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Part 1 . INTRODUCTION

Use the following information to work Problems 3 to 6. The Social Network had world-wide box office receipts of $225 million. The movie had a production budget of about $70 million and additional marketing costs of about $50 million. Creating a successful movie brings pleasure to millions, generates work for thousands, and makes a few people rich. 3. What contribution does a movie like The Social Network make to coping with scarcity? When you buy a movie ticket to see a movie in a theater, are you buying a good or a service? Scarcity still exists but the amount of entertainment available in the economy increases. Buying a ticket to watch a movie is buying a service. 4.

Who decides whether a movie is going to be a blockbuster? How do you think the creation of a blockbuster movie influences what, how, and for whom goods and services are produced? The audience decides whether a movie will be a blockbuster because the audience decides whether to attend the movie. The “what” question is affected in three ways: First, one good or service that is produced is the blockbuster movie. Second, the people whose incomes are higher as a result of the blockbuster then buy an assortment of goods and services and so this assortment of goods and services is produced. Finally, the “what” question is influenced if the movie leads to spinoff goods (such as toys) or creates a series of sequels or similar films. The “how” question is affected to the extent that movies use different production methods. Some movies, for instance, have a lot of special effects while other movies have few or none. The “for whom” question is influenced because those people who receive the profits of a blockbuster movie have higher incomes and so more goods and services are produced for them.

What are some of the components of marginal cost and marginal benefit that the producer of a movie faces? Some of the marginal costs the producer faces are the cost of an actor or actress, the costs of the crew for a day, the costs of a location, and the costs of advertising in a newspaper. The marginal benefits the producer enjoys are his or her salary and/or profit participation from the movie, royalties from the movie, the prestige resulting from a successful movie, and any awards given to the producer of the movie.

Suppose that Jesse Eisenberg had been offered a bigger and better part in another movie and that to hire him for The Social Network, the producer had to double Jesse’s pay. What incentives would have changed? How might the changed incentives have changed the choices that people made? The higher pay would have increased Mr. Eisenberg’s incentive to make The Social Network rather than the other movie and perhaps affected his

Chapter 1 . Getting Started

choice to make The Social Network rather than the other movie. The higher pay would have increased the incentive of the producer to decrease the expense of other aspects of the movie so the producer might have chosen to reduce the pay of the other stars in the movie. 7.

What is the social interest? Distinguish it from self-interest. In your answer give an example of self-interest and an example of social interest. The social interest looks at what is best for society as a whole; choices that are best for society as a whole are said to be in the social interest. The selfinterest looks at what is best for the individual; choices that are best for the individual making the choice are said to be in the self-interest. An example of a choice made in the self-interest is a student’s decision to take an economics class. An example of a choice made in the social interest is a firm’s decision to reduce its air pollution.

Pam, Pru, and Pat are deciding how they will celebrate the New Year. Pam prefers to take a cruise, is happy to go to Hawaii, but does not want to go skiing. Pru prefers to go skiing, is happy to go to Hawaii, but does not want to take a cruise. Pat prefers to go to Hawaii or to take a cruise but does not want to go skiing. Their decision is to go to Hawaii. Is this decision rational? What is the opportunity cost of the trip to Hawaii for each of them? What is the benefit that each gets? Pam, Pru and Pat’s decision to go to Hawaii is rational. All three of them considered the cost and benefit of various New Year’s plans. All three were at least willing to go to Hawaii while Pam and Pat were unwilling to go skiing and Pru was unwilling to go on a cruise. The opportunity cost of the trip for Pam is a cruise; for Pru, it is skiing; and for Pat, it is a cruise. The benefit each receives is the pleasure, the relaxation, excitement, and/or knowledge gained from the trip.

Label each of the entries in the list as a positive or a normative statement. • Low-income people pay too much for housing. The entry that low-income people pay too much for housing is a normative statement. •

The number of U.S. farms has decreased over the past 50 years. The entry about the number of farms is a positive statement.

•

Toyota expands parts production in the United States. The entry about Toyota expanding parts production is a positive statement.

•

Imports from China are swamping U.S. department stores. The entry about imports is a normative statement.

•

The population of rural United States is declining. The entry about the population in rural areas is a positive statement.

Part 1 . INTRODUCTION

Use the following information to work Problems 10 to 12. Hundreds line up for 5 p.m. Eminem ticket giveaway Eminem fans lined up all day to get a free ticket to his secret concert at which he will release his new album Relapse (his first in 5 years). Source: Detroit Free Press, May 18, 2009 10. With tickets free and the show to be held in the 1,500-seat Detroit theater, what is free and what is scarce? Explain your answer. The seats in the concert are scarce—there are only a limited number (1,500) available. Also scarce is the time the enthusiastic fans spent in line to acquire the tickets. The publicity that Eminem received is not free to him because he paid for the theater, hauling equipment to the theater, and so on. 11. What do you think Eminem’s incentive is to give a free show? Was his decision made in self-interest or in the social interest? Explain your answer. Eminem likely wants to allow his most enthusiastic fans the opportunity to see him in concert. He also has the incentive to promote his album by the publicity he gets from having the free concert and the resulting massive demand for tickets. This publicity will lead to increased sales of his album and increased income to him. Eminem’s decision to give a free concert had elements of both self-interest and social interest. To the extent that his decision was motivated by the free publicity and rise in album sales, the decision was motivated by selfinterest. However to the extent that a desire to allow his most enthusiastic fans the chance to see him perform, the decision also had elements of social interest. 12. Is the marginal benefit from the concert zero? Explain your answer. The marginal benefit from the concert was not zero. Regardless of the price paid for the concert, Eminem’s fans enjoyed the concert and therefore enjoyed a marginal benefit from it. 13. Read Eye on the Benefit and Cost of School on p. 15 and explain why both you and Clayton Kershaw made the right decision. Clayton Kershaw made the correct decision to skip college because the opportunity cost to him of attending college (which includes his forgone salary playing baseball) vastly exceeded the benefits to him of attending college. For most students, the opportunity cost of attending college is not so large, so for most students the benefits from attending college exceed the opportunity cost of attendance. For these students, attending college is the correct decision.

Chapter 1 . Getting Started

 Instructor Assignable Problems and Applications 1.

