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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-

Part 2 . A CLOSER LOOK AT MARKETS

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

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

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

Chapter 6 . Efficiency and Fairness of Markets

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

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

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

Chapter 6 . Efficiency and Fairness of Markets

10. The winner of the men’s or women’s tennis singles at the U.S. Open is paid twice as much as the runner-up, but it takes two to have a singles final. Is this compensation arrangement efficient? Is it fair? Explain why it might illustrate the big tradeoff. The compensation arrangement is efficient because all the participants play their hardest in an attempt to win the prize. As a result, the quality of play is extremely high and the “amount” of tennis produced is large. The fair results approach to fairness asserts that the compensation scheme is unfair because income is not equally distributed. The fair rules approach asserts that the scheme is fair because the players voluntarily enter the tournament and the symmetry principle is not violated. This arrangement might illustrate the big tradeoff because if the winner was paid less and the loser was paid more, both the ultimate winner and the ultimate loser have an incentive to play less hard, that is, they may decrease the amount of tennis they produce. Use the following information to work Problems 11 and 12. eBay saves billions for bidders On eBay, the bidder who places the highest bid wins the auction and pays only what the second highest bidder offered. Researchers Wolfgang Jank and Galit Shmueli reported that purchasers on eBay in 2003 paid $7 billion less than their winning bids. Because each bid shows the buyer’s willingness to pay, the winner receives an estimated consumer surplus of $4 or more. Source: InformationWeek, January 28, 2008 11. What method is used to allocate goods on eBay? How does an eBay auction influence consumer surplus from the good? eBay is using market price to allocate the goods. The market price is the price established in the auction. If someone is willing and able to pay that price, the person will get the item. For the vast majority of auctions the winning bidder will enjoy a consumer surplus so eBay increases consumer surplus. For instance, if there are bidders on a unique item, the winning bidder—who sets the price for the good—will pay a price that is equal to the value of the item to the bidder with the second-highest valuation plus the minimum bid increment. The winning bidder has some consumer surplus as long as his or her value of the good exceeds the price that must be paid, which will almost always be the case. Indeed, a person chooses to buy on eBay rather than elsewhere if the person believes that his or her consumer surplus is largest by purchasing on eBay. 12. Read Eye on Price Gouging on p. 160 and explain why it was inefficient to stop Mr. Shepperson from selling his generators. After the hurricane the marginal benefit from a generator skyrocketed

Part 2 . A CLOSER LOOK AT MARKETS

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

Chapter 6 . Efficiency and Fairness of Markets

 Instructor Assignable Problems and Applications 1.

Panic in paradise: Are high fares the new reality for Hawaii? On March 31, 2008, Hawaii lost 15 percent of its air service as Aloha Airlines and the cheap-flight airline ATA suddenly shut down. Stranded travelers were offered flights to West coast cities at $1,000 one way. Within a month, the fare to west coast cities dropped to about $200 a round trip. Stranded travelers complained of price gouging. Source: USA Today, April 23, 2008 Under what conditions would the $1,000 fare be considered “price gouging”? Under what conditions would the $1,000 fare be an example of the market price method of allocating scarce airline seats? The stranded passengers believed that the surviving airlines had taken advantage of their emergency need for essential flights back to the mainland by sharply boosting the price much higher than normal, which is gouging. If $1,000 is the equilibrium price at which the quantity demanded of flights equaled the quantity supplied, then the $1,000 fare is an example of resources being allocated by the market price. The table shows the demand schedule for Price Quantity Quantity haircuts and the supply schedule for hair(dollars per demanded supplied cuts. Use the table to work Problems 2 and 3. haircut) (haircuts per day) 2. What is the quantity of haircuts 0 100 0 10 80 0 bought, the value of a haircut, and the 20 60 20 total surplus from haircuts? 30 40 40 The equilibrium quantity of haircuts 40 20 60 is 40 per day. The value of the 40th 50 0 80 haircut is $30. The total surplus is equal to the sum of the consumer surplus plus the producer surplus. Figure 6.3 helps in calculating the consumer surplus and producer surplus. The consumer surplus is equal to the area of the dark grey triangle. The consumer surplus equals 1/2 × 40 haircuts × $20 per haircut), or $400. The producer surplus is equal to the lighter grey area which is also $400 so total surplus is $400 + $400 = $800. 3.

