4

c. The falling demand for renewable diesel means the price of a substitute in the production for cooking oil falls. As a result of a decrease of the price of a substitute in production, the supply curve for the product in question shifts to the right. Thus, if the price of renewable diesel falls, the supply of cooking oil will shift to the right. 4.5 Because demand is falling, and the exit of some smaller firms will cause supply to fall, the equilibrium quantity will definitely decrease. You cannot tell for certain if the new equilibrium price will be higher or lower than the old equilibrium price. If the decrease in demand is greater than the decrease in supply, the new equilibrium price will be lower. If the decrease in demand is less than the decrease in supply (as is shown on the graph), the new equilibrium price will be higher.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.6 a. The following graph illustrates an increase in the demand for coffee from D1 to D2 due to the millennials’ “unquenchable thirst” for coffee. The supply curve shifts to the left from S1 to S2 as the result of dry weather in Brazil and Asia. The shifts in demand and supply would each increase the equilibrium price of coffee, but an increase in demand by itself would increase the equilibrium quantity while a decrease in supply by itself would cause the equilibrium quantity to decrease. The graph shows that the equilibrium quantity of coffee will increase from Q1 to Q2 if the increase in demand is greater than the decrease in supply.

b. The quantity of coffee sold over time is a result of changes in both demand and supply. The quantity of coffee sold can increase due to an increase in supply even if demand hasn’t increased. 4.7 Draw a demand and supply graph showing the market equilibrium in the winter, label both the demand and supply curves “winter,” and label the equilibrium price created by these curves as “winter.” Add to your graph the demand curve for summer, making sure it is to the right of the winter demand curve. Look at the graph to see how the equilibrium price in the summer could be lower than the equilibrium price you have established for the winter. The only way for this to happen is for the summer supply

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 25 curve to shift to the right by enough to cause the equilibrium price to be lower in the summer than it is in the winter. The demand for watermelons does increase in the summer compared with in the winter, but the increase in the supply of watermelons in the summer is even greater, so the equilibrium price falls.

4.8 The demand will be greater if the season is moved, and therefore price will be higher.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.9 The student’s analysis is correct. The decrease in demand will decrease the equilibrium price and the equilibrium quantity. The increase in supply will decrease the equilibrium price and increase the equilibrium quantity. The equilibrium price, therefore, will definitely decrease, but the equilibrium quantity could increase or decrease, depending on which change is larger—the decrease in demand or the increase in supply. The graph shows changes in demand and supply of equal magnitude, so the equilibrium quantity does not change.

4.10 The student’s reasoning is incorrect. He should have said, “Increased production leads to a lower price, which increases the quantity demanded. There is a movement along the demand curve, but the demand curve does not shift.” 4.11 The student’s analysis is incorrect—the shift from D1 to D2 will not happen. There will be a movement along the demand curve, D1, due to the price change, but the demand curve will not shift. 4.12 a. Scenario a. is shown in Graph 1. The demand for premium bottled water rises because a decrease in the supply of sports drinks will increase the price of sports drinks, which are substitutes for premium bottled water. The shift in the demand curve for premium bottled water results in a movement along the supply curve for premium bottled water. b. Scenario b. is shown in Graph 4. The demand for premium bottled water falls when incomes fall, assuming premium bottled water is a normal good. The shift in the demand curve for premium bottled water results in a movement along the supply curve for premium bottled water. c. Scenario c. is shown in Graph 3. An improvement in technology reduces the cost of producing premium bottled water and shifts the supply curve for premium bottled water to the right. d. Scenario d. is shown in Graph 2. A rise in an input’s price shifts the supply curve for premium bottled water to the left.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 27

4.13 The rising costs will cause the supply curve to shift to the left, from S1 to S2, while the improvement in quality will cause the demand curve to shift to the right from D1 to D2. Because we don’t know if the demand curve shifts to the right more than the supply curve shifts to the left, we don’t know if the equilibrium quantity purchased will increase or decrease. If the shift in the supply curve is greater, as shown in the figure, the equilibrium quantity will fall. We do know that the equilibrium price of childcare services will rise as a result of the regulation.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply

4.14 The graph with the vertical demand curve is more likely to represent the market for the cancer-fighting drug. If the price of this good rises, patients are unlikely to reduce the quantity they demand, but if the price of the BMW rises, households will reduce the quantity they demand as they switch to buying other luxury cars.

Suggestions for Critical Thinking Exercises CT3.1 Students often have more difficulty with supply as they’re generally on the demand side of most markets. By working together, they will see this and better understand the topic as they talk to each other and describe what they find to be most difficult. CT3.2 It should be a market. Students are likely to have difficulty picking the appropriate theoretical representation of data. Students may also have a problem with this question as they are presented with data and asked what they represent, the type of question they are not used to addressing. CT3.3 The order would be (i) an external (or exogenous) event, (ii) a curve shifting, and (iii) a new equilibrium. Students sometimes have difficulty integrating these separate pieces in the correct order.

CHAPTER 3 | Where Prices Come From: The Interaction of Demand and Supply 29

SOLUTIONS TO CHAPTER 3 APPENDIX A-1

Quantitative Demand and Supply Analysis Learning Objective: Use quantitative demand and supply analysis.

Review Question 3A.1 The intercept of a demand curve identifies the price at which quantity demanded of the good is zero. This is the price at or above which no one will be willing to purchase the good. The intercept of a supply curve identifies the price at which producers will begin to supply the good. This is the price at or below which no firms will be willing to sell the good.

Problems and Applications 3A.2

a. W = 10; L = 60 b. W = 12; L = 72

3A.3

a. P = 50; Q = 100 b. P = 62.5; Q = 75 c. P = 50; Q = 50

CHAPTER 4 | GDP: Measuring Total Production and Income SOLUTIONS TO END-OF-CHAPTER EXERCISES 4.1

Gross Domestic Product Measures Total Production Learning Objective: Explain how total production is measured.

Review Questions 1.1 In microeconomics, we focus on a particular market and can measure production by the quantity of the units produced. In macroeconomics, we look at the production of all goods and services, and measuring production by the quantity of goods and services produced isn’t feasible because it would involve adding together goods and services measured in different units. Therefore, in macroeconomics, economists measure quantity by market value. 1.2 The total of every good and service sold during the year would be larger than GDP, because some of the goods and services sold are intermediate goods and services, and some were produced in a prior year. 1.3 All the money a business receives from the sale of its output is paid out as income to the owners of the factors of production. 1.4 GDP = C + I + G + NX. Consumption (C) is spending by households on goods and services, and investment (I) is spending by firms on new plant, equipment, buildings, and changes in inventories, and by households and firms on new single-family and multi-unit houses. Government purchases (G) are made by the federal, provincial, local, and municipal governments for goods and services, and net exports (NX) equal exports minus imports. Exports are goods and services produced in Canada that are purchased by foreign firms, households, and governments, and imports are goods and services produced in foreign countries, but purchased by Canadian firms, households, and governments. 1.5 A firm’s “value added” refers to the additional market value a firm gives to a product. It is equal to the difference between the price for which the firm sells a good and the price it paid other firms for intermediate goods.