Which of the following are components of the opportunity cost of being a full-time student? The cost of: • Tuition and books The costs of tuition and books are part of the opportunity cost of being a full-time student because these expenses are paid only because the person is a student. •

Residence and a meal plan The costs of residence and a meal plan are not part of the opportunity cost of being a full-time student because expenses for housing and meals would be paid, perhaps by the student or perhaps by his or her family, even if the person was not a student.

•

A subscription to the New Yorker magazine If the subscription was required by a class and the individual subscribed only because of the class requirement, then the cost of the subscription is an opportunity cost of being a student. However if the person would have subscribed to the New Yorker even if he or she was not a student, then the cost of the subscription is not an opportunity cost of being a student.

•

The income a student will earn after graduating The income earned after graduation is not an opportunity cost of being a student.

Think about the following news items and label each as involving a what, how, or for whom question: • Today, most stores use computers to keep their inventory records, whereas 20 years ago most stores used paper records. Stores using computers for inventory records today versus paper 20 years ago answers the how question. •

Health-care professionals and drug companies recommend that Medicaid drug rebates be made available to everyone in need. Deciding whether to offer lower Medicaid drug rebates, which would lower the prices for drugs, is a for whom question.

•

A doubling of the gas tax might lead to a better public transit system. Deciding whether a better public transit system gets built answers a what question. Because not everyone will use the public transportation equally nor will everyone pay the same amount of taxes, there also is a for whom aspect of the headline.

On Friday May 3, 2013, the headlines in the list appeared in The Wall Street Journal. Classify each headline as a signal that the news article is about a mi-

Part 1 . INTRODUCTION

croeconomic topic or a macroeconomic topic. Explain your answers. • Job Gains Calm Slump Worries This entry is a macroeconomic topic because the slump concerns a turndown in the overall economy and neither an individual nor a business makes the decision to slow the aggregate economy. •

Washington Post’s Profit Falls This entry is a microeconomic topic because it concerns the profit outcome of one business, the Washington Post.

•

Overcapacity, Fuel Costs Hit Shipping This entry is a microeconomic topic. It describes the situation within one sector—shipping—which is being affected by overcapacity and a rise in the price of fuel.

•

Green Shoots in Greece? This entry is a macroeconomic topic because the “green shoots” mean that growth in different sectors is starting to grow. It is a sign that perhaps the overall Greek economy is starting to grow.

Your school decides to increase the intake of new students next year. To make its decision, what economic concepts would it have considered? Would the school have used the “economic way of thinking” in reaching its decision? Would the school have made its decision on the margin? The school would consider the extra revenue that each additional student would bring and compare that to the extra cost of providing each student with instruction and service. By comparing the extra revenue and the extra cost, the school is making its decision on the margin and is using the economic way of thinking. If the school compares the additional revenue to the additional cost, it makes its decision on the margin.

Provide two examples of a monetary incentive and two examples of nonmonetary incentive, a carrot and a stick of each, that government policies use to influence behavior. A monetary carrot that the students might answer because it is close to their lives is student aid, such as Pell grants. A monetary stick might be taxes on liquor. A non-monetary carrot is government support for youth sports, such as allowing little league teams to use a county park, and a non-monetary stick is jail terms for illegal drug or alcohol use.

Think about each of the items in the list and explain how they affect incentives and might change the choices that people make: • A hurricane hits Central Florida. The hurricane affects the people in Central Florida and the consumers who purchase the products produced in Central Florida, such as oranges or vacation services. Residents’ incentives change if they suffered

Chapter 1 . Getting Started

damage from the hurricane because they have the incentive to repair the damage. If the price of home repair rises, residents who specialize in home repair have an incentive to work longer hours to earn the higher price. If the hurricane raises the price of the goods and services produced in Central Florida, consumers have the incentive to buy less of these particular goods and services because they are more expensive. •

The World Series begins tonight but a storm warning is in effect for the area around the stadium. The report of the possible storm decreases fans’ incentive to attend the game. Some fans decide to stay at home and watch the game on television.

•

The price of a personal computer falls to $50. The fall in the price of a computer increases consumers’ incentive to buy a computer. More consumers decide to buy a computer. The fall in the price of a computer decreases producers’ incentives to produce computers. Fewer producers decide to produce computers.

•

Unrest in the Middle East sends the price of gas to $5 a gallon. The rise in the price of gasoline affects drivers’ incentives to buy gasoline and large gas-guzzling cars. Drivers decide to buy less gasoline and fewer large gas-guzzling cars. They also might decide to ride public transportation more often.

Does the decision to make a blockbuster movie mean that some other more desirable activities get fewer resources than they deserve? Is your answer positive or normative? Explain your answer. Making a blockbuster movie means that some other activities get fewer resources. But whether “more desirable” activities get fewer resources than they “deserve” is a normative answer for two reasons. First the question of whether an activity is more desirable or less desirable depends on the person’s judgment and values. Second the determination of whether an activity gets fewer resources than it deserves also involves the normative decision about the quantity of resources an activity deserves. So the answer to the question of whether making a blockbuster movie means that other more desirable activities get fewer resources than they deserve is a normative answer that depends on the student’s values.

Provide two examples of economics being used as a tool by each of a student, a business, and a government. Classify your examples as dealing with microeconomic topics and macroeconomic topics. Students might answer that they use economics as a tool when they budget their student aid and when they decided which college to attend based on the costs of their options. Both instances deal with microeconomics. A business uses economics as a tool when it decides the price it charges for its product and the salaries it pays its managers. Both instanc-

