Answers Text Questions

Chapter 1: Economics and Economic Reasoning

Colander’s Economics, 6th EditionAnswers to End-of-Chapter Questions

by David Colander

A Note about the Answers

The following answers are meant as guides to answering the end-of-chapter questions, not as definitive answers. The same questions often have many answers; this is especially true of policy-oriented questions. Although we have tried hard to see that mistakes are eliminated, the reality is that, as in any human endeavor, mistakes are inevitable. If you have checked and double-checked your answer and it is substantially different from that found here, assume that our answer is wrong, not yours. If you do come to a different answer, or think an answer misses an important aspect of the question, please check for corrections at my website to see if the answer has changed. If you don’t find it there, please e-mail me at [email protected] with your answer and an explanation of why you think it is better. I will get back to you and if I think you are right, I will post the change on the Web page marked “Corrections,” together with your name and a thank-you.

Chapter 1: Economics and Economic ReasoningQuestions for Thought and Review

1. The author focuses on coordination rather than on scarcity to emphasize that wants are changeable and partially society-determined, and to emphasize that the degree of scarcity changes as the quantity of goods, services and usable resources changes with technology and human action which underlie production.

2. The responses will be varied since this question asks individual students about choices they have made. In these responses students should be encouraged to consider all the costs and benefits, and to be clear about the concept of the marginal costs and marginal benefits; sunk costs should not be included in the decision-making process.

3. Regretting a decision doesn’t necessarily mean that we did not use the economic decision rule when making the decision. At the time the decision was made, we weighed the marginal costs and marginal benefits, undertaking the activity if the marginal benefits exceeded the marginal costs and not undertaking the activity if the marginal costs exceeded the marginal benefits. Many decisions are made without knowing the full marginal costs and marginal benefits. Sometimes these marginal costs and marginal benefits are revealed at a later date making us regret our initial decision. An example is going out to a restaurant. From recommendations, we assume that the marginal benefit is one thing. If that recommendation overstates our actual experience, we will have overestimated the marginal benefit of eating out. We may regret having spent the money to eat out.

4. The opportunity cost of buying a $20,000 car is the benefit we would have gained by using that $20,000 for the next-best alternative, which could be spending it on other goods or saving it.

5. Only the marginal costs and benefits of taking the job are relevant. That means the sunk cost of the bachelor’s degree is irrelevant. Therefore, the relevant costs are the opportunity cost of taking the job (forgone earnings from your current job) and the tuition to attend the business school. The relevant benefit is the increased lifetime earnings of $300,000.

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6. I would spend the $5 million on those projects that provide the highest marginal benefit per dollar spent. The opportunity cost of spending the money on one project is the lost benefit that the college would have received by spending it on some other project. Thus, another way to restate the decision rule is to spend the money on the project that minimizes opportunity cost per dollar.

7. No, since the marginal cost of drug control exceeds the marginal benefit, government should not spend $4,170 to deter one person from using drugs.

8. Three ways (among many) that dormitory rooms could be rationed include: administrative decree, lottery, and a market system. In the first, individual behavior would be forced to fit the will of the administrator. Individuals would likely complain and try to influence the administrator's decision. In the second, individual behavior would be forced to fit the luck of the draw; individuals would likely attempt to trade rooms after the draw. In the final example, individual behavior would have already been subject to economic forces, and thus, there will be no tendency to trade after one has "bought" the room one can afford. Because administrative decree is not necessarily an efficient system, some people would likely attempt to trade rooms after the allocation.

9. It depends on the perspective one takes. It is economically reasonable to legalize organ sales. But from a moral perspective, organ sales are against unethical, and poorer people might feel compelled to sell their organs to support their family, a result that many people would final morally reprehensible. Economics has nothing definitive to say on normative moral issues such as this.

10. It suggests that policy should be willing to give up more in possible gains to avoid losses than otherwise would be the case. Economic policies should be risk averse—more committed to maintaining the current standard of living than in risking economic losses by trying to improve it.

11. Two examples of social forces are our unwillingness to charge friends interest, and our unwillingness to “buy” dates with other people. These issues are still subject to economic forces; however, there is no market in “dates” or in loans to friends, and hence the economic force does not become a market force.

12. Two examples of political or legal forces are rent control laws and restrictions on immigration. They both prevent the invisible hand from working. The rent control laws place a price ceiling on rent, causing shortages of apartments, and the immigration restrictions cause the number of immigrants seeking entry to exceed those allowed to enter, which tends to cause wage rates to differ among countries.

13. An economic model is a framework that places the generalized insights of the theory in a more specific contextual setting. Policymakers need to understand the empirical evidence supporting the theory as well as real-world economic institutions to make policy recommendations.

14. No; economic theory proves nothing about what system is best. It simply gives ways to look at systems, and what the advantages and disadvantages of various systems will likely be. Normative decisions about what is best can only follow from one’s value judgments.

15. Two microeconomic problems are the pricing policies of firms (price fixing in particular) and how wages are determined in labor markets. (Why do athletes and celebrities make so much money anyway?) Two macroeconomic problems are unemployment and inflation.

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16. Banks are economic institutions. They take a cost-benefit approach to deciding to whom to give loans and influence decision making by allowing individuals to spend more money than they either earn or have as wealth.

17. A good economist always tries to be objective. However, no one can ever be completely objective, even some of the time. Sometimes the best we can hope for is an awareness of the cultural norms and value judgments that influence our views and decisions. Additionally, many policy issues (such as organ markets and minimum wage laws) should probably not be approved in a purely objective way, since they are also moral and social issues.

Chapter 1: Problems and Exercises

1. The marginal costs are the additional costs. They are 15 cents per mile for miles above 150 plus the cost of gas. The initial payment can be forgotten because it is a sunk cost; it is not part of marginal costs.

2. a. The opportunity cost of attending college is the sacrifice one must make by attending college. It can be estimated by figuring out the benefit of the next-best alternative. If that alternative is working, one would guess the likely wage that could be earned at a job that does not require a college degree (minimum wage? more?) and then multiply by 40 hours for each week in college.

b. The opportunity cost of taking this course could also be estimated using the same technique as in a if you otherwise would be working for these hours. If you had taken another course instead, the opportunity cost would be the benefit you would have received from taking that course.

c. The opportunity cost of attending yesterday’s lecture again would depend on what you otherwise could have done with the time (sleep? eat lunch with an interesting person?). Although this is no longer a choice to you, past activities do have opportunity costs.

3. a, b. Parts a or b have no “right” answers. Most people would say “no” to a and “yes” to b. c. People tend to believe that children should be afforded greater protection than afforded to adults and

are therefore repulsed by the idea of sacrificing a child even though it would save the lives of other children. A sick person is closer to death and therefore their life tends to be valued less.

d. Brain imaging suggests that the moral sense behind one’s answers does not come from rational thought, but instead from emotion—gut responses. This suggests that a kind of moral intuition exists that is quite separate from reason. If that is the case, opportunity costs were not central to the decision. It was a moral, not an economic decision. Opinions among philosophers and economists differ on this issue.

4. a. It depends on the perspectives used to answer the question. From a pure economic perspective, we would conclude that it is reasonable to execute hackers based on cost benefit analysis. However, since this decision by no means can be simplified to pure economics, we need to take into consideration social, political, and religious factors. Therefore, Landsburg’s argument should be evaluated in a more complete context.

b. Cost benefit analysis can be extended to many areas, such as social welfare programs and almost all the policy discussions. (Source: “Feed the Worms Who Write the Worms to the Worms,” http://slate.msn.com/id/2101297#ContinueArticle), Slate Magazine, May 26, 2004.)

5. a. This is a matter of personal views; there are arguments for and against it. An argument against the practice is that wealthy songwriters would have too much power in promoting their songs. The songs of those songwriters who can afford to share profits will get more play time and become even more famous at the detriment to new entrants into the industry. Arguments for this practice is that it

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could be used to offset racism as in the example given or to the extent that new songwriters have the capability of offering such royalty share, to promote new kinds of music.

b. The royalty payment gave Freed a strong incentive to choose what he considered the best song, and to promote that song heavily. The flat payment would have just given him an incentive to play any song, and no long-term interest in whether the song succeeded or failed.

c. Product placement in movies is legal, as are free newspapers to professors for getting your class to use the newspaper. Direct payment to doctors for prescribing a particular type of drug is illegal, although taking doctors to lunch is not.

6. a. Greater willingness to pay. Sponsorship of a stadium is a way of advertising a company and its products. Teams that are new to a city are expected to receive above-average media exposure and therefore greater benefits.

b. Greater willingness to pay. Corporations are willing to pay more at stadiums that are in more populated areas because their advertising will reach a larger number of people.

c. Lower willingness to pay. Stadiums with already well-established names are worth less because the current name is so highly recognized that it will take longer for people to adopt the new name. (Source: “What’s in a Name? Price Variation in Sport Facility Naming Rights,” Eastern Economic Journal, Fall 2003.)

7. a. It depends. On the basis of cost benefit analysis, one could figure out cases where most people would say that they should be dishonest, but cost benefit analysis is not the final arbiter, if you believe that dishonesty is wrong. Additionally, you should consider the effects of dishonesty on your reputation and future interactions.

b. You can make yourself more believable by developing a reputation for honesty. Developing such a reputation usually has a cost because it requires one to be honest even when most people would be dishonest. To encourage the other person to tell the truth, you could use economic incentives. For example, in the kissing situation, tell them you’ll kiss them again if they say yes—then they’ll have a strong incentive to be honest.

8. The person who gains the kidney benefits if it works when transplanted into his or her body, and will no longer have the emotional and financial burden of dialysis. The person selling the kidney gains the $30,000. Their gains will also have impacts on others (their families, for example). Both parties must undergo surgery and face all of the attendant risks and costs. The seller also faces the potential cost of a future illness or injury harming his or her only remaining kidney causing a need for the seller to need dialysis. As to whether a society should allow this transaction, we must recognize that this is a question of value judgments and cultural norms. In our society we have chosen not to allow such transactions because (among other reasons) those with more money would have increased access to organs and would therefore have advantages over those of limited means, and the poor could be exploited in such transactions.

9. Assuming who pays for dates reflects supply and demand considerations, and assuming that the majority of the Chinese are heterosexual, this suggests there will be a shortage of women, and thus men will be paying a higher percentage of the cost of dates in the future. Each woman will be able to choose between several men for each date, forcing them to compete and lower their “price.”

10. a. Micro with macro implications.b. Micro.

c. Micro with macro implications. d. Micro. e. Micro.

f. Macro with micro implications

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11. a. In this exercise you are asked to obtain prices on a gallon of milk from a supermarket and a convenience store.

b. Most likely, the price in the convenience store is higher (unless they are being used as a loss-leader). Someone will buy milk at a higher price because it is more convenient to purchase it at that store (conveniently located and open longer hours) or the store may be the only source at a given time.

c. Unlike milk (which is a standardized product), clothes come in different brands, types, and perhaps quality. Saks clothes cost more, but one is also buying the Saks cachet.

12. a. Positive statement since it is a statement of fact.b. Normative.c. This could be seen as a positive statement since it is a statement of fact, although since it deals with

normative issues, it could also be interpreted as a normative statement.d. Since this is relating a normative goal with a decision, this could be statement in the art of

economics. It could also be seen as a normative statement if one interprets it as a normative imperative.

e. Positive statement since it is a statement of fact.

13. The Theory of Moral Sentiments emphasizes the importance of morality. The invisible hand directs people’s selfish desires (tempered by the social and political forces) to the common good but is based on certain presuppositions about the morality of individuals, which constrains individuals’ selfish actions. What Smith is suggesting is that the marginal cost and marginal benefit used by individuals must be interpreted within a social context.

Chapter 1: Web Questions

1. Students’ answers to this question will vary. Here is an example. Quantitative economist, executive secretary, WTO unit advisor to Egypt, financial analyst, marketing executive, web ad sales manager, project manager, etc. The CIA is offering a job to an economist that would analyze foreign economies, international trade, international finance, etc. General Electric is offering a job to an economist with responsibilities that include developing pricing and quantitative market models for General Electric.

2. On www.movingideas.com we found an article about a case heard by the Supreme Court on April 1, 2003 to review University of Michigan’s policy to promote a diverse student body. Whether their policy is legal depends on affirmative action laws, or legal forces. Another example of a political force is the United States-led war on Iraq in 2003. All major news organizations covered this event. We found an article on The American Prospect at www.prospect.org. The war affects business domestically and abroad.

3. Students’ answers to this question will vary.a. A map is similar to an economic model because both provide a way of understanding relationships

among variables, but are not specific. Both must be combined with additional knowledge to apply to the real world. Maps need to be combined with landmarks and traffic indicators to travel. Economic models need to be combined with a knowledge of economic institutions to make policy recommendations.

b. A limitation of maps is that they cannot provide every detail of a town such as important landmarks,

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crosswalks, or the address of a specific person.c. The map we used was not topographic, so we could not use it to determine elevation

change. It did have a legend and so, we could estimate distances. It did not indicate traffic speeds. This suggests that if we wanted to estimate travel time accurately, we might have difficulty. This suggests that the map or model chosen needs to fit one’s purpose. If we wanted to estimate the time it would take to hike a mountain, for instance, having a topographic map would be more important.

Chapter 2: Trade, Trade-Offs, and Government PolicyQuestions for Thought and Review

1. The accompanying grade production possibility curve embodies the principle of increasing marginal opportunity costs. The table is presented below. Notice that the amount of points lost on the History grade for each 10-point gain in the Economics grade steadily increases.

History Economics 40 10060 8080 68

2. If there were decreasing marginal opportunity costs, the production possibility curve would be convex with respect to the origin instead of concave. This means that (in terms of the example on page 26 of the text) we would gain more and more guns for every pound of butter we give up. An example of this is found in a situation in which a practice makes perfect; i.e., smaller and smaller numbers of hours devoted to a task, or sport, will result in bigger and bigger gains in performance.

3. In the figure to the right, wadget production is measured on the vertical axis and widget production is measured on the horizontal axis. If the society becomes more productive in its output of widgets, it can produce more of them, and the end point of the curve on the horizontal axis will move to the right, as shown. If the society is also less productive in its production of wadgets, the end point on the vertical axis will move down, as shown. The result is a new production possibilities curve.

4. If a society became equally more productive in the production of both widgets and wadgets, the production possibility curve would shift out to the right as shown in the accompanying graph.

5. The theory of comparative advantage underlies the shape of the production possibility curve. By taking advantage of each person's comparative advantage, higher total output can be reached than if each produced on their own, or if each produced goods where they did not have a comparative advantage. As more and more of a good is produced, resources that have less of a comparative advantage are brought into the production of a good, causing the production possibility curve to be bowed outward.

6. This statement can be true or false depending on the implicit assumptions made in the analysis. It is true since individuals will eliminate all inefficiencies they see through trading. It might be false if not everyone knows all the benefits and the inefficiencies, or does not have the opportunity to correct the inefficiencies, or if the costs of eliminating the inefficiency is too high.

7. A democratic system has elected officials who often promise more of everything, obscuring the difficult tradeoffs that actually exist. They do so to increase the chances of getting elected.

8. There are no gains to trade when neither of two countries has a comparative advantage in either of two goods.

9. If a particular distribution of income is one of society’s goals, a particular production technique that leads to greater output, but also an undesirable distribution of income, might be considered an inefficient method of production. Remember, efficiency is achieving a goal as cheaply as possible. Maximizing output is not the only goal of a society.

10. The fact that the production possibilities model tells us that trade is good does not mean that in the real world, free trade is the best policy. The production possibilities model does not take into account the importance of institutions and government in trade. For example, the model does not take into account externalities associated with some trades, the provision of public goods, or the

need for a stable set of institutions of rules. The production possibility model shows maximum total output, but that is not the only societal goal to take into account when formulating policy.

11. No. By definition, if one country has a comparative advantage in producing one set of goods, the other country has a comparative advantage in the other set of goods. Even though U.S. wages are higher than wages in China and India, to the degree that those higher wages are supported by comparative advantages in technology, institutional structure, specialized types of knowledge and entrepreneurial know-how, they can continue. If there is a large trade imbalance, then forces will be set in motion, such as exchange rate adjustment, which will change the relative wage structure among countries to prevent outsourcing from continuing. Additionally, many jobs cannot be outsourced effectively because they require physical proximity to the point of sale.

12. Outsourcing is a product of the law of one price as it relates to the prices of factors. Because wages of workers in India and China are lower than in the United States, aspects of production that currently are done in the United States but can be done in China and India will tend to be outsourced as long as their workforce has the skills, their plants have the technology, and their countries have the necessary infrastructure. Net outsourcing will continue as long as the relative wage differential between the United States and China and India is such that it is more cost effective for firms to shift production. A fall in the U.S. exchange rate or a rise in Chinese wages are likely to slow and eventually stop outsourcing.

13. The wage differential between countries can be reduced by changes in exchange rates. A fall in a country's exchange rate will lower its relative wage, and a rise in a country's exchange rate will raise its relative wage.

14. The six roles of government in a market economy are (1) providing a stable set of institutions and rules, (2) promoting effective and workable competition, (3) correcting for externalities, (4) ensuring economic stability and growth, (5) providing public goods, and (6) adjusting for undesired market results. Which of the six is the most controversial is open to debate. One possibility is the sixth role, adjusting for undesired market results. The problem is determining what results are “undesirable” and what rules should guide government in deciding on the desired result. Intervening in the market might create more problems than it solves.

15. People have made decisions based on the rules that were set up, so changing them after the game has been started may be more unfair than continuing to play by the original rules. Such decisions must be made based on the marginal cost and benefit of changing the rules.

16. Pollution permits require firms pay the cost of pollution they create. By making these permits tradable, firms that face the lowest cost of reducing pollution will reduce pollution emissions the most. Permits assign rights, thereby correcting for the externality.


1. a. See the accompanying graph.b. As the output of food increases, the marginal opportunity cost is increasing. To illustrate, giving up

4 of clothing (from 20 to 16) results in a gain of 5 food (from 0 to 5), but giving up another 4 clothing (from 16 to 12) results in a gain of 4 food (from 5 to 9), and this pattern continues.

c. If the country gets better at producing food, the endpoint of the production possibilities curve on the horizontal axis will move to the right.

d. If the country gets equally better at producing food and clothing, the endpoint of the production possibility curve on the horizontal axis will move right, and the endpoint of the production possibility curve on the vertical axis will move up by the same proportion.

2. a. From the numbers alone, one would choose not to work because the opportunity cost of working is giving up an $80,000 increase in lifetime income while the benefit is $32,000 of income now. Although there is a correlation between working time and GPA, we cannot conclude that working an after-school job causes the decrease in GPA. Therefore one might be able to maintain a decent GPA while working. Moreover, earning money might be the priority for a particular student for a particular period of time, due to certain circumstances, such as saving for college that will lead to even greater lifetime earnings.

b. It depends on the particular student. Working takes time from study and thus might be a reason for the decrease in GPA. But the situation varies from student to student.

3. a. See the accompanying graph.b. The United States has a comparative advantage in the

production of wheat because it can produce 200 additional tons of wheat for every 100 fewer bolts of cloth while Japan can produce 50 additional tons for every 100 fewer bolts of cloth. Japan has a comparative advantage in producing cloth.

c. A number of trades are possible. One is that the United States produces 1000 tons of wheat and Japan produces 1000 bolts of fabric. The United States trades 400 tons of wheat for 400 yards of fabric. The United States ends up with 600 tons of wheat and 400 yards of fabric while Japan ends up with 400 tons of wheat and 600 yards of fabric. Both end up with more of each good.

d. The combined production possibility curve with specialization and trade is shown in the graph. It is the outermost curve.

4. a. A Toyota in the U.S. costs 4/3 Chevrolets, while in Japan a Toyota costs 2 Chevrolets.b. Japan has the comparative advantage in producing Chevrolets.

c. Since Japan has the comparative advantage in producing Chevrolets, it should produce Chevrolets and the U.S. should produce Toyotas, regardless of the fact that the U.S. demands more Chevrolets than Toyotas.

5. The fact that lawns occupy more land in the United States than any single crop does not mean that the United States is operating inefficiently. Although the cost of enjoying lawns is not included in GDP, lawns are nevertheless produced consumption goods and are included in the production possibility curve for the United States. The high proportion of land devoted to lawns implies that the United States has sufficient food that it can devote a fair amount of land to the production of goods for enjoyment such as lawns.

6. Following the hint that society’s production possibility curve reflects more than just technical relationships, we realize that trust is an input to production to the extent that it is necessary for transactions. If everyone could fake honesty, the production possibility curve would shift inward since no one could trust anyone else leading to the disintegration of markets. If some could fake honesty, those few will gain at the expense of others. This is an example of the tragedy of the commons.

7. This exercise asks students to gather information about the limitations on businesses of different types in their communities. They are then asked to make judgments as to whether the limitations were necessary (are they clear about the goals involved?) and whether the number of limitations is correct. The information is linked to the text’s material in part d. Part e asks students to learn about business taxes in their communities, and part f has them gather a sense of business satisfaction.

8. A merit good is a good that government believes is good for you even if you choose not to buy it. An example might be operas. A demerit good is a good that government believes is bad for you even if you choose to buy it. An example is alcohol or drugs. A public good is a good that if supplied to one person must be supplied to all and whose consumption by one does not preclude the consumption by another. An example is national defense. An externality is the effect of a trade on a person not involved in the trade. An example is cigarette smoke.

a. Individuals might disagree as to the categorization of a good as a merit, demerit or public good or a good that involves an externality. In the case of an externality, they may believe that given sufficient property rights, the externality will be solved most efficiently by the market, not government.

b. We discuss the issues of market failure and government failure in the case of operas. There is market failure only if people do not value operas as much as they should. This normative statement is valid only if the “should” can be measured against some absolute truth as to the value of operas, otherwise how would one decide who decides the value of operas? Because it is only through the market that value is revealed, we’d argue that government intervention in this case will likely lead to government failure—the failure of government to accurately value operas. With government intervention, the value will likely reflect the preferences of those with political power, not necessarily those of the general population.


1. The answer to this question will vary depending on what country is chosen. We chose Brazil.a. Brazil’s major industries are textiles, shoes, chemicals, cement, lumber, iron ore, tin, steel, aircraft,

motor vehicles and parts, other machinery and equipment. Brazil imports machinery and equipment, chemical products, oil, electricity, autos and auto parts.

b. Brazil has a comparative advantage in those goods it produces—textiles, shoes, lumber iron ore, and others. We chose these goods because it produces them. This may not be the best way to determine comparative advantage because there may be other reasons why Brazil produces these goods. For example, government may provide subsidies to produce them.

c. Brazil’s trading partners are the United States, Argentina, Germany, Japan and Italy. Argentina is one of its trading partners because of its geographic proximity.

2. a. The defining belief of libertarians is that everyone should be free to do as they choose, so long as they don't infringe upon the equal freedom of others.

b. We were scored as centrists. We’d agree with this result. Government intervention can improve market results in certain cases. Government involvement in the market economy needs to be assessed on a case-by-case basis.

c. Libertarian’s main objections to government regulation is that regulations limit an individual's choices, especially their choices about what to do with their property.

Chapter 2: Appendix A

1. See the accompanying graph.

2. See the accompanying graph.a. The relationship is nonlinear because it is not straight. It is

curved.b. From 0 to 5, cost declines as quantity rises (inverse).

From 5 to 10, cost rises as quantity rises (direct).c. From 0 to 5, the slope is negative (slopes down). From 5

to 10, the slope is positive (slopes up).d. The slope between 1 and 2 units is the change in cost

(30-20) divided by the change in quantity (1 - 2), or -10.

3. See the accompanying graph.

4. a. 1 b. -3 c. 1/3 d. -3/4 e. 0

5. a. C b. A, E c. B,D d. B is a local maximum; D is a local minimum.

6. a. See line a in the accompanying graph. b. See line b in the accompanying graph.c. See line c in the accompanying graph.

7. a. y = 5x + 1,000 b. y = 3x + 1,500.

8. a. line graph b. bar graph c. pie chart d. line graph

Chapter 3: The Evolving U.S. Economy in Perspective Questions for Thought and Review

1. The central coordinating mechanism in a market economy is price.

2. The central coordinating mechanism in Soviet-style socialism is the central planners.

3. Market economies solve the three problems through markets and the system of rewards and payments. What gets produced is what businesses believe can be sold. How it gets produced is determined by business; generally they choose the method that makes the largest profit. Those who are willing to pay for the goods at the market-determined prices will get them. Thus, supply and demand determine what, how, and for whom to produce.

4. Soviet-style socialism solves the three problems by using administrative control. Central planners decide what to produce according to what they believe is socially beneficial. Central planners decide how to produce guided by what they believe is good for the country. Central planners decide distribution based on their perception of individuals’ needs.

5. The answer to this question requires determining what is meant by better. Economics can explain how each system functions and explain how efficient each is, but economics does not provide an answer to normative questions without imposing normative judgments.

6. Markets have little role in most families. In most families decisions about who gets what are usually made by benevolent parents. Because families are small and social bonds strong, this benevolence can work. Thus, a socialist organization seems more appropriate to a family and a market-based organization to a large economy where social bonds don’t hold the social unit together. The propensity to look after the common good is much stronger in a family than in an entire economy.

7. False. Past systems such as, feudalism and mercantilism, as well as the more recent Soviet-style socialism and market economies have all involved planning. The difference is in who does the planning. Feudalism relied on tradition for the planning. In mercantilism, the government did most of the planning. In Soviet-style socialism, central planners did the planning. In market economies, the managers of firms do the planning, with consumers deciding whether those plans are correct.

8. An economy depends on coordination, and the mechanisms of coordination depend on the people who choose which goods to supply and what to demand. People supply the labor that makes the economy run. Economic growth, and what is considered a resource depend on technology, and people develop new technologies. Even the institutions that oversee the economy are governed by that economy’s people. It follows that the economy’s ultimate strength resides in its people.

9. Consumers decide what goods they want, and demonstrate their decisions in their willingness to pay for the goods. Businesses decide what to produce, but their decisions reflect consumer desires. Thus, there is no contradiction. However, advertising, in which businesses attempt to influence behavior, can mediate the principle of consumer sovereignty.

10. Business is dynamic; it involves meeting new problems constantly, recognizing needs, and meeting those needs in a timely fashion. These are precisely the skills of entrepreneurship.

11. You would most likely choose a sole proprietorship because it’s easy to start, requires minimal bureaucratic hassle, and is controlled by you, the owner. If you need more money than you have to start this business, you might consider taking on a partner. This would also allow you to share the work and the risk, but you will also have to share the profits and figure out a way to maintain a friendship while working together.

12. The two largest categories of federal expenditures are income security and health and education.

13. The answer to this question depends on what you mean by importance. Using United States measures that typically relate importance to international power, this statement is inaccurate or at least misleading. Most classifications of countries are based on the total output or production, but even these statistics do not necessarily capture a nation's importance or the strategic role it plays in the world economy. A knowledge of economic geography is needed to assess a country's importance to the world economy. Area and population are two useful indicators of a country's potential, but they need to be quantified and assessed, and there is no guarantee that a country with high economic potential will in fact be able to overcome domestic difficulties and become a major player in the world economy.

14. The Internet has added competition by increasing the amount of information available to consumers and reducing the importance of geographic location to production and sales. Increasing the amount of information to consumers lowers the cost of comparison shopping, which gives consumers more negotiating power with sellers. Because location doesn’t matter, the Internet broadens the potential marketplace for both inputs and outputs, increasing competitive pressures in both factor and goods markets by increasing the number of suppliers.

15. Globalization increases competition by allowing greater specialization and division of labor. Because companies can move operations to countries with a comparative advantage, they can lower production costs and increase competitive pressures. The decreased importance of geographical location increases the size of potential markets, increasing the number of suppliers in each market and thus increasing competition.

16. Convergence is more likely to occur for four reasons: (1) India and China have adopted more market-based economic systems in the past decade, making them stronger competitors; (2) these countries have large numbers of well-educated workers, (3) they have increasing access to capital and technology, and (4) they are developing the infrastructure needed to increase their economic competitiveness.

17. The law of one price rules, meaning that U.S. wages can only exceed foreign wages to the degree

that U.S. workers are more productive than foreign workers. The adjustments, therefore, that will need to occur will equalize wage rates. So, either Western nominal wages will grow slowly and foreign nominal wages will grow rapidly and catch up or U.S. exchange rates will decline to equalize wages. Some combination of the two is most likely.


1. a. Such an idea could be expanded to include college courses, but that is unlikely to happen because the quantity of college courses demanded would decline as people substitute toward taped lectures.

Substitution, however, is not perfect since videocassettes cannot provide the interaction between student and instructor or among students. Social forces would act against the movement away from college classroom instruction even if the invisible hand pressed action toward it.

b. Technical problems are virtually nonexistent. Tapes are easily made and VCRs are available cheaply. Socially, the problems are substantial. A diminishing role of the university would significantly change its role of providing a focal point for intellectual discussion and discovery thus changing the nature of education. There would be great social pressures to maintain this role of American colleges. The economic issues are substantial. A course could be taught once and used over a period of years. This would reduce the demand for professors and create revenues for certifying agencies that would regulate the distribution and quality of the tapes. If these college-at-home courses became an accepted educational credential, the demand for traditional college education would fall, putting major competitive pressure on traditional colleges.

c. Even though the program is technically possible and cost efficient, it will not necessarily be a success because social forces will play a major role in limiting the market. Social forces are not weak.

2. a. The fact that more money is spent on adults than on children in the family does not imply that the children are deprived or that the distribution is unfair. Children and adults have different needs. Moreover, it is the parents who earn the money, so it is only through their beneficence, and requirements of law, that they provide for their children at all.

b. Yes, these percentages probably change with income. The lower the income, the larger the percent of total expenditures spent on children. The reason is that most families want to provide a basic level of needs for their children. Many families feel that luxuries should not be given to children until the children have learned how to work for them themselves.

c. Our suspicion is that the allocation would not be significantly different in Soviet-style socialist countries as compared to capitalist countries. If, however, the average income in socialist countries were lower, the percentage of total expenditure spent on children might be higher, as described in b.

3. When making such trade agreements, it is important for countries to realize that trade includes not only economic issues, but cultural and social ones as well. While free and unregulated trade is generally the most economically beneficial (maximizes consumption possibilities), these economic benefits can be overpowered by the loss of cultural identity as a result of globalization. Taking into consideration such losses is a government’s responsibility when negotiating trade agreements. These losses must be weighed against the benefits of free trade.

4. a. Innovation requires a certain level of freedom of thought and a possibility of profit-making from the innovation. Neither was the case with Soviet-style socialism. Government planners directed production with income based on need, so workers had neither the freedom nor the incentive to innovate.

b. Both freedom and the possibility of making profits provide the means and incentives for innovation in capitalist countries.

c. Schumpeter’s argument was based on the idea that profit-making by innovators was necessary for innovation to occur. As firms become larger, however, the individual ceases to become the direct beneficiary of his or her innovations.

d. Since his predictions did not materialize, one must believe either that firms have been able to create incentive structures to foster innovation or that some other venue for innovation has arisen. Firms have large research and development departments designed to promote innovation. In addition, individual innovators have been able to raise enough capital to start their own companies to profit directly from their innovations. In the United States there has been enormous growth in the number of such firms. The U.S. government has been a large motivator of innovation through its strong

patent and copyright system, as well as providing subsidies for research at universities and support of military innovations, both of which have large spillovers into private industry.

5. a. Firms may produce in Germany, because (1) transportation costs to/from the other countries may be very high, so that if these costs are included, it would not be efficient to produce there; (2) there might be tariffs or quotas for imports into Germany that will prevent producing elsewhere; (3) the productivity of German labor may be so much higher that unit labor costs in Germany are the lowest; and (4) historical circumstances may have led to production in Germany and the cost of moving production may exceed potential gains.

b. Yes, one would expect some movement from Greece and Italy into Germany, but this is limited by social restrictions such as language and culture. With such high unemployment in Germany already, one would not expect much short-run movement. Movement in the long run, however, may be substantial.

c. I would need to know the stability of politics, the worker productivity, the infrastructure such as roads, as well as tax differences between the two countries.


1. a. Levi Strauss is a corporation. It is most likely a corporation because of its size. For large firms, limited liability becomes important.

b. Levi Strauss is a global corporation because it has business units throughout the Americas, Europe, the Middle East, Africa, and Asia. These business units both manufacture and market Levi products.

c. Shares of Levi Strauss today are privately held, although in 1971 the company traded shares publicly. In 1985, those shares were repurchased by the descendants of the founder of Levi Strauss.

2. In the 1930s, government intervened very little in the market. During the Depression, however, as many people became unemployed and needed assistance, the role of government expanded and capitalism’s evolution away from a pure market economy began. The Social Security Act was signed into law in 1935. The Act established two programs–a pension program for retired workers and an income support program for the unemployed. Both are administered by the federal government. In the late 1990s and early 2000s, there have been proposals to privatize portions of the Social Security system, giving workers more say about where their money is invested. This would move the pendulum back toward a market economy.

Chapter 4: Supply and DemandQuestions for Thought and Review

1. The law of demand states that quantity demanded falls as price increases; or alternatively, that quantity demanded rises as price falls. Price is inversely related to quantity demanded because as price rises, consumers substitute other goods whose price has not risen.

2. The law of supply states that quantity supplied rises as price increases or, alternatively, that quantity supplied falls as price decreases. Price is directly related to quantity supplied because, as price rises, people and firms rearrange their activities to supply more of that good in order to take advantage of the higher price.

3. Four shift factors of demand are income, price of other goods, tastes, and expectations. As income rises, demand increases. As the price of other substitute goods rise, demand increases. As tastes change to favor a particular good, the demand for that good increases. If people expect the price of a good to fall in the future, demand will fall now.

4. A change in the price causes a movement along the demand curve, a movement to a new point on the same curve. A shift in the demand curve means that the quantities will be different at all prices; the entire curve shifts.

5. Saying that supply increases means that the curve has shifted to the right, which is not the result of a price change. The correct statement is that, normally, as price rises, the quantity supplied increases.

6. Shift factors of supply include the price of inputs, technological advances, changes in expectations, and taxes and subsidies. As the price of inputs increase, the supply curve shifts to the left. As technological advances are made that reduce the cost of production, the supply curve shifts to the right. If a supplier expects the price of her good to rise, she may decrease supply now to save and sell later. Other expectational effects are also possible. Taxes paid by suppliers shift the supply curve to the left. Subsidies given to producers shift the supply curve to the right.

7. When adding two supply curves, sum horizontally the two individual supply curves, as in the accompanying diagram.

8. In the accompanying graph, the demand curve has shifted to the left, causing a decrease in the market price and the market quantity.

9. The price of airline tickets rises during the summer months because demand for airline travel increases as more people take vacations. This is shown in the accompanying graph

10. Sales volume increases (equilibrium quantity rises) when the government suspends the tax on sales by retailers because the price to demanders falls and hence equilibrium quantity demanded rises. This occurs because the supply curve shifts to the right because they do not have to pay taxes on their sales (cost of production declines).

11. Increased security measures imposed by government will increase the cost of providing air travel. This will shift the supply curve to the left, increase equilibrium price to P1 and decrease equilibrium quantity to Q1 as shown in the accompanying graph. They also might reduce demand (the hassles of the increased security and the additional time it takes to travel), further decreasing equilibrium quantity and offsetting the rise in price, in this case to P2.

12. Customers will flock to stores demanding that funky “economics professor” look, creating excess demand. This excess demand will soon catch the attention of suppliers, and prices will be pushed upward.

13. As substitutes for bottled water—clean tap water—decrease, demand for bottled water increases enormously, and there will be upward pressure on prices. Social and political forces will, however, likely work in the opposite direction—against “profiteering” in people’s misery.

14. Because the price of gas rose significantly, we’d expect people to purchase fewer gas-guzzlers and more fuel-efficient cars such as diesel cars. Demand for diesel cars rose 10-15 percent.

15. Increasing oil production (not as a result of a price change) will shift the supply of oil out to the right. The price of oil will decline as shown in the accompanying graph.

16. It suggests that the job is being rationed, which means that the wage is above the equilibrium wage.

17. It suggests that the price is above the equilibrium price so that the quantity supplied exceeds the quantity demanded, as you can see in the accompanying graph.

18. The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. It affects the supply/demand model by drawing our attention to the

possibility that supply and demand are interdependent. Feedback effects must be taken into account to made the analysis complete.

19. A supply/demand analysis that includes only economic forces will likely be incomplete because social and political forces will also impact equilibrium price and quantity. One example is the prediction that a disaster that leads to loss of electricity will lead to higher prices for flashlights might be wrong if there are laws that prohibit such price gouging during emergencies. Social and political forces must be added to the supply/demand model.

20. The greatest feedback effects are likely to occur in the markets that are the largest. This is most likely to be true for housing and manufactured-goods markets.


1. a.Price Market

Demand2 644 566 448 3610 2812 2014 1216 8

b. See the accompanying graph of the table.c. At the market price of $4, the total market demand is 56. If the price rises to $8, the total market

demand will fall to 36.d. All of the curves will shift to the right.

2. a. The market demand and market supply curves are shown in the accompanying graph.

b. At a price of $37, quantity demanded is 32 and quantity supplied is 18. Excess demand is 14. At a price of $67, quantity demanded is 10 and quantity supplied is 46. Excess supply is 36.

c. Equilibrium price is $47. Equilibrium quantity is 24.

3. The following results are shown in the accompanying graph.

a. The bad weather causes a decrease in supply. This is shown by a shift in supply from S0 to S1. Equilibrium price rises from P0 to P1 while equilibrium quantity falls from Q0 to Q1.

b. The medical report causes a decrease in demand. This is shown by a shift in demand from D0 to D1. Equilibrium price falls from P0 to P2 and equilibrium quantity falls from Q0 to Q1.

c. The innovation causes an increase in supply. This is shown as a shift in supply from S1 to S0. Equilibrium price falls from P1 to P0 while equilibrium quantity rises from Q1 to Q0.

d. The drop in income causes a decrease in demand. This is shown by a shift in demand from D0 to D1. Equilibrium price falls from P0 to P2 and equilibrium quantity falls from Q0 to Q1.

4. a. I would expect wheat prices to decline since the supply of wheat is greater than expected. Wheat commodity markets are very competitive, so the initial 35 percent increase in output was already reflected in the current price of wheat. It is only the additional 9 percent increase that will push down the price of wheat.

b. This is graphically represented by a shift to the right in the supply of wheat, as shown in the accompanying graph. Equilibrium price falls from P0 to P1 while equilibrium quantity rises from Q0 to Q1.

5. a. The cars in Italy are most likely much smaller than in the United States. Italians would be likely to want to conserve gasoline and thus demand smaller cars that use less gasoline.

b. As in (a), Italians will want to conserve gasoline more and thus use public transportation more than Americans use it.

c. As in (a) and (b), Italians will be more concerned with fuel efficiency in their desire to conserve gasoline since it is relatively more expensive there. Raising the price of gasoline in the United States to $4 per gallon will decrease the size of cars driven in the U.S., increase U.S. use of public transportation, and increase the fuel efficiency of cars purchased in the U.S

6. a. The tax shifts the supply curve to the left because it increases the cost of supplying the natural gas abroad. Equilibrium price rises while equilibrium quantity declines.

b. The tax will likely reduce the price of natural gas in Argentina as more gas is diverted to the domestic market.

c. It depends; it will have a tendency to push it up, but probably since Argentina is such a small percentage of the world market, the effect would be difficult to distinguish.

7. a. It increased the demand for housing and increased housing prices.b. It increased the demand for housing and decreased housing prices.c. The price would increase more in San Francisco.

8. a. It would likely raise the value significantly – it was estimated that it would raise it to 50,000 a sheet. See the accompanying graph.

b. It would probably lower the value of the stamps – it was estimated that it would lower the price of the sheet to 100 a sheet. See the accompanying graph.

c. They would likely sue; they did and they lost.

9. a. The number of punitive awards would decline because the incentive for plaintiffs to pursue a case declines. The demand curve shifts down by the amount of the tax, lowering the equilibrium price of punitive awards.

b. The number of pre-trial settlements would rise because both the plaintiff would be willing to accept a lower settlement that is not taxes and the defendant would pay a lower punitive award.

10. a. Because the market for pencils is relatively small, supply/demand analysis would be appropriate without modification.

b. Because the labor market is very large, supply/demand analysis would not be appropriate without modification. For example, an increase in labor supply will likely lead to greater income and greater demand for goods, which will lead to an increase in quantity of goods produced and therefore an increase in the demand for labor. In this case there are significant feedback effects.

c. Aggregate markets such as savings and expenditures include feedback effects, so supply/demand analysis would not be appropriate without modification.

d. The CD market is relatively small. Supply/demand analysis would be appropriate without modification.


1. The age group 0 to 24 is projected to increase somewhat from 2000 to 2025 to 2050. The age group 25 to 54 is expected to increase less than other groups from 2000 to 2025 to 2050. The age group 55

to 85+ is expected to increase significantly from 2000 to 2025 to 2050. The number of people aged 85 or greater will rise from about 5 million in 2000 to 8 million in 2025 to 22 million in 2050.

a. As the number of elderly rises the demand for nursing homes will increase. The quantity of nursing homes supplied will rise as will their price.

b. The demand for prescription drugs will shift to the right as the number of elderly increase and need drugs to address their health needs. The quantity of prescription drugs supplied will rise as will their price.

c. The demand for baby high chairs will also rise, but not by as much as the increase in products demanded by the elderly. The quantity of high chairs supplied will rise as will their price.

d. The demand for college education will also rise, but not by as much as the increase in products demanded by the elderly. The quantity of college degrees supplied will rise as will their price.

2. The answers to these questions will depend upon the current “Short-Term Energy Outlook.” The answer given here should be used as a guide.

a. The Persian Gulf War is the most significant factor that is affecting supply. Iraq is unable to contribute to world oil supply. This shifts the supply of oil to the left. In addition, oil strikes in Venezuela are also limiting oil supply. No demand factors were mentioned specifically, but the end of the heating season would be expected to reduce demand for oil. The reductions in supply will lead to higher prices while the reduction in demand will mediate those price increases.

b. World oil prices are forecast to remain high and volatile while the U.S. is at war with Iraq. The effect of the supply and demand factors on price and quantity are shown in the accompanying graph.

c. Higher crude oil, an input to the production of gasoline, will reduce the supply of gasoline and increase its price. As summer ends, the demand for gasoline will decline and put downward pressure on gas prices. The net effect is a decline in the near term, but a rise in the future. Higher crude oil will reduce the supply of home heating oil and a colder winter will increase demand. Both will work to increase the price of home heating oil. Gas is a substitute for oil. As the price of oil increases, the demand for gas will increase. This will lead to higher natural gas prices in the near term.

3. a. Alaska, Delaware, Montana, New Hampshire and Oregon have no state sales tax. Mississippi, Rhode Island, and Tennessee have the highest state sales tax.

b. Sales taxes paid by producers increase the cost of production and shift the supply of goods to the left. Equilibrium price paid by consumers rises (price received by producers falls) and quantity falls as shown in the accompanying graph.

c. Delaware has no sales tax while New Jersey has a 6% sales tax. This reduces the quantity of goods purchased in Delaware. The demand for goods in New Jersey shifts to the right and equilibrium quantity sold rises.

Chapter 5: Using Supply and Demand

Chapter 5: Using Supply and DemandQuestions for Thought and Review

1. If price and quantity both rise, the simplest cause would be a shift of the demand curve to the right.

2. If price fell and quantity remained constant, a possible cause would be a shift out of the supply curve and a shift of the demand curve in to the left. Another possibility would be a shift of the demand curve in to the left with a vertical supply curve.

3. See the accompanying graph. A price ceiling of Pc below Pe will cause a shortage shown by the difference between Qd and Qs.

4. As you can see in the accompanying graph, the rent controls create a situation in which demanders are willing to pay much more than the controlled price and much more than the equilibrium price. These payments are sometimes known as key money. In this graph, landlords are willing to supply QS at the current controlled rent, PC. Consumers are willing to pay up to PB for the quantity QS. Key money can be an amount up to the difference between PB and PC.

5. See the accompanying graph. A price floor of Pf above Pe will cause a surplus shown by the difference between Qs and Qd.

4. A minimum wage, Wmin, above the equilibrium wage WE will result in the quantity of laborers looking for work to increase to QS and the quantity of employers looking to hire to decrease to QD. The difference between the two is a measure of the number of unemployed.


7. A $4 per unit tax on suppliers shifts the supply curve up by $4 shown as a shift in the supply curve from S0 to S1. Equilibrium price will rise by $4 only if the demand curve is perfectly vertical. In this case, quantity would not change. Otherwise, equilibrium price rises by less than $4 and equilibrium quantity falls as shown in the accompanying graph. The price increases from P0 to P1 and quantity declines from Q0 to Q1

8. Political turmoil in South Africa likely led both foreign and domestic investors to question the economic stability of the country. Foreign investors reduced their demand for South African investments, and therefore their demand for the rand. This shifted the demand for the rand to the left. Domestic investors did likewise, shifting their investments to those outside South Africa, shifting the supply of rand to the right. The combination led to a lower price for the rand in terms of other currencies.

9. A quota places a quantity restriction on imports. Consumers are willing to pay a higher price, P1, for the lower quantity than the equilibrium price without a quota, P0. Therefore, quotas lead to higher import prices as shown in the accompanying graph.

10. Excess supply in U.S. agricultural markets is caused by the government’s policy of agricultural price supports, or price floors on agricultural products. Political forces prevent the invisible hand from working.

11. It would likely increase the number since it reduces the cost of having a car that you drive very little.

12. Import disruptions shifted the supply curve for rice to the left. Equilibrium price rose and quantity fell as the accompanying graph shows.

13. The demand went up enormously because loose tobacco became a cheaper substitute for the taxed cigarettes; some companies more than quadrupled their sales.

14. Public post-secondary education is an example of a third-party payer market because it is heavily subsidized by state government and in most cases, a student’s parents. Those consuming the good, students, do not pay the entire cost of the education they receive. This likely leads to greater expenditures on post-secondary education than if students had to pay the entire cost of their education.


15. Governments likely support third-party-payer markets for a variety of reasons. It could be that they believe the market does not distribute the good equitably (poorer people have less access to the good); there are positive externalities associated with the good (for example, public education); or that some other market failure exists.


1. a. An import quota will increase the price of imported sugar. The accompanying graph shows how a higher imported sugar price increases the price that domestic producers can charge and increase the quantity they can supply to the market. For example, at P0, domestic consumers demand the quantity C-B from importers and quantity B from domestic producers After the quotas, the import price is P1. Domestic consumers demand the quantity D-A from importers and quantity A from domestic producers.

b. The government could also have imposed a tariff on imported sugar. This would also have raised the price of imported sugar.

c. A minimum required import level of 1.25 million will limit the ability of the United States to support domestic sugar prices.

2. a. A weakly enforced anti-scalping law would add an additional cost to those selling scalped tickets and push up the resale cost of tickets to include the expected cost of being caught, which would be fairly small given weak enforcement. In the accompanying graph, this shifts the supply curve from S0 to S1, raising equilibrium slightly price from P0 to P1. (Note: This assumes that only selling, not buying, is illegal.)

b. A strongly enforced anti-scalping law (against suppliers) would push up prices far more as the cost of supply rose and the supply curve shifted to the left. If enforcement were sufficiently strong, a two-tier price system would emerge with a low legal resale price at P0 and another very high price, P2.

3. a. As shown in the accompanying graph, the controlled price is below equilibrium. At this price the quantity of apartments demanded exceeds the quantity of apartments supplied. Since there are more apartments demanded than supplied at this price, apartments are hard to find.

b. Since at the existing quantity supplied, Qs, demanders would be willing to pay Pb, there is a strong incentive to make side payments to existing tenants to acquire the apartment. At Pb, more tenants are willing to supply their apartments than at Pc, so a side payment can induce a tenant to give up their apartments. This is one form of rationing. When market price rationing does not take place, some other form of rationing must supplement it.


c. Eliminating rent controls would most likely allow the market price of apartments to increase and eliminate side payments. The quantity supplied will rise until it equals the quantity demanded at the market price. The price, quantity combination is (Pe, Qe) in the graph.

d. The political appeal of rent control is that it benefits those who currently have apartments. Apartment owners are more likely to vote, and this is why it is maintained.

4. a. The government subsidy of mohair provided an enormous incentive, for those who were allowed to sell mohair, to sell large quantities at lower price than otherwise. The elimination of this subsidy shifted the supply curve to the left (shown below as a shift from S0 to S1, increasing the market price for mohair from P0 to P1 and decreasing the quantity demanded and supplied from Q0 to Q1.

b. This program was likely kept in existence because not many people knew about it (mohair is a relatively small market), and ranchers had no incentive to broadcast the subsidy.

c. A law that requires that suppliers receive $3.60 more than the market price is the same as a tax, but the revenue goes to the supplier. The demand curve would shift to the left (down) to include this tax. The quantity demanded would fall dramatically. Consumers would not support this law because they would have to pay an enormously high price. Suppliers would support this law only if they were guaranteed that they could sell at that high price.

5. a. Computer pricing of roads could end bottlenecks and rush hour congestion by price rationing. Currently at zero price, at certain times, the quantity demanded greatly exceeds the quantity supplied, resulting in congestion. Raising prices, during those times, could eliminate excess demand and reduce the congestion. This technological change will spread out congestions over wider geographic areas and over the day, as individuals with more flexibility with respect to route and timing will choose to demand less of the current high demand route at rush hour.

b. Some of the problems are administrative: disputes may arise over computer accuracy and possibility of cheating the system. Other problems might be the regressive nature of the pricing scheme if low income individuals are the one who have less flexibility regarding route and timing. They will be the ones to pay more for the use of roads compared to higher income individuals who might have more flexibility and can avoid the high cost routes.

c. This is an individual question. A professor in a rural area would change his habits very little because there is no rush hour traffic. A student with a more flexible schedule and who lives in an urban area may be more likely to change driving habits or to use public transportation or carpooling.

