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s and for 35 years afterward, a plant in Holland, Michigan produced 46 billion Life Savers a year, in 200 million rolls. However, in 2002, the Kraft Company announced that it would close the Michigan plant and move Life Saver production across the border to Montreal, Canada. One reason is that Canadian workers are paid slightly less, especially in healthcare and insurance costs that are not linked to employment there. Another main reason is that the United States government keeps the sugar price high for the benefit of sugar farmers, with a combination of a government price floor program and strict quotas on imported sugar. According to the Coalition for Sugar Reform, from 2009 to 2012, the price of refined sugar in the United States ranged from 64% to 92% higher than the world price. Life Saver production uses over 100 tons of sugar each day, because the candies are 95% sugar. A number of other candy companies have also reduced U.S. production and expanded foreign production. From 1997 to 2011, sugar-using industries eliminated some 127,000 jobs, or more than seven times the total employment in sugar production. While the candy industry is especially affected by the cost of sugar, the costs are spread more broadly. U.S. consumers pay roughly $1 billion per year in higher food prices because of elevated sugar costs. Meanwhile, sugar producers in low-income countries are driven out of business. Because of the sugar subsidies to domestic producers and the quotas on imports, they cannot sell their output profitably, or at all, in the United States market. The fact that protectionism pushes up prices for consumers in the country enacting such protectionism is not always acknowledged openly, but it is not disputed. After all, if protectionism did not benefit domestic producers, there would not be much point in enacting such policies in the first place. Protectionism is simply a method of requiring consumers to subsidize producers. The subsidy is indirect, since consumers pay for it through higher prices, rather than a direct government subsidy paid with money collected from taxpayers. However, protectionism works like a subsidy, nonetheless. The American satirist Ambrose Bierce defined “tariff” this way in his 1911 book, The Devil’s Dictionary: “Tariff, n. A scale of taxes on imports, designed to protect the domestic producer against the greed of his consumer.” The effect of protectionism on producers and consumers in the foreign country is complex. When a government uses an import quota to impose partial protectionism, Brazilian sugar
producers receive a lower price for the sugar they sell in Brazil—but a higher price for the sugar they are allowed to export to the United States. Notice that some of the burden of protectionism, paid by domestic consumers, ends up in the hands of foreign producers in this case. Brazilian sugar consumers seem to benefit from U.S. protectionism, because it reduces the price of sugar that they pay (compared to the free-trade situation). On the other hand, at least some of these Brazilian sugar consumers also work This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 473 as sugar farmers, so protectionism reduces their incomes and jobs. Moreover, if trade between the countries vanishes, Brazilian consumers would miss out on better prices for imported goods—which do not appear in our single-market example of sugar protectionism. The effects of protectionism on foreign countries notwithstanding, protectionism requires domestic consumers of a product (consumers may include either households or other firms) to pay higher prices to benefit domestic producers of that product. In addition, when a country enacts protectionism, it loses the economic gains it would have been able to achieve through a combination of comparative advantage, specialized learning, and economies of scale, concepts that we discuss in International Trade. 20.2 \| International Trade and Its Effects on Jobs, Wages, and Working Conditions By the end of this section, you will be able to: • Discuss how international trade influences the job market • Analyze the opportunity cost of protectionism • Explain how international trade impacts wages, labor standards, and working conditions In theory at least, imports might injure workers in several different ways: fewer jobs, lower wages, or poor working conditions. Let’s consider these in turn. Fewer Jobs? In the early 1990s, the United States was negotiating the North American Free Trade Agreement (NAFTA) with Mexico, an agreement that reduced tariffs, import quotas, and nontariff barriers to trade between the United States, Mexico, and Canada. H. Ross Perot, a 1992 candidate for U.S. president, claimed, in prominent campaign arguments, that if the United States expanded trade with Mexico, there would be a “giant sucking sound” as U.S. employers relocated to Mexico to take advantage of lower wages. After all, average wages in Mexico were, at that time, about one-eighth of
those in the United States. NAFTA passed Congress, President Bill Clinton signed it into law, and it took effect in 1995. For the next six years, the United States economy had some of the most rapid job growth and low unemployment in its history. Those who feared that open trade with Mexico would lead to a dramatic decrease in jobs were proven wrong. This result was no surprise to economists. After all, the trend toward globalization has been going on for decades, not just since NAFTA. If trade did reduce the number of available jobs, then the United States should have been seeing a steady loss of jobs for decades. While the United States economy does experience rises and falls in unemployment rates—according to the Bureau of Labor Statistics, from spring 2007 to late 2009, the unemployment rate rose from 4.4% to 10%. It has since fallen back to under 5% as of the end of 2016—the number of jobs is not falling over extended periods of time. The number of U.S. jobs rose from 71 million in 1970 to 145 million in 2014. Protectionism certainly saves jobs in the specific industry being protected but, for two reasons, it costs jobs in other unprotected industries. First, if consumers are paying higher prices to the protected industry, they inevitably have less money to spend on goods from other industries, and so jobs are lost in those other industries. Second, if a firm sells the protected product to other firms, so that other firms must now pay a higher price for a key input, then those firms will lose sales to foreign producers who do not need to pay the higher price. Lost sales translate into lost jobs. The hidden opportunity cost of using protectionism to save jobs in one industry is jobs sacrificed in other industries. This is why the United States International Trade Commission, in its study of barriers to trade, predicts that reducing trade barriers would not lead to an overall loss of jobs. Protectionism reshuffles jobs from industries without import protections to industries that are protected from imports, but it does not create more jobs. Moreover, the costs of saving jobs through protectionism can be very high. A number of different studies have attempted to estimate the cost to consumers in higher prices per job saved through protectionism. Table 20.2 shows a sample of results, compiled by economists at the Federal Reserve Bank of Dallas. Saving a job through protectionism typically costs much more than the actual worker’s salary. For example, a study published in 2002 compiled evidence that using protectionism to save an average job in the textile and apparel
industry would cost $199,000 per job saved. In other words, those workers could have been paid $100,000 per year to be unemployed and the cost would only be half of what it is to keep them working in the textile and apparel industry. This result is not unique to textiles and 474 apparel. Chapter 20 \| Globalization and Protectionism Industry Protected with Import Tariffs or Quotas Annual Cost per Job Saved Sugar Polyethylene resins Dairy products Frozen concentrated orange juice Ball bearings Machine tools Women’s handbags Glassware Apparel and textiles Rubber footwear Women’s nonathletic footwear $826,000 $812,000 $685,000 $635,000 $603,000 $479,000 $263,000 $247,000 $199,000 $168,000 $139,000 Table 20.2 Cost to U.S. Consumers of Saving a Job through Protectionism (Source: Federal Reserve Bank of Dallas) Why does it cost so much to save jobs through protectionism? The basic reason is that not all of the extra money that consumers pay because of tariffs or quotas goes to save jobs. For example, if the government imposes tariffs on steel imports so that steel buyers pay a higher price, U.S. steel companies earn greater profits, buy more equipment, pay bigger bonuses to managers, give pay raises to existing employees—and also avoid firing some additional workers. Only part of the higher price of protected steel goes toward saving jobs. Also, when an industry is protected, the economy as a whole loses the benefits of playing to its comparative advantage—in other words, producing what it is best at. Therefore, part of the higher price that consumers pay for protected goods is lost economic efficiency, which we can measure as another deadweight loss, like what we discussed in Labor and Financial Markets. There’s a bumper sticker that speaks to the threat some U.S. workers feel from imported products: “Buy American—Save U.S. Jobs.” If an economist were driving the car, the sticker might declare: “Block Imports—Save Jobs for Some Americans, Lose Jobs for Other Americans, and Also Pay High Prices.” Trade and Wages Even if trade does not reduce the number of jobs, it could affect wages. Here, it is important to separate issues about the average level of wages from issues about whether the wages of certain workers may be helped or hurt by trade. Because trade raises
the amount that an economy can produce by letting firms and workers play to their comparative advantage, trade will also cause the average level of wages in an economy to rise. Workers who can produce more will be more desirable to employers, which will shift the demand for their labor out to the right, and increase wages in the labor market. By contrast, barriers to trade will reduce the average level of wages in an economy. However, even if trade increases the overall wage level, it will still benefit some workers and hurt others. Workers in industries that are confronted by competition from imported products may find that demand for their labor decreases and shifts back to the left, so that their wages decline with a rise in international trade. Conversely, workers in industries that benefit from selling in global markets may find that demand for their labor shifts out to the right, so that trade raises their wages. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 475 View this website (http://openstaxcollege.org/l/fairtradecoffee) to read an article on the issues surrounding fair trade coffee. One concern is that while globalization may be benefiting high-skilled, high-wage workers in the United States, it may also impose costs on low-skilled, low-wage workers. After all, high-skilled U.S. workers presumably benefit from increased sales of sophisticated products like computers, machinery, and pharmaceuticals in which the United States has a comparative advantage. Meanwhile, low-skilled U.S. workers must now compete against extremely lowwage workers worldwide for making simpler products like toys and clothing. As a result, the wages of low-skilled U.S. workers are likely to fall. There are, however, a number of reasons to believe that while globalization has helped some U.S. industries and hurt others, it has not focused its negative impact on the wages of low-skilled Americans. First, about half of U.S. trade is intra-industry trade. That means the U.S. trades similar goods with other high-wage economies like Canada, Japan, Germany, and the United Kingdom. For instance, in 2014 the U.S. exported over 2 million cars, from all the major automakers, and also imported several million cars from other countries. Most U.S. workers in these industries have above-average skills and wages—and many of them do quite well in the world of
globalization. Some evidence suggested that intra-industry trade between similar countries had a small impact on domestic workers but later evidence indicates that it all depends on how flexible the labor market is. In other words, the key is how flexible workers are in finding jobs in different industries. The effect of trade on lowwage workers depends considerably on the structure of labor markets and indirect effects felt in other parts of the economy. For example, in the United States and the United Kingdom, because labor market frictions are low, the impact of trade on low income workers is small. Second, many low-skilled U.S. workers hold service jobs that imports from low-wage countries cannot replace. For example, we cannot import lawn care services or moving and hauling services or hotel maids from countries long distances away like China or Bangladesh. Competition from imported products is not the primary determinant of their wages. Finally, while the focus of the discussion here is on wages, it is worth pointing out that low-wage U.S. workers suffer due to protectionism in all the industries—even those in which they do not work. For example, food and clothing are protected industries. These low-wage workers therefore pay higher prices for these basic necessities and as such their dollar stretches over fewer goods. The benefits and costs of increased trade in terms of its effect on wages are not distributed evenly across the economy. However, the growth of international trade has helped to raise the productivity of U.S. workers as a whole—and thus helped to raise the average level of wages. Labor Standards and Working Conditions Workers in many low-income countries around the world labor under conditions that would be illegal for a worker in the United States. Workers in countries like China, Thailand, Brazil, South Africa, and Poland are often paid less than the United States minimum wage. For example, in the United States, the minimum wage is $7.25 per hour. A typical wage in many low-income countries might be more like $7.25 per day, or often much less. Moreover, working conditions in low-income countries may be extremely unpleasant, or even unsafe. In the worst cases, production may involve the child labor or even workers who are treated nearly like slaves. These concerns over foreign labor standards do not affect most of U.S. trade, which is intra-industry and carried out with other high-income countries that have labor standards similar to the United States, but it is, nonetheless, morally and economically important. 476 Chapter 20
\| Globalization and Protectionism In thinking about labor standards in other countries, it is important to draw some distinctions between what is truly unacceptable and what is painful to think about. Most people, economists included, have little difficulty with the idea that production by six-year-olds confined in factories or by slave labor is morally unacceptable. They would support aggressive efforts to eliminate such practices—including shutting out imported products made with such labor. Many cases, however, are less clear-cut. An opinion article in the New York Times several years ago described the case of Ahmed Zia, a 14-year-old boy from Pakistan. He earned $2 per day working in a carpet factory. He dropped out of school in second grade. Should the United States and other countries refuse to purchase rugs made by Ahmed and his co-workers? If the carpet factories were to close, the likely alternative job for Ahmed is farm work, and as Ahmed says of his carpet-weaving job: “This makes much more money and is more comfortable.” Other workers may have even less attractive alternative jobs, perhaps scavenging garbage or prostitution. The real problem for Ahmed and many others in low-income countries is not that globalization has made their lives worse, but rather that they have so few good life alternatives. The United States went through similar situations during the nineteenth and early twentieth centuries. In closing, there is some irony when the United States government or U.S. citizens take issue with labor standards in low-income countries, because the United States is not a world leader in government laws to protect employees. According to a recent study by the Organization for Economic Cooperation and Development (OECD), the U.S. is the only one of 41 countries that does not provide mandated paid leave for new parents, and among the 40 countries that do mandate paid leave, the minimum duration is about two months. Many European workers receive six weeks or more of paid vacation per year. In the United States, vacations are often one to three weeks per year. If European countries accused the United States of using unfair labor standards to make U.S. products cheaply, and announced that they would shut out all U.S. imports until the United States adopted paid parental leave, added more national holidays, and doubled vacation time, Americans would be outraged. Yet when U.S. protectionists start talking about restricting imports from poor countries because of low wage levels and poor working conditions, they are making a very similar argument. This is not to say that labor conditions
in low-income countries are not an important issue. They are. However, linking labor conditions in low-income countries to trade deflects the emphasis from the real question to ask: “What are acceptable and enforceable minimum labor standards and protections to have the world over?” 20.3 \| Arguments in Support of Restricting Imports By the end of this section, you will be able to: • Explain and analyze various arguments that are in support of restricting imports, including the infant industry argument, the anti-dumping argument, the environmental protection argument, the unsafe consumer products argument, and the national interest argument • Explain dumping and race to the bottom • Evaluate the significance of countries’ perceptions on the benefits of growing trade As we previously noted, protectionism requires domestic consumers of a product to pay higher prices to benefit domestic producers of that product. Countries that institute protectionist policies lose the economic gains achieved through a combination of comparative advantage, specialized learning, and economies of scale. With these overall costs in mind, let us now consider, one by one, a number of arguments that support restricting imports. The Infant Industry Argument Imagine Bhutan wants to start its own computer industry, but it has no computer firms that can produce at a low enough price and high enough quality to compete in world markets. However, Bhutanese politicians, business leaders, and workers hope that if the local industry had a chance to get established, before it needed to face international competition, then a domestic company or group of companies could develop the skills, management, technology, and economies of scale that it needs to become a successful profit-earning domestic industry. Thus, the infant industry argument for protectionism is to block imports for a limited time, to give the infant industry time to mature, before it starts competing on equal terms in the global economy. (Revisit Macroeconomic Policy Around the World (http://cnx.org/content/m64022/latest/) for more information on the infant industry argument.) The infant industry argument is theoretically possible, even sensible: give an industry a short-term indirect subsidy This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 477 through protection, and then reap the long-term economic benefits of having a vibrant, healthy industry. Implementation, however, is tricky. In many countries, infant industries have gone from babyhood to senility and obsolescence without