Problems and Applications 1.6 The value of intermediate goods and services, though not counted directly, is included in the value of the final goods and services and therefore is included in GDP. The value of the computer chip is not counted separately but is included in the value of the new PC. 1.7 a. The purchase of flour by a bakery is the purchase of an intermediate good, not a final good, because the flour is included in the bread, or other final goods, the bakery produces. b, c, and d are all purchases of final goods because they are not purchased to become part of other goods or services.

CHAPTER 4 | GDP: Measuring Total Production and Income 31 1.8 a. Consumption b. Not included because the car is not new production. c. Not included because seats are intermediate goods, not final goods. d. Investment 1.9 The value of the house built in 2010 would not be included in the GDP of 2022 because the sale does not represent new production. The value of the services of the real estate agent who helped sell or buy the house in 2022 would be included in the GDP of 2022 because those services were newly provided in 2022. 1.10 Nominal GDP = (100 × $60) + (100 × $2) + (50 × $25) = $7450. Cotton is an intermediate good (in this case, it is used in the production of shirts), so it is not included directly in calculating GDP. 1.11 The statement is incorrect, because it confuses investment in the economic sense of purchases of machinery, factories, and houses with financial investment in stocks and bonds. 1.12 Cutting debt and increasing personal savings requires, for a given amount of income, a decrease in consumer spending. If consumers decided to reduce their spending at the same time, the economy will most likely grow slowly or even shrink in the short run. 1.13 Profits are one part of the income paid to the owners of the factors of production. A business uses the money it receives from the sale of its product to pay wages to labour, interest to capital, rent to natural resources, and profits to the owners of the firm. 1.14 Value added by the artist = ($800 × 10) − $5000 = $8000 – $5000 = $3000 Value added by the local art store = ($1000 × 10) – ($800 × 10) = $10 000 – $8000 = $2000

4.2

Does GDP Measure What We Want It to Measure? Learning Objective: Discuss whether GDP is a good measure of well-being.

Review Questions 2.1 GDP measures the value of final goods and services produced in a country during a given period and the level of income in the country during that same period. Although production of goods and services is not the only factor in determining the quality of life of people in a country, we would normally expect that when a country produces few goods and services, the quality of life in the country will be less than when it produces more goods and services. 2.2 GDP does not include household production and the informal economy. Even if GDP included all production, it would still not be a perfect measure of economic well-being because it does not consider many things that affect well-being. For example, GDP does not include the value of leisure and is not adjusted for the negative effects of pollution or crime and other social problems.

CHAPTER 4 | GDP: Measuring Total Production and Income

Problems and Applications 2.3 a. It is likely to increase measured GDP because work outside the home is measured while work inside the home is not measured. b. This is likely to increase measured GDP if it results in increased government expenditures on law enforcement and increased private expenditures on security. (However, an increase in the crime rate might indicate that the level of production in the informal economy is increasing, which should reduce measured GDP, not increase it.) c. It is likely to reduce measured GDP as more production moves to the informal economy. 2.4 Real GDP per capita is the level of real output or income per person. Real GDP per capita for Canada has risen since 1890. A higher income level today may be due to Canadians working more hours or simply being more productive. The fact that the typical Canadian today works fewer hours while earning a higher income suggests that the economic well-being of the average Canadian has increased more than is indicated by comparing 1890 real GDP per capita with current real GDP per capita. The average person has more leisure time today than in 1890, and the value of this time is not included in GDP. 2.5 Sorted by GNI Country Singapore UAE Norway US Canada Australia South Korea Greece China Iran Venezuela Zimbabwe

Real GNI per Person (2020 PPP) 88 155 67 462 66 494 63 826 48 527 48 085 43 044 30 155 16 057 12 447 7 045 2 666

HDI 0.938 0.89 0.957 0.926 0.929 0.944 0.916 0.888 0.761 0.783 0.711 0.571

CHAPTER 4 | GDP: Measuring Total Production and Income 33 Sorted by HDI Country Norway Australia Singapore Canada US South Korea UAE Greece Iran China Venezuela Zimbabwe

Real GNI per Person (2020 PPP) 66 494 48 085 88 155 48 527 63 826 43 044 67 462 30 155 12 477 16 057 7 045 2 666

HDI 0.957 0.944 0.938 0.929 0.926 0.916 0.89 0.888 0.783 0.761 0.711 0.571

The two rankings parallel each other in the sense that countries with higher real GNI per person tend to be countries with a higher HDI, while countries with lower real GNI per person tend to be those with a lower HDI. However, the orders do not match perfectly. For example, the United Arab Emirates’ real GNI per person was the second highest at $67 462, but the country’s HDI was only seventh out of 12. The possible reasons for the observed differences include differences in factors that affect the HDI but not GNI, such as life expectancy at birth, adult literacy, and school enrolment. 2.6 a. Household consumption would likely change the most. b. Compensation of employees (wages and salaries) and gross mixed income (net mixed income) would likely change the most. c. Government capital consumption and compensation of employees (both wages and salaries and benefits) would likely change the most. 2.7 a. A summary statistic is a single number that characterizes an underlying set of data. GDP is a summary statistic of how well an economy is doing because it measures how much an economy produces during a period of time, which equals a country’s total income. b. GDP provides a summary measure of the performance of an overall economy but not a perfect measure. It excludes production in the informal economy and household production and does not include the value of leisure or adjust for the negative effects of pollution, crime, and other social problems.

CHAPTER 4 | GDP: Measuring Total Production and Income

4.3

Real GDP versus Nominal GDP Learning Objective: Discuss the difference between real GDP and nominal GDP.

Review Questions 3.1 Nominal GDP can change because of either quantity changes or price changes. When there is inflation, nominal GDP overstates the increase in total production. Statistics Canada separates price changes from quantity changes by calculating real GDP. 3.2 The GDP deflator is a measure of the average prices of the final goods and services included in GDP and equals nominal GDP divided by real GDP, multiplied by 100. 3.3 a. Nominal GDP is greater than real GDP. b. Nominal GDP equals real GDP. c. Nominal GDP is less than real GDP.

Problems and Applications 3.4 a. Real GDP, 2018

= (100 × $50) + (100 × $2) + (50 × $30) = $6700

Real GDP, 2019

= (100 × $50) + (120 × $2) + (65 × $30) = $7190

b. Growth rate of real GDP, 2019 $7190 − $6700 × 100 = 7.3% $6700 3.5 a. Disagree. Nominal GDP is less than real GDP if the current price level, which is used in calculating nominal GDP, is less than the base-year price level, which is used in calculating real GDP. A fall in the price level during the year is neither necessary nor sufficient to cause nominal GDP to be less than real GDP. b. Disagree. If prices increase more than the quantity of production decreases, nominal GDP can increase when real GDP declines. c. Agree. If a recession is so severe that both the quantity of production and the price level decline, both real and nominal GDP will decline. d. Disagree. Nominal GDP could decline because either the GDP deflator declined or total production (real GDP) declined. In fact, between 2008 and 2009, nominal and real GDP both declined, while the GDP deflator increased.