6. a. Boards often exist to benefit the consumer, but also to benefit those who currently produce. Often those who are currently certified attempt to limit the number of new certifications to limit the supply and thus boost the price.

b. Possible changes include eliminating the board of certification, limiting its regulation to only those skills that it addresses directly, or requiring continual recertification so that skills of those already certified reflect the current demand for skills in that market.

c. A political difficulty with implementing these changes is that a relatively small group of those currently certified will be hurt and will lobby hard for the status quo. Those currently certified may have more “clout” with the board if the board is comprised of certified hairdressers. The benefits of the changes are also large, but they are spread out over large groups of consumers, with each consumer benefiting very little. Therefore, it will be easier for the small group, whose benefit per individual is large, to organize.


7. a. The Oregon Health Plan includes a prioritized list of medical services that determine whether a service is covered. The list is based on comparative benefit to those covered. Those services that have the highest net benefit are ranked highest.

b. Economists should not oppose the Oregon Plan because it involves rationing. The market involves rationing through the price mechanism. Economists might oppose the Oregon Plan because in general they support the market as the least-cost method of providing goods and services. Economists are open to the argument that the market may not distribute goods and services in the way that society wants, which may require government intervention.

c. In the market, the interaction of demand and supply determines the equilibrium price and quantity that is bought and sold. Those who are able to pay the equilibrium price are the ones who receive the health care. The Oregon Plan uses its benefit-ranking system rather than price as the rationing mechanism.

8. a. Frequent-flyer programs allow companies to lower their effective prices without lowering their reported prices. Companies also use them to get business travelers to choose their airline. Such programs are an example of a third-party-payer system: The business traveler gets the benefit (frequent-flyer miles), while the business pays for the current flight.

b. Other examples include points that hotels give to travelers and bonus checks based on charges that Discover gives those who use its credit card.

c. Firms likely do not monitor these programs because it would be too costly to do so.

9. a. Equilibrium price is $6 and equilibrium quantity is 300.b. In a third-party payer system where the consumer pays $2, quantity demanded will be 900.

Suppliers require payment of $14 to supply that quantity.c. Total spending in a is $1,800. Total spending in b is $12,600.

10. a. This would represent a shift in demand to the left assuming the decline in Cookie Monster’s popularity represents a decline in the popularity of cookies. The price and quantity of cookies would likely fall as shown in the graph below.

b. This is represented by a shift in demand for bread (high in carbohydrates) to the left. Equilibrium price and quantity falls as the accompanying graph shows.

11. a. This is because there are only a limited number of airways in the industry.

b. No, since they get the money, television networks would have no incentives to produce high definition television.

12. a. Both the shift in demand to the right and the shift of supply to the left lead to a higher equilibrium price of oil, in this case over $40 a barrel. The effect on equilibrium quantity is indeterminate. While the shift in demand to the right would lead to a rise in equilibrium quantity, the shift in supply to the left would reduce it. Whether equilibrium quantity rises or falls depends on the relative size of the shifts. The graph below shows no effect on equilibrium quantity and a significant increase in price.


b. The increase in the oil quota shifted supply to the right, reducing the price of oil from $42 a barrel to $38 a barrel. Equilibrium quantity increased.

.

13. a. The supply curve is vertical at 10,000 tickets. We know there is an excess demand at $130 because there is a secondary market for scalped tickets at a higher price. The accompanying graph shows excess demand of Qd – 10,000.

b. The people represented by Qd-10,000 will make offers to scalpers for any amount above $130 up to the equilibrium price (if there had been a market) of $2,000. The accompanying graph shows the range of $200 to $2,000.

c. If scalping became legalized, more people would be willing to sell their tickets when there is no risk of being arrested and fined. The shift of the supply curve for resold tickets to the right will reduce the secondary-market price of Final-Four tickets.

14. a. They would likely fall. In fact, they fell by 13 percent.b. They also would likely fall. In fact, they fell by 22 percent.c. The graphs below show the effect of increasing co-payments. The graph on the left has a co-

payment of $15. Consumers demand Q1 and the shaded region shows the medical claim costs. In the accompanying graph, consumers must pay the first $1,500 of medical costs, demonstrated by the lower-shaded region. (For simplicity, we assume that consumers end up purchasing 50 units at a cost of $30 per unit.) As you can see, however, the medical cost to the firm (upper shaded area) is much smaller. In addition, the units of medical services demanded are lower, illustrating the second question – hospital admissions declined.


15. a. Japan prescribes many more drugs than the U.S. because Japanese doctors have a financial incentive to do so.

b. It would lead to many more drugs being produced, even if they were not really innovative, as happened when Japan tried this.

c. Drug reps would likely provide free samples and other gifts to doctors and have drug lunches for them where they tout the advantages of their drugs.

16. a. This represents a shift of the supply curve to the left because the offended decide not to supply organs, increasing the legal price significantly and perhaps reducing the equilibrium quantity to a quantity that is below the amount currently provided at zero cost.

b. How responsive quantity supplied is to price affects the slope of the supply curve. If quantity supplied is very responsive to price, the equilibrium price might be quite low and legalizing organ sales would have significant benefits to society. In fact, the authors of the study estimate the equilibrium price of kidneys to be less than $1000.


1. a. Shadow markets are alternative or black markets that develop as result of a shortage in the legal market. One develops when there is rent control because rent control creates shortages and it is difficult for government to regulate the entire housing market.

b. Because the quantity supplied is less than quantity demanded, some other way of rationing besides price emerges. One method of rationing is first-come first serve and hoarding. Those who have the apartments will hoard them–by not ever moving and by “giving” them to heirs. Housing is particularly easy to hoard because it is a durable good. Because of hoarding practices, it is more difficult for newcomers to find housing in a city with rent control.

c. Vacancy rates are much lower in rent control cities compared to cities without rent control. This makes sense because rent controls create shortages.

2. a. The minimum wage, adjusted for inflation, has fallen nearly consistently since 1979. If the inflation-adjusted minimum wage is on the vertical axis, this will reduce the shortage of jobs (number of unemployed) that results from the minimum wage.

b. According to the article, minorities are disproportionately represented among minimum wage earners. Compare column 1 to column 4 for each subcategory. If column 1 is greater than column 4, that category is over-represented among minimum-wage earners.

c. The author says that the job-loss effect is small or minimal. He cites the observation that the 90-cent increase in 1996/97 did not lead to lower employment levels among minorities. The minimum wage did not prevent economic growth during the mid-1990s from raising employment levels among low-wage earners.



1. a. The tables are shown below:

Price (Dollars

per gallon)

Quantity Demanded

(Gallons per year)

Quantity supplied (Gallons per year

600 -1501 500 02 400 1503 300 3004 200 4505 100 6006 0 750

b. See the accompanying graph. Equilibrium price is 3 and equilibrium quantity is 300.c. P=3; Q=300

2. a. The following are the demand and supply tables after the hormone is introduced:

Price (dollars per

gallon)

Quantity Demanded (gallons per

year)

Quantity Supplied

(gallons per year)

0.00 600 2251.00 500 1252.00 400 2752.50 350 3503.00 300 4254.00 200 5755.00 100 7256.00 0 875

The hormone (a technological advance) shifts the supply curve to the right by 125,000 gallons, The demand curve is unchanged.

b. The original supply curve is S0. The growth hormone shifts the supply curve to S1 (to the right by 125). Equilibrium price falls to $2.50 a gallon, and equilibrium quantity rises to 350 million gallons (point B).

c. The demand curve remains the same at QD = 600 - 100P. The supply curve becomes QS = -25 + 150P. To solve the two equations, set them equal to one another: 600 - 100P = -25 - 150P and solve for P. Doing so, we get


P = 2.5. Substituting this value for P into either the demand or supply equation gives us equilibrium quantity of 350.

d. Quantity supplied would be 425 (-25 + 150 3 3) and quantity demanded would be 300 (600 - 100 3 3). There would be excess supply of 125. The price floor is shown in the accompanying graph.

3. a. The demand curve is QD = 10-P; the supply curve is QS = 2P -5. To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $5, Q = 5.

b. The new demand curve is 13-P. To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $6, Q = 7.

c. The new supply curve is 2P-8. To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $7, Q = 6.

4. a. A demand curve follows the formula QD = a - bP, where a is the price-axis intercept and b is the slope of the curve. A shift in demand is reflected in a change in a. An increase in demand increases a and a decrease in demand reduces a.

b. A supply curve follows the formula, QS = a + bP, where a is the price-axis intercept and b is the slope of the curve. A shift in supply is reflected in a change in a. An increase in supply increases a and a decrease in supply decreases a.

c. A movement in supply or demand is reflected in the effect of a change in P on either QS or QD.

5. a. P = 4; Q = 6b. Since the government set price is above the equilibrium price, it is a price floor. Thus it would

create a surplus. Solving the equations, we see the surplus would be 2 million bushels.

6. a. The new supply equation is QS = -150 + 150(P - 1) where P is the equilibrium price, or QS = -300 + 150P.

b. P = 3.60; Q = 240.c. Farmers receive $2.60 per gallon, while demanders pay $3.60 per gallon.

7. a. The new demand equation is QD = 600 -100(P+1) where P is the price suppliers receive, or QD = 500-100P.

b. P = 3.60; Q = 240.c. Farmers receive $2.60 per gallon. It doesn’t matter who pays the tax, the market outcome is the

same.

8. a. The new supply equation is QS = -150 + 150(P + 1) where P is the equilibrium price, or QS = 150P.b. P = 2.40; Q = 360.c. Farmers receive $3.40 per gallon.

9. Equilibrium price is $2.a. P = $3 is above equilibrium price, so it is a price floor. There is a surplus of 8.b. P = $1.50 is below equilibrium price, so it is a price ceiling. There is a shortage of 4.c. P = $2.25 is above equilibrium price, so it is a price floor. There is a surplus of 2.d. P = $2.50 is above equilibrium price, so it is a price floor. There is a surplus of 4.

Chapter 6: Describing Supply and Demand Elasticities

Chapter 6: Describing Supply and Demand ElasticitiesQuestions for Thought and Review

1. E = percentage change in quantity/percentage change in price=20/10=2. It is elastic.

2. I would check to see if other things remained equal, suspecting that they did not, since the rise in price did not have the expected effect. If all other things did indeed remain equal, the elasticity would be zero.

3. The price elasticity of demand equals percentage change in quantity demanded divided by the percentage change in price = (16,000/18,000)/(.25/1.375)= 88.9/18.2 = 4.9.

4. Price elasticity of demand is equal to the percentage change in quantity divided by the percentage change in price. Pizzas went from $8 to $2 and quantity from 1 to 100. The price elasticity of demand is (1.96/1.2) = 1.60.

5. a. Cars: The broader the category, the less elastic the demand.b. Leisure travel: It is more of a luxury.c. Rubber during the 20th century: There are more substitutes now.

6. They are both the same. Any supply curve that goes through the origin has an elasticity of 1.

7. In real life elasticities are difficult to measure. A 1% rise in price would probably be swamped by other effects.

8. To the degree that colleges are trying to get as much revenue as possible, they will keep raising tuition until the demand is no longer inelastic. Colleges don’t raise their tuition by more than what they currently do because they are not profit maximizers, and because social pressures such as student protests would result if they raised tuition too much.

9. If the author is profit maximizing, he or she would prefer to raise price. Raising price with an inelastic demand increases revenue. Because the author’s cost is sunk cost, profit also rises.

10. More eager students will agree to go to a school even if they don’t get much financial aid. That is, they have less elastic demands and thus will tend to get less financial aid. Whether this practice is justified is a difficult normative issue, with many alternative views.

11. Lowering price will increase output and hence increase costs. Sellers are interested in profits, not total revenue, so the effect of increasing output on costs must also be taken into account. Increasing prices with an inelastic demand increases revenues and lowers costs. Thus, it definitely increases profit.

12. a. Vodka: normal, luxury (except in Russia). Individuals tend to drink more hard liquor as their income rises. (It depends on the type: Absolut vodka is more of a luxury than store brands.)

b. Table salt: normal, necessity. It is a small portion of people’s income, and its consumption doesn’t increase with income.

c. Furniture: normal, luxury (depends on the type). While we all need some furniture, the wealthy spend large sums on furniture. The rest of us get by with cheap stuff.

d. Perfume: normal, luxury (depends on the type). The rich blow money on perfume; the rest of us get by with toilet water, or we smell a bit.


e. Beer: normal, inferior. Beer, the cheapest type of alcohol, tends to be the poor person’s drink. As income increases, beer drinkers will choose to drink less beer and more expensive alcohol such as wine and liquor. However, new micro breweries are trying to change beer’s image, and to make certain types of beer be seen as a luxury.

f. Sugar: normal, necessity. It is not used significantly more by rich than by poor.

13. a. Close to zero. While they are substitutes, they are not close substitutes.b. Negative. They are complements.c. Positive. They are close substitutes.d. Close to zero. They are at best distant substitutes.

14. If there were only two (assuming no saving) the goods must be substitutes because if a person doesn’t consume one, he or she would have to consume the other.

15. If demand is inelastic raising tax rates will increase tax revenue paid by consumers. Similarly with supply. With elastic supply and demand, increasing taxes will decrease quantity supplied and quantity demanded enough to cause a decrease in tax revenue. Thus what happens to total tax revenue depends both on the elasticity of supply and demand.

16. To answer this question, use the formula from the chapter: percentage change in price = percentage change in supply divided by sum of demand and supply elasticities. Here, percentage change in price = 5/(1 + .2) = 4.17 percent. The pre-terrorism price was $1.75, so the new price is 1.04 X 1.75 = $1.82.


1. a. Since the price falls by 60/330 (about 18%) the price elasticity would be approximately one.b. About the same, since price per ounce decreases by nearly 18% from $0.24 to $0.20.

2. a. Using standard reasoning, we would answer that firms decreased the size of the coffee cans to hide price increases from consumers. However, in reality people often react differently to changes in the size of packages compared to the equivalent change in price.

b. Examples include candy bars, soap, and canned tuna fish.

3. a. Since demand is assumed to be highly elastic, Professor Heise would respond that this program would significantly increase the quality of the students enrolled, thereby increasing GPA, and increase the total number of applicants. If the college had the resources and facilities needed to enroll more students, enrollment could increase. If it did not have the resources, or didn’t want to change the size of the size of the college, enrollment would remain the same numerically, but be of higher quality. The change in income is uncertain. If total enrollment did not increase, net income would fall; if enrollment increased, income would likely increase.

b. If the demand had been highly inelastic, the response in quantity demanded would be small, and the program would have little effect except to lower revenue from tuition.

4. a. A price rise of 10 percent will reduce fuel consumption anywhere from 4 to 8.5 percent. Quantity demanded would range from 9.15 to 9.6 million gallons.

b. This suggests that there are other forces besides price at work here; making adjustments to higher prices is much easier than making adjustments to lower prices. This may be due to learning the true cost of substitutes when those substitutes are consumed. One can imagine a scenario in which a price hike significantly changes driving behavior—commuters may switch to ride sharing or public transportation, to which there may be perceived social barriers (costs). Once those barriers are


overcome and the perceived costs are lowered after those alternatives are used, a larger decline in the price of gasoline is required to induce those who switched to return to driving their own cars.

5. Keep in mind that the definition of elasticity is percent change in quantity divided by percent change in price. We want to show that elasticity of supply is less than one. Elasticity of supply can be written as (% change in Q/ % change in P), or (change in Q/Q)/(change in P/P). Arranging terms, we have: (change in Q/change in P)X(P/Q). Since (change in Q/change in P) = 1/slope, this can be rewritten as (1/slope)(P/Q). The slope of a line crossing the quantity axis is given by P/(Q-a), where a is the quantity supplied at zero price (a > 0). Substituting into the equation for the elasticity, we have {1/[P/(Q-a)]}(P/Q)=(Q-a)/Q= Q/Q-a/Q=1-a/Q=E. Since a>0 and Q>0, a/Q >0 and 1-a/Q <1 so that E<1 and the curves are inelastic.

6. Point A: 3; point B: 1/3; point C: 3/2; point D: 7/6.

7. A to B: 3; G to H: 6/7; E to F: 1/2; C to D: 1/3.

8. a. 0.5 b. 0.60

9. a. .06. b. Since E > 0, they are complements.c. Demand for hot dogs would have to rise for the two to be substitutes.

10. a. Neither state is maximizing revenue. Maximum revenue is collected when elasticity is one. Both are collecting less than the maximum revenue: in California elasticity is less than one and in Massachusetts elasticity is greater than one.

b. I would recommend that Massachusetts lower its price and California raise its price.

c. Massachusetts, because not only is it not collecting maximum revenue, it could simultaneously lower price and increase revenues, making both those who buy vanity plates and the treasury happy.

d. Elasticity of demand equals one at price P* in the accompanying graph. California is below at a price such as P1, where demand is inelastic. So, you can see that raising the price from prices below P1 will result in greater revenue gained (BC) than lost (F). Massachusetts is at a price above P*, such as P0, where demand is elastic. So you can see that lowering the price to P* will result in greater revenue gained (CE) than lost (A).

11. a. 3.33 percent. b. 14.29 percent. c. 5 percent.

12. a. Peak hour travelers are likely to be commuters who have little choice but to go to work and therefore have lower demand elasticity than those who ride busses during off-peak hours, and are more likely using buses for errands or other more discretionary activities.

b. Demand tends to be less elastic in the short run because there are few substitutes. If fares rose enough, in the long run people could find alternative modes of transportation – purchase a car, find someone to share rides with, etc.

c. Tolls are likely a much smaller portion of high income commuter’s total income, contributing to a less-elastic demand.

13. a. The elasticity of demand for drinking is .42; the elasticity of binge drinking is .765.


b. Binge drinking is more elastic. One possible explanation is that binge drinking (drinking 5 or more drinks at one occasion) is a larger percent of one’s income and has a close substitute—drinking fewer. It is easier for students to decrease the amount they drink rather than to quit altogether.Source: “Alcohol Advertising and Alcohol Consumption by Adolescents,” NBER Working Paper 9482.

14. a. Liquor producers would not support a tax on beer because the cross-price elasticity between beer and hard liquor is negative. The beer tax would also reduce liquor consumption.

b. Wine producers would support a tax on beer because the cross-price elasticity between beer and wine is positive. The beer tax would increase wine consumption.

15. a. Total revenue rose from $1,465 million to $1,494 million.b. 0.46.c. It assumes other things constant, such as income, the price level, and the prices of other

entertainments. These are unlikely to remain constant.

16. a. 0.31 (40,000/260,000)/(20/40).b. Since the demand is inelastic, it doesn’t make sense to lower the price because it reduces the total

revenue.c. Then it makes sense to lower the price in order to increase the circulation for more advertising

revenue.

17. a. Supply-side measures shift the supply curve to the left, raising the price of drugs and reducing quantity demanded as shown in the accompanying graph.

b. If the demand for drugs is inelastic, a reduction in supply will increase total revenue going to the drug industry. Since less is being produced, total cost also decreases so that total profit also increases.

c. Demand-side measures shift the demand curve to the left, reducing the supply of drugs and reducing equilibrium quantity. Total revenue to the drug industry declines. What happens to profits depends on whether costs fall by more or less than the decline in revenue.


1. a. Young adults would be affected more. Price elasticity of overall youth cigarette demand was estimated to be as high as –1.44, increasing the price of cigarettes could reduce smoking by over 14 percent. Overall elasticity was only 0.3 to 0.5.

b. Cigars, pipes, loose tobacco and other tobacco products for cigarettes could be taxed.c. Long-run effects of price on demand will be larger than short-run; in this paper it is estimated to be


about 0.8. Sustained taxes will result in long-run reductions in cigarette use among all segments of the population.

2. a. $5.50 to $8.50 by 2003 and $10.50 by 2007 which is about a 55 percent increase initially and a 91 percent increase by 2007.

b. The estimate of labor demand elasticity used is 0.22. Inelastic.c. Labor costs will be raised $6.6 million per year. Since demand is inelastic, a rise in the minimum

wage will raise total labor costs. The two are consistent. If elasticity of demand were greater than one, one would expect labor costs to fall when the minimum wage is raised.

d. In the long-run firms can keep labor costs down by hiring fewer workers and by finding substitutes for labor, such as outsourcing or automation. What accounts for the difference is that in the long run, all factors of production are variable. In the short run, firms have fewer substitutes in production and will have to accept the higher labor costs.Source: The Effects of the Proposed Santa Fe Minimum Wage Increase, by David McPherson.

Chapter 7: Taxation and Government Intervention Questions for Thought and Review

1. With either excess supply or excess demand, the number of trades will be lower than if price were allowed to move to its equilibrium price. That means there is a loss of surplus.

2. Decision making based on costs and benefits means you make purchases if the marginal benefits are greater than the price. Thus, when you decide to make a purchase, you are likely receiving something worth more to you than what you had to spend to buy it, or else you wouldn’t have bought it. That net benefit is consumer surplus.

3. To the extent that home values reflect income, property tax based on the value of the home is an example of the ability to pay principle. An assessment for sidewalks per home is an example of the benefit principle.

4. If demand is inelastic, raising a tax increases revenue paid by consumers; similarly with supply. Thus, what happens to total tax revenue depends on the elasticity of both supply and demand.

5. Because labor supply is elastic, raising the tax rate will reduce the percent of hours worked by more than the percent decrease in wages paid. That is, total income will decline as will total revenue collected by taxes. Social Security cannot be financed by increasing tax rates. Source: “Why Do Americans Work So Much More than Europeans?” Quarterly Review, July 2004.

6. If suppliers were strong lobbyists, the government would prefer demand to be more inelastic, because then consumers will bear the largest portion of the tax. If the suppliers had to bear the greatest burden they would have an incentive to lobby against the tax.

7. I’d recommend inelastic goods with a price elasticity of demand and supply as close to zero as possible. Examples would be cigarettes, salt, required medications, a per capita tax, and a land tax.

8. The demander. The more inelastic the demand curve, the larger percentage of the burden is borne by the demander.


9. With a perfectly elastic demand, suppliers will pay the entire cost of the tax regardless of how elastic supply is—unless supply is also perfectly elastic, in which case no goods will be bought or sold after the tax, so no one will bear the burden.

10. The demander will pay 30 percent of the tax [.3/(.7+.3) X 100) and the supplier will pay the remaining 70 percent.

11. If the economist wanted to get as much revenue as possible from as little output reduction (welfare loss) as possible, he would suggest taxing goods with inelastic supplies.

12. No. Tenants shouldn’t worry too much. In the short run the supply of apartments is highly inelastic so the owner will bear the majority of the tax burden; it will not be passed on to tenants. In the long run supply is more elastic so the renter will pay some of the tax. So in the long run, tenants should worry more.

13. If the tax were based on street frontage or area of the ground floor/foundation rather than square feet of living space, individuals would have an incentive to build in this style.

14. For an equivalent percentage rise in price, the more elastic and demand and supply, the greater the shortage that will be created. The reason is that the response in quantity supplied and demanded is greater when price elasticity is greater.

15. Rent seeking is attempting to transfer surplus from one group to another; for firms it usually involves restricting supply in order to increase price. The firm would have a greater incentive to rent-seek when demand is inelastic.


1. a. Consumers will likely complain the most because they have fewer alternatives. There will, however, be more suppliers who are kept out of the market.

b. In the accompanying graph you can see that the suppliers decrease output significantly, but the opportunity cost of their doing so is not great. Those fewer demanders who are hurt are hurt a lot; they will likely scream loudly. The actual number of complaints will depend on the costs of complaining and the expected benefits of complaining.

2. a. Because income above a certain level are not taxed, payroll taxes are regressive. Because low-income workers receive greater benefits at retirement than they contributed and high-income workers receive less, considering the Social Security system as a whole, it is likely progressive.

b. The benefit principle is that individuals who receive the benefit should pay the tax. A system that follows this principle exactly would mean that workers would receive all that they paid into the system plus any returns the funds earned while in trust by the government. That is not the case. So, considering this principle only, the system is not fair.

c. The ability-to-pay principle says that individuals who are most able to bear the burden of the tax should pay. A system that follows this principle would have high-income workers subsidizing the benefits of the low-income workers, which to some degree describes the current Social Security system. So, considering this principle only, the system is fair.


3. a. Because there were students asked to defer enrollment, there was excess demand as shown by the distance between Q0 and Q1 in the accompanying graph..

b. The market solution for excess demand is to raise tuition until excess demand is eliminated.

c. The state may have decided not to increase tuition in fear that lower-income students might not be able to afford the tuition. Another solution, however, would be to price discriminate – subsidizing education of those with lower income by charging higher prices to higher income students.

4. a. It depends on one’s view. If one sees cigarette smoking as harmful, anything that decreases smoking is good. If one uses the consumer-surplus model, assuming individuals know what they want, then it hurts smokers.

b. It shows a loss of consumer and producer surplus (deadweight loss to society).c. The large majority of the money was spent on general budget items, not anti-smoking campaigns. A

typical example is Erie County in New York State; it has already spent 99 percent of its money, and less than 1 percent went toward anti-smoking campaigns. This is because once they had the money, they had little incentive to actually spend it on anti-smoking campaigns.

5. a. A tax that is based on the number of stories a building has, which is the type of tax they had in Paris when this roof was popular.

b. If a story were interpreted as including living space created in the attic, or if the tax were based on square-footage of living-space, then the Mansard roof would decline in importance.

c. There are many. If taxes are based on outside appearance, then the inside of a building would tend to be more elaborate than the outside.

6. a. Because the elasticity of demand among the top students was greater than one, lowering tuition would lead to a proportionally greater percentage increase in enrollment. Total tuition would rise.

b. The program distinguished among top students because their elasticities likely differed. The top 10 percent were likely being offered scholarships at other academic institutions, giving them greater choices, which made their elasticities greater.

c. It could be that the President did not reduce tuition for all students because the elasticity of demand for all students was less than one. This scheme allowed them to price discriminate – and take advantage of differing elasticities. Another reason is that price is sometimes an indicator for quality. By lowering tuition across the board, they could be sending a signal that their college has lost relative academic standing. Using this scheme they are sending a signal that they desire to increase their relative standing.

7. Welfare loss is shown by the bolded triangles in the figures below.


a. b.

c. d.

8. a. A poll tax would have no incentive effect, since there is no way to avoid paying it. A tax on property, where supply is somewhat elastic, will reduce the quantity of property supplied (negative incentive effect), resulting in a loss of consumer and producer surplus.

b. Margaret Thatcher was almost thrown out of office because of this tax, and her successor, John Major, returned to a property tax. Citizens were far more concerned with the distributional consequences associated with a poll tax than they were with the loss of efficiency associated with a property tax.

9. See the accompanying graph. a. In the case of a tax, t, the revenue (rectangles A and B)

goes to the government.b. In the case of a price floor, Pf, the “revenue” (areas A

and B) goes to the suppliers who still supply. c. The bolded area in the accompanying graph represents

the welfare loss, the same for both the tax and the price floor.

10. a. With time the job searchers will get discouraged and drop out of the labor force, disguising the unemployment. Another possibility is that firms invest in machinery to replace labor, increasing the long term job shortage.

b. It is likely to decrease.


11. a. The equilibrium price is $6, the equilibrium quantity is 45.b. Producer surplus is the area below equilibrium price and above the supply curve. Assuming the

supply curve intersects the price axis at $1, the numerical value is ½ 3 45 3 5 = 112.50.c. Consumer surplus is the area above equilibrium price and below the demand curve. Assuming the

demand curve intersects the price axis at $15, the numerical value is ½ 3 45 3 9 = 202.50.d. Producer surplus is the area above the supply curve below $10 up to 25. Numerically this is equal to

187.50 (6325 – ½(3325)). Consumer surplus is the area below the demand curve above $10 up to 25. Numerically this is 62.50 (1/2(2535)).

12. a. Before the tax, equilibrium price is $6 and equilibrium quantity is 200. After the tax, equilibrium price is $8 and equilibrium quantity is 100.

b. Producer surplus before the tax is the area above the supply curve and below price. This is a triangle with base 200 and height 4. So, producer surplus is 1/2 (200)(4) = 400. After the tax, the triangle representing producer surplus has a height of 2 and base of 100. So producer surplus is 1/2 (100)(2) = 100.

c. Consumer surplus before the tax is the area below the demand curve and above price. This is a triangle with base 200 and height 4. So consumer surplus is 1/2 (200)(4) = 400. After the tax, the triangle representing consumer surplus has a height of 2 and base of 100. So consumer surplus is 1/2 (100)(2) = 100.

d. Total tax revenue is $4 times equilibrium quantity, 100, or $400.

13. a. Percent borne by demander = 80; percent borne by supplier = 20.b. Percent borne by demander = 40; percent borne by supplier = 60.c. Percent borne by demander = 67; percent borne by supplier = 33.d. Percent borne by demander = 50; percent borne by supplier = 50.e. Consumers will relatively more elastic demand curves bear a smaller percent of the tax. The same is

true for producers.


1. a. California ranks 8th highest among the states with gasoline taxation.b. In transportation expenditures, highway investment per $1000 of personal income, California ranks

49th in the nation.c. Fuel taxes correlate with the amount of road usage and are earmarked for transportation uses. Thus,

it is based upon the benefit principle.d. With fuel economy cars and alternative fuels, fuel taxes have grown slower than vehicle miles

traveled. What accounts for this change is that people buy more efficient cars and substitute other modes of transportation such as walking.

e. The tax rate is the same across income levels; however, low income groups spend a much greater share of their income on gasoline and therefore gasoline tax has a regressive impact.

2. a. 1) Taxation should bear as lightly as possible on production. 2) It should be easy and cheap to collect, and fall directly on the ultimate payer. 3) It should be certain. 4) It should bear equally so as to give no individual an advantage.

b. The broad based taxes burden production, but they are relatively easy and cheap to collect at least compared to other taxes and the burden is shared relatively equally. They do not necessarily fall on the ultimate payer.

c. A land value tax best fits the criteria.d. The tax falls directly on the owner; tax on land does not affect cost of production or its supply, so

price is not increased. Because quantity sold doesn’t change, the welfare loss is zero.


3. a. The original moratorium expired in 2003, but a new 3-year moratorium was signed into law in December.

b. New taxes on Internet sales will reduce the quantity of goods purchased over the Internet to decline significantly because there are close substitutes—goods from brick and mortar stores. This suggests that the elasticity of demand is high.

c. I would argue that Internet sales should be placed on equal footing with sales from brick and mortar stores. In addition, Internet sales, because they are not taxed, results in a loss of state revenue. These are arguments for taxing Internet sales.

Chapter 8: The Logic of Individual ChoiceQuestions for Thought and Review

1. Marginal utility is the satisfaction you get from consuming an additional unit of a good over and above what you’ve already consumed while total utility is the satisfaction you’ve gotten from consuming all the goods you’ve consumed so far.

2. According to the principle of diminishing marginal utility, marginal utility falls as one consumes more of a good. Marginal utility of the last unit consumed rises as one consumes less of the good.

3. The principle of diminishing marginal utility means that as individuals increase their consumption of a good, at some point consuming another unit of that good will not yield as much additional pleasure as did consuming the preceding unit or units. This is important because the marginal utility you get from a good plays a central role in determining how much you're willing to pay for it and how much of it you will demand. If the principle of diminishing marginal utility seldom held, the patterns of consumption and demand would be radically different; individuals' consumption would focus on a single good.

4. Economists’ theory of value depends on the underlying assumptions. Given those assumptions, price and value are related. If those assumptions (such as assumed rationality and freedom of choice) don’t hold, the statement is true; if they do hold, the statement is false.

5. This question asks students to put a utility value on their study pattern and consider it in terms of rational choice. It is likely that their study patterns are rational.

6. There are many psychological explanations for people’s actions, but economists use an easy underlying psychological foundation: rational self-interest.

7. This question asks students to explain the motivations for four choices they have made in the past year. The student will explain in each case that the opportunity cost of not undertaking the activity was greater than the opportunity cost of undertaking that activity. In other words the marginal utility per dollar of the activity undertaken exceeded the marginal utility per dollar of all other choices at that time.

8. The law of demand states that quantity demanded falls as price rises and quantity demanded rises as price falls. If you are already in equilibrium and the price of a good rises, you will no longer be in equilibrium. The marginal utility per dollar of the good whose price has risen is too low. To raise it, you must reduce your consumption of that good. Therefore, as the price of the good rises, you consume less of it—the law of demand.


9. The law of supply states that as price increases quantity supplied increases. The opportunity cost to the supplier is the value of the next best alternative they had when they supplied that good. If we are talking about labor it is the next best alternative value of the person's time. The opportunity cost of that forgone pleasure tends to increase the more you supply which is why opportunity costs underlie the law of supply.

10. If the supply curve is perfectly inelastic, the supplier has no alternative; thus, the opportunity cost is zero.

11. As usual, the answer is: it depends. Specifically, it depends on their utility function. If they value the uses of their time spent in "voluntary simplicity," it would definitely be rational. If most people had this type of utility function, then a decrease in measured production could well be associated with an increase in total utility.

12. For Americans, a large part of utility (happiness) is relative to others. As everyone gets more relative happiness does not increase.

13. What explains this paradox is the difference between total utility and marginal utility. Although our total utility for the consumption of water (a necessity) is much higher than that of diamonds (a luxury), the marginal utility of a gallon of water is much lower than the marginal utility of another diamond because of the principle of diminishing marginal utility. It is the marginal utility that determines willingness to pay, and thus defines the demand curve.

14. Most people buy goods without a lot of thinking. An example of ours is when we buy meat at the store. We have a general idea of what the price should be, and if the price is lower than that (and a sign or sticker says sale) we buy it. It follows the principle of rational choice only if that principle takes into account the costs of deciding.

15. The purpose of conspicuous consumption, according to Thorstein Veblen, is to demonstrate to others that one can afford the goods consumed. Utility is derived not from consuming the good or its functionality, but from how much one spent for the good, or its price. An example of such goods today is a Rolex watch. People don’t buy Rolex watches just to keep the time, but to show to others that they can afford to buy a $10,000 watch.


1. The table looks like this (interpret marginal as between the two numbers).

Cans of Soda Total Utility Marginal Utility

0 0 01 10 102 22 123 32 104 40 85 44 46 44 07 42 -2

a. Marginal utility begins to fall at the third soda.


b. Scout will not consume the 7th soda because it reduces total utility. It provides negative marginal utility.

c. We don’t know whether Scout is following the utility maximizing rule without more information. If this were her only choice and the soda were free, she’d drink 6 cans of soda—maximize total utility. Drinking 2 cans would maximize marginal utility.

2. Given the information in the table, the best combination to purchase will be where the (MU/P) is equal for all three goods. Doing the calculations, we have:

Number (MU/P) for A

(MU/P) for B

(MP/P) for C

1 20 10 8.332 18 7 1.673 15 6 1.674 10 5 1.675 5 4 1.676 2 4 1.677 27 3 21.678 220 2 21.67

(Note that marginal utility should be interpreted between units of consumption.) We start by buying that good with the highest util per dollar. With $20 to spend we would buy 1 of A, for 20 utils per dollar, leaving me with $10 to spend. We would then buy 1 more of A, getting 18 utils to the dollar. This would exhaust our money.

3. From the information in the table, the marginal utility per dollar is:

Number (MU/P) for A

(MU/P) for B

(MP/P) for C

1 10 25 152 9 20 103 8 15 84 7 10 65 6 8 56 5 6 4

(Note that marginal utility should be interpreted between units of consumption)a. With $12 to spend the consumer should buy 1 of A, 4 of B, and 2 of C.b. If the price of B rose to $2 its (MU/P) would be cut in half. The consumer should now buy 1 of A, 2

of B, and 2 of C.c. If the price of C was 0.50 but the other prices are the same as in part a, the (MU/P) for C would

increase, and the consumer would buy all 6 of C, and 5 of B and 2 of A.

4. You should continue your present pattern of consumption. One more widget will give you 2 more units of utility for $2, and one more wadget will give you 3 more units of utility for $3, and since (MU1/P1) = (MU2/P2), your present consumption pattern gives you as much total utility considering your income and prices, as any variation.


5. I would expect that Wicksteed would equate the marginal utility of fresh eggs divided by their cost including walking time to fetch them and the marginal utility of visits from friends divided by the cost to induce them to visit.

6. a. If he or she is not a 100 percent rational economist, it is likely that you will lose your spouse or significant other—or at least lose his or her love or fondness.

b. The utility gained from a diamond is not just its brilliance or perfection but also the knowledge that it is real (and thus expensive) and that some sacrifice (driven by affection) was made for its purchase. A fake diamond suggests that there was little sacrifice and thus the giver’s love was cheap as well.

c. Who is to say that the utility from the consumption of a product is not just?

7. I would buy 2 Charlie Parker at $10 each, and 4 Lester Young CDS at $5 each. When the price of Lester Young CDS rises to $10, we would buy 3 Charlie Parkers and 1 Lester Young. This demonstrates the law of demand because as the price rises, we buy a smaller quantity.

8. a. Since the “rational” move now suggests that the first person should keep all the money, one would expect that the offers would be smaller, which is what economists have found. See: R. Forshthe, J. Horowitz, N. E. Savin and M. Sefton, “Fairness in Simple Bargaining Experiments,” Games and Economic Behavior, 1994.

b. Since the second person can impose no penalty on the first for making less than a 50-50 offer, he should accept any amount that he gets. That is what economics researchers have found.


1. This is one example.a. From Newark to Fort Lauderdale, $169 through Cleveland or $172 direct. The price is higher for

direct flights because people who are willing to have a stop are more responsive to price.b. $187 and $229. Business demand is more inelastic than pleasure demand.c. $235 and 268. Demand is more inelastic.

2. a. iwon.com is a full search engine.b. The site gives out prizes to increase use, and thereby increase their advertising revenue since that is

tied to usage.c. Advertisements are in the links, they include webMD, Sprint and DVD Express.d. If advertising works it likely means that preferences can be influenced.


1. Zachary’s budget constraint for a, b, and c are shown in the accompanying graph.


2. With budget constraint in a, Zach will be on utility curve II. With budget constraint in b, Zach will be on utility curve III. With budget constraint in c, Zach will be on a utility curve that is to the right of III.

a. Zachary prefers the budget constraint that is the furthest to the right, c.b. The marginal rate of substitution for a is -2, for b is -1 and for c is -1. The marginal rate of

substitution equals the slope of the budget constraint at the optimal combination of goods. Even though we do not know the optimal combination with budget constraint c, we can still figure out the marginal rate of substitution for that combination.

3. A horizontal line. A straight line with negative slope if marginal utility were constant.

4. It would be bowed away from the origin if there were increasing marginal utility.

Chapter 9: Production and Cost Analysis IQuestions for Thought and Review

1. Economists include all opportunity costs as costs. This includes not only explicit costs but also implicit costs such as the opportunity cost of the owners of the business. Accountants don’t include this second item as a cost. Economists include changes in the value of any assets owned by the firm in revenue (implicit revenue) as well as total sales. Accountants include only total sales. An example of an implicit cost is the salary the owner of the firm could have earned if the owner worked somewhere else. An example of implicit revenue is a rise in the value of the building owned by the firm.

2. The terms long run and short run do not necessarily refer to specific periods of time independent of the production process. The long run, by definition, is a period in which the firm can vary the inputs as much as it wants; in the long run, all inputs are variable. The question is whether a firm ever really gets to this degree of flexibility. It may be true that firms are always constrained in regard to what production decisions they can make, so in reality this statement is probably true.

3. Marginal product is the additional output that will be forthcoming from an additional worker, other inputs constant. Average product is output per worker, the total output divided by the number of workers.

4. If average productivity is falling, short-run average variable cost is rising; to say that productivity falls is equivalent to saying that cost rises.

5. If marginal cost is increasing, average costs could be rising, falling, or constant. The direction of average costs depends upon whether marginal cost is higher or lower than average cost.

6. If average productivity is falling, average costs must be rising; if marginal productivity is falling, marginal cost must be rising. But there is no necessary relationship between average productivity and marginal costs.

7. If neither factor is fixed there is no diminishing marginal returns. However, the quick order premium means that short-run marginal costs are 50% higher than long-run average costs. Assuming constant returns, then both the long-run and short-run marginal cost curves are flat. Thus,


once you have determined an initial production level, to change in the short run you must use the short-run marginal costs. The average total cost curve will initially be U-shaped, but then it will become asymptotic to the short run marginal cost curve as in the accompanying graph.

8. The shapes of the short-run average cost curve and marginal cost curve would be the same as in the more usual case where machines are the fixed factor. Either way you are still adding more and more of a variable factor to a fixed factor and encountering diminishing marginal productivity as a result. The marginal cost and average cost curves would be U-shaped.

9. This is true because the fixed cost will be spread over such a large quantity of output that the average fixed cost, the difference between average variable cost and average fixed cost, will approach zero.

10. These statements are true. Labor does not need to be produced (at least in the time periods that microeconomic analysis usually considers) and hence the choice for individuals is how to divide up that labor among various activities such as work, play, and studying (opportunity costs). Goods that need to be produced ultimately depend on the opportunity costs of the factors producing them, but in the standard economic model, those costs are assumed fixed; thus, the opportunity costs are assumed fixed. This leaves the analysis of production free to focus on technical aspects of production such as diminishing marginal productivity as the determinant of costs, and hence supply.

11. Assuming one organizes one's studying reasonably, initially you focus on the parts of the text that are most likely to show up on the exam, and are most likely to raise one's grade. Then, the areas of study's influence on the grade decrease. At some point additional studying can have a negative return.

12. Productivity gains can reduce the percentage of labor costs per vehicle, allowing GM either to lower its price (thereby increasing the quantity of its cars sold) or to increase its profits (making its shareholders happy).

13. This is not true. While profits are important to business, because of internal monitoring problems it is not clear that managers maximize profit. They may waste profit potential in high-priced benefits for themselves and in inefficiency generally. The market, however, provides a limit on inefficiency, and firms that exceed that limit and have losses go out of business.


1. Her accounting profit is revenue minus explicit costs: $170,000. Her economic profit is revenue minus (explicit and implicit costs): 41,000.

Explicit Costs: Labor 40,000Rent 10,000 Ingredients 35,000Utilities 5,000Total 90,000Implicit Costs:Opportunity cost of Labor 125,000Opportunity cost of Capital 4,000Total 129,000Total Cost 219,000


Revenue 260,000

Economic Profit 41,000Accounting Profit 170,000

b. Since she is earning economic profit with her current business that she would forgo if she were to accept the position, which significantly exceeds the present value of what she can sell the firm for, she should continue to bake her own cookies.

2. Rent is $4,000; labor is $40,000; utilities are $5,000; total revenue is $100,000; the opportunity cost of the entrepreneur is $50,000; and that of the funds invested is $4,000. By the accounting definition of cost and profit, Economan is making a profit equal to $100,000 - ($4,000 + $40,000 + $5,000) = $51,000. From an economist’s point of view, where explicit and implicit costs are considered, Economan now has a loss of $100,000 - ($4,000 + $40,000 + $5,000 + $50,000 + $4,000) = -$3,000.

3. From the data given:

Q FC VC TC AVC AC MC AFC0 100 0 100 0.00 inf 01 100 40 140 40.00 140.00 40 100.002 100 60 160 30.00 80.00 20 50.003 100 70 170 23.33 56.67 10 33.334 100 85 185 21.25 46.25 15 25.005 100 130 230 26.00 46.00 45 10.00

(Note: Marginal costs should be interpreted as between levels of output.)

4. a. Given the price of labor at $15 per hour, and the data in the total product table; the following table represents the average variable costs:

Labor TP VC AVC AP MP MC1 5 15 3.00 5.0 5 3.002 15 30 2.00 7.5 10 1.503 30 45 1.50 10.0 15 1.004 36 60 1.67 9.0 6 2.50


5 40 75 1.88 8.0 4 3.75

b. This is done in the next column. The AVC curve is shown in the accompanying graph, and the AP curve is shown below it. You can see that the AVC curve and AP curve are mirror images of each other.

c. The MP curve is shown below it.d. As you can see from the graphs, the MC curve and the

MP curve are approximate mirror images of each other.

5. a. See the graph below on the left.b. The marginal cost curve intersects the AVC curve at the

minimum of the AVC curve. This is to the left of the intersection of the MC curve and the ATC curve, which is at the minimum of the ATC curve.

c. See graph below on the right. d. The ATC and AFC curves shifted down because they are the only two of the four that include fixed

costs. The MC and AVC curves did not shift because they include only variable costs.

6. a. The AFC, ATC, AVC, and MC curves are shown below on the left.b. The AFC curve has its normal shape. Because average variable costs do not change, the marginal

cost curve is coincident with the average variable cost as shown. The ATC curve is always falling since the costs are always above the MC curve. They asymptotically approach $25.

c The law of diminishing marginal productivity is not operative.d. The new AFC, ATC, AVC, and MC curves are shown in the right-hand graph below. The AFC

curve remains the same. The MC curve is now upward-sloping, with a slope of 10. The AVC curve is also upward-sloping, with a slope of 5. The ATC curve now has a more normal shape, with a minimum where it intersects the MC curve.

e. Marginal costs would have to decline at first and then rise for the curves to have their “normal” shapes.


7. a. Assuming labor can be hired and fired and is a variable cost, this will shift up AVC, ATC and MC.b. This involves a shift up of the AFC and the ATC.c. This will shift up AVC, ATC and MC.d. This will shift down AVC, ATC and MC.

8. a. The marginal cost is zero initially and 35 cents if you are over. NEED GRAPH.b. NEED GRAPH.c. You wouldn’t. It is too difficult. You would guess at it. Companies are expecting that, which is

why they offer such plans.d. They are relying on people’s gullibility and bringing them in as customers on the expectation of

lower prices than they are getting, then relying on the difficult cost of changing phones to keep them customers.

e. They were against the portability of phone numbers because portability reduces the cost of change, and thus discourages the practice of offering confusing plans.


1. The answer to this question will be different for every student. This is the information retrieved in 2002 for travel between Allentown, PA and Chicago, IL. It cost $500 for the week. The first 700 miles were free and additional mileage was 30 cents a mile.

a.

b. Average fixed cost falls as total number of miles driven rises.c. Marginal cost increases up to 1500 miles and falls thereafter.

2. This answer is based on 2001 data.a. The operating cost of producing an acre of corn is $170.83. The total cost of producing an acre of

Miles Total Cost

MarginalCost

Average Fixed Cost

AverageVariable

Cost0 $500

500 $500 0 $1 01000 $590 $90 $0.50 $.091500 $740 $150 $0.33 $.142000 $890 $150 $0.25 $.195


corn is $390.59.b. Two major components of the variable costs are seed and fertilizer.c. Two major components of fixed costs are land and equipment.d. Each acre yielded an average 139 bushels. Dividing operating cost per acre by 139, we calculate the

price of corn needed to cover operating costs to be $1.23 per bushel. e. Dividing total cost per acre by 139, we calculate the price of corn needed to cover total costs to be

$2.81 per bushel.

Chapter 10: Production and Cost Analysis IIQuestions for Thought and Review

1. Technical efficiency in production means that as few inputs as possible are used to produce a given output. Economic efficiency means using the method that produces a given level of output at the lowest possible cost.

2. It is incorrect because in the long run firms can change any input they want. In the long run there would be no fixed cost—all costs would be variable. The shape of the long-run average total cost curve is determined by economies of scale.

3. The inputs used in studying would certainly be labor, probably energy (i.e., lighting, temperature control), and a place (desk, bed, etc.) which would represent the "plant." Pens or pencils and paper to take notes and a highlighter to mark the text are also likely inputs to be mentioned, as well as study snacks (food for thought?). The shapes of the long-run average total cost curve and the marginal cost curve will depend on whether or not there are economies or diseconomies of scale in studying, and that will be determined by the relation between the usage of the resources above and the study time.

4. If production relationships were only technical relationships, diseconomies of scale would never occur because the same technical process could be used over and over again at the same cost. In reality, however, the social dimensions of production relationships introduce the potential for diseconomies of scale because, as the firm size increases, monitoring costs increase and team spirit or morale generally decreases.

5. The draftsman was right because marginal cost curves pass through the minimum points of their short-run average cost curves, and short-run average cost curves are not all tangent to the long-run average total cost curve at these minimum points. Thus Viner really wanted the marginal cost curves to pass through two different points simultaneously, which was not possible.

6. An entrepreneur is an individual who sees an opportunity to sell an item at a price higher than the average cost of producing it. The entrepreneur then looks at the cost of production to see if a profit can be made. If so, he or she will create supply by organizing production.

7. No, not in the long run. In the long run you should not continue to produce at a loss, and since all inputs are variable you can get out of business. In the short run it depends on what portion of your costs are fixed.

8. Cost curves are defined within a period of time. In the short run, technology is assumed constant. In the long run, technological change shifts the cost curves down. It does not explain the downward-sloping portion of cost curves.


9. The marginal costs of an additional car driving on a road would be the added costs of the road's usage. This includes the added wear and tear to the road surface, which is minimal. There could also be a congestion cost which at certain times can be substantial. Most likely the marginal cost curve would be a straight line at close to zero, and then a highly inelastic line as the highway becomes congested. The congestion factor means marginal costs increase as more and more cars use the road.

10. Producing steel in this fashion involves an enormous fixed cost. These fixed costs must be spread out over sufficient production to lower average total costs and make the average total production costs (which includes fixed costs) less than the price.

11. Because the second farmer can produce the same amount of corn with fewer inputs, both methods cannot be technically efficient. All economically efficient methods are also technically efficient, so it is not possible for both methods to be economically efficient either.


1. a. I would expect them to fall considerably.b. It would likely not fall as fast as I otherwise would have predicted.c. They would fall precipitously.

2. a. Variable costs would likely include: Manufacturing labor and materials and possibly sales costs to the extent that they are for the sale of additional production. Certain other costs have a variable component to them, but they will unlikely vary directly with production.

b. Fixed costs would likely include: Factor overhead, operating expenses and profit, R&D, interest, and to some extent advertising. In the real world, the division between fixed and variable costs is not as clear-cut as in the texts.

c. If output were to rise, average total cost would likely fall because fixed costs seem relatively important. This is the case for many real-world firms.

3. a. Ford was taking advantage of both economies of scope (combining production of different models to lower the cost of production for both) and economies of scale (increasing production of cars on one assembly line to lower average cost per unit).

b. The plan shifted the average total cost curve down.

4. a. The long-run cost curve is shown in the accompanying graph. Initially it will fall because of economies of scale.

b. It will later rise due to diseconomies of scale.c. The average cost curves in the short run are also U-shaped. Their

shape is due initially to increasing marginal productivity and eventually decreasing marginal productivity.

d. There is no fixed component.e. A straight line.