ever having reached the profitable maturity stage. Meanwhile, the protectionism that was supposed to be short-term often took a very long time to be repealed. As one example, Brazil treated its computer industry as an infant industry from the late 1970s until about 1990. In an attempt to establish its computer industry in the global economy, Brazil largely barred imports of computer products for several decades. This policy guaranteed increased sales for Brazilian computers. However, by the mid-1980s, due to lack of international competition, Brazil had a backward and out-of-date industry, typically lagging behind world standards for price and performance by three to five years—a long time in this fast-moving industry. After more than a decade, during which Brazilian consumers and industries that would have benefited from up-to-date computers paid the costs and Brazil’s computer industry never competed effectively on world markets, Brazil phased out its infant industry policy for the computer industry. Protectionism for infant industries always imposes costs on domestic users of the product, and typically has provided little benefit in the form of stronger, competitive industries. However, several countries in East Asia offer an exception. Japan, Korea, Thailand, and other countries in this region have sometimes provided a package of indirect and direct subsidies targeted at certain industries, including protection from foreign competition and government loans at interest rates below the market equilibrium. In Japan and Korea, for example, subsidies helped get their domestic steel and auto industries up and running. Why did the infant industry policy of protectionism and other subsidies work fairly well in East Asia? An early 1990 World Bank study offered three guidelines to countries thinking about infant industry protection: 1. Do not hand out protectionism and other subsidies to all industries, but focus on a few industries where your country has a realistic chance to be a world-class producer. 2. Be very hesitant about using protectionism in areas like computers, where many other industries rely on having the best products available, because it is not useful to help one industry by imposing high costs on many other industries. 3. Have clear guidelines for when the infant industry policy will end. In Korea in the 1970s and 1980s, a common practice was to link protectionism and subsidies to export sales in global markets. If export sales rose, then the infant industry had succeeded and the government could phase out protectionism. If export sales did not rise, then the infant industry policy had failed and the government could phase out protectionism. Either way, the protectionism would be temporary. Following these rules
is easier said than done. Politics often intrudes, both in choosing which industries will receive the benefits of treatment as “infants” and when to phase out import restrictions and other subsidies. Also, if the country's government wishes to impose costs on its citizens so that it can provide subsidies to a few key industries, it has many tools for doing such as direct government payments, loans, targeted tax reductions, and government support of research and development of new technologies. In other words, protectionism is not the only or even the best way to support key industries. this website (http://openstaxcollege.org/l/integration) to view a presentation by Pankaj Ghemawat Visit questioning how integrated the world really is. 478 Chapter 20 \| Globalization and Protectionism The Anti-Dumping Argument Dumping refers to selling goods below their cost of production. Anti-dumping laws block imports that are sold below the cost of production by imposing tariffs that increase the price of these imports to reflect their cost of production. Since dumping is not allowed under World Trade Organization (WTO) rules, nations that believe they are on the receiving end of dumped goods can file a complaint with the WTO. Anti-dumping complaints have risen in recent years, from about 100 cases per year in the late 1980s to about 200 new cases each year by the late 2000s. Note that dumping cases are countercyclical. During recessions, case filings increase. During economic booms, case filings go down. Individual countries have also frequently started their own anti-dumping investigations. The U.S. government has dozens of anti-dumping orders in place from past investigations. In 2009, for example, some U.S. imports that were under anti-dumping orders included pasta from Turkey, steel pipe fittings from Thailand, pressuresensitive plastic tape from Italy, preserved mushrooms and lined paper products from India, and cut-to-length carbon steel and non-frozen apple juice concentrate from China. Why Might Dumping Occur? Why would foreign firms export a product at less than its cost of production—which presumably means taking a loss? This question has two possible answers, one innocent and one more sinister. The innocent explanation is that demand and supply set market prices, not the cost of production. Perhaps demand for a product shifts back to the left or supply shifts out to the right, which drives the market price to low levels—even below the cost of production. When a local store has
a going-out-of-business sale, for example, it may sell goods at below the cost of production. If international companies find that there is excess supply of steel or computer chips or machine tools that is driving the market price down below their cost of production—this may be the market in action. The sinister explanation is that dumping is part of a long-term strategy. Foreign firms sell goods at prices below the cost of production for a short period of time, and when they have driven out the domestic U.S. competition, they then raise prices. Economists sometimes call this scenario predatory pricing, which we discuss in the Monopoly chapter. Should Anti-Dumping Cases Be Limited? Anti-dumping cases pose two questions. How much sense do they make in economic theory? How much sense do they make as practical policy? In terms of economic theory, the case for anti-dumping laws is weak. In a market governed by demand and supply, the government does not guarantee that firms will be able to make a profit. After all, low prices are difficult for producers, but benefit consumers. Moreover, although there are plenty of cases in which foreign producers have driven out domestic firms, there are zero documented cases in which the foreign producers then jacked up prices. Instead, foreign producers typically continue competing hard against each other and providing low prices to consumers. In short, it is difficult to find evidence of predatory pricing by foreign firms exporting to the United States. Even if one could make a case that the government should sometimes enact anti-dumping rules in the short term, and then allow free trade to resume shortly thereafter, there is a growing concern that anti-dumping investigations often involve more politics than careful analysis. The U.S. Commerce Department is charged with calculating the appropriate “cost of production,” which can be as much an art as a science. For example, if a company built a new factory two years ago, should it count part of the factory’s cost in this year’s cost of production? When a company is in a country where the government controls prices, like China for example, how can one measure the true cost of production? When a domestic industry complains loudly enough, government regulators seem very likely to find that unfair dumping has occurred. A common pattern has arisen where a domestic industry files an anti-dumping complaint, the governments meet and negotiate a reduction in imports, and then the domestic producers drop the anti-dumping suit. In such cases, anti
-dumping cases often appear to be little more than a cover story for imposing tariffs or import quotas. In the 1980s, the United States, Canada, the European Union, Australia, and New Zealand implemented almost all the anti-dumping cases. By the 2000s, countries like Argentina, Brazil, South Korea, South Africa, Mexico, and India were filing the majority of the anti-dumping cases before the WTO. As the number of anti-dumping cases has increased, and as countries such as the United States and the European Union feel targeted by the anti-dumping actions of others, the WTO may well propose some additional guidelines to limit the reach of anti-dumping laws. The Environmental Protection Argument The potential for global trade to affect the environment has become controversial. A president of the Sierra Club, an This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 479 environmental lobbying organization, once wrote: “The consequences of globalization for the environment are not good. … Globalization, if we are lucky, will raise average incomes enough to pay for cleaning up some of the mess that we have made. But before we get there, globalization could also destroy enough of the planet’s basic biological and physical systems that prospects for life itself will be radically compromised.” If free trade meant the destruction of life itself, then even economists would convert to protectionism! While globalization—and economic activity of all kinds—can pose environmental dangers, it seems quite possible that, with the appropriate safeguards in place, we can minimize the environmental impacts of trade. In some cases, trade may even bring environmental benefits. In general, high-income countries such as the United States, Canada, Japan, and the nations of the European Union have relatively strict environmental standards. In contrast, middle- and low-income countries like Brazil, Nigeria, India, and China have lower environmental standards. The general view of the governments of such countries is that environmental protection is a luxury: as soon as their people have enough to eat, decent healthcare, and longer life expectancies, then they will spend more money on items such as sewage treatment plants, scrubbers to reduce air pollution from factory smokestacks, and national parks to protect wildlife. This gap in environmental standards between high-income and low-income countries raises two worrisome possibilities in a world of increasing global trade: the “race to the bottom�
� scenario and the question of how quickly environmental standards will improve in low-income countries. The Race to the Bottom Scenario The race to the bottom scenario of global environmental degradation runs like this. Profit-seeking multinational companies shift their production from countries with strong environmental standards to countries with weak standards, thus reducing their costs and increasing their profits. Faced with such behavior, countries reduce their environmental standards to attract multinational firms, which, after all, provide jobs and economic clout. As a result, global production becomes concentrated in countries where firms can pollute the most and environmental laws everywhere “race to the bottom.” Although the race-to-the-bottom scenario sounds plausible, it does not appear to describe reality. In fact, the financial incentive for firms to shift production to poor countries to take advantage of their weaker environmental rules does not seem especially powerful. When firms decide where to locate a new factory, they look at many different factors: the costs of labor and financial capital; whether the location is close to a reliable suppliers of the inputs that they need; whether the location is close to customers; the quality of transportation, communications, and electrical power networks; the level of taxes; and the competence and honesty of the local government. The cost of environmental regulations is a factor, too, but typically environmental costs are no more than 1 to 2% of the costs that a large industrial plant faces. The other factors that determine location are much more important to these companies than trying to skimp on environmental protection costs. When an international company does choose to build a plant in a low-income country with lax environmental laws, it typically builds a plant similar to those that it operates in high-income countries with stricter environmental standards. Part of the reason for this decision is that designing an industrial plant is a complex and costly task, and so if a plant works well in a high-income country, companies prefer to use the same design everywhere. Also, companies realize that if they create an environmental disaster in a low-income country, it is likely to cost them a substantial amount of money in paying for damages, lost trust, and reduced sales—by building up-to-date plants everywhere they minimize such risks. As a result of these factors, foreign-owned plants in low-income countries often have a better record of compliance with environmental laws than do locally-owned plants. Pressuring Low-Income Countries for Higher Environmental Standards In some cases, the issue is not so much whether globalization will pressure low-income countries to reduce their
environmental standards, but instead whether the threat of blocking international trade can pressure these countries into adopting stronger standards. For example, restrictions on ivory imports in high-income countries, along with stronger government efforts to catch elephant poachers, have been credited with helping to reduce the illegal poaching of elephants in certain African countries. However, it would be highly undemocratic for the well-fed citizens of high-income countries to attempt to dictate to the ill-fed citizens of low-income countries what domestic policies and priorities they must adopt, or how they should balance environmental goals against other priorities for their citizens. Furthermore, if high-income countries want stronger environmental standards in low-income countries, they have many options other than the threat of protectionism. For example, high-income countries could pay for anti-pollution equipment in low-income countries, 480 Chapter 20 \| Globalization and Protectionism or could help to pay for national parks. High-income countries could help pay for and carry out the scientific and economic studies that would help environmentalists in low-income countries to make a more persuasive case for the economic benefits of protecting the environment. After all, environmental protection is vital to two industries of key importance in many low-income countries—agriculture and tourism. Environmental advocates can set up standards for labeling products, like “this tuna caught in a net that kept dolphins safe” or “this product made only with wood not taken from rainforests,” so that consumer pressure can reinforce environmentalist values. The United Nations also reinforces these values, by sponsoring treaties to address issues such as climate change and global warming, the preservation of biodiversity, the spread of deserts, and the environmental health of the seabed. Countries that share a national border or are within a region often sign environmental agreements about air and water rights, too. The WTO is also becoming more aware of environmental issues and more careful about ensuring that increases in trade do not inflict environmental damage. Finally, note that these concerns about the race to the bottom or pressuring low-income countries for more strict environmental standards do not apply very well to the roughly half of all U.S. trade that occurs with other high-income countries. Many European countries have stricter environmental standards in certain industries than the United States. The Unsafe Consumer Products Argument One argument for shutting out certain imported products is that they are unsafe for consumers. Consumer rights groups have sometimes warned that the World Trade Organization would require nations to reduce their health and safety standards for imported products. However, the WTO
explains its current agreement on the subject in this way: “It allows countries to set their own standards.” It also says “regulations must be based on science.... And they should not arbitrarily or unjustifiably discriminate between countries where identical or similar conditions prevail.” Thus, for example, under WTO rules it is perfectly legitimate for the United States to pass laws requiring that all food products or cars sold in the United States meet certain safety standards approved by the United States government, whether or not other countries choose to pass similar standards. However, such standards must have some scientific basis. It is improper to impose one set of health and safety standards for domestically produced goods but a different set of standards for imports, or one set of standards for imports from Europe and a different set of standards for imports from Latin America. In 2007, Mattel recalled nearly two million toys imported from China due to concerns about high levels of lead in the paint, as well as some loose parts. It is unclear if other toys were subject to similar standards. More recently, in 2013, Japan blocked imports of U.S. wheat because of concerns that genetically modified (GMO) wheat might be included in the shipments. The science on the impact of GMOs on health is still developing. The National Interest Argument Some argue that a nation should not depend too heavily on other countries for supplies of certain key products, such as oil, or for special materials or technologies that might have national security applications. On closer consideration, this argument for protectionism proves rather weak. As an example, in the United States, oil provides about 36% of all the energy and 25% of the oil used in the United States economy is imported. Several times in the last few decades, when disruptions in the Middle East have shifted the supply curve of oil back to the left and sharply raised the price, the effects have been felt across the United States economy. This is not, however, a very convincing argument for restricting oil imports. If the United States needs to be protected from a possible cutoff of foreign oil, then a more reasonable strategy would be to import 100% of the petroleum supply now, and save U.S. domestic oil resources for when or if the foreign supply is cut off. It might also be useful to import extra oil and put it into a stockpile for use in an emergency, as the United States government did by starting a Strategic Petroleum Reserve in 1977. Moreover, it may be necessary to discourage people from using oil, and to start a high