CHAPTER 4 | GDP: Measuring Total Production and Income 35 3.6 The only way for nominal GDP to rise while real GDP is constant (or nearly so) is if the value of the GDP deflator is higher. To see this point, look at the formula for the GDP deflator:

= GDP deflator

Nominal GDP × 100. Real GDP

With nominal GDP higher and real GDP the same, the GDP deflator must be higher. A higher GDP deflator means a higher inflation rate. Therefore, the author must be expecting higher oil prices to increase the inflation rate in Canada. 3.7 a. (1)

(2)

(3)

(4)

(5)

GDP Percentage Deflator Real GDP Change Nominal (base year (base year in Real Year = 2016) = 2016) GDP GDP

(6)

(7)

(8)

GDP Deflator Real GDP Percentage (base year (base year Change in = 2018) = 2018) Real GDP

2014 2015 2016

$ 980.00 1020.00 1050.00

90 92 100

$1088.89 1108.70 1050.00

-----1.8% −5.3%

81.8 83.6 90.9

$1198.04 1220.10 1155.12

----1.8% −5.3%

2017

1200.00

105

1142.86

8.8%

95.5

1256.55

8.8%

2018

1400.00

110

1272.73

11.4%

100.0

1400.00

11.4%

The calculations for the annual percentage change in real GDP are not affected by the change in the base year.

A change in the base year used to calculate the GDP deflator would result in the same values for the annual percentage changes in real GDP.

3.8 It is likely that the article is referring to the percentage change in real GDP, which measures the value of output, holding constant the change in the price level. Because changes in nominal GDP measure the change in the value of output in current year prices, it would not be possible to determine how much the euro zone’s economy grew—how much more output of final goods and services were produced and sold, holding prices constant—if the 2 percent change referred to nominal GDP. 3.9 The GDP deflator is calculated as [nominal GDP/real GDP] × 100. The percentage change is calculated as [(value in the second period – value in the first period)/ value in the first period] × 100.

CHAPTER 4 | GDP: Measuring Total Production and Income

2012 2013 2014 2015 2016

Nominal GDP Real GDP GDP Deflator $16 155 $15 355 105.2 16 692 15 612 106.9 17 393 15 982 108.8 18 037 16 397 110.0 18 569 16 662 111.4

Percentage Increase — 1.62% 1.79 1.08 1.31

As shown in the table, 2014 saw the largest percentage increase in the price level.

4.4

Other Measures of Total Production and Total Income Learning Objective: Become familiar with other measures of total production and total income.

Review Questions 4.1 GDP is the market value of all final goods and services produced within Canada. GNI is the market value of all final goods and services produced by residents of Canada, even if the production takes place outside Canada. For Canada, GDP is almost the same as GNI. In many countries, GDP is much larger than GNI. 4.2 National income is the total income received by a country’s residents. National income is equal to GDP minus the value of depreciation, or the consumption of fixed capital. Household income, which is income actually received by households, is national income minus corporations’ retained earnings plus payments received by households from the government in the form of transfer payments or interest on government bonds. Household disposable income, which represents the income available for households to spend, is equal to household income minus personal tax payments, such as the federal personal income tax. 4.3 Gross domestic income is GDP calculated as the sum of income payments to households. Wages, which include all compensation received by employees including fringe benefits, comprise a majority of gross domestic income and are more than three times as large as profits, the second-largest income category.

Problems and Applications 4.4 GNI would be larger than GDP. The country has relatively more of its firms and residents working in other countries. 4.5 With GDP significantly above GNI, the value of income produced within Ireland is significantly above the value of income produced by the residents of Ireland, making the Irish people appear to be richer than they are. 4.6 The federal personal income tax partially accounts for the difference between household income and household disposable income. Therefore, the levels of national income and household income will not change, while the level of household disposable income will decrease.

CHAPTER 4 | GDP: Measuring Total Production and Income 37 4.7 To forecast the level of consumption spending by households, we should focus on the income measure that is most closely related to the households’ ability to spend, which is household disposable income.

Real-Time Data Exercises D4.1

a. In the first quarter of 2021, total personal consumption expenditures were $15 070.1 billion, personal consumption expenditures on durable goods were $1 940.7 billion, personal consumption expenditures on non-durable goods were $3 278.3 billion, and personal consumption expenditures on services were $9 851.2 billion. All figures are expressed as annual rates. b. [($1 940.7 billion + $3 278.3 billion)/$15 070.1 billion] × 100 = 34.6%

D4.2

a. In the first quarter of 2021, gross private domestic investment was $3 920.0 billion, private non-residential fixed investment was $2 960.7 billion, and private residential fixed investment was $1 051.3 billion. All figures are expressed as annual rates. b. $3 920.0 billion − [$2 960.7 billion + $1 051.3 billion] = −$92.0 billion, which equals the change in inventories.

D4.3

a. Real exports of goods and services in 2020 were $2 216.9 billion, and in 2019 they were $2 546.6 billion. Real imports of goods and services in 2020 were $3 142.9 billion and in 2019 they were $3 464.2 billion. b. Net exports in 2020 equaled − $926.0 billion (= $2 216.9 billion − $3 142.9 billion) and in 2019 they equaled − $917.6 billion (= $2 546.6 billion − $3 464.2 billion).

D4.4

a. In the first quarter of 2021, nominal GDP equaled $22 061.5 billion and nominal GNP equaled $22 255.7 billion. Both figures are expressed as annual rates. b. With GNP greater than GDP, foreign production by U.S. firms exceeded U.S. production by foreign firms by $194.2 billion in the first quarter of 2021.

D4.5

a. In the first quarter of 2021, personal income equaled $22 101.6 billion, disposable personal income equaled $22 079.6 billion, and personal consumption expenditures equaled $15 070.1 billion. All figures are expressed as annual rates. b. The difference between personal income and disposable personal income is personal tax payments which in the first quarter of 2021 equaled $22.0 billion (= $22 101.6 billion − $22 079.6 billion).

D4.6

a. Nominal GDP equaled $22 061.5 billion in the first quarter of 2021 and equaled $21 561.1 billion in the first quarter of 2020. Real GDP equaled $19 086.4 billion in the first quarter of 2021 and equaled $19 010.8 billion in the first quarter of 2020. All figures are expressed as annual rates. b. The GDP price deflator in the first quarter of 2021 equaled 115.6 = [($22 061.5 billion/ $19 086.4 billion) × 100], and in the first quarter of 2020 it equaled 113.4 = [($21 561.1 billion/$19 010.8) × 100]. c. The inflation rate from the first quarter of 2020 to the first quarter of 2021 as measured by the GDP price deflator was 1.94 percent [= (115.6 − 113.4)/113.4) × 100].

CHAPTER 4 | GDP: Measuring Total Production and Income d. The nominal and real GDP lines intersect at the base year because the current-year prices used for nominal GDP and the base-year prices used for real GDP are the same when the base year is the current year. The value of the GDP deflator in the year when the nominal and real GDP lines intersect is 100.

D4.7

a. Nominal GDP in the first quarter of 2021 equaled $22 061.5 billion, and in the first quarter of 2020 it equaled $21 561.1 billion. Both figures are expressed as annual rates The GDP Implicit Price Deflator in the first quarter of 2021 equaled 115.588, and in the first quarter of 2020 it equaled 113.415. b. Real GDP in the first quarter of 2021 is approximately $19 086.3 billion [($22 061.5 billion/115.588) × 100], and in the first quarter of 2020 it equaled $19 010.8 billion [($21 561.1 billion/113.415) × 100]. c. The growth rate of the real GDP from the first quarter of 2020 to the first quarter of 2021 was approximately 0.4 percent = [($19 086.3 billion – $19 010.8 billion)/$19 010.8 billion) × 100].