Part 1 . INTRODUCTION

es are microeconomic examples. The government use economics as a tool when it decides whether to increase taxes on cigarettes or lower the interest rate. The first example is microeconomic in nature and the second involves macroeconomics. Use the following news clip to work Problems 9 to 12. Obama will drive up miles-per-gallon requirements Obama’s revision of auto-emission and fuel-economy standards will require automakers to boost fuel economy to 35.5 miles per gallon by 2016, notching up 5% each year from 2012, to limit the amount of carbon dioxide cars can emit. Source: USA Today, May 18, 2009 9. What are two benefits of the new miles-per-gallon requirements? Are these benefits in someone’s self-interest or in the social interest? Two benefits of the new miles-per-gallon requirements are: (1) less gasoline will be used, and (2) carbon emissions will be lowered. Consumers benefit from the new mileage standards because their expenditure on gasoline will decrease which enables them to increase their consumption of some other goods and services. It is also in the social interest because more gasoline, or oil from which gasoline is made, is available for other uses. Lower carbon emissions are in the self-interest of everyone and in the social interest because these emissions cause global warming. 10. What are two benefits of the new auto-emission standards? Two benefits of the new auto-emission standards are: (1) a reduction in carbon emissions, which brings a decrease in the contribution of human activity to global warming and climate change, and (2) cleaner air, which contributes to improved health. 11. What costs associated with the new miles-per-gallon requirements arise from decisions made in self-interest and in the social interest? Automobile producers and buyers make their decisions in pursuit of their self-interest, but boosting gas mileage requires more costly engines, which in turn means the cost of producing automobiles and their prices will rise. President Obama’s decision to impose the new regulations is intended to serve the social interest, so all the costs associated with the new miles-pergallon regulation arise from this decision made in the social interest. 12. What costs associated with the new auto-emission standards arise from decisions made in self-interest and in the social interest? Automobile producers and buyers make their decisions in pursuit of their own self-interest but achieving new emission standards requires more costly engines and emission control technologies, which in turn means the cost of producing automobiles and their prices will rise. President Obama’s decision to impose the new regulations is intended to serve the social interest, so all the costs associated with the new emissions standard regulation arise from this decision made in the social interest.

Chapter 1 . Getting Started

 Multiple Choice Quiz 1.

Which of the following describes the reason why scarcity exists? A. Governments make bad economic decisions. B. The gap between the rich and the poor is too wide. C. Wants exceed the resources available to satisfy them. D. There is too much unemployment. Answer: C Answer C uses the definition of scarcity on page 2. 2.

Which of the following defines economics? Economics is the social science that studies ___________. A. the best way of eliminating scarcity B. the choices made to cope with scarcity, how incentives influence those choices, and how the choices are coordinated C. how money is created and used D. the inevitable conflict between self-interest and the social interest Answer: B Answer B uses the definition of economics on page 2. 3.

Of the three big questions, what, how, and for whom, which of the following is an example of a how question? A. Why do doctors and lawyers earn high incomes? B. Why don’t we produce more small cars and fewer gas guzzlers? C. Why do we use machines rather than migrant workers to pick grapes? D. Why do college football coaches earn more than professors? Answer: C Answer C describes how grapes are picked. 4

Which of the following is not a key idea in the economic way of thinking? A. People make rational choices by comparing costs and benefits. B. Poor people are discriminated against and should be treated more fairly. C. A rational choice is made at the margin. D. Choices respond to incentives. Answer: B Answer B is not part of description of the economic way of thinking on page 8.

Part 1 . INTRODUCTION

A rational choice is ___________. A. the best thing you must forgo to get something B. what you are willing to forgo to get something C. made by comparing marginal benefit and marginal cost D. the best for society Answer: C Answer C is part of description of a rational choice on pages 8 and 9. 6.

Which of the following best illustrates your marginal benefit from studying? A. The knowledge you gain from studying 2 hours a night for a month B. The best things forgone by studying 2 hours a night for a month C. What you are willing to give up to study for one additional hour D. What you must give up to be able to study for one additional hour Answer: C Page 10 shows that answer C is the marginal benefit from studying. 7.

The scientific method uses models to ___________. A. clarify normative disagreements B. avoid the need to study real questions C. replicate all the features of the real world D. focus on those features of reality assumed relevant for understanding a cause and effect relationship Answer: D Answer D uses the definition of an economic model on page 12.

Which of the following is a positive statement? A. We should stop using corn to make ethanol because it is raising the cost of food. B. You will get the most out of college life if you play a sport once a week. C. Competition among cell phone providers across the borders of Canada, Mexico, and the United States has driven roaming rates down. D. Bill Gates ought to spend more helping to eradicate malaria in Africa. Answer: C Answer C is a positive statement because it can, in theory, be tested.

Chapter

Appendix: Making and Using Graphs ANSWERS TO APPENDIX CHECKPOINT

 Study Plan Problems A

2002

803

2004

767

139

2005

620

586

2006

385

1,033

5 Draw a scatter diagram to show the relationship 6 between the quantities sold of compact discs and music videos. Describe the relationship. Figure A1.1 illustrates the relationship of the data from the spreadsheet between the quantities sold of compact discs and the quantities sold of music videos. Over all the period, there appears to be a positive or direct relationship; that is, when more compact discs are sold, more music videos are sold.

2010

226

1,162

2012

211

1,392

The spreadsheet in the table provides data on the U.S. economy: Column A is the year; the other columns are quantities sold in millions per year of compact discs (column B), music videos (column C), and singles downloads (column D). Use this spreadsheet to work Problems 1 and 2. 1.

Part 1 . INTRODUCTION

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

The quantity sold was the highest in 2002. The quantity sold was the lowest in 2012. The quantity sold never increased. The quantity sold decreased the most between 2006 and 2008 when it decreased by 235 million. Over the entire time period covered in the figure, there is a downward trend in the quantity of compact discs sold.

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

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

Appendix 1 . Making and Using Graphs

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

Balloon rides (number per day) 50°F

70°F

90°F

32 27 18 10

50 40 32 27

40 32 27 18

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

Part 1 . INTRODUCTION

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

2002

803

2004

767

139

2006

620

586

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

2008

385

1,033

2010

226

1,162

2012

211

1,392

Appendix 1 . Making and Using Graphs

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

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

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

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

Part 1 . INTRODUCTION

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

Hot chocolate (number per week) 50°F

70°F

90°F

40 30 20 10

30 20 10 0

20 10 0 0

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

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

 Study Plan Problems and Applications 1.

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

Chapter

Part 1 . INTRODUCTION

produce goods or services. Once it is discovered, it will become a factor of production. Which factor of production earns the highest percentage of total U.S. income? Define that factor of production. What is the income earned by this factor of production called? Labor earns by far the largest percentage of total U.S. income, 69 percent of total income in 2011. Labor consists of the work time and the work effort that people devote to producing goods and services. The income earned by labor is a wage.