-powered program to seek out alternatives to oil. A straightforward way to do this would be to raise taxes on oil. Additionally, it makes no sense to argue that because oil is highly important to the United States economy, then the United States should shut out oil imports and use up its domestic supplies more quickly. U.S. domestic oil production is increasing. Shale oil is adding to domestic supply using fracking extraction techniques. Whether or not to limit certain kinds of imports of key technologies or materials that might be important to national security and weapons systems is a slightly different issue. If weapons’ builders are not confident that they can continue to obtain a key product in wartime, they might decide to avoid designing weapons that use this key product, or they can go ahead and design the weapons and stockpile enough of the key high-tech components or materials to last through an armed conflict. There is a U.S. Defense National Stockpile Center that has built up reserves of many This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 481 materials, from aluminum oxides, antimony, and bauxite to tungsten, vegetable tannin extracts, and zinc (although many of these stockpiles have been reduced and sold in recent years). Think every country is pro-trade? How about the U.S.? The following Clear It Up might surprise you. How does the United States really feel about expanding trade? How do people around the world feel about expanding trade between nations? In summer 2007, the Pew Foundation surveyed 45,000 people in 47 countries. One of the questions asked about opinions on growing trade ties between countries. Table 20.3 shows the percentages who answered either “very good” or “somewhat good” for some of countries surveyed. For those who think of the United States as the world’s leading supporter of expanding trade, the survey results may be perplexing. When adding up the shares of those who say that growing trade ties between countries is “very good” or “somewhat good,” Americans had the least favorable attitude toward increasing globalization, while the Chinese and South Africans ranked highest. In fact, among the 47 countries surveyed, the United States ranked by far the lowest on this measure, followed by Egypt, Italy, and Argentina. Country Very Good Somewhat Good Total China South Africa South Korea Germany Canada United Kingdom Mexico Brazil
Japan United States 38% 42% 24% 30% 29% 28% 22% 13% 17% 14% 53% 43% 62% 55% 53% 50% 55% 59% 55% 45% Table 20.3 The Status of Growing Trade Ties between Countries (Source: http://www.pewglobal.org/files/pdf/258.pdf) 91% 87% 86% 85% 82% 78% 77% 72% 72% 59% One final reason why economists often treat the national interest argument skeptically is that lobbyists and politicians can tout almost any product as vital to national security. In 1954, the United States became worried that it was importing half of the wool required for military uniforms, so it declared wool and mohair to be “strategic materials” and began to give subsidies to wool and mohair farmers. Although the government removed wool from the official list of “strategic” materials in 1960, the subsidies for mohair continued for almost 40 years until the government repealed them in 1993, and then reinstated them in 2002. All too often, the national interest argument has become an excuse for handing out the indirect subsidy of protectionism to certain industries or companies. After all, politicians, not nonpartisan analysts make decisions about what constitutes a key strategic material. 20.4 \| How Governments Enact Trade Policy: Globally, 482 Chapter 20 \| Globalization and Protectionism Regionally, and Nationally By the end of this section, you will be able to: • Explain the origin and role of the World Trade Organization (WTO) and General Agreement on Tariffs and Trade (GATT) • Discuss the significance and provide examples of regional trading agreements • Analyze trade policy at the national level • Evaluate long-term trends in barriers to trade These public policy arguments about how nations should react to globalization and trade are fought out at several levels: at the global level through the World Trade Organization and through regional trade agreements between pairs or groups of countries. The World Trade Organization The World Trade Organization (WTO) was officially born in 1995, but its history is much longer. In the years after the Great Depression and World War II, there was a worldwide push to build institutions that would tie the nations of the world together. The United Nations officially came into existence in 1945. The World Bank, which assists the poorest people in the world, and the International Monetary Fund, which addresses issues raised by international financial transactions, were both created in 1946. The
third planned organization was to be an International Trade Organization, which would manage international trade. The United Nations was unable to agree to this. Instead, 27 nations signed the General Agreement on Tariffs and Trade (GATT) in Geneva, Switzerland on October 30, 1947 to provide a forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade. In 1995, the GATT transformed into the WTO. The GATT process was to negotiate an agreement to reduce barriers to trade, sign that agreement, pause for a while, and then start negotiating the next agreement. Table 20.4 shows rounds of talks in the GATT, and now the WTO. Notice that the early rounds of GATT talks took a relatively short time, included a small number of countries, and focused almost entirely on reducing tariffs. Since the mid-1960s, however, rounds of trade talks have taken years, included a large number of countries, and have included an ever-broadening range of issues. Main Subjects Number of Countries Involved Year 1947 1949 1951 1956 1960–61 1964–67 1973–79 Place or Name of Round Geneva Tariff reduction Annecy Tariff reduction Torquay Tariff reduction Geneva Tariff reduction Dillon round Kennedy round Tokyo round Tariff reduction Tariffs, anti-dumping measures Tariffs, nontariff barriers Table 20.4 The Negotiating Rounds of GATT and the World Trade Organization This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 23 13 38 26 26 62 102 Chapter 20 \| Globalization and Protectionism 483 Year Place or Name of Round Main Subjects 1986–94 Uruguay round Tariffs, nontariff barriers, services, intellectual property, dispute settlement, textiles, agriculture, creation of WTO 2001– Doha round Agriculture, services, intellectual property, competition, investment, environment, dispute settlement Table 20.4 The Negotiating Rounds of GATT and the World Trade Organization Number of Countries Involved 123 147 The sluggish pace of GATT negotiations led to an old joke that GATT really stood for Gentleman’s Agreement to Talk and Talk. The slow pace of international trade talks, however, is understandable, even sensible. Having dozens of nations agree to any treaty is a lengthy process. GATT often set up separate trading rules for certain industries, like agriculture, and separate trading rules for certain countries, like the low-income countries. There were rules, exceptions to rules, opportunities to opt out of
rules, and precise wording to be fought over in every case. Like the GATT before it, the WTO is not a world government, with power to impose its decisions on others. The total staff of the WTO in 2014 is 640 people and its annual budget (as of 2014) is $197 million, which makes it smaller in size than many large universities. Regional Trading Agreements There are different types of economic integration across the globe, ranging from free trade agreements, in which participants allow each other’s imports without tariffs or quotas, to common markets, in which participants have a common external trade policy as well as free trade within the group, to full economic unions, in which, in addition to a common market, monetary and fiscal policies are coordinated. Many nations belong both to the World Trade Organization and to regional trading agreements. The best known of these regional trading agreements is the European Union. In the years after World War II, leaders of several European nations reasoned that if they could tie their economies together more closely, they might be more likely to avoid another devastating war. Their efforts began with a free trade association, evolved into a common market, and then transformed into what is now a full economic union, known as the European Union. The EU, as it is often called, has a number of goals. For example, in the early 2000s it introduced a common currency for Europe, the euro, and phased out most of the former national forms of money like the German mark and the French franc, though a few have retained their own currency. Another key element of the union is to eliminate barriers to the mobility of goods, labor, and capital across Europe. For the United States, perhaps the best-known regional trading agreement is the North American Free Trade Agreement (NAFTA). The United States also participates in some less-prominent regional trading agreements, like the Caribbean Basin Initiative, which offers reduced tariffs for imports from these countries, and a free trade agreement with Israel. The world has seen a flood of regional trading agreements in recent years. About 100 such agreements are now in place. Table 20.5 lists a few of the more prominent ones. Some are just agreements to continue talking. Others set specific goals for reducing tariffs, import quotas, and nontariff barriers. One economist described the current trade treaties as a “spaghetti bowl,” which is what a map with lines connecting all the countries with trade treaties looks like. There is concern among economists who favor free trade that some of these regional agreements may
promise free trade, but actually act as a way for the countries within the regional agreement to try to limit trade from anywhere else. In some cases, the regional trade agreements may even conflict with the broader agreements of the World Trade Organization. 484 Chapter 20 \| Globalization and Protectionism Participating Countries Australia, Brunei, Canada, Chile, People’s Republic of China, Hong Kong, China, Indonesia, Japan, Republic of Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Chinese Taipei, Thailand, United States, Vietnam Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom* Canada, Mexico, United States Argentina, Bolivia, Brazil, Chile, Columbia, Ecuador, Mexico, Paraguay, Peru, Uruguay, Venezuela Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam Angola, Botswana, Congo, Lesotho, Madagascar, Malawi, Mauritius, Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia, Zimbabwe Trade Agreements Asia Pacific Economic Cooperation (APEC) European Union (EU) North America Free Trade Agreement (NAFTA) Latin American Integration Association (LAIA) Association of Southeast Asian Nations (ASEAN) Southern African Development Community (SADC) Table 20.5 Some Regional Trade Agreements * Following the 2016 referendum vote to leave the European Union, the UK government triggered the withdrawal process on March 29, 2017, setting the date for the UK to leave by April 2019. Trade Policy at the National Level Yet another dimension of trade policy, along with international and regional trade agreements, happens at the national level. The United States, for example, imposes import quotas on sugar, because of a fear that such imports would drive down the price of sugar and thus injure domestic sugar producers. One of the jobs of the United States Department of Commerce is to determine if there is import dumping from other countries. The United States International Trade Commission—a government agency—determines whether the dumping has substantially injured domestic industries, and if so, the president can impose tariffs that are intended to offset the unfairly low price. In the arena of trade policy, the battle often seems to be between national laws that increase
protectionism and international agreements that try to reduce protectionism, like the WTO. Why would a country pass laws or negotiate agreements to shut out certain foreign products, like sugar or textiles, while simultaneously negotiating to reduce trade barriers in general? One plausible answer is that international trade agreements offer a method for countries to restrain their own special interests. A member of Congress can say to an industry lobbying for tariffs or quotas on imports: “Sure would like to help you, but that pesky WTO agreement just won’t let me.” This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 485 If consumers are the biggest losers from trade, why do they not fight back? The quick answer is because it is easier to organize a small group of people around a narrow interest (producers) versus a large group that has diffuse interests (consumers). This is a question about trade policy theory. Visit this website (http://openstaxcollege.org/l/tradepolicy) and read the article by Jonathan Rauch. Long-Term Trends in Barriers to Trade In newspaper headlines, trade policy appears mostly as disputes and acrimony. Countries are almost constantly threatening to challenge other nations' “unfair” trading practices. Cases are brought to the dispute settlement procedures of the WTO, the European Union, NAFTA, and other regional trading agreements. Politicians in national legislatures, goaded on by lobbyists, often threaten to pass bills that will “establish a fair playing field” or “prevent unfair trade”—although most such bills seek to accomplish these high-sounding goals by placing more restrictions on trade. Protesters in the streets may object to specific trade rules or to the entire practice of international trade. Through all the controversy, the general trend in the last 60 years is clearly toward lower barriers to trade. The average level of tariffs on imported products charged by industrialized countries was 40% in 1946. By 1990, after decades of GATT negotiations, it was down to less than 5%. One of the reasons that GATT negotiations shifted from focusing on tariff reduction in the early rounds to a broader agenda was that tariffs had been reduced so dramatically there was not much more to do in that area. U.S. tariffs have followed this general pattern: After rising sharply during the Great Depression, tariffs dropped off to less than 2% by the end of the century. Although
measures of import quotas and nontariff barriers are less exact than those for tariffs, they generally appear to be at lower levels than they had been previously, too. Thus, the last half-century has seen both a dramatic reduction in government-created barriers to trade, such as tariffs, import quotas, and nontariff barriers, and also a number of technological developments that have made international trade easier, like advances in transportation, communication, and information management. The result has been the powerful surge of international trade. 20.5 \| The Tradeoffs of Trade Policy By the end of this section, you will be able to: • Asses the complexity of international trade • Discuss why a market-oriented economy is so affected by international trade • Explain disruptive market change Economists readily acknowledge that international trade is not all sunshine, roses, and happy endings. Over time, the average person gains from international trade, both as a worker who has greater productivity and higher wages because of the benefits of specialization and comparative advantage, and as a consumer who can benefit from shopping all over the world for a greater variety of quality products at attractive prices. The “average person,” however, is hypothetical, not real—representing a mix of those who have done very well, those who have done all right, and those who have done poorly. It is a legitimate concern of public policy to focus not just on the average or on the success stories, but also on those who have not been so fortunate. Workers in other countries, the environment, and prospects for new industries and materials that might be of key importance to the national economy are also all 486 legitimate issues. Chapter 20 \| Globalization and Protectionism The common belief among economists is that it is better to embrace the gains from trade, and then deal with the costs and tradeoffs with other policy tools, than it is to cut off trade to avoid the costs and tradeoffs. To gain a better intuitive understanding for this argument, consider a hypothetical American company called Technotron. Technotron invents a new scientific technology that allows the firm to increase the output and quality of its goods with a smaller number of workers at a lower cost. As a result of this technology, other U.S. firms in this industry will lose money and will also have to lay off workers—and some of the competing firms will even go bankrupt. Should the United States government protect the existing firms and their employees by making it illegal for Technotron to use its new technology? Most people who live in
market-oriented economies would oppose trying to block better products that lower the cost of services. Certainly, there is a case for society providing temporary support and assistance for those who find themselves without work. Many would argue for government support of programs that encourage retraining and acquiring additional skills. Government might also support research and development efforts, so that other firms may find ways of outdoing Technotron. Blocking the new technology altogether, however, seems like a mistake. After all, few people would advocate giving up electricity because it caused so much disruption to the kerosene and candle business. Few would suggest holding back on improvements in medical technology because they might cause companies selling leeches and snake oil to lose money. In short, most people view disruptions due to technological change as a necessary cost that is worth bearing. Now, imagine that Technotron’s new “technology” is as simple as this: the company imports what it sells from another country. In other words, think of foreign trade as a type of innovative technology. The objective situation is now exactly the same as before. Because of Technotron’s new technology—which in this case is importing goods from another county—other firms in this industry will lose money and lay off workers. Just as it would have been inappropriate and ultimately foolish to respond to the disruptions of new scientific technology by trying to shut it down, it would be inappropriate and ultimately foolish to respond to the disruptions of international trade by trying to restrict trade. Some workers and firms will suffer because of international trade. In a living, breathing market-oriented economy, some workers and firms will always be experiencing disruptions, for a wide variety of reasons. Corporate management can be better or worse. Workers for a certain firm can be more or less productive. Tough domestic competitors can create just as much disruption as tough foreign competitors. Sometimes a new product is a hit with consumers; sometimes it is a flop. Sometimes a company is blessed by a run of good luck or stricken with a run of bad luck. For some firms, international trade will offer great opportunities for expanding productivity and jobs; for other firms, trade will impose stress and pain. The disruption caused by international trade is not fundamentally different from all the other disruptions caused by the other workings of a market economy. In other words, the economic analysis of free trade does not rely on a belief that foreign trade is not disruptive or does not pose tradeoffs; indeed, the story of Technotron begins with a particular disruptive market change—a new