5. a. In the short run, the college is probably right. However, it depends on how short the short-run is. To the extent that fewer laborers could be hired to prepare less food and to the extent that the empty dining halls could be used for other purposes, these are variable costs and could be rebated as saved variable costs. In reality, labor contracts are somewhat fixed and the opportunity cost of college dining halls (or the additional seats available) is minimal. Thus they are indivisible costs so that one less meal does not allow fewer laborers or alternative uses of the space.


b. At the planning stage, the argument can be made that they are all variable costs and that the college could plan for a percentage of off board students, building fewer dining halls and hiring fewer laborers. In fact some dining halls allow a set number of off board students and do not charge board. Still, however, colleges must accommodate visitors and all students who would like board and must build a too-large hall. Thus the variability of demand also plays a role. However, the longer the time period, the higher the relevant marginal cost.

c. It would be hard to do, but that won't stop the administration from doing so. They probably would argue that the $6.00 cost is justified because it is the expectation of guests (peak use) that led them to build the large dining halls. Therefore, some of the cost of the building space should be assigned to them. However, if that is correct, it is difficult to see why that higher marginal cost should not be used for determining rebates.

6. a. It is possible that both methods are technically efficient because neither dressmaker is using more of both inputs to produce the same number of garments.

b. The economically efficient method is the least-cost method. The cost of 800 garments for the first dressmaker is $46,000 [(160 3 $100) + (3,000 3 $10)]. The cost of the same number of garments for the second dressmaker is $40,000 [(200 3 $100) + (2,000 3 $10)]. Therefore, the second method is economically efficient. The first method is not.

7. a.Units Total

CostAverage Total Cost

1 $16,000 $16,0002 $21,000 $10,5003 $26,000 $8,6674 $31,000 $7,7505 $36,000 $7,2006 $41,000 $6,8337 $46,000 $6,5718 $51,000 $6,3759 $56,000 $6,22210 $61,000 $6,100

b. It exhibits decreasing returns to scale because average total costs are declining.c. Fixed cost of producing whales is $11,000.d. Variable cost of producing whales is $5,000 per whale.


1. a. About.com provides information related to a variety of areas, including economics such as data. The service is free.

b. The fixed costs associated with running About.com include designing and setting up the website, finding new information and posting it. The marginal cost of providing About.com to one additional person is zero.

c. The advertising we saw was MSN, Allegra, Wal-Mart, and many others.d. An entrepreneur will supply this to the market if the profit exceeds the profit he or she would have

earned in another venture. Some assumptions have to be made to answer this question. The assumption is that About.com sells advertising space on its home page. This is the revenue that About.com receives for its services. Advertisers pay to be on this home page based upon the marginal cost and marginal benefit of such advertisements. It must be that BellSouth and other


advertisers get paying customers from these advertisements. Otherwise they would not pay to advertise on About.com.

2. a. Glaxo and SmighKline likely merged to create economies of scope—efficiencies in production and research that would lead to greater productivity.

b. The article mentions difficulty of monitoring a business with many offices, bureaucratic hassles associated with layers of management, and loss of “spark” in leadership.

c. These problems are associated with diseconomies of scale—increasing long-run cost as production rises. Perhaps long-run costs are higher for a combined firm GlaxoSmithKline than for separate Glaxo and SmithKline companies.


1. Due to diminishing marginal productivity, the marginal rate of substitution falls as the firm adds more of the variable input.

2. See the accompanying graph. The dotted line is the original isocost curve. Each of the following is shown with respect to the dotted line.

a. This is line a in the graph.b. The isocost curve rotates in along the machinery axis as

shown in the graph to line b.c. The isocost curve shifts in along both axes as shown to line

c.

3. As shown in the accompanying graph, land is cheaper in the United States than in Japan. And, labor is cheaper in Japan than in the United States. This accounts for the differing isocost lines. For each country to produce efficiently (equate the marginal rate of substitution to the relative costs of inputs), then, they will choose different combinations of labor and land. Japan will choose more labor and less land as shown by point A. The U.S. will choose more land and less labor as shown by point B.


4. Technical efficiency in production means that as few inputs as possible are used to produce a given output. On the accompanying graph, this would be anywhere on the isoquant curve, including points A and B. Economic efficiency means using that method that produces a given level of output at the lowest possible cost. Given the cost of inputs, the efficient point to produce that level of output corresponding to the isoquant curve is point B.

5. See the accompanying graph. The efficient combination of inputs for isocost line A is point A.

a. Technological innovation that makes land and labor equally more productive will increase the output that corresponds to Isoquant A.

b. The isocost curve rotates in along the x-axis to Isocost B. The firm cannot produce as much as before. The efficient combination of inputs is now point B on a lower isoquant curve.

6. If the price of labor falls to $3, the isocost curve shifts out along the labor axis, intersecting at 20 units of labor. Producing 60 earrings with the new labor costs is now inefficient. The firm can now produce more than 60 earrings, shown by point D and the new isoquant curve, I2, to the right of the one corresponding to 60 earrings, I1.

7. A rise in the cost of machines shifts the isocost curve in along the machine axis to intersect at 12 machines. The firm can no longer produce 60 earrings. It must produce fewer at a point such as A.

Chapter 11: Perfect Competition

Chapter 11: Perfect CompetitionQuestions for Thought and Review

1. Buyers and sellers must be price takers because if sellers set prices, they would be able to raise them to make a profit and the demand curve they would face would not be horizontal.

2. Typical marginal cost, marginal revenue, and average total cost curves are shown in the accompanying graph. The profit-maximizing level of output is Q*. The total profit is shown by the shaded rectangle. As we have drawn it, the firm is not in long-run equilibrium since it is earning a profit.

3. The typical MC, MR, and ATC curves for a firm in long-run equilibrium are shown in the accompanying graph. Because the firm is in long-run equilibrium, it does not earn any economic profit.

4. The firm’s supply curve is that portion of the firm’s marginal cost curve that lies above the minimum of the average variable cost curve. The sum of all individual firms’ marginal cost curves (above the minimum AVC curve) is the market supply curve.

5. The typical ATC , AVC and MC curves are shown in the accompanying graph. The price at which the firm shuts down temporarily is P1, minimum of the AVC curve. The price at which the firm exits the market in the long run is higher at P2, the minimum of the ATC curve.

6. The shutdown point is the same as the point at which a firm exits a market in the long run when there are no fixed costs. That is, when AVC are the same as ATC.

7. The long-run market supply curve is upward sloping for an increasing cost industry because as output rises, average total cost curve shifts up. Increased marginal costs increase the price at which firms make zero profit and increases the long-run equilibrium price. As output rises, so does


equilibrium price. Thus, the long-run supply curve is upward sloping. The long-run market supply curve is downward sloping for a decreasing cost industry because as output rises, average total costs shift down. Decreased marginal costs decreases the price at which firms make zero profit and decreases the long-run equilibrium price. As output rises, equilibrium price falls. Thus, the long-run supply curve is downward sloping. The long-run market supply curve is horizontal for a constant cost industry because as output rises, average total costs do not change. Increased profits entice new entrants and the equilibrium price falls to the original price at which no profits are made.

8. A technological development that shifts the MC curve down will shift the market supply curve to the right. Market price will fall and output will rise. Profit for each firm will still be zero because the price will decline sufficiently so that each firm earns zero profit.

9. If a perfectly competitive firm is owned by its workers, its output decisions will differ from those of any other perfectly competitive firm because its goal will be to maximize profit, but not at the expense of existing workers. This will cause its decisions to differ from the non worker-owned firm.

10. If both firms are producing where MR = MC and we could buy either for the same amount, I’d buy the one with the highest total profit. Remember, it is total profit, not profit per unit that is maximized by a firm. If there are perfectly competitive firms, however, eventually both will earn 0 economic profits regardless of which we bought.

11. The firm should produce where MR = MC. If the price is $20, then for the perfectly competitive firm, MR also is $20. If MC is four times the quantity, produce 5 units (MC = 4 × 5 = 20).

12. This question requires students to find current articles in newspapers and apply supply/demand analysis to them.

13. a. Firstly, the average total cost curve is mislabeled as the average fixed cost curve. With that correction, the profit maximizing output level is not where MC = ATC as indicated, but rather where MC = MR.

b. Firstly, the demand curve facing a single firm in a competitive market is perfectly elastic (horizontal) instead of upward sloping. Secondly, the firm's supply curve is that portion of the marginal cost curve that is upward sloping; the MC curve should be shown to be upward sloping.

c. As with (b) the demand curve facing a single firm in a competitive market is horizontal instead of downward sloping. Secondly, the profit maximizing level of output is not where MC = AVC, but where MC = P = MR. Third, the MC curve should go through the minimum point of the ATC curve. It currently doesn’t.

d. This graph would never represent any real firm since the firm would have shut down where ATC = P. Output should be zero. Also the ATC curve cannot be below the AVC curve.

14. If the older retail stores had higher costs than the new stores, they would be forced to cut prices below their costs. If that happened, they might stay in business in the short run, assuming they were covering their average variable costs, but they wouldn’t stay in business in the long run. If the market remains perfectly competitive, equilibrium price will fall.


1. a. Given that this is a perfectly competitive firm. To maximize profits a competitive firm should produce where MR = MC (and MC are rising). This is between 4 and 5.

b. If the price of the good increased to $15, MR would also increase to $15, and the profit maximizing level of output would increase to between 5 and 6.


2. a. With the information given, the clear answer is to change output in an attempt to lower costs and achieve an economic profit. We are not told whether MR = MC at the level of output at which ATC = $4. If it is, then it is maximizing profit, even though at a loss. If the firm is perfectly competitive, in the long run it should close.

b. If we now know that AVC = $3.50, we know that price is less than the average variable cost but not whether we are at the quantity where MR = MC. If AVC cannot be reduced, the firm should stop producing since it loses more by producing than it would if it shut down.

3. If this situation refers to the output level at which MR = MC, the price covers the AVC of $4, but only half of the AFC; in the short run the firm should still produce. By producing it will lose $2 per unit, but if it did not produce it would lose $4 per unit. In the long run the firm will go out of business.

4. a. Zapateria will produce 500 pairs of shoes if the market price is $70 because at 500 pairs, the market price of equals marginal costs of $70.

b. The total profit that Zapateria will earn is $20 times 500 pairs of shoes, or $10,000.c. Since Zapateria is making an economic profit, it should expect other shoe stores to enter the market.d. The long-run equilibrium price is $40 a pair because at $40 a pair, zero profit is made.

5. a. The market equilibrium price and the price that each firm gets for its product is $14.b. The market equilibrium quantity is 50 units. Each firm produces 5 units.c. Each firm is making $17 total profit.d. Firms will begin to exit the market when the price falls below $9.75, the minimum average total

costs.

6. a. As demand decreases, price will decrease in the short run. As price declines, some firms will exit the market. As firms exit, market supply will decrease, which will cause price to rise. Because it is a decreasing cost industry, however, marginal costs will be lower than with the original equilibrium and the price at which zero profit is made falls. Market equilibrium price falls in the long run.

b. The market equilibrium quantity falls.c. The number of firms also falls because the decrease in demand decreased economic profits, making

firms exit the market.d. Profit per firm returns to zero for all firms, and for the industry in the long run.

7. a. Output Q* shown in the accompanying graph is the profit-maximizing level of output. A slightly larger quantity would not be preferred because the marginal cost of the additional output exceeds marginal revenue, reducing total profit.

b. Reducing quantity below where MC = MR would not make sense to a profit maximizing firm since the MC would be below MR, meaning the loss in revenue from reducing output will exceed the saving from reducing marginal cost, reducing total profit.

c. The shutdown point is at the minimum of the AVC curve (where MC = AVC), at price Ps in the accompanying graph.

d. The fact that the permit would be lost if the firm shut down shifts the AVC curve down because the permit now must be counted as a marginal benefit of remaining in business. Its value will be lost of the firm shuts down. This lowers the price at which shut down is chosen.


8. a. Once the new tomato is generally available, it will likely reduce the price of equal-quality tomatoes in the off-season. However, the new, higher-quality tomato may well sell for more than the cardboard-tasting ones normally bought in winter.

b. Its effects on farmers depend on what the biotechnology firm charges for its seeds. If the prices for the seeds are high enough to extract the benefit of the better tomato, farmers will be no better off. Further, since the demand for tomatoes is fairly inelastic, the increased supply of good tomatoes (reducing their price) in the off-season will reduce revenues of farmers.

c. Tomatoes will be grown in areas much farther from their point of sale.d. To the degree that the price of tomatoes falls, tomatoes in the winter will more likely be moved from

the rear to the front of the salad bar.

9. a. In the short run, the price of gold would decline as the supply curve shifts to the right. In the long run, the drop in the price of gold would have caused some gold mining firms to shut down. If there are no specialized inputs for the mining of gold, the price will rise again to its original level, P0, the supply curve shifts back to S0.

b. I would advise them to sell the gold slowly, reducing the fall in price in the short run and allowing time for price to rebound and thus gain the maximum revenue from the sales. In addition, in the long run, demand is more elastic making the change in price due to a shift in supply smaller. This savings from minimizing the price decline must be weighted against the lost interest central banks would receive from investing the cash from the sale of gold.

10. a. Reconstituted milk can be shipped from low-cost production areas to high-cost production areas, threatening local dairy monopolies with competition.

b. This probably resulted from strong regional lobbies to protect regional markets from other lower-cost regions.

c. He is most likely incorrect economically, but correct politically. Price supports cause overproduction of milk and its elimination most likely will cut production. He made this statement because he wanted to get reelected and his supporters are dairy farmers who benefit from the price supports.

11. a. In the short run, the demand curve shifts to the left. Equilibrium price and quantity decline as shown in the accompanying graph.

b. In the short run, this firm operates at a loss shown by the shaded region in the accompanying graph though not below the shut-


down point (minimum of the AVC curve). In the long run, price is higher than average variable costs and this firm shuts down

c. In the long run, some firms exit the industry and the supply curve shifts to the left. Because it is a constant-cost industry, sufficient number of firms exit so that price returns to its previous level at an even smaller equilibrium quantity (Q2) as shown in the accompanying graph.

12. a. He receives $26.14 million in rent. b. He will supply no baseball services at a salary below

$60,000 since he could be a stockbroker for $60,000. It is vertical at $60,000 as shown in the accompanying graph because he is willing to supply the maximum number of hours that can be worked no matter what a baseball team pays him above $60,000. (This assumes he can have only one job at a time.)

c. His salary will decline, but as long as the cap is above $60,000 the amount he will play baseball will not.

13. a. Because Americans will be able to import more from China, Mexico will likely face a decline in the demand for its textiles. The demand curve will shift to the left and equilibrium price and quantity will decline (to P1 and Q1

respectively). In the long run some businesses will exit the market. Because we are assuming an increasing-cost industry, as some firms exit the market costs of production decline, shifting the average total cost curves of the remaining firms down. The supply curve will shift to the left (to S1), raising equilibrium price back up (to P2), but not back to its original level. Equilibrium quantity will fall even further to Q2 as shown in the accompanying graph.

b. The imposition of a new tax will shift the supply of French restaurants up because the tax increases their costs. In the short run equilibrium price will rise (to P1) and equilibrium quantity


will fall (to Q1). For some firms the price increase will not be sufficient to cover the increase in taxes in the long run. This is also the long-run equilibrium.

14. a. Price is at the minimum of the average variable cost curve as shown in the accompanying graph.

b. Assuming the market is perfectly competitive, Zany Brainy stores close, the supply curve shifts to the left, raising the market equilibrium price to a level at which firms in the market no longer earn losses but normal profit (zero economic profit). The market supply and demand curves are in the accompanying graph.


1. EBay is a market set up like an auction. Both buyers and sellers are price takers, there is a large number of firms, there are no barriers to entry, and there are profit-maximizing entrepreneurial firms. The conditions that might be met is complete information, however, items generally do have descriptions and photos, and homogeneous products (products may vary slightly).

2. One possible answer is, Vermont 7.5%; New Jersey 7.5%; California 6.64%; South Dakota 8.1%; Alabama 7.25%.

a. 6.64%-8.1%, a wide range.b. Both buyers and sellers are price takers, there is a large number of firms, there is a homogeneous

product, there are profit-maximizing entrepreneurial firms. It may appear that sellers are price takers because they are posting their rates, but they face many competitors. Their posted prices are set by the market. There is a lack of complete information and some barriers to entry (cost to establishing a lending institution).

c. Very few markets are perfectly competitive. Since the auto loan market doesn’t meet all six conditions, it isn’t surprising that there is a spread of loan rates.

Chapter 12: Monopoly

Chapter 12: MonopolyQuestions for Thought and Review

1. As shown in the accompanying graph, the profit maximizing condition MR = MC holds for both a perfect competitor and a monopolist. The difference is that for a perfect competitor, MR = P and so P = MC at the profit-maximizing level of output. In the case of a monopolist, MR < P, and so P > MC at the profit-maximizing level of output. The monopolist produces Qm and charges a price of Pm. The perfect competitor produces Qc and accepts a price of Pc.

2. This is not necessarily true. Monopolists may or may not make pure economic profit. In long-run equilibrium perfectly competitive firms tend to break even, which means they make only a normal profit. So profit is not the distinguishing factor. Instead, the distinguishing characteristic is that the monopolist can restrict output to hold up the market price; a perfect competitor cannot affect the market price.

3. To sell an additional unit the monopolist has to reduce the price not only to the marginal buyer but to all buyers.

4. The development of such a machine would probably reduce the demand for college education to the extent that it would be a lower-priced substitute. (But remember, gaining knowledge is not the only aspect of college—what about the social experiences, the sports, etc.?) If one college could monopolize the production of this machine, it could probably charge close to the current price of college and hire professors to do pure research with the proceeds.

5. A lump sum tax on a monopolist would change her fixed costs but not the variable costs (or marginal costs). Consequently, the output and pricing decisions would not be affected.

6. A monopolist will tend to sell at a point on the demand curve where demand is elastic, but as the fish gets older (and smelly) the monopolist will wish to lower its price. The price will not be likely be in the inelastic range, but it may if the fish are rotting and the monopolist needs to sell all its inventory.

7. Both computer printers and cheap home faxes require, but don’t come with, cartridges. If these cartridges are specific to the machine, the company will have a monopoly in them, and can charge a high price relative to the cost. So what the firm is doing is buying a monopoly in cartridges by giving the printer of fax away free. (I recently paid $40 for a color ink cartridge for a printer that initially was given away free.)

8. One cost is the lost profit by Bayer, which will likely lead to lower investment in drug research. If drug makers believe that government will ignore patents on future drugs, thereby lowering future profits, they will spend less on developing new drugs. So the cost to society of a policy of disregarding a patent is having fewer drugs to fight disease in the future.

9. Price discrimination arguments for the unexplained examples in the text:1. Monday and Tuesday nights tend to be slow at most movie theaters, so lowering the price attracts

customers who can go to the movies any night (elastic demand). Those who can only go on


weekends, (people work and go to school, people with children need baby-sitters) and who therefore have a more inelastic demand pay the higher, undiscounted, price.

2. Most people tend to buy tires to replace busted ones and cannot wait for a sale (inelastic demand). By running a sale about half the time the company can hope to attract those customers who are wanting to upgrade their tires or are planning to replace older tires and can afford to wait.

3. People with inelastic demands don't worry what they spend on liquor, so they don't care how the costs are divided between food and liquor. People who are looking to dine out, however, have more elastic demands. Therefore, food prices are lower.

4. Parents and relatives who are visiting friends in colleges will often frequent college-town stores. Since they are there for only a short time and may want a token of the area, college-town stores will charge a high price for their goods. Students, on the other hand, are there for 9 or more months and tend to have more elastic demands. That is why they are given discounts.

10. The first thing to note is that publishers have pricing power. Therefore, they are able to price discriminate—charge buyers with different elasticities of demand different prices. The publisher charges a higher price to those who are eagerly awaiting the next book in a series and buy the book upon first release; their demand is less elastic. The publisher prints the book in hard cover to give the customer the feeling that they are buying a higher quality book. Publishers charge a lower price to those who are willing to wait a year (have more elastic demand.

11. In the accompanying graph, the welfare loss is shown as the bolded triangle.

12. A perfectly elastic marginal cost curve is shown in the accompanying graph as the horizontal straight line MC0. Because the opportunity cost of providing additional units does not increase, welfare loss is greatest with constant marginal costs—shown below as the shaded triangle. One can see that welfare loss falls with increasing marginal costs by rotating the marginal cost curve up. An example, MC1, is shown. Welfare loss is bounded by the MC curve, the demand curve, and the quantity line.

13. Blocking entry raises fares and reduces the number of flights. Airlines should be willing to spend up to the additional rent they will gain by blocking entry.

14. Removing copyrights would remove the monopoly to a text and cause the price of textbooks to fall and output to rise. The argument for copyrights (and patents) is that without some guarantee of profits from their ideas, people would be unlikely to engage in the effort (and incur the costs) associated with generating new ideas, products, etc. If that is the case, then copyrights may be


justified. If people would write good books anyway, then probably society would be better off without copyrights because more books would be sold at a lower price.

15. In industries with strong economies of scale, efficiency tends to increase as the number of firms decreases. As each firm increases its output, its costs per unit fall and it becomes more efficient.


1. Given the information in the problem, we can calculate:

Q P TR MR FC VC TC ATC2 12 24 24 20 6 26 13.003 11 33 9 20 9 29 9.674 10 40 7 20 12 32 8.005 9 45 5 20 15 35 7.006 8 48 3 20 18 38 6.337 7 49 1 20 21 41 5.868 6 48 -1 20 24 44 5.509 5 45 -3 20 27 47 5.2210 4 40 -5 20 30 50 5.0011 3 33 -7 20 33 53 4.8212 2 24 -9 20 36 56 4.67

a. See accompanying graph.b. The monopolist would produce where MR = MC,

at 6 units of output.c. A perfectly competitive firm would produce where

P = MC, shown on the graph where demand crosses MC; thus at 11 units of output.

2. This is what is wrong in the graphs shown:a. The marginal revenue curve is too steep. It should

cut the x-axis at Q. In addition, quantity should be determined where MR = MC.b. The curve labeled ATC is really the MC curve. Correctly labeled, the profit-maximizing level of

output is determined where MC = MR.c. Quantity should be determined MR = MC, not MC = demand. Also, the MC curve should intersect

the ATC curve at the minimum point of the ATC curve. Lastly, profit is drawn incorrectly. The rectangle cannot extend past the quantity sold.

d. Quantity should be determined where MR = MC.

3. a. Wyeth-Ayerst Labs likely priced Norplant differently in the two countries because of the differing elasticities of demand for Norplant between the two. Charging more in the U.S. suggests that the elasticity of demand for Norplant is lower in the U.S. than in other countries.

b. Price discriminating due to differing elasticities is not inherently unfair. Such normative issues have many answers.


c. With such a large differential one would expect the two to converge. Specifically, as competition in the production of Norplant increases, the price of Norplant would be expected to decline in the U.S. Once the patent expires, the prices would converge at the zero-profit price.

4.Q P TR MR TC MC ATC0 4.20 0.00 3.201 3.80 3.80 3.80 4.20 1.00 4.202 3.40 6.80 3.00 5.60 1.40 2.803 3.00 9.00 2.20 7.80 2.20 2.604 2.60 10.40 1.40 10.40 2.60 2.605 2.20 11.00 0.60 13.40 3.00 2.686 1.90 11.40 0.40 16.80 3.40 2.80

a. Fixed cost is $3.20 per month per resident.b. MC = MR at 3 collections per month. The price charged is $3 per pickup. Profit is 40 cents per

pickup per person.c. P = MC at 4 collections per month. The price charged would be $2.60 per pickup. There would be

only normal profits. Economic profit would be zero.d. The city government should prefer competitive bidding unless there is a natural monopoly. The

quality of the pickup would be expected to be greater for the competitive industry because monopolists do not face competitors.

5. a. Since MC is falling and always below ATC, the firm will not cover its costs at a price equal to marginal cost. To stay in business, firms must at least cover costs.

b. It would set quantity where MR = MC and then charge a price that consumers are willing to pay for that quantity (reading from the demand curve).

c. At a minimum it must be allowed to charge its average cost. Alternatively if the government subsidized all fixed costs, it could price at its marginal cost.

6. a. The most likely reason is price discrimination; individuals in Palo Alto have a less elastic demand

than individuals in Pleasanton, and people with inelastic demands (short on time or about to run out of gas) cannot afford to look for a lower price.

b. One possible policy is the following: They might suggest ruling that firms must charge the same price at all stations. The problem with this policy is one of enforcement. It would require enormous amounts of data and a large bureaucracy to enforce, as does any type of price control. Also, gas stations in places with higher real estate prices and wages have higher costs to cover and therefore may need to charge higher prices.

c. Probably not; what the policy suggested in b would do is to equalize it, which would tend to help richer communities where gas prices now tend to be higher, and hurt poorer communities where gas prices tend now to be lower.

7. a. This is partly an example of price discrimination; the offers are limited to specific groups such as students or educators, who have more elastic demands.

b. If most subscribers get the discount, the reason is less likely to be price discrimination, although the publisher is still price discriminating because people who buy a single issue are still paying $3.95 per magazine. The other reason why Time might offer the magazine at such a low cost is that they have an incentive to have a large subscriber base.


c. The reason they can afford not to have subscription revenue cover costs is that a magazine does not get revenue only from the sale of its product; magazines get most of their revenue from advertising. The higher the subscription base, the more advertisers are willing to pay, and the higher the magazine’s advertising revenue.


1. a. We found documents about assignment of licenses to Nextel Communications, Inc. by Motorola, Inc. at http://www.fcc.gov/transaction/nextel-motorola.html. We read a letter by Southern LINC dated November 2000 in opposition to the merger. Their argument is that Nextel controls a large amount of the spectrum already and gaining greater frequencies would not be in the public interest. Specifically it states that “no new product line can be successful,” which is to the detriment of the consumer.

b. In a letter responding to Southern LINC’s opposition, Motorolla states that granting of additional licenses would enhance consumer choice by allowing Nextel to offer additional services. Other benefits are mentioned.

c. The theory of the monopolist is the basis for opposing party’s arguments. What was in dispute was the definition of the market and therefore whether the granting of additional licenses was in the public interest. If the market is more narrowly defined, it is easier to argue that controlling a concentration of the spectrum will reduce competition and harm consumers. If the market is defined in a wider basis, as Motorolla argues, the anticompetitive effects are smaller.

2. a. A patent is “a property right granted by the Government of the United States of America to an inventor “to exclude others from making, using, offering for sale, or selling the invention throughout the United States or importing the invention into the United States” for a limited time in exchange for public disclosure of the invention when the patent is granted.” Inventors can produce and sell their inventions without a patent. An example is Coca-cola.

b. The cost of a patent has been estimated by some to be between $5,000 and $10,000 over the life of the patent. The basic filing fee is $750 and maintenance fees are $890 at 3.5 years, $2,050 at 7.5 years, and $3,150 and 11.5 years. However, cost will also include a patent search, the patent application process, amendments to the patent application.

c. The term of a new patent is 20 years from the date on which the application for the patent was filed in the United States. The government probably sets expiration dates for patents both to help consumers through lower prices and to stimulate further innovation.


1. a. For a competitive industry the profit maximizing output is 8.8 and the price is 41.2.b. For a monopolist the profit maximizing output is 7.33 and price is 42.66.c. The quantity is lower and the price is higher for the monopolist.

2. a. Q = 2, P = $39.50b. ATC = $52c. Profit = -$25

3. a The profit-maximizing level of output does not change as fixed costs change.b. ATC = $78.c. Profit = -$77.

http://www.fcc.gov/transaction/nextel-motorola.html


4. a. Q = 6, P = $18b. Q = 12, P = 0

Chapter 13: Monopolistic Competition, Oligopoly, and Strategic Pricing Questions for Thought and Review

1. A Herfindahl index of 1200 means that the sum of the squared market shares of all the firms in the industry is 1200. The related concentration ratios vary widely. Thus it is impossible to say which industry is more concentrated.

2. Firms differentiate products through advertising. The overriding objective of product differentiation is to maintain or increase market share by creating its own small monopolistic niche.

3. Of the main characteristics of monopolistic competition, having many sellers gives it its competitive aspect and product differentiation gives it its monopolistic aspect, by allowing for monopolistic niches within markets.

4. Product differentiation makes us better off to the degree that we prefer having choices of different varieties of the same product. However, in some cases, the differences may be imagined rather than real. Firms reinforce product differentiation with advertising, and so there is a question whether devoting resources to advertising is a benefit (due to increased information) or a waste.

5. As shown in the accompanying graph, the profit maximizing condition MR = MC holds for both a perfect competitor and a monopolistic competitor. The monopolistic competitor, however, does have some market control and thus, MR < P, and so P > MC at the profit-maximizing level of output. However, to maintain that market share it must advertise, which raises its ATC until it earns no profit. The monopolistic competitor produces Qm and charges a price of Pm. At Qm, average total cost is Pm and it earns no profit. The monopolistic competitor faces some competition. The perfect competitor produces Qc and accepts a price of Pc. It also makes no profit because there are no barriers to entry and new entrants into the market eliminate any profit.

6. The monopolistic competitor does not earn economic profits because of free entry into the market.

7. Barriers to entry in the restaurant industry would include the advertising expense needed to introduce the new restaurant as well as the licenses required to operate such an establishment. In the automobile industry a major barrier would be the size of plant and amount of equipment a firm would need to compete with the existing firms, as well as the advertising to introduce the new brand and develop the long-term brand reputation on which auto makers are so dependent.

8. Strategic pricing is the central characteristic of oligopoly. Monopolistic competitors face too many competitors to price strategically.

9. The two extremes of an oligopoly model are the cartel model which is equivalent of a monopoly and the contestable market model which, if there are no barriers to entry, is equivalent to a competitive industry. In both models firms set their price based on reactions to other firms.


10. A cartel model is probably more likely to judge based on performance, since a cartel is recognizable in that it acts like a monopolist, restricting output to raise price. Under the contestable market level, an oligopoly could perform exactly the same way that a perfectly competitive market does as long as there are no entry/exit barriers.

11. Smith meant that such discussions can lead to collusion, formal or informal, meaning that the firms act in harmony rather than competing. Generally this results in higher prices being charged to consumers.

12. (In answering this question students may be aware of media coverage in the 1990s that suggested colleges colluded in establishing financial aid packages for students and in setting tuition.) Since colleges are not profit maximizers, it is difficult to characterize them as a cartel type of oligopoly. There certainly has been implicit and even explicit collusion; the goals of that collusion are complicated and not simply profit maximization.

13. This requires an individual answer based upon personal experience. One possibility would be sharing the purchase of a television with a roommate. Even if only one bears the burden of the cost of the television, both will be able to watch it (assuming the TV must be in a common room). Each, therefore, has the incentive to hold out and let the other bear the entire cost of the television to maximize expected utility. Since they are living together and the game is played many times, there is stronger reason to cooperate and share in the cost of the television, especially since cheating has other consequences such as ruining the relationship with your roommate.

14. The breakfast cereal market is definitely oligopolistic; the firms made interdependent strategic pricing decisions.


1. a. Given this table the monopolistic competitor would produce where MC = MR which is at Q = 8.b. The firm's marginal costs are constant at 6, its total variable costs are $48 at 8 units of output. Since

a monopolistic competitor makes zero economic profits in equilibrium and its total revenue at 8 units of output is $112, fixed costs must be $64. Average fixed costs are $8.

2. a. The demand curve is kinked at $8 and the MR curve is discontinuous at $4. There are two places where MC = MR, at quantities 4 and 8, as shown.

b. The firm would prefer the equilibrium with the lower output, higher price, and higher profit. This is where output is 4 and price is about $7 a unit.

c. If marginal cost falls, the level of output rises by a lot while the price falls by just a little.

d. If marginal cost rises, the level of output falls by a little while the price rises by a lot.

e. This part asks students to survey firms in their area about pricing strategies. The kinked demand model presented in the book is more likely.

3. a. See the accompanying graph. The profit maximizing quantity is 150, the price will be $9, and profit will


be $3 per unit or $450.b. In the long run, with entry, costs would rise (advertising would increase) and the demand curve

would shift in (shown by the bolded dotted lines) causing price to fall until all firms break even.c. If marginal cost falls to zero, the firm should produce 300 units of output (point B on graph), and

charge a price of $6 (point A). The entire $6 will be profit (segment AB on graph) per unit, for a total profit of $1800.

4. a. This market is most likely characterized by oligopoly or possibly monopolistic competition. We say oligopoly because the largest firm will consider the response of its rivals in its decisions. We say monopolistic competition because there are many firms but their products are differentiated. There is some label recognition and loyalty.

b. The Herfindahl index is 428.49 + 289 + 44.9 + 4.84 + 4 + 51.4 = 822.63.c. The four-firm concentration ratio is 46.6% = 20.7 + 17 + 6.7 + 2.2.

5. a This is an example of colluding, trying to raise price or restrict quantity to increase profit. b. If one of us were the Braniff chairman, we would not have gone along because such an action

would be subject to a law suit and heavy fines. There would be other ways to implicitly collude and arrive at the same solution that would not attract government scrutiny.

c. Crandell should not have been so direct in his attempt to collude with Braniff. There are a number of ways to collude indirectly. Besides, as former President Nixon might say "It is wrong."

6. a. See the table below.

b. If the game is played only once, we would advise that Mr. Notsonice’s profit-maximizing strategy is to cheat to maximize expected profit. What his “best” strategy is depends on how much he values being honest.

c. If the game were played over and over, we would advise that his profit-maximizing policy would be to develop some level of trust between the two players and agree not to cheat, avoiding the prisoner’s dilemma.

d. The benefit of colluding would have to be greater than the expected benefit of cheating. It would have to be more than $3 million.

7. a. Mattel might want to buy Fisher Price (1) to increase market share to 35 and increase its ability to set prices and increase profit, (2) to enjoy economies of scope decreasing their joint average total costs, and (3) to get a good buy if they believe Fisher Price is undervalued.

b. Since entry is relatively easy in this market, judging the market by performance would suggest that the merger would not add to the monopolistic nature of the market.

c. Arguments against allowing such a large concentration would include Mattel's new ability to control the distribution routes of toys in general, thus creating barriers to entry and moving the market to a monopoly position.

d. The four-firm concentration ratio for the entire industry would most likely be much lower since the wider the definition of the market the lower the concentration ratio.


8. a. The hypothetical payoff matrix is shown in the accompanying graph. If neither offers free shipping each earns $1,000 profit. If only Amazon.com offers free shipping its profits are $2,000 while Buy.com loses $300. If both offer free shipping each earns profit of $200.

b. Amazon.com is best off when it offers free shipping and Buy.com does not. It makes a profit of $2,000.

c. Buy.com is best off when it offers free shipping and Amazon.com does not. It makes a profit of $2,000.

d. Joint profits are maximized when neither offers free shipping. Combined profits are $2,000, instead of $1,700 in the case when one offers free shipping and the other does not.

e. Answers to this question will vary. At the time we answered the question, Amazon.com offered free shipping on purchases of $25 or more and Buy.com offered free shipping with no minimum purchase.

9. a. This is likely monopolistic competition. There are many firms and their products are differentiated.b. This behavior is a type of advertising to increase demand and reduce elasticity of demand. This

advertising attempts to differentiate one product from the other 29,999 products for sale. It also provides a barrier to entry for competitors.

c. Monpolistic competitors earn no profit in the long run. P=ATC as shown in the accompanying graph.

d. Their argument is likely that the high cost of shelf space is a barrier to entry to them and is therefore unfair competitive practice. The retailer is using its monopoly power over shelf space to extract profit from the supplier.

e. An argument on the other side is that firms that produce better products have the profit available to afford to pay the slotting fee and therefore that willingness to pay a high slotting fee is an indication to consumers of a better-quality product.


1. a. The Agency will delineate the product market as a product or group of products such that a hypothetical profit-maximizing firm, which was the only present and future seller of those products ("a monopolist"), would impose at least a "small but significant and nontransitory" increase in price. That is, assume that buyers likely would respond to an increase in price for a tentatively identified product group only by shifting to other products, what would happen? If the alternatives were, in the aggregate, sufficiently attractive at their existing terms of sale, an attempt to raise prices would result in a reduction of sales large enough that the price increase would not prove profitable, and the tentatively identified product group would prove to be too narrow.

b. Cross price elasticity of demand shows the responsiveness of supply and demand to changes of other goods. The Agency takes into account; 1) evidence that buyers have shifted or have considered shifting purchases between products in response to relative changes in price or other


competitive variables and 2) evidence that sellers base business decisions on the prospect of buyer substitution between products in response to relative changes in price or other competitive variables.

c. Market concentration is a function of the number of firms in a market and their respective market shares. As an aid to the interpretation of market data, the DOJ uses the Herfindahl-Hirschman Index ("HHI") of market concentration.

d. The DOJ divides the spectrum of market concentration as measured by the HHI into three regions that can be broadly characterized as unconcentrated (HHI below 1000), moderately concentrated (HHI between 1000 and 1800), and highly concentrated (HHI above 1800).

2. a. Answers will vary. I tried to under-price my competitor by 10 percent. I’d shut down if the price went below $500, which is the per unit variable cost.

b. My cumulative loss was about $125 million and market share was 50 percent. My competitor’s cumulative loss was $26 million.

c. My competitor used a similar pricing strategy—to under-price me.d. The other firm was likely to gain all the market because its unit variable costs were lower than mine.

3. a. OPEC’s objective is to maintain a stable and prosperous petroleum market. It meets this objective mainly through coordinating the production policies and quotas for the 11 members.

b. OPEC’s 11 members are: Algeria, Libya, Nigeria, Indonesia, Iran, Iraq, Kuwait, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela. They account for more than 40% of the world’s oil production. OPEC is a cartel; it is a combination of firms that act like a single firm.

c. For example, Russia, Mexico, Britain. OPEC takes their production into account when setting prices.

Chapter 14: Real-World Competition and TechnologyQuestions for Thought and Review

1. The monitoring problem is that employees have differing incentives than those of the owners, and may act in their own interests to the detriment of the firm. Incentive-compatible contracts have incentives for each of the two parties that correspond as closely as possible.

2. False. While profits are important to business, because of internal monitoring problems it is not clear that managers maximize profit. They may waste profit potential in high-priced benefits for themselves and in inefficiency generally. The market, however, provides a limit on inefficiency, and firms that exceed the limit and have losses go out of business.

3. Economists recognize that there is a monitoring problem: employees' incentives differ from the owner's incentives and it's costly to see that the employee does the owner's bidding. When appropriate monitoring doesn't take place, high-level managers can pay themselves very well. To get a sense of whether they are really "worth it" one could compare the salaries to those earned where closer monitoring does take place (the text suggests comparing U.S. salaries to those earned in similar industries in Japan).

4. X-inefficiency is the result of firms operating far less efficiently than they could technically. The economic forces of a market would knock a firm out of business if it operates less efficiently than the rest of the market. Only a monopolist can produce inefficiently and remain in the game.

5. X-inefficiency refers to firms operating far less efficiently than they could technically. Such firms have monopoly positions but don't make monopoly profits because the inefficiency raises their costs. Competition generally pushes prices down, and so puts pressure on profits. If firms respond by trying to cut costs, then competition will have the effect of reducing (if not eliminating) X-


inefficiency. If, however, entry of new firms is impeded, as it is in the real world, all existing firms would remain inefficient forever.

6. This is not true because even if existing colleges are inefficient, competition from for-profit colleges would not necessarily force them out of business. The political and social forces can keep such colleges from developing. Moreover, some colleges receive state assistance or have endowments that allow them to hold their costs down even if they are inefficient.

7. This could be true. If it were easier for consumers than producers to collude, the result would be to force prices down. If prices fell below the equilibrium level, this could result in shortages as suppliers would be reluctant to provide quantity at a low price. The final collusive equilibrium would depend on the rationing mechanism for supply.

8. This is true. By the same reasoning used in the answer to question 7, the price could decrease below the competitive equilibrium level. At that below-equilibrium price, some consumers could not get goods, but the consumers who could get goods would be able to hold the prices low nonetheless; it would be in their interest to do so.

9. This is false. Patents are not necessarily bad and neither are monopolies. Patents encourage the research and development of new products by offering some limited monopoly profits. Without patents many new products might not be developed.

10. Natural monopolies, by definition, are the result of a process in which market conditions dictate that monopoly is the most efficient way to produce in that industry. To break up such firms would likely result in higher costs, and thus while it would be true that there could be more competitors, the benefits associated with more competition (principally, lower prices) would not be achieved.

11. Technically competent firms may succeed, but the statement “will succeed” is false. Success depends on much more than technical ability. Luck, legal fights, marketing ability, and a non-collusive industrial environment all play a role in making a firm successful.

12. It launched a marketing campaign to retain brand recognition and loyalty to round up before the year 2000. In the year 2000 it also began to lower price to further cement its position in the market and discourage entry.

13. Firms are not interested in just short-term profit, they also look to long-term profit. The company believes establishing a market position in the short run will increase long run profits.

14. It needs to be dynamically efficient and able to promote cost-reducing or product-enhancing technological change. For this it needs funds to carry on research or new technologies and an ability to earn profits from that research. Oligopoly best meets these criteria.

15. The basic supply and demand framework of perfect competition assumes technology is unchanging or is unaffected by market structure, so the equilibrium reached in this model may not encourage the development of more efficient technologies because in such an equilibrium there is no incentive to innovate, nor are there profits that can be used for R&D.

16. Network externalities lower costs as more people use a product. As network externalities broaden the use of a product, the need for a single standard becomes more important and eventually wins out. The firm with the standard is the big winner and will dominate the market. Even better technology will have a hard time competing with the standard.


17. This is an example of a bilateral monopoly. Stations which face less competition have more market power and are able to set higher prices. Because wholesalers also have market power, they are able to extract some of the higher prices that those stations charge by charging higher gas prices in zones where there are fewer gas stations. This type of price discrimination is called zone pricing.

18. An advantage is that the prize will not limit future use of the idea, and thus will provide more efficiency. The disadvantage is that to achieve the same level of economic reward, the prize will have to be large, which means that it would have to be funded by taxes, which would have negative incentive effects. Also, directing prizes at specific invention goals may discourage the development of technologies whose discovery has not yet been foreseen; many of the most important technologies today have been invented in that way.


1. a. These differences do not undermine economists' analysis of pricing, although they do not directly fit into it. The high prices of these goods are based on social preferences (i.e. status/conspicuous consumption) as well as the differences in advertising brand, which are not taken into account in basic pricing models.

b. These are all examples of high fixed costs and low marginal costs.c. What is being sold is more than the good; the image is part of the product and much of the cost is in

the production of that image. This suggests that the cost of producing is lower than the cost of selling.

d. Each of these would be characterized as a luxury market as opposed to a necessities market where economists' pricing analysis holds better. In luxury markets, buyers can afford to be irrational (or whimsically rational) and be led to believe that the products do in fact differ. These are all monopolistically competitive markets, with many sellers selling differentiated products.

2. If suppliers were able to restrict their output to Qr, price would rise to Pr. Suppliers kept out of the market lose area E in producer surplus. The consumers, on the other hand, lose both areas D and B. Area B is transferred to suppliers as additional revenue leaving D and E as deadweight loss.

3. a. Two reasons are: (1) it is a promotional tool appearing to give out free merchandise to stimulate consumer excitement for the product; (2) it is a way to create a third party payer system whereby the individuals making the decision which airline to fly and receive free merchandise, are not the ones who endure the direct cost of the purchased airline ticket. (3) It encourages brand loyalty.

b. Another example of such programs is credit cards which provide rebates for high use. A person who uses the credit card for business will enjoy the benefits of the program, but the firm pays for it.

c. Although this does represent a cost to the firm, the cost of monitoring these programs probably exceeds the benefits of eliminating their misuse. The cost of monitoring may include disgruntled employees who lose the benefits. (Note, large companies have begun negotiating with airlines for cheaper fares but no mileage benefits on business flights.)

d. Since these benefits are income to the individual, they should be taxed as such. However, the cost of measuring this income and enforcing the taxes make it too costly to implement relative to additional revenues.


4. See the accompanying graph. The monopolist would be willing to spend any of its profit. This is depicted as the shaded rectangle.

5. a. Perfectly competitive markets are the most statically efficient because competition in the market weeds out inefficient firms so that products to the market at least cost and least price. Perfectly competitive markets, however, are the least dynamically efficient because they do not promote technological change; there is no incentive of future profits to innovate nor are there profits to devote to researching innovations.

b. Monopolistically competitive firms price the same as a monopolist, so it is not statically efficient. Firms restrict output and price exceeds marginal cost resulting in welfare loss. Monopolistically competitive firms do not have the long-term profits to devote to research and development, though if they were able to discover an innovation, it may be able to generate future profits because it already controls some market power.

c. Oligopolists, because they price between the competitor and monopolist price, are somewhat more statically efficient than monopolists. Oligopolistic markets are the most conductive to technological change because they have profits to devote to research as well as the potential for future profits as an incentive to innovate. Because oligopolists do face some competitors, they will likely devote money to innovate to maintain their market share.

c. Monopolistic markets, like monopolistically competitive markets, are the least statically efficient because they can restrict output the most and therefore charge the highest prices, creating deadweight loss. Monopolists do earn profits needed to research innovations, but because they already have monopoly positions, they have less incentive to devote funds to innovation.

6. a. It would likely decrease the importance of art museums that exist to show “originals.”b. It would reduce the rents of individuals—if not the holders of the art, who would gain from the

royalties of selling the reproductions, but the museums and museum curators that exist to show current art. Also there are other large social resistance to this sort of innovation that makes museums irrelevant.

c. These are allowed, but are owned by either the symphony or music label who sells them. Listeners are often barred from recording concerts.

d. It would likely increase the demand for symphonies and for musicians to play in them because there would be no alternative ways to listen to the music.

e. The most likely explanation is historical circumstance.

7. a. The answers will vary based on the drug.b. The answer will vary depending on the drug.c. The online price will likely be lower. Purchasers don’t buy drugs online because the level of trust

needed between vendor and purchaser is high for drugs due to the potential dangers of poorly produced drugs.

d. The answer will vary. Some people are distrustful of online purchases.e. The drug market is less-than-perfectly competitive.


8. a. It is essentially buying a monopoly on the campus. b. There would be more competition, and lower prices for soda. c. It depends. It is a transfer of consumer surplus from students to the college; whether it is a gain

depends on what the college does with the money that it receives.

9. a. I would expect it to sell for about $10 to $15 dollars per hundred, if it was a reasonably competitive market.

b. I would conclude that the market must not be competitive in the standard way that economists talk about competition.

c. This suggests that the imperfections are on the demand side, not the supply side (imperfect information), since most people could get their drugs from Costco. However, because many drugs have third party payers, the demander is not always concerned with finding the lowest price drug, but is rather concerned with convenience.


1. a. Compensation issues on the game of Greed! for CEOS are stock options, pay perks, and stock grants.

b. Compensation issues on the game of Greed! for workers are insufficient pay to cover rising childcare cost, higher health care costs, and loss of jobs due to those jobs moving overseas.

c. The AFL-CIO comes from the perspective of the worker and labor unions.

2. We chose Laurence Ellison, CEO of Oracle.a. The 6-year average annual return for Oracle was 19 percent, above the industry average by 7

percent.b. The average over the past 5 years is about $139,524.c. What’s fair is difficult to say. Forbes gave him a B rating. We would need to know how his

compensation is determined—whether it was based on performance and what risks he took to receive that salary. Also, what are his opportunity costs?

Chapter 15: Antitrust Policy and RegulationQuestions for Thought and Review

1. Judgment by performance is the view that competitiveness of a market should be judged by the behavior of firms in that market. Judgment by structure is the view that competitiveness of a market should be judged by the structure of that market.

2. In the Standard Oil case the Court determined that the company was a structural monopoly (it controlled 90 percent of its market), but that alone was not a violation of the Sherman Act. Rather, it was the firm’s behavior that brought it into violation. Thus, the firm was found guilty of unfair business practices. In the ALCOA case the key issue was the determination of the firm’s market, and hence its share of that market. Determining that ALCOA had 90 percent of the aluminum market, the Court declared it a monopoly, and ALCOA was broken up.

3. Whether a particular company, even one as important as Standard Oil, was, or was not, broken up would probably not have much impact on the economy. However, if the populist forces that led to the breakup of Standard Oil had not existed, our entire industrial structure could have been different. How? That is tough to say: Maybe the United States would have had a Communist revolution; maybe the firms and the United States would have been stronger. The possibilities are endless.


4. The Clayton Antitrust Act gave specific guidelines and provided for more vigorous enforcement than the vague Sherman Act. It made four specific monopolistic practices illegal when their effect was to lessen competition.

5. A tie-in contract is one in which products are linked, even though there is no legitimate reason why they should be linked. To decide whether some college requirement is a tie-in contract, one would have to look at the specific course offerings and the tuition procedures of the school. Some make sense; some don't. Whether such rules should be against the law is a much more difficult question: for government to enter into internal rule-making of non-profit firms would involve an enormous increase in government control and regulation which has significant costs, and schools can make a credible argument that the required classes provide a more educated population and thus are a public service.

6. Financial aid is often need-based, and so in some sense is an attempt to equalize the price as a proportion of income for students. Again, the test is the impact, and for many students financial aid is the key to access to the college of their choice. It may be more discriminatory not to have it. Moreover, the fact that something is discriminatory does not necessarily make it bad.

7. Interlocking directorships are against the law because having the same individuals on the boards of supposedly competing firms tends to lessen the degree of competition. The cost of the regulation is an intrusion of government into private issues and that the regulation makes it harder to get knowledgeable people on the board, which makes appropriate monitoring more difficult. As with all such policy questions, a decision might be made by weighing the costs and benefits.

8. As an economist for the firm, I would want the broader definition of the market to make the firm’s share a smaller proportion. Thus, I would argue for the three-digit industry as the definition of the market.

9. As Mattel, we would want there to be more competition, so we would argue that the relevant market was as broad as possible. This would make it less likely that the merger would violate the merger guidelines. Since the offer is unsolicited, we would assume that Hasbro does not want to be taken over. Thus, if we were the lawyers for Hasbro we would argue for the narrowest definition of market.

10. In some ways the service has improved, but in other ways it has worsened. What would have happened in the absence of the breakup is difficult to say. What this tells us is that making judgments about policy is enormously difficult and requires intricate knowledge of the industry affected.