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

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

A Job Creation through Entrepreneurship Act, debated in the House of Representatives in 2009, would award grants to small business owners, some of which would be aimed at women, Native Americans, and veterans. The Act would provide $189 million in 2010 and $531 million between 2010 and 2014. Explain how you would expect this Act to influence what, how, and for whom goods and services are produced in the United States. The answer to the what question would change because more of the goods and services produced by the groups receiving the grants—small business owners, particularly women, Native Americans, and veterans—would be produced. If these groups of producers produced their goods and services using different technologies than the rest of the producers, then the question of how goods and services would change. For whom goods and services are produced would change because the producers receiving the © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

subsidies would have larger profits and therefore be able to buy more of the goods and services produced. 8.

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

Part 1 . INTRODUCTION

For-profit colleges may face aid cuts The Obama administration proposes a new rule: Federal aid to for-profit colleges will be cut if students in vocational programs graduate without a degree. Millions of low-income students are borrowing heavily to attend colleges and too many of them are dropping out, and failing to get a job. Source: USA Today, June 2, 2011 How do you think the personal distribution of income would change if all graduates could obtain a well-paying job that uses their knowledge gained in college? The personal distribution of income would become more equal. As it is now, students who graduate from colleges with worthless degrees have little human capital and have low incomes. If these students had acquired more human capital and a worthwhile degree, their incomes would be higher. When the incomes rise of initially low-income people, the personal distribution of income becomes more equal. 10. Read Eye on the Dreamliner on p. 41 and then answer the following questions: • How many firms are involved in the production of the Dreamliner and how many are identified in the figure on p. 41? Over 400 firms are involved in the production of the Dreamliner. Only 15 of them are identified in the figure. • Is the Dreamliner a capital good or a consumption good? Explain why? The Dreamliner is a capital good because it will be used to produce services (airline travel) throughout many future years. • State the factors of production that make the Dreamliner and provide an example of each. All the factors of production—land, labor, capital, and entrepreneurship—are used to make the Dreamliner. The copper used for wiring is an example of the land used; the engineer who helped design the landing gear is an example of labor; the huge cranes that lift the various pieces of the Dreamliner to assemble them is an example of capital; and the creative and imaginative input of Boeing’s top managers who organize the resources used to produce the Dreamliner exemplify entrepreneurship. • Explain how the production of the Dreamliner influences what, how, and for whom, goods and services are produced. Dreamliner influences “what” goods and services are produced by creating a demand for components manufactured around the world. It influences “how: goods are produced because Boeing and the other © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

•

400 firms all determine the best way to produce each particular part of the Dreamliner. It influences “for whom” because factors of production employed to make the Dreamliner receive income from this production, thereby increasing the quantity of goods and services they can purchase. Use a graph to show where in the circular flow model of the global economy the flows of the components listed on p. 41 appear and where the sales of Dreamliners appear. Except for the components built in the United States, spending on the other components appear in the flow of expenditure on U.S. imports. Sales of Dreamliners appear in the flow of expenditure on U.S. exports.

Part 1 . INTRODUCTION

 Instructor Assignable Problems and Applications 1.

Boeing’s Dreamliner has had a rocky start. • Why doesn’t Boeing manufacture all the components of the Dreamliner at its own factory in the United States? Boeing wants to manufacture the Dreamliner at the lowest possible cost. It would be more expensive for Boeing to manufacture Dreamliners at its own factory in the United States because Boeing does not have the expertise possessed by its subcontractors and because the wages Boeing pays U.S. workers exceed the wages its subcontractors pays their workers. • Describe some of the changes in what, how, and for whom, that would occur if Boeing manufactured all the components of the Dreamliner at its own factories in the United States. If Boeing manufactured all the components of the Dreamliner at its own factories in the United States, more components would be produced in the United States and more capital would have been used in their production. U.S. workers and investors would have received higher incomes but the Dreamliner would cost more to produce so Boeing would have earned a lower profit. • State some of the tradeoffs that Boeing faces in making the Dreamliner. Boeing faced a huge number of tradeoffs. For example, when designing the plane, Boeing’s engineers had to make decisions about fuel economy and passenger load. Increasing the passenger load decreased fuel economy, so the engineers traded passenger load for fuel economy. Another example revolves around the construction of the Dreamliner. Boeing could have constructed the plane using just a few companies but instead it used over 400. Boeing was trading off the simplicity of dealing with just a handful of companies for the increased specialization by dealing with many specialized companies. • Why might Boeing’s decisions in making the Dreamliner be in the social interest? Building the Dreamliner itself advances the social interest because it increases the quantity of comfortable, rapid transportation. The amount of high-quality transportation available in the economy increases, which benefits society. The decisions in making the Dreamliner advance the social interest because they were designed to make the Dreamliner at low cost and thereby avoid wasting resources. 2. The global economy has three cell-phone users for every fixed line user. Two in every three cell-phone users lives in a developing nation and the © 2015 Pearson Education, Inc.

Chapter 2 . The U.S. and Global Economies

growth rate is fastest in Africa. In 2000, 1 African in 50 had a cell phone; in 2009, it was 14 in 50. Describe the changes in what, how, and for whom telecommunication services are produced in the global economy. What: As the number of cell phone users increases, the global economy has been producing more cell phone telecommunication services. More cell phones are produced, fewer land phones are produced, and presumably more cell phone frequencies are used. How: More telecommunication services are being produced using cell phones rather than fixed-line phones. For whom: While the amount of telecommunication services has been rising throughout the world, it definitely has been increasing rapidly in Africa. So more telecommunication services are being produced for residents of Africa as well as for residents in the rest of the world. 3.

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

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

In the African nation of Senegal, to enroll in school a child needs a Birth Certificate that costs $25. This price is several weeks’ income for many families. Explain how this requirement is likely to affect the growth of human capital in Senegal. Human capital growth depends, in part, on the extent of schooling: More schooling means more human capital. Because of Senegal’s hefty fee for a © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

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

China’s prosperity brings income gap The Asian Development Bank [ADB] reports that China has the largest gap between the rich and the poor in Asia. Ifzal Ali, the ADB’s chief economist, claims it is not that the rich are getting richer and the poor are getting poorer, but that the rich are getting richer faster than the poor. Source: Financial Times, August 9, 2007 Explain how the distribution of personal income in China can be getting more unequal even though the poorest 20 percent are getting richer. The distribution of income in China can be getting more unequal even when the poorest 20 percent are getting richer because the richest 20 percent are getting richer even faster. Because the rich are getting richer faster, the fraction of the nation’s total income received by the poorest 20 percent falls, which makes the personal distribution of income more unequal.