technology—that causes real tradeoffs. In thinking about the disruptions of foreign trade, or any of the other possible costs and tradeoffs of foreign trade discussed in this chapter, the best public policy solutions typically do not involve protectionism, but instead involve finding ways for public policy to address the particular issues resulting from these disruptions, costs, and tradeoffs, while still allowing the benefits of international trade to occur. What’s the Downside of Protection? The domestic flat-panel display industry employed many workers before the ITC imposed the dumping margin tax. Flat-panel displays make up a significant portion of the cost of producing laptop computers—as much as 50%. Therefore, the antidumping tax would substantially increase the cost, and thus the price, of U.S.manufactured laptops. As a result of the ITC’s decision, Apple moved its domestic manufacturing plant for Macintosh computers to Ireland (where it had an existing plant). Toshiba shut down its U.S. manufacturing plant for laptops. And IBM cancelled plans to open a laptop manufacturing plant in North Carolina, instead deciding to expand production at its plant in Japan. In this case, rather than having the desired effect of protecting U.S. interests and giving domestic manufacturing an advantage over items manufactured elsewhere, it had the unintended effect of driving the manufacturing completely out of the country. Many This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 487 people lost their jobs and most flat-panel display production now occurs in countries other than the United States. 488 Chapter 20 \| Globalization and Protectionism KEY TERMS anti-dumping laws laws that block imports sold below the cost of production and impose tariffs that would increase the price of these imports to reflect their cost of production common market economic agreement between countries to allow free trade in goods, services, labor, and financial capital between members while having a common external trade policy disruptive market change innovative new product or production technology which disrupts the status quo in a market, leading the innovators to earn more income and profits and the other firms to lose income and profits, unless they can come up with their own innovations dumping selling internationally traded goods below their cost of production economic union economic agreement between countries to allow free trade between members, a common external trade policy, and coordinated monetary and fiscal policies free trade agreement economic agreement between countries to allow free trade between members General Agreement on Tariffs and Trade (
GATT) forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade; the precursor to the World Trade Organization import quotas numerical limits on the quantity of products that a country can import national interest argument the argument that there are compelling national interests against depending on key imports from other nations nontariff barriers ways a nation can draw up rules, regulations, inspections, and paperwork to make it more costly or difficult to import products protectionism government policies to reduce or block imports race to the bottom when production locates in countries with the lowest environmental (or other) standards, putting pressure on all countries to reduce their environmental standards World Trade Organization (WTO) organization that seeks to negotiate reductions in barriers to trade and to adjudicate complaints about violations of international trade policy; successor to the General Agreement on Tariffs and Trade (GATT) KEY CONCEPTS AND SUMMARY 20.1 Protectionism: An Indirect Subsidy from Consumers to Producers There are three tools for restricting the flow of trade: tariffs, import quotas, and nontariff barriers. When a country places limitations on imports from abroad, regardless of whether it uses tariffs, quotas, or nontariff barriers, it is said to be practicing protectionism. Protectionism will raise the price of the protected good in the domestic market, which causes domestic consumers to pay more, but domestic producers to earn more. 20.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions As international trade increases, it contributes to a shift in jobs away from industries where that economy does not have a comparative advantage and toward industries where it does have a comparative advantage. The degree to which trade affects labor markets has much to do with the structure of the labor market in that country and the adjustment process in other industries. Global trade should raise the average level of wages by increasing productivity. However, this increase in average wages may include both gains to workers in certain jobs and industries and losses to others. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 489 In thinking about labor practices in low-income countries, it is useful to draw a line between what is unpleasant to think about and what is morally objectionable. For example, low wages and long working hours in poor countries are unpleasant to think about, but for people in low-income parts of the world, it may well be the best option open to them. Practices like
child labor and forced labor are morally objectionable and many countries refuse to import products made using these practices. 20.3 Arguments in Support of Restricting Imports There are a number of arguments that support restricting imports. These arguments are based around industry and competition, environmental concerns, and issues of safety and security. The infant industry argument for protectionism is that small domestic industries need to be temporarily nurtured and protected from foreign competition for a time so that they can grow into strong competitors. In some cases, notably in East Asia, this approach has worked. Often, however, the infant industries never grow up. On the other hand, arguments against dumping (which is setting prices below the cost of production to drive competitors out of the market), often simply seem to be a convenient excuse for imposing protectionism. Low-income countries typically have lower environmental standards than high-income countries because they are more worried about immediate basics such as food, education, and healthcare. However, except for a small number of extreme cases, shutting off trade seems unlikely to be an effective method of pursuing a cleaner environment. Finally, there are arguments involving safety and security. Under the rules of the World Trade Organization, countries are allowed to set whatever standards for product safety they wish, but the standards must be the same for domestic products as for imported products and there must be a scientific basis for the standard. The national interest argument for protectionism holds that it is unwise to import certain key products because if the nation becomes dependent on key imported supplies, it could be vulnerable to a cutoff. However, it is often wiser to stockpile resources and to use foreign supplies when available, rather than preemptively restricting foreign supplies so as not to become dependent on them. 20.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally Governments determine trade policy at many different levels: administrative agencies within government, laws passed by the legislature, regional negotiations between a small group of nations (sometimes just two), and global negotiations through the World Trade Organization. During the second half of the twentieth century, trade barriers have, in general, declined quite substantially in the United States economy and in the global economy. One reason why countries sign international trade agreements to commit themselves to free trade is to give themselves protection against their own special interests. When an industry lobbies for protection from foreign producers, politicians can point out that, because of the trade treaty, their hands are tied. 20.5 The Tradeoffs of Trade Policy International trade certainly has income distribution effects. This is hardly surprising
. All domestic or international competitive market forces are disruptive. They cause companies and industries to rise and fall. Government has a role to play in cushioning workers against the disruptions of the market. However, just as it would be unwise in the long term to clamp down on new technology and other causes of disruption in domestic markets, it would be unwise to clamp down on foreign trade. In both cases, the disruption brings with it economic benefits. SELF-CHECK QUESTIONS 1. Explain how a tariff reduction causes an increase in the equilibrium quantity of imports and a decrease in the equilibrium price. Hint: Consider the Work It Out "Effects of Trade Barriers." 2. Explain how a subsidy on agricultural goods like sugar adversely affects the income of foreign producers of imported sugar. 3. Explain how trade barriers save jobs in protected industries, but only by costing jobs in other industries. 4. Explain how trade barriers raise wages in protected industries by reducing average wages economy-wide. 5. How does international trade affect working conditions of low-income countries? 490 Chapter 20 \| Globalization and Protectionism 6. Do the jobs for workers in low-income countries that involve making products for export to high-income countries typically pay these workers more or less than their next-best alternative? 7. How do trade barriers affect the average income level in an economy? 8. How does the cost of “saving” jobs in protected industries compare to the workers’ wages and salaries? 9. Explain how predatory pricing could be a motivation for dumping. 10. Why do low-income countries like Brazil, Egypt, or Vietnam have lower environmental standards than highincome countries like the Germany, Japan, or the United States? 11. Explain the logic behind the “race to the bottom” argument and the likely reason it has not occurred. 12. What are the conditions under which a country may use the unsafe products argument to block imports? 13. Why is the national security argument not convincing? 14. Assume a perfectly competitive market and the exporting country is small. Using a demand and supply diagram, show the impact of increasing standards on a low-income exporter of toys. Show the tariff's impact. Is the effect on toy prices the same or different? Why is a standards policy preferred to tariffs? 15. What is the difference between a free trade association, a common market, and an economic union? 16. Why would countries promote protectionist laws, while also negotiate for freer trade internationally? 17. What might account
for the dramatic increase in international trade over the past 50 years? 18. How does competition, whether domestic or foreign, harm businesses? 19. What are the gains from competition? REVIEW QUESTIONS 20. Who does protectionism protect? From what does it protect them? 28. What is dumping? Why does prohibiting it often work better in theory than in practice? 21. Name and define three policy tools for enacting protectionism. 22. How does protectionism affect the price of the protected good in the domestic market? 23. Does international trade, taken as a whole, increase the total number of jobs, decrease the total number of jobs, or leave the total number of jobs about the same? 24. Is international trade likely to have roughly the same effect on the number of jobs in each individual industry? 25. How is international trade, taken as a whole, likely to affect the average level of wages? Is international trade likely to have about the same 26. effect on everyone’s wages? 27. What are main reasons for protecting “infant industries”? Why is it difficult to stop protecting them? 29. What is the “race to the bottom” scenario? 30. Do the rules of international trade require that all nations impose the same consumer safety standards? 31. What is the national protectionism with regard to certain products? interest argument for 32. Name several of the international treaties where countries negotiate with each other over trade policy. 33. What is the general trend of trade barriers over recent decades: higher, lower, or about the same? If opening up to free trade would benefit a nation, just eliminate their trade trade 34. then why do nations not barriers, and not bother with international negotiations? 35. Who gains and who loses from trade? 36. Why is trade a good thing if some people lose? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 \| Globalization and Protectionism 491 37. What are some ways that governments can help people who lose from trade? CRITICAL THINKING QUESTIONS 38. Show graphically that for any tariff, there is an equivalent quota that would give the same result. What would be the difference, then, between the two types of trade barriers? Hint: It is not something you can see from the graph. 39. From the Work It Out "Effects of Trade Barriers," you can see that a tariff raises the price
of imports. What is interesting is that the price rises by less than the amount of the tariff. Who pays the rest of the tariff amount? Can you show this graphically? 40. If trade barriers hurt the average worker in an economy (due to lower wages), why does government create trade barriers? 41. Why do you think labor standards and working conditions are lower in the low-income countries of the world than in countries like the United States? 42. How would direct subsidies to key industries be preferable to tariffs or quotas? 43. How can governments identify good candidates for infant industry protection? Can you suggest some key characteristics of good candidates? Why are industries like computers not good candidates for infant industry protection? argues 44. Microeconomic is theory economically rationale (and profitable) to sell additional output as long as the price covers the variable costs of production. How is this relevant to the determination of whether dumping has occurred? that it 45. How do you think Americans would feel if other countries began to urge the United States to increase environmental standards? 46. Is it legitimate to impose higher safety standards on imported goods that exist in the foreign country where the goods were produced? 47. Why might the unsafe consumer products argument be a more effective strategy (from the perspective of the importing country) than using tariffs or quotas to restrict imports? 48. Why might a tax on domestic consumption of resources critical for national security be a more efficient approach than barriers to imports? 49. Why do you think that the GATT rounds and, more recently, WTO negotiations have become longer and more difficult to resolve? 50. An economic union requires giving up some political autonomy to succeed. What are some examples of political power countries must give up to be members of an economic union? 51. What are some examples of innovative products that have disrupted their industries for the better? 52. In principle, the benefits of international trade to a country exceed the costs, no matter whether the country is importing or exporting. In practice, it is not always possible to compensate the losers in a country, for example, workers who lose their jobs due to foreign imports. In your opinion, does that mean that trade should be inhibited to prevent the losses? 53. Economists sometimes say that protectionism is the “second-best” choice for dealing with any particular problem. What they mean is that there is often a policy choice that is more direct or effective for dealing with the problem—a choice that would still allow the benefits of trade to occur. Explain why protectionism is a
“second-best” choice for: a. helping workers as a group b. helping industries stay strong c. protecting the environment d. advancing national defense 54. Trade has income distribution effects. For example, suppose that because of a government-negotiated reduction in trade barriers, trade between Germany and the Czech Republic increases. Germany sells house paint to the Czech Republic. The Czech Republic sells alarm clocks to Germany. Would you expect this pattern of trade to increase or decrease jobs and wages in the paint industry in Germany? The alarm clock industry in Germany? The paint industry in Czech Republic? The alarm clock industry in Czech Republic? What has to happen for there to be no increase in total unemployment in both countries? 492 Chapter 20 \| Globalization and Protectionism PROBLEMS 55. Assume two countries, Thailand (T) and Japan (J), have one good: cameras. The demand (d) and supply (s) for cameras in Thailand and Japan is described by functions: the QdT = 60 – P following QdJ = 80 – P P QsT = –5 + 1 4 QsJ = –10 + 1 2 57. The country of Pepperland exports steel to the Land of Submarines. the quantity demanded (Qd) and quantity supplied (Qs) in each country, in a world without trade, are given in Table 20.6 and Table 20.7. Information for P Price ($) Qd Qs P is the price measured in a common currency used in both countries, such as the Thai Baht. a. Compute the equilibrium price (P) and quantities (Q) in each country without trade. b. Now assume that free trade occurs. The freetrade price goes to 56.36 Baht. Who exports and imports cameras and in what quantities? 56. You have just been put in charge of trade policy for Malawi. Coffee is a recent crop that is growing well and the Malawian export market is developing. As such, Malawi coffee is an infant industry. Malawi coffee producers come to you and ask for tariff protection from cheap Tanzanian coffee. What sorts of policies will you enact? Explain. 60 70 80 90 100 230 200 170 150 140 180 200 220 240 250 Table 20.6 Pepperland Price ($) Qd Qs 60 70 80 90 100 430 420 410 400 390 310 330 360 400 440 Table 20.7 Land of Submarines a. What would be the equilibrium price and quantity
in each country in a world without trade? How can you tell? b. What would be the equilibrium price and quantity in each country if trade is allowed to occur? How can you tell? c. Sketch two supply and demand diagrams, one for each country, in the situation before trade. e. d. On those diagrams, show the equilibrium price and the levels of exports and imports in the world after trade. If the Land of Submarines imposes an antidumping import quota of 30, explain in general terms whether it will benefit or injure consumers and producers in each country. f. Does your general answer change if the Land of Submarines imposes an import quota of 70? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix A 493 A \| The Use of Mathematics in Principles of Economics (This appendix should be consulted after first reading Welcome to Economics!) Economics is not math. There is no important concept in this course that cannot be explained without mathematics. That said, math is a tool that can be used to illustrate economic concepts. Remember the saying a picture is worth a thousand words? Instead of a picture, think of a graph. It is the same thing. Economists use models as the primary tool to derive insights about economic issues and problems. Math is one way of working with (or manipulating) economic models. There are other ways of representing models, such as text or narrative. But why would you use your fist to bang a nail, if you had a hammer? Math has certain advantages over text. It disciplines your thinking by making you specify exactly what you mean. You can get away with fuzzy thinking in your head, but you cannot when you reduce a model to algebraic equations. At the same time, math also has disadvantages. Mathematical models are necessarily based on simplifying assumptions, so they are not likely to be perfectly realistic. Mathematical models also lack the nuances which can be found in narrative models. The point is that math is one tool, but it is not the only tool or even always the best tool economists can use. So what math will you need for this book? The answer is: little more than high school algebra and graphs. You will need to know: • What a function is • How to interpret the equation of a line (i.e., slope and intercept) • How to manipulate a line (i.e., changing the slope or the intercept) • How to compute and interpret a growth