Suggestions for Critical Thinking Exercises CT4.1 Students will likely misunderstand the meaning of the word investment. By thinking more about it and comparing notes with their peers, students will remember this important concept better than they otherwise would. Research in other disciplines has shown that in some instances, simply talking about ideas that conflict with students’ prior knowledge does not lead to much change in students’ views. CT4.2 Answers will vary by student, but by asking students what they expected and what they learned, they should be able to learn the material in a deeper way. CT4.3 The best interpretation is that inflation occurred. Nominal GDP grows, but production is constant; therefore, the GDP deflator increased. This question will encourage students to consider several key points from this chapter.

CHAPTER 5 | Unemployment and Inflation SOLUTIONS TO END-OF-CHAPTER EXERCISES 5.1

Measuring the Unemployment Rate and the Labour Force Participation Rate Learning Objective: Define the unemployment rate and the labour force participation rate, and understand how they are computed.

Review Questions 1.1 The unemployment rate is calculated monthly from data gathered by Statistics Canada in its Labour Force Survey (LFS). The unemployment rate equals the percentage of the labour force that is unemployed: (Unemployed/Labour force) × 100. The three conditions to be counted as unemployed are that the person (1) did not work in the previous week, (2) was available for work, and (3) actively looked for work in the past four weeks. 1.2 The challenge of measuring unemployment is in collecting the data and properly identifying what is happening to people and why. For example, Statistics Canada must determine whether someone actually wants to work or not. The official Statistics Canada measure of the unemployment rate understates the true degree of unemployment to the extent that it does not count discouraged workers as unemployed because they have stopped looking for a job, and it counts involuntary part-time workers as employed even though these workers would prefer to work more hours. The official Statistics Canada measure overstates the true degree of unemployment because (1) some people are not actively looking for work but they claim to do so to remain eligible for government payments to the unemployed and (2) some people have jobs in the informal economy that they do not disclose. 1.3 The labour force participation rate measures the percentage of the working age population that is in the labour force: (Labour force/Working age population) × 100. Since 1970, the labour force participation rate for men has gradually declined, while the rate for women has significantly increased. The overall labour force participation was higher in 2021 than in 1970. In recent years, the decline in the labour force participation rate of prime-age men has been a policy concern. The labour force participation rate for women has declined somewhat since the 2007–2009 recession. Participation of both men and women fell significantly during the COVID-19 pandemic. 1.4 The employment–population ratio measures the percentage of the working-age population that is employed: (Employment/Working-age population) × 100. An unemployed person dropping out of the labour force would decrease the unemployment rate, but it would not change the employment– population ratio. 1.5 The Survey of Household Spending is a sample of about 18 000 households chosen to represent the Canadian population and provides information on household spending habits. The Labour Force Survey is a different survey of households that focuses on labour market activity (employment) of those in the household, not how much and on what they spend.

CHAPTER 5 | Unemployment and Inflation

Problems and Applications 1.6

Working-Age Population (Feb. 2019) Employment Unemployment Unemployment Rate Labour Force Labour Force Participation Rate Employment–Population Ratio

30 575 898 18 662 000 1 212 334 6.1% 19 874 300 65% 61.0%

The number of people unemployed can be found using the definition that the unemployment rate equals the number of unemployed divided by the sum of the number of unemployed and the number of employed. The labour force equals the employed plus the unemployed. The labour force participation rate equals the labour force divided by the working-age population. The employment– population ratio equals the number of employed divided by the working-age population. 1.7 The key is to realize that the labour force is not a fixed number of people. If enough people enter the labour force, with most becoming employed and only some becoming unemployed, then the unemployment rate could decrease while the number of unemployed increases. 1.8 For the unemployment rate to remain unchanged while the number of people employed decreased, the number of people in the labour force must have fallen by even more than the fall in employment. For employment overall to fall while Saskatchewan and Alberta saw increases, other provinces must have seen employment fall. 1.9 For this to occur, more of those remaining in the labour force would have been employed than previously. Those leaving the labour force would have been unemployed. 1.10 a. No, they are not counted as unemployed by Statistics Canada. These people have left the job market and no longer “want” to have a paid job. They have chosen to do other things instead. Therefore, they don’t meet the definition of “unemployed” used by Statistics Canada. b. Yes, new entrants to the labour market are counted as unemployed if they don’t find a job immediately. They meet the definition of unemployment used by Statistics Canada: They are able to work, they want to work, and they have looked for work, but they don’t have a job. 1.11 The unemployment rate can increase while employment increases if the number of discouraged workers and other people not previously counted as unemployed entering the labour force more than offsets the effect of the employment increase. In this case, the number of people counted as unemployed in Georgia was increasing faster than the increase in employment, causing the unemployment rate to increase. 1.12 It’s unlikely that only 3 million jobs were created during this period. What was most likely being referred to was the increase in the total number of jobs compared to March 2020. In order for the total number of jobs to increase by 3 million, many more than 14 million jobs would have to have been created, as some jobs would have been “destroyed” during the same period. If we saw 1 million new jobs created but 1 million jobs destroyed (perhaps because of firms closing), we wouldn’t see any increase in the total number of jobs.

CHAPTER 5 | Unemployment and Inflation 41

5.2

Types of Unemployment Learning Objective: Identify the four types of unemployment.

Review Questions 2.1 The four types of unemployment are frictional unemployment, structural unemployment, cyclical unemployment, and seasonal unemployment. Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs. Structural unemployment is unemployment that arises from a persistent mismatch between the skills and attributes of workers and the requirements of jobs. Cyclical unemployment is unemployment caused by a business cycle recession. Seasonal unemployment is unemployment caused by changes in economic activity due to changes in the seasons. 2.2 The natural rate of unemployment is the normal rate of unemployment, consisting of frictional unemployment plus structural unemployment. The natural rate of unemployment is also called the full-employment rate of unemployment. Economists do not define full employment as being an unemployment rate equal to zero because the creating and destroying of jobs that leads to frictional unemployment and the structural changes in the economy from factors such as innovation that lead to structural unemployment are ongoing features of a growing, dynamic economy. No economy attains an unemployment rate of zero, even during wartime.

Problems and Applications 2.3 Decisions are made by comparing the marginal cost and benefit associated with the activities. The decision of applying for graduate school depends on the opportunity cost of attending versus the payoff received from a graduate degree. During a recession, jobs are less plentiful and the chances of getting a high-wage job offer are lower. This means that the opportunity cost of attending graduate school is lower, so new university and college graduates are more likely to attend graduate school instead. Conversely, demand in the job market is higher during an economic expansion, so the opportunity cost of attending graduate school is also higher. 2.4 Disagree. The economy would operate less efficiently if frictional unemployment were eliminated. By devoting time to job search, workers end up with jobs they find satisfying and in which they can be more productive. Government policies to enhance the job search process of matching workers with jobs could make the economy operate more efficiently, but entirely eliminating frictional unemployment would not be efficient. 2.5 For someone frictionally unemployed, the advice would be to keep searching. The person has the required skills, but matching worker skills to job openings takes time. For someone structurally unemployed, the advice would centre on the need to retrain or to find another occupation. For someone cyclically unemployed, the advice would be to realize that the search will take longer because of the recession and to consider temporarily taking a lower-paying job or going back to school until the economy picks up. 2.6 Efficiency wages can increase the productivity of workers as well as workers’ incomes. They can also increase the profitability of firms. The main disadvantage of efficiency wages is they tend to increase unemployment.