11. The anti-trust case against IBM likely led them to pass on acquiring DOS because they feared that enlarging their control on the PC market could force a government-enforced break-up. This took IBM out of the front of the PC market and it took years for their competitive position to improve.

12. Microsoft was charged with having a monopoly in the personal computer operating systems market. In a dynamic view of the market, technological advances, such as open-source operating systems and the merging of software and hardware, will see the market open to more competition in the future.

13. According to the 1982 guidelines this merger would be challenged, however, the 1997 guidelines from the Department of Justice allows some mergers even if they do not meet the guidelines if the companies can show that their merger will lower price or improve a product or service.


14. Conglomerate mergers occur when two relatively unrelated businesses merge. They tend to be approved under our antitrust laws on the assumption that they do not significantly restrict competition. These mergers should be considered like other mergers in terms of their effect, and approved or not on that basis. A blanket policy against such mergers might eliminate some mergers that would benefit firms, consumers, and the economy.

15. The globalization of the U.S. economy has enlarged the relevant market to the international market in some cases. Policy focus has changed from: Is the industry competitive enough to not take advantage of the consumer? to: Is the industry internationally competitive so that it can compete effectively in the world economy?

16. The two methods government may use to deal with natural monopolies are regulation and government ownership. Price regulation usually takes the form of requiring the firm to charge its average total cost plus a profit margin; this gives the firm no incentive to hold down costs, and cost increases lead directly to price increases. Another problem is that once regulation is established it may extend far beyond the natural monopolies and be introduced into industries where competition could work. Government ownership of natural monopolies is used most often in countries outside the United States, and also has the problem of no incentive to hold costs down or to introduce new technologies. Government-owned firms guarantee jobs and offer high wages, but they pass higher costs on to the consumers.

17. An industrial policy is the formal policy that government takes toward business. There are difficult political issues involved in such a policy. To avoid these problems one would want it administered by a semi-autonomous agency such as the Fed, which would be immune to political pressures. Whether this is possible is difficult to say.


1. a. Since 1982, the Department of Justice has looked at mergers that would result in a Herfindahl index of over 1000. There is no Ecofame guideline which exactly corresponds to a Herfindahl index of 1000 since the Ecofame index places more weight on large market shares than does the Herfindahl index. One might consider a hypothetical industry where the four top firms each have 16 percent of the market and all other firms are very small. Such an industry would have a four firm concentration ratio of 64, a Herfindahl index of about 1,000, and an Ecofame value of about 16,000. Thus an Ecofame value of 16,000 would correspond to a Herfindahl value of 1000 for this particular industry structure.

b. The result of using the cubes instead of the squares is that the effect of large market shares is magnified. So uneven market shares would be more strongly discouraged. Whether this is an advantage or a disadvantage may be a matter of point of view.

2. In a monopolistic competition model the firms have only a small share of the market and make no profit, so antitrust would have little effect. In a cartel market, firms get together and allocate market share. Antitrust would prevent that, holding prices down and increasing quantity supplied. The graph of monopoly is the relevant graph. In a contestable market model, potential competition, not market structure, determines equilibrium, so antitrust would have little effect unless it influenced barriers to entry and exit.

3. a. In the toy industry, the four-firm concentration ratio is 35. The Herfindahl index is about 121 + 225 + 25 + 16 + 65 = 452. This value assumes there are 69 firms, 65 of which have one percent of the market apiece. In the infant/preschool market the four-firm concentration ratio is 72. The Herfindahl


index is about 64 + 144 + 729 + 625 +28 = 1590. This value assumes there are 32 firms, 28 of which have one percent of the market apiece.

b. I would suggest using the broader toy industry that has a lower concentration ratio and Herfindahl index.

c. The merger might decrease competition to the extent that increased market share allows Mattel to limit output and increase prices or if it is then able to create significant barriers to entry by controlling distribution.

d. It may increase competition since a combined Mattel and Fisher Price (15% market share) might be in a better financial position to compete against Hasbro, which already enjoys a 15 percent market share. This is especially true if there are economies of scope and scale, since production costs would decline.

4. a. The likely basis of this suit was predatory pricing to keep price so low that American Airlines’ competitors would go out of business and so that the company would enjoy a monopoly position and raise prices.

b. Knowledge of their financial instability only strengthens the argument. It suggests that American Airlines would not have to hold prices down for too long before its competitors folded.

5. a. Regulating the price of a monopolist makes the relevant demand curve perfectly elastic. In this example, regulators set price where MC intersects demand. Monopolist charges Pc and produces Qc. The demand curve would be the marginal revenue curve, and the monopolist would produce where MC = MR = P just as a competitor would as shown in the graph at the right.

b. Regulation in a contestable market view of the competitive process is far less likely to have the effect shown in the diagram because with contestable markets, with fewer barriers to entry, the oligopoly will set prices closer to the competitive price thus eliminating the need for regulation. There would not be much room for regulation to reduce price and increase output.

c. If one follows the cartel view, the argument for regulation is much stronger since the stronger is the cartel, the closer it can restrict supply and increase price. As the cartel or cartels become stronger, then, regulation is far more effective in reducing price and increasing output as in the graph above.


1. a. The FTC is likely to challenge a merger at HHI levels of 1800 and above, and perhaps some of those that are slightly lower as well.

b. The FTC also considers changes in market conditions that might affect the choice of the relevant market, the availability of substitutes from other markets, ease of entry into the market, and efficiency issues (i.e. economies of scale/scope).

2. a. “FTC Seeks Court Order to Force Blockbuster to Comply with Premerger Rules” (3/4/05) and “NHL gets $3 billion offer for entire league” (3/4/05).

b. The FTC claims that Blockbuster has not provided adequate pricing data, a condition of its merger with Hollywood Video. The NHL article discusses how the purchase of the entire league might stifle competition and make it difficult for union negotiations.

c. Both are horizontal mergers because both Blockbuster and Hollywood videos rent videos. Also independent owners of the NHL all provide the same product—teams, space and equipment. Combining them would result in one owner of all teams, space and equipment.


Chapter 16: Work and the Labor MarketQuestions for Thought and Review

1. Social and political forces are more active in the labor market than in most other markets because of the key role labor markets play in determining people's income and the key role jobs play in a person's life. People often define themselves in terms of their jobs.

2. This chapter opens with a quotation from Voltaire: “Work banishes those three great evils: boredom, vice, and poverty.” Welfare laws, to the degree that they discourage work, therefore, can be said to harm the people they are meant to help. While they help people in the short run, they establish a dependency relationship, which can hurt people in the long run.

3. As noted in the text, the choice for many people depends on their views of the real costs of being arrested, etc. The student is asked to assess whether the benefit of the large amount of compensation is worth the cost of the risk, and why.

4. As argued by University of Chicago economist, Sherwin Rosen, assuming that individuals want to see the best, the new technology would give a greater premium for the best performers of each genre, and thus would increase inequality.

5. It depends. If the demand for such goods is high enough, and individuals are willing to pay, firms can have a strong incentive to sell fair trade goods. For example, regular coffee beans cost about $1 wholesale and sell for about $5 per pound retail, for a profit of $4. However, fair trade beans can sell for about $8.50 per pound, but cost only about $1.40 wholesale. The profit margins are higher and thus firms have an enormous incentive to sell coffee made from fair trade beans. If demand for a fair-trade good is low, however, firms will have little incentive to sell such goods.

6. The elasticity of the labor supply is measured by the percent change in the quantity supplied divided by the percent change in the wage. In this case, 5 divided by 20 is less than 1 (it is 0.25), so the supply is said to be inelastic.

7. A choice of a career should be made on the basis of what you will enjoy and be good at. Assuming these were equal, expected income can play a role. Since plumbing generally requires a license and carpentry does not, it is likely that monopoly rents will be higher in plumbing, which is why he was so advised.

8. Supply/demand analysis is partial equilibrium analysis; immigration policy often affects the general economy and thus requires an analysis of spillover effects and changes that partial equilibrium analysis cannot capture.

9. As you can see in the accompanying graph the minimum wage causes excess supply of workers shown by the difference between the quantity supplied and the quantity demanded. Economic theory does not tell us that such a law would be a bad idea. That depends on what one's goals are and how one judges the redistributional consequences of the minimum wage.


10. If the labor market were monopsonistic, so that the pay were less than the competitive wage, the minimum wage could change the effective supply facing the monopsonist and could raise the wage and increase employment simultaneously, as in the accompanying graph. In the graph, the monopsonist would hire Qm workers, paying Wm. With a minimum wage We, higher than Wm, the monopsonist would hire Qf workers, higher than Qm, paying Wf, a wage higher than Wm.

11. Comparable worth laws would likely politicize the labor market much more than it currently is politicized. It would involve an enormous increase in government involvement in pay.

12. The fact that unemployment among blacks is nearly twice as high as it is among whites can be explained by many factors, including discrimination. There are also differences in existing income levels, with the result that many blacks reside in poorer neighborhoods and thus do not have equal access to education and other services that would lead to higher employment. The choices available in terms of opportunities may also lead young people to choose nonmarket activities over participation in the labor force. Possible solutions will vary, but could include stronger antidiscrimination enforcement, better educational programs and law enforcement to decrease the payoffs to illegal, non-market activities.

13. On average, women receive about 85 percent of the pay that men receive to do the same kind of job. Somewhat more than half of that difference can be explained by factors like length of time on the job, but there is still a relatively large difference that can be attributed to discrimination. There is demand-side discrimination, which occurs when an employer hires a man rather than an equally qualified woman or pays a woman less for doing the same job as an equally qualified man. There is also sociological supply-side discrimination, which includes examples like women changing jobs to move with her partner (thus lowering her average pay) or women taking a larger role in child care (and therefore perhaps missing work or meetings), again resulting in lower pay and reduced opportunities for promotion and advancement. The reasons that are most responsible for the difference may vary from situation to situation.


1. a. The conclusion is that obese women earn less because they are less productive, because employers discriminate against obese women, or because obese women tend to pursue lower-paid jobs.

b. Findings do not necessarily mean that there is “beauty” discrimination. The difference could be due to differences in productivity between obese and healthy-weight women. Since the comparison is family income, the difference could also be attributed to differences in other sources of family income such as spouse’s pay. The authors found that 80 percent of the differential is due to marriage-market differences.

c. The larger income penalty for women could be due to a more stringent beauty standard for women. Source: Journal of Human Resources, 1966.

2. a. Based on standard economic theory, one would expect the number of teens employed to rise and the employment of nonteens to decline as the relative wage of teens declines. This assumes that the


minimum wage is above the market-clearing wage. Further, one would expect that a large number of employees would lose their jobs at the end of their training period (six months) for “just” reasons, such as not learning the job adequately.

b. It is likely that the administrative costs of participating in the program were higher than the benefits of hiring teens at the lower training wage. It could also be that market clearing wage in teen labor market was already higher than the subminimum wage. A third possibility is the focal point phenomenon: teens may focus on the mandated minimum wage as their reservation wage and refuse to accept a job at the subminimum training wage.

3. a. One would expect economists' salaries to decline or at least to rise less than average salaries.b. Since economists are bright, dynamic individuals, it is likely that they will leave the traditional

market for economists and either start their own business or accept jobs in other markets or in other countries. This would mitigate the decline in their wages.

c. In most markets, prices do not adjust downward quickly for institutional reasons. In the meantime, the supply curve may shift inward as unemployed economists leave the market altogether. Currently employed economists have an incentive to see that their salaries do not fall and will work toward keeping their salaries high by limiting the number of new Ph.D.'s or by using social influences to keep their wages from falling.

4. a. Since they will have to pay 20 percent of what they save in added tuition in addition to the 20 percent income tax rate, the implicit marginal tax rate they face on income they save will be 36 percent. The tax on assets is a tax on savings after income taxes have been subtracted, so the tuition tax has to be adjusted to make it a tax on pre-income-tax income. So the relevant tax on tuition as a percent of pretax income is (1 - ti) 3 tt = [(1 - 0.2) X 0.2 = 0.16] where ti is income tax and tt is the tuition tax. Add this to the 20 percent income tax to get 36 percent.

b. The second child will raise it to 48.8% = [(1 - 0.36) X 0.2 + 0.36] X 100. The third child will raise it to 59.04% = [(1 - 0.488) X 0.2 + 0.488] X 100.

c. This is a complicated question, but one could argue that divorced parents share in the obligation to pay for college equally and therefore the relative incomes and asset shares of combined incomes and assets should be used to determine contributions. In reality one parent might alone bear the burden of the cost, having to shoulder contributions by both. The second part to this question is for the student to research.

d. An ability-based scholarship program would attract students of significantly higher caliber if their elasticity of demand is high, but it would most likely compromise the diversity of the student body with respect to income. It would also promote retaliation by other schools, and the long-run benefit in having brighter students might be very small.

5. a. Firms pay above “market wages” because they want to establish close personal ties with their workers. Doing so can lead employees to work at maximum efficiency and the gain in efficiency may exceed the additional cost. If so, it is known as an “efficiency wage” when firms do so it would be an example of social forces modifying the invisible hand result.

b. Firms do not change wage rates much when demand fluctuates both to keep good social relations with workers and also, in some instances, to avoid violating contracts that determine wages. This is an example of social and political/ legal forces modifying the invisible hand result.

c. Firms keep wages of various disciplines roughly equal to keep good social relations with the workers. Pay will vary somewhat because of market conditions in the disciplines, but generally social issues predominate. So again this is an example of social forces modifying the invisible hand result.

6. a. Firms hire children because children’s marginal productivity relative to their wage is higher than it is for alternative workers. Children’s marginal product/wage ratio could be higher because the child


wage is lower or because the marginal product is higher. Children are often energetic, pliable, and dexterous. For certain jobs these traits could make the children’s productivity high. Children may also be more trainable than older employees.

b. Children work for the same reasons that others work—they need money, work is what is expected of them, and so on.

c. In deciding whether there should be an international ban on child labor, one must look at the effects of that ban. What are the children’s opportunity costs of working? If the ban will lead to children starving, the ban does them no good; if it allows them to go to school while the firm hires their parents instead, the ban may help the children. One must also look at the ease with which some firms may get around the ban. If it can be easily avoided in some countries, then the ban will likely hurt industries in those countries where it is effective. Also, one should consider whether the work gives children anything useful (such as education) besides pay.

7. a. At the school we looked at, among college professors, the share of household work done was more equal than expected but females still had slightly more responsibility for child rearing. The sample included only dual income families. This suggests that even those who might be enlightened about equality of the sexes experience some supply-side discrimination.

b. Salaries at most colleges, on average, is equal for equal rank and years of service up until the higher salaries, where information is often confidential, and there are few women. Discrimination from somewhere, however, is suggested by the relatively high proportion of untenured and non-tenure track women compared to men as well as the small relative number of full and chaired female professors.

c. These findings in (a and b) suggests that institutional supply-side discrimination may affect a woman's ability to devote the time and mobility necessary to get a tenure track position and attain tenure at the peak of her child-bearing years.

8. a. Assuming that both markets are perfectly competitive (and we know how competitive campaigns are), Derek Jeter contributes much more to society than does the President of the United States

b. First of all, neither market is perfectly competitive. Neither Jeter nor U.S. Presidents are easily replaceable. In addition, institutional factors enter into the decision about what to pay. Being a U.S. President is considered to be a service to one’s country and presidents get many non-wage perks, such as Air Force One and the White House. And after leaving office, past Presidents can sell their biographies for many millions of dollars. The adjustments suggest that calculating marginal productivity is difficult and perhaps ultimately impossible.

9. a. Based on estimated marginal revenue product, the following pays are reasonable: Alex Rodriguez: $15.5 million; Barry Bonds, $20.0 million; Sammy Sosa, $10.6 million. Barry Bonds is paid close to his marginal revenue product whereas Sammy Sosa and Alex Rodriguez are paid more than their marginal revenue product. What is reasonable depends on one’s goal. The goal could be to create a winning team, not maximize revenue.

b. Some baseball owners are not trying to maximize profits; they are just trying to win and enjoy owning a baseball team. The basic labor model assumes profit maximization, not fun for owners.

10. a. I would expect the test scores to increase.b. It would have to give them low test scores, otherwise the teachers would have an incentive to have

only good students to take the test.c. It would make them much more likely to teach to the test, and conduct more test preparation

sessions.d. In this case, the test scores returned to what they were before the program was implemented. No

lasting changes in structure resulted.


11. a. It should rise because fewer workers are working with the same amount of capital.b. According to Mancur Olson, an economist of Maryland University, and author of Big Bills Left on

the Sidewalk, the real reason is the countries are not using their resources effectively – that they are operating far within their production possibilities frontier, and squandering their human and social capital.

12. a. No, one would expect that drivers would work more on busy days when their effective wage rate is higher, and less on slow days, because their marginal return is higher on busy days.

b. It can do so because failing to achieve the daily income target feels like incurring a loss, so drivers put in longer hours to avoid it. Beating their target feels like a win, so once they have achieved it, there is less incentive to keep working.

13. a. Professional organizations oppose the increase because allowing a greater number of immigrants into professional sectors will provide competition for their jobs and tend to reduce wages.

b. High-tech firms claim that there is a shortage of professional workers. Increasing the number of visas would reduce wage pressures, allowing these firms to reduce the cost of production.

c. The answer will differ among students. I would support the increase because increasing the number of highly-educated immigrants will reduce the cost of goods provided by professionals and ultimately reduce the price of these goods to consumers. In addition, these new immigrants will spend their income on goods, thereby increasing demand for products and increasing the demand for U.S. workers.

14. a. Increases in marginal tax rates for large changes in income were significantly higher in the 1970s than in the early 2000s. Therefore, in the early 2000s, families could take home a larger percentage of their increase in wages than in the 1970s. France has very high tax rates. In fact, Edward Prescott estimates that for every 100 euros worth of goods produced, Europeans as a whole are taxed 60 euros.

b. Other possible explanations are institutional changes in France and the U.S. that occurred at the same time. For example, in the U.S. unions are much less powerful today than 30 they were years ago.

15. a. No. If Wal-Mart’s suppliers were operating in a perfectly competitive market, the price at which they sell their product is set by the market. No one firm sets the price.

b. Yes, if the market were monopsonistic, the purchaser (in this case Wal-Mart) would be able to set the price at which it buys goods.

c. The limit on the price Wal-Mart could name is equal to the least price a firm would be willing to supply the good at the quantity Wal-Mart is willing to purchase. In the long run, firms will not be willing to sell their goods at a price that is lower than the marginal cost of producing the good. Source: “The Wal-Mart You Don’t Know” Fast Company, December 2003, page 68)


1. a. Pay equity, according to NCPE, means the elimination of sex and race based discrimination in the wage setting system; that is, the criteria employers use to set wages must be sex and race neutral.

b. The Equal Pay Act of 1963 and Title VII of the Civil Rights Act of 1962 are the two laws that are designed to protect workers from wage discrimination.

c. The NCPE believes women are still segregated into a few low-paying occupations. Anti-discrimination laws cover pay equity within occupations.


2. a. Stephen Moore in his commentary states that he believes immigration should be increased for highly skill workers.

b. Externalities; every additional high-tech worker brings to the United States about $110,000 of free human capital.

c. In 1998, the unemployment rate in the high-tech field was less than 2%, the high tech fields were growing rapidly.

d. No, Stephen Moore would not argue that the number of visas for unskilled labor should increase. Unskilled labor does not have the externalities of additional jobs for the U.S.


1. At a wage of $7.00 they would hire 33 workers. If the price of the good fell to $1.00, the marginal revenue product would fall and they would reduce the workers they hire to 30.

2. They would likely hire fewer workers since they would take into account the fall in the marginal revenue product that hiring more workers would cause.

3. A likely reason for the switch is technological advances that lowered the cost of machines or a rise in the relative pay students demand.

4. Yes. Widespread introduction of such programs would likely reduce the demand for teachers and lower their pay.

5. It can pay up to the marginal revenue product or up to $9.00. (MRP = P x MPP = 3 x 3).

6. If the firm were a monopolist, the marginal revenue would be less than $3.00, and thus the amount it would be willing to pay would fall.

7. Num. of workers TP MPP AP MRP

1 10 109 18

2 19 9.58 16

3 27 97 14

4 34 8.56 12

5 40 8

8. a. The proposal that should be adopted is the one that minimizes costs. Using the cost minimization condition, proposal A is the one that minimizes costs (30/5 = 42/7 = 36/6).

b. If the price of labor rises to $14, none of the proposals meets the cost minimization condition. There are other combinations that would meet the cost minimization condition.

Chapter 17: Who Gets What? The Distribution of Income Questions for Thought and Review

1. Research has shown that income differs substantially between men and women, and between whites and blacks. Some of these variations are the result of sociological and cultural differences, but a


substantial fraction is the result of discrimination. There is no evidence to indicate discrimination exists on the basis of hair color, although there might be some.

2. The top 20 percent of individuals in Bangladesh earn 38 percent of the income.

3. A Lorenz curve is a geometric representation of the size distribution of income among families in a given country at a given time. To do this just for lawyers, you would be showing how income is distributed just among members of that profession. (It might surprise people to find out that the distribution is not as even as they might think.)

4. Arguments could be made for both approaches. Poverty could be defined relatively since one of our concerns is the distribution of income and the gap between the rich and poor. Poverty could also be defined absolutely since another of our concerns is that people have enough to eat, which is an absolute concept.

5. Nowadays in the United States classification is based on characteristics other than source of income, including education, what someone reads, and job or career. Using these factors one could argue for a class distinction between managerial decision makers and other workers. Whether it makes sense to do so depends upon the light it sheds on social and economic problems.

6. The observed difference may be due to supply and demand factors. If many people wish to be English teachers and few wish to be garbage collectors, then market factors will result in a higher wage for the garbage collectors—and if one believes in the market mechanism, this is right. That question raises other, more complicated questions about fairness of compensation and the social value of different occupations; it has no right answers.

7. This question raises issues of fairness and equality and requires value judgments. As the author notes, considering the circumstances that have led to someone starving or being homeless, or that are involved in someone's consumption of chocolate, will affect some people's judgments about the appropriateness of society's response.

8. The answer to this question will depend in part on the individual student’s circumstances. In general, the incentive effects of a tax may result in a switch from labor to leisure.

9. Expenditure programs have been quite effective as a method of redistribution; taxation has not proved effective.

10. On the surface the democratic system of one person/one vote would seem to suggest that the politics of redistribution would favor the poor, but it doesn’t. One would expect that the poor would use their power to make sure that income was redistributed to them from the rich, but they don’t. The reasons for this include the fact that many of the poor don’t vote, and so consequently they are not seen as a voting bloc by politicians. Another reason is that when poor people do vote, they vote with other issues in mind. Also, campaigns require financing, which is often supplied by the rich, and so their interests may be more represented than those of the poor.


1. a. See the accompanying graph. b. A perfectly equal distribution of income

would be shown by a diagonal line; thus


the country with the most equal distribution of income among the three is the Czech Republic.c. The country with the least equal distribution of income among these three is Mexico.d. One could not tell which country has the most progressive tax system without looking at the curves

over time and examining other factors that determine the curves’ shapes.

2. a. Taking into account in-kind benefits and unreported income would reduce the number of people seen in poverty. Taking account of the fact that food makes up only a quarter of the family’s budget would increase the number of people in poverty. Taking account of home ownership and cost-of-living differences would involve distributional consequences. It would raise the level of poverty for some groups and lower it for others.

b. What is fair involves normative judgments. Even if the adjustments were made, one could still argue that the current definition of poverty is too low and that benefits should be increased.

3. If people's desire for equality is so great that any sense of initiative is undermined, economic growth based on individual initiative is impossible, and all people will be brought down to the lowest level of income.

4. Four conditions that you might list before you would favor equality of income are (1) that individuals have essentially the same needs, (2) that they work the same amount, (3) that they have essentially the same health, and (4) that they have put in the same effort up to this point.

a. Depending on what conditions you listed, it could change your views on welfare in a number of different ways.

b. Again, it depends on what conditions you chose. If the condition does not include differences in ability, then you would likely favor a progressive income tax.

c. If the tax were progressive in wage rates, rather than income, hard work would be encouraged and raw ability (if represented by wage level) would be taxed more. If you did not list ability, then you should say that the conditions would be better met.

5. a. You will pay no tax on the first $10,000, $5000 on the next $20,000, $6000 on the next $20,000, and $8750 on the remaining $25,000, for a total tax payment of $19,750.

b. Dividing $19,750 by your income of $75,000 gives an average tax rate of 26.33 percent. The marginal tax rate will be the tax on one more dollar of income, which in your case will be 35 percent.

c. If the two systems are designed to bring in the same amount of revenue, the question will be how that revenue is collected (meaning from whom) and that is hard to assess without knowing more about what conditions will make someone eligible.

6. a. This would increase the incentive to work since working longer hours will not push one up into the higher tax bracket.

b. To the extent that the wage rate measures taxability better than income does, this tax system is fair.c. Making the tax system regressive in hours worked would further increase the incentive to work

longer hours, likely increasing the average number of hours worked.d. Instituting such a tax system faces enormous difficulties. Wage rates for each individual would have

to be measured, and many positions have no explicit wage rate. Some method for calculating wage rates of salaried positions would have to be designed. Also, measuring and verifying the hours each employee works would be difficult, especially for the self-employed.

7. a. To the extent that redistributing income to the poor makes others feel that the society is more just and therefore increases their utility, income redistribution may be a public good. This is likely to occur when the poor are seen as innocent victims for their circumstances.


b. To the extent that people in a society believe redistribution is unjust and therefore decreases their utility, income redistribution may be a public bad. This is more likely to occur when the poor are viewed as being responsible for their circumstances.

c. When real wages increase, people are expected to volunteer less because the opportunity cost of working also rises. As a result, they have less information about the poor and are more likely to view income redistribution as a public bad.


1. a. Long term capital gains are presently taxed at 20% if you are in the 28% income tax bracket, 10% if your regular tax bracket is 15%. Short term capital gains are taxed as ordinary income and thus very widely, and may be as high as 28% or more.

b. The alternative minimum tax, AMT, is an alternative set of rules to determine the minimum tax one should be required to pay. It is an extra tax some have to pay on top of regular tax. The original idea was to prevent people with high incomes from using special tax benefits to pay little or no tax.

c. Education credits are tax benefits for families to help with the cost of higher education. These tax credits are for parents filing jointly who can take the cost of tuition up to a maximum, in the case of Lifetime Learning or Hope for only the first two full years, for dependent children.

2. a. Social Security earnings credits are based on wages an employee earns and these credits are used later to determine eligibility for Social Security benefits. In 2005, one credit is earned for each $920 in earnings up to a max of 4 credits a year.

b. Most people need 40 credits (10 years of work) to qualify for Social Security benefits.c. There is no charge for a social security number.d. Medicare is automatic age 65 or with the start of Social Security or Railroad Retirement benefits.

Someone who is on Social Security disability for more than 24 months or someone with permanent kidney failure is also automatically eligible.

e. Part A Medicare is hospital insurance and carries no fee, Part B is medical insurance and at present carries a fee of $45.50 a month.

Chapter 18: Government Policy and Market Failures

Chapter 18: Government Policy and Market FailuresQuestions for Thought and Review

1. Reasons for a potentially beneficial role of government intervention include: preventing restraints on trade, correcting informational and rationality problems, correcting for externalities, and preventing unfairness.

2. The marginal social benefit of a good that exhibits positive externalities is greater than the private social benefit because the trade results in a benefit to people outside the trade.

3. A market incentive program is more efficient because it makes use of the powerful force of the invisible hand, and unlike the direct regulation approach, it gets people to equate the marginal costs with the marginal benefit, making it so the costs of a policy are distributed in the most efficient way.

4. An economist might argue about the word acceptable. While not many people would argue that any pollution is good, an economist who realizes that eliminating pollution completely is probably an impossible goal would find pollution acceptable if it could be reduced to a cost-efficient level.

5. This tax is an example of a tax incentive program that attempts to make the price of oil reflect the negative externality. If it works it should provide an incentive for the users with the lowest cost of reduction to decrease their consumption of oil. If those with the lowest costs are significant users, then there will be a significant reduction. The effect depends on how high the tax is and the alternatives available to oil consumers.

6. The tax on oil will probably affect the pollution coming from oil, but it is possible that users could switch to other fuel sources that actually result in other and greater forms of pollution. Moreover, some types of pollution would be unaffected. Thus, the net impact on the environment is difficult to predict.

7. If economists support a tax on a specific good, it is usually because of a suspected externality. In the case of gasoline, the likely externality involves carbon emissions. The higher tax would encourage individuals to use less gasoline and to switch to less polluting alternatives.

8. The public aspect of safety is that if safety provides a safe environment, it is provided for all people and one person enjoying safety does not preclude others from benefiting from that safety. Naming streets allows people to orient themselves in towns and facilitates communication. Once a street is named, it benefits all people. No one can be excluded from referring to that name. In addition, one person using that street name does not preclude others from referring to that street with its name. Before the street is named, however, if a particular name is used to refer to more than one street, the value of that name in providing geographic orientation will be diminished. The public good aspect of the lighthouse and newspaper is that once it is produced it can be consumed over and over again and benefit those who use it. Though in the case of the newspaper, the owner can keep others from benefiting by keeping it to himself. A steak dinner has no public good aspects, since it is both rival and excludable.

9. Non--excludability and non-rivalry both increase the ability of free-riders to enjoy the benefit of the product, without paying for it.

10. You might offer the average, $600. If sellers of cherries want $700, your $600 would buy you only lemons, since only the seller knows whether they are selling a chance on a lemon; thus you would likely lower your asking price to reflect the fact that there are now only lemons in the market.


11. Three examples of signaling are (1) car warrantees, (2) 90-day return policies, and (3) academic credentials.

12. In a market, when buyers and sellers have different amounts of information about the good for sale, a problem occurs called the adverse selection problem. The problem is that the market for quality products disappears. In commercial dating services, the seller certainly has more information about the negative (and positive) aspects of the product than the buyer. We suspect that the market has fewer “acceptable” dates than the general population.

13. Not only would buyers and sellers not have equal information to make a decision, they would not have any information, so the mix would become a potluck and the distribution of problems would reflect the natural aging of cars.

14. To keep rates to a minimum, insurance companies estimate information about individuals by categorizing them. If everyone paid the same amount, low-cost customers would be paying for high-cost customers and eventually change companies, leaving only high-cost customers. One would expect that, statistically, married drivers are safer drivers.

15. The FDA protects us from unsafe drugs, but in so doing it creates enormous bureaucratic hassles for the manufacturers of all new drugs, many of which could be beneficial. In some cases, by the time the FDA has approved a drug many potential users are already dead. This question requires weighing the costs against the benefits.

16. Many answers are possible, beginning with (1) the label on their breakfast cereal, (2) the roads they use to get to school, (3) either the school they go to (if it is public) or the federal funds their school receives (if it is private), (4) the tax they pay on the snack at the snack bar, and (5) the laws that are enforced on the roadways. The benefits of labeling are that consumers can better plan nutritional balance and are better informed about the product they are buying. Whether this is justified is unclear. If consumers wanted such labeling, there would be market pressure to include that information on cereal boxes. Some labeling, such as whether the product contains genetically modified food, could unnecessarily alarm consumers. This would hurt those companies that use genetically modified food and help others that don’t. Whether genetically modified food is harmful is still up for debate.

17. While there are benefits of licensing, it is often used as a way of restricting entry into the profession and thwarting competition. Thus, while some type of certification program may be warranted, licensing is probably not warranted.

18. The advanced degree serves the same purpose as a license. It reduces the supply and increases the wage.

19. If the informational alternative were introduced, existing doctors would likely lose, as their monopoly would be reduced. Customers who have wider options will gain, as will individuals just starting careers in medicine who have more options about what type of study to pursue. Some customers who have less ability to shop around may lose if they end up going to inadequate doctors who were previously excluded.

20. Three market failures that possibly justify national parks are (1) National parks are possibly public goods. Use by one does not deplete their use by others, and it is difficult to exclude to exclude people from using them. National parks are not pure public goods because they can be gated with


toll booths at their entrances, requiring fees to enter. However, one aspect of national parks – existence value – is not be excludable. Existence value is the value a citizen of a country derives from the knowledge that the country has national parks. National parks create national pride and identity. This value is both nonrival and nonexcludable, leading to underproduction of national parks by the private market. (2) National parks create positive externalities. People who visit national parks learn about taking care of the environment, our national heritage, the complexity of nature – education that can be brought into other parts of economic life. Another positive externality is that they provide resources for a variety of research that themselves provide benefits to society. (3) National parks may experience increasing returns to scale. That is, the market is small relative to the size of the technically efficient firm. Thus, national parks can be seen as a natural monopoly of sorts, justifying government intervention. Source: “Market Failures and the Rationale for National Parks,” Journal of Economic Education, Fall 2002.

21. City parks are examples of public goods. Use by one person does not deplete its use to others and they are nonexcludable. Asking for voluntary contributions to sustain city parks will result inn too few parks because of the free rider problem. Once built, it would be difficult to exclude the people who did not voluntarily contribute to its building from using it, thus no individuals have the incentive to be the ones to pay for it.

22. Pro People should undergo testing before getting life insurance because the person who is more likely to seek thrills is a greater risk to the insurance company, and should bear these higher costs themselves, rather than having them passed on to non-risk seekers.

Con People should not undergo testing before getting life insurance because whether a person is a greater risk depends on revealed behavior not the proclivity toward a particular behavior. We, not our genes, decide our behavior. Undergoing such testing would end up with people who have the gene but who avoid such behavior to unnecessarily pay a higher premium.


1. a. The graph of the market demand curve is shown in the accompanying graph. The market curve and the demand curve for B are the same from quantity 4 and up. Remember that with public goods, sum the individual demand curves vertically to create the market demand curve.

b. Because people do not actually purchase public goods, their true preferences are not revealed. Because people will not directly pay for those goods, they will tend to overstate the value they receive from public goods.

c. The socially optimal amount of the public good at a price of $2 is 4 units.

d. Given the free-rider problem, the answer to c is most likely an overestimate.

2. a. Proposal A would force a downward shift in each demand curve, while Proposal B would raise the price at each quantity, also shifting the demand curves down.

b. The consumers in group 1 have a more elastic demand, so a small increase in price results in a large decrease in quantity; these consumers can more easily adjust their usage and would therefore favor Proposal A. The members of group 2 would be more likely to favor the tax because changing their usage is more difficult. Their inelasticity can be interpreted to mean that they are more willing to pay a higher price than to use less.


3. a. Assuming perfect competition, the price and quantity will be set where demand crosses marginal cost with equilibrium price, P0, and equilibrium quantity, Q0.

b. The socially efficient price and quantity would be where demand crosses marginal social cost, a higher price and a smaller output (P1, Q1).

c. Such a proposed ban would have to be assessed in terms of the costs and benefits to everyone involved. There is a lot of pertinent information not given here: for example, is this a community where commercial fishing represents a major industry? Is sport fishing a major tourist attraction? The answer to this question largely depends upon the specifics of the situation; it is true that the market outcome is not the same as the social optimum, but a commercial fishing ban could lead to an even less-desirable outcome.

4. a. The price of getting rid of garbage rose while the price of getting rid of recyclables did not. People substituted recycling for disposing.

b. The weight of garbage fell by less than volume because the fee was based on volume; people stuffed the bags fuller, placing more garbage into a 32-gallon bag.

c. With a flat fee, the marginal cost of placing out more garbage was essentially zero, so in the graph below, Q0 garbage pick-up was demanded. With volume pricing, the price rose to P1, and quantity demanded fell to Q1.

5. a. The advantages of such fees reduce the quantity of animal trophies demanded, (assuming poaching can be prevented) thus reducing the damage to the stock of animals. Further, the revenue could be used to improve the stock of animals or meet other needs of African nations. This also provides an incentive for the local people to preserve big game since the price they could receive by poaching is less than the revenue from the fees.

b. One argument against it is that condoning such slaughter at any price is immoral. A second argument is that, by the time the optimal price is found, the animals may well be extinct.

6. a. Most likely the price of all cars in California rose, and air quality rose as well.b. This law could possibly have increased pollution if consumers held on to their older, less efficient

but lower-cost, higher-performance gas cars and delayed purchase of an electric car. This would have increased the average age of cars on the road, increasing pollution. Furthermore, if electric cars (the most likely candidates) were designed to meet the no-pollution requirement, it could be that the process of generating sufficient electricity to run the cars would produce even more pollution, at which point even more regulation might be imposed. (The law was modified and never went fully into effect.)

c. Economists generally favor market incentive programs over direct regulation. A market incentive program to reduce pollution by a certain percent might be to tax drivers of older, high-pollution cars and use the tax revenue to subsidize those who purchase the new, no-pollution cars. This approach will more likely equate marginal cost with marginal benefit. Another market incentive program would be to increase taxes on gasoline, causing demand for gasoline to decrease as people switch to more efficient vehicles.


7. a. No, their findings do not necessarily mean that the U.S. had too many regulations. The “right” number of regulations is a normative issue; one could argue that the price society would pay for the ill effects of non-regulation would be greater than $662 billion.

b. Each regulation must be examined in terms of marginal cost and marginal benefit to see whether it is worthwhile.

8. a Some dairy farmers would probably argue that labeling is unnecessary since the drugs they administer have been certified by the FDA. Dairy farmers who do not use BST would support BST labeling.

b. If BST were to be listed on milk containers, one could argue that all drugs and antibiotics should be listed. However, such listing (without more information) may cause consumer concern. To support BST labeling but not other labeling, one must argue that BST is different.

c. One would suspect that dairy farmers who support BST labeling would not support the broader law that might include drugs that they do use. Only those few farmers who use wholly organic farming would support full labeling.


1. a. Cap and Trade is a program that has two goals, first focusing on a pollution problem and putting a limit on how much pollution can be emitted and second, allowing the environmental offenders options with pollution allowances, and options to trade allowances with other companies.

b. Case #1 addresses the negative externalities associated with acid rain (SO2 in rain water).c. Cap and trade works because it allows firms to decide whether to directly reduce pollution or

purchase pollution reduction from firms who find it less costly to reduce emissions. d. Revising the Clean Air Act and allowing the act of polluting to be recognized and traded created a

successful marketplace and reduced pollution resulting from SO2 in rain water.

2. a. OSHA was established in 1970 to assure safe and healthy working conditions by assisting states and providing research, information, education, and training in the field of occupational safety and health.

b. The market failure was lack of information. Workers were not being compensated for the hazard of unsafe, unhealthy workplaces because they were unaware of the hazards or lacked the ability to ask for safer environments.

c. Most workers come under OSHA’s jurisdiction, a few examples of exceptions are miners, transportation workers and the self employed.

e. OSHA conducts inspections to point out problems, to educate and train workers, and to enforce safety and health codes with the help of the individual states and the Department of Labor.

Chapter 19: Politics and Economics: The Case of Agricultural MarketsQuestions for Thought and Review

1. The good/bad paradox is the phenomenon of doing poorly because you're doing well. The increase in supply as the result of a good harvest lowers the price and results in less income to the farmers. If demand were perfectly elastic (a horizontal line) the shift in supply would have no effect on price. Thus the more elastic the demand, the less the effect on price and the less likelihood of the paradox. It's important to emphasize that the good/bad paradox refers to the entire market. The worst of all possible cases is where you have a poor year, but other producers have a good year. In this case you receive a low price and have a low output.


2. A price support system achieved through acreage restriction is illustrated in the accompanying graph. The graph shows that, under this system, the farmers gain rectangle A as income from the government in the form of payments not to grow wheat, and rectangle B from consumers who pay more for the wheat the farmers do grow.

3. The taxpayers' group would prefer the economic incentives for not producing because it costs less; in the example in the text, buying the surplus means the government pays the farmers $5 a bushel, rather than $2.20 with the incentives program.

4. As shown in the accompanying graph, the method of price support that is most costly to the taxpayer is the subsidies on sales to keep prices down; taxpayers must finance the subsidy payments on all subsidized farm products, represented by areas A, B, and C.

5. As shown in the textbook, the price support method that is least costly to the taxpayer is regulatory measures, which have no direct cost to taxpayers other than the cost of enforcing and administering the regulations.

6. Tariffs and quotas generally accompany price support systems in order to prevent lower-priced foreign products from competing in the domestic market.

7. The elasticity of supply affects the cost of price supports in the four options illustrated in the text. When the supply is elastic a small change in price causes a large change in quantity, and the cost of the subsidy is less. As supply grows more inelastic, the cost of the program increases.

8. Governments find grandfathering a good option when they institute price supports because it is the easiest way of restricting supply. Existing suppliers retain their level of output, added or new entry is denied or limited, and the policy is easy to enact because there is no group lobbying against it, and easy to enforce.

9. This is false. This is an extremely broad statement. As the chapter points out in detail, all government regulation has benefits and costs, and in some cases one can assess the net impact. It seems highly unlikely that all government intervention would make society worse off. Whether society is worse off must be based on normative judgments, not on positive economic theory.

10. The nonrecourse loan is a price support system in which government buys goods in the form of collateral on defaulting loans. The land bank program is an incentive-based price support in which the government supports prices by giving farmers economic incentives to reduce supply.

11 The U.S. government subsidizes the production of corn, which lowers it price. Consequently the quantity of corn demanded rises. The demand comes in the form of eating greater amounts of corn syrup, corn-fed beef and chickens, and processed foods. What we choose to be in our diets depends


on the cost of foods we eat. The lower the price, the more we eat because the corn-based products are generally unhealthy, their low prices lead to increased obesity.


1. a. The graphs below illustrate the effect of a supply increase in each of the four situations presented in the question. When both supply an demand are inelastic, (1) there is a large change in price and a smaller change in quantity. When supply is elastic and demand is inelastic, (2) there is a larger change in price and a smaller change in quantity. When both are elastic, (3) there is a small change in price and a larger change in quantity. When supply is inelastic and demand is elastic, (4) the increase in supply causes a small change in price and a larger change in quantity.

b. The effect of a government price guarantee in each case is illustrated in the graphs below. In each graph, A is the increase in farmers' revenue, B and C is the decrease in their revenue, and C and D are the excess burden, the loss to society that results.


c. Farmers prefer the situation with the inelastic demand and elastic supply. In each graph, A is the increase in farmer's revenue, B and C is the decrease in revenue, C and D are the excess burden, and the loss to society.

2. The graph below shows an increase in demand sufficient to raise the market price to Ps. The market quantity is also increased to Qs. The cost to the government is the shaded rectangle. If instead supply is restricted (shown in the far right graph), the government must pay the farmers (Ps - P1) for every unit not grown at price Ps, resulting in a cost equal to the area of the bolded rectangle. Therefore, assuming that you cannot use the corn, the second policy is preferred.

3. a. The regulations of Dr. Wiley's Law were likely the result of strong lobbying by the food industry to protect their own interests from competition under the guise of consumer protection.

b. A skeptical economist would likely look at the effects of this law on prices and competition to determine the motives behind passage of the law.

c. This is very significant because it suggests that it was the lobbying of existing producers that supported the law to protect their interests, not the consumer's interests.


4. a. Consumers of peanuts pay more in higher prices—estimated at between $190 and $369 million a year—and suffer from reduced consumption.

b. See the accompanying graph. Area B represents additional costs to consumers, while areas D and E represent deadweight loss of the program.

c. The land with peanut quotas is a government license to sell millions of pounds of peanuts and thus is priced higher to include the present value of the future returns to that license.

d. The government’s costs would likely rise enormously in the attempt to keep supply constrained to maintain the 50 percent above competitive equilibrium price.

e. If the United States limited the guaranteed high price to U.S. producers only, administrative procedures would have to be set up to see that imported peanuts are not passed off as U.S.-produced peanuts.

5. a. Mr. A would be willing to spend up to $100,000 to stop passage of the law.b. Mr. B would be willing to spend up to $100,000 to get the law passed.c. The implications for social policy is that individuals are willing to spend lots of money to pass laws

that benefit them as individuals. A reduction in such rent-seeking, by limiting the ability of individuals to affect laws, could benefit society.

6. a. The reason the difference exists is mostly political. A small group of ranchers benefits greatly from the reduced fee and is a strong lobby for the cause.

b. An advantage to getting a lower fee could be that the U.S. government could require more from ranchers in their care of the land. Also, it helps ranchers who have a difficult time competing, and allows for wider use of public lands.

c. One would expect excess demand because at the price below equilibrium, the quantity of land supplied is lower than the quantity demanded.

7. a. The sugar producers would choose to default on their loans because the price government pays is higher than the market price.

b. The three options for the government are: (1) give the sugar away to the poor, (2) destroy the sugar, and (3) give the sugar away to foreign nations as a type of humanitarian aid. The associated problems are: (1) giving to the poor would further decrease the demand for sugar and the government would need to buy more sugar as more producers default on their loans, (2) destroying the sugar incurs a cost and is morally unacceptable, and (3) giving away free sugar would be seen as dumping overseas and is likely to destroy the foreign country’s sugar market.

c. It would increase substantially to keep these programs intact.d. Companies that use sugar will likely fight against it, because they will face higher sugar prices, as

will consumers. Those who produce substitutes for sugar, such as corn syrup and honey, might also lobby against it.


1. a. Using numbers from spring 2005, raw sugar in the world market was 12.2 cents per pound. In the domestic market, sugar was 20.54 cents.

b. What accounts for the difference is that imported sugar is subjected to quotas, which along with U.S. Farm program, helps to keep U.S. sugar prices higher than world sugar prices.


c. Prices are maintained with price tariff quotas, the Secretary of Agriculture establishes the tariff rate quota amount and is authorized to increase the total quota amount (above the GATT minimum) if domestic supplies of sugar may be inadequate to meet the domestic demand at reasonable prices.

2. a. Genetically engineered crops are crops that are the result of seeds that have been genetically altered to borrow desirable traits from another crop that currently do not exist in that particular crop. They benefit farmers because they are pest-resistant, poor weather-tolerant, and can be shipped and stored better.

b. Genetic engineering has led to stronger crops resistant to a greater number of pests. This has lowered operating costs and boosted yield for those farmers using genetically engineered seeds. In the short run this has increased farm profits.

c. In the long run, because demand for crops is inelastic, this is likely to lead to greater farm production, but lower farm income and lower profits.

3. a. The tobacco quota is a numerical limit on the amount of tobacco that quota owners can sell. The Federal government subsidized the sale of tobacco produced by holders of quotas. The quota buyout ends this price support program buy buying the quotas from the tobacco quota owners.

b. The tobacco quota increases the price of tobacco sold on the market.c. The cost of the buyout is expected to be $9.6 billion for the buyout and an additional $740 million to

administer the buyout. Whether the government should buy back the quotas is debatable. The buyout is being financed by government charges to tobacco companies, so in theory it doesn’t cost the government anything to buy back the quotas. Some quota holders may have purchased the quotas from other owners and it doesn’t seem fair to them to change the rules without compensation. The buyouts may be used to invest in alternative crops. The quotas, however, were given out for free.

d. The government is likely buying back quotas because the health-hazards of smoking are well-documented. In addition, the incidence of smoking among the population has declined. Buying back quotas when smoking was more prevalent may have been politically difficult.

Chapter 20: Microeconomic Policy, Economic Reasoning, and BeyondQuestions for Thought and Review

1. A Pareto optimal policy is one that benefits some people and hurts no one. It's hard to object to such a policy, although one could if one saw certain social values as inviolate. Such issues are, for the most part, academic, since, in reality, no such policy can exist. All real world policies hurt someone.

2. The problem with proposing only Pareto optimal policies would lie in developing them. As the text points out, there are no examples of real-world policies that benefit some people without hurting anyone. If economists seek to propose only Pareto optimal policies, they may end up proposing no policies. Focusing only on Pareto optimality condemns them to irrelevancy in real-world affairs.

3. All economists are not likely to oppose any policy, price controls included. Economists will support or oppose policies based in part on value judgments and in part on their reading of the political and social institutions within which economic policies are instituted. Differences over these lead to differences in policy recommendations. Most, but not all, economists, based on their reading of history, oppose price controls.

4. The usual arguments against the buying and selling of body organs include the concern that people might seek to make such sales for the money involved and exploit the poor, and that those with the ability to pay would get needed organs sooner than those without means, again favoring the well-off


over the poor. Some may believe that it is immoral to sell body parts. Arguments for selling body parts include that both parties freely enter the transaction, and that both sellers (since they decided they preferred the money to the body part) and buyers benefit. Economic theory provides no answers to such questions.

5. Some of this analysis will depend on whether or not the course is a requirement. If it is, taking it would have more benefits than if it were optional (in which case the benefits would be the knowledge gained, getting to know that professor, meeting other students you might not have met, etc.). The cost would be tuition expense, book(s), supplies, any added cost of transportation or food (because of the effect on your schedule), and the opportunity costs of courses not taken, professors not taken, students not met, etc.

6. The textbook suggests a method for valuing one’s life. Your answer should consider what you would pay to reduce their chance of dying by a certain amount. The value of life is that amount times the inverse of the reduced probability of dying.

7. Most people can (and many unknowingly do) function with only one kidney. Thus it can be argued that having two kidneys means having one more than you need to live a perfectly normal life. Aside from the expense, pain, etc., of having the kidney removed, selling one for a million dollars may sound like a good deal. However, should the remaining kidney become diseased, the seller would be left with no choice but dialysis, or obtaining a transplant himself or herself. The question is whether the million dollars is worth the risk. (There are also cultural and religious factors involved here.)

8. An economist might propose a policy that has little chance of adoption because he or she might be removed from the concerns that make policies unadoptable (i.e., political concerns). In so doing, economists put ideas into the real world and may influence the way people think. The goal behind policy proposals is not always to get them implemented.

9. There is usually an inertia that makes any change difficult and people need to be educated about issues such as safety belts before they can make informed decisions. This can explain the difference in attitudes. There seems to be no reason why people today would value their lives more than in the 1970s. The introduction of airbags also involved informational issues. People needed to be convinced that airbags save lives. In the 1990s there is still some debate about the negative consequences for children with passenger side airbags.

10. Most politicians say that they are out to do the public good, but in practice they often do things that just sound good in their quest to be reelected.

11. If the hourly wage is higher on welfare than in a job, rational individuals will choose welfare. The policy recommendations from such information are many. One could call for a much higher minimum wage. Alternatively, one could call for a reduction of welfare, or the establishment of subsidized day care as part of the support if the welfare recipient works. Since the welfare payments are so widely distributed, one could also argue for equalizing welfare payments across states. Arguments against these proposals include that the minimum wage is not actual a “living wage,” that working isn’t actual a viable option for many on welfare, and that costs of living differ geographically.