rate (i.e., percentage change) • How to read and manipulate a graph In this text, we will use the easiest math possible, and we will introduce it in this appendix. So if you find some math in the book that you cannot follow, come back to this appendix to review. Like most things, math has diminishing returns. A little math ability goes a long way; the more advanced math you bring in, the less additional knowledge that will get you. That said, if you are going to major in economics, you should consider learning a little calculus. It will be worth your while in terms of helping you learn advanced economics more quickly. Algebraic Models Often economic models (or parts of models) are expressed in terms of mathematical functions. What is a function? A function describes a relationship. Sometimes the relationship is a definition. For example (using words), your professor is Adam Smith. This could be expressed as Professor = Adam Smith. Or Friends = Bob + Shawn + Margaret. Often in economics, functions describe cause and effect. The variable on the left-hand side is what is being explained (“the effect”). On the right-hand side is what is doing the explaining (“the causes”). For example, suppose your GPA was determined as follows: GPA = 0.25 × combined_SAT + 0.25 × class_attendance + 0.50 × hours_spent_studying This equation states that your GPA depends on three things: your combined SAT score, your class attendance, and the number of hours you spend studying. It also says that study time is twice as important (0.50) as either combined_SAT score (0.25) or class_attendance (0.25). If this relationship is true, how could you raise your GPA? By not skipping class and studying more. Note that you cannot do anything about your SAT score, since if you are in college, you have (presumably) already taken the SATs. course, economic models = Of money_spent_on_econ_books + money_spent_on_music, assuming that the only things you buy are economics books and music. like Budget relationships economic variables, express using Most of the relationships we use in this course are expressed as linear equations of the form: 494 Appendix A Expressing Equations Graphically y = b + mx Graphs are useful for two purposes. The first is to express equations visually
, and the second is to display statistics or data. This section will discuss expressing equations visually. To a mathematician or an economist, a variable is the name given to a quantity that may assume a range of values. In the equation of a line presented above, x and y are the variables, with x on the horizontal axis and y on the vertical axis, and b and m representing factors that determine the shape of the line. To see how this equation works, consider a numerical example: y = 9 + 3x In this equation for a specific line, the b term has been set equal to 9 and the m term has been set equal to 3. Table A1 shows the values of x and y for this given equation. Figure A1 shows this equation, and these values, in a graph. To construct the table, just plug in a series of different values for x, and then calculate what value of y results. In the figure, these points are plotted and a line is drawn through them 12 15 18 21 24 27 Table A1 Values for the Slope Intercept Equation Figure A1 Slope and the Algebra of Straight Lines This line graph has x on the horizontal axis and y on the vertical axis. The y-intercept—that is, the point where the line intersects the y-axis—is 9. The slope of the line is 3; that is, there is a rise of 3 on the vertical axis for every increase of 1 on the horizontal axis. The slope is the same all along a straight line. This example illustrates how the b and m terms in an equation for a straight line determine the shape of the line. The This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix A 495 b term is called the y-intercept. The reason for this name is that, if x = 0, then the b term will reveal where the line intercepts, or crosses, the y-axis. In this example, the line hits the vertical axis at 9. The m term in the equation for the line is the slope. Remember that slope is defined as rise over run; more specifically, the slope of a line from one point to another is the change in the vertical axis divided by the change in the horizontal axis. In this example, each time the x term increases by one (the run), the y term rises by three. Thus, the slope of this line is three. Specifying a
y-intercept and a slope—that is, specifying b and m in the equation for a line—will identify a specific line. Although it is rare for real-world data points to arrange themselves as an exact straight line, it often turns out that a straight line can offer a reasonable approximation of actual data. Interpreting the Slope The concept of slope is very useful in economics, because it measures the relationship between two variables. A positive slope means that two variables are positively related; that is, when x increases, so does y, or when x decreases, y decreases also. Graphically, a positive slope means that as a line on the line graph moves from left to right, the line rises. The length-weight relationship, shown in Figure A3 later in this Appendix, has a positive slope. We will learn in other chapters that price and quantity supplied have a positive relationship; that is, firms will supply more when the price is higher. A negative slope means that two variables are negatively related; that is, when x increases, y decreases, or when x decreases, y increases. Graphically, a negative slope means that, as the line on the line graph moves from left to right, the line falls. The altitude-air density relationship, shown in Figure A4 later in this appendix, has a negative slope. We will learn that price and quantity demanded have a negative relationship; that is, consumers will purchase less when the price is higher. A slope of zero means that there is no relationship between x and y. Graphically, the line is flat; that is, zero rise over the run. Figure A5 of the unemployment rate, shown later in this appendix, illustrates a common pattern of many line graphs: some segments where the slope is positive, other segments where the slope is negative, and still other segments where the slope is close to zero. The slope of a straight line between two points can be calculated in numerical terms. To calculate slope, begin by designating one point as the “starting point” and the other point as the “end point” and then calculating the rise over run between these two points. As an example, consider the slope of the air density graph between the points representing an altitude of 4,000 meters and an altitude of 6,000 meters: Rise: Change in variable on vertical axis (end point minus original point) Run: Change in variable on horizontal axis (end point minus original point) = 0.100 – 0.307 = –
0.207 = 6,000 – 4,000 = 2,000 Thus, the slope of a straight line between these two points would be that from the altitude of 4,000 meters up to 6,000 meters, the density of the air decreases by approximately 0.1 kilograms/cubic meter for each of the next 1,000 meters. Suppose the slope of a line were to increase. Graphically, that means it would get steeper. Suppose the slope of a line were to decrease. Then it would get flatter. These conditions are true whether or not the slope was positive or negative to begin with. A higher positive slope means a steeper upward tilt to the line, while a smaller positive slope means a flatter upward tilt to the line. A negative slope that is larger in absolute value (that is, more negative) means a steeper downward tilt to the line. A slope of zero is a horizontal flat line. A vertical line has an infinite slope. Suppose a line has a larger intercept. Graphically, that means it would shift out (or up) from the old origin, parallel to the old line. If a line has a smaller intercept, it would shift in (or down), parallel to the old line. Solving Models with Algebra Economists often use models to answer a specific question, like: What will the unemployment rate be if the economy grows at 3% per year? Answering specific questions requires solving the “system” of equations that represent the model. Suppose the demand for personal pizzas is given by the following equation: 496 Appendix A where Qd is the amount of personal pizzas consumers want to buy (i.e., quantity demanded), and P is the price of pizzas. Suppose the supply of personal pizzas is: Qd = 16 – 2P where Qs is the amount of pizza producers will supply (i.e., quantity supplied). Finally, suppose that the personal pizza market operates where supply equals demand, or Qs = 2 + 5P Qd = Qs We now have a system of three equations and three unknowns (Qd, Qs, and P), which we can solve with algebra: Since Qd = Qs, we can set the demand and supply equation equal to each other: Subtracting 2 from both sides and adding 2P to both sides yields: Qd = Qs 16 – 2P = 2 + 5P 16 – 2P – 2 = 2 + 5P
– 2 14 – 2P = 5P 14 – 2P + 2P = 5P + 2P 14 = 7P = 7P 14 7 7 2 = P In other words, the price of each personal pizza will be $2. How much will consumers buy? Taking the price of $2, and plugging it into the demand equation, we get: Qd = 16 – 2P = 16 – 2(2) = 16 – 4 = 12 So if the price is $2 each, consumers will purchase 12. How much will producers supply? Taking the price of $2, and plugging it into the supply equation, we get: Qs = 2 + 5P = 2 + 5(2) = 2 + 10 = 12 So if the price is $2 each, producers will supply 12 personal pizzas. This means we did our math correctly, since Qd = Qs. Solving Models with Graphs If algebra is not your forte, you can get the same answer by using graphs. Take the equations for Qd and Qs and graph them on the same set of axes as shown in Figure A2. Since P is on the vertical axis, it is easiest if you solve each equation for P. The demand curve is then P = 8 – 0.5Qd and the supply curve is P = –0.4 + 0.2Qs. Note that the vertical intercepts are 8 and –0.4, and the slopes are –0.5 for demand and 0.2 for supply. If you draw the graphs carefully, you will see that where they cross (Qs = Qd), the price is $2 and the quantity is 12, just like the algebra predicted. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix A 497 Figure A2 Supply and Demand Graph The equations for Qd and Qs are displayed graphically by the sloped lines. We will use graphs more frequently in this book than algebra, but now you know the math behind the graphs. Growth Rates Growth rates are frequently encountered in real world economics. A growth rate is simply the percentage change in some quantity. It could be your income. It could be a business’s sales. It could be a nation’s GDP. The formula for computing a growth rate is straightforward: Percentage change = Change in quantity Quantity Suppose your job pays $10 per hour. Your
boss, however, is so impressed with your work that he gives you a $2 per hour raise. The percentage change (or growth rate) in your pay is $2/$10 = 0.20 or 20%. To compute the growth rate for data over an extended period of time, for example, the average annual growth in GDP over a decade or more, the denominator is commonly defined a little differently. In the previous example, we defined the quantity as the initial quantity—or the quantity when we started. This is fine for a one-time calculation, but when we compute the growth over and over, it makes more sense to define the quantity as the average quantity over the period in question, which is defined as the quantity halfway between the initial quantity and the next quantity. This is harder to explain in words than to show with an example. Suppose a nation’s GDP was $1 trillion in 2005 and $1.03 trillion in 2006. The growth rate between 2005 and 2006 would be the change in GDP ($1.03 trillion – $1.00 trillion) divided by the average GDP between 2005 and 2006 ($1.03 trillion + $1.00 trillion)/2. In other words: = $1.03 trillion – $1.00 trillion ($1.03 trillion + $1.00 trillion) / 2 = 0.03 1.015 = 0.0296 = 2.96% growth Note that if we used the first method, the calculation would be ($1.03 trillion – $1.00 trillion) / $1.00 trillion = 3% growth, which is approximately the same as the second, more complicated method. If you need a rough approximation, use the first method. If you need accuracy, use the second method. A few things to remember: A positive growth rate means the quantity is growing. A smaller growth rate means the quantity is growing more slowly. A larger growth rate means the quantity is growing more quickly. A negative growth rate means the quantity is decreasing. The same change over times yields a smaller growth rate. If you got a $2 raise each year, in the first year the growth rate would be $2/$10 = 20%, as shown above. But in the second year, the growth rate would be $2/$12 = 0.167 or 16.7% growth. In the third year, the same $2 raise would correspond to a $2/$14 = 14.2%. The moral of the story is this: To keep
the growth rate the same, the change must increase each period. Displaying Data Graphically and Interpreting the Graph Graphs are also used to display data or evidence. Graphs are a method of presenting numerical patterns. They 498 Appendix A condense detailed numerical information into a visual form in which relationships and numerical patterns can be seen more easily. For example, which countries have larger or smaller populations? A careful reader could examine a long list of numbers representing the populations of many countries, but with over 200 nations in the world, searching through such a list would take concentration and time. Putting these same numbers on a graph can quickly reveal population patterns. Economists use graphs both for a compact and readable presentation of groups of numbers and for building an intuitive grasp of relationships and connections. Three types of graphs are used in this book: line graphs, pie graphs, and bar graphs. Each is discussed below. We also provide warnings about how graphs can be manipulated to alter viewers’ perceptions of the relationships in the data. Line Graphs The graphs we have discussed so far are called line graphs, because they show a relationship between two variables: one measured on the horizontal axis and the other measured on the vertical axis. Sometimes it is useful to show more than one set of data on the same axes. The data in Table A2 is displayed in Figure A3 which shows the relationship between two variables: length and median weight for American baby boys and girls during the first three years of life. (The median means that half of all babies weigh more than this and half weigh less.) The line graph measures length in inches on the horizontal axis and weight in pounds on the vertical axis. For example, point A on the figure shows that a boy who is 28 inches long will have a median weight of about 19 pounds. One line on the graph shows the length-weight relationship for boys and the other line shows the relationship for girls. This kind of graph is widely used by healthcare providers to check whether a child’s physical development is roughly on track. Figure A3 The Length-Weight Relationship for American Boys and Girls The line graph shows the relationship between height and weight for boys and girls from birth to 3 years. Point A, for example, shows that a boy of 28 inches in height (measured on the horizontal axis) is typically 19 pounds in weight (measured on the vertical axis). These data apply only to children in the first three years of life. Boys from Birth to 36 Months Girls from Birth to 36 Months Length (
inches) Weight (pounds) Length (inches) Weight (pounds) 20.0 22.0 8.0 10.5 20.0 22.0 7.9 10.5 Table A2 Length to Weight Relationship for American Boys and Girls This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix A 499 Boys from Birth to 36 Months Girls from Birth to 36 Months 24.0 26.0 28.0 30.0 32.0 34.0 36.0 38.0 13.5 16.4 19.0 21.8 24.3 27.0 29.3 32.0 24.0 26.0 28.0 30.0 32.0 34.0 36.0 38.0 13.2 16.0 18.8 21.2 24.0 26.2 28.9 31.3 Table A2 Length to Weight Relationship for American Boys and Girls Not all relationships in economics are linear. Sometimes they are curves. Figure A4 presents another example of a line graph, representing the data from Table A3. In this case, the line graph shows how thin the air becomes when you climb a mountain. The horizontal axis of the figure shows altitude, measured in meters above sea level. The vertical axis measures the density of the air at each altitude. Air density is measured by the weight of the air in a cubic meter of space (that is, a box measuring one meter in height, width, and depth). As the graph shows, air pressure is heaviest at ground level and becomes lighter as you climb. Figure A4 shows that a cubic meter of air at an altitude of 500 meters weighs approximately one kilogram (about 2.2 pounds). However, as the altitude increases, air density decreases. A cubic meter of air at the top of Mount Everest, at about 8,828 meters, would weigh only 0.023 kilograms. The thin air at high altitudes explains why many mountain climbers need to use oxygen tanks as they reach the top of a mountain. Figure A4 Altitude-Air Density Relationship This line graph shows the relationship between altitude, measured in meters above sea level, and air density, measured in kilograms of air per cubic meter. As altitude rises, air density declines. The point at the top of Mount Everest has an altitude of approximately 8,828 meters above sea level (the horizontal axis) and air density of 0.023 kilograms per cubic meter (