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

Chapter 2 . The U.S. and Global Economies

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

Part 1 . INTRODUCTION

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

Chapter 2 . The U.S. and Global Economies

 Multiple Choice Quiz 1.

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

Which of the following statements about U.S. production is correct? A. Construction accounts for a larger percentage of total production than does manufacturing. B. Real estate services account for 12.6 percent of the value of total production, larger than any other item of services or goods. C. Consumption goods and services represent 85 percent of U.S. production by value and that percentage doesn’t fluctuate much. D. The manufacture of goods represents more than 50 percent of total production. Answer: C Answer C is correct as the data on page 32 show. 3.

Which of the following items is not a factor of production? A. An oil rig in the Gulf of Mexico B. A ski jump in Utah C. A bank loan to a farmer D. An orange grove in Florida Answer: C Answer C is not a factor of production because it is financial capital; see page 35. 4.

What is human capital? A. Immigrant labor B. Someone who operates heavy equipment C. Your professor’s knowledge of the economy D. A car assembly line robot Answer: C Answer C uses the definition of human capital on page 35.

Part 1 . INTRODUCTION

Which of the following statements is correct? A. Labor earns wages and entrepreneurship earns bonuses. B. Land earns interest and capital earns rent. C. Entrepreneurship earns interest and capital earns profit. D. Capital earns interest and labor earns wages. Answer: D Page 37 shows that answer D is correct. 6.

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

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

The Economic Problem

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

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

Beef (pounds) and and and and

0 300 500 600

Part 1 . INTRODUCTION

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

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

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

Describe how the opportunity cost of controlling malaria changes as more resources are used to reduce the number of malaria cases. As more resources are used to control malaria, the opportunity cost increases. Indeed, the malaria chief indicated that the opportunity cost of eliminating the last 10 percent of malaria would have an extremely high © 2015 Pearson Education, Inc.

Good food (units) 0 30 50 60 65 67

Chapter 3 . The Economic Problem

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

Explain how the following events influence U.S. production possibilities: • Some retail workers are re-employed building dams and wind farms. When these former retail workers are re-employed at their new occupations, more dams and wind farms are produced and fewer retail services are produced. The opportunity cost of the increased numbers of dams and wind farms is the forgone production of retail services. There is a movement along the PPF. • More people take early retirement. As more people retire, the quantity of labor available in the economy shrinks. As a result, the nation’s PPF shifts inward. • Drought devastates California’s economy. The nation’s PPF shifts inward as a result of the drought. The drought decreases the amount of productive land, thereby decreasing production of agricultural products and shifting the PPF inward. Use the following information to work Problems 7 and 8. Figure 3.3 (on the next page) shows Tom’s production possibilities and Figure 3.4 (on the next page) shows Abby’s production possibilities. Tom uses all his resources and produces 2 rackets and 20 balls an hour. Abby uses all her resources and produces 2 rackets and 40 balls an hour. 7. What is Tom’s opportunity cost of producing a racket? What is Abby’s opportunity cost of a racket? Who has a comparative advantage in producing rackets? Who has a comparative advantage in producing balls? If Tom increases his production by 1 racket, he forgoes 10 balls. So his opportunity cost of 1 racket is 10 balls ÷ 1 racket, or 10 balls per racket. © 2015 Pearson Education, Inc.

Part 1 . INTRODUCTION

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

If Tom and Abby specialize and trade 15 balls for 1 racket, what are the gains from trade? Both Tom and Abby gain from their specialization and trade. Tom could produce 4 rackets and then trade 2 of the rackets for 30 balls. Tom would wind up with 2 rackets and 30 balls, 10 more balls than he had without the specialization and trade. Abby could produce 80 balls and then trade 30 of them for 2 rackets. Abby would wind up with 2 rackets and 50 balls, also 10 more balls than she had without the specialization and trade.

Read Eye on the Environment on p. 66 and describe a tradeoff faced when deciding how to generate electricity and whether to use wind power. Using wind power to generate electricity requires that the wind turbines be located in areas with wind which often are not near population centers. Long transmission lines are required which means transmissions losses are large. If other sources are used to generate power, long transmission lines are not necessary and smaller generating facilities are required because transmissions losses are less. If wind power is used to generate power, more resources are used and fewer other goods can be produced. © 2015 Pearson Education, Inc.

Chapter 3 . The Economic Problem

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

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

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

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

Part 1 . INTRODUCTION

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

and

opportunity cost of an increase in chicken production 400 and from 300 pounds to 500 pounds a year? Explain your 200 and 0 and answer. If the farm expands chicken production from 300 pounds to 500 pounds, soybean production decreases from 400 to 200 bushels. The opportunity cost of the additional 200 pounds of chicken is 200 bushels of soybean, or 1 bushel of soybeans per pound of chicken. 7.

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

In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. Who has a comparative advantage in producing caps? If Sue and Tessa specialize and trade, who will gain? Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of pro© 2015 Pearson Education, Inc.

0 300 500 550

Chapter 3 . The Economic Problem

ducing one cap is (4 jackets) ÷ (40 caps) or 0.1 jackets per cap. Tessa forgoes 4 jackets to produce 80 caps, so Tessa’s opportunity cost of producing one cap is (4 jackets) ÷ (80 caps) or 0.05 jackets per cap. Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps. If Tessa specializes in caps and Sue specializes in jackets, both Sue and Tessa gain from trade. For instance, suppose they settle upon a price of 1 jacket for 15 caps. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket) ÷ (15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa also gains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap. Use the following information to work Problems 9 to 11. Cheap broadband’s a winner Inexpensive broadband access has created a new generation of television producers and the Internet is their native medium. Source: The New York Times, December 2, 2007 9. How has inexpensive broadband changed the production possibilities of video entertainment and other goods and services? Inexpensive broadband means that the production video entertainment increases when all resources are used for this purpose. It does not change the production of other goods and services when all resources are used for that purpose. 10. Sketch a PPF for video entertainment and other goods and services before broadband. As illustrated in Figure 3.5 by the production possibilities frontier labeled “Initial PPF,” the PPF has video entertainment on one axis and other goods and services on the other. The PPF is bowed outward as a conventional PPF. 11. Explain how the arrival of inexpensive broadband has changed the PPF. The arrival of inexpensive broadband shifts the PPF outward as shown by the change from the initial PPF to the new PPF in Figure 3.5. The intersection of the new PPF along the axis measuring video entertainment increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

Part 1 . INTRODUCTION

 Multiple Choice Quiz 1.