Suppose that all salons agree to charge $40 a haircut. How do consumer surplus and producer surplus change? What is the deadweight loss created? If the price is $40 a haircut, the quantity of

Part 2 . A CLOSER LOOK AT MARKETS

haircuts is 20. The consumer surplus in Figure 6.4 is the dark triangle and is $100, so the consumer surplus has decreased by $300. The producer surplus in Figure 6.4 is the light grey area and is $500, so the producer surplus has increased by $100. The deadweight loss is $200. Note that the deadweight loss is equal to the gain in producer surplus minus the loss in consumer surplus.

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

If farmers were charged the same price as city residents pay, how would the price of agricultural produce, the quantity of produce grown, consumer surplus, and producer surplus change? If farmers are charged the same price for water as city residents, farmers’

Chapter 6 . Efficiency and Fairness of Markets

costs increase. The increase in costs decreases the supply of agricultural products, so the price of agricultural produce rises and the quantity decreases. Consumer surplus decreases and producer surplus also decreases. 6.

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

New Zealand’s private forests In the early 1990s, the government auctioned half the national forests, converting these forests from public ownership to private ownership. The government’s decision was an incentive to get the owners to operate like farmers—that is, take care of the resource and to use it to make a profit. Source: Reuters, September 7, 2007 Was the timber industry efficient before the auction and did logging companies operate in the social interest or self-interest? What effect has private ownership had on efficiency of the timber industry? Probably before the auction the New Zealand timber industry was not operating efficiently. The forests were owned by the government and the government does not face the same incentives faced by private owners. Logging companies, operating in their self-interest, have the incentive to cut as much timber as economically possible to make the largest possible profit. They do not have the incentive to preserve any particular forest because they can switch to another forest if one becomes depleted. When logging companies negotiate how much timber and what price they must pay for the timber they will cut, private owners have the incentive to limit the amount of the harvest to insure that there will be timber to be cut in the future so that the owner can make a profit in the future as well as the present. With government ownership, however, the same incentive does not exist because the government is not trying to insure its profitability in the future. Logging companies were probably able to convince government officials to allow more than the efficient amount of logging, so the forests were likely over-logged when the government owned them. Since auction it is probable that the New Zealand timber industry has operated efficiently. The private forest owners have the incentive to limit the extent of logging so that the owner can sell logging rights throughout the future. With this institutional set up, logging companies have operated in their self-interest which has been the same as the social interest.

Chapter 6 . Efficiency and Fairness of Markets

 Multiple Choice Quiz 1.

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

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

When the marginal benefit from a good exceeds its marginal cost, ______. A. there is overproduction of the good B. a deadweight loss, which is the excess of marginal benefit over marginal cost, arises C. producer surplus decreases and consumer surplus increases D. total production increases and efficiency increases Answer: B Figure 6.9(a) on page 155 shows the deadweight loss when the marginal benefit exceeds the marginal cost. 6.

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

The allocation of resources is fair ______. A. in the fair-rules view if everyone has equal opportunity B. in the fair-results view if most resources are distributed to the poorest people C. in the fair-rules view if owners of the resources are protected by property rights and all transfers of resources are voluntary D. in the fair-results view if resources are transferred voluntarily so that everyone has the same quantity Answer: C Page 159 discusses the rules view of fairness.

Chapter

Government Actions in Markets ANSWERS TO CHAPTER CHECKPOINTS

 Study Plan Problems and Applications 1.

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

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

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

Price (dollars per month)

0 10 20 30 40

Quantity Quantity demanded supplied (units per month)

30 25 20 15 10

0 10 20 30 40

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

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

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

Chapter 7 . Government Actions in Markets

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

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

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

Use the following news clip to work Problems 9 and 10. Coal shortage at China plants The government of China has set price controls on coal and gasoline in an attempt to shield poor families and farmers from rising world energy prices. Chinese power plants have run short of coal, sales of luxury, gas-guzzling cars have increased, and gasoline consumption has risen. Oil refiners are incurring losses and plan to cut production. Source: CNN, May 20, 2008 9. Are China’s price controls price floors or price ceilings? Draw a graph to illustrate the shortages of coal and gasoline created by the price controls. China’s price controls are price ceilings. In the face of increased demand, China’s price controls have kept the price from rising to its equilibrium. As a result the quantity demanded exceeds the quantity supplied and shortages have resulted. Figure 7.4 (on the next page) illustrates the situation in the market for coal; the figures for gasoline is similar. In Figure 7.4 at the controled price of $550 per ton, the quantity of coal