the vertical axis). 500 Appendix A Altitude (meters) Air Density (kg/cubic meters) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500 7,000 7,500 8,000 8,500 9,000 9,500 10,000 1.200 1.093 0.831 0.678 0.569 0.484 0.415 0.357 0.307 0.231 0.182 0.142 0.100 0.085 0.066 0.051 0.041 0.025 0.022 0.019 0.014 Table A3 Altitude to Air Density Relationship The length-weight relationship and the altitude-air density relationships in these two figures represent averages. If you were to collect actual data on air pressure at different altitudes, the same altitude in different geographic locations will have slightly different air density, depending on factors like how far you are from the equator, local weather conditions, and the humidity in the air. Similarly, in measuring the height and weight of children for the previous line graph, children of a particular height would have a range of different weights, some above average and some below. In the real world, this sort of variation in data is common. The task of a researcher is to organize that data in a way that helps to understand typical patterns. The study of statistics, especially when combined with computer statistics and spreadsheet programs, is a great help in organizing this kind of data, plotting line graphs, and looking for typical underlying relationships. For most economics and social science majors, a statistics course will be required at some point. One common line graph is called a time series, in which the horizontal axis shows time and the vertical axis displays another variable. Thus, a time series graph shows how a variable changes over time. Figure A5 shows the unemployment rate in the United States since 1975, where unemployment is defined as the percentage of adults who want jobs and are looking for a job, but cannot find one. The points for the unemployment rate in each year are plotted This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix A 501 on the graph, and a line then connects the points, showing how the unemployment rate has moved up and down since 1975. The line graph makes it easy to see, for
example, that the highest unemployment rate during this time period was slightly less than 10% in the early 1980s and 2010, while the unemployment rate declined from the early 1990s to the end of the 1990s, before rising and then falling back in the early 2000s, and then rising sharply during the recession from 2008–2009. Figure A5 U.S. Unemployment Rate, 1975–2014 This graph provides a quick visual summary of unemployment data. With a graph like this, it is easy to spot the times of high unemployment and of low unemployment. Pie Graphs A pie graph (sometimes called a pie chart) is used to show how an overall total is divided into parts. A circle represents a group as a whole. The slices of this circular “pie” show the relative sizes of subgroups. Figure A6 shows how the U.S. population was divided among children, working age adults, and the elderly in 1970, 2000, and what is projected for 2030. The information is first conveyed with numbers in Table A4, and then in three pie charts. The first column of Table A4 shows the total U.S. population for each of the three years. Columns 2–4 categorize the total in terms of age groups—from birth to 18 years, from 19 to 64 years, and 65 years and above. In columns 2–4, the first number shows the actual number of people in each age category, while the number in parentheses shows the percentage of the total population comprised by that age group. Year Total Population 19 and Under 20–64 years Over 65 1970 2000 2030 205.0 million 275.4 million 351.1 million 77.2 (37.6%) 107.7 (52.5%) 20.1 (9.8%) 78.4 (28.5%) 162.2 (58.9%) 34.8 (12.6%) 92.6 (26.4%) 188.2 (53.6%) 70.3 (20.0%) Table A4 U.S. Age Distribution, 1970, 2000, and 2030 (projected) 502 Appendix A Figure A6 Pie Graphs of the U.S. Age Distribution (numbers in millions) The three pie graphs illustrate the division of total population into three age groups for the three different years. In a pie graph, each slice of the pie represents a share of the total, or a percentage. For example, 50% would be half of the pie and 20% would
be one-fifth of the pie. The three pie graphs in Figure A6 show that the share of the U.S. population 65 and over is growing. The pie graphs allow you to get a feel for the relative size of the different age groups from 1970 to 2000 to 2030, without requiring you to slog through the specific numbers and percentages in the table. Some common examples of how pie graphs are used include dividing the population into groups by age, income level, ethnicity, religion, occupation; dividing different firms into categories by size, industry, number of employees; and dividing up government spending or taxes into its main categories. Bar Graphs A bar graph uses the height of different bars to compare quantities. Table A5 lists the 12 most populous countries in the world. Figure A7 provides this same data in a bar graph. The height of the bars corresponds to the population of each country. Although you may know that China and India are the most populous countries in the world, seeing how the bars on the graph tower over the other countries helps illustrate the magnitude of the difference between the sizes of national populations. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix A 503 Figure A7 Leading Countries of the World by Population, 2015 (in millions) The graph shows the 12 countries of the world with the largest populations. The height of the bars in the bar graph shows the size of the population for each country. Country Population China India United States Indonesia Brazil Pakistan Nigeria Bangladesh Russia Japan Mexico Philippines 1,369 1,270 321 255 204 190 184 158 146 127 121 101 Table A5 Leading 12 Countries of the World by Population Bar graphs can be subdivided in a way that reveals information similar to that we can get from pie charts. Figure A8 offers three bar graphs based on the information from Figure A6 about the U.S. age distribution in 1970, 2000, and 2030. Figure A8 (a) shows three bars for each year, representing the total number of persons in each age bracket for each year. Figure A8 (b) shows just one bar for each year, but the different age groups are now shaded inside the bar. In Figure A8 (c), still based on the same data, the vertical axis measures percentages rather than the number of persons. In this case, all three bar graphs are the same height, representing 100% of the population, with each bar divided according to the percentage of population in each age group.
It is sometimes easier for a reader to run his or her eyes across several bar graphs, comparing the shaded areas, rather than trying to compare several pie graphs. 504 Appendix A Figure A8 U.S. Population with Bar Graphs Population data can be represented in different ways. (a) Shows three bars for each year, representing the total number of persons in each age bracket for each year. (b) Shows just one bar for each year, but the different age groups are now shaded inside the bar. (c) Sets the vertical axis as a measure of percentages rather than the number of persons. All three bar graphs are the same height and each bar is divided according to the percentage of population in each age group. Figure A7 and Figure A8 show how the bars can represent countries or years, and how the vertical axis can represent a numerical or a percentage value. Bar graphs can also compare size, quantity, rates, distances, and other quantitative categories. Comparing Line Graphs with Pie Charts and Bar Graphs Now that you are familiar with pie graphs, bar graphs, and line graphs, how do you know which graph to use for your data? Pie graphs are often better than line graphs at showing how an overall group is divided. However, if a pie graph has too many slices, it can become difficult to interpret. Bar graphs are especially useful when comparing quantities. For example, if you are studying the populations of different countries, as in Figure A7, bar graphs can show the relationships between the population sizes of multiple countries. Not only can it show these relationships, but it can also show breakdowns of different groups within the population. A line graph is often the most effective format for illustrating a relationship between two variables that are both changing. For example, time series graphs can show patterns as time changes, like the unemployment rate over time. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix A 505 Line graphs are widely used in economics to present continuous data about prices, wages, quantities bought and sold, the size of the economy. How Graphs Can Be Misleading Graphs not only reveal patterns; they can also alter how patterns are perceived. To see some of the ways this can be done, consider the line graphs of Figure A9, Figure A10, and Figure A11. These graphs all illustrate the unemployment rate—but from different perspectives. Figure A9 506 Appendix A Figure A10 Presenting
Unemployment Rates in Different Ways, All of Them Accurate Simply changing the width and height of the area in which data is displayed can alter the perception of the data. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix A 507 Figure A11 Presenting Unemployment Rates in Different Ways, All of Them Accurate Simply changing the width and height of the area in which data is displayed can alter the perception of the data. Suppose you wanted a graph which gives the impression that the rise in unemployment in 2009 was not all that large, or all that extraordinary by historical standards. You might choose to present your data as in Figure A9 (a). Figure A9 (a) includes much of the same data presented earlier in Figure A5, but stretches the horizontal axis out longer relative to the vertical axis. By spreading the graph wide and flat, the visual appearance is that the rise in unemployment is not so large, and is similar to some past rises in unemployment. Now imagine you wanted to emphasize how unemployment spiked substantially higher in 2009. In this case, using the same data, you can stretch the vertical axis out relative to the horizontal axis, as in Figure A9 (b), which makes all rises and falls in unemployment appear larger. A similar effect can be accomplished without changing the length of the axes, but by changing the scale on the vertical axis. In Figure A10 (c), the scale on the vertical axis runs from 0% to 30%, while in Figure A10 (d), the vertical axis runs from 3% to 10%. Compared to Figure A5, where the vertical scale runs from 0% to 12%, Figure A10 (c) makes the fluctuation in unemployment look smaller, while Figure A10 (d) makes it look larger. Another way to alter the perception of the graph is to reduce the amount of variation by changing the number of points plotted on the graph. Figure A10 (e) shows the unemployment rate according to five-year averages. By averaging out some of the year-to-year changes, the line appears smoother and with fewer highs and lows. In reality, the unemployment rate is reported monthly, and Figure A11 (f) shows the monthly figures since 1960, which fluctuate more than the five-year average. Figure A11 (f) is also a vivid illustration of how graphs can compress lots of data. The graph includes monthly data since 1960, which over almost 50 years, works out to
nearly 600 data points. 508 Appendix A Reading that list of 600 data points in numerical form would be hypnotic. You can, however, get a good intuitive sense of these 600 data points very quickly from the graph. A final trick in manipulating the perception of graphical information is that, by choosing the starting and ending points carefully, you can influence the perception of whether the variable is rising or falling. The original data show a general pattern with unemployment low in the 1960s, but spiking up in the mid-1970s, early 1980s, early 1990s, early 2000s, and late 2000s. Figure A11 (g), however, shows a graph that goes back only to 1975, which gives an impression that unemployment was more-or-less gradually falling over time until the 2009 recession pushed it back up to its “original” level—which is a plausible interpretation if one starts at the high point around 1975. These kinds of tricks—or shall we just call them “presentation choices”— are not limited to line graphs. In a pie chart with many small slices and one large slice, someone must decided what categories should be used to produce these slices in the first place, thus making some slices appear bigger than others. If you are making a bar graph, you can make the vertical axis either taller or shorter, which will tend to make variations in the height of the bars appear more or less. Being able to read graphs is an essential skill, both in economics and in life. A graph is just one perspective or point of view, shaped by choices such as those discussed in this section. Do not always believe the first quick impression from a graph. View with caution. Key Concepts and Summary Math is a tool for understanding economics and economic relationships can be expressed mathematically using algebra or graphs. The algebraic equation for a line is y = b + mx, where x is the variable on the horizontal axis and y is the variable on the vertical axis, the b term is the y-intercept and the m term is the slope. The slope of a line is the same at any point on the line and it indicates the relationship (positive, negative, or zero) between two economic variables. Economic models can be solved algebraically or graphically. Graphs allow you to illustrate data visually. They can illustrate patterns, comparisons, trends, and apportionment by condensing the numerical data and providing an intuitive sense of relationships in the data. A line graph shows the relationship
between two variables: one is shown on the horizontal axis and one on the vertical axis. A pie graph shows how something is allotted, such as a sum of money or a group of people. The size of each slice of the pie is drawn to represent the corresponding percentage of the whole. A bar graph uses the height of bars to show a relationship, where each bar represents a certain entity, like a country or a group of people. The bars on a bar graph can also be divided into segments to show subgroups. Any graph is a single visual perspective on a subject. The impression it leaves will be based on many choices, such as what data or time frame is included, how data or groups are divided up, the relative size of vertical and horizontal axes, whether the scale used on a vertical starts at zero. Thus, any graph should be regarded somewhat skeptically, remembering that the underlying relationship can be open to different interpretations. Review Questions Exercise A1 Name three kinds of graphs and briefly state when is most appropriate to use each type of graph. Exercise A2 What is slope on a line graph? Exercise A3 What do the slices of a pie chart represent? Exercise A4 Why is a bar chart the best way to illustrate comparisons? Exercise A5 How does the appearance of positive slope differ from negative slope and from zero slope? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix B 509 B \| Indifference Curves Economists use a vocabulary of maximizing utility to describe people’s preferences. In Consumer Choices, the level of utility that a person receives is described in numerical terms. This appendix presents an alternative approach to describing personal preferences, called indifference curves, which avoids any need for using numbers to measure utility. By setting aside the assumption of putting a numerical valuation on utility—an assumption that many students and economists find uncomfortably unrealistic—the indifference curve framework helps to clarify the logic of the underlying model. What Is an Indifference Curve? People cannot really put a numerical value on their level of satisfaction. However, they can, and do, identify what choices would give them more, or less, or the same amount of satisfaction. An indifference curve shows combinations of goods that provide an equal level of utility or satisfaction. For example, Figure B1 presents three indifference curves that represent Lilly’s preferences for the tradeoffs that she faces in her two main relaxation activities: eating doughnuts and reading paperback books. Each indifference
curve (Ul, Um, and Uh) represents one level of utility. First we will explore the meaning of one particular indifference curve and then we will look at the indifference curves as a group. Figure B1 Lilly’s Indifference Curves Lilly would receive equal utility from all points on a given indifference curve. Any points on the highest indifference curve Uh, like F, provide greater utility than any points like A, B, C, and D on the middle indifference curve Um. Similarly, any points on the middle indifference curve Um provide greater utility than any points on the lowest indifference curve Ul. The Shape of an Indifference Curve The indifference curve Um has four points labeled on it: A, B, C, and D. Since an indifference curve represents a set of choices that have the same level of utility, Lilly must receive an equal amount of utility, judged according to her personal preferences, from two books and 120 doughnuts (point A), from three books and 84 doughnuts (point B) from 11 books and 40 doughnuts (point C) or from 12 books and 35 doughnuts (point D). She would also receive the same utility from any of the unlabeled intermediate points along this indifference curve. 510 Appendix B Indifference curves have a roughly similar shape in two ways: 1) they are downward sloping from left to right; 2) they are convex with respect to the origin. In other words, they are steeper on the left and flatter on the right. The downward slope of the indifference curve means that Lilly must trade off less of one good to get more of the other, while holding utility constant. For example, points A and B sit on the same indifference curve Um, which means that they provide Lilly with the same level of utility. Thus, the marginal utility that Lilly would gain from, say, increasing her consumption of books from two to three must be equal to the marginal utility that she would lose if her consumption of doughnuts was cut from 120 to 84—so that her overall utility remains unchanged between points A and B. Indeed, the slope along an indifference curve as the marginal rate of substitution, which is the rate at which a person is willing to trade one good for another so that utility will remain the same. Indifference curves like Um are steeper on the left and flatter on the right. The reason behind this shape involves diminishing marginal utility—the notion that as a person consumes more of a good, the marginal utility from each additional unit becomes lower. Compare two
different choices between points that all provide Lilly an equal amount of utility along the indifference curve Um: the choice between A and B, and between C and D. In both choices, Lilly consumes one more book, but between A and B her consumption of doughnuts falls by 36 (from 120 to 84) and between C and D it falls by only five (from 40 to 35). The reason for this difference is that points A and C are different starting points, and thus have different implications for marginal utility. At point A, Lilly has few books and many doughnuts. Thus, her marginal utility from an extra book will be relatively high while the marginal utility of additional doughnuts is relatively low—so on the margin, it will take a relatively large number of doughnuts to offset the utility from the marginal book. At point C, however, Lilly has many books and few doughnuts. From this starting point, her marginal utility gained from extra books will be relatively low, while the marginal utility lost from additional doughnuts would be relatively high—so on the margin, it will take a relatively smaller number of doughnuts to offset the change of one marginal book. In short, the slope of the indifference curve changes because the marginal rate of substitution—that is, the quantity of one good that would be traded for the other good to keep utility constant—also changes, as a result of diminishing marginal utility of both goods. The Field of Indifference Curves Each indifference curve represents the choices that provide a single level of utility. Every level of utility will have its own indifference curve. Thus, Lilly’s preferences will include an infinite number of indifference curves lying nestled together on the diagram—even though only three of the indifference curves, representing three levels of utility, appear on Figure B1. In other words, an infinite number of indifference curves are not drawn on this diagram—but you should remember that they exist. Higher indifference curves represent a greater level of utility than lower ones. In Figure B1, indifference curve Ul can be thought of as a “low” level of utility, while Um is a “medium” level of utility and Uh is a “high” level of utility. All of the choices on indifference curve Uh are preferred to all of the choices on indifference curve Um, which in turn are preferred to all of the choices on Ul. To understand why higher indifference curves are preferred to lower ones, compare point B on indifference curve Um to point F on indifference curve Uh. Point F has