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

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

The table above shows the PPF of an island community. This community’s opportunity cost of producing 1 pound of fish ______. A. is the increase in the quantity of berries gathered as the quantity of fish increases by 1 pound B. increases as the quantity of berries gathered increases C. is 10 pounds of berries if the quantity of fish increases from 2 to 3 pounds D. increases as the quantity of fish caught increases Answer: D Page 66 discusses why opportunity increases as production of the good increases. © 2015 Pearson Education, Inc.

Chapter 3 . The Economic Problem

The table above shows the PPF of an island community. Choose the best statement. A. When a drought hits the island, its PPF shifts outward. B. When the islanders discover a better way of catching fish, the island’s PPF shifts outward. C. When islanders reduce the time they spend gathering berries, the PPF shifts inward. D. If the islanders decide to spend more time gathering berries but continue to spend the same amount of time fishing, they face a tradeoff. Answer: B Page 68 shows that technological progress, such as exemplified in answer B, shifts the PPF outward. 5.

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

Chapter

Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

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

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

•

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

•

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

•

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

•

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

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

Part 1 . INTRODUCTION

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

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

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

Chapter 4 . Demand and Supply

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

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

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

Part 1 . INTRODUCTION

Use the following information to work Problems 7 and 8. Pricier bread and cereal. Coming soon? Wheat and corn prices surged last week and could hit the items in your grocery basket by mid-summer. It’s a case of two extremes: drought in parts of the United States and in Europe have sparked fears of a supply crunch of wheat, while supplies of corn are being threatened by flooding and heavy rain in the Midwest. Source: CNN Money, May 19, 2011 7. Explain why the drought will lead to a rise in the price of bread. The drought decreases the supply of wheat. The price of wheat rises. Wheat is used to produce bread. The higher price of wheat increases the cost of producing bread. The supply of bread decreases, which raises the price of bread. 8.

Use graphs to show why the price of corn has risen and show its effect on the price of cereals. The drought decreases the supply of corn. In Figure 4.2, the supply curves shifts leftward from S0 to S1. The price of corn rises, in the figure from $5.90 per bushel to $6.10 per bushel. Corn is used to produce cereal. The higher price of corn increases the cost of producing cereal. The supply of cereal decreases, shown in Figure 4.3 by the leftward shift from S0 to S1. The price of cereal rises, in the figure from $2.30 per pound to $2.50 per pound.

Chapter 4 . Demand and Supply

Read Eye on Tuition on p. 1017 and explain how we know that tuition has risen because the demand for college places has increased and not because the supply has decreased? We know that the demand has risen because the quantity of students attending college has increased. If the higher tuition was the result of a decrease in supply, the number of students attending college would have decreased.

Part 1 . INTRODUCTION

 Instructor Assignable Problems and Applications 1.

Why can we be confident that the market for college education is competitive and that an increase in demand rather than the greed of college administrators is the reason for the ongoing rise in tuition? There are over 4,500 public, private, 2-year and 4-year schools in the United States. Even if college administrators were greedy, the fact that there are thousands of other colleges with whom they compete keeps their greed from affecting the tuition they charge. If one greedy administrator raised the tuition at his or her college, a large number of students would switch to other colleges whose administrators had not raised the tuition.

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

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

4. Rain falls on wheat parade The price of wheat has fallen from $9 a bushel to $7 a bushel in the past seven months as rain and snow fell on the southern states. Source: The Wall Street Journal, February 12, 2013 Explain the effect of the fall in the wheat price on the market for cereals. Wheat is a key ingredient in many cereals. The fall in the price of wheat

Chapter 4 . Demand and Supply

means that the cost of producing cereal based on wheat has fallen. The fall in the cost increases the supply, thereby shifting the supply curve rightward. The price of cereal falls and the quantity increases. The table shows the demand and supply Price Quantity Quantity schedules for boxes of chocolates in an av(dollars demanded supplied per box) erage week. Use this information to work (boxes per week) 13.00 1,600 1,200 Problems 5 and 6. 14.00 1,500 1,300 5. If the price of chocolates is $17.00 a 15.00 1,400 1,400 box, describe the situation in the mar16.00 1,300 1,500 ket. Explain how market equilibrium 17.00 1,200 1,600 is restored. 18.00 1,100 1,700 At the price of $15.00 a box, the quantity supplied equals the quantity demanded. At a price of $17.00 a box, the quantity demanded is 1,200 boxes and the quantity supplied is 1,600 boxes. There is a surplus of 400 boxes a week and the price falls. As the price falls, the quantity demanded increases, the quantity supplied decreases, and the surplus decreases. The price falls until the surplus disappears. The market equilibrium occurs at a price of $15.00 a box and 1,400 boxes a week so the price falls to $15.00 a box. 6.

During Valentine’s week, more people buy chocolates and chocolatiers offer their chocolates in special red boxes, which cost more to produce than the everyday box. Set out the three-step process of analysis and show on a graph the adjustment process to the new equilibrium. Describe the changes in the equilibrium price and the equilibrium quantity. Starting with the demand side, Valentine’s week increases people’s preferences for boxes of chocolate so the demand for boxes of chocolate increases. The demand curve for chocolates shifts rightward, from D0 to D1 in Figure 4.4. Moving to the supply side, the fancy red box raises the cost of producing boxes of chocolate, which decreases the supply. The rise in the cost of producing boxes of chocolates shifts the supply curve leftward, from S0 to S1 in Figure 4.4. After these changes, at the initial price of a box of chocolate, $15.00, in Figure 4.4 there is a shortage of 600 boxes of chocolate per week. The shortage forces the price higher, so the equilibrium price of a box of chocolate rises, to $18.00 in the figure. The

Part 1 . INTRODUCTION

problem points out that people buy more boxes of chocolate during Valentine’s week. This result means that the change in demand exceeds the change in the supply, that is, the magnitude of the increase in demand exceeds that of the decrease in supply. Figure 4.4 illustrates this situation and in the figure the equilibrium quantity increases from 1,400 boxes per week to 1,500 boxes per week. 7.