12. Any decision about prisons involves complicated ethical and moral as well as economic considerations. In reference to the economic issues alone, it would seem that it does make sense to


build more prisons since, assuming prisons are currently full, the marginal benefits of additional prisons are greater than the marginal costs.


1. a. The device reduces the probability of a crash by 1/3. Multiply this by the cost of the crash ($30,000) to find the most someone would be willing to pay for the device -- $10,000. This exceeds the cost of the device, so installing them makes sense.

b. The reason is that people do not want to be tracked with their violations of the law, and there are some invasion-of-privacy arguments against it.

c. They will likely be first installed in cars where the owner of the car is different from the driver – in rental fleets, in teenagers’ cars.

d. They will likely reduce violations significantly.

2. a. A higher percentage of births by C-section are done at for-profit hospitals, most likely because the profit margin for C-sections is higher than that for vaginal births.

b. The implication that can be drawn is that goodwill cannot be relied on to lead to low-cost health programs. Other mechanisms must be instituted to ensure efficiency.

c. In the case of fixed payment, the for-profit hospital would probably do more vaginal births, which cost less than C-sections. The C-section rate would most likely rise at nonprofit institutions as necessary C-sections are limited at for-profit hospitals and shift toward nonprofit hospitals.

3. a. Because the cost of using a road is now close to zero, excess demand results. In the accompanying graph, excess demand is Qd - Qs. By charging a price of P1 to use the roads, excess demand could be reduced or eliminated.

b. Some will attempt to disable the readers. Other will share rides. Still others will shift to vehicles which don't have readers, such as motorcycles. Still others will find out where the readers are and go around them, or if prices are to rise at certain time, go right before.

c. This will likely result in an increase in congestion right before prices change. Pre-peak load congestion might be avoided if the start of the peak load price is a lottery, say equally probable between 4 and 5 o'clock, with the knowledge after what time it is not available. It could also be a price gradient, where prices rise a few cents a minute for the hour before rush hour, and continue rising until it reaches its peak price.

4. a. Since the supply of teenage baby-sitters shifted to the left just as the demand for them shifted to the right, the equilibrium wage probably rose dramatically, reducing the number of times parents go out without their children.

b. The price of baby-sitters probably rose as described in a.c. The average age of baby-sitters probably fell as parents loosened their requirements of babysitters in

an attempt to find substitutes for the reduced number of 14- to 17-year-olds.

5. a. The price of pigs will most probably rise slightly, as a new demand for pig organs develops, shifting the demand for pigs to the right.

b. I doubt that it is Pareto optimal. Some people will be made better off, but individuals who feel that such use of pigs is immoral will be hurt. The rise in the price of pigs will also hurt some people.

c. If this program were successful, it would significantly reduce the black market price of human organs since the black market would be replaced by an open market for organs, and black market


demand would fall.

6. a. According to standard economic reasoning, the value of an additional dollar spent in preventing death is (assuming the journal’s figures are correct) more valuable in the United States than in Sweden and in Portugal, and thus more money should go to saving lives in the United States. However, there are moral issues that complicate matters and make the answer unclear.

b. This is a complicated question. First, many Americans fly in Portugal and, second, it would be bad publicity for an airline to value lives of people differently by national origin or to even acknowledge making such a marginal cost/marginal benefit analysis with regard to safety precautions at all. Moreover, there are those sticky moral issues, which lead one to value all life equally.

c. To the degree that the cost of the standard is the same, the standard economic answer is yes. If noneconomic factors are included, the answer is not so clear-cut.

7. a. If the issues of liberty (freedom of choice and from government regulation) are removed, it would make more sense to spend more on the improvement of car seat belt standards since its cost of saving a life is currently significantly below that of landfill disposal bans. There is, however, a cost imposed on individuals when they are required to wear a seat belt. When aggregated across all Americans, these costs could theoretically change the cost/benefit ratio.

b. If these figures correctly value these regulations, then one should first look at other life saving expenditures to see if their cost is lower. As a general rule, lower cost regulations (with the same marginal benefit) should be imposed first, making the seatbelt standards the more attractive regulation.

8. a. The likely effect of that proposal would be a flood of criticism. Certain human rights such as the sanctity of the human body are held in high regard regardless of societal status. A proposal that, on its face, seems economically sound is not acceptable if it does not include issues of human rights.

b. That was the effect because the economic model did not account for all issues. Morality issues provoke strong political reactions.

9. a. If 70 percent of families choose male offspring, monogamous heterosexual marriages will be difficult to maintain as there will be too few women. Women might start having two husbands (as they do in a few cultures).

b. It will likely push down the female dowry since the quantity of demanded women significantly exceeds the quantity supplied (assuming the distribution of individual sexual preferences does not change).

c. On supply/demand grounds, a family would be wise to have a daughter since their relative importance would rise as their expected relative supply declines. Having a daughter would make it more likely that they would be able to have grandchildren and continue their family line.

10. a. The study is based on the cost benefit analysis that states that a consumer will purchase a helmet if the value of the reduced risk of head injury is greater than the cost of the helmet. So the value of life is greater than or equal to the annualized cost of helmet divided by the change in the probability of death due to the purchase of the helmet.

b. $1.6 million.c. Because the helmet will be less effective in saving life, the probability of reducing the risk of death

falls, so that the value of life increases.d. Firstly, this measures how much the parents value their children’s life, not the value children place

on their own lives because parents make the buying decision. Another difficulty is addressed in part c. This calculation also places no value on reducing the risk of injury.

11. a. Because treatment costs less than criminal justice, I would recommend treatment.


b. I would have to know the social benefit of reducing drug use by one person.c. No, the costs exceed the benefits.


1. a. (Assuming head of a household with two children.) In this example the monthly budget was overspent by $158.

b. With a minimum wage budget, things like new clothing, eating out, trips, movies would become luxuries. It may be prudent to give up owning a car and use public transportation and ride sharing.

2. a. According to the New Party, a living wage at an absolute minimum means that someone working full time should never fall below the poverty line, the exact amount varies from state to state but at this time generally between $6.50 and $7.50 an hour with health benefits.

b. At this time minimum wage is $5.15 per hour.c. The New Party’s arguments for a living wage include: an honest day’s work should be rewarded

with an honest day’s pay; the economy is moving in the wrong direction, too many working Americans still cannot make ends meet; and tax dollars do not fix problems but often make them worse—subsidies are not the answer.

3. a. Six of the rights granted by the Constitution include; freedom of speech, the right to bear arms, the right to peaceable assembly, the right to a speedy and public trial, the right against unreasonable search and seizure, and the right to petition the government for redress of grievances.

b. Yes, these rights are inalienable, nontransferable.c. This is a normative question. You may be able to sell your silence but not your right to freedom of

speech. d. Though Libertarians believe in a totally free market, they also believe in individual freedom. There

is no market for something that is not transferable.

Chapter 21: International Trade PolicyQuestions for Thought and Review 1. A country does better producing and exporting that good for which it has a comparative advantage

and importing goods for which other countries have a comparative advantage.

2. If Widgetland produces only widgets, it can make 240 of them and the opportunity cost is 1/1. If Wadgetland makes only wadgets could produce 720 of them at an opportunity cost of .25/1 (widgets to wadgets). Since the opportunity costs differ, there is a basis for trade in production. Widgetland should produce 240 widgets, and trade 60 of the widgets for 120 wadgets. Wadgetland should produce only 720 wadgets and trade 120 wadgets for 60 widgets. Both countries will be better off.

3. Outsourcing to China and India today differs from outsourcing in the past in two ways: (1) the potential size of that outsourcing is much larger today (those countries have combined population of about 2.5 billion) and (2) China and India are able to compete on a larger number of production levels (China and India have adopted more technological advances).

4. Traders get big gains from trade in newly opened markets. The more competition that exists in international trade, the more the traders’ gains will be reduced and the more gains are passed to the citizens.


5. Smaller countries tend to get more of the gains from trade because more opportunities are opened up for them. This is true only under the condition that competition among traders prevails. International traders in small countries often have little competition and so keep large shares of the gains from trade for themselves; hence the people of the small country may not get the gains from trade.

6. Countries producing goods with economies of scale get a larger gain from trade. Trade allows an increase in production and if there are economies of scale, the increase can lower the average cost of production, and lower the price of the good in the producing country.

7. Three reasons are: (1) Economists can identify both the costs and benefits of trade. Laypeople often do not recognize that the decline in product prices is the result of trade, while they can readily identify that lost jobs are the costs. (2) Economists know that comparative advantage implies that each country is better at producing at least one good. Laypeople worry that since wages are lower in China, it has a comparative advantage in all goods and the U.S. will lose all its jobs. Economists admit that because the U.S. has a trade deficit, the U.S. will face difficult economic forces to restore a more nearly equal division of comparative advantage. (3) Economists recognize that trade occurs in more sectors than manufacturing. They see the comparative advantage that the U.S. has in trading services. Laypeople tend to see trade as trade in manufactured goods only.

8. Any three of the following ten would be correct: (1) Skills of the U.S. labor force, (2) U.S. governmental institutions, (3) U.S. physical and technological infrastructure, (4) English as the international language of business, (5) wealth from past production, (6) U.S. natural resources, (7) cachet, (8) inertia, (9) U.S. intellectual property rights, and (10) relatively open immigration policy.

9. Inherent comparative advantages are those that are based on factors that are relatively unchangeable while transferable comparative advantages are those based on factors that can change relatively easily. A country would prefer to have an inherent comparative advantage because it would not lose that comparative advantage or face the adjustment costs that accompany the change of comparative advantages.

10. The law of one price is that in a competitive market there will be pressure for equal factors to be priced equally. It is important to any discussion of the future of the U.S. economy because relative wages are higher in the United States than in most other countries. The U.S. faces forces that will adjust these wages until the relative prices are equal. This will likely happen by a combination of the following: (1) faster wage growth in other countries, (2) slower wage growth in the United States, and (3) a decline in the value of the dollar.

11. The two methods by which the wage gap between Chinese and U.S. workers will likely fall are (1) relatively slow wage growth in the United States and relatively faster wage growth in China and (2) a fall in the value of the dollar relative to the Chinese yuan.

12. An equitable method might be to tax those who gain from the trade liberalization and give the proceeds to those who are hurt by it. Assuming the original distribution is equitable and the government is not trying to redistribute income, this method is equitable because the combined policies make everyone better off. The political problems with implementation includes: (1) Everyone will try to exaggerate the amount they are hurt and minimize the amount they are helped. Thus actually finding a tax that accomplishes the goal will be difficult. (2) Once the taxes and subsidies are in place, they may not be removed after the adjustment of displaced workers is complete. Losers will be overcompensated and gainers will be taxed too much. (3) Those who have


big gains (big business) may have more political power and be able to prevent the implementation of this policy.

13. The answer in part will depend on what advice is being given. Most economists would argue that some trade restrictions might benefit a country, but almost no country can limit its restrictions to the beneficial ones. Trade restrictions are additive; most economists would not recommend them, even in a recession.

14. Economists support free trade because it forces domestic producers to operate efficiently and it increases consumer welfare.

15. Tariffs and quotas have similar effects on limiting trade (both shift the supply curve to the left). The big difference is who gets the revenue from the resulting increase in the price of imports. With a tariff the government gets the revenue. With a quota, the revenues accrue to the foreign producers. You can see this graphically in the margin graph on page 493 of the text.

16. Both increase the price of the import, helping the domestic producers. In the case of the voluntary restraint, increases in price result in increased revenue to foreign firms and increased demand is met entirely by the domestic market. In the case of the tariff, the revenue raised goes to the domestic government.

17. This is a normative question. Some aspects to think about would be your concern about the health of American consumers, how does the price competition affect American growers, and how the trade affects Mexican farmers.

18. With a price floor, there is a loss of consumer surplus, higher prices and lower quantities.

19. The benefits are that there will be more internal competition among the four countries. The danger is that the combination of countries might place stronger restrictions on outside goods, thereby decreasing international competition.

20. The WTO is the successor to GATT. Both work toward agreements to reduce trade. WTO includes enforcement mechanisms that GATT did not have.


1. a Since their opportunity costs differ, they can gain from specializing: Nebraska will produce only wheat, and Iowa will produce only corn. If Iowa produces only corn, it can increase its production of corn by 60 million to 180 million. Similarly Nebraska can increase its production of wheat to 180 million. There is now 180 million bushels of both to be divided in whatever way the states decide, making it possible to meet the distribution given in the question.

b. The states together produce 180 million bushels of both corn and wheat, and consume 160 million bushels, so the trader gets 20 million bushels of corn and 20 million bushels of wheat.

2. a. No. Both countries’ opportunity cost of producing pickles is 2/1 (they must give up 2 olives to get 1 pickle). Neither has a comparative advantage, so there is no basis for trade.

b. If there are economies of scale, it definitely pays for both countries to specialize since doing so would lower total costs. Which one should specialize is an open question since neither has a comparative advantage.


3. a. The gains to domestic producers is shown in the graph to the right. Domestic producers now produce B at Pt instead of A at Pw. Domestic producers gain additional revenue shown by areas FHKG and ABKE.

b. The revenue to the government is the quantity supplied by foreign producers, BC, multiplied by the tariff. This is shown in the accompanying graph as HIJK.

c. The cost to domestic producers to produce additional units is shown by area ABKHE.

d. The gain to domestic producers is greater than the cost to domestic producers by area FHEG.

4. a. Firms may produce in Germany, because (1) transportation costs in the other countries may be very high, so that if these costs are included, it would not be efficient to produce there; (2) there might be tariffs or quotas for imports into Germany that will prevent producing elsewhere; (3) the productivity of German labor may be so much higher that unit labor costs in Germany are the lowest; and (4) historical circumstances may have led to production in Germany and the cost of moving production may exceed potential gains.

b. One would expect some short-run movement from Greece and Italy into Germany, but only in the long run will there be substantial movement. Social restrictions such as language and culture will limit labor mobility. With such high unemployment in Germany already, one would not expect much short-run movement.

c. I would need to know how stable the political system is, what the worker productivity rates are, how sound the infrastructure (such as roads) is, and what the tax differences are between the two countries.

5. a. The countries can move to those points through specialization and trade. Machineland has the comparative advantage in machines and should specialize in them and trade them for food from Farmland. If Machineland produces 200 machines and Farmland produces 200 of food, then they can trade on a 1 to 1 basis to reach points B and D.

b. At points A and C the total production of machines is 110 and of food is 170. By specialization the total production of each would increase to 200.

c. Your share should compensate you and still allow for the two nations to gain from trade. Eventually the above-normal returns will be competed away.

d. Economies of scale would mean that the production possibilities curves would not be straight lines, and would be a further argument in favor of specialization; the recommendation doesn’t change, but the economic case behind it becomes stronger.

6. a. The production possibility curve is shown in the accompanying graph.

b. Since Busytown can produce more cars when all of its resources are devoted to producing cars, Busytown has an absolute advantage in producing cars. Neither has an absolute advantage in producing gourmet meals since if each devotes all of its resources to producing meals, each can produce 50, but Lazyasiwannabe has a comparative advantage in gourmet meals. It must give up 1 cars for each gourmet meal while Busytown must give up 1.2 cars for each gourmet meal.

c. Busytown should produce 60,000 cars and Lazyasiwannabe should produce 50,000 meals.


Lazyasiwannabe then offers Busytown 22,000 meals for 24,000 cars. Since Busytown must give up only 24,000 cars for 22,000 meals (instead of the 26,4,00 cars it would have to if it made 22,000 meals itself) it accepts this offer. Lazyasiwannabe ends up with 28,000 meals and 24,000 cars while Busytown ends up with 22,000 meals and 36,000 cars.

7. a. Three assumptions are that the good is tradable, that transportation costs are minimal, and that taxes between the two countries do not differ significantly.

b. To the degree that production facilities and labor can move easily, the law of one price should hold for labor, too. Given the wage differentials that exist among countries with seemingly equivalent productivities, it seems that these conditions do not hold for labor.

c. Since capital is more mobile than labor, the law of one price should have a greater tendency to hold for capital. Financial capital is a great example. Interest rates among countries tend to equate much faster than wages.

8. a. With the quota, the quantity of clothes sold was fixed. Suppliers charged the price (P0) consumers were willing to pay for that quantity. With the removal of the quota, as the accompanying graph demonstrates, equilibrium quantity rose (to Q1) and equilibrium price fell (to P1).

b. Consumers benefited because they were able to buy a greater quantity at a lower price. Graphically this is shown by an increase in consumer surplus shown by the shaded region in the accompanying graph.

c. The short-run effect of the removal of the quota is that profits declined because the equilibrium price declined. If economies of scale lower average total costs by more than the decline in equilibrium price, in the long run profits might increase with the removal of the quotas.

9. a. Yes, if the deductions in lost taxes exceed the amount collected. This is indeed the case. Congressional tax experts have estimated that the deductions exceed the amount corporations pay in taxes by $6 billion a year.

b. The natural suggestion would be to eliminate the tax, including the accompanying deductions from corporate taxable income.

c. It is likely that the companies want the tax because they benefit from it—in other words, because the tax results in lower taxable corporate income, it is an implicit subsidy, and they will lobby strongly to keep it. The government may keep the tax because it wants to encourage exports. (Source: “U.S. Overseas Tax Is Blasted,” The Wall Street Journal, May 5, 2004)

10. a. Economists opposed the tariff because it creates dead weight loss and hurts the welfare of the whole society.

b. The tariff shifts the supply of imports up, increasing equilibrium price to P1 and lowering equilibrium quantity to Q1 as shown in the accompanying graph.

c. The tariff would help the economy by increasing the price of imported goods, making domestic goods relatively more competitive and allowing domestic producers to raise their prices if they chose to do so. It would also provide revenue for government that it could spend on consumption or investment goods, further stimulating the domestic economy.


d. The macro economy would be worsened because a retaliatory tariff reduces the trade between countries, thereby hurting both of them. They do not benefit from the full extent of their comparative advantages.


1. a. WTO uses a multilateral system of consultants and panels of experts through a set procedure to settle disputes.

b. The timetable for the settlement procedure is to complete it within one year, or 15 months if there is an appeal.

c. If a country chooses not to abide by the settlement the penalty can be trade sanctions, if possible in the sector of the dispute.

2. a. Three trade barriers listed are biotechnology bans, quotas on lumber, and export control licensing.b. The biotechnology bans are implemented because of perceived health risks to genetically modified

food. The lumber quotas are to save American jobs in the timber industry. Export control licensing of satellites has shifted from the Commerce Department for security reasons.

c. The ban on genetically modified food is hurting the U.S. agriculture market. The import quota on lumber has led to a 35 percent increase in the price of U.S. lumber. We are losing business from China due to the change in license control.

3. a. The members of ASEAN are: Indonesia, Malaysia, Philippines, Singapore, Thailand, Brunei Darussalam, Cambodia, Laos, Myanmar, and Vietnam.

b. Asean was established in 1967 with the first five countries. c. Asean states that the aims of the association are 1) to accelerate the economic growth, social

progress and culture development in the region through joint endeavors in the spirit of equality, and 2) to promote regional peace and stability.

d. Combined GDP in ASEAN countries was $737 billion in the late 1990s.

4. The answer to this question depends on the country chosen.


2. a. The opportunity cost for Greece of making 1 million olives is 1,000 pounds of cheese. The opportunity cost for France of making 1 million olives is 250 pounds of cheese. The opportunity cost for Greece of making 1,000 pounds of cheese is 1 million olives. The opportunity cost for France of making 1,000 pounds of cheese is 4 million olives.

b. They are worse off since France has a comparative advantage in producing olives and Greece has a comparative advantage in producing cheese. Under the new law France produces 50,000 pounds of cheese and Greece produces 500 million olives—point A. They could have had a greater combination: 100,000 pounds of cheese produced by Greece and 600 million olives (200 million by France and 400 million by Greece)—point B. Their combined possibility curve if they were able to trade is the outermost production possibility curve shown.


c. See the accompanying graph. All the points in the shaded area were unattainable without specialization and trade.

Chapter 22: Economic Growth, Business Cycles, Unemployment, and InflationQuestions for Thought and Review

1. Economic growth is measured by increases in total output and increases in output per person.

2. The U.S. per capita growth rate of 1.5 to 2.0 percent per year is lower than those of Japan (4.8 percent per year) and China (3.4 percent per year), close to those of Western Europe (2.5 percent per year) and Latin America (1.4 percent per year), and higher than those of Eastern Europe (1.0 percent per year) and Africa (0.8 percent per year).

3. Real output is a measure of the total goods and services an economy actually produces stated in constant prices. Potential output is a measure of the total goods and services an economy is capable of producing given its resources and institutions.

4. A representative business cycle is shown in the accompanying graph. Each of the four phases—peak, downturn, trough, and upturn—is clearly labeled.

5. Besides predicting the recessions that did occur, the index has also predicted many recessions that did not occur. So the predictions have not been especially accurate. Predicting recessions is difficult because business cycles have varying durations and intensities. The leading indicators are called indicators and not predictors because they're only rough approximations of what's likely to happen in the future.

6. Reducing unemployment to 1.2 percent today is not likely for several reasons. One is that a low inflation rate seems to be incompatible with low unemployment. Another is that today’s economy differs from that of the World War II period, when there was an enormous ideological commitment to the war effort and acceptance of strong wage and price controls.

7. Structural unemployment results from the institutional structure of the economy or changes in the economy itself, while cyclical unemployment results from fluctuations in economic activity (business cycles.)

8. Structural unemployment, because it results from changes in the structure of the economy, is best studied in the long-run framework. Cyclical unemployment, which results from fluctuations in economic activity, is best studied in the short-run framework.

9. Some economists argue that the unemployment rate undercounts unemployment because people who have gotten frustrated and stopped trying to find jobs are considered voluntarily idle and are not counted as unemployed; also, the unemployment rate doesn’t include people who are underemployed. Others point out that, because of unemployment insurance, people often say they


are looking for work when they really aren't, and therefore unemployment is overstated. So there are tendencies both to overestimate and underestimate the problem.

10. Okun’s rule of thumb states that a 1 percentage point change in the unemployment rate will cause income to change in the opposite direction by 2 percent. Thus, a 2 percentage point rise in unemployment will likely cause income to decrease by 4 percent.

11. Real output is $166.67 (250/150 X100 = $166.67).

12. Real output rose 13 percent (15 – 2).

13. Expectations are central to understanding inflation because the ultimate change in prices is due both to the prices producers would like and the inflation that they expect. Because expectations of inflation can be self-fulfilling in this way, they play an important role in any ongoing inflation, and can ‘snowball’ a small inflationary pressure into accelerating inflation.

14. False. While inflation doesn’t make the nation any poorer on average, it does have costs. Its costs include ‘shoe-leather’ costs, capricious distributional effects, the destruction of the informational value of prices, and the breaking down of the institutional structure within which markets work.

15. Inflation is generally associated with low unemployment both because both tend to accompany economic upturns; low unemployment rates give workers greater leverage in demanding wage increases and since labor is a large portion of the production of many goods, these wage increases get passed on as price increases in most industries. However, once expectations of inflation are built in, there can be high inflation with high unemployment,.


1. a. The labor force participation rate is the total number of people employed and/or looking for work (or the labor force) as a fraction of the population over 16 years old. In this instance it is 148,203,000/224,640,000 X 100 = 65.9 %.

b. The unemployment rate is the total number of unemployed as a fraction of the labor force. In this instance it is 8,047,000/140,156,000 X 100 = 5.4%.

c. The employment rate is the total number of unemployed as a fraction of the labor force. Since the labor force equals the unemployed plus the employed, we know that in this instance it is (148,203,000 - 8,047,000)/ 148,203,000 X 100, or 94.5%.

2. a. The index in 2005 is 68/64 X 100 = 106.25.b. Real output is Nominal output/Price index X 100 = $300 billion/115 X 100 = $260.9 billion.c. Percent change in nominal output = Percent change in real output + Percent change in the price

level. Thus, rise in nominal output = 5 percent + 2 percent = 7 percent.d. Percent change in nominal output = Percent change in real output + Percent change in the price

level. Thus, inflation = percent change in nominal output – percent change in real output= 7 percent - 3 percent = 4 percent.

3. Deciding the purpose of life and therefore what constitutes a desired lifestyle is a complicated issue. To the extent that work provides a sense of self-worth and identity, complete idleness is not desirable. This, however, is a normative question. Unemployment within our culture and set of institutions is a measure of aggregate well-being to the extent that employment provides a sense of well-being and sufficient income to support a desired lifestyle. The Eloi are all unemployed, but if they can support their desired lifestyle with the work of machines, unemployment is not so bad. This


example shows that unemployment must be understood within this broader framework-its meaning is specific to a set of institutions and a culture.

4. a. Possible explanations include Japanese cultural emphases on tradition, honor, and loyalty. In Japan, firms are less willing to lay off workers in times of excess supply and workers are less likely to change employers in search of higher compensation. Another explanation is the nature of Japanese production. One could suggest that Japanese production does not rely on a changing base of skills so that the skills of workers always match the skills demanded by a particular firm.

b. It is impossible to say which is better. Each needs to be judged within the broader system of the economy.

c. The answer to this question depends on the distribution of layoffs and hires in each of the economies. If layoffs in Japan were unavoidable and occurred among mid to-low ranking employees, the average tenure of Japanese employees would decline. If instead the elderly were asked to retire earlier, the average tenure would decline much less. In the United States firms would have to lay off fewer workers than usual due to the booming economy, and average tenure would rise.

5. a. 4% b. 5% c. It fell by $120 million d. -1% e. 4%


1. a. The unemployment rate was 5.2% in March 2005 and the CPI inflation rate was 0.6%.b. The consensus forecast for unemployment in 2005 was 5.2% and for inflation in 2003 was 2.4

percent.c. These appear to be reasonable predictions, though the outcome of the Iraqi War provides additional

uncertainty.

2. a. The answers to this question will depend upon the current state of the economy. See the accompanying graph. The copy of the Economic Report of the President for Spring 2003 did not include quarterly data back to 1989, so we looked on BEA’s web site at www.bea.doc.gov to find it. The peak and trough are marked.

b. The economy is currently in an expansion. c. It has been in an expansion for just a few

quarters.d. The last recession was in 2001.

Chapter 23: National Income AccountingQuestions for Thought and Review

1. It depends on whether more foreign businesses and individuals conduct business in the country relative to domestic businesses and individuals. If more foreign businesses and individuals conduct business in the country relative to domestic businesses and individuals, then GDP will be greater than GNP.

2. If you add up all transactions, you will include intermediate goods—so the amount will far exceed both GDP and GNP, which are measures of final output of an economy.

http://www.bea.doc.gov/


3. A stock concept is the amount of something at a given point in time. A flow concept has a time period associated with it. A stock is the amount of water in a reservoir; a flow is the amount of water that flows over Niagara Falls every hour.

4. The aggregate value added at each stage of production is, by definition, precisely equal to the value of final sales. Thus, the value-added rate should also be 15 percent. (Technical note: This is assuming the value-added tax is an income-based rather than consumption-based.)

5. If the United States introduces universal child care, GDP should increase because some child care provided at home would then become a market transaction. The welfare implications of that rise will depend on how society views this change. For example, would the quality and amount of child care increase? Would there be fewer neglected and abused children? Would an increase in the number of well-cared-for children eventually mean lower unemployment, more productive workers, and higher wages?

6. NDP is actually preferable to GDP as the expression of a country’s domestic output because NDP takes depreciation into account. Depreciation is a cost of producing goods. However, measuring true depreciation is difficult because asset values fluctuate, and so GDP rather than NDP is generally used in discussions of economic activity.

7. Employee compensation is the largest component of national income for most countries.

8. Transfer payments are not included in national income, so nothing directly would happen to it.

9. Personal income differs from national income because it measures the income actually received by households as opposed to the income they earned. Thus, unearned income (transfer payments) is added and income earned but not received (corporate retained earnings, indirect business taxes, and social security taxes) is subtracted from national income to arrive at personal income. In addition, because non-business interest is not included in national income, but is received by households, non-business interest must be added.

10. The difference between domestic personal income and national personal income is the addition of net foreign factor income to domestic personal income.

11. GDP does not measure happiness nor does it measure economic welfare. GDP measures economic activity. Economists talk about GDP because it is measurable and they need something to talk about. Moreover, GDP figures are used to make comparisons of one country's production with another country's and of one year's production with another year's. Besides, GDP does have some relation to happiness.


1. a. GDP is the sum of the value added by the three firms: 550 + 1850 + 950 = 3350.b. A 10 percent value-added tax would generate (.10)(3350) = $335 of revenue.c. A 10 percent income tax would generate the same revenue.d. A 10 percent sales tax on final output would generate (.10)(1000 + 2100 + 1000) = $410 of revenue.

2. a. GDP should fall as nonmarket transactions increase. An example is a person who cleans his partner’s house for a fee cannot receive that fee as a married partner.

b. GDP would not change.c. GDP would rise by the broker’s commission.


d. GDP would not change.e. GDP would not change.f. GDP would rise.

3. Students can search on the Internet to find this information. One source is www.worldbank.org (The World Development Report).

4. GDP = C + I + G + (X - M) = 500 + 185 + 195 + 4 = 884.GNP = GDP + Net foreign factor income = 884 + 2 = 886.NDP = GDP - Depreciation = 884 - 59 = 825.NI = GNP -– Depreciation = 886 - 59 = 827.PI = NI + Transfers from government + Non-business interest income - Corporate retained earnings - Social Security taxes = 780 + 72 + 10 - 51 -47-35 = 619.DPI = PI - Personal taxes = 702 - 91 = 611.

5. a. The expenditure approach:GDP = C + I + G + (X - M) = 700 + 500 + 300 + 275 = 1775GNP = C + I + G + (X - M) + net foreign factor income = 700 + 500 + 300 + 275 + (-3) = 1772.The income approach:National income = wages + rents + interest + profits + proprietor's income: 972 + 25 + 150 + 600 = 1747. GNP = NI + depreciation = 1,747 + 25 = 1772.GDP = GNP - net foreign factor income = 1775.

b. NDP = GDP - depreciation = 1775 - 25 = 1750. NNP = GNP - depreciation = 1772 - 25 = 1747.

National income = wages + rents + interest + profits + proprietor's income: 972 + 25 + 150 + 600 = 1,747.

c. PI = NI + transfers + net non-business interest income – corporate retained earnings – indirect business taxes - social security contrib. = 1747 + 0 +20 - 60 – 100-0 = 1607.

d. DPI = PI - personal taxes = 1607 - 165 = 1442.

6. a. GDP = C + I + G + (X - M) = 485.GNP = GDP + Net foreign factor income = 488.NI = Compensation + Rent + Profits + Net interest = 475.

NNP = NI = 475.NNP = NDP + Net foreign factor income: NDP = 472.

b. Depreciation = GDP - NDP = 13.c. GDP C + I + G + (X - M) = 480.

GNP = GDP + Net foreign factor income = 483.NI = Compensation + Rent + Profits + Net interest = 486.NNP = NI = 486.NNP = NDP + Net foreign factor income: NDP = 483.Depreciation = GDP - NDP = 23.

7. a. 2000: 8,509.7; 2001: 8,857.7; 2002: 9,190.8; 2003: 9,215.7.b. Since inflation was positive in every year, nominal GDP growth always exceeded real GDP growth

in each of the last three years.c. It is impossible to say in which year society's welfare increased the most. GDP measures market

activity, not welfare.

http://www.worldbank.org/



1. These data are for 2004.a. Consumption: $8,419.9 billion; Investment: $2,020.4 billion; Government expenditures: $2,226.5

billion; Net exports: -$677.9 billion.b. Nominal GDP was $11,988.9 billion; real GDP (2000 dollars) was $10,993 billion.c. GDP increased 3.8 percent. 2.1 percentage points was due to a rising price level.d. Increases in consumption contributed the most to GDP growth. Net exports detracted from GDP

growth.

2. a. The economic contributions of household and volunteer work. b. Crime, depletion of nonrenewable resources, family breakdown and loss of leisure time. The

depletion of nonrenewable resources is the largest of these categories.c. The GDP has been rising faster than has the GPI in recent years.

3. a. Outsourcing is a type of trade, specifically, the importing of services. Therefore, imports, services is the most relevant category. Looking at the subcategories, I would choose "other private services."

b. 11.7% 10.9% 6.8% 11.1% 7.4%c. Insourcing would be captured in the same category for exports--"other private services." Percent

changes in this category over the past five years are: 3.2 6.3 7.3 6.1 5.0d. Imports of other private services have exceeded export s of private services.

Chapter 24: Growth, Productivity, and the Wealth of NationsQuestions for Thought and Review

1. a. Answers will vary. Students can do some research about developing countries either at the library or on the Internet to find out about what it is like to live in a developing country.

b. Answers will vary. Answers will mention the lack of some products such as cars, air-conditioning, dishwashers, TVs, the Internet as well as the need to work longer hours to provide for the goods that did exist. Figure 24-1 supports this.

2. A person living in 1910 is most likely to work more to buy a dozen eggs than the person living in 2005. The reason is that, since 1910, the United States real income has been rising, on average, by more than the growth in the population. This means that real income per person has gone up since 1910. Thus, the person living in 2005 has a higher real income than the person living in 1910 and so is likely to work less to buy the dozen eggs.

3. The answer to this question is more complicated than comparing increases in relative income. In terms of real income, the poor are doing relatively better than the rich because growth has made everyday goods available to the poor that weren’t available previously. To the extent that growth has lengthened life expectancy, growth has increased the life expectancy of the poor more than the rich because it has improved the basic diet of the poor more.

4. Through free trade, countries can produce the goods in which they have a comparative advantage and trade for those in which they do not, allowing for greater specialization and division of labor, which can result in higher productivity and greater economic growth for the involved countries.

5. An increase in savings in the United States can lead to an increase in investment. As investment in the economy increases, total output in the economy will increase and this would raise people’s income. Having more investment money available for research and development can also lead to


greater technological growth, which will further accelerate income growth. As a result, the standard of living will be higher. But this is a more long-run effect; in the short run, if a politician is to implement policies to encourage saving, it might inhibit aggregate spending in the economy cause income growth to stagnate, so the policy would not be able to meet its objective of raising the standard of living in the short run. Because politicians generally have to act with a mind to short-run concerns in order to win elections, the policy may not be politically viable.

6. The three types of capital are physical capital, human capital, and social capital. Physical capital includes the buildings and machines that are available for the production process. Human capital includes the workers’ skills that are embodied in them through education, experience, and on-the-job training (i.e., through people’s knowledge). Social capital includes the habitual way of doing things that guides people in how they approach production in the economy.

7. Informal property rights limit growth by limiting the size of companies (they must stay small to remain below the government’s radar) and by limiting access to business and individual loans, since people don’t have legal collateral.

8. Two ways in which growth through technology differs from growth through the accumulation of physical capital are: (1) Accumulation of physical capital increases output by simply increasing the amount of the capital available for production whereas technology increases output by making the existing capital more efficient and thereby increasing the marginal return to available capital. (2) Technology can also change the types of goods people buy in an economy by introducing new types of products; accumulation of physical capital does not make such a change.

9. The two actions governments can take to promote the development of new technologies are (1) to create patents and protect property rights, and (2) to implement policies to provide funding for research.

10. Thomas Malthus based his prediction that population growth would exceed the growth in goods and services on the law of diminishing marginal productivity of labor. But his prediction did not come true because labor has become more efficient as a result of education and technological progress, which has increased the output per worker.

11. If individuals suddenly needed more food to subsist, the subsistence line would rotate to the left. Population would decrease and output would fall, as is shown in the accompanying graph.

12. Convergence might not occur because (1) factors of production are not entirely mobile, (2) countries have different institutional structures, (3) factors of production in one country are not always comparable to those in other countries, and (4) technology tends to remain concentrated in particular geographic areas.


13. Network externalities are when the use of a good by one individual makes that technology more useful to other people. Because of these spillover effects, the effect of the technological change is magnified.

14 The following are three ways in which growth can be undesirable: (1) Growth may contribute to increased pollution. (2) Growth changes traditional cultures with beautiful handiwork, music, and dance into cultures of modern gadgets. (3) Some argue that the number of average working hours has increased because of growth in the economy.

15. Credentialism can lead to the employment of workers who have the necessary degree but do not have the required skills for the job. Thus the average return from these workers would be less and the production process with which they are involved would become less efficient. Also, credentialism can lead to workers who are skilled and innovative but aren’t able to obtain the proper credentials being excluded from jobs in which they could be productive.

16. To compete with the others, the producer has an incentive to innovate (i.e., to invest in technological advance so that he can increase his efficiency and so take a lead among his competitors). But technological innovation is usually associated with a high cost initially, and the producer who has advanced his production process cannot afford to impose a high price on his product due to competition in the industry and so he cannot sustain his technological improvement. Also, competition prevents the sharing of information among firms, which can stifle further innovation.

17. The answer may vary depending on the student’s perceptions. I would say yes if it wants to attract Western businesses who have an interest in maintaining their property rights. I would say yes if it wants avoid possible retaliatory measures by Western countries. I would say no if it thinks that copying other’s patents would lead to greater growth without much cost. A downside to this is that it would limit the incentives for Pakistanis themselves to innovate, thereby lowering potential growth.

18. Communities are willing to give tax relief to new-technology firms to help them survive during the initial stages, when the start-up costs are very high. If these companies survive, they will be able to provide employment opportunities to the community members and thereby play a role in increasing the community’s total income and standard of living.


1. a. They will be about the same in about 76 years b. They will be the same in about 44 years.

2. Constant returns to scale refers to the relationship between increases in all inputs and output. In this case, only one input rose, so we cannot make any conclusion about returns to scale.

3. Nepal: 65.5 years; Kenya: 42.4 years; Singapore: 10 years; Egypt: 18.5 years.

4. a. -4.8%b. 4.6%c. 4%d. 2.0%


5. a. While developing an educational system for a developing country, one might emphasize technical education, especially at the high school level. The reason for this is that most students in underdeveloped countries cannot afford to pursue higher education and stop at the high school level. Therefore, if high schools focus a little more on the technical aspect, then these students would be able to garner some technical knowledge to be more efficient in this world of rapid technological change.

b. Because the United States is a rich country, it can afford a more eclectic educational system that teaches less directly relevant aspects of knowledge.

6. a. The borrowing circle probably would not work in the United States, because the strong social forces in Bangladesh that eliminate the need for collateral do not exist in the United States. Perhaps there are some minority groups that do not have the necessary collateral to get loans in the traditional way but whose culture could provide the social forces to make repayment of loans more certain.

b. A possible modification of the program would be to require proof that the “traditional” methods of financing are not open. This would limit the program to those who have few options but do have a good business plan and intention to repay. Another modification would be to require that the business be maintained in the neighborhood where the cosigners live. This would maintain the social forces that ensure repayment.

c. Minorities often face the same problems because they do not have adequate assets for collateral necessary to gain traditional financing. They also may face discrimination by banks and venture capitalists, or they may not be as trusting of the financial system as their majority counterparts. Nevertheless, they may have good business plans and an intention to repay.

7. a. It exhibits decreasing marginal productivity.b. If the population is at L1, it will grow. The surplus food is shown by Q1 – S1.

c. At L2 population is declining because there is not enough food to go around.d. The intersection of the two curves gives the level of population, L*, at which the economy is in a

steady state. It is a steady state because there is no surplus or shortage—there is just enough to keep people at their subsistence level.

8. Political structure can be viewed as a type of capital if it contributes to production. The longer a country is a democracy, the stronger and more well-developed are the institutions that protect civil liberties and provide secure property and contract rights. These provide the necessary incentives to innovate and produce. A stable political environment also fosters investment in technology because it makes it more likely that the firm will be around in the long term. However, although all the empirical evidence shows a correlation, the causal effects may be from development to democracy.


(Source: “Democracy and Growth: A Relationship Revisited,” Eastern Economic Journal, Winter 2003.)


1. This information was found in the World Development Indicators files.a. Students have to subtract the population growth from the average annual growth in output. Kenya =

0.1 %; Mexico = -0.1%; United States = 2.1%; Japan = 2.7%;b. Kenya = 3.1%; Mexico = 1.9%; United States = 1.0%; Japan = 0.4;c. Kenya = 19.7%; Mexico = 23.1%; United States = ; Japan = 32.3%.

2. This question was answered according to the Index of Economic Freedom, 2005. The ratings for the top two are Hong Kong = 1.35; Singapore = 1.6. The ratings for the bottom two are North Korea = 5.0 and Burma = 4.6.

a. The top two are countries where there is the greatest absence of government coercion or constraint in the following spheres beyond what is necessary for the citizens’ protection: production, consumption and distribution.

b. GDP per capita growth rates published in the report were as follows: Singapore = 6.5%; Hong Kong = 7.2% ; North Korea = 0.1% ; Burma = -1.8. The two do seem to be related, but we would caution that economic upturns and downturns will mask the long-term trends in these economies, which is affected more greatly by economic freedom.

3. The term of a patent is 20 years although exceptions can be made for, say pharmaceuticals.a. Shortening the length of patents means that the new product or the technological innovation will

become “common knowledge” soon. As such, it will be available to other sectors of production that might use it or might develop new ideas from it. Also, for certain sectors (such as pharmaceuticals) there can be enormous short-term consumer gains from having the product available in cheaper ‘generic’ forms sooner rather than later.

b. If the length of the patent if shortened, then there is reduced incentive to spend on R&D and technology since companies reap the economic benefits for a shorter time period and their funds are indirectly being used to provide new technologies to other sectors.

Chapter 24: Questions from Alternative Perspectives

1. This can be viewed as a type of capital. The longer a country is a democracy, the stronger and better developed are its institutions that protect civil liberties and provide secure property and contract rights. By doing this, it provides the necessary incentives to innovate and produce. However, all the empirical evidence shows is correlation; the causal effects may be from development to democracy.

Chapter 25: Aggregate Demand, Aggregate Supply and Modern MacroeconomicsQuestions for Thought and Review

1. The central difference between activist and laissez-faire economists is their differing views about whether the economy is self-regulating. Laissez-faire economists (Classicals) believe the pricing mechanism will bring the economy to an equilibrium (potential output and full employment) while activist economists (Keynesians) do not share that belief.


2. Classicals felt that if the wage was lowered, the Depression would end. They saw unions as preventing the fall in wages, and they saw the government lacking the political will to break up unions.

3. Five factors that shift the AD curve are: changes in foreign income, changes in expectations, changes in exchange rates, changes in the distribution of income, and changes in government aggregate demand policy.

4. Say there is a rise in the price level. That would make the holders of money poorer (the wealth effect). It would also reduce the real money supply, increasing the interest rate (the interest rate effect). Assuming fixed exchange rates, it would also make goods less internationally competitive (the international effect). All three account for the quantity of aggregate demand decreasing—decreasing spending as the price level rises. These initial increases are then multiplied by the multiplier effect as the initial spending reverberates through the economy.

5. Two factors that shift the SAS curve are changes in productivity and changes in input prices.

6. If the economy is in short-run equilibrium below potential output, input prices will fall, causing the short-run aggregate supply curve to shift down and the price level to fall. This will set the wealth, interest rate, and international effects in motion, increasing the quantity of aggregate demand and thereby bringing the economy into long-run equilibrium at potential output.

7. This implies that productivity is increasing significantly. If computers are a large portion of the economy, and wages do not rise by the full amount of the productivity increase, the result will be to lower the SAS curve. It can also shift out the potential output curve to the right, increasing equilibrium potential output and lowering the price level.

8. Yes, they would emphasize the inherent value of the program rather than discussing the program’s effect on aggregate demand. This is because programs that increase aggregate demand when the economy is close to potential will ultimately lead to inflation and little increase in real output.

9. Countercyclical fiscal policy is difficult to implement because it is difficult to assess the condition of the economy at any one time, it takes a long time to enact new government policies, and politically it is difficult to raise taxes when the economy is doing well (or at any time). Often times politics, not the needs of the economy, guide tax and spending decisions.

10. To design an appropriate fiscal policy, it is important to know the level of potential output because where the economy is relative to potential tells you whether to implement expansionary or contractionary policy. Conducting fiscal policy without having an estimate of potential output would be like driving without being able to see the road.

11. As can be seen in the following diagram, a large increase in potential output (shifting the LAS curve to the right) would cause downward pressure on the price level from P0 to P1. As the price level shifts down the output level increases from Y0 to Y1. This is the argument some economists used to suggest policymakers didn’t need to worry about inflation.


12. The simple model abstracts from a number of important issues such as the problem of estimating potential income. Without knowing potential income, we cannot know whether expansionary or contractionary policy is called for. Also, the model does not take into account the difficulties in implementing fiscal policies and the uncertain effectiveness of those policies.


1. a. The SAS curve will shift up since wages rise by more than the rise in productivity.b. The SAS curve will shift down since productivity rises by more than the rise in wages.c. The SAS curve will shift up since wages rise and productivity declines.d. The SAS curve will not shift since the wage increase is exactly offset by a productivity increase.

2. a. Keynes used models not in a mechanistic way, but in an interpretive way. He was a Marshallian who saw economic models as an engine of analysis, not an end in themselves.

b. It fits in nicely with the “other things constant” assumption since the policy relevance follows only when one has eliminated that assumption and taken into account all the things held at the back of one’s mind.

c. It definitely was primarily in the art of economics since the above method is the method used in the art of economics.

3. a. The AD curve will be steeper because a change in the price level will be offset by a change in the exchange rate eliminating the international effect on the AD curve.

b. The AD curve will become steeper if a fall in the price level doesn't make people feel richer since the fall in the price will not cause them to increase their expenditures. This is an example of the wealth effect not working.

c. The AD curve will be steeper if a fall in the price level creates expectations of a further fall in the price level (it may even be backward bending) since the fall in the price level will cause people to shift expenditures further out into the future.

d. Assuming poor people consume more than rich people, the AD curve will shift to the right.e. The AD curve will shift to the right by a multiple of 20. f. The AD curve will shift to the left by a multiple of 10.

4. a. An increase in the availability of inputs will shift the LAS curve to the right.b. A civil war will presumably destroy productive capacity or otherwise halt production and cause a

shift in the LAS curve to the left. In the short run, it will also increase the prices of inputs and increase inflationary expectations shifting the SAS up.

c. To the degree that the rise in oil prices results in an overall rise in the price level, this will shift the SAS curve up. Otherwise, other relative prices will decline to offset the rise in oil prices and the SAS curve will not shift at all.

d. If wages that were fixed become flexible and aggregate demand increases, the SAS curve will shift up as wages rise.


5. a We would suggest that the rise in oil prices will shift the SAS curve up and the drop in world income will shift the AD curve in, causing equilibrium income to fall even more below potential (to point B in the accompanying graph).

b. We might suggest expansionary fiscal and monetary policy to shift the AD curve out (from AD0 to AD2) and bring equilibrium income to its potential. We would caution the government about the possible inflationary consequences, but since the economy is significantly below potential, we would argue that it is a risk worth taking.

c. A real business cycle economists would say that the actual level of the economy is the best estimate of its potential income. He would suggest that the policy would be inflationary because it is not affecting the real supply-side issues. If the economy were left on its own, the SAS curve will shift down below SAS0 until output reached its potential .

6. a. The slowing of foreign economies will reduce exports, shifting the AD curve to the left by a multiple of the initial decline in exports (from AD0 to AD1 in the graph below). I would recommend that the government increase expenditures by an amount equal to the initial decline in exports. This will shift the AD curve back to its initial position, as shown in the graph.

b. An economy operating above potential is shown by point A in the accompanying graph. To keep the inflation from rising (the SAS curve from shifting up), the government should reduce expenditures enough (shifting the AD curve from AD0 to AD1) to bring the economy back to long-run equilibrium at potential output, YP, and the price level, P1, as shown below.

c.


c. A new technology that increases potential output will shift the LAS curve (from LAS0 to LAS1), creating excess capacity and downward pressure on factor prices. If left alone, the price level will fall and real output will rise. If the government wants to keep the price level constant, it can increase expenditures enough to increase output to the new potential (shifting the AD curve from AD0 to AD1).


1. a. The CPI has been relatively low in the past year or so. This would suggest that the economy is at or below potential output.

b. The fact that inflation is low suggests government should do nothing. If it follows expansionary fiscal policy, it risks igniting inflation.

2. a-b.The level of output and price level is shown in the accompanying graph.

c. Since the curve involves shifts in both the SAS curve and AD curves, all we can say is that these are points of equilibrium given certain assumptions. It is neither an AD nor an SAS curve. In order to draw one or the other, simplifying assumptions must be made regarding what is held constant.

3. The Consumer Confidence index fell in February 2005 after rising the previous month. This suggests that the AD curve might shift in to the left. If the trend continues equilibrium output will likely be lower than otherwise and inflation pressures will be weakened. The situation is shown in the accompanying graph. Assuming the economy begins at potential output (point A), a weak consumer confidence may reduce expenditures, shifting the AD curve in to the left. In the short run, the economy will move to point B, at a lower price level, P1, and lower real output, Y1. If expenditures don’t rise at some point, the short-run aggregate supply curve will eventually shift down and the economy will return to its potential output but at a lower price level. (Not shown.)

Chapter 26: The Multiplier Model

Chapter 26: The Multiplier ModelQuestions for Thought and Review 1. If planned expenditures are below actual production, income will decline. Here’s how: when

planned expenditures are below actual production, firms will see that their inventories are building up faster than they’d like. In response, they cut production. As production falls, so does income. Consumption falls by a fraction of the decline in income leading to a further decline in planned expenditures. This process continues until planned expenditure equals actual production.

2. At levels of output above equilibrium inventories are building up because planned expenditures are below actual production. People are not buying all that is produced.

3. The aggregate expenditures curve shifts down by the decline in autonomous expenditures.

4. The AE curve becomes steeper when the marginal propensity to expend increases. Equilibrium income rises.

5. If savings were immediately translated into investment, the size of the multiplier would be infinite since leakages from the economy would be zero. However, autonomous expenditures would no longer exist. In short, under these conditions the multiplier model would break down.

6. Shocks to aggregate expenditures are any sudden changes in factors that affect C, I, G, X, or M. This includes consumer sentiment, business optimism, foreign income, and government policy. It is possible that people could change their marginal propensities to consume and save, and this could also have an effect on the economy.