greater consumption of both books (five to three) and doughnuts (100 to 84), so point F is clearly preferable to point B. Given the definition of an indifference curve—that all the points on the curve have the same level of utility—if point F on indifference curve Uh is preferred to point B on indifference curve Um, then it must be true that all points on indifference curve Uh have a higher level of utility than all points on Um. More generally, for any point on a lower indifference curve, like Ul, you can identify a point on a higher indifference curve like Um or Uh that has a higher consumption of both goods. Since one point on the higher indifference curve is preferred to one point on the lower curve, and since all the points on a given indifference curve have the same level of utility, it must be true that all points on higher indifference curves have greater utility than all points on lower indifference curves. These arguments about the shapes of indifference curves and about higher or lower levels of utility do not require any numerical estimates of utility, either by the individual or by anyone else. They are only based on the assumptions that when people have less of one good they need more of another good to make up for it, if they are keeping the same level of utility, and that as people have more of a good, the marginal utility they receive from additional units of that good will diminish. Given these gentle assumptions, a field of indifference curves can be mapped out to describe the preferences of any individual. The Individuality of Indifference Curves Each person determines his or her own preferences and utility. Thus, while indifference curves have the same general shape—they slope down, and the slope is steeper on the left and flatter on the right—the specific shape of indifference This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix B 511 curves can be different for every person. Figure B1, for example, applies only to Lilly’s preferences. Indifference curves for other people would probably travel through different points. Utility-Maximizing with Indifference Curves People seek the highest level of utility, which means that they wish to be on the highest possible indifference curve. However, people are limited by their budget constraints, which show what tradeoffs are actually possible. Maximizing Utility at the Highest Indifference Curve Return to the situation of Lilly’s choice between paperback books and doughnuts. Say that books cost $6, dough
nuts are 50 cents each, and that Lilly has $60 to spend. This information provides the basis for the budget line shown in Figure B2. Along with the budget line are shown the three indifference curves from Figure B1. What is Lilly’s utility-maximizing choice? Several possibilities are identified in the diagram. Figure B2 Indifference Curves and a Budget Constraint Lilly’s preferences are shown by the indifference curves. Lilly’s budget constraint, given the prices of books and doughnuts and her income, is shown by the straight line. Lilly’s optimal choice will be point B, where the budget line is tangent to the indifference curve Um. Lilly would have more utility at a point like F on the higher indifference curve Uh, but the budget line does not touch the higher indifference curve Uh at any point, so she cannot afford this choice. A choice like G is affordable to Lilly, but it lies on indifference curve Ul and thus provides less utility than choice B, which is on indifference curve Um. The choice of F with five books and 100 doughnuts is highly desirable, since it is on the highest indifference curve Uh of those shown in the diagram. However, it is not affordable given Lilly’s budget constraint. The choice of H with three books and 70 doughnuts on indifference curve Ul is a wasteful choice, since it is inside Lilly’s budget set, and as a utility-maximizer, Lilly will always prefer a choice on the budget constraint itself. Choices B and G are both on the opportunity set. However, choice G of six books and 48 doughnuts is on lower indifference curve Ul than choice B of three books and 84 doughnuts, which is on the indifference curve Um. If Lilly were to start at choice G, and then thought about whether the marginal utility she was deriving from doughnuts and books, she would decide that some additional doughnuts and fewer books would make her happier—which would cause her to move toward her preferred choice B. Given the combination of Lilly’s personal preferences, as identified by her indifference curves, and Lilly’s opportunity set, which is determined by prices and income, B will be her utility-maximizing choice. The highest achievable indifference curve touches the opportunity set at a single point of tangency. Since an infinite number of indifference curves exist, even if only a few of them are drawn on any given diagram, there will always exist one indifference curve that touches the budget line
at a single point of tangency. All higher indifference curves, like Uh, will be completely above the budget line and, although the choices on that indifference curve would provide 512 Appendix B higher utility, they are not affordable given the budget set. All lower indifference curves, like Ul, will cross the budget line in two separate places. When one indifference curve crosses the budget line in two places, however, there will be another, higher, attainable indifference curve sitting above it that touches the budget line at only one point of tangency. Changes in Income A rise in income causes the budget constraint to shift to the right. In graphical terms, the new budget constraint will now be tangent to a higher indifference curve, representing a higher level of utility. A reduction in income will cause the budget constraint to shift to the left, which will cause it to be tangent to a lower indifference curve, representing a reduced level of utility. If income rises by, for example, 50%, exactly how much will a person alter consumption of books and doughnuts? Will consumption of both goods rise by 50%, or will the quantity of one good rise substantially, while the quantity of the other good rises only a little, or even declines? Since personal preferences and the shape of indifference curves are different for each individual, the response to changes in income will be different, too. For example, consider the preferences of Manuel and Natasha in Figure B3 (a) and Figure B3 (b). They each start with an identical income of $40, which they spend on yogurts that cost $1 and rental movies that cost $4. Thus, they face identical budget constraints. However, based on Manuel’s preferences, as revealed by his indifference curves, his utility-maximizing choice on the original budget set occurs where his opportunity set is tangent to the highest possible indifference curve at W, with three movies and 28 yogurts, while Natasha’s utility-maximizing choice on the original budget set at Y will be seven movies and 12 yogurts. Figure B3 Manuel and Natasha’s Indifference Curves Manuel and Natasha originally face the same budget constraints; that is, same prices and same income. However, the indifference curves that illustrate their preferences are not the same. (a) Manuel’s original choice at W involves more yogurt and more movies, and he reacts to the higher income by mainly increasing consumption of movies at X. (b) Conversely, Natasha’s original choice (Y
) involves relatively more movies, but she reacts to the higher income by choosing relatively more yogurts. Even when budget constraints are the same, personal preferences lead to different original choices and to different reactions in response to a change in income. Now, say that income rises to $60 for both Manuel and Natasha, so their budget constraints shift to the right. As shown in Figure B3 (a), Manuel’s new utility maximizing choice at X will be seven movies and 32 yogurts—that is, Manuel will choose to spend most of the extra income on movies. Natasha’s new utility maximizing choice at Z will be eight movies and 28 yogurts—that is, she will choose to spend most of the extra income on yogurt. In this way, the indifference curve approach allows for a range of possible responses. However, if both goods are normal goods, then the typical response to a higher level of income will be to purchase more of them—although exactly how much more is a matter of personal preference. If one of the goods is an inferior good, the response to a higher level of income This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix B 513 will be to purchase less of it. Responses to Price Changes: Substitution and Income Effects A higher price for a good will cause the budget constraint to shift to the left, so that it is tangent to a lower indifference curve representing a reduced level of utility. Conversely, a lower price for a good will cause the opportunity set to shift to the right, so that it is tangent to a higher indifference curve representing an increased level of utility. Exactly how much a change in price will lead to the quantity demanded of each good will depend on personal preferences. Anyone who faces a change in price will experience two interlinked motivations: a substitution effect and an income effect. The substitution effect is that when a good becomes more expensive, people seek out substitutes. If oranges become more expensive, fruit-lovers scale back on oranges and eat more apples, grapefruit, or raisins. Conversely, when a good becomes cheaper, people substitute toward consuming more. If oranges get cheaper, people fire up their juicing machines and ease off on other fruits and foods. The income effect refers to how a change in the price of a good alters the effective buying power of one’s income. If the price of a good that you have been buying falls, then in
effect your buying power has risen—you are able to purchase more goods. Conversely, if the price of a good that you have been buying rises, then the buying power of a given amount of income is diminished. (One common source of confusion is that the “income effect” does not refer to a change in actual income. Instead, it refers to the situation in which the price of a good changes, and thus the quantities of goods that can be purchased with a fixed amount of income change. It might be more accurate to call the “income effect” a “buying power effect,” but the “income effect” terminology has been used for decades, and it is not going to change during this economics course.) Whenever a price changes, consumers feel the pull of both substitution and income effects at the same time. Using indifference curves, you can illustrate the substitution and income effects on a graph. In Figure B4, Ogden faces a choice between two goods: haircuts or personal pizzas. Haircuts cost $20, personal pizzas cost $6, and he has $120 to spend. Figure B4 Substitution and Income Effects The original choice is A, the point of tangency between the original budget constraint and indifference curve. The new choice is B, the point of tangency between the new budget constraint and the lower indifference curve. Point C is the tangency between the dashed line, where the slope shows the new higher price of haircuts, and the original indifference curve. The substitution effect is the shift from A to C, which means getting fewer haircuts and more pizza. The income effect is the shift from C to B; that is, the reduction in buying power that causes a shift from the higher indifference curve to the lower indifference curve, with relative prices remaining unchanged. The income effect results in less consumed of both goods. Both substitution and income effects cause fewer haircuts to be consumed. For pizza, in this case, the substitution effect and income effect cancel out, leading to the same amount of pizza consumed. The price of haircuts rises to $30. Ogden starts at choice A on the higher opportunity set and the higher indifference curve. After the price of haircuts increases, he chooses B on the lower opportunity set and the lower indifference 514 Appendix B curve. Point B with two haircuts and 10 personal pizzas is immediately below point A with three haircuts and 10 personal pizzas, showing that Ogden reacted to a higher price of hairc
uts by cutting back only on haircuts, while leaving his consumption of pizza unchanged. The dashed line in the diagram, and point C, are used to separate the substitution effect and the income effect. To understand their function, start by thinking about the substitution effect with this question: How would Ogden change his consumption if the relative prices of the two goods changed, but this change in relative prices did not affect his utility? The slope of the budget constraint is determined by the relative price of the two goods; thus, the slope of the original budget line is determined by the original relative prices, while the slope of the new budget line is determined by the new relative prices. With this thought in mind, the dashed line is a graphical tool inserted in a specific way: It is inserted so that it is parallel with the new budget constraint, so it reflects the new relative prices, but it is tangent to the original indifference curve, so it reflects the original level of utility or buying power. Thus, the movement from the original choice (A) to point C is a substitution effect; it shows the choice that Ogden would make if relative prices shifted (as shown by the different slope between the original budget set and the dashed line) but if buying power did not shift (as shown by being tangent to the original indifference curve). The substitution effect will encourage people to shift away from the good which has become relatively more expensive—in Ogden’s case, the haircuts on the vertical axis—and toward the good which has become relatively less expensive—in this case, the pizza on the vertical axis. The two arrows labeled with “s” for “substitution effect,” one on each axis, show the direction of this movement. The income effect is the movement from point C to B, which shows how Ogden reacts to a reduction in his buying power from the higher indifference curve to the lower indifference curve, but holding constant the relative prices (because the dashed line has the same slope as the new budget constraint). In this case, where the price of one good increases, buying power is reduced, so the income effect means that consumption of both goods should fall (if they are both normal goods, which it is reasonable to assume unless there is reason to believe otherwise). The two arrows labeled with “i” for “income effect,” one on each axis, show the direction of this income effect movement. Now, put the substitution and income effects together. When the price of
pizza increased, Ogden consumed less of it, for two reasons shown in the exhibit: the substitution effect of the higher price led him to consume less and the income effect of the higher price also led him to consume less. However, when the price of pizza increased, Ogden consumed the same quantity of haircuts. The substitution effect of a higher price for pizza meant that haircuts became relatively less expensive (compared to pizza), and this factor, taken alone, would have encouraged Ogden to consume more haircuts. However, the income effect of a higher price for pizza meant that he wished to consume less of both goods, and this factor, taken alone, would have encouraged Ogden to consume fewer haircuts. As shown in Figure B4, in this particular example the substitution effect and income effect on Ogden’s consumption of haircuts are offsetting—so he ends up consuming the same quantity of haircuts after the price increase for pizza as before. The size of these income and substitution effects will differ from person to person, depending on individual preferences. For example, if Ogden’s substitution effect away from pizza and toward haircuts is especially strong, and outweighs the income effect, then a higher price for pizza might lead to increased consumption of haircuts. This case would be drawn on the graph so that the point of tangency between the new budget constraint and the relevant indifference curve occurred below point B and to the right. Conversely, if the substitution effect away from pizza and toward haircuts is not as strong, and the income effect on is relatively stronger, then Ogden will be more likely to react to the higher price of pizza by consuming less of both goods. In this case, his optimal choice after the price change will be above and to the left of choice B on the new budget constraint. Although the substitution and income effects are often discussed as a sequence of events, it should be remembered that they are twin components of a single cause—a change in price. Although you can analyze them separately, the two effects are always proceeding hand in hand, happening at the same time. Indifference Curves with Labor-Leisure and Intertemporal Choices The concept of an indifference curve applies to tradeoffs in any household choice, including the labor-leisure choice or the intertemporal choice between present and future consumption. In the labor-leisure choice, each indifference curve shows the combinations of leisure and income that provide a certain level of utility. In an intertemporal choice, each indifference
curve shows the combinations of present and future consumption that provide a certain level of This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix B 515 utility. The general shapes of the indifference curves—downward sloping, steeper on the left and flatter on the right—also remain the same. A Labor-Leisure Example Petunia is working at a job that pays $12 per hour but she gets a raise to $20 per hour. After family responsibilities and sleep, she has 80 hours per week available for work or leisure. As shown in Figure B5, the highest level of utility for Petunia, on her original budget constraint, is at choice A, where it is tangent to the lower indifference curve (Ul). Point A has 30 hours of leisure and thus 50 hours per week of work, with income of $600 per week (that is, 50 hours of work at $12 per hour). Petunia then gets a raise to $20 per hour, which shifts her budget constraint to the right. Her new utility-maximizing choice occurs where the new budget constraint is tangent to the higher indifference curve Uh. At B, Petunia has 40 hours of leisure per week and works 40 hours, with income of $800 per week (that is, 40 hours of work at $20 per hour). Figure B5 Effects of a Change in Petunia’s Wage Petunia starts at choice A, the tangency between her original budget constraint and the lower indifference curve Ul. The wage increase shifts her budget constraint to the right, so that she can now choose B on indifference curve Uh. The substitution effect is the movement from A to C. In this case, the substitution effect would lead Petunia to choose less leisure, which is relatively more expensive, and more income, which is relatively cheaper to earn. The income effect is the movement from C to B. The income effect in this example leads to greater consumption of both goods. Overall, in this example, income rises because of both substitution and income effects. However, leisure declines because of the substitution effect but increases because of the income effect—leading, in Petunia’s case, to an overall increase in the quantity of leisure consumed. Substitution and income effects provide a vocabulary for discussing how Petunia reacts to a higher hourly wage. The dashed line serves as the tool for separating the two effects on the graph. The substitution effect tells how Petunia would