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

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

•

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

Illustrate your answer with a graphical analysis. Figure 4.5 shows the effect of making home loans more difficult to obtain. Before the change in difficulty, the demand curve is D0. In the figure the price of a new home is $350,000. After the increase in difficulty, the demand decreases and the demand curve shifts leftward, in the figure from D0 to D1. The supply curve does not shift. The price of a new home falls, in the figure from $350,000 to $275,000. 8. Alabama food prices jump in May Alabama Farmers Federation announced that food prices in May will increase. In previous unprofitable years, farmers reduced their herds with the result that in 2009 meat production will fall. Bacon is expected to rise by 32 cents a pound to $4.18 and steaks by 57 cents to $8.41 a pound. Source: The Birmingham News, May 21, 2009 Explain why the reduction of herds will lead to a rise in meat prices today. Draw a graph to illustrate. The reduction in herds decreases the supply of meat and shifts the supply curve of meat leftward. The demand for meat does not change. The decrease in supply raises the price of meat. In Figure 4.6 (on the next page), the leftward shift of the supply curve from S0 to S1 illustrates the decrease in supply. In the figure the equilibri-

Chapter 4 . Demand and Supply

um price of steak rises from its initial price $7.84 per pound to the new equilibrium price of $8.41 per pound. This rise of 57 cents per pound is the amount of the increase mentioned in the news clip.

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

10. Steel output set for historic drop Steel producers expect to cut output by 10 percent response to cancelled orders from construction companies and car and appliance producers. Source: Financial Times, December 28, 2008 Explain how the cancellation of orders change the market for steel. What happens to the equilibrium price of steel? The cancellation of orders decreases the demand for steel so that the demand curve for steel shifts leftward. The cancellation of orders does not change the supply of steel, so the supply curve of steel does not shift. As the demand curve shifts leftward, there is a movement down along the supply curve of steel and a decrease in the quantity of steel supplied. The equilibrium price falls.

Part 1 . INTRODUCTION

 Multiple Choice Quiz 1.

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

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

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

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

Chapter 4 . Demand and Supply

When floods wiped out the banana crop in Central America, the equilibrium price of bananas ________ and the equilibrium quantity of bananas ________. A. rose; increased B. rose; decreased C. fell; increased D. fell; decreased Answer: B Figure 4.12(b) on page 102 illustrates this case of a decrease in supply. 6.

A decrease in the demand for chocolate with no change in supply will create a ________ of chocolate at today’s price, but gradually the price will ________. A. surplus; fall B. shortage; fall C. surplus; rise D. shortage; rise Answer: A Figure 4.11(b) on page 100 illustrates this case of a decrease in demand. 7.

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

Chapter

Elasticities of Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

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

If the price of a wool sweater did not change, calculate the cross elasticity of demand for wool sweaters with respect to the price of home heating oil. Are home heating oil and wool sweaters substitutes or complements? Why? The cross elasticity of demand for wool sweaters with respect to home heating oil is:  Percentage change in quantity of sweaters demanded   10 percent   =     20 percent  = 0.50. Percentage change in price of heating oil     Home heating oil and sweaters are substitutes because as the price of home heating oil rises, you can stay warm by using less home heating oil and putting on a sweater. The cross elasticity of demand for a substitute is positive.

Part 2 . A CLOSER LOOK AT MARKETS

The figure shows the demand for movie tickets. Is the demand for movie tickets elastic or inelastic over the price range $7 to $9 a ticket? If the price falls from $9 to $7 a ticket, explain how the total revenue from the sale of movie tickets will change. Calculate the price elasticity of demand for movie tickets when the price is $8 a ticket. The percentage change in the quantity of movie tickets demanded equals  300 tickets − 100 tickets    × 100 , or 100  (100 tickets + 300 tickets) ÷ 2 )  percent. The percentage change in the price of a movie ticket equals  $9 a ticket − $7 a ticket    × 100 , or 25  ($9 a ticket + $7 a ticket) ÷ 2 )  percent. So the demand for movie tickets is elastic because the percentage change in the quantity demanded is larger than the percentage change in price. Because the demand is elastic, the fall in the price of a movie ticket increases the total revenue from the sale of movie tickets. When the price is $9 a ticket, the total revenue is $9 a ticket × 100 tickets, which is $900. When the price is $7 a ticket, the total revenue is $7 a ticket × 300 tickets, which is $2,100. So the total revenue increases by $1,200. The price elasticity of demand for movie tickets is the percentage change in the quantity of movie tickets demanded divided by the percentage change in the price of a movie ticket. The percentage change in the quantity of movie tickets  300 tickets − 100 tickets   × 100 , which is 100 perdemanded equals   (100 tickets + 300 tickets) ÷ 2 )  cent. The percentage change in the price of a movie ticket equals  $9 a ticket − $7 a ticket    × 100 , which is 25 percent. So the price elas ($9 a ticket + $7 a ticket) ÷ 2 )  ticity of demand for movie tickets at the price of $8 is 100 percent ÷ 25 percent, or 4.00.

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

Chapter 5 . Elasticities of Demand and Supply

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

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

The price elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in the price. The change in the U.S. quantity supplied is 24 percent and the change in the price is 46 percent. So for the United States, the price elasticity of supply equals 24 percent ÷ 46 percent, which is 0.5. The U.S. supply of corn is not elastic; it is inelastic. 9.

Calculate the world price elasticity of supply of corn. The price elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in the price. The change in the world quantity supplied is 9.9 percent and the change in the price is 46 percent. So the world price elasticity of supply equals 9.9 percent ÷ 46 percent, which is 0.2.

10. Read Eye on the Price of Gasoline on p. 121 and then explain why the demand for gasoline is more inelastic in the short run than in the long run. Which is likely to be more inelastic, the demand for premium gasoline or the demand for all grades of gasoline? The demand for gasoline is more inelastic in the short run because there are more substitutes for gasoline as more time elapses since the price changed. In particular, when the price of gasoline rises, as more time elapses consumers can switch to smaller, more fuel efficient cars. Consumers are less likely to make this substitution immediately because switching cars is expensive and they are more likely to make the substitution the longer the price of gasoline remains high. The demand for all grades of gasoline is more inelastic than the demand for premium gasoline. There are reasonably close substitutes for premium gasoline—mid-octane gasoline and low-octane gasoline—but there are very few substitutes for all grades of gasoline.