7. In mid-2005, the government budget was in deficit and the state of fiscal policy was expansionary (lower taxes and higher expenditures). Although taxes were lowered because of the administrations’ ideological beliefs in lower taxes and for political reasons, and expenditures were raised to increase national security and to fight a war in Iraq, the policy made some economic sense because inflation was not believed to be a threat, although some upward pressure on prices was building due to higher energy costs. Signs currently point to the economy beginning to expand faster, so this policy may not be economically viable for too much longer. (This answer may change as the economy progresses.)

8. If the mpe is 0.5, the multiplier is 2. Every $1 increase in autonomous expenditures will raise income by $2. To close a recessionary gap of $200 the government needs to generate $100 of additional autonomous spending. It can accomplish this by increasing government expenditures by $100, or by cutting taxes by somewhat more than that (about $200).

9. Cutting taxes by $100 has a smaller effect on GDP than increasing expenditures by the same amount because people don’t spend the entire amount of the tax cut—they save some of it, too. The multiplier begins with the increased individual spending resulting from the tax cut, or the mpc times the tax cut.

10. The effects of this invention on the economy would be manifold and in many ways unpredictable because such major shocks have social, institutional, and political effects, as well as economic effects. The obvious effect is that the demand for the pill would likely be tremendous (after people were sure it was safe), and so production of the pill would gear up to meet the demand. Market structure and pricing decisions will play a big role in determining the new effect of the change. Alternative forms of transportation would suffer decreases in demand (cars, mass transit, airplanes,


etc.), and levels of production of those goods and services would adjust, as would employment in those industries and related industries. Measured GDP might actually fall.

11. The circular flow diagram of the economy that would more accurately describe the multiplier model would include leakages of savings to investment that cause the diagram to pulsate as the economy continually overshoots equilibrium in response to shocks to the economy.

12. A mechanistic model states the equilibrium independent of where the economy has been or where people want it to be. A mechanistic model is used as a direct guide for policy prescriptions. An interpretive model is used as a guide that highlights dynamic interdependencies and suggests the possible response of aggregate output to various policy initiatives.

13. If there is a delay, it will mean that the initial multiplier effects can be small or non-existent, and then, suddenly, they become large and fast. Uncertain, changing, expectations can add to the ambiguity of the model’s result.


1. If the mpe is .8, then the value of the multiplier is (1/.2) or 5. If autonomous expenditures are $4,200, the equilibrium level of income in the economy is 5 x 4200 = $21,000. This is demonstrated in the accompanying graph.

2. a. If the mpe is .66, the value of the multiplier is 3. A decrease in autonomous expenditures of $20 will likely result in a decrease in income of $60.

b. This is demonstrated in the accompanying graph.

3.a. Given the mpe is 0.8 and autonomous investment has

risen by 20, income will increase by 100 (the multiplier is 1/.2 or 5, and 5 X 20 is 100).

b. The multiplier is now only 2 (1/.5), and so the change in investment causes income to change by 40.

c. The decrease in exports and increase in investment cancel each other out so that autonomous expenditures in the aggregate are unchanged.

d. See the graphs below. The graph on the left corresponds to (a) and the accompanying graph corresponds to (b). The graph to (c) would show the AE curve not moving at all.


4. Given that the mpe is .6, I0 = 1,000; G0 = 8,000; C0 = 10,000; and (X0 - M0) = 1,000, then:a. Y = 10,000 + .6Y + 1,000 + 8,000 + 1,000.

Y - .6Y = 20,000; 0.4Y = 20,000; Y = 50,000.Thus, the level of income in the country is $50,000.

b. If net exports increase by $2,000, income will increase by $5,000 (the multiplier is 2.5, or 1/.4).c. According to Okun’s law, a one-percentage-point change in unemployment will cause a 2 percent

change in income in the opposite direction. Thus, if income has increased by $5,000, which is a 10 percent increase, then unemployment should drop by 5 percentage points.

d. If the mpe falls from 0.6 to 0.5, the multiplier decreases from 2.5 to 2. The answer to part a would now be $40,000; the answer to part b would be $4,000; and the answer to part c is that unemployment should fall by 5 percentage points.

5. a. A likely culprit was a decline in investment spending, partly due to increased bank regulation and Federal Resolution Trust Corporation scrutiny of loans in the wake of the failed S&Ls and liquidity problems of commercial banks in the late 1980s and early 1990s. This was commonly known as the credit crunch, where lower interest rates failed to increase investment spending in the early 1990s. This is shown as a shift down of the AE curve from AE0 to AE1 and a decline in real income.

b. An improvement would be graphically represented by a shift up of the AE curve shown in the graph as the shift from AE1 to AE2 and a rise in real income. The improvement occurred most likely as a result of expectations of an improving economy and further reductions in interest rates increasing consumption and investment expenditures. Government expenditures did not change much in this period and probably did not contribute to the economic improvement.

c. President Bush would have had to increase government expenditures or reduce taxes significantly to stop the slowdown, but given the political atmosphere regarding the high deficit and debt, it is unlikely he could have done so.

d. President Clinton faced the same political imperatives to decrease the size of the deficit, so he implemented some policies designed to affect potential output (the supply side). He lowered some taxes, calling them ‘supply-enhancing tax cuts,’ changed the composition of government spending calling the changes ‘supply-enhancing changes’, and raised other taxes (discounting their effects on the economy).

6. Given that income is $50,000, the mpe is .75:a. To reduce unemployment by 2 percentage points (again, by Okun’s rule of thumb) requires a 4

percent increase in income, which in this case is $2,000. The multiplier is 4.0, calculated as [1/(1 -


mpe)]. To generate a $2,000 increase in income, increase government spending by $500 or decrease taxes by about $650.

b. If the mpe is .67, the multiplier is about 3, which means that to generate a $2,000 increase in income, government spending would have to increase by $666.66.

c. If the mpe is .5, then the multiplier is 2.0, which means that to generate a $2,000 increase in income, government spending would have to increase by $1,000.

7. a. If the mpe is .5, the multiplier is 2, because there is a recessionary gap of $800, government spending would have to increase by $400 to bring the economy back to long-run equilibrium.

b. If the mpe is .8, the multiplier is 5, because there is an inflationary gap of $1500, government spending would have to decrease by $300 to bring the economy back to long-run equilibrium.

c. If the mpe is .2, the multiplier is 1.25. Because there is an inflationary gap of $1,200, the government will want to reduce expenditures by $960.

d. If the mpe is .7, the multiplier is 3.33. Because there is an recessionary gap of $1,500, the government will want to reduce expenditures by $450.

8. a. If the mpe is .5, the multiplier is 2. To eliminate the inflationary gap, the government should undertake a contractionary fiscal policy. Since the economy is $36,000 above potential, we would advise decreasing government spending by $18,000.

b. Using Okun’s rule of thumb, since income falls by 6 percent, we would expect unemployment to rise by 3 percentage points to 8 percent.

c. The multiplier now becomes 5, so we would advise decreasing spending by $7,200. We would not change our answer to b.


1. a. Consumer confidence slipped in March 2005, after having already declined in February 2005. It is now at 102.4 (1985=100) down from 104.4 in February.

b. Falling consumer confidence means that consumption expenditures, and hence aggregate demand will fall. The multiplier model says that the decline in national output will be greater than the fall in aggregate demand.

c. CEO confidence has fallen in the past three quarters (2004Q2 – 2004Q4). It stood at 61 in the fourth quarter of 2004.. (A reading of more than 50 reflects more positive than negative responses).

d. They match somewhat. Both are falling. We would therefore expect the economy to be weaker than in 2004. It is unclear what will happen to inventories. If business confidence rises before consumer confidence, inventories will rise. On the other hand, consumption expenditures haven’t been following consumer confidence well. If consumer spending remains strong while business cut back production, inventories will fall.

2. a. Inventories were up 0.9 percent in January 2005 from the previous month. Inventories are 8 percent above levels a year ago.

b. Rising inventories either mean that consumer expenditures, and therefore aggregate demand, are falling, or that production is rising faster than aggregate demand is rising (or a combination of the two). Either way, production is outpacing expenditures. Unless expenditures pick up, eventually producers will want to cut production. In terms of the multiplier model, it is possible that the economy is going to slow or experience a recession.


1. We would suggest a decrease in taxes. To determine precisely how much we would need to determine what the multiplier is. Assuming all other marginal propensities are zero, the multiplier is


5. The tax cut would initially affect the economy by only .8 times the tax cut, so to increase output by 400, we would decrease taxes by 100 (.8 X 100 X 5 = 400).

2. We would recommend increasing expenditures by 80.

3. This makes the multiplier 3.57. This means that we would increase expenditures by about 112, or cut taxes by about 140.

4. This makes the multiplier 2.08. This means that we would increase expenditures by about 192 or cut taxes by about 213.

5. Making taxes and imports endogenous reduces the size of the multiplier because they increase the leakages from the expenditure flow. Because of taxes and imports, increases in income will lead to lower increases in expenditures than otherwise.

6. This would make the multiplier = 1/(1 - c + ct + m - mt). It would be a slightly higher multiplier. (The difference between the two assumptions is whether we are assuming government imports.)

Chapter 26: Appendix B

1. a. As shown in the left-hand graph below, an increase in autonomous expenditures shifts the AE curve up and causes a movement along the AP curve to the right and results in a higher equilibrium income level twice the shift in the AE curve.

b. As shown in the right-hand graph below an increase in autonomous expenditures shifts the AD curve to the right by twice the increase in autonomous expenditures. Since the price level is fixed, real output increases by twice the rise in autonomous expenditures.


c. Since prices are somewhat flexible, the rise in expenditures is split between an upward shift of the AE curve and a rise in prices that causes a downward shift of the AE curve that is smaller than the initial upward shift. The rise in income is less than twice the initial shock. This is shown in the graph an the right

.In the AS/AD model, a flexible price means that the shift in the AD curve is split between increases in the price level and increases in real output. Real output rises by less than the multiplier times the increase in autonomous expenditures.

2. a. The AD curve will become steeper.b. An increase in the size of the multiplier makes the AD curve flatter because the effect of changes in

the price level on aggregate demand will be augmented even more by the multiplier.c. An increase of $20 in autonomous expenditures has no effect on the slope of the AD curve; it only

affects its position.d. A decline in the price level disrupting the financial market will make the AD curve steeper because

it decreases the price-level interest rate effect.

Chapter 27: Money, Banking, and the Financial SectorQuestions for Thought and Review

1. Although financial institutions don't produce any tangible real assets, they are nonetheless considered a vital part of the economy because of their central role in transferring savings into investment and in making the real economy more efficient.

2. 6 percent.

3. Because inflation expectations have risen, the demand for existing bonds paying a lower interest rate would fall. Bond prices would also fall, driving up interest rates; in this case, interest rates rose from about 4.5 to 4.8 percent.

4. Because the inflation rate was lower than expected, the demand for existing higher-interest rate bonds would rise (they would require a lower interest rate premium). Interest rates fell; in this case from 4.87 to 4.68 percent.

5. . Money is to the economy as oil is to an engine because money is a financial asset that makes the real economy function smoothly by serving as a medium of exchange, a unit of account, and a store of wealth. Without it, the economy comes to a screeching halt.


6. The three functions of money are: (1) it serves as a medium of exchange; (2) it serves as a unit of account; and (3) it serves as a store of wealth.

7. In order to maintain money’s usefulness and to prevent large fluctuations in the price level, the money issuer (in the U.S., the Federal Reserve System), must issue neither too much nor too little money. To issue money without restraint would destroy the social convention that gives money its value.

8. Two components of M2 that are not components of M1 are savings deposits and small-denomination time deposits.

9. Banks earn revenue by lending the money from deposits. They can do so because at any specific day only a fraction of their deposits are withdrawn and they hold just a fraction of their total deposits as reserves. So if everyone tried to withdraw their deposits at the same time, the bank would not have enough money on hand to let them do so unless at the same time all borrowers repaid their loans. (Note: From Don Leet and Scott Houser, JEE, Fall 2003.)

10. The equation for the simple money multiplier is 1/r; the equation for the approximate real-world multiplier is 1/(r + c). Since c is positive, the simple multiplier is larger.

11. Money doesn't have to have any inherent value to function as a medium of exchange. All that's necessary is that everyone believes that other people will accept it in exchange for their goods. This is the social convention that gives money value.

12 If the U.S. government were to raise the reserve requirement to 100 percent, the interest rates banks pay to depositors would decrease and possibly even become negative (you’d have to pay to have the bank handle your money), because significant opportunities for profitable loans would be lost.

13. A benefit of government guarantees is that it prevents inappropriate panic about a bank’s ability to pay back its obligations; a cost of government guarantees is that it prevents appropriate panic about a bank’s ability to pay back its obligations.

14. What brought the S&Ls down were bad loans, particularly in real estate. The reasons that S&Ls made those bad loans are complex. Government deregulation in the 1980s expanded the kinds of loans S&Ls could make and the ways they could compete for deposits. Due to moral hazard and perverse incentives (government, not the bank managers, would have to pay if the S&L went down), S&Ls made risky loans and paid high interest on their deposits. When the real estate market soured, the S&Ls’ net worth crumbled and the government had to step in to bail out the S&Ls and pay back depositors.

15. Panics occur when depositors lose faith in a bank and all try to take their funds out at once. The U.S. banking system is less susceptible to panics because the government guarantees the obligations of various financial institutions. Panics may still occur if the government is perceived as unwilling or unable to live up to those guarantees.

16. To be considered money, the currencies would have to fulfill the functions of money. They only partially fulfill those functions since they have only limited acceptability as a medium of exchange, store of value, and unit of account. Thus, while they are partial moneys, we would not consider them full moneys.



1. a. If individuals hold no cash, the simple money multiplier is the reciprocal of the reserve requirement. Thus for the following reserve requirements the simple multiplier is found by dividing the requirement percentage into 1: 5%, 20; 10%, 10; 20%, 5; 25%, 4; 50%, 2; 75%, 1.33; 100%, 1.

b. If the ratio of currency individuals hold to their deposits is 20%, the multiplier becomes (1)/(r + c) and so for the following reserve ratios their multipliers are now: 5%, 4.0; 10%, 3.33; 20%, 2.5; 25%, 2.22; 50%, 1.43; 75%, 1.05; 100%, 0.83.

2. For a deposit of $100 and a reserve ratio of 5 percent,a. The bank can lend out $95.b. There is now an additional $195 in the economy.c. The multiplier is 20.d. John’s $100 will ultimately turn into $2,000.

3. a. Neither b. Both c. M2 d. Both e. Neither f. Neither g. Both

4. a. money b. not money c. not money d. not money e. money f. not moneyg. not money

5. a. Nothing happens to M2. M1 declines by $150b. Nothing happens to M1 or M2c. Nothing happens to M2, M1 rises by $50d. Nothing happens to M1 or M2.

6. a. As more counterfeit money is printed and not identified as counterfeit, the value of money circulated will decline.

b. As businesses become suspect of currency that is circulated, they will favor cashless transactions such as check cash cards and likely offer benefits for using such cards. In this case, the volume of cashless transactions will increase.

c. As counterfeiting increases, the U.S. Treasury will likely spend more to introduce additional security measures. The cost of not doing so will be the loss in the purchasing power of circulating money and the loss to businesses that accept identified counterfeit currency.

7. a. No because they are hard to move. In this case, pearl shells were used for small transactions.

b. It would lower the value of the stones, causing a general inflation in prices.c. If they could be distinguished, which in this case they could, the new stones would sell at a discount

to the older stones, which they did.d. Yes, in some ways money is a marker of individuals’ “gifts to the marketplace.”


1. a. Evocash is an alternative to money that aims to become globally acceptable. Its main purpose is to facilitate Internet transactions. You must purchase evocash at a rate of $1 = 1 evo. You spend evo by selecting “evocash” as payment for the purchase of a good at Internet vendors.

b. Currently, evocash is not as liquid as dollars. It will take time before it can be used as a generally acceptable medium of exchange. However, it does fulfill the three functions of money as far as the websites where evocash is accepted are concerned.

c. Evocash is money in the sense that it has the potential to fulfill the functions of money if people start believing that others will accept it in exchange for their goods.


2. a. There is about $575 billion of U.S. currency in circulation today but most of it resides outside of the U.S. Assuming that the world population is about 6 billion, this means that there is approximately $95 per person in the world.

b. People typically withdraw cash at ATMs over the weekend, so there is more cash in circulation on Monday than on Friday.

c. 1.5 years.d. Most of this is in the form of U.S. Government Securities owned by the Federal Reserve System.

Some of it also consists of gold certificates, special drawing rights, and “eligible” paper such as bills of exchange or promissory notes.

e. Bureau of Engraving and Printing.


1. Students gain a financial asset and the government incurs a financial liability.

2. It is a financial asset because it has value due to an offsetting liability of the Federal Reserve Bank.

3. No. In economic terminology he is saving. Investing is the act of spending the money on real investment goods in economic terminology.

4. No, she is not correct. While a loan is a loan, that loan is a financial asset to the one issuing the loan because it has value just as a bond does.

5. $2.50.

6. $0.50

7. At 6% interest rate, $2,000 five years from now is worth $1500 today, so take the $2,000 five years from now. At a 10% interest rate, the $2,000 five years from now is worth about $1,241, so take the $1,400 today.

8. a. Market rates are above 10 percent because its price is below face value.b. Its yield is 12.24 percent.c. Its price will rise.

9. As interest rates rise, one would have to save less money today to get $100 in ten years, so the present value falls.

10. Substituting into the present value formula PV = $1,060/1.1, we find that the bond is worth $964 now.

11. Using the annuity table, we find that a dollar a year for 40 years with a 6 percent interest rate is worth $15.05 now. Thus $100 would be worth $1,505.

12. Using the present-value table, we see that at a 3 percent interest rate, $1 30 years from now would be worth $0.41 now, so $200 in 30 years would be worth $82 now.

13. Since we're not sure how long your expected lifetime is, we can use the annuity rule which says that the present value of an annuity is the flow of income divided by the interest rate, which in this case would be $200/.09 = $2,222.22. You should be willing to pay no more than $2,222.22 for that


annuity. The amount you are willing to pay does depend on your expectations about future changes in the interest rate and about your own life expectancy; if you expected the interest rate to decline in the future, you would be willing to pay more than $2,222.22, whereas if you expect to live for only a few more years, you would be willing to pay less.

14. If the interest rate is still 9 percent, the value of a lump sum of $20,000 in 10 years can be calculated using the annuity table in Table A27-1. You should be willing to pay $20,000 X 0.42, or about $8,400 for this offer.

15. To find the present value of a perpetuity of $100 per year, use the annuity rule, which says that the present value is equal to the amount of the cash flow divided by the interest rate. Thus the present value will be: $1000 if the interest rate is 10 percent; $2000 if the interest rate is 5 percent; $500 if the interest rate is 20 percent.

a. Using the same interest rates, the future values of $100 are: $110 in one year and $121 in two years at 10 percent; $105 in one year and $110.25 in two years at 5 percent; and $120 in one year and $144 in two years at 20 percent

b. Using the rule of 72, your money will double in: about 7.2 years at 10 percent, about 14.4 years at 5 percent, about 3.6 years at 20 percent.

16. An investment bank facilitates borrowing. It does not take in deposits and often does not make loans. A commercial bank takes in deposits and makes loans.

17. False. The difference has nothing to do with which is more important. The difference is that in primary markets new issues are sold and in secondary markets existing stocks and bonds are resold. The secondary market is much larger.

18. The prospects must not be very good, or the interest rate must be extremely high. Generally, stocks sell for a minimum of multiples of 10 or 12 times earnings. This multiple can be roughly determined by dividing the expected earnings (the annuity) by the interest rate. More recently, the average price/earnings ratio has been 30, a historically high figure.

19. On the surface it might seem that the primary market contributes more to the production of tangible real assets because it is here that new firms find the financing for their ideas. A secondary financial market only transfers existing financial assets from one saver to another, and such a transaction does not represent any new savings. However, the existence of a secondary market plays an important role in enticing people to buy in the primary market because it makes their financial asset more liquid, and, hence, more valuable. Thus on a deeper level it is hard to say which contributes more.

20. Money market assets usually pay lower interest rates than do longer-term capital assets because they offer the buyer more liquidity and less risk of asset value fluctuation.

21. Asset Liability Market a. Lamar Credit Union money

b. Pension USA Sandra capital First bank initially held the asset, but then FNMA held it. Finally, Pension USA held it as owner of

share in FNMA mortgage fund. All along it was a liability to Sandra.

Asset Liability Market c. First Bank Sean moneyd. residents of

Providence Providence capital


e. Lanier the firm capital (secondary market)No financial asset has been created, it has just changed hands.

Asset Liability Market f. Lanier the firm capital (primary market)

22. a. Agree/Disagree. Technically, a rise in stock prices does not imply a richer economy. If, however, the rise in stock prices reflects underlying real economic improvement such as finding the cure for cancer or a technological advance, society will be richer not because of the rise in stock prices, but because of the underlying cause of their rise.

b. Disagree. If both the real and financial asset are worth $1 million, then they have the same value as long as they are valued at market prices. Just as financial assets bear a risk of no repayment, real assets bear a risk of a fluctuation in prices.

c. Disagree. Although financial assets have a corresponding liability, they facilitate trades that could not otherwise have taken place and thus have enormous value to society.

d. Disagree. The value of an asset depends not only on the quantity but also on its price per unit. The price of land per acre in Japan exceeds that in the United States by so much that the total value of land in Japan also exceeds that in the United States.

e. Disagree. The stock market valuation depends on the supply and demand for existing stock. There is, however, a relationship between relative growth in GDP and the rise in stock prices to the extent that growth in stock prices and GDP growth both reflect economic well-being in a country. Also, many of the companies are multinational companies, and where the company is based may not reflect where its value added is generated.

Chapter 27: Appendix B

1. Starting with the initial balance sheet: Assets Liabilities & Net Worth

Cash 20,000 Demand dep 200,000Loans 225,000 Net worth 150,000Phys assets 105,000 Total 350,000 Total 350,000

a. If an immigrant enters the country and deposits $10,000 in a bank the result is:Assets Liabilities & Net WorthCash 30,000 Demand dep 210,000Loans 225,000 Net worth 150,000Phys assets 105,000 Total 360,000 Total 360,000

b. If the bank keeps 10% of this deposit and lends the rest, the result is:Assets Liabilities & Net WorthCash 21,000 Demand dep 210,000Loans 234,000 Net worth 150,000Phys assets 105,000 Total 360,000 Total 360,000

c. 80% of the loan amount ($9000) gets deposited back in the bank, and the result is: Assets Liabilities & Net Worth

Cash 28,200 Demand dep 217,200Loans 234,000 Net worth 150,000


Phys assets 105,000 Total 367,200 Total 367,200

d. After the money multiplier is all through multiplying, the initial $10,000 will have become $40,000 (if everyone deposits 80% of what they receive back into the bank), and the final balance sheet will be:

Assets Liabilities & Net WorthCash 23,200 Demand dep 232,000Loans 253,800Net Worth 150,000Physical Assets 105,000

Total 382,000 Total 382,000

2. a. The effect on the balance sheet is shown below:Assets LiabilitiesCash $10,000 Demand deposits $50,000

-1,000 -1,0009,000 49,000

Loans 100,000 Net worth 110,000Physical assets 50,000 Total assets $159,000 Total liabilities and

net worth $159,000

b. The reserve ratio is now 18 percent. This is less than the required 20 percent. The bank must decrease loans by $800 to meet the reserve requirement. But this shows up as $800 less in demand deposits and $800 less in cash. The bank must again reduce loans, but this time by $640. Demand deposits once again decline. This continues until the final position indicated by the following T-account:

Assets LiabilitiesCash $ 9,000 Demand deposits $ 45,000Loans 96,000 Net worth 110,000Physical assets 50,000 Total assets $155,000 Total liabilities and

net worth $155,000c. The money multiplier is 5.d. Total money supply declined by $5,000.

3. a. The bank is holding $7500 in excess reserves.b. $50,000 new money would be created: (1/0.15) * 7,500.The final T-account is shown below:

Assets LiabilitiesCash 30,000 Demand deposits 200,000Loans 370,000 Net worth 550,000

Phys. assets 350,000 Total Assets 750,000 Total Liabilities and net worth 750,000


Chapter 28: Monetary Policy and the Debate about Macro Policy Questions for Thought and Review

1. The Fed is a semi-autonomous agency of the federal government. Although it is owned by member banks, its officials are appointed by government. It is a creation of Congress, but has much more independence than do most public agencies.

2. There are few regional Fed banks in the western part of the United States because in 1913, when the Fed was established, the West and South were less populated and less important economically than the rest of the country. As these regions grew, the original structure remained because no one wanted to go through the political wrangling that restructuring would bring about.

3. Six explicit functions of the Fed include: 1) conducting monetary policy; 2) supervising financial institutions; 3) serving as a lender of last resort; 4) providing banking services to the U.S. government; 5) issuing coin and currency; and 6) providing financial services to commercial banks.

4. Three tools by which the Fed can affect the money supply are: (1) changing the reserve requirement, which changes the amount of reserves banks keep and thereby changes the money supply; (2) changing the discount rate, which changes the cost of borrowing by banks from the Fed and thereby changes the money supply (actually, it works more as a signal); and (3) open market operations, which change reserves as the Fed buys and sells bonds, and thereby changes the money supply.

5. When the Fed buys bonds the price of bonds rises and the interest rate falls.

6. The Federal funds rate is the interest rate that banks charge one another for Fed funds or reserves. As the Fed buys and sells bonds, it changes reserves, thereby changing the price (interest rate) banks charge for loaning reserves overnight—the Federal funds rate. Other, longer-term interest rates, such as the Treasury bill rate, are only indirectly affected.

7. Defensive policies are simply changes to offset fluctuations in the demand for money. Therefore a change in the direction of monetary policy would be an offensive action.

8. When the Fed takes money out of the economy, banks are in violation of Fed regulations and have no choice but to contract their loans in order to meet their reserve requirements. When the Fed puts money into the economy, banks have excess reserves but there is no regulation that they are violating. Although they may have a financial incentive to make loans, they are not required to do so. Since they are not required to make loans, and thus will not necessarily reduce interest rates, increasing investment and expanding the economy, the saying “You can lead a horse to water, but you can’t make it drink” is relevant.

9. To increase income by 240, investment should increase by 80 (the income multiplier is 3). To increase investment by 80 requires decreasing the interest rate by 4 percentage points (investment increases by 20 for every 1 percentage point drop in interest). To change the interest rate by 4 requires a change of 20 in the money supply (each change of 5 in the money supply changes the interest rate by 1 percent). Since the money multiplier is 4, reserves should increase by 5. Thus the recommended policy is an open market purchase that would increase reserves by 5.

10. The nominal interest rate is equal to the real interest rate plus the expected inflation rate. If the nominal interest rate is 6 percent and the expected inflation rate is 5 percent, the real interest rate is 1 percent.


11. If we consider the example of an open market sale by the Fed, the initial transaction or "splash" would be the Fed sells a bond, and in exchange a person writes a check to the Fed which the Fed presents to the person's bank for payment. The bank now must adjust to this change, and the "ripples" will show up on its balance sheet. Paying cash to the Fed means that the bank's reserves are too low, and the bank must figure out a way to meet its reserve requirement. It may call in loans to do so, but that in turn could mean that someone paid the loan from a checking account, which has further balance sheet implications. Now that the bank wants to make fewer loans, it will increase its interest rates, which will discourage investment and have further ripple effects on the economy.

12. Treasury bills pay interest; cash does not.

13. From 2001 to 2003 the Fed engaged in expansionary monetary policy by lowering the Federal Funds Rate target. They then began running a contractionary monetary policy in 2003-4.

14. The Taylor rule suggests that the Fed will target a Fed funds rate of 5.5 percent [2 + 3 + .5(1) + .5(0)].

15. The tools of monetary policy are those things over which the Fed has direct control such as the open market operations. These tools have a direct effect on operating targets such as the Fed funds. These operating targets, in term will affect intermediate targets such as consumer confidence. It is these intermediate targets that then impact the Fed’s ultimate targets—prices, growth and employment. Because the Fed cannot directly control its ultimate targets, Fed must rely on adjusting its tools to try to achieve its ultimate targets.


1. In each case, expansionary monetary policy shifts the AD curve to the right. The difference is whether the shift results in an increase in real output, an increase in the price level, or a combination of the two.

a. In the short run, when the economy is significantly below potential, the shift of AD curve to the right from AD0 to AD1 will increase both real output and the price level. Because the economy is below potential, there are no cost pressures to shift the SAS curve up. The economy moves from point A to point B (output rises to Y1 and the price level rises to P1) in the accompanying graph.

b. When the economy is significantly above potential, the effect of the shift of the AD curve to the right is entirely on the price level, not real output. As the AD curve shift

Real Output

Price Level

P

Y

LAS

0

0

1

P

SAS

Y1

0

AD

B

A

AD

1


to the right, cost pressures rise immediately, shifting the SAS curve up so that real output doesn’t change at all, only the price level rises. Graphically this can be shown as an economy moving from point A to point C in the accompanying graph. The AD curve shifts from AD 0 to AD1, but the SAS curve shifts up from SAS0 to SAS1 so that output remains at Y0 while the price level rises to P1.

2. a. If people hold no cash, the money multiplier is 1/r. If this is equal to 3, then the current reserve requirement is 33 percent. To increase the money supply by 200, the Fed should lower the reserve requirement to 32 percent.

b. Lowering the discount rate will encourage banks to borrow. This will increase the amount of reserves in the system so that the money supply increases. If the Fed wishes to increase the money supply by 200, and the multiplier is 3, reserves must be increased by 66.67. If banks will borrow an additional 20 for every point the discount rate is lowered, the Fed should lower the rate by 3.33 percentage points.

c. To increase the money supply by using open market operations, the Fed should buy bonds, thus increasing the level of reserves in the banking system. To achieve an increase of 200 (if the multiplier is 3) the Fed should buy 66.67 worth of bonds.

3. a. Decreasing the reserve requirement from 20 percent will provide banks with excess reserves and will increase the multiplier. To calculate exactly how much we would need to know the current money supply.

b. Because the current money multiplier is 5 (1/0.2), the Fed would buy $400,000 worth of bonds, increasing reserves, and so increase the money supply by $2 million.

4. a. Increasing the reserve requirement would lower the multiplier, calculated as [l/(r + c)]. To calculate exactly how much, we would need to know the current money supply.

b. The money multiplier is [l/(r + c)] = 2.5. If the Fed sold $800,000 worth of bonds it would decrease reserves by $800,000 and so decrease the money supply by $2 million.

c. This part of the question requires information from a local bank. Reevaluate a and b in view of this -information.

5. a. The money multiplier, assuming no cash holding, would be one.b. The money supply would decrease enormously.c. This could be offset by the Federal government buying up Treasury bills, directly increasing the

money supply or by the Federal government making loans directly.d. Since this eliminates a significant role of banks as lenders, eliminating a market within which they

receive at least a normal profit, they would most likely oppose it.

6. a. This would increase excess reserves enormously.b. Banks would most likely favor this proposal because they would now earn interest on their assets

held at the Fed.c. Central banks would likely oppose this because it would reduce their superiority and may require

that they ask Congress for appropriation to pay the interest, reducing their political independence.d. This would increase the interest rate paid by banks because the additional interest would increase

their profit margin. The initial increased profit margin would shift the demand for depositors out as new banks entered the market and as existing banks competed for more deposits. This would increase the interest paid to depositors until the normal profits are once again earned.

7. The Taylor rule is that the Fed funds target is 2 + current inflation + ½(current inflation – inflation target) + ½(percent output deviates from potential output).


a. Fed funds rate target will be 2.5 percent [2 + 2 + ½ (-1) + ½ (-2)].b. Fed funds rate target will be 7.5 percent [2 + 4 + ½ (2) + ½ (3)].c. Fed funds rate target will be 5.5 percent [2 + 4 + ½ (1) + ½ (-2)].

8. a. Since the money multiplier is 2.5, we would issue a directive for the Fed open market window to buy 24 worth of government bonds.

b. We could have also reduced the discount rate and lowered the reserve requirement, although by how much cannot be determined with the information given.

c. Using the quantity theory, we would predict that the price level would rise because of the increase in the money supply.

9. a. This Act will reduce float because money will be transferred almost immediately from bank to bank.b. Because checks will be less likely to be transferred by truck or air, weather will be less likely to

affect the level of float, so its variability will decline, unless computer glitches arise.c. If the variability of float declines so will the level of defensive Fed actions designed to offset this

variability.


1. a. Alan Greenspan is chairman. He has been the chairman since August 11, 1987.b. The seven members are Alan Greenspan, Roger W. Ferguson, Jr, Edward Gramlich, Susan Schmidt

Bies, Mark W. Olson, Ben S. Bernanke, Donald L. Kohn. c. All of them have bachelor’s degrees. Most also have either a Ph.D. in economics or a MBA degree,

or both. Some of them have held posts in private consulting firms, and most of the have had prior experience in public economics related commissions and committees.

2. a. According to the Beige Book of March 2005, consumer spending was moderate, labor markets strengthened with some wage pressure, retail prices were flat to modestly up, and manufacturing was growing solidly.

b. The most recent FOMC action was an increase in the Fed funds rate by 25 basis points on March 22, 2005.

c. Because the economy shows signs of moderate growth with little price pressures, it should not change monetary policy.


1. Since the question does not indicate an initial bank balance sheet, let’s assume an initial bank balance sheet shown below.

Initial Bank Balance SheetAssets LiabilitiesReserves 100,000,000 Demand deposits 1,000,000,000T-bill holdings 0 Net worth 5,000,000Loans 905,000,000 Total Assets 1,005,000,000 Total Liabilities 1,005,000,000

First, individuals buy $1 million T-bills from the Fed, by withdrawing $1,000,000 from the bank leaving the bank with too few reserves.


Assets LiabilitiesReserves 99,000,000 Demand deposits 999,000,000T-bill holdings 0 Net worth 5,000,000Loans 905,000,000 Total Assets 1,004,000,000 Total Liabilities 1,004,000,000

To meet its reserve requirement the bank must call in $900,000 in loans. These loans are repaid by individual withdrawals of demand deposits of $900,000.

Assets LiabilitiesReserves 99,000,000 Demand deposits 998,000,000 loans repaid +900,000 deposits withdrawn -900,000

T-bill holdings 0 Net worth 5,000,000Loans 904,000,000 Total Assets 1,003,000,000 Total Liabilities 1,003,000,000

Again the bank calls in loans to meet reserve requirements. Each round, the amount called in gets smaller and smaller until the bank arrives at its final position with money supply having fallen by 10,000,000.

2. Let’s assume the following initial bank balance sheet:Initial Bank Balance SheetAssets LiabilitiesReserves $100,000,000 Demand deposits $1,000,000,000T-bill holdings 0 Net worth 5,000,000Loans 905,000,000 Total assets $1,005,000,000 Total liabilities $1,005,000,000

First, individuals sell $2 million in T-bills to the Fed, and deposit the $2 million in the bank. The bank now has more reserves than is required:Assets LiabilitiesReserves $102,000,000 Demand deposits $1,002,000,000T-bill holdings 0Loans 905,000,000 Net worth 5,000,000Total liabilities $1,007,000,000 Total assets $1,007,000,000

It has excess reserves of $1.8 million, which it lends out. These loans are redeposited at the bank as demand deposits:Assets LiabilitiesReserves $102,000,000 Demand deposits $1,002,000,000Loans given -1,800,000 New deposits +1,800,000 New deposits +1,800,000 T-bill holdings 0 Net worth 5,000,000Loans 906,800,000 Total assets $1,008,800,000 Total liabilities $1,008,800,000

It still has excess reserves of 1.62 million, which it lends out. Each round, the amount called in gets smaller and smaller until the bank arrives at its final position with money supply having risen by


$20 million.Assets LiabilitiesReserves $102,000,000 Demand deposits $1,020,000,000T-bill holdings 0 Net worth 5,000,000Loans 923,000,000 Total assets $1,025,000,000 Total liabilities $1,025,000,000

Chapter 29: Inflation and Its Relationship to Unemployment and Growth Questions for Thought and Review

1. Lenders lose out because they are paid a fixed nominal interest rate—when inflation increases, their real interest rate decreases. They would not lose out if the interest rate were indexed to inflation or if the lender was able to adjust the interest rate periodically.

2. Adaptive expectations.

3. 2 percent.

4. The real interest rate is 5 percent: Real interest rate = Nominal interest rate - Inflation.

5. The Fed cannot target nominal interest rates less than 0, so deflation will set a floor on real interest rates, in this case 2 percent.

6. The three assumptions are that velocity is constant, real income is independent of the money supply, and the direction of causation is from money to prices.

7. Inflation will be 10 percent.

8. Financial institutions have changed enormously and financial markets have become increasingly connected internationally, increasing the flow of money among countries.

9. Developing countries. In those countries the money supply is growing so quickly it dominates any other factors that might affect the relationship.

10. Governments and central banks sometimes increase money supply even when they know the consequences because sometimes the political ramifications of not increasing the money supply (which can include a collapse of government) are thought to be worse.

11. An inflation tax is an implicit tax on the holders of cash and the holders of any obligations specified in nominal terms. The holders of cash and the holders of any obligations specified in nominal terms pay the tax.

12. Quantity theorists are more likely to support rules because they have less trust in government undertaking beneficial actions and believe that the long-run effects of monetary policy are on the price level while the short run effects cannot be predicted.

13. From money to the price level.

14. The insider/outsider theory of inflation divides workers into insiders and outsiders. It is an example of an institutionalist theory of inflation, which says that social pressures prevent economic pressures


from working. In it, insiders push up wages and outsiders find themselves experiencing unemployment; because the costs of raising wages are not borne by those who make the decision, there is little pressure on insiders not to raise wages

15. The quantity theory emphasizes control of the money supply; institutionalist theories also require control of the money supply, but they have other methods such as labor market structural changes or income policies that are used in conjunction with control of the money supply.

16. Alfred Marshall would say that it is impossible to separate the roles of supply and demand in influencing price and that therefore we cannot distinguish between cost-push and demand-pull inflation.

17. The short-run Phillips curve is illustrated on page 696 of the text in Figure 29-3(a). The short-run curve shows the trade-off between inflation and unemployment when expectations of inflation are constant. The long run Phillips curve is shown in Figure 29-4(b) as the vertical curve. The long-run curve shows the trade-off (or lack thereof) when expectations of inflation equal actual inflation.

18. No, as long as expectations of inflation are constant, the economy will stay on the same short-run Phillips curve.

19. It depends. With short-run, long-run, and shifting curves, just about any combination of inflation and unemployment rates can fit some Phillips curve. So, yes, the Phillips curve is a figment of economists' imaginations. But then again, aren't all models simply structures imposed on reality and doesn't reality only get interpreted through imaginary imposed structures? If so, to suggest that the Phillips curve is "nothing but a figment" is incorrect. Reality is itself a figment of imagination. (If you follow this answer, you might consider shifting to a philosophy major.)

20. Economists see a trade-off between inflation and growth because low inflation reduces price uncertainty and thereby encourages investment that increases the efficiency of the market system, allows businesses to enter into long-term contracts more easily and reduces the costs of using money.


1. a. Use the equation, MV = PQ. Real output is $2,000.b. Nominal output is $4,000.c. If the money supply rises from 500 to 600, the price level will rise from 2 to 2.4.d. If the government established price controls, either shortages would result if the economy were

perfectly competitive, or real output would rise if the economy had monopolistic elements. Within the quantity theory framework, an increase in the money supply that was not allowed to have an impact on the price level would have to be accompanied by either a decrease in the velocity of money or an increase in the quantity of goods sold.

e. We would look at the empirical evidence, and see whether it has remained constant in the past when similar circumstances have prevailed.


2. a. The economy is at point A on short-run and long-run Phillips curve on the accompanying graph.

b. The answer to this question really hinges on what kind of change would be popular. Should you try to cut unemployment further? If so, then we would recommend increasing government expenditures, moving the economy to a point such as B in the accompanying graph. Or would a better strategy be cutting inflation? If so, then we would recommend reducing government expenditures, which will increase unemployment while reducing inflation.

c. We have chosen the “lower unemployment” option. An increase in aggregate expenditures will cause a movement up along the short-run Phillips curve. Unemployment will fall, but inflation will rise. In the long run, as expectations of inflation adjust to actual inflation, the short-run Phillips curve shifts up. Unemployment returns to its target rate of 5 percent, but inflation is higher than before, as shown as point C on the graph.

3. a. Stopping inflation tends to transfer money from debtors to creditors. Creditors are generally rich, and can golf regardless of their wealth. Debtors, faced with a decrease in their wealth, must cut back on discretionary expenditures, of which golf is one.

b. Since the exchange rate was fixed, any differential in inflation rates between the two countries could not be offset a change in the exchange rate. The fact that goods in dollar equivalent pesos in Argentina were higher than in NYC suggests that the Argentinean inflation rate remained greater than in the U.S. and the high prices of goods were serving as an anchor on the economy.

c. In an inflation (with interest rates falling behind inflation), people look for real assets to buy to protect their wealth. This increases the demand for goods relative to services, increasing their price. When the inflation is stopped, the opposite occurs.

d. One reason why luxury auto dealers were shutting down was the same as the argument given in (a). A second reason is equivalent to that given in (c). A third reason is that wealthy Argentineans who would most likely purchase such a car also probably had foreign bank accounts denominated in dollars. The car in dollars was cheaper because the peso was overvalued at the fixed exchange rate. The demand for luxury cars fell as Argentineans substituted dollar-denominated luxury cars for peso-denominated cars.

4. The advantage of indexing grades is that it provides a benchmark with which to measure a student’s performance in his or her class. It would distinguish between an A received in a difficult class in which many did not receive A’s and an A earned in an easy class in which A’s were plenty. It allows for comparisons across different schools with different grading standards .But it also does not allow for the self-selection of intelligent students into upper-level classes, where all may be deserving of A’s and that of less intelligent (or at least less diligent) students into ‘slacker classes’ where no one deserves an A. It might result in professors making distinctions among students whose abilities are virtually the same just to make a given distribution of grades

5. a. One would expect real output to decline.b. One would expect unemployment to rise.


c. One would expect inflation to fall.

6. a. He would likely be a quantity theorist since quantity theorists see inflation most connected to long-term growth because low inflation means that the informational job of prices is working better and more investment will take place.

b. Inflation can affect household decisions in a number of ways. It can add uncertainty about the future, leading them to save less and make fewer major purchases. Alternatively, it could lead them to temporarily supply more labor than they would otherwise, causing a temporary spurt in growth and then a fall in growth once they recognize their mistakes.

7. a. Answers may differ. Five goods we buy frequently are newspapers, soda, gas, shirts, and coffee.b. This requires research by the student. Answers will depend on goods chosen.c. Answer will depend on good chosen.

8. a. Increases in productivity shifts the long-run aggregate supply curve to the right. This allows policy makers to increase aggregate demand (perhaps through expansionary policy which would keep interest rates low, as desired) without increasing the price level. In this example, the economy moves from point A to point B.

b. Increase in productivity shifts the long-run Philips curve to the left because it allows a lower unemployment rate at every rate of inflation. Policymakers, therefore are able to increase aggregate demand, shifting the short-run Phillips curve to the left, resulting in lower unemployment and the same inflation rate. In this example, the economy moves from point A to point B.


1. Year M1 billions GNP billions Velocity1959 140.38 507.43 3.611960 140.31 527.38 3.761961 143.05 545.63 3.811962 146.48 586.53 4.001963 150.93 618.68 4.101964 156.80 664.38 4.241965 163.47 720.10 4.411966 170.96 789.30 4.621967 177.67 834.08 4.691968 190.13 911.45 4.791969 201.42 985.35 4.891970 209.12 1039.68 4.971971 223.17 1128.60 5.061972 239.05 1240.43 5.19


1973 256.35 1385.55 5.411974 269.20 1501.00 5.581975 281.44 1635.18 5.811976 297.19 1823.93 6.141977 319.98 2031.40 6.351978 346.31 2295.88 6.631979 372.71 2566.38 6.891980 395.75 2795.55 7.061981 424.88 3131.35 7.371982 453.00 3259.23 7.191983 503.17 3534.95 7.031984 538.65 3932.75 7.301985 587.00 4213.00 7.181986 666.51 4452.85 6.681987 743.63 4742.48 6.381988 774.98 5108.33 6.591989 782.47 5489.05 7.011990 811.07 5803.25 7.161991 859.53 5986.23 6.961992 966.36 6318.95 6.541993 1079.00 6642.33 6.161994 1145.48 7054.30 6.161995 1143.10 7400.55 6.471996 1106.32 7813.18 7.061997 1069.88 8300.73 7.761998 1080.71 8759.95 8.111999 1102.44 9256.15 8.402000 1104.05 9824.60 8.902001 1136.98 10082.20 8.872002 1185.18 10387.5 8.76

b. One dollar in 1960 supported approximately $3.8 in total income. This rose to about $5.0 in 1970, and $7.1 in 1980. By 1990, one dollar circulated enough to support approximately $7.2 in total income and in 2000 it supported $8.9 in total income.

c. As can be seen the velocity of money has on average been rising over the last couple of decades.d. The quantity theory of money assumes that the velocity of money is constant. This is obviously not

the case as can be seen by the above chart. Thus, this theory will not be able to predict accurately the growth in nominal GDP due to the growth of the money supply.

2. a. The article suggests that there is an inverse relationship between the two (i.e. as interest rates rise, inflation falls).

b. The article emphasizes the quantity theory viewpoint since it says that changes in interest rates (due to changes in money supply) will lead to changes in the inflation rate.

c. The Fed has to estimate the state of the economy and then make decisions regarding interest rates.d. The terrain could include variables like production, employment, consumer expenditures and their

expectations etc.

Chapter 30: Aggregate Demand Policy in Perspective

Chapter 30: Aggregate Demand Policy in Perspective Questions for Thought and Review

1. Franklin D. Roosevelt's statement was made during the Depression of the 1930s, which was partly caused by people getting scared and cutting back their spending. The multiplier then took over and turned that decrease into a much larger decrease. To get the multiplier working in reverse, and so countershock the economy, the government would have had to get people to spend more than they wanted to; hence Roosevelt's attempt to calm people's fears and to encourage them to spend.

2. If the economy has a recessionary gap, the following trade policies can be adopted: (1) An export-led growth policy in which the country lobbies to remove other countries’ restrictions on its exports. (2) Allowing its currency to depreciate, which means that the exchange rate of its currency relative to other currencies should fall, making its goods more competitive in the international market.

3. To offset a cut in taxes, the U.S. government should implement a policy that reduces net exports by the mpe times the tax cut; such policies include instituting new or higher tariffs.

4. The budget process begins a year and a half before the budget is implemented, making it difficult to know what type of fiscal policy will be needed. In addition, many budget decisions are made for political reasons (few politicians would vote for a tax increase in an election year even if such an increase were needed). Finally, nearly two-thirds of the budget is mandated by federal programs and cannot be easily changed.

5. State balanced budget requirements are procyclical because during downturns, tax revenue generally falls, making it necessary for state governments to raise tax rates and cut expenditures in order to maintain a balanced budget. Such actions slow the economy even further. The opposite is true during expansions: tax revenues rise so that states accumulate surpluses. They cut tax rates and increase expenditures, contributing to a greater expansion.

6. Automatic stabilizers reduce taxes and raise expenditures during contractions without additional government action. They therefore act to offset contractions. Likewise during recoveries, automatic stabilizers increase taxes and reduce expenditures, which act to slow the recovery.

7. Three alternatives to monetary and fiscal policy are directed investment policies, autonomous consumption policy, and trade policy.

8. If interest rates have no effect on investment, there would be no crowding out. Crowding out occurs when the government’s sale of bonds to finance expansionary fiscal policy causes interest rates to rise, choking off private investment.

9. Increasing government spending shifts out aggregate demand and thereby increases income and reduces unemployment. This makes people better off in the short run and more likely to vote for the incumbent President. The exception would be if the economy is already above potential income and there is a significant inflation threat.

10. Increasing taxes shifts the aggregate demand curve in to the left, decreasing income, increasing unemployment and making people less likely to vote for those in office. The maxim holds because people tend to have short memories.

11. Monetary policy is considered the more effective tool since politically fiscal policy has proven almost impossible to use due to the time lag, political issues, and budgetary difficulties.


12. Policies followed now affect expectations of future policies, and those expectations can affect how the economy operates. By thinking about policy as a process, not a one-time event, policymakers can take these effects into account.

13. A policy regime is a contingent rule about how policy makers will respond to different events; a policy is a one-time action that does not consider policy as a process.

14. Stagflation is a central banker’s nightmare because it must choose whether to lower unemployment and accept still higher inflation or lower inflation and accept still higher unemployment. It cannot tackle both problems at once.


1. a. If the mpe is .8, the multiplier is 5. Every one-dollar increase in autonomous expenditures will raise income by five dollars. To close a recessionary gap of $400 the government needs to generate $80 of additional autonomous spending. It can accomplish this by increasing government expenditures by $80.

b. If the government wishes to achieve the same end by changing taxes, it should decrease taxes by $100. This will generate $80 of additional autonomous spending. Again, with a multiplier of 5, this will cause a $400 increase in aggregate income.

c. If there is a marginal tax rate of 0.2 (instead of taxes being exogenous), the multiplier is [1/(1 - c + (c ( t))] or [1/(1 - .8 + (.8)(.2))], which is equal to 2.77. With regard to your answers to parts a and b, the government must generate added expenditures of $144.40 to close the recessionary gap, either through an increase in government spending of that amount (part a) or a decrease in taxes of $180.50 (part b).

d. With a marginal propensity to import of .2 the multiplier changes to [1/(1 - c + ct + m)] or [1/(1 - .8 +.16 +.2)] which is equal to [1/.56] or 1.79. With this multiplier, to close a recessionary gap of $400 the government would have to generate $224 in new expenditures, either through an increase in government spending of that amount or a cut in taxes of $280.

e. The first graph below shows the shift in the AE curve resulting from an increase in government expenditures of $80 or a reduction of taxes of $100 when the mpe and mpc are .8. The graph below it shows the shift in the AE curve necessary to close the recessionary gap when the marginal tax rate is .2. Notice that the slope of the AE curve is smaller (.64). The AE curve must shift up by more to achieve the same increase in output. Finally, the AE curve for part d has an even smaller slope (.44) shown below the first two graphs. Here the AE curve must shift up by even more.