have changed her hours of work if her wage had risen, so that income was relatively cheaper to earn and leisure was relatively more expensive, but if she had remained at the same level of utility. The slope of the budget constraint in a labor-leisure diagram is determined by the wage rate. Thus, the dashed line is carefully inserted with the slope of the new opportunity set, reflecting the labor-leisure tradeoff of the new wage rate, but tangent to the original indifference curve, showing the same level of utility or “buying power.” The shift from original choice A to point C, which is the point of tangency between the original indifference curve and the dashed line, shows that because of the higher wage, Petunia will want to consume less leisure and more income. The “s” arrows on the horizontal and vertical axes of Figure B5 show the substitution effect on leisure and on income. The income effect is that the higher wage, by shifting the labor-leisure budget constraint to the right, makes it possible for Petunia to reach a higher level of utility. The income effect is the movement from point C to point B; that is, it shows how Petunia’s behavior would change in response to a higher level of utility or “buying power,” with the wage rate remaining the same (as shown by the dashed line being parallel to the new budget constraint). The income effect, encouraging Petunia to consume both more leisure and more income, is drawn with arrows on the horizontal and vertical axis of Figure B5. 516 Appendix B Putting these effects together, Petunia responds to the higher wage by moving from choice A to choice B. This movement involves choosing more income, both because the substitution effect of higher wages has made income relatively cheaper or easier to earn, and because the income effect of higher wages has made it possible to have more income and more leisure. Her movement from A to B also involves choosing more leisure because, according to Petunia’s preferences, the income effect that encourages choosing more leisure is stronger than the substitution effect that encourages choosing less leisure. Figure B5 represents only Petunia’s preferences. Other people might make other choices. For example, a person whose substitution and income effects on leisure exactly counterbalanced each other might react to a higher wage with a choice like D, exactly above the original choice A, which means taking all of the benefit of the higher wages in the form of income while working the same number
of hours. Yet another person, whose substitution effect on leisure outweighed the income effect, might react to a higher wage by making a choice like F, where the response to higher wages is to work more hours and earn much more income. To represent these different preferences, you could easily draw the indifference curve Uh to be tangent to the new budget constraint at D or F, rather than at B. An Intertemporal Choice Example Quentin has saved up $10,000. He is thinking about spending some or all of it on a vacation in the present, and then will save the rest for another big vacation five years from now. Over those five years, he expects to earn a total 80% rate of return. Figure B6 shows Quentin’s budget constraint and his indifference curves between present consumption and future consumption. The highest level of utility that Quentin can achieve at his original intertemporal budget constraint occurs at point A, where he is consuming $6,000, saving $4,000 for the future, and expecting with the accumulated interest to have $7,200 for future consumption (that is, $4,000 in current financial savings plus the 80% rate of return). However, Quentin has just realized that his expected rate of return was unrealistically high. A more realistic expectation is that over five years he can earn a total return of 30%. In effect, his intertemporal budget constraint has pivoted to the left, so that his original utility-maximizing choice is no longer available. Will Quentin react to the lower rate of return by saving more, or less, or the same amount? Again, the language of substitution and income effects provides a framework for thinking about the motivations behind various choices. The dashed line, which is a graphical tool to separate the substitution and income effect, is carefully inserted with the same slope as the new opportunity set, so that it reflects the changed rate of return, but it is tangent to the original indifference curve, so that it shows no change in utility or “buying power.” The substitution effect tells how Quentin would have altered his consumption because the lower rate of return makes future consumption relatively more expensive and present consumption relatively cheaper. The movement from the original choice A to point C shows how Quentin substitutes toward more present consumption and less future consumption in response to the lower interest rate, with no change in utility. The substitution arrows on the horizontal and vertical axes of Figure B6 show the direction of the substitution effect motivation. The substitution effect suggests that, because
of the lower interest rate, Quentin should consume more in the present and less in the future. Quentin also has an income effect motivation. The lower rate of return shifts the budget constraint to the left, which means that Quentin’s utility or “buying power” is reduced. The income effect (assuming normal goods) encourages less of both present and future consumption. The impact of the income effect on reducing present and future consumption in this example is shown with “i” arrows on the horizontal and vertical axis of Figure B6. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix B 517 Figure B6 Indifference Curve and an Intertemporal Budget Constraint The original choice is A, at the tangency between the original budget constraint and the original indifference curve Uh. The dashed line is drawn parallel to the new budget set, so that its slope reflects the lower rate of return, but is tangent to the original indifference curve. The movement from A to C is the substitution effect: in this case, future consumption has become relatively more expensive, and present consumption has become relatively cheaper. The income effect is the shift from C to B; that is, the reduction in utility or “buying power” that causes a move to a lower indifference curve Ul, but with the relative price the same. It means less present and less future consumption. In the move from A to B, the substitution effect on present consumption is greater than the income effect, so the overall result is more present consumption. Notice that the lower indifference curve could have been drawn tangent to the lower budget constraint point D or point F, depending on personal preferences. Taking both effects together, the substitution effect is encouraging Quentin toward more present and less future consumption, because present consumption is relatively cheaper, while the income effect is encouraging him to less present and less future consumption, because the lower interest rate is pushing him to a lower level of utility. For Quentin’s personal preferences, the substitution effect is stronger so that, overall, he reacts to the lower rate of return with more present consumption and less savings at choice B. However, other people might have different preferences. They might react to a lower rate of return by choosing the same level of present consumption and savings at choice D, or by choosing less present consumption and more savings at a point like F. For these other sets of preferences, the income effect of a lower rate of return on
present consumption would be relatively stronger, while the substitution effect would be relatively weaker. Sketching Substitution and Income Effects Indifference curves provide an analytical tool for looking at all the choices that provide a single level of utility. They eliminate any need for placing numerical values on utility and help to illuminate the process of making utility-maximizing decisions. They also provide the basis for a more detailed investigation of the complementary motivations that arise in response to a change in a price, wage or rate of return—namely, the substitution and income effects. If you are finding it a little tricky to sketch diagrams that show substitution and income effects so that the points of tangency all come out correctly, it may be useful to follow this procedure. Step 1. Begin with a budget constraint showing the choice between two goods, which this example will call “candy” and “movies.” Choose a point A which will be the optimal choice, where the indifference curve will be tangent—but it is often easier not to draw in the indifference curve just yet. See Figure B7. 518 Appendix B Figure B7 Step 2. Now the price of movies changes: let’s say that it rises. That shifts the budget set inward. You know that the higher price will push the decision-maker down to a lower level of utility, represented by a lower indifference curve. But at this stage, draw only the new budget set. See Figure B8. Figure B8 Step 3. The key tool in distinguishing between substitution and income effects is to insert a dashed line, parallel to the new budget line. This line is a graphical tool that allows you to distinguish between the two changes: (1) the effect on consumption of the two goods of the shift in prices—with the level of utility remaining unchanged—which is the substitution effect; and (2) the effect on consumption of the two goods of shifting from one indifference curve to the other—with relative prices staying unchanged—which is the income effect. The dashed line is inserted in this step. The trick is to have the dashed line travel close to the original choice A, but not directly through point A. See Figure B9. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix B 519 Figure B9 Step 4. Now, draw the original indifference curve, so that it is tangent to both point A on the original budget line and to a point C on
the dashed line. Many students find it easiest to first select the tangency point C where the original indifference curve touches the dashed line, and then to draw the original indifference curve through A and C. The substitution effect is illustrated by the movement along the original indifference curve as prices change but the level of utility holds constant, from A to C. As expected, the substitution effect leads to less consumed of the good that is relatively more expensive, as shown by the “s” (substitution) arrow on the vertical axis, and more consumed of the good that is relatively less expensive, as shown by the “s” arrow on the horizontal axis. See Figure B10. Figure B10 Step 5. With the substitution effect in place, now choose utility-maximizing point B on the new opportunity set. When you choose point B, think about whether you wish the substitution or the income effect to have a larger impact on the good (in this case, candy) on the horizontal axis. If you choose point B to be directly in a vertical line with point A (as is illustrated here), then the income effect will be exactly offsetting the substitution effect on the horizontal axis. If you insert point B so that it lies a little to right of the original point A, then the substitution effect will exceed the income effect. If you insert point B so that it lies a little to the left of point A, then the income effect will exceed 520 Appendix B the substitution effect. The income effect is the movement from C to B, showing how choices shifted as a result of the decline in buying power and the movement between two levels of utility, with relative prices remaining the same. With normal goods, the negative income effect means less consumed of each good, as shown by the direction of the “i” (income effect) arrows on the vertical and horizontal axes. See Figure B11. Figure B11 In sketching substitution and income effect diagrams, you may wish to practice some of the following variations: (1) Price falls instead of a rising; (2) The price change affects the good on either the vertical or the horizontal axis; (3) Sketch these diagrams so that the substitution effect exceeds the income effect; the income effect exceeds the substitution effect; and the two effects are equal. One final note: The helpful dashed line can be drawn tangent to the new indifference curve, and parallel to the original budget line, rather than tangent to the original indifference curve and parallel to the new budget
line. Some students find this approach more intuitively clear. The answers you get about the direction and relative sizes of the substitution and income effects, however, should be the same. Key Concepts and Summary An indifference curve is drawn on a budget constraint diagram that shows the tradeoffs between two goods. All points along a single indifference curve provide the same level of utility. Higher indifference curves represent higher levels of utility. Indifference curves slope downward because, if utility is to remain the same at all points along the curve, a reduction in the quantity of the good on the vertical axis must be counterbalanced by an increase in the quantity of the good on the horizontal axis (or vice versa). Indifference curves are steeper on the far left and flatter on the far right, because of diminishing marginal utility. The utility-maximizing choice along a budget constraint will be the point of tangency where the budget constraint touches an indifference curve at a single point. A change in the price of any good has two effects: a substitution effect and an income effect. The substitution effect motivation encourages a utility-maximizer to buy less of what is relatively more expensive and more of what is relatively cheaper. The income effect motivation encourages a utilitymaximizer to buy more of both goods if utility rises or less of both goods if utility falls (if they are both normal goods). In a labor-leisure choice, every wage change has a substitution and an income effect. The substitution effect of a wage increase is to choose more income, since it is cheaper to earn, and less leisure, since its opportunity cost has increased. The income effect of a wage increase is to choose more of leisure and income, since they are both normal goods. The substitution and income effects of a wage decrease would reverse these directions. In an intertemporal consumption choice, every interest rate change has a substitution and an income effect. The substitution effect of an interest rate increase is to choose more future consumption, since it is now cheaper to earn This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix B 521 future consumption and less present consumption (more savings), since the opportunity cost of present consumption in terms of what is being given up in the future has increased. The income effect of an interest rate increase is to choose more of both present and future consumption, since they are both normal goods. The substitution and income effects of an interest rate decrease would reverse these directions. Review Questions Exercise B1
What point is preferred along an indifference curve? Exercise B2 Why do indifference curves slope down? Exercise B3 Why are indifference curves steep on the left and flatter on the right? Exercise B4 How many indifference curves does a person have? Exercise B5 How can you tell which indifference curves represent higher or lower levels of utility? Exercise B6 What is a substitution effect? Exercise B7 What is an income effect? Exercise B8 Does the “income effect” involve a change in income? Explain. Exercise B9 Does a change in price have both an income effect and a substitution effect? Does a change in income have both an income effect and a substitution effect? Exercise B10 Would you expect, in some cases, to see only an income effect or only a substitution effect? Explain. Exercise B11 Which is larger, the income effect or the substitution effect? 522 Appendix B This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix C 523 C \| Present Discounted Value As explained in Financial Markets, the prices of stocks and bonds depend on future events. The price of a bond depends on the future payments that the bond is expected to make, including both payments of interest and the repayment of the face value of the bond. The price of a stock depends on the expected future profits earned by the firm. The concept of a present discounted value (PDV), which is defined as the amount you should be willing to pay in the present for a stream of expected future payments, can be used to calculate appropriate prices for stocks and bonds. To place a present discounted value on a future payment, think about what amount of money you would need to have in the present to equal a certain amount in the future. This calculation will require an interest rate. For example, if the interest rate is 10%, then a payment of $110 a year from now will have a present discounted value of $100—that is, you could take $100 in the present and have $110 in the future. We will first shows how to apply the idea of present discounted value to a stock and then we will show how to apply it to a bond. Applying Present Discounted Value to a Stock Consider the case of Babble, Inc., a company that offers speaking lessons. For the sake of simplicity, say that the founder of Babble is 63 years old and plans to retire in two years, at which point the company will be disbanded. The company
is selling 200 shares of stock and profits are expected to be $15 million right away, in the present, $20 million one year from now, and $25 million two years from now. All profits will be paid out as dividends to shareholders as they occur. Given this information, what will an investor pay for a share of stock in this company? A financial investor, thinking about what future payments are worth in the present, will need to choose an interest rate. This interest rate will reflect the rate of return on other available financial investment opportunities, which is the opportunity cost of investing financial capital, and also a risk premium (that is, using a higher interest rate than the rates available elsewhere if this investment appears especially risky). In this example, say that the financial investor decides that appropriate interest rate to value these future payments is 15