CHAPTER 5 | Unemployment and Inflation

2.7 The workers referred to in the article are likely to be structurally unemployed because they lack the skills required for the available jobs or because they have addiction problems or other personal troubles that make it difficult for them to remain employed. 2.8 a. Discouraged workers are people who would like to have a job but have become discouraged about their prospects of finding one and have given up looking for a job as a result. Because these people are not looking for work, they are not included in the official unemployment rate. Increases in the number of discouraged workers is an indication that the economy is not performing well, even if the official unemployment rate is falling. b. Full employment is the level of employment at which we only observe frictional and structural unemployment. Involuntary part-time or discouraged workers may be suffering from either frictional or structural unemployment. Those who are involuntarily working part-time jobs may be between full-time jobs, so they are frictionally unemployed. Discouraged workers may not have the skills employers demand or may be in the wrong location to find a job that uses their skills and are thus structurally unemployed.

5.3

Explaining Unemployment Learning Objective: Explain what factors determine the unemployment rate.

Review Questions 3.1 The payment of employment insurance likely raises the unemployment rate. The employment insurance payments lower the opportunity cost (the income lost by not working) of continuing to search for a job, which leads the unemployed to spend more time searching for a job. The payment of employment insurance lessens the severity of recessions by helping the unemployed maintain their income and spending. 3.2 a. Minimum wage laws likely increase the rate of unemployment if they are set above the marketclearing wage rate. (Author’s note: This is still subject to some debate.) b. Labour unions, by negotiating higher wages for their members, tend to increase the unemployment rate. c. Efficiency wages, like labour unions, tend to increase the unemployment rate. 3.3 A significant reason that the unemployment rate in the United States has been lower than the unemployment rates in Canada and countries in Western Europe is the more generous unemployment compensation payments and social insurance programs in Canada and Western Europe, which lower the opportunity cost of continuing to search for a job.

Problems and Applications 3.4 If Parliament eliminated the employment insurance system, the opportunity cost of job search would increase, decreasing the level of frictional unemployment. There would be conflicting effects on the level of real GDP. Lower frictional unemployment would increase real GDP, but the possibility of less effective matching of worker skills to jobs due to less time for job search would decrease real

CHAPTER 5 | Unemployment and Inflation 43 GDP. Well-being would probably decrease if the employment insurance system were eliminated because unemployed workers would suffer large drops in income. 3.5 Prices were much lower in 1965 than they are today. It is difficult to state whether $0.50 was below the equilibrium wage in 1965 without information about the level of wages in 1965. 3.6 If this analyst is correct, we cannot conclude that Costco is paying efficiency wages and Walmart is not. The higher Costco wages would be due to the higher-skilled workers required to sell Costco’s higher-cost products. 3.7 a. and c. are likely to increase the unemployment rate. Lengthening the time workers are eligible to receive employment insurance lowers the opportunity cost of a job search. An increase in union membership pushes more wages above market wages, thereby increasing unemployment, at least temporarily until these workers can find jobs in the non-union sector of the economy. b. and d. are likely to reduce the unemployment rate. Abolishing the minimum wage lowers the wage from above the market wage for some workers, thereby increasing the number of workers firms will employ. Making information on job openings more available shortens the search involved in frictional unemployment. 3.8 Henry Ford was paying an efficiency wage, which can cut a firm’s cost by increasing the productivity of workers. Paying an efficiency wage results in an increase in the quality of workers willing to work for the firm and a decrease in the turnover of workers. 3.9 By paying an efficiency wage (a wage above the minimum required) Amazon may attract higherquality workers and increase worker productivity. These higher wages will improve Amazon’s profits if the increase in productivity is greater than the increase in wages. Extra credit: By paying higher than required wages, Amazon also can reduce the likelihood of consumer boycotts and regulatory action. By paying a higher wage, Amazon may be protecting the profits it is currently earning.

Measuring Inflation 5.4

Learning Objective: Define price level and inflation rate, and understand how they are computed.

Review Questions 4.1 The GDP deflator is the broadest measure of the price level because it includes the prices of all final goods and services included in GDP. The consumer price index measures the prices of goods and services purchased by consumers. The producer price index measures the prices of goods and services at all stages of the production process. 4.2 The potential biases include the substitution bias, the increase in quality bias, the new product bias, and the outlet bias.

Problems and Applications 4.3 The statement misinterprets the CPI. The inflation rate in 2021 is the percentage change in the CPI since 2020, not since the base year.

CHAPTER 5 | Unemployment and Inflation

4.4 The CPI, at any point in time, uses a fixed market basket, comparing the cost of buying the fixed market basket in the current period to the cost of buying the fixed market basket in the base period. As a fixed market basket, Statistics Canada uses the quantities in the market basket, not the quantities actually purchased in the current period. 4.5 a.

City

Percentage Change in House Price

Halifax

Montreal

18.3%

Toronto

7.4%

Winnipeg

22.5%

Regina

7.6%

Edmonton

6.3%

Vancouver

12.4%

The percentage change is calculated as [(January 2022 index value – January 2021 index value)/January 2021 index value] × 100. Winnipeg saw the largest increase and Edmonton the smallest. b. The home price index measures how much housing prices in the city have changed since the base month. It does not give information on which city had the most expensive homes in January 2021. 4.6 a. During the period from point B to C when the CPI did not change, the country experienced zero inflation. b. During the period from point C to D when the CPI decreased, the country experienced deflation. c. During the period from point A to B when the CPI increased at a decreasing rate, the country experienced a slowdown in inflation (disinflation). d. During the period from point 0 to A when the CPI increased at an increasing rate, the country experienced an increasing inflation rate. 4.7 Until Statistics Canada updates the market basket of goods used to compute the CPI to include the new television models, the introduction of the new models will have no effect on the CPI. Once the new models are included in the CPI market basket, they will most likely contribute to the increase in quality bias that causes changes in the CPI to overstate the true inflation rate. Increases in the prices of these new models partly reflect their improved quality and partly are pure inflation. Statistics Canada attempts to make adjustments so that only the pure inflation part of price increases is included in the CPI, but these adjustments are difficult to make, so the recorded price increases overstate the pure inflation in some products.

CHAPTER 5 | Unemployment and Inflation 45

5.5

Using Price Indexes to Adjust for the Effects of Inflation Learning Objective: Use price indexes to adjust data for the effects of inflation.

Review Questions 5.1 A nominal variable is a variable measured in current dollars, which means that it is measured using the actual prices from that year. A real variable is a variable measured in constant dollars, which means that it is measured using prices from the base year. That is, a real variable is adjusted for the effects of inflation. 5.2 The real wage for a given year between 2004 and 2022 can be calculated by using this formula: Real wage = (Nominal Wage/CPI) × 100. For example, the real wage for 2004 would be calculated as Real wage2004 = (Nominal Wage2004 / CPI2004) × 100. 5.3 As prices of goods and services decrease during a period of deflation, nominal earnings are likely to rise slowly and may even fall. Real earnings will not fall as much as nominal earnings and will rise if the decline in prices is greater than the decline in nominal earnings. Therefore, real average hourly earnings are likely to increase faster than nominal average hourly earnings during a period of deflation.