2. a. In the standard AS/AD model, a tax cut will shift the AD curve to the right, leading to an increase in the price level and real output, as shown in the accompanying graph. Congressman Stable’s views fit this model well.

b. If Congressman Growth is correct, the tax cut will shift the LAS curve to the right. If the economy had previously been in long-run equilibrium, the economy will now be below potential and there will be pressures for factor prices to decline. Assuming nothing else happens in the meantime, the SAS curve will shift down, leading to a lower price level and higher real output, as shown in the accompanying graph.

c. In the short run, Congressman Stable is likely to be correct.

d. The tax cut will require government to finance a higher budget deficit. This would lead to higher interest rates and lower investment. If there is perfect crowding out, the decline in investment will completely offset the expansionary effect of the tax cut. In this case, the tax cut will have no effect on either the price level or real output.

Real Output

Price Level

P

Y

0

0

1

P

SAS

Y1

0

AD

A

AD

1


3. a. In the standard model, an increase in the tax rate will shift the AD curve to the left as shown in the accompanying graph. This will lead to a lower price level and lower real output.

b. If there were partial crowding out, the increase in taxes will require government to finance a lower budget deficit. This would lead to lower interest rates and higher investment. If there were partial crowding out, the AD curve would shift to the left by an amount that is less than shown in a. The price level and real output will not decline by as much as shown in the answer to a.

c. If there is perfect crowding out, the rise in investment will completely offset the contractionary effect of the tax increase and the tax increase will have no effect on either the price level or real output. The AD curve will shift right back to its original position.

4. a. In 1995 the unemployment rate fell below the target rate of 6 percent without generating inflationary pressures. He was probably changing his estimates to reflect that reality.

b. It would shift the LAS curve out.c. Using Okun’s rule of thumb—which says that for every 1 percentage point rise in the

unemployment rate, income falls by 2 percent—a 0.5 percentage point decline in the target unemployment rate would imply a rise in potential income of 1 percent, or $100 billion.

5. a. President Clinton's policy does not fit well with the multiplier model because with that model the two goals are inconsistent with one another in the short run. To increase output and employment using stimulative fiscal tools requires an increase in the deficit.

b. His policy might have the desired effect if a reduction in government expenditures to reduce the deficit reduces the interest rate so much and affects expectations positively to such a degree that their effect on investment and consumption expenditures offsets the decline in government spending.

c. The reduction in the deficit shifts the AD curve to the left, but the increase in investment expenditures resulting from the reduction in interest rates shifts the AD curve to the right by so much that, on net, output rises as shown in the accompanying graph.

d. I would look at interest rates and investment expenditures to see if the explanation is correct.


1. a. The four key economic targets are: low inflation, low level of unemployment, high and stable level of economic growth, and external balance between imports and exports.

b. The main policy tools are: Income tax (rates and allowances): This is the key variable of the fiscal policy and can be used to alter consumer expenditures.


VAT and other indirect taxes: This indirect tax works like the income tax and can be used to alter expenditures. It is also an important source of government revenue.Government expenditure: This is also a part of the fiscal policy. It includes expenditures on things like defense and highways etc. Interest rate: This is a part of the government’s monetary policy and can be used to control variables like the inflation rate.

c. Assuming that the economy is in equilibrium below the potential output, if income taxes are increased, the resulting fall in aggregate demand will lead to a fall in output at the same level of prices. Thus there will be lower economic growth, greater unemployment, but no change in the inflation rate. The model also predicts imports to decrease.

d. Assuming that the economy is in equilibrium below potential output, the model predicts that the increase in government spending will lead to greater output and hence greater economic growth. There will also be less unemployment and more imports though the inflation rate would remain the same.

2. a. The process starts off by the formulation of the President’s budget for a fiscal year. The budget documents are then prepared and transmitted to the Congress. The Congress, after reviewing this budget, develops its own budget and accepts the expenditure and revenue bills. The agency managers then execute the budget in the fiscal year after which information for the actual spending and receipts becomes available.

b. It takes about two years. For example, for Fiscal Year 2001 (begins October 1, 2000) the President formulated the budget between February-December 1999, and the data on the expenditures and receipts became available in October-November 2001.

c. The President and the Congress have to decide upon the discretionary spending, which accounts for one-third of all federal spending. The remaining two-thirds of all federal spending, called mandatory spending, is authorized by permanent laws.

Chapter 31: Politics, Deficits, and Debt Questions for Thought and Review

1. It follows from the long-run framework. The long-run framework directs one to avoid deficits; in the short-run framework deficits are useful if the economy is significantly below potential.

2. The government can finance a deficit in either of two ways: by selling bonds or by printing money.

3. It depends. Your cash flow budget is in deficit since your expenditures exceed your income. However, if you consider your tuition expense an investment in your future and separate it out as part of your capital budget, then your current account budget will have a surplus.

4. There are technical aspects of the deficit that must be understood in order to undertake a meaningful discussion of the problems deficits and debts pose for society. Since a deficit is defined as a shortfall of revenues compared to expenditures, these technical aspects include what you define as revenue and what you define as expenditure.

5. The structural deficit is greater than the actual deficit because the economy is above its potential. Assuming expenditures do not change with income, tax revenues are $50 billion dollars higher than they would be if the economy were at its potential, so the structural deficit is $150 billion. The passive surplus is $50 billion because tax revenues are $50 billion higher because the economy is operating above potential. The structural and the passive deficit add up to the actual deficit.


6. A structural deficit would exist even if the economy were at its potential level of income, which would be at full employment, or at where the unemployment rate is equal to the normal rate of unemployment. If an economist believed that the normal rate of unemployment was 4 percent instead of 6 percent, then the difference between the economy’s current state and the potential income level would be larger, leading to a greater passive deficit and therefore a smaller structural deficit. Thus, it is Mr. A who should also say that the structural deficit is $20 billion.

7. Given that the nominal deficit is $300 billion, the inflation rate is 20 percent, and the debt is $2 trillion, the real deficit is calculated as the difference between the nominal deficit and the product of the inflation rate and the total debt, or 300 billion - (.20 )( 2 trillion) = (-100) billion. There is a real surplus of $100 billion.

8. It would not differ; expected inflation does not enter into the determination of the real deficit.

9. Debt is defined as accumulated deficits, and is also a summary measure of a country's financial situation. Debt must be viewed in relation to a country's assets, but, like income and revenues, assets and debts are subject to varying definitions. There's no unique answer to how assets and debts should be valued, and there are different types of debt.

10. Three ways individual debt can be said to differ from government debt are: (a) government is ongoing and therefore never needs to pay back the debt; (b) government can pay off the debt by creating money; and (c) much of the government debt is internal debt owed to its own citizens and agencies.

11. No. Financing internal debt causes redistribution; it does not make the society poorer.

12. Deficits are only a summary measure of the economy. A government can undertake significant future obligations and therefore get itself into trouble even if it is not running a deficit.

13. Debt service is a good measure of whether debt is a problem because interest payments are the result of past expenditures and do not result in additional productive expenditures. They are the burden of the debt: if the debt service is large and is hurting the governments ability to fund today’s expenditures, that debt could be considered a problem

14. Because of the baby boom, there were many people working and relatively few collecting Social Security in the late 1990s. This caused a surplus in the Social Security Trust Fund. Since that Trust Fund is part of the government budget, the Social Security system is a primary reason for the surpluses.

15. Two real solutions are increasing the retirement age and cutting benefits when baby boomers retire.

16. It depends. Clearly, there is some tendency for the deficit to raise the interest rate, thereby decreasing investment and hence future growth. However, to the degree that the government spending is itself productive, not having the deficit could also decrease future growth. The ultimate -effect depends on the relative size of the two effects.


Chapter 31: Problem and Exercises

1. The completed table is shown below:Revenues Expenditures Debt

1997 $141 $150 $5831998 $153 $150 $5801999 $156 $153 $5832000 $171 $153 $5652001 $179 $162 $548

2. a. The passive deficit must be zero since it is defined as zero at potential output.b. The structural deficit is $200 billion.c. Now $60 billion of that deficit is passive and $140 is structural since revenue would increase by $60

billion if output rose to potential.d. Now there is a passive surplus of $30 billion, and a structural deficit of $230 billion because

revenue would decline by $30 billion if output declined to potential.e. The structural deficit is likely of more concern to policymakers because normal stabilization policies

will not remove it.

3. The real deficit is calculated as the nominal deficit less the product of the inflation rate and the total debt. Therefore,

a. Real deficit = 220 billion - (.10 X 3 trillion) = (-80) billion ($80 billion surplus)b. 50 billion - (.02 X 1 trillion) = $30 billionc. 30 billion - (-.04 X 500 billion) = $50 billiond. $100 billion surplus + $60 billion = $160 billion surplus.

4. a. Debt service payments are 0.06 times $360 billion = $21.6 billion.b. The nominal deficit is 160 - ($21.6 + 145) = $6.6 billion.c. The real deficit equals the nominal deficit

($6.6 billion) - 0.03 X $360 billion = $4.2 billion surplus.

5. Since the real deficit is rising at a faster rate than real growth in the economy, the deficit/GDP ratio is rising. It can only continue to do so as long as it can sell the bonds, but at some point the debt/GDP ratio will become so large that creditors will begin to doubt the country's ability to repay the debt. Then, selling bonds will become more difficult and eventually impossible.

6. To make the deficit look as small as possible, we would do the following:a. Enter government pensions when they become payable, not on an accrual basis.b. Treat the sale of land as current income rather than spreading it out with the sale of an asset.c. Include Social Security taxes as a current revenue because at this time revenue from Social Security

exceeds payment.d. Count prepayment of taxes as current income instead of reserves for future taxes.e. Count expenditures on F-52 bombers as capital expenditures do not include their depreciation in the

government accounts.


1. a. The current major reform proposal is to allow current workers to place a portion of current payroll taxes into private investment accounts that they will then draw from during retirement.


b. Proponents of the reform proposal argue that the private accounts would earn more than is earned by the Social Security trust fund and reduce the problem of trust fund insolvency.

c. Opponents of the reform proposal point out that diverting current payroll taxes would require a significant infusion of money to pay retirement benefits to current retirees. This borrowing would raise interest rates and potentially harm economic growth.

2. a. 28 percent is held as bills, 49 percent as notes, and 19 percent as bonds, 3 percent is held as inflation-indexed notes and an additional 1 percent as inflation-indexed bonds.

b. Intragovernmental holdings are securities held by government trust funds, revolving funds, and special funds.

c. The debt will decline during a year in which there is a budget surplus.

Chapter 32: Macro Policies in Developing Countries Questions for Thought and Review

1. Students can use the list in the text for some examples of the kinds of things they would have to give up, as well as for examples of some of the things they would have to do.

2. You can’t just judge an economy; you must judge the entire culture. Some developing countries have cultures that, in some people’s view, are preferable to ours.

3. Suicide rates are lower in developing countries because there is little ambiguity and few questions about the meaning of life. Americans could learn a great deal from an experience of living in a developing country, especially some Americans who do not truly appreciate what they have. But learning this lesson would require hardship; the fact that suicide rates are lower in developing countries does not mean that life in developing countries is easier or happier. Thus it would be hard to say that Americans would be better off living in such a country.

4. The exchange rate method uses current exchange rates to compare relative incomes while the purchasing power parity method compares incomes by looking at the domestic purchasing power of money in different countries. Because many developing countries’ currencies are undervalued, the current exchange rate overstates the income disparity between developed and developing countries.

5. Development refers to an increase in productive capacity and output brought about by a change in underlying institutions; growth refers to an increase in output brought about by an increase in inputs. Developing economies are changing their production functions, while growing economies are increasing inputs and production on a given production function.

6. Three ways in which institutions differ in developing countries are that (a) basic market institutions with well-defined property rights do not, in many cases, exist; (b) there is often a dual nature to the economy; and (c) fiscal structures with which to adequately implement fiscal policy often do not exist.

7. Governments in developing countries often seem more arbitrary and oppressive than governments in developed countries because of their lack of stable, well-developed fiscal, financial, and political institutions, and because of the demands they must meet simply to stay in power, and the lack of direct accountability for governmental actions. The uncertainty inherent in this kind of situation leads to changing policies and rules, which often seem arbitrary. The need to maintain power in the absence of accountability constraints can lead to ‘oppressive’ policies.

8. An economist might favor activist policies in developed countries and laissez-faire policies in developing countries because the policies one favors depends on the desire and the ability of


government to work for and achieve the goals of its policies. Different views of government can lead to different views of policy. Since many economists have a serious concern about the political structure in developing countries, but less concern about it in developed countries, they can favor one set of policies for developing countries and another set for developed countries.

9. The dual economy refers to the existence of a traditional, less developed, often barter economy and a second internationally oriented modern market sector which is highly developed.

10. A regime change is a change in the entire structure within which the government and economy interact, whereas a policy change is a change in one aspect of government action.

11. An inflation tax is the transfer of wealth from the holders of IOUs denominated in the unit of account, such as cash or bonds, to the issuers of those IOUs when there is inflation (cash) or when inflationary expectations are not fully adjusted (bonds).

12. Governments act to maintain their positions in power, and often feel that in order to do so, they have no choice but to print more money; central banks in developing countries often do not enjoy full independence, and thus cannot resist these pressures (and may not want to, since they also desire to keep the government in power.) For those making the decisions, the short-term benefits of the ‘inflation solution,’ keeping regimes in power, outweigh any long-term hyperinflationary consequences.

13. Conditionality is the making of loans that are subject to conditions by the IMF. Often, countries will ask the IMF for loans to cover balance of payments deficits, but the IMF will in turn place conditions on those loans which often include running a balance of payments surplus.

14. Investment and savings are low in developing countries because income is low, and poor people don’t have a whole lot left over to save. The rich often put their savings abroad due to the fear of political instability. As for the middle class, which is usually small in developing countries, the underdeveloped financial sector leaves them with few opportunities to invest their savings.

15. Even though developing countries may be unstable and offer a risky environment for investing, if a country has a motivated, cheap work force, a relatively stable government supportive of business, and sufficient infrastructure investment, multinational companies will have a strong motivation to invest in the country.

16. An investor thinking of making an investment in a developing country should be concerned about the country’s political stability and its economic condition (inflation, etc.). The existing amount of debt may also be a matter of concern.

17. The right education is a necessary component of any successful development strategy. The wrong education is an enormous burden. Developing countries tend to have too much of the wrong education and too little of the right education. But when students from such countries study abroad, they are often faced with a hard choice at the end of their education, and many choose not to return home, resulting in a brain drain.

18. Corruption limits investment and growth because knowing that payments of graft must be made prevents many people from undertaking actions that might lead to growth. Tax revenues are often diverted to those in power instead of going into legitimate productive investment, and the same is sometimes true of foreign aid money from abroad. But that does not answer the issue, since one must deal with the political reasons why the government increases the money supply.


19. While a country's population can never be higher than its natural resources can support, overpopulation can be an obstacle to development. Whether a country should control the size and the makeup of its population is a matter of considerable debate. Individuals differ substantially in their assessment of the morality of these programs, but even if one believes that population control is an appropriate government concern, it does not seem that such programs will be successful, by themselves, in limiting population growth.

20. The UN could encourage the development of microcredit banks, like the Grameen Bank, which provide a low-cost alternative to money lenders. There are also significant social and cultural limitations in many areas that limit women entrepreneurs, as well as the lack of day-care alternatives to being a full-time mother.


1. This exercise has students interview a foreign student in their school or class about the obstacles to economic development.

2. This exercise asks you to spend a day living like someone in a developing country, and then to read this chapter and contemplate the degree to which someone in such a situation can pull himself or herself up by the bootstraps.

3. a. If the cost of the recycling is the opportunity costs, this program should be accepted for plastics but not for glass. Even this, though, may not be right since the $400 per ton does not include the cost of the negative publicity of Germany sending its trash to a developing country, or the negative externalities of creating large landfills in developing countries as opposed to recycling.

b. Whether this will benefit the developing country depends upon the opportunity costs of the alternative uses of the resources that will be devoted to the program and the long-term consequences of dumping on the land. If the present value of the future stream of income minus the damage to the land exceeds the value of the land, the program would be beneficial. The distribution of the costs and benefits, however, must also be considered. The income will most likely go to a few, but the damage to the land will most likely affect many. The country must weight the marginal social cost and the marginal social benefits, taking into account the environmental harms from creating a large landfill.

c. Alternatives include monitoring of waste to include least-environmentally damaging waste, assurances that the revenue be used to improve the lives of the majority in the country who are those most likely to be hurt by the program, requiring that the proposal be ratified by referendum so that the populace decide whether to accept the trash, and training the developing country to recycle at a lower cost, rather than trash, the packaging materials.

4. a. I would want to emphasize those skills which have the highest per-dollar return—those that would lead to development. These would probably be the basic reading, writing, and problem-solving skills that fit the indigenous culture, as well as technological and computer training.

b. This differs from the ideal educational system in the United States because the U.S. culture is different and U.S. economic problems are different. Thus, in the United States the focus would be more abstract analysis and becoming generally educated and cultured, while in developing countries the focus would be agricultural science and basic skills.

c. This is an open-ended question. The relevant question would be: How much would individuals be willing to pay for courses that do not result in a credential compared to how much they would be -willing to pay for a credential without the coursework?


5. This is a student research question.

6. a. I agree with this statement because of the differing importance of institutions. A detailed knowledge of a country’s institutions and culture is necessary to make prescriptions for development. I disagree with this statement to the degree that the lessons learned from a general theory say that development requires stability of political structures and of economic environment and the need for savings applies across countries. The solutions are specific to the countries but fall within a general framework.

b. This argument is made for developing countries because culture and traditional institutions play a larger role in the growth in these economies.

7. a. If one cannot get title to land, one cannot borrow on it, and thus cannot finance buying it, or borrow against it to start a new business. Both can slow and even stop development.

b. Without titles, public utilities do not know whom to bill for services, and thus will keep public services from developing.


1. a. Three social challenges are disease, lack of sufficient education, and inadequate nutrition.b. Three economic challenges are government-owned businesses, lack of infrastructure and military

conflict.c. Three environmental challenges are destruction of natural habitat, lack of sufficient sanitation, and

lack of sufficient drinkable water.d. An additional challenge not listed is a well-developed market with rule of law.

2. a. From their website: “The Bretton Woods Project works as a networker, information-provider, media informant and watchdog to scrutinize and influence the World Bank and International Monetary Fund …. It monitors projects, policy reforms and the overall management of the Bretton Woods institutions with special emphasis on environmental and social concerns.”

b. Criticisms about the World Bank and IMF focus on conditions placed on borrowing countries for access to funding (which may include loss of local economic authority), its dominance by industrialized nations as well as projects that it has funded that may harm the environment. One recent criticism is the disregard for indigenous people’s right to self determination. See http://forestpeoples.gn.apc.org/index.htm. Another criticism is of human rights violation at a World Bank supported gold mine. http://www.leat.or.tz/active/buly

Chapter 33: International Finance Questions for Thought and Review

1. If a country is running a balance of trade deficit, the amount of goods it is exporting is less than the amount of goods it is importing. This is only one part of the current account, which is the part of the balance of payments that lists all short-term flows of payments. A deficit in merchandise could be offset by a surplus in other areas of the account.

2. When someone sends 100 British pounds to a friend in the United States, the transaction will show up in the component of the current account called net transfers, which include foreign aid, gifts, and other payments to individuals not exchanged for goods or services. It will also appear on the capital account as a receipt of foreign currency just like the purchase of a British stock or bond.

http://forestpeoples.gn.apc.org/index.htm


3. The capital and financial account measures the flow of payments between countries for assets such as stocks, bonds, and real estate, and a surplus means that capital inflows were more than capital outflows. To buy United States assets, foreigners need dollars, so the net capital inflows represent a demand for dollars that can balance the excess supply of dollars due to a current account deficit. In the short run, a current account deficit, necessarily balanced by a capital account surplus, is nice because current expenditures, which include the trade balance, give society immediate pleasure.

4. A capital and financial account deficit means that financial outflows are more than financial inflows. The excess supply of dollars is balanced by a current account surplus, which means Americans are producing more than they are consuming. In the long run, capital account deficits are nice because you are building up holdings of foreign assets, which will provide a future stream of income.

5. Holding the exchange rate above the equilibrium market exchange rate will make a country's exports more expensive and its imports cheaper than they otherwise would have been. It will also require the country to finance the deficit using official reserves or borrowing to do so. It can allow the government to temporarily not make the contractionary macro adjustments that otherwise would be necessary to bring the economy into equilibrium.

6. In the early 1980s the U.S. government was pursuing tight monetary policy and expansionary fiscal policy. The high interest rate resulted in a strong dollar. Expansionary fiscal policy failed to stimulate domestic demand as export demand fell sharply due to the high dollar. This, accompanied by the high interest rate that had cut investment, drove the economy into a recession with twin deficits, but a strong dollar.

7. When a foreign country’s purchasing power parity exchange rate is less than the market exchange rate, the price of goods in that country tends to be relatively cheaper than at home. This tends to make traveling there less expensive.

8. It was likely increasing because imports are positively correlated with national income.

9. The schematics are shown on page 804 in the text.

10. If Japan ran an expansionary monetary policy, it would increase Japanese imports of U.S. goods and make American goods comparatively more competitive, and thereby decrease the U.S. trade deficit. The U.S. dollar would rise relative to the Japanese yen.

11. A contractionary fiscal policy by Japan would have an ambiguous effect on the value of the U.S. dollar because the effect via the interest rate and income paths oppose one another, and the effect through the price level is a long-run effect.

12. Since the effect of monetary policy is to push the exchange rate down in all effects, this will not change the effect presented in the chapter, other than to eliminate the effect through income and replace it with the effect through prices.

13. The effect of expansionary fiscal policy on the exchange rate is ambiguous, while contractionary monetary policy has the effect of increasing exchange rates. The net effect will depend on which influence is stronger.

14. We would use a combination of purchasing power parity, current exchange rates, and estimates of foreign exchange traders to determine the long-run exchange rate of the Neverback. This combination approach can be justified only by the “that’s all we have to go on” defense. Since no


one really knows what the long-run equilibrium exchange rate is, and since that exchange rate can be significantly influenced by other countries’ policies, the result we arrive at could well be wrong.

15. The real exchange rate remains constant since the change in the price level offsets the change in the exchange rate.

16. Both fixed and flexible exchange rate systems have advantages and disadvantages. While fixed exchange rates provide international monetary stability and force governments to make adjustments to meet their international problems, they have some disadvantages as well: they can become unfixed, creating enormous instability; and their effect of forcing governments to make adjustments to meet their international problems can be a disadvantage as well as an advantage. Flexible rates provide for orderly incremental adjustment of exchange rates and allow governments to be flexible in conducting domestic monetary and fiscal policies, but also allow speculation to cause large jumps in exchange rates (and, as before, the government flexibility may be a disadvantage too). Given the pluses and minuses of both systems, most policymakers have opted for a policy in between-partially flexible exchange rates.

17. He will more likely prefer fixed exchange rates. They provide an anchor, which restricts government temptations to use expansionary monetary policy.

18. They will sell that currency, which will force the government to use reserves to protect the currency. Once the government runs out of reserves, it may be forced to devalue the currency, making the speculator’s predictions self-fulfilling.

19. If a country eliminates tariffs, the demand for imports will likely increase. To buy more imports residents of the country will have to supply more of their own currency, depressing their currency’s value.

20. He was advocating significant trade restrictions. These trade restrictions would have likely provoked retaliation by our trading partners, hurting international cooperation, and hurting the world economy.

21. No. It is extremely difficult to affect exchange rates. Since we don’t know what the correct exchange rates are, it is probably best not to try to significantly change the exchange rates determined by the market by foreign exchange intervention. If one is going to change exchange rates, one must change one’s domestic monetary and fiscal policies.

22. The U.S. would want to hold up the value of the dollar to help prevent the surge in import prices that would result from the fall in exchange rates, and to keep foreigners from buying our assets cheaply. Other countries would want a higher value of the dollar in order to keep their goods competitive with U.S. goods.

23. Three advantages of the euro for Europe are the elimination of the cost of exchanging currencies, facilitation of price comparisons and the creation of a larger market.

24. Two disadvantages is loss of independent monetary policy for those countries that adopt the euro and loss of national identity because the country must give up its own currency.

25. A common currency would tie these countries together much more closely, create a larger common market, and make price comparisons among Canada, the United States and Mexico easier. It would be politically difficult since each country would have to give up its own currency, which is a source


of national identity. Since the U.S. dollar would likely predominate, this would be especially problematic for Canada and Mexico. These countries would also have to give up their independent monetary policy. Since the economic conditions in the three countries can differ substantially, doing so would likely be unacceptable for Canada and Mexico.


1. a. This suggests that it was running a capital account deficit since the two largely offset each other.

b. If the private balance of payments was in surplus, China must have a fixed or partially flexible exchange rate regime, because the central bank was selling its currency.

c. It had to be selling its currency to equalize the balance of payments. In the accompanying graph, the Chinese central bank had to be supplying (QS – QD) yen.

d. The value of the yuan would likely rise. That is, it would take more dollars to buy a yuan, or alternatively each yuan would get more dollars.

e. The inflation would increase the price of Chinese goods increasing the real exchange rate of the yuan, and thereby reducing the pressure on the yuan to rise.

2. The graph to the right shows the fundamental analysis of the supply and demand for British pounds sterling in terms of dollars, and the effect of the following changes:

a. A rise in the UK price level causes foreign goods to become cheaper. British demand for foreign currencies will tend to increase, and foreign demand for pounds will tend to decrease. Thus supply of pounds shifts outward from S0 to S1 and the demand for the pound shifts inward from D1 to D0. The exchange rate value of the pound falls from P1 to P2.

b. A reduction in U.S. tariffs would tend to shift the demand for pounds to the right from D0 to D1 as Americans buy more imports from the UK. If supply is at S1, the exchange rate value of the pound rises from P2 to P0.

c. A boom in the UK economy means an increase in its income, causing an increased demand for imports and an increase in the demand for the foreign currency to buy those imports, thus resulting in an increase in the supply of pounds. (This may also set off an expectations effect.) Thus, the supply of pounds shifts outward from S0 to S1. If demand is at D0, the exchange rate value of the pound falls from P0 to P2.

d. If interest rates in the UK rise, there will be an increased demand for its assets, so the demand for pounds will increase from D0 to D1 and the supply of pounds will decrease from S1 to S0 as fewer British investors sell their pounds to buy foreign assets. The exchange rate value of the pound rises from P2 to P1.


3. a. This is an enormous change. In order to bring it about, the Never-Never government would have to run an enormously expansionary monetary policy, reducing the real interest rate possibly to negative amounts and probably generating significant inflation. As far as trade policies are concerned, the government could eliminate all tariffs or even subsidize imports, causing imports to rise and other countries’ currencies to appreciate relative to the Neverback. Of course, since there’s already a large trade deficit, this may not be a viable option.

b. Holders of Neverbacks will demand foreign currencies (increase supply of Neverbacks) since the return on Neverback assets has declined. This is shown as a rightward shift in the supply of Neverbacks. Likewise, potential foreign investors will demand fewer Neverbacks for the same reason. This is shown as a leftward shift in the demand for Neverbacks. The effect is to reduce the exchange rate value of the Neverback to $10 per Neverback.

4. a. Supplier b. Supplier c. Supplier d. Demander e. Demander f. Demander.

5. a. We would suggest buying U.S. dollars and selling currencies of the EU. (Increased growth in the EU will increase European demand for US goods, thereby causing the dollar to appreciate.)

b. We would suggest buying U.S. dollars. Since U.S. interest rates are expected to be higher, the quantity of U.S. assets demanded will rise, and thus the demand for dollars and the price of dollars will increase.

c. Since the market will likely already have responded to the higher expected interest rates, the rise will likely have the same effect as a fall in interest rates. Thus, we would suggest selling U.S. dollars.

d. We suggest selling U.S. dollars by reasoning opposite to that in b.e. We would suggest selling U.S. dollars in the expectation of a decrease in demand for U.S. dollars as

U.S. goods become more expensive. Also U.S.-denominated assets such as bonds will be worth less with greater inflation making foreign assets more attractive to investors.

f. We would suggest buying because, if the U.S. government imposed new tariffs, the demand for imports would decline, shifting the supply of dollars to the left. This would lead to a higher value of the dollar.

6. a. Current account b. Current account c. Current and capital and financial accounts d. Current account e. Capital and financial account

7. a. Three assumptions of the law of one price are that (1) there are zero transportation costs, (2) the goods are tradable, and (3) there are no barriers to trade. (There are many others.)

b. For it to apply directly, labor would have to be completely mobile and of identical efficiency and ability in all countries. Thus, it does not apply directly. However, assuming capital is flexible, there will be significant indirect pressure toward an equalization of wage rates.

c. Since capital is more mobile than labor, we would expect that the law of one price would hold more for capital than for labor.

8. a. If foreigners start believing that there is an increased risk of default, they will require a higher premium to buy U.S. bonds. That is, they will offer a lower price to buy them (demand for U.S. bonds will shift to the left). As this happens, bond prices will fall and interest rates, which move in the opposite direction from their prices, will rise. The value of the dollar will fall as a result of the lower demand for bonds (foreigners will not be purchasing as many dollars). That is, the demand for dollars will also decline, lowering the value of the dollar.

b. Higher interest rates increase the cost of borrowing. This hurts in the short run by reducing aggregate spending and crowding out private investment, a source of long-term growth for the U.S. economy. A lower value of the dollar may increase the competitiveness of U.S. goods in the global economy, but it also makes imports to the United States more expensive, which, in addition to


hurting individuals, may hurt businesses who use imports as intermediate goods in their production processes.


1. a. Country Implied PPP of the Dollar Exchange RateAustralia 1.03 1.68Britain 1.32 1.58Israel 5.78 4.05Malaysia 1.8 3.8Russia 15.7 28.5

All the currencies are overvalued except the Israeli shekel, which is undervalued.b. The Big Mac Index is limited because it measures purchasing power parity only in terms of Big

Macs. People don’t just consume Big Macs. Including more goods in a purchasing power parity index would make the index more accurate.

c. In designing an index it would be important to include a wide variety of goods in order to measure overall changes in purchasing power parity, everything from food and clothing to tires and light bulbs.

d. You could check the validity of the Big Mac index by comparing its implied purchasing power parities in U.S. dollars to purchasing power parities calculated for a wide basket of goods.

2. The answer to this question depends on the country chosen. We chose Brazil.a. The Brazilian currency is the real.b. The currency remained virtually unchanged from 2004 to 2005.c. Brazil has gotten inflation under control. Unemployment is expected to decline as the economy

continues to grow. Fiscal spending is under control. The economy appears to be in good health, which may be contributing to a stable currency.

3. a. The problem facing this country is a chronic trade deficit without sufficient funds to pay for the deficit. Part of the cause is rising inflation.

b. We recommended negotiating with unions to cut wages.c. Negotiations were a failure. The country is on the brink of defaulting on international debt. So,

instead we devalued the country’s currency. The IMF lent the country money to help the economy adjust to the devaluation. Imports became more expensive, making consumers unhappy, but the country’s exports were more competitive. The IMF loan helped mediate the effects of the increased import prices by providing funds for businesses to buy imports.

Chapter 34: Monetary and Fiscal Policy in a Global Setting Questions for Thought and Review

1. At the time that this was written, the dollar had fallen against the yen. This makes U.S. exports cheaper to the Japanese, but may signal weaker investor confidence in the U.S. economy. This may mean foreign investors are pulling out of U.S. assets, which will also lead to lower stock prices and perhaps higher interest rates. A lower dollar also means imports are more expensive, which puts upward pressure on domestic inflation, and makes traveling in foreign countries more expensive. Whether the dollar should be higher or lower depends on who you are. Manufacturers whose sales depend on exports want a lower dollar. Investors likely want a higher dollar.


2. At the time that this was written, the U.S. trade deficit had risen to record highs. Still, it is unclear whether we should want to lower the U.S. trade deficit. The trade deficit was in part due to the fact that the economy has been growing for nine consecutive years. As long as the United States can borrow or sell assets, it can have a trade deficit. On the other hand, the more the United States borrows, the more U.S. assets foreigners own. Eventually, the United States will have to run a trade surplus.

3. If Japan and China ran an expansionary monetary policy, it would increase Japanese and Chinese imports of U.S. goods and thereby decrease the U.S. trade deficit.

4. A contractionary monetary policy by Japan and China would decrease Japanese and Chinese importation of US goods and would make the U.S. trade deficit worse.

5. The answer to this question hinges on what is meant by "justified." If that means that the United States is complaining about the actual negative consequences it experiences because of this policy, such as a higher trade deficit and possibly an artificially high value for the dollar, one can say the complaint is justified. If the argument centers on fairness, the issue is clearly complicated by the question of whether a nation should put its goals ahead of or secondary to international goals.

6. If the recession was caused by a fall in domestic expenditures, we would expect that its trade balance was moving toward surplus. If, however, the recession was caused by a fall in exports, we would expect that its trade balance was moving toward deficit. The G-8 countries were trying to get Japan to boost its economy by increasing aggregate expenditures with expansionary monetary policy.

7. A sudden drop in the value of the dollar would result in inflationary pressures for the United States. To counteract that decline, the United States would have to run contractionary monetary and fiscal policies, both of which would help boost the dollar. Unfortunately, it would also slow U.S. economic activity.

8. To finance the debt the U.S. government has to sell more bonds. Because foreign also demand these bonds (demand is greater), the government doesn’t have to pay as high interest rates as it would if only U.S. investors demanded government bonds. Thus, the interest rate doesn’t rise as much and crowding out is reduced.

9. If the financial and capital account were balanced and remained balanced, the exchange rate for a country that gained a comparative advantage in most goods would rise because the demand for its currency would rise. Demand for currency would rise because foreigners would want to buy more goods from this country because it could produce goods at a lower cost than other countries and therefore could offer those goods for lower prices. Another way to look at it is that exports would exceed imports, creating a trade surplus, which would not be offset by a financial and capital account deficit, so that there would be an excess demand for the currency.

10. The costs of internationalizing the debt are that interest and profits must be paid on the capital owned by foreigners. Future consumption must be reduced to pay that amount.


1. Increased money → increased income → increased imports → increased trade deficit.


2. a. I’d rather be holding other currencies because their price is expected to rise. I could buy them low and sell them high for a profit.

b. The same argument doesn’t hold for China because it has greater concerns than personal profit, such as the effect of a falling dollar on its economy.

c. It might want to buy dollars to keep up the dollar’s value. In fact, since the government can print yuan, it could theoretically buy as many dollars as it desires. It would want to buy dollars if it feels that the declining dollar would harm its exports. A declining dollar makes Chinese exports more expensive for Americans to buy and falling exports would slow the Chinese economy.

3 a. A decrease in a country's competitiveness and an increase in the trade deficit are probably due to expansionary fiscal policy which would increase inflation, reducing competitiveness, and increase income, increasing imports and increasing the trade deficit. Expansionary monetary policy would make the trade deficit larger, but its effect on competitiveness through the exchange rate is ambiguous.

b. If interest rates have risen steadily along with a rise in the exchange rate, it is likely that fiscal policy has been very expansionary.

c. Running more contractionary fiscal policy and expansionary monetary policy would reduce the interest rate and thereby push down the exchange rate making the country more competitive, while maintaining a constant domestic macro policy.

4. a. We would suggest that the IMF require a contractionary policy for both monetary and fiscal policy. I would, however, suggest a relatively more contractionary fiscal policy so that the exchange rate would also fall while inflation falls, boosting exports.

b. This would tend to slow inflation, after an initial burst due to a fall in the exchange rate. The policy, however, would hinder growth and push the economy into a recession.

c. We suspect that the country would not be happy about the proposal because its adoption might lead to a deep recession, which is politically unpopular.

5. The first advice I would give would be to explain that at most, I can talk about tendencies rather than achieving goals. Not all goals are simultaneously achievable. That advice given, I would provide the following recommendations:

a. We would suggest a contractionary fiscal policy, which lowers inflation and the interest rate directly and reduces the trade deficit by lowering income. It will also increase the capital inflow, which will tend to allow an increase in the trade deficit.

b. This would require a combination of monetary and fiscal policies—expansionary monetary policy would lower the trade surplus and lower interest rates, but would cause upward pressure on prices. To offset this, contractionary fiscal policy could be used, but that would also result in increasing the trade surplus and raising interest rates.

c. An expansionary monetary policy will reduce interest rates, depressing the dollars, which will tend to reduce the trade deficit. This will tend to reduce unemployment too. However, the increase in income and prices will tend to increase the trade deficit.

d. This combination of goals is difficult to achieve. Expansionary fiscal policy will tend to reduce unemployment and increase interest rates. But to offset the effect of higher income on increasing the trade deficit, an expansionary monetary policy will have to be implemented to depress the dollar and spur exports to lower the trade deficit. This works in the opposite direction from expansionary fiscal policy by reducing employment and the interest rate. Life is tough.

6. a. One would expect less stabilization, because when income falls, foreign incomes will likely fall too, and thus decrease exports, which will further decrease income.

b. This would increase the possibility of a global recession.


c. Answers on this can differ; an expected answer is that one will need coordinated counter cyclical policy organized through G-8, World Bank, or some other international organization.


1. a. Canada, Mexico, Japan, Germany, China. b. Canada, Mexico, Japan, Germany, China.c. We would encourage them to follow expansionary monetary and fiscal policies.d. Netherlands, Belgium, Australia, Singapore, and Hong Kong.

2. a. Conditionality is the requirement by the IMF that its aid recipients follow certain policies, or conditions, in order to receive aid.

b. Typical IMF financing preconditions include reducing government spending, budget deficits, and foreign (external) debt, reducing the rate of money growth to control inflation, raising real interest rates to market levels and removing barriers to export growth. When implemented, these conditions lead in the short term to (a) a devaluation of local currency, (b) a lower trade deficit and (c) domestic problems including slower growth and unemployment.

c. Mexico, Russia, Pakistan, Thailand and South Korea are examples of countries that have received IMF financing over the past five years.

d. Mission creep is the term used to describe the increasing influence of the IMF on domestic policies of its aid recipients. In addition to the enforcement of financial reform in exchange for aid, the IMF has been accused of advocating an agenda in relation to geopolitics and international security, social safety nets, government corruption, the environment and human rights.

Answers to Questions from an Alternative Perspective

Questions from Alternative Perspectives are designed to get you to think. As such they often do not have a single answer, and full answers considering all the dimensions of the question would often take many pages. The “answers” provided here are not meant to be definitive; they are merely suggestive. If you have a different view argue it. It is through such argumentation that one acquires a deeper understanding of economic issues.

Chapter 1

1. Austrian

Most economists would answer “yes” because they see economic variables, such as unemployment as objective measures, which makes them available as measures for planning. Most economists see only individual preferences, not social preferences, as subjective. Austrians believe in a radical subjectivity, uncertainty with respect to time, knowledge, and matters beyond preferences. This eliminates the possibility of using objective economic analysis as the basis for government planning. For an Austrian study on the nature of time and uncertainty for economics see the work of Mario Rizzo and Gerald O’Driscoll, Jr.

2. Religious

a. The rational choice model assumes that individuals are one-dimensional, that they know what they want, and that they will do what is in their best interest. Addictive behavior undermines that assumption, leading to a conflict between passion and reason.


b. The conflict suggests that we have to be careful not to apply the economic model in cases where that conflict is important, such as in behaviors that have addictive elements. Where there is a conflict between passion and reason there may be greater reason for government to limit access to the addictive good or behavior.

3. Feminist

a. Patriarchy is a social institution in which men exercise a disproportionate amount of social power and are in the position to define the roles of women and children, as well as make most decisions. Because patriarchy affects how people behave and interact, it is an institution. It definitely affects the labor market because those who are in power will make hiring decisions that perpetuate their position of power. For example, husbands and fathers may make, or heavily influence, the decisions whether a woman will look for work.

b. Some economists might argue that men and women are merely expressing their preferences in job choices, while feminist economists might argue that these choices are culturally determined by institutions, or patterns of behavior, such as patriarchy. It is impossible to separate the free market from the institutions within which it is embedded. The free market may not determine the institutions or mores of a society, it operates within those institutions.

4. Institutionalist

a A free market outcome would provide flu vaccine to those willing and able to pay the most for it, which will not include all of those given priority under the rationing scheme.

b The determination of which option is “just” requires delving into theories of justice. The free market solution best mirrors commutative justice—one based on efficiency of exchange; the rationing scheme best mirrors distributive justice—one based on some notion of fairness that favors those with a greater predisposition to illness.

5. Post-Keynesian

a This answer will differ among students.

b. Most students will likely answer this question: no. The standard theory presented in the book is based on the assumption that decision makers have full information of all factors that might influence their decisions: They have substantive knowledge of all possible outcomes of their decision-making and the consequences of each decision. Most likely you had limited knowledge of the pros and cons of all schools when deciding which college to attend, and turned to the advice and norms of a small group of friends, family members, or teachers to help you make a decision.

c Recognizing that you have limited time, knowledge, and ability to compute all possible outcomes of each economic decision, you probably relied on social norms and rules of thumbs to help you make economic decisions (e.g. when you go to a grocery store you continue to buy diet coke even though other diet sodas might provide you with a higher level of satisfaction at a lower price because you are in the habit of buying diet coke and uncertain of the exact benefit the other diet drinks will give you).

d The implication of this behavior is that individuals do not follow the economic decision rule of gaining complete information to optimize their choices, but rely on rules of thumb or habit to come up with a satisfactory outcome even though it might not be the most optimizing.


6. Radical

a It implies that there is no clear-cut distinction between positive and normative economics and that seemingly positive economics has implicit value judgments hidden within it.

b Economics is value-laden. The relevant question about whether the distinction is tenable is whether it is relatively less value laden than the alternatives. That is an open question.

Chapter 2

Austrian

1. In a market economy competition in the market process translates individual actions into actions that are good for society. There is no such mechanism for government; government has a monopoly on power, which allows individuals in government to use that monopoly to achieve their ends, which may not be “good” ends. This monopoly on power makes government less reliable than the market to do good, since the government is not subject to entry and exit as the market always faces. Also, whether or not every individual voice is taken into account depends on the government system, while the market will always include any individual’s voice by either their entry or exit.

2. Religious

a Most people would say that while it might be a component of the goals of society, it is not “the” goal of society. Other goals might include virtues such as kindness and generosity.

b If a country is Christian, maximizing should not be "the" goal of society.

c In a Christian society the paramount goal would be to discern and fulfill the will of God.

3. Feminist

a. Companies definitely think that sex sells products. Just look at the cover of any number of magazines.

b. Sex is used in the advertising of numerous products.

c. All people are subject to abuse by advertising, but women are more likely to be portrayed as objects instead of people, and are therefore at greater risk of exploitation.

d. While men and women may both be used in advertising, typically men are shown to be in a dominant position of power, while women are shown in subordinate positions.

4. Institutionalist

a Back in the 1950s President Eisenhower warned of the Military Industrial complex, which maintains all types of military spending on projects so that they continue to generate jobs for those areas. Senators with power on the appropriations committee inevitably have larger defense expenditures in their districts than senators not on the appropriations committee. This spending must come from somewhere, and the most likely place is from consumer goods.

b The short-term consequence is a loss in consumer goods. The long-term consequences are potentially much more serious, because in order for the military to justify the expenditures, wars are necessary; thus the production of military goods over consumer goods can increase the probability of wars. Some might


argue that the latest Iraq war is an example, with Halliburton benefiting from it, and the former head of Halliburton, Vice President Cheney, leading the group pushing for the U.S. entrance into the war.

5. Radical

a Yes, for many low wage jobs it does, although technology is changing that to some degree.

b The policy implications are for society to take into account in its policy decisions not only what is produced, but the methods and means of production.

Chapter 3

1. Austrian

a The dangers of government intervention and support of activities is that once intervention begins, it is hard to limit. For example, if the state supports children the state will want control of those children, which will impinge upon individual’s freedoms.

b. If governments financially supports families it might induce them to attempt to limit the number of children that families can have, such as the People’s Republic of China did. Alternatively, the government may want more children for an increase in the size of the military and, in order to achieve its ends, limit birth control, as Romania did in its socialist period, and force individuals to have more children.

2. Religious

He meant that strongly held religious beliefs can lead people to violate the law, because they hold the law of God above the law of the state. There is debate about whether he is correct, but as can be seen with some religious fundamentalists who incorporate violence into their belief system, the state may face serious problems when people rely on religion as their primary guide for action.

3. Feminist

a Economists know relatively little about intra-household decision-making and have generally assumed that households have a single joint utility function. In one popular theory, those with power (parents) are assumed to be benevolent while those without power (children) are assumed to be selfish. Widespread wife and child abuse as well as evidence for unequal food distribution within the family which harms women and children clearly undermines this simply notion of household decision-making. b

Absolutely. Bargaining is likely to take place among individuals within a household. A child might agree to eat certain foods in exchange for getting a toy, for example.

c The ability to walk away from the bargain is what gives someone power. Paying the bill also gives power. In families with separate checking accounts, the individual with higher income is likely to have greater bargaining power. d Individuals are more likely to act cooperatively within a household because there are additional mechanisms besides money to maintain accountability.

e It makes sense within the theory of social behavior of groups of various sizes and strength of relations.

4. Institutionalist


The dilemma is obvious and represents an inherent conflict in a society whose values are greatly influenced by the Judeo-Christian ethic of charity towards all, and the free market ethic which emphasizes the unbridled pursuit of self-interest. Here discussion can be used to delineate concepts of justice and the difficulty of universal application.

5. Radical

a To some degree consumer’s desire influence what is produced, but with so much advertising, it is difficult to determine people’s true desires, and whether those desires are being created by business.

b Again, views can differ on this issue, and it is difficult to say which view is correct.

c The other group that has some sovereignty is business. If business sovereignty holds, then the analysis based on consumer sovereignty is misleading, and should not necessarily be followed.

Chapter 4

1. Austrian

It is difficult to estimate supply and demand curves without a market. Consumers have an incentive to overstate demand, while suppliers have an incentive to overstate costs. Without the need to pay in a market, it is almost impossible to get individuals to reveal their true preferences. Central planners tried many incentive schemes to get around this problem and never completely succeeded. One thing that did abate this problem was to allow grey markets—semi-legal markets where individuals’ true supply and demand were revealed. Overall, the socialist experience suggests that central planning for a large country cannot adequately reveal consumers’ preferences.

2. Religious

a There is some truth to this saying; if people were only selfish, they would lose much that makes them human.

b Yes, there is a conflict, although how strong the conflict is a matter of debate.

c No probably not, although, again, the answer is debatable. Markets would not work well if people were purely selfless. In many ways the society would simply not need markets.

3. Feminist

a Women and men have not been equally free to choose the amount of education they receive. Established in 1833, Oberlin College was the first co-educational college. By the 1880s, 30 percent of all undergraduates in the United States were women. Today women receive 58 percent of all undergraduate degrees.

b Women did not have the right to vote until 1920. Women today continue to face difficulties in reaching the higher levels of administration in commercial enterprises.

c To the extent that women are not free to choose, they are not represented in the analysis of supply and demand. The questions that economists consider, and therefore the models economists use, are likely to have been affected by the fact that women have less representation in the field of economics. Thus, if economists base their conclusions on the models alone, they cannot be objective.


4. Institutionalist

You will want to examine the determinants of supply and demand, and the conditions under which they may or may not hold. There is also the problem of interdependency. Discussion of each should include problems of measurement since, ultimately, science requires any and all propositions to be tested. Many of the ideas from which economic analysis is derived are beyond direct systematic measurement. Thus, economic analysis is, in many respects, a belief system: we act as if it were true because we believe it to be true.

5. Post-Keynesian

a Consumers follow rules of thumb for a variety of reasons, one being to save time. Given that much of our consumption is repetitive (that is, buying the same brand of soda, soap, toothpaste, and so on at the same grocery store). We find that much of our consumption is based on routine habits that give us a satisfactory outcome that might not be the optimum.

b Our decisions to buy goods are usually based on past behavior—habits that have been incorporated in our consumer behavior. This behavior could have come from family, friends or advertisement and affects our consumption more than the desire to optimize. This allows room for advertisement and social norms to determine our consumption rather than price.

6. Radical

The hiring decisions of multinational corporations don’t appear to be very responsive to wages and working conditions, suggesting that few jobs are likely to be lost to better paying wages. In addition, labor demand is not fixed by changes with public policy and can be augmented by public spending and tax policies.

Chapter 5

1. Austrian

I might decide to hire my friends, or to hire those with whom I like to work—such as those from a preferred ethnic group or gender. Is doing so fair? Fairness is a judgment question and judgments differ. From most people’s perspective, such methods are not fair. The problem is that wage controls set an equal base wage level, but leave open possibilities for other inequalities. Rather than helping the least skilled end of the labor pool it prices them out of the market, increasing their unemployment, and promoting other forms of discrimination. Austrians believe that these market distortions are not good for society and prefer little or no government intervention.

2. Religious

This is a judgment question and judgments differ. Christians believe that people should care about society, not just about themselves. So, since spending $20 of your own would likely free up $100,000 of Medicare resource for someone else, Christian values would suggest choosing to spend the $20. A primary Christian value is stewardship.

3. Feminist

There are likely a number of reasons why women are paid less than men. Part of the pay gap may be explained by differences in work experience, education, on-the-job training, and work interruptions for


women. Economists typically measure discrimination as a residual – that part of the pay gap that remains “unexplained” after accounting for these factors. The second part of the question is a judgment question and judgments differ. A law that requires firms to pay equal wages to those with comparable skills may be difficult to implement. How would the skills be assessed? Others argue that assessment itself would add costs to a firm’s production and increase product prices. However, if the reason for the pay gap is discrimination, the law can change values and make it more costly to discriminate. Since discrimination necessarily implies that hiring is on the basis of something other than productivity, reducing discrimination may promote efficiency. Feminists generally support such laws.