Chapter 7 . Government Actions in Markets

demanded is 100 million tons per week, the quantity of coal supplied is 97.5 million tons per week so there is a shortage of 2.5 million tons per week. 10. Explain how China’s price controls have changed consumer surplus, producer surplus, total surplus, and the deadweight loss in the markets for coal and gasoline. Draw a graph to illustrate your answer. China’s price controls aim to keep the price from rising to the equilibrium level. A price ceiling decreases the quantity available to the quantity supplied at the price ceiling. In Figure 7.5, the quantity with the price control is 97.5 million tons of coal per week. Because the price and quantity decrease, producer surplus decreases. Because the quantity decreases and search costs are incurred, consumer surplus decreases. Because the quantity decreases and marginal benefit exceeds marginal cost, a deadweight loss arises. Figure 7.5 shows the changes in consumer surplus, producer surplus, and deadweight loss. With no price ceiling the consumer surplus is equal to area A + area B + area C. With the price ceiling consumer surplus is equal to area A. Search costs are area B + area E. The producer surplus without the price ceiling is equal to area E + area F + area G. With the price ceiling the producer surplus is equal to area G. Without the price ceiling there is no deadweight loss. With the price ceiling there is a deadweight loss equal to area C + area F and area B + area E are resources lost to search activity. 11. Read Eye on Price Regulation on p. 185 and explain why a mismatch between intention and outcome is inevitable if a price regulation seeks to block the laws of supply and demand. Price regulations have as their purpose the goal of changing the market outcome. For example, minimum wage laws raise the wage rate paid lower-skilled workers and rent controls lower the rent paid for apartments. In both instances, the law is designed to change the equilibrium

Part 2 . A CLOSER LOOK AT MARKETS

price (the wage for the minimum wage and the rent for rent controls) determined by supply and demand. Because the equilibrium price is the only price at which there is neither a shortage nor a surplus, a law that changes the price automatically creates either a shortage or a surplus. In the Eye on Price Regulation, the cap on executive pay would create a shortage of executives.

Chapter 7 . Government Actions in Markets

 Instructor Assignable Problems and Applications 1.

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

Because the supply is perfectly elastic, the buyers pay all the tax and the sellers pay none of the tax. The price rises 20 percent. The elasticity of demand is 1.0, so the quantity demanded decreases by 20 percent. Before the tax, 240 boats were bought, so the tax decreases the number of boats sold by (240 boats) × (20 percent), which is 48 boats. So after the tax, 192 boats are bought. The government collects a tax of 20 percent on each boat, so the government collects $200,000 tax on each. The total tax revenue the government collects is ($200,000 a boat) × (192 boats), which is $38.4 million. 3.

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

Chapter 7 . Government Actions in Markets

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

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

Part 2 . A CLOSER LOOK AT MARKETS

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

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

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

Use the following information to work Problems 8 and 9. Crop prices erode farm subsidy program High corn and soybean prices mean farmers are making the most money in their lives. At the same time, grain prices are far too high to trigger payouts under the U.S. primary farm-subsidy program’s “price support” formula. The market has done what Congress couldn’t do and that is “slash farm subsidies.” Source: The Wall Street Journal, July 25, 2011 8. Draw a graph to illustrate the soybean market when the soybean price was low. Show the quantity of soybeans produced, the subsidy farmers received, and the deadweight loss created. Figure 7.10 (on the next page) illustrates the market for soybeans. In the

Chapter 7 . Government Actions in Markets

absence of the price support, the equilibrium price is $12.00 per bushel and 2.9 billion bushels are produced. With a price support of $12.50 per bushel, 3.1 bushels are produced. The subsidy the farmers received is illustrated in the figure as the light grey rectangle (some of which lies behind the deadweight loss triangle). The deadweight loss is the dark grey triangle in the figure. 9.

In the market for corn with a price support, explain why the corn price has risen and ended up being too high to “trigger payouts.” The price of corn has risen because rising demand for corn has increased the price and because a poor growing season has decreased the supply, which has also boosted the price. The equilibrium price of corn exceeds the support price, so the support price has no effect on the market. At the equilibrium price, the quantity demanded equals the quantity supplied and there is no surplus that the government needs to purchase.

Part 2 . A CLOSER LOOK AT MARKETS

 Multiple Choice Quiz 1.

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

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

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

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

Chapter 7 . Government Actions in Markets

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

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

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

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

Global Markets in Action ANSWERS TO CHAPTER CHECKPOINTS

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

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

Chapter

Part 3 . A CLOSER LOOK AT MARKETS

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

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

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