Problems and Applications 5.4 In the United States, the real minimum wage in 1957 was $3.70 [($1.00/27) × 100], and in 2016 it was $3.02 [($7.25/240) × 100]. In France, the real minimum wage in 1957 was €2.38 [(€0.19/8) × 100], and in 2016 it was €9.21 [(€9.76/106) × 100]. Between 1957 and 2016, there was an 18.4 percent decrease in the real minimum wage in the United States [($3.02 – $3.70)/$3.70] × 100. And there was a 287.7 percent increase in the real minimum wage in France [(€9.21 – €2.38)/€2.38] × 100. It does not matter whether we have information about the base year as long as we have the CPI data. Whatever the base year is, we would get the same percentage increase in prices. The percentage increase in the price level was less in the United States—[(240 – 27)/27 × 100] = 788.9 percent—than in France—[(106 – 8)/8 × 100] = 1225.0 percent. 5.5 Real GDP in 2019 = (Nominal GDP in 2019/CPI in 2019) × 100 = (2311/136) × 100 = $1699 billion. Real GDP in 2020 = (Nominal GDP in 2020/CPI in 2020) × 100 = (2207/137) × 100 = $1611 billion, making the percentage change in real GDP = (1699 - 1611)/1699 × 100% = -5.2%, or a 5.2% decrease in real GDP. 5.6 If three cups of coffee and a doughnut can be purchased in 2022 for $10 and in 2062 for $2000, the CPI would have to be 200 times greater in 2062 than in 2022 because 200 × $10 = $2000. Therefore, the CPI in 2062 would be 240 × 200 = 48 000. 5.7 The real receipts in 2020 dollars for each film are listed in the last column below. The first column shows the rankings of the top 10 films based on their earnings in 2020 dollars. Real receipts in 2020 dollars equal the nominal receipts reported in the third column multiplied by the CPI in 2020 divided by the CPI in the year that the movie was released.

CHAPTER 5 | Unemployment and Inflation

Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Film Gone with the Wind Snow White and the Seven Dwarfs Star Wars: A New Hope 101 Dalmatians Jaws ET: The ExtraTerrestrial Titanic Star Wars: The Force Awakens Avatar Avengers: Endgame Star Wars: The Phantom Menace Black Panther Jurassic World The Avengers Avengers: Infinity War Star Wars: The Last Jedi Incredibles 2

Total Box Office Receipts 200 852 579

Year Released 1939

CPI 14

184 925 486

1937

460 998 007

1977

144 880 014 260 758 300

1961 1975

30 54

435 110 554

1982

659 363 944

1997

161

936 662 225

2015

237

760 507 625 858 373 000

2009 2019

215 256

474 544 677

1999

167

700 426 566 652 270 625 623 357 910 678 815 482

2018 2015 2012 2018

251 237 230 251

620 181 382

2017

245

608 581 744

2018

251

Real Receipts (2020 dollars) $3 715 772 712 3 421 121 491 1 957 352 194 1 250 797 454 1 250 674 069 1 161 790 036 1 060 715 910 1 023 609 773 916 146 395 868 432 059 735 970 487 722 750 919 712 818 953 701 955 212 700 451 035 655 620 318 627 978 772

5.8 The economy of Venezuela was suffering from hyperinflation and on the verge of collapse. The hyperinflation would have wiped out the 60 percent increase in the minimum wage, leaving the real minimum wage lower. With the economy near collapse, jobs were hard to find and there was little food available to purchase.

CHAPTER 5 | Unemployment and Inflation 47

Real versus Nominal Interest Rates 5.6 Learning Objective: Distinguish between the nominal interest rate and the real interest rate. Review Questions 6.1 The nominal interest rate is the stated interest rate on a loan, while the real interest rate is the nominal interest rate minus the inflation rate. 6.2 Because the nominal interest rate is the real interest rate plus the inflation rate, an increase in expected inflation raises the nominal interest rate by the increase in the expected rate of inflation, assuming that the real interest rate remains constant. 6.3 It is impossible to know whether a particular nominal interest rate is “high” or “low” without knowing the inflation rate. It is the real interest rate that matters to borrowers and lenders, not the nominal interest rate. A nominal interest rate of 5 percent with an inflation rate of 0 percent has a higher real interest rate than a nominal interest rate of 20 percent with an inflation rate of 19 percent. 6.4 If the economy is experiencing deflation, the nominal interest rate will be lower than the real interest rate. The real interest rate equals the nominal interest rate minus the inflation rate, but with deflation the inflation rate is negative.

Problems and Applications 6.5 The reporter does not understand the definition of deflation. Deflation occurs when the price level declines. Inflation, even if only half the national rate, increases the price level. It is not possible for the CPI to drop below zero. The reporter should have written that the change in the CPI drops below zero when there is deflation. 6.6 The real interest rate on a loan with a nominal interest rate of 20 percent and 19 percent inflation is 1 percent. The real interest rate on a loan with a nominal interest rate of 5 percent and 2 percent inflation is 3 percent. Therefore, you should prefer the loan with the 20 percent nominal rate. 6.7 If the monthly inflation rate is 4 percent, the annual inflation rate is about 60 percent. To see this, notice that at a 4 percent inflation rate, the price level is rising 4 percent per month. If the price level starts at 100, after two months it would have increased to 100 × 1.04 × 1.04 = 108.2; after three months it would have increased to 100 × 1.04 × 1.04 × 1.04 = 112.5; and after twelve months to 100 × (1.04)12 = 160.1, or by 60.1 percent. So, the real interest rate would be 4% − 60% = –56%. 6.8 Real interest rate = Nominal interest rate – Inflation rate. With $1000, you can purchase 500 hamburgers at the beginning of the year. If you lend $1000 for one year at an interest rate of 5 percent, you will receive $1050 at the end of the year. With the higher price of hamburgers, at the end of the year you can buy $1050/$2.08 = 504.8 hamburgers. So, you can purchase [(504.8 − 500)/500] × 100 = 0.96% more hamburgers. Therefore, the real interest rate you receive on the loan is 0.96 percent. Notice that this is very close to the real interest rate on the loan, calculated by subtracting the 4 percent inflation in hamburger prices from the 5 percent nominal interest rate on the loan. 6.9 Lenders would agree to a nominal interest rate of almost 0 percent, because with deflation, the real interest rate would be higher than the nominal interest rate by the rate of deflation.

CHAPTER 5 | Unemployment and Inflation

5.7

Does Inflation Impose Costs on the Economy? Learning Objective: Discuss the problems inflation can cause.