4. Institutionalist

a We can see cultural evolution through history; the appendix to Chapter 3 can be used to trace the cultural evolution of the market system. Here it is important to stress that religious values and social relationships had to evolve to accommodate the needs of the new forms of economic organization that emerged. Markets change overnight and increasingly require rapid adaptation by individuals, which can cause shocks to social relationships. One might question the long-term (in)stability caused by market evolution. The outcomes of biological evolution are driven by natural selection: those organisms with traits giving it a competitive edge in the competition for limited energy propagate; others disappear. In this context, the only purpose is to successfully reproduce. Some economists believe that the purpose of cultural evolution is betterment of the human condition for all.

b In the U.S. market evolution has elevated living standards for everyone relative to those of say 1775. We see access to fresh fruits and vegetables year round; many diseases have been eliminated; life spans have increased greatly. Yet, we are social beings who are aware of our social position. One may be well fed, but one may still feel socially destitute because one’s relative level of welfare is many magnitudes below that of others. In this sense, market evolution has failed to contribute to betterment.

5. Religious

a Islamic women wear Burkhas both because it is a tradition and tradition governs much of our behavior. For many Muslims who wear Burkhas because they see the Burkha as celebration of the sanctity of women. This makes it much more than a simple good; it is a representation of their faith.

b This is a judgment questions and judgments differ.

6. Radical

a Today’s rent controls are designed to be less invasive than the ones described in the book, and thus they do not have the strong effects described there. they still have some effects, and the policy question is whether the income redistribution effects they have are sufficiently desirable to warrant the costs of the policies.

b This is a judgment question; economics can tell one about what the costs and benefits of a mechanism are; not about what is an appropriate mechanism.

c This again is a judgment question that requires an integration of normative issues into the analysis. Most mainstream economists would argue that it is better to deal with the underlying income distribution issues, rather than specific ones, and that one must consider the problems of government intervention. Radical economists would argue that, while they say that, they seldom do deal with those problems.

Chapter 6


1. Austrian

a There is no hard and fast rule about how to distinguish the short from the long run. A good off-the-cuff answer would be that the long run is a period of time in which sufficient substitutes for the good arise. The question then becomes: What is a sufficient number of substitutes?

b The concepts have far less meaning; all individual decisions are made as forward looking decisions, and such forward looking decisions do not fit nicely into the time frames in the models. The elasticity measure is more an exercise for students than an actual number that firms use.

2. Feminist

a This may happen because white men are perceived as having greater bargaining power and more information. Women may be perceived as more likely to buy on impulse. And both women and blacks may be perceived as being less informed about the value of automobiles. These highly stereotypical representations reflect cultural bias and may explain why women prefer to buy automobiles for a fixed price on-line over bargaining at dealerships.

b Price discrimination is allowing for racial or sexual discrimination because women and blacks are perceived as having inelastic demand curves. The car dealers are likely to drive a harder bargain with women and blacks, whereas they may be more willing to give in to a white male. (Source: Ian Ayres, “Fair driving: Gender and race discrimination in retail car negotiations.” Harvard Law Review 104 (1991): 817-72))

3. Religious

a It may be a useful distinction, but it integrates positive and normative issues, and mainstream economists generally attempt to avoid such an integration. Many religions incorporate stewardship of the earth and low consumption. For these religions this distinction is important to using resources wisely.

b Yes, it would fundamentally change the nature of economic analysis.

c Mainstream would argue that it does not, because normative issues can be added later; some religious economists would argue that it does because the normative issues are generally not added later. The bias is that elasticities are given, not pliable or potentially impacted by calls toward virtuous behavior.

4. Institutionalist

a It suggests that there are few job alternatives and few alternatives for employees.

b It suggests that while the supply demand model makes it look as if the minimum wage will only cause problems, a more nuanced view of the problem suggests that there may well be a role for the minimum wage.

5. Post-Keynesian

Because it takes time for individuals to substitute one good for another you can have cases where the short and long-run elasticities are very different. By raising prices with different elasticities in the short and long run will affect the total revenues of the firm , that is, increasing them in the short run but


decreasing them in the long run as consumers substitute one good for another. Depending upon its degree of market power, the firm can manipulate its prices to maximize its return given different levels of elasticities, or the firm, besides maximizing profits, might be interested in its market power to control the supply and substitution ability of consumers.

6. Radical

a Elasticities do reflect power. When one group holds disproportionate power over another, they can control the elasticities of the supply and demand of the goods. Thus, they can influence the perceived demand for labor, making it seem highly elastic, so that wage increases are difficult for workers to achieve.

b This is a normative question that mainstream economics provides little guidance on. Radical economists believe that something should be done.

Chapter 7

1. Austrian

a Taxation without representation can be seen as robbery because it is not a tax that was chosen by elected representation. To the extent that our elected representatives follow the will of their constituents, taxes are not robbery because those taxes will be used to fund projects supported by society. To the extent this is not true, taxes are robbery.

b Many Austrians would support a voluntary approach to government finance. This would lead to a much smaller government and much more freedom for individuals. Austrians are not against collective action per se, but they are against involuntary transactions.

3. Feminist

a The issue of taxation leaves out the fact that, to the extent that women do not make the buying decisions, their surpluses are not accounted for in the model. Also, to the extent that women are not in government positions that decide taxation, their desires regarding taxes are not represented.

b One could frame the question so that it involves normative issues.

c Yes, women would get less weight than men in the model of consumer surplus.

3. Institutionalist

People with the least money to spend necessarily—for example, a single dollar—receive no surplus. Those with the most money, who were willing and able to pay more for each unit yet need not do so, receive a great deal of surplus. Thus, the distribution of income, which is itself a function of access to and control of the production process, determines whose welfare is maximized.

4. Radical

Econometric evidence suggests that the payroll tax is highly regressive in both competitive and non-competitive labor markets. Empirical studies find that in competitive markets with an inelastic labor supply and little bargaining power, workers bear the burden of their share of the payroll tax and much of the employers’ share in the form of wages that are lower than in the absence of the tax. In non-


competitive markets, workers have a more elastic supply and more bargaining power, and the employers are unable to shift their share of the payroll tax backwards onto labor. But empirical evidence suggests that employers who sell their products in non-competitive markets can shift the burden of their share of the labor tax forward onto consumers in the form of higher prices for their products.

5. Religious

Economists’ surplus approach weights people’s views by their income, and thus is not directly consistent with this view, although there are some subtle issues that could reduce the disparity.

Chapter 8

1. Religious

a This is a judgment question; most people will answer that no, not all decisions are economic decisions. Some decisions are based on one’s values, or what the Divine has called them to do.

b The decision of tithing is normally thought of as a duty to God, not as an economic decision. If it is seen as an economic decision, the process of tithing is partially undermined.

2. Austrian

Austrians believe that only the market can reveal people’s true demand, and without the market there is no way of knowing people’s true demands.

3. Feminist

a Households differ in how they make decisions, but in large parts of the world, men have a predominant voice in household decision making.

b Yes, bargaining generally takes place, but the degree of bargaining depends on social mores.

c Social mores, taught psychology, legal structure, and ability to withdraw from the relationship, tend to give individuals power.

d People tend to act somewhat competitively and somewhat cooperatively in most walks of life.

4. Post-Keynesian

a Following Thorstein Veblen he believed that people engage in what he called conspicuous consumption, which is contrary to the views of neoclassical economics. He argued in essence that consumers’ preferences are endogenous and depended on prices where neoclassical economics argue that preferences are exogenous and independent of prices. The implication is that you do not have consumer sovereignty but consumer dependency.

b It might be difficult to distinguish between goods that are bought because people want them or being influenced by advertisement and conspicuous consumption.

5. Radical

a To impose equal burden in lost utility, the tax rate on the rich would be higher than the tax rate on the poor.


b This would eliminate the pressure to tax different incomes at different rates. Income tax rates would not vary with income and the income tax would be proportional

c Assuming one wanted to maximize utility of society, if this were true and if one wanted equal levels of marginal utility, one would tax the rich until their income reached that of others.

Chapter 9

1. Austrian

a Entrepreneurs generally develop broadly-defined business plans, which include expected costs and expected market conditions, before entering a business. These costs and market conditions, however, are highly uncertain; the tables should be seen as simply an exercise for students. They lose the uncertainty under which real world decisions are made.

b Ultimately businesses must make decisions based upon highly imperfect knowledge, knowledge that they get by entering the business itself. Models that do not show the uncertainty and risk of business miss an important element or real-world markets.

c Governments have even less information than businesses in making decisions, and government is not gaining information by running the business. The implication is that government should be very hesitant to intervene in the market.

2. Religious

a This is an empirical question, and can only be answered by empirical evidence. Assuming no prosecution is possible, the standard model would suggest that firms would do so, although doing so would create negative publicity for them, which would limit the amount that they do.

b From most religious perspectives, they should not do this because it is unethical. They should do what is good for society.

3. Feminist

a. Probably not. There seems to be no objective reason for this. It is possible that women sell men’s underwear because men prefer to buy underwear from women and men sell refrigerators because women perceive men as knowing more about gadgets and therefore trust men, or at least firms believe this to be true. It is also possible that men tend to be given the higher paying jobs, and refrigerator sales come with commissions, because they are perceived as the primary “bread-winner” whereas women’s income is perceived as supplemental.

b It is also possible that because of traditional roles of women and men, women indeed know more about clothing, including underwear, and men know more about appliances, such as refrigerators.

4. Institutionalist

To the extent that consumers’ preferences are shaped by firms, people are maximizing the welfare of the owners of businesses when they make consumption decisions. If consumers, however, perceive their preferences to be real, is there really any difference between maximizing their own welfare and the welfare of the firm? The student should first, discover that we are slaves to Madison Avenue, second,


focus on the information flows that lead them to become slaves, and third, decide the first step towards liberation is to kill their television!

5. Radical

This approach reduces Wal-Mart’s fixed costs and raises their variable costs, allowing Wal-Mart to alter more of their costs with production levels, and boost their profits.

Chapter 10

1. Austrian

True costs are revealed through the workings of the market process. Without the market, one has little sense of the true costs.

b There is probably no one optimal method of finding costs, but experience in an actual competitive market place is probably the best that firms can do.

2. Feminist

a To the extent that women provide less detail about their job, they lead employers to believe that they know less than men and therefore have less experience.

b Women who have completed their formal education may periodically withdraw from the labor force. Working without pay in volunteer work for non-profits as well as years of experience as a household executive provide women with the experience of multitasking, delegating, managing schedules, and carrying out complicated tasks required on PTAs and other volunteer positions.

3. Religious

It suggests that differences in productivity are not inherent, but are matters of luck and circumstance, and it thereby undermines some aspects of the moral arguments for paying more productive people more.

4. Institutionalist

a An example is large-scale hog farming. The environmental consequences of large-scale hog farming are enormous: contamination of ground water, destruction of fresh water lakes, streams and rivers (deadly algae blooms in tidal ecosystems). There are also problems with airborne pollutants, not the least of which is ammonia. The presence of a large-scale hog farm will reduce property values in the associated area. The conclusion is that packaged pork is a subsidized commodity.

b The implication for policy is that a system should be set up that requires firms to internalize their costs. One way to do this is to tax producers based on the costs that they externalize. Another option is regulate the production process to reduce or eliminate the environmental consequences.

5. Radical

If the empirical work that shop floor participation will improve productivity is true, one would expect that firms that adopt it would out-compete firms that do not. One reason why it might not be done is that giving workers a larger voice in the work process might undermine employers’ control of the production process and reduce some of the prerogatives of bosses, which is ideologically unacceptable.


Chapter 11

1. Austrian

a The theory of perfect competition does not reflect the real world, at least not to the satisfaction of Austrians. In fact, the theory’s assumptions of product homogeneity and perfect knowledge precludes much of what actual competition in the real world does. Also, innovation, which is a central aspect of real-world competition, is unexplained by this model.

b If the government has any role at all, it might have a role in establishing and protecting property rights and enforcing contracts.

c The danger of government intervening in the market is that will likely undermine competition. Individuals will have an incentive to lobby government to establish and enforce rights to their advantage and the government will have the incentive to serve itself and not the market.

2. Feminist

a Given the assumptions, if the discrimination is costly, it is difficult for discrimination to persist in a perfectly competitive industry because firms that do so will have higher costs and will not be able to offer their goods at the same low price as their competitors (unless all firms are equally discriminatory). However, if all firms discriminate against blacks, for example, then the market would not punish those firms that discriminate. That, however, would not be a perfectly competitive industry since characteristics of the buyers and sellers matter, and in perfect competition, they do not.

b In some ways, eliminating discrimination, by reducing costs, will increase economic efficiency because firms that will be better able to assign jobs according to comparative advantage will have a competitive advantage.

3. Institutionalist

a As a market structure, perfect competition explains nothing in the real world. It exists only as a fiction in the minds of economists and their students who are taught this myth as truth. Its functional role is to legitimize the belief system that free markets are the best of all possible worlds. This is a good place to introduce students to Candide and contemplate why some proclaim economists as Panglossians.

b The text spends so much time on perfect competition because the model provides a useful starting point for understanding firm behavior. Students need to be reminded, however, that it is only a starting point and all the issues that are not brought into the analysis must at some point be considered.

4. Post-Keynesian

a Unless the firm has complete knowledge of its costs and marginal revenue it cannot produce at the optimum profit-maximizing level of output.

b Because of instrumental or bounded rationality where firms have limited knowledge to maximize they can follow the work of Herbert Simon who developed a model of a payoff where you have outcomes that are satisfactory or not. Once a satisfactory outcome is found, even though it is not the optimum the firm will stop searching and accept it even though it is not the optimum profit-maximizing level of output.


5. Radical

a The supply of the Internet has aspects of competition, but also aspects of monopoly.

b It would be difficult. The need for agreed-upon rules to conduct business requires a level of conscious planning that is difficult to organize in industries with many providers and low marginal costs, which makes marginal cost pricing (the equilibrium of a competitive model) unlikely.

Chapter 12

1. Austrian

An Austrian would say that this suggests that governments should have only a minimal amount of power. Power should reside in the mechanism of the marketplace.

2. Feminist

Men tend to have a monopoly of the best jobs if, by best jobs, one means the highest-paying jobs. The monopoly is protected by limiting entry—the “old boys network” for hiring employees. As more women become entrepreneurs and can under-price firms that discriminate against women, the monopoly may erode.

3. Institutionalist

a As neither the rules of the game nor the goals of its players have changed, Veblen’s analysis remains poignant from Rockefeller to Gates. A good class exercise would be to summarize Rockefeller’s techniques, then have students find parallels in the Microsoft trial summarized in the text.

b The implication is that government has a role to play in enforcing fair business practices.

4. Radical

a This is a normative question that has different answers depending on one’s normative views. Radical economists generally believe that the length of patents should be reduced.

b There is an argument that can be made for each. Not giving the patents in the first place might well reduce the medicines that are developed, but it would significantly lower the costs of medicines that are developed. A strong argument can be made that the length of the patents should be shorter than they currently are.

c Arguments can be made to this effect; it depends on the characteristics of each industry.

d Research in areas where there are no patents could be publicly funded, or funded by foundations.

5. Religious

a This is a debatable question that the courts will have to answer. Currently, they have allowed life forms to be patented.

b Most religiously oriented economists would argue that life forms should not be patented because life is created by the Divine. No one has the right to usurp that position.


c It might undermine some people’s conception of God, but it need not, since one still has to deal with the problem of who created life and the existence of matter itself.

Chapter 13

1. Austrian

a Firms differentiate their product in many ways, for example, through innovative packaging and marketing.

b There are very few examples of exactly homogenous products. Some vegetables might be homogeneous, but even here differences exist, for example Vidalia onions and just plain sweet onions.

c It suggests that very few real-world markets are perfectly competitive.

d It is difficult to say whether this market structure is fair or not; it just “is”. Some may believe that packaging and marketing expenditures do not benefit society, but that is a value judgment upon which people reasonably disagree. Nothing should be done about it because such product differentiation is at the core of competition among firms. It leads to innovative products that will benefit society.

2. Feminist

If women are more likely to collaborate and trust others, as empirical evidence suggests they are, women may be more likely to avoid the prisoner’s dilemma problem, since they will not be as willing to believe that the other prisoner will follow their self-interest.

3. Institutionalist

a The distinction between real and unreal is one of perception. Perceptions depend upon interpretation of information flows. These flows are engineered to stimulate a perception that a difference is important, thus real.

b Because perceptions are inherently subjective there is no objective universal answer to a.

c To the extent that our preferences are based on advertising and society, there aren’t even objective individual answers to a or b. Economists assume preferences are given, but they are social constructs purposefully constructed to advance vested interests.

d My answer suggests that the benefits of the market are themselves an illusion and not objective.

4. Post-Keynesian

Market structures may emerge by the strategic competitive behavior of firms. As firms work through different kinds of strategies of competition, collusion and co-operation, they might be creating their own market structure though not necessarily aware of what they are doing.

5. Radical

a Based on that evidence one would say that the level of competition has decreased. However, an argument can be made that competition has increased in some aspects of the economy because of


globalization, which makes the world the relevant market.

b The U.S. economy is far from perfectly competitive, but it is also far from monopolistic. Economists differ on where the U.S. economy is in this broad range.

Chapter 14

1. Austrian

a For Austrian economists, the behavior and incentive-problems faced by managers and politicians are similar. They both reflect monitoring problems. Managers have more information than shareholders, and politicians have more information than citizens. Managers and politicians could take advantage of this asymmetric information to fulfill their goals instead of the goals of their constituents.

b A key difference between managers and politicians is that it is much more difficult to vote out a politician than it is to fire a manager.

c This difference suggests that that politicians have a greater ability to take advantage of their power for personal gain than do managers.

2. Religious

a Heads of religious organizations tend to receive less than CEOs in profit-making institutions.

b There are many possible explanations. One is that money is less important to heads of religious organizations. Another is that they are less productive.

c This is a normative question, but most religious economists would accept some difference, although, from their normative view, they see the compensation of some CEOs as too high.

3. Feminist

As of 2005 only 1 of the 12 was a woman. There are many reasons for this. One might be discrimination against women as executives – the “glass ceiling.” Another may be that at the time that men are building their careers, women are having children and that women tend to be left with a greater proportion of the household responsibilities. Another reason is that women have broader goals, such as caring for their employees by providing more generous benefit packages that may conflict with the goal of earning the highest salary.

4. Institutionalist

If the rate at which a renewable resource is extracted is determined by financial markets, then at, say, a 10 percent rate of return, only biological resources growing faster than 10 percent can be retained. Financial optimality requires all others with a financial value (a positive price) be harvested to extinction. This is the logic of the free market when applied to natural resources.

5. Post-Keynesian

a In a world where consumers and firms face uncertainty and incomplete information, “rules of thumb” make a lot of sense and allow one to make decisions in the real world of complexity.


b Using rules of thumb in face of uncertainty allows the firm to come up with a satisfactory, though perhaps not the optimum, outcome. For example, by following rules of thumb that represent the behavior of the majority, though not optimizing for the firm, the rule provides less uncertainty about the future.

c One implication is that when reality is too complex, individuals and firms rely on the opinions of others. This creates social norms and conventions accepted by the majority such as financial ratios where outcome is not based on individual optimizing but group behavior and making economic decisions based on conventions.

6. Radical

a If a group can control the marketplace of ideas, they can control what people believe and what government does. Having such control is powerful, and in our economy we have institutions, such as a free press, and a university system, which is designed to prevent, or at least minimize, such control. Whether they work is debatable.

b This is a difficult question that has no one answer. Most economists would support maintaining constant vigilance and protecting the free market place of ideas. That is why this book includes an alternative perspectives section.

Chapter 15

1. Austrian

a The market process will likely always include some amount of monopoly power. It takes time for firms to enter the market and compete with a firm that has introduced new products to the market. Sometimes firms will dominate a market because of the quality of their products.

b It is difficult to say whether government should use high or low prices as an indication of monopoly power. A firm could sell below cost to run its competitors out of the market. Alternatively a dominant firm that faces little competition will likely charge high prices. Prices must be viewed within dynamic market conditions.

c What is viewed as high or low is subjective. One measure would be to compare the market price with the cost of production. This measure is suggested because in a perfectly competitive market, price will equal marginal cost. The problem with this approach, however, is that a monopolist has less of an incentive to keep its costs low because it can charge high prices.

2. Religious

a Most religious ethical systems see “heedless self interest” as bad morals, because they see the need to take others into account. Remember the Golden Rule: “Do unto others as you would have them do unto you.”

b When self-interest leads to undesirable social results, as it sometimes does when market failures exist, it is bad economics.

3. Institutionalist


They use power any and every way they can, from supporting election campaigns, through lobbying efforts and running public information campaigns. They do it using patent laws and through “competitive”—read that as predatory—pricing strategies. They do it by forcing suppliers to give them scale discounts: they do it by forcing retailers to exclusively carry their product line. Only the imagination is the limit here.

4. Feminist

a Tocqueville was describing what feminist economists call the dual spheres notion – the notion popular throughout much of American history that a woman’s place is in the home and a man’s place is in the workplace. The division of labor was justified because it was assumed that there were inherent differences between men and women. Increasingly those “inherent” differences between men and women are seen as culturally derived.

b Feminists believe that dividing the work of women and men in society is not specialization based on comparative advantage but instead based on socially determined types of appropriate work.

6. Radical

a They likely occur because they are in the interest of the managers who make the decisions to merge.

b This is a question that would take much research to answer. Arguments can be made on both sides.

c Radical economists would favor stronger antitrust laws and more antitrust enforcement.

Chapter 16

1. Austrian

Once the ability to compete by a willingness to work for less is removed (a seller may sell a good for a lower price), rationing moves to a non-monetary realm. This reduces the cost of exhibiting prejudice since all workers at the minimum wage level will be priced the same.

2. Religious

a Most Christians would see moral problems with discrimination, but as economists there is a need to see the pressures toward discrimination to carefully consider the ramifications of any law.

b Christian economists are committed to a Christian ethical position that requires them to take ethical views into account. Other economists may be so committed, but do not need to be.

3. Feminist

a This statement reflects the fact that society has increasingly accepted women in the paid labor market, but still holds on to the notion that they are also ultimately responsible for work within the home as well. This is what Arlie Hochschild and Anne Machung have referred to as the “second shift.” It results in increased stress on married couples as these duties are negotiated and may affect employers’ views about women as employees.

b If women who are relatively more capable than men in market jobs are not working in market jobs there will likely be less output than there otherwise would be.


4. Institutionalist

People work for far more than pay. They work for job satisfaction, and being an economist might provide more job satisfaction than being in business.

5. Radical

a Radical economists emphasize nonmarket forces much more than do mainstream economists.

b This is a judgment question; judgments differ; Radical economists believe that they are unfair.

c This is a judgment question; judgments differ; Radical economists believe they do.

Chapter 17

1. Institutionalist

a The costs of transfers is a subjective judgment. Most people would say that the costs of transfers to the rich are less than the gains of those same transfers to the poor. In terms of dollars, transfers cost the rich about 4 percent of total personal income (about $10 trillion in 2005) or about $400 billion.

b Because most of their income is discretionary (not needed for food and rent), they have considerable financial resources available to change the transfer structure.

c The bottom quintile has about 1.8 percent before transfers. While transfers nearly double their income, they have little to no discretionary income: nearly all of it goes to necessities such as food and rent.

2. Religious

a Following the Old Testament, it suggests that Americans are righteous people. Following the New Testament, t suggests that for some people it is going to be very difficult getting through the eye of the needle.

b This is a judgment question; judgments differ. Religious economists would likely suggest government institutions that support religious beliefs. The Bible encourages people to be generous with that they have and to help others.

3. Radical

a It leaves about $4 a day per person for food.

b It leaves about $8 a day per person for other things.

4. Austrian

a I would probably not like it.

b It would likely reduce my incentive to work.

c It would likely reduce his incentive to work, and increase his incentive to increase transfers from government.


d If I voluntarily gave the money it would not reduce the incentive to work; it might increase it.

5. Feminist

a This is a judgment question; judgments differ. From many feminist economist’s perspective, more government programs to achieve more equal distribution of income would be effective.

b This is a judgment question; judgments differ. Many feminist economists would argue that daycare could be subsidized, and flex-time could be encouraged by public policy.

Chapter 18

1. Austrian

a Yes, it could.

b In Austrian economists view, the structure of the micro course is slanted toward government action, and government failure is not given sufficient focus.

2. Religious

a There is some truth to this saying; if people were only selfish, they would lose much that makes them human.

b Yes, there is a conflict, although how strong the conflict is a matter of debate.

c No probably not, although, again, the answer is debatable. Markets would not work well if people were purely selfless. In many ways the society would simply not need markets.

3. Institutionalist

Intervention becomes acceptable if it improves the capacity of the provisioning system to better the human condition. The result is that policies to provide things like universal health care are not questions of “if, but of “how”?

4. Post-Keynesian

a Asymmetric information is likely to exist in the used automobile market.

b The seller of the car could offer a warranty for the car.

c It could, since there are no barriers to entry, but it seems to be very expensive for small firms to create such warranties, leaving a potential for government action.

5. Radical

a Providing safe drinking water has public goods aspects to it; it benefits the entire community, not just the individual, and many of the costs are joint.

b This is a judgment question; judgments differ. Most Radical economists believe that private provision of water is bad policy.


c From a Radical perspective, public provisioning of basic services makes the most sense.

Chapter 19

1. Austrian

a American agricultural policy helps keep nations poor by flooding the world market with cheap subsidized food, making it difficult for developing countries to compete.

b There are many different arguments they use. For example, they might point out that subsidies prevent the market from working, and that the subsidies more than offset the foreign aid they receive. But ultimately, it is internal politics, not theoretical arguments that lead to government subsidies of agriculture.

2. Religious

This is a judgment question; judgments differ. Some religious economists believe that it suggests that because we are made in the image of God and since and since we share much the same structure as animals, we should treat animals more humanely than we currently do.

3. Post-Keynesian

a The reason is an increase in productivity and competition.

b It suggests that farmers will be increasingly pushed off the land. The implications for policy of this fact is a judgment question, and judgments differ.

4. Feminist

a There is no logical reason; historical precedent seems to be the biggest reason.

b It suggests that daughters are treated less equally than sons.

c One possible reason is that the boys have moved off the farm because they have better prospects, and the daughters are the only ones left to run the farm. Also women may have stronger ties to community, or women may simply be expressing their preferences to do what male children have been allowed to do in generations past – choose farming as an occupation.

5. Radical

a It is highly likely that agribusiness has hurt small farmers and farm communities.

b It has hurt small farmers by selling at a lower price than the small farmers could produce at, and thereby forcing them out of business.

c Yes, small farmers tend to reinvest their profits in the farm and community; agribusiness tends to look more broadly as to where to invest.

Chapter 20

1. Austrian


a Often, policy goals do not match outcomes. For economists this is a serious problem that goes under the name government failure.

b Politicians often have a short-run policy horizon, which means the goals matter much more than outcomes, especially if the politician will be out of office by the time of the outcome.

2. Institutionalist

a An example of a market failure is in the music provision market, where there is an almost zero marginal cost of providing music to another person, but the businesses do not allow people to hear it in order to protect their monopoly.

b A free market advocate would likely say that nothing should be done, since the business is simply following its self interest.

c An Institutionalist would likely look for another institutional structure that he or she believes would achieve a preferable outcome.

3. Post-Keynesian

a Social norms are created by society as a whole. It is difficult to attribute their creation to a single group.

b Norms hold society together. Without them there would likely be no society, which would make almost everyone worse off.

c Norms make policy analysis much more difficult. The right and wrong answers that follow from the markets turn into shades of grey.

4. Radical

a This is a judgment question and judgments differ. Radical economists tend to believe that cost/benefit analysis is not an especially good tool.

b Yes, it tends to work better when the issue being studied does not have large distributional consequences or moral dimensions of the problem.

5. Religious

a This is a judgment question and judgments differ. Religious economists tend to believe that economists worry too much about the advice being scientific, and not enough about whether it is good advice.

b The presentation of economics would likely be less focused on abstract models and more focuses on the nuances of policy decisions.

Chapter 21

1. Austrian

An Austrian would tend to agree with this statement because they believe that people tend to know what is good for them much better than government

2. Religious


This is a judgment question and judgments differ. A religiously oriented economist is more likely to give weight to such issues than is a mainstream economist.

3. Post-Keynesian

a Outsourcing tends to undermine the bargaining power of U.S. workers.

b It will likely lead to lower U.S. wages than otherwise would have been the case.

c Since lawyers do not face competition from outsourcing, it will not tend to lower lawyers’ wages.

d Yes, given that lawyers tend to have more influence in government, they would likely institute policies to limit outsourcing.

4. Radical

a This is a judgment call but an argument could be made that since there are economies to scale in the production of cloth and the production of cloth has linkages to other important industries (for example, chemical and machine making) that are key to an initiating industrial revolution that are missing in the production of wine, Ricardo’s advice was self-serving for England.

b No, I probably would have advised them to specialize in wine making.

5. Radical

a Some Radical economists would argue that they did not follow that strategy because they were protecting their infant industries.

b Some Radical economists would argue that it suggests that economists’ call for free trade might be self-serving for developed economies because free trade allows them greater access to the markets of developing economies.

Chapter 22

1. Austrian

Austrians believe that government’s attempts to deal with business cycles can often lead to the creation of government programs that cost a lot but have little benefit.

2. Institutionalist

Institutionalists believe that this proposition is very reasonable. Firms’ focus on making money and the financial issues can leave real issues secondary, and can bring about waves of pessimism and optimism. Institutionalists believe that fundamental to Mitchell’s analysis was the insight that the production of goods is a normal daily aspect of life in all societies since the beginning of time. Production occurs because it is necessary to reproduce culture. Institutionalists believe that the money economy has perverted this timeless process by giving control to a group that allows culture to reproduce itself only if that group is able to profit from that activity. Thus, during the Great Depression, farmers destroyed their crops while people went hungry; it was why workers were available yet factories were empty: business owners did not expect a profit and thus used their power to idle the economy imperiling the reproduction of culture and threatening democracy itself.


3. Post-Keynesian

a Since the Great Depression, the government has been more active in the economy and has used monetary and fiscal policy to stabilize the economy. Post-Keynesians believe that these policies are responsible for avoiding severe depressions since that time.

b These policies are definitely Keynesian

c Post-Keynesians believe that these policies are still relevant today.

4. Radical

a This is a judgment question and judgments differ. Radical economists would agree with Vickrey that unemployment should be very low.

b Radical economists believe that unemployment tends to hurt the people who are the weakest and poorest in society, and who need the most help. If such policies generate inflation, then institutions should be changed to eliminate the inflation through other means than unemployment.

c Vickrey supported a plan put forward by Abba Lerner and the author of this textbook. It was called a market anti-inflation plan, and it was a plan in which firms could only raise their price if they bought the right to do so from another firm that lowered its price by an offsetting amount.

5. Feminist

a. There are a number of possibilities. It might be that sellers think they can take advantage of women more than they can take advantage of men.

b. This information means that the CPI might understate the cost of living for women, and overstate it for men.

Chapter 23

1. Feminist

a Most feminist economists believe that the reason is an underlying bias against women that devalues the work that women do – paid and unpaid.

b Feminists believe that treating the unpaid work that women do within the home as “leisure” in our national income accounting framework not only devalues women but also works against them when they retire if benefits, such as Social Security, are calculated in part on income earned in a lifetime.

c One would have to estimate the value of providing those services in the market, by doing market studies of what similar jobs pay.

2. Religious

a Measures of issues that relate to individual welfare, such as amount of crime, survey measures of welfare of society, not happiness of the individual, and amount of pollution, or the stability of family relationships might be included. Some people might include church attendance; others may not.


b This is a judgment question; judgments differ. Government expenditures on defense might not be included if the religious ethic is against war.

3. Institutionalist

a An Institutionalist will say GDP accounting shapes thought processes and social values by legitimating some economic contributions (Tazers, a type of gun) and de-legitimating others (homemaking). Because one activity is valued, we socially ascribe values towards those engaging in the activity and give them social status. The opposite happens for non-valued activities. Furthermore, just because expenditures are rising does not mean social welfare has increased. Many expenditures are to reduce bads. This means scarce resources are used to ameliorate the harmful effects of things that free markets allowed to happen. Institutionalists believe that a rising GDP can give the impression that things are getting better even when they are getting worse!

b Businesses that produce market goods and services benefit.

4. Austrian

Austrians believe that government spending is for the most part unproductive and therefore should not be included in GDP as an equal input with consumption. The reason is that Austrians believe that the political process tends to waste resources since they are not subject to competition and market incentives.

5. Austrian

a Austrians believe that the collection of statistics can be a private good, not a public good, and can be most efficiently provided by private firms.

b Austrians believe that government bureaucrats whose job depends on having the data collected are often the large supporters, as are individuals who what to expand the role of government, since the data are often used to provide justification of government action, even when the quality of the data is often poor.

6. Radical

a This is a judgment question; judgments differ. Most Radical economists believe that the Genuine Progress Indicator would provide a better indicator.

b Radical economists support the Genuine Progress Indicator because it is more inclusive of dimensions that they believe are important for a good society.

Chapter 24

1. Austrian

a No, in absolute terms, the poor have not become poorer.

b Based on the growth model, as more capital in collected, one would expect the income of the poor to increase.

2. Institutionalist


Given American’s current habits, it would take many earths to provide those resources.

3. Post-Keynesian

a Post-Keynesians believe that such a policy would be consistent with new growth theory, which states that technology is central to growth.

b Those believing in the classical theory model would not see industrial policy as so important since the models focuses on capital, not technology.

4. Radical

a They could fit into those arguments, but what is interesting for Radical economists is that mainstream economics does not give much discussion to them.

b This is an empirical question upon which economists disagree because the data are not very good. Most Radical economists see a positive relationship between equality and growth.

5. Religious

a Most religiously oriented economists see that property rights are consistent with everything ultimately belonging to God. For religious economists property rights are temporary; God is eternal. We are stewards of what God has provided.

Chapter 25

1. Austrian

a It could be consistent with the AS/AD model if one sees the AS curve and AD curves driven by expectations, and agrees that the expectation of government involvement shifted both back.

b Austrians would favor an institutional system that had far less government involvement.

2. Institutionalist

a When oil production declines, the production possibility curve shifts in, the LAS curve in to the left and the result is an increase in the price level. An increase in AD will correct for the unemployment but cause even more inflation. Because the physical supply of oil is declining the production possibility curve will shift inward. Declining physical output will make investment in alternative resources more costly (greater opportunity cost in terms of consumption goods).

b This will shift real income from individuals and nations that are net consumers of oil to individuals and nations that are net producers of oil. Institutionalists believe that most likely the costs will be disproportionately carried by the least advantaged, both in the United States and by developing countries.

3. Post-Keynesian

a Keynes argued that the economy could get stuck in a rut and that the forces of adjustment may not be strong enough to return the economy to its potential output in any politically acceptable period of time. He argued that this meant that unemployment could be caused by a shortage of aggregate demand, not only institutional barriers in the market.


b Post-Keynesians see that the Classical propositions are incorrect both on common sense grounds—the fallacy of composition—and on empirical grounds; Classical economics had no explanation of the Great Depression.

4. Radical

a The excess capacity is shown by the gap between the quantity of aggregate demand and the potential output at the price level. If the price level is flexible, there is no problem.

b What should be done is a judgment question and judgments differ. Classicals tend to believe that the economy should be left to itself, allowing the price level to fall. Radical economists believe that the easiest and best policy is for the government to increase aggregate demand to restore full employment.

c It suggests that the model (positive economics) embodies in it certain biases toward specific policies. For example, the AS/AD model suggests that if the wage and price level were flexible, the problem of unemployment would not exist.

d Both the Radical and the Classical policy solutions are value laden. Policy solutions must necessarily be based on values. Which is more value laden is a judgment question and judgments differ.

Chapter 26

1. Austrian

His work points out that people are not dumb; they figure out ways to make things work on their own, and many times the net result of this self-organization is far better than organization imposed from the top. Austrians believe that when people are treated as intelligent agents, they will act intelligently; when they are treated as dumb, they will still act intelligently, but often their intelligence will be working toward thwarting the plan.

2. Feminist

From today’s perspective, this statement seems extremely biased against women, but it was a prevalent view at the time. Feminist economists see work as a human right, not a gender-based privilege. Moreover, they point out that men would have been unlikely to have been willing to do many of the women’s jobs at the time.

3. Institutionalist

While each option will cause aggregate expenditures to shift up and thus stimulate GDP, each will have different implication for locating on the production possibility curve. There is no reason to believe this option would cause technological bias: it is not spending on new medical technology, only allowing all Americans to use existing technology. Greater access to health care should extend life spans and improve worker productivity. In the long term this should push the production curve outward. An increased military presence in the Middle East will cause a technological bias toward the production of military goods. The military presence will increase oil consumption and accelerate dependence on oil from that region. Development of energy alternatives will cause technological bias from oil using technologies. Institutionalists believe that as oil dependence decreases, there should be a move along the curve away from military spending: we won’t need the troops in the Middle East.

4. Radical


a Radical economists believe that these data suggest that the multiplier is very large.

b These data suggest that consumption spending has been the driving force in the U.S. economy, and that it may not be sustainable because consumers have so much debt.

5. Post-Keynesian

Fazzari’s findings suggest that spending-side factors are far more important. Post-Keynesians believe that this suggests that policies that increase spending will be central to maintaining the economy at a high level of employment.

Chapter 27

1. Austrian

a Yes, money could be privately supplied. Economists disagree as to whether the government ought to be the monetary authority. Austrians believe that the monetary system works better the less government is involved.

b Yes, money has been supplied privately. (See the work of Lawrence White, and his former student George Selgin.) People knew its value in the same way they know the value of anything—by the information generated in the market by what people would give them in exchange for the money.

2. Feminist

a Since its inception only a very small percentage of the governors have been women. See: http://www.federalreserve.gov/bios/boardmembership.htm.

b Currently, (as of 2005) about all that one can say about the current members is that they are people with a background in economics. All but one of the Governors of the Federal Reserve Board are men.

3. Institutionalist

Two examples include judging the value of someone by the clothes they wear: Did you see Sue; it looks like she got her clothes at the Salvation Army; and people’s discussions about how much money they have made on their houses: My house has gone up $40,000 in value last year. There are many more.

4. Post-Keynesian

a Post-Keynesians believe that the money supply is much more endogenous than is suggested by the textbook presentation.

b Post-Keynesians see the money supply being determined by the supply and demand of banks and depositors for financial instruments. Post-Keynesians may believe that the central bank may influence the creation of money, but does not determine it.

5. Radical

a This presentation of the story makes the results of the tight money policy more devastating. Radical economists tend to believe that this story is the more accurate presentation.

b Radical economists believe that it suggests the need for more financial regulation.


c This is a judgment question; judgments differ. Radical economists find this story more convincing.

6. Religious

a In profit sharing the lender has a stronger stake in the business, and the payment he receives depends on how well the business does.

b In an interest paying system, a failed business could be forced to pay back the debt even though the business was not a success. In a profit sharing system, that would not be the case.

Chapter 28

1. Austrian

His argument was the financial institutions can create an almost infinite number of effective substitutes for money, which undermines the ability of the Fed to control the economy with monetary policy.

2. Feminist

a Some feminists would argue that an almost exclusive focus on men in prominent quotations perpetuates male bias in the economics profession. It ignores the contributions of women economists and political economists such as Mary Wollstonecraft, Charlotte Perkins Gilman, Joan Robinson, Marianne Ferber, Barbara Bergmann, and Heidi Hartmann among many more.

b This is a judgment question, and judgments differ. Most feminists believe that we should be concerned.

3. Institutionalist

a When interest rates are very low, it is unlikely that they will go any lower, which makes people worried about holding long-term bonds, since the value of fixed interest rate bond fall when interest rates rise, and they want to avoid that capital loss. Thus, they prefer to hold money even if it pays no interest.

b One possibility is to change the nature of money, making it lose value. There were such proposals put forward in the Great Depression. Another possibility would be for monetary policy to be directed to foreign exchange, and not on local bonds. By lowering the price of the country’s currency, such a policy could stimulate the economy.

4. Post-Keynesian

If it were accepted that money were non-neutral, then there would be less focus on using monetary policy only to fight inflation, and more consideration of using monetary policy to expand the economy.

5. Radical

a This is a judgment question and judgments differ. Radical economists believe that the Fed’s conduct of monetary policy helps the rich bondholders more than it helps the poor.

b This is a judgment question and judgments differ. Radical economists believe that the Fed should serve the interests of the entire society, with special focus on low income individuals.

Chapter 29


1. Austrian

a Many Austrians believe that if the government kept a very low profile, and did not undertake inflationary financing of the large amount of spending that it does because of political pressures, that there would be far less inflation than there is. For Austrians, government is not the solution; government is the problem.

b Governments might not stop inflation because of political pressure.

2. Religious

a There is no objective “just” weight; it is a subjective “just” weight that is backing money. Most religiously oriented economists would hold that gold is not what gives value money but shared trust, and that shared trust in humanity comes from God.

b Inflation can be seen as an injustice because it changes the value of the measure that people made plans around. How much of an injustice in part depends on the expectations the people held. If they expected the inflation, then the inflation doesn’t change the value they expected and therefore is not an injustice.

c The injustice of inflation is born by those who experience but did not expect it and could not adjust for it.

3. Institutionalist

a If you graph this you will see that there are several business cycle oscillations where sophisticated statistical analysis is not needed to see the role of oil on the macro economy. For instance, the oil embargo of 1973 and the Iranian Revolution and the oil shock of 1979 both caused inflation and unemployment. The expansion in 1983 was partly driven by declining oil prices; similarly, the expansion in the 1990s was partly driven by declining oil prices.

b In the AS/AD model the oil shock shifts the SAS curve up, increasing prices and reducing output in the short run, creating a recession if nominal demand does not increase.

c If one uses expansionary fiscal policy, one can prevent the recession, but only at the cost of more inflation. The conclusion one can draw from this is that there are difficult tradeoffs in macro policy.

4. Post-Keynesian

a This is a judgment question and judgments differ. Post-Keynesians believe that the cause of inflation is deeply integrated with the price setting institutions.

b Post-Keynesians recommend the use of incomes policies involving tax and market incentives to fight inflation. They believe that such policies are likely to distribute the costs of fighting inflation more fairly.

c If one believes that inflation is caused by excess demand, then incomes policies make far less sense. The answer to inflation is to reduce demand.

6. Radical

a The Radical view emphasizes social conflict between different classes of people; the textbook view downplays that social conflict. The differences in views are primarily ones of emphasis rather than


totally different views.

b This is a judgment question and judgments differ.

Chapter 30

1. Austrian

Austrians believe that individuals know what is in their best interest and that savings should be neither encouraged nor discouraged by the market.

2. Post-Keynesian

a In the standard argument the unemployment was caused by a fall in demand, creating a gap between potential and actual output. If the price level fell to where the AD curve intersected the unchanging long-run AS curve, the economy would achieve full employment.

b That standard model assumes that as demand falls, the long-run AS curve will remain where it is. Post Keynesians see the long-run AS curve as something of an illusion; when demand falls, supply falls with it, which means that a fall in the price level will not solve the problem. They also see the AD curve as highly inelastic—almost vertical, so it is not clear that there is any fall in the price level that will achieve equilibrium.

3. Institutionalist

These voter initiatives are generally financed by out-of-state anti-taxation groups. Of course, reduced taxation necessarily translates into less government and only government has the power to constrain the free market. It is reasonable to conclude these groups want to replace government control with control by business.

4. Post-Keynesian

a It would mean that there is much more uncertainty about policy, and that policy must be designed more to deal with society’s attempts to deal with uncertainty than with problems based on rational calculation by agents.

b Post Keynesians would be most comfortable with reasonable expectations. Such expectations encompass a wide range of expectations.

5. Radical

a Radical economists believe that it would take a commitment by government to maintain full employment, and the willingness to design incomes policies that would limit any inflationary pressures in a fair way.

b A full employment regime would give workers much more power and reduce the power of employers and other capitalists, requiring them to pay higher wages and accept lower profits.

c Within today’s political environment it is highly unlikely that any true full employment regime is possible. Radical economists believe that true full employment does not exist because it is not in the interest of those in power.


6. Religious

a Society is deeply divided about the weights that should be given to various goals, which is one of the reasons why policy is so difficult to carry out.

b Religiously oriented economists believe that religious beliefs should play a central role in establishing those values, and that society currently does not give enough weight to religious values.

Chapter 31

1. Austrian

Austrians believe that our lack of knowledge of the right policy is a severe limit to useful monetary and fiscal policy. But even if we could determine the correct policy, politics would present a serious problem for government’s ability to implement it.

2. Institutionalist

a Low income groups have the highest mpc.

b To achieve the greatest demand stimulus from a given tax cut, the cut should go to the poor. Generally, recent tax cuts have gone to the rich.

c Tax cuts will increase the debt, and the rich receive most of the interest payments on the debt.

d The pattern seen by some Institutionalists is that the rich get the benefits.

3. Post-Keynesian

a Bush’s initial argument for the tax cut was a Classical-type supply-side argument. When the economy fell into a recession he started using Keynesian-type demand-side arguments to support the tax cut. Most Post-Keynesians feel that the effect of a tax cut is primarily through it effects on demand, although in the longer run there may be some supply-side effects.

b From a Post-Keynesian point of view, President Bush should not worry about the deficit and should focus on using aggregate demand policy to achieve full employment.

4. Radical

a The textbook tries to be neutral as to what has to be done, and presents the Social Security problem without discussing the distributional consequences of the problem. Radical economists believe that one must directly deal with the distributional consequences of the problem.

b Both positions suggest that diverting Social Security funds into private accounts will not solve the real problem of Social Security.

5. Feminist

a A program that provides a “baby bonus”—a payment for each child that a woman has would be a policy with a gender effect.


b A tax on large sporting events, such as football or basketball, would affect men more than women and thus would not be general neutral.

c Feminists believe that such effects are important to consider because if one does not, then women are likely to be shortchanged by the government.

Chapter 32

1. Religious

a Based on the Bible, many religiously oriented economists believe that governments of developed countries should provide more development aid than they are currently providing.

b Yes, biblical norms would be consistent with making that aid conditional on the aid being used for useful purposes.

2. Institutionalist

a Often the finger is pointed at the developing nations themselves. Many Institutionalists believe that it is often more complicated than that.

b The direct consequences are experienced by the people in the country. However, when economies are incapable of supporting a population, civil discord, rebellion, and warfare can be the result, which can be problematic for the entire world.

c The more one believes that the cause and consequence of a lack of development go beyond the country itself, the stronger the argument for aid.

3. Feminist

a Women are likely credited because they often are the harder workers and have the stronger social bonds.

b It suggests that policies aimed at educating women and in promoting gender equality can be useful in bringing about development.

4. Religious

a Loans place someone in someone else’s debt, and can prevent them for having hope for development, making them an instrument of oppression.

b Loans that are used to positively transform a society, and which generate revenues to pay back the loans can be an instrument of development. By the paying of shiria, rather than interest which is paid only when the development works, one can limit the oppressive aspects of loans.

c The conditions for these loans “are to participate in equity capital and grant loans for productive projects and enterprises besides providing financial assistance to member countries in other forms for economic and social development.” By participating in equity capital the loans are less likely to be oppressive, and more likely to be made for productive investments.

5. Radical


a This is a judgment question and judgments differ. Radical economists are very skeptical of free trade and financial liberalization policies, and they favor policies that provide more democratic controls over capital flows and economic development, such as taxes on the rapid turnover of capital, capital controls, requirements for local content for multinational production, and minimum labor standards. That is not to say that they are not skeptical of national control because government policy in the developing world often works in favor of the ruling elite.

b This is a judgment question and judgments differ. Radical economists are very skeptical of free trade and financial liberalization policies, but they are also skeptical of national control because such policies oven works in favor of the ruling elite.

Chapter 33

1. Austrian

a Having all currencies on a gold standard would eliminate currency risk and promote more trade among nations.

b The cost of such a policy would be limiting countries ability to conduct domestic monetary policy. Most Austrians would see that as a good thing because they believe that discretionary monetary policy often does more harm than good.

2. Religious

a Jesus would argue for an exchange rate that valued earthly things low and eternal wealth high.

b I would suspect that wealthy people would value earthly things at a higher value than Jesus would value them.

c I suspect that the perceived value of earthly things fall as one gets older.

3. Feminist

a There is no good reason. It is probably historical happenstance.

b One reason it has remained that way is that the traders are self-perpetuating; they hire people like themselves.

c Yes, one of the reasons trading rooms have remained primarily male is that the conversation is permeated with male locker room humor, and the rooms are extremely unpleasant for women, and socially sensitive individuals.

d This answer will be individual specific.

4. Post-Keynesian

His argument is that the pressures for change are so strong, once people start expecting a major change in the price of a currency, a small tax will not stop them from buying in a financial crisis. The tax would slow capital flows in normal times when there is no need to slow them, and not stop capital flows in crises when there is a need to slow them.

5. Radical


a This is a judgment question and judgments differ. Radical economists are especially wary of financial liberalization. That they identify as the chief cause of the financial crisis of East Asia. But so too is Nobel-prize-winning economist, Joseph Stiglitz who is a former chief economist at the World Bank and head of the Clinton Council of Economic Advisers.

b This, too, is a judgment question and judgments differ. As stated above in a Radical economists are very wary of financial liberalization.

Chapter 34

1. Austrian

Governments in developing countries tend to be even more problematic and representative of special interests than those in developed countries, which makes an activist monetary and fiscal policy of even more dubious value.

2. Religious

a This is a judgment question and judgments differ. Some religiously oriented economists are very concerned about the trade deficit and the position that might put the U.S. government in the future relative to foreign governments.

b Yes, at one point in the Bible, it states that “Neither a lender nor a borrower be.”

c An argument can be made that the U.S. international debt is going to undermine the position of the United States in the world.

3. Institutionalist

a Private savings, government savings, and international savings (which is the inverse of the trade deficit, must sum to zero.

b The international capital inflows were financing both the U.S. private borrowing and the U.S. government borrowing.

c The international capital inflows reduced the degree of crowding out that would otherwise have occurred.

4. Post-Keynesian

a This is a judgment question and judgments differ. Many Post-Keynesians are concerned about whether the international borrowing can continue, and the likely shortage in demand that will exist if it does not continue to finance private and government spending.

b This is a judgment question and judgments differ. Most Post-Keynesians agree with the first position—that the international trade deficit reflects a structural imbalance in the U.S. economy.

5. Radical

If the friend is correct, the empirical studies cast doubt on the convergence hypothesis, and on the argument that one should support globalization to achieve greater income equality.

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