Chapter 5 . Elasticities of Demand and Supply

 Instructor Assignable Problems and Applications Use the following information to work Problems 1 and 2. Why the tepid response to higher gasoline prices? Most studies report that when U.S. gas prices rise by 10 percent, the quantity purchased falls by 1 to 2 percent. In September 2005, the retail gasoline price was $2.90 a gallon, about $1.00 higher than in September 2004, but purchases of gasoline fell by only 3.5 percent. Source: The New York Times, October 13, 2005 1. Calculate the price elasticity of demand for gasoline implied by what most studies have found. The price elasticity of demand equals the percentage change in the quantity demanded, 1 or 2 percent, divided by the percentage change in price, 10 percent. Doing the division shows that most studies have found that the price elasticity of demand equals 0.1 or 0.2. 2.

Compare the elasticity implied by the data for the period from September 2004 to September 2005 with that implied by most studies. What might explain the difference? From September 2004 to September 2005, the price of gasoline increased by 41.67 percent (The percentage change equals ($2.90 − $1.90) ÷ $2.40, where $2.40 is the average of the September 2004 and September 2005 price). The quantity demanded decreased by 3.5 percent, so the price elasticity of demand over this year was 3.5 percent ÷ 41.67 percent, which is 0.08. The price elasticity of demand of demand for gasoline calculated over this year is slightly smaller than the conventional range. The price elasticity of demand over the year is probably smaller than normal because other factors that affected the demand for gasoline also changed. In particular, income increased. Gasoline is a normal good, which means that the increase in income increased the demand for gasoline and thereby increased the equilibrium quantity of gasoline. So the 3.5 percent change in the quantity reported in the news clip was composed of two parts: The decrease in the quantity demanded moving along the demand curve resulting from the higher price and the (offsetting) increase in the quantity resulting from higher income. The elasticity of demand should use only the decrease in the quantity demanded resulting from the price rise. Because the decrease in the quantity demanded from a higher price is offset by the increase from higher income, the reported 3.5 percent change in quantity is less than what would be the change resulting from only a higher price, so the computed elasticity of demand is smaller than the conventional range.

When heavy rain ruined the banana crop in Central America, the price of bananas rose from $1 to $2 a pound. Growers sold fewer bananas, but

Part 2 . A CLOSER LOOK AT MARKETS

their total revenue was unchanged. By what percentage did the quantity demanded of bananas change? Is the demand for bananas elastic, unit elastic, or inelastic? Because the total revenue did not change, the percentage change in bananas demanded equals the percentage increase in price. Using the midpoint method, the percentage increase in the price equals ($1.00 ÷ $1.50) = 66.67 percent. So the quantity of bananas demanded decreased by 66.67 percent. The demand for bananas is neither elastic nor inelastic; it is unit elastic because the percentage increase in the price equals the percentage decrease in the quantity of bananas demanded. 4.

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

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

Chapter 5 . Elasticities of Demand and Supply

pasta. So the estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is −(5 percent) ÷ (25 percent), which is −0.2. 6.

“In a market in which demand is price inelastic, producers can gouge consumers and the government must set high standards of conduct for producers to ensure that consumers get a fair deal.” Do you agree or disagree with each part of this statement? Explain how you might go about testing the parts of the statement that are positive and lay bare the normative parts. Most of this statement is normative in nature. The terms “gouge,” “high standards of conduct,” and “fair deal” are all normative. To the extent that the statement can be interpreted as a positive statement, the first part might mean “in a market in which demand is price inelastic, producers can set a higher price than otherwise.” If this is the meaning of the first part, then it is testable by determining the extent to which the price elasticity of demand affects the equilibrium price in markets.

Use the following information to work Problems 7 and 8. Almonds galore! The quantity of almonds harvested in 2008–2009 was expected to increase by 22 percent, while total receipts of growers was expected to increase by 17 percent. Source: Almond Board of California 7. Was the price of almonds expected to rise or fall? Did a change in the supply of or demand for almonds bring about this expected change in the price? The price of almonds is expected to fall because the increase in the quantity of almonds exceeds the increase in growers’ receipts. Specifically, when the quantity increases by 22 percent, if the price does not change, growers’ receipts would also increase by 22 percent. Because growers’ receipts are expected to increase by only 17 percent, it must be the case that the price of almonds is expected to fall. If a change in demand is expected to lower the price of almonds, it must be the case that the demand for almonds is expected to decrease. But if the demand for almonds decreases, then the quantity of almonds decreases, which is not what is expected. If a change in supply is expected to lower the price of almonds, it must be the case that the supply of almonds is expected to increase. And if the supply of almonds increases, then the quantity of almonds increases, which is the outcome noted above. Consequently it is a change in supply, specifically an increase in supply, that is bringing about the expected fall in price.

Part 2 . A CLOSER LOOK AT MARKETS

If the price of almonds changed as a result of a change in the supply of almonds, is the demand for almonds elastic or inelastic? Explain your answer. The total revenue test indicates that the demand for almonds is elastic. The increase in the supply of almonds lowers the price but increases the total revenue. The total revenue test demonstrates that this outcome—the price and total revenue change in opposite directions—occurs when the demand is elastic.

Chapter 5 . Elasticities of Demand and Supply

 Multiple Choice Quiz 1.

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

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

The price elasticity of demand for a good is 0.2. A 10 percent rise in the price will _______ the total revenue from sales of the good. A. decrease B. increase C. decrease the quantity sold with no change in D. not change Answer: B The total revenue test on page 121 shows that a rise in the price increases the total revenue if demand is inelastic. 4.

If the price of a good falls and expenditure on the good rises, the demand for the good is _______. A. elastic B. perfectly elastic C. inelastic D. unit elastic Answer: A The total revenue test on page 121 shows that demand is elastic.

Part 2 . A CLOSER LOOK AT MARKETS

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

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

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

Chapter

Efficiency and Fairness of Markets ANSWERS TO CHAPTER CHECKPOINTS

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

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