Review Questions 7.1 We know from the circular flow of expenditures and income that when inflation increases the nominal value of expenditures, it must also increase nominal incomes. Consequently, inflation does not reduce the purchasing power of the average consumer. 7.2 Inflation affects the purchasing power of money. People with incomes rising faster than the rate of inflation enjoy an increasing purchasing power, while people with incomes rising more slowly than the rate of inflation are hurt by a decreasing purchasing power. In general, inflation particularly hurts people on fixed incomes, such as retired persons who may be receiving a pension of a fixed number of dollars each year. (As we noted, however, the Canada Pension Plan, Old Age Security, and other social security payments tend to move at the same rate as the CPI, but not always.) 7.3 Unanticipated inflation is the greater problem. Anticipated inflation can be incorporated into nominal interest rates and nominal wage contracts. Unanticipated inflation causes the actual real interest rate and actual real wage rate received to differ from the expected real interest rate and the expected real wage rate. 7.4 Deflation can cause consumers to reduce their current spending in anticipation of future lower prices, and unanticipated deflation increases the burden on borrowers by raising the real interest rate above the expected real interest rate. 7.5 Menu costs are the costs of changing prices. The term comes from the notion that restaurants would have to reprint menus to change (increase) the prices they charged. The internet has likely reduced menu costs for many firms. Online retailers can change the price they charge for each item with a few keystrokes, while previously they would have to pay an employee to replace every price tag on each individual item. 7.6 If inflation turns out to be lower than anticipated, borrowers tend to benefit at the expense of lenders. A higher than expected inflation rate reduces the value of money paid by borrowers to lenders, reducing the real interest rate. So when inflation rises unexpectedly, borrowers pay back less in terms of purchasing power (they give up fewer other purchases) than they were expecting. 7.7 a. Frank is likely to have a higher real income 10 years from now. Real income is income adjusted for inflation. James’s fixed pension income will have been constantly eroded by inflation, while Frank will constantly have to purchase new GICs. The GICs that Frank purchases will be subject to interest rates that change with the rate of inflation. The nominal rate of interest tends to adjust in response to inflation so that the real interest rate is moderately stable. Thus, Frank will be better protected from inflation than will James. b. In this situation James is likely to have a higher income than Frank. Frank’s GICs cannot account for unanticipated inflation, while James’s pension is now adjusted for inflation every year. If inflation is higher than expected in any given year, Frank’s interest payments will be lower in real terms than he was expecting. He will have to wait until his GICs are up for renewal in order to get an interest rate that reflects the higher inflation rate.

CHAPTER 5 | Unemployment and Inflation 49 7.8 If the actual inflation rate is 6 percent rather than 2 percent, Apple will benefit at the expense of those that lent it money (purchased bonds). In this scenario the real interest rate turns out to be zero rather than the expected real interest rate of 4 percent. This means that Apple’s lenders receive no financial benefit from their loan.

Real-Time Data Exercises D5.1

a. The CPI for August 2019 was 256.3 and for August 2018 was 251.9. b. The inflation rate as measured by the CPI from August 2018 to August 2019 equalled [(256.3 – 251.9)/251.9] × 100 = 1.7 percent.

D5.2

a. and b. Data used in the graph in (c) below covers the period from August 2013 to August 2019. c.

Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

d. The inflation rate of 2.95 percent in July 2018 was the highest during these years with the inflation rate of 2.85 percent in June 2018 and 2.74 percent in May 2018 being the second and third highest. D5.3

a. and b. Data used in the graph in (c) below covers the period from July 2009 to August 2019. c.

Federal Reserve Economic Data (FRED) website (fred.stlouisfed.org).

CHAPTER 5 | Unemployment and Inflation d. The inflation rate as measured by the CPI was more volatile than the inflation rate as measured by the CPI less prices of food and energy. In July 2010 the inflation rate measured by the CPI was 1.34 percent but measured by the CPI less food and energy prices was 0.96 percent. In February 2017, the inflation measured by the CPI was 2.73 percent, but measured by the CPI less food and energy prices it was 2.19 percent. In August 2019, the two inflation rates were 1.76 percent as measured by the CPI and 2.39 percent as measured by the CPI less food and energy prices.

D5.4

a. The CPI for food and beverages in August 2019 was 258.2, and in August 2012 it was 234.1. The CPI for apparel in August 2019 was 125.1, and in August 2012 it was 125.3. The CPI for transportation in August 2019 was 210.3, and in August 2012 it was 217.6. The CPI for medical care in August 2019 was 501.3, and in June 2012 it was 417.6. b. The inflation rate over the entire period from August 2012 to August 2019 for food and beverages was [(258.2 – 234.1)/234.1] × 100 = 10.329 percent; for apparel it was [(125.1 – 126.3)/126.3] × 100 = −10.095 percent; for transportation it was [(210.3 – 217.6)/217.6] × 100 = −3.435 percent; for medical care it was [(501.4 – 417.6)/417.6] × 100 = 20.1 percent. These inflation rates are the percentage changes over the entire five-year period, not annual inflation rates. c. Transportation experienced the lowest inflation rate (−3.35 percent), and medical care experienced the highest inflation rate (20.1 percent).

D5.5

a. In August 2019, the number of unemployed equalled 6044 thousand, the civilian labour force equalled 163 922 thousand, and workers with part-time employment for economic reasons, slack work, or business conditions equalled 2678 thousand. These data are reported monthly and measured in thousands of persons. b. The civilian unemployment rate equalled [(6044 thousand/163 922 thousand) × 100] = 3.7 percent. The civilian unemployment rate including persons who are underemployed equalled [(6044 thousand + 2678 thousand)/163 922 thousand] × 100 = 5.3 percent.

D5.6

a. In August 2019, the number of unemployed men equalled 3233 thousand, the number of unemployed women equalled 2812 thousand, the civilian labour force for men equalled 86 832 thousand, and the civilian labour force for women equalled 77 090 thousand. These data are reported monthly and are measured in thousands of persons. b. The unemployment rate for men equalled [(3233 thousand/86 832 thousand) × 100] = 3.7 percent, and the unemployment rate for women equalled [(2812 thousand/77 090 thousand) × 100] = 3.6 percent.

D5.7

a. In August 2019, the number of unemployed equalled 6044 thousand, civilian employment equalled 157 878 thousand, and those not in the labour force equalled 95 510 thousand. b. The working-age population equals the labour force plus those not in the labour force. In August 2019, the labour force equalled 6044 thousand + 157 878 thousand = 163 922 thousand, and the working-age population equalled 163 922 thousand + 95 510 thousand = 259 432 thousand. The employment–population ratio equals civilian employment divided by the working-age population, which for August 2019 equalled [(163 922 thousand/259 432 thousand) × 100] = 63.18 percent. c. If the economy entered a recession, one would expect the employment–population ratio to decline as fewer people would have jobs.

CHAPTER 5 | Unemployment and Inflation 51 D5.8

a. The civilian unemployment rate equalled 3.6 percent in the second quarter of 2019, and it equalled 4.4 percent in the second quarter of 2017. The natural rate of unemployment equalled 4.381 percent in the second quarter 2019 and 4.611 percent in the second quarter of 2017. Note that the natural rate of unemployment is calculated on a quarterly, not monthly, basis. b. The cyclical unemployment rate equals the unemployment rate minus the natural rate of unemployment. The cyclical unemployment rate equalled (3.6 percent − 4.4 percent) = −0.8 percent in the second quarter of 2019 and equalled (4.4 percent − 4.6 percent) = −0.2 percent in the second quarter of 2017. c. The economy improved over the two-year period, and the unemployment rate in the second quarter of 2019 was further below the natural rate of unemployment than in the second quarter of 2017.

D5.9

a. In August 2019, the number of unemployed equalled 6 044 000, civilian employment equalled 157 878 000, employment level—part-time for economic reasons equalled 4 381 000, and not in the labour force, searched for work and available equalled 1 561 000. b. The official unemployment rate equals the number of unemployed divided by the labour force, which equals the unemployed plus the employed. For August 2019, the official unemployment rate equalled [(6 044 000/(6 044 000 + 157 878 000) × 100] = 3.7 percent. c. This broader measure of the unemployment rate would include as unemployed the three categories of unemployed: unemployed; employed but part-time for economic reasons; and not in the labour force, searched for work and available. In August 2019, this broader measure of the unemployment rate equalled [(6 044 000 + 4 381 000 + 1 561 000)/(6 044 000 + 4 381 000 + 1 561 000 + 157 878 000)] × 100 = [11 986 000/169 864 000] × 100 = 7.1 percent. d. One would expect the gap between the official rate of unemployment and the broader rate of unemployment to widen during recessions and narrow during expansions. One would expect the number of part-time workers for economic reasons and discouraged workers to rise during a recession and fall during an expansion.

D5.10 a. In September 2019, the three-month Treasury bill interest rate equalled 1.89 percent and the University of Michigan inflation expectation equalled 2.70 percent. b. The expected real interest rate equals the nominal interest rate minus the expected inflation rate. In September 2019, the expected real interest rate for the three-month Treasury bill equalled 1.89 percent − 2.70 percent = −0.81 percent. c. If the actual inflation rate is greater than the expected inflation rate, borrowers gain and lenders lose from the actual real interest (nominal interest rate minus the actual inflation rate) being below the expected real interest rate. D5.11 a. In August 2019, the CPI equalled 256.6 and average hourly earnings of private production and non-supervisory employees equalled $23.59, and in August 2019, the CPI equalled 252.1 and average hourly earnings equalled $22.80. b. The average hourly real wage in August 2019 equalled [($23.59/256.6) × 100] = $9.19, and in August 2018 equalled [($22.80/252.1) × 100] = $9.04. With the CPI having a base period of 1982–1984, the real wage is measured in 1982–1984 dollars. c. The percentage change in the average hourly nominal wage equalled [(23.59 – 22.80)/22.80] × 100 = 3.46 percent, and the percentage change in the average hourly real wage equalled [(9.19 – 9.04)/9.04] × 100 = 1.7 percent.

CHAPTER 5 | Unemployment and Inflation d. Given that the average hourly real wage increased 1.7 percent from August 2018 to August 2019, the average worker was better off.

Suggestions for Critical Thinking Exercises CT5.1

The unemployment rate would likely increase as unemployment increased by a large number. If you check the expansions after the recessions of 1991, 2001, and 2007–2009, you’ll see the unemployment rate rising for a time.

CT5.2

A key part in the construction of the CPI is seeing how much a consistent market basket of goods and services costs at different times. The GDP deflator compares real GDP (constructed with constant prices) to nominal GDP to compute the GDP deflator.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles SOLUTIONS TO END-OF-CHAPTER EXERCISES 6.1

Long-Run Economic Growth Learning Objective: Discuss the importance of long-run economic growth.

Review Questions 1.1 Real GDP per capita increased by almost three times. The actual increase in living standards is likely to be larger as this measure does not account for many of today’s goods and services, increases in life expectancy, and the like. 1.2 The rule of 70 is a quick way to calculate the approximate number of years it will take for a quantity such as real GDP per capita to double. Dividing 70 by the growth rate per year yields the approximate number of years to double. If real GDP per capita grows at the rate of 7 percent per year, it will take 10 years (70/7) for real GDP per capita to double. 1.3 The most important factor that explains increases in real GDP per capita in the long run is labour productivity, which is the quantity of goods and services that can be produced by one worker or by one hour of work. 1.4 Potential real GDP is the level of real GDP attained when all firms are producing at capacity. Historically, potential real GDP has substantially increased over time.

Problems and Applications 1.5 There is no one correct answer to this question, but there are some relevant considerations: An income of $1 000 000 in 1900 represents 23 times more basic purchasing power than $50 000 in 2021, so with that income you could have many more goods and services in 1900 than in 2021. Even though there were no automatic dishwashers, microwaves, or airplanes in 1900, with $1 000 000 you could afford to have servants wash the dishes, cook, do the laundry, and provide other desired personal services. You could travel in private train cars and in luxurious suites on ocean liners. With an income of $1 000 000 in 1900, you could live what in many ways would be a more luxurious life than with an income of $50 000 today. However, you would not have television, personal computers, the Internet, movies, iPads, streaming services, smartphones, or many other goods available today that we often think of as necessities. So, a person living with an income of $50 000 in 2021 might in fact enjoy a higher living standard than a person living with an income of $1 000 000 in 1900. 1.6 A positive relationship between economic prosperity and life expectancy may be due to increased spending on health care in an economy with a higher income level. Therefore, greater economic prosperity would imply a health care sector that is larger relative to the economy. In addition, because the use of the health care system increases with age, as life expectancy increases and the average age of the population increases, we should expect that more people will use the health care system for more years. This should cause the health care sector in Canada to expand relative to the size of the economy. Copyright © 2024 Pearson Canada Inc.

CHAPTER 6 | Economic Growth, the Financial System, and Business Cycles

1.7 Increases in real GDP per capita not only increase the amount of goods and services available to a country’s citizens but also increase life expectancy at birth and allow people to have a higher portion of leisure time over the course of their lives. So, a rising GDP per capita should ordinarily result in a rising quality of life. 1.8 a. Growth rate for 1991 =

8015 − 8034 × 100 = –0.24% 8034

Growth rate for 1992 =

8287 − 8015 × 100 = 3.39% 8015

Growth rate for 1993 =

8523 − 8287 × 100 = 2.85% 8287

Growth rate for 1994 =

8871 − 8523 × 100 = 4.08% 8523

b. Average annual growth =

−0.24% + 3.39% + 2.85% + 4.08% = 2.52% 4

1.9 Using the rule of 70, it will take approximately 38.8 years for real GDP per capita to double if it grows at 1.8 percent a year. If the annual growth rate falls to 1.5 percent, real GDP per capita will take approximately 46.7 (70/1.5) years to double. 1.10 Many developing countries have faced difficulties implementing policies that boost economic growth, such as protecting private property and avoiding political instability and corruption. India faces particular challenges around property rights and corruption. (Thankfully, the political system seems fairly robust.) 1.11 a. The government measure would understate the rate of growth of labour productivity, because the government calculates labour productivity using the official measure of work hours, not the adjusted measure that Smith believes to be more accurate. If Smith is correct, workers are producing the measured level of output in fewer hours than the official work hours used in the calculation in the government statistics. b. Increases in real GDP per capita as calculated by the economists and Statistics Canada would understate increases in well-being. For any given level of output, workers are working fewer hours and consuming more leisure, increasing their well-being beyond that indicated by increases in real GDP per capita alone. 1.12 Real wages increase when workers produce more output per hour. Business firms generally pay workers the marginal revenue product of their labour, which increases as labour productivity increases. Looked at another way, the real wages of workers as a group cannot increase unless the output the workers produce is also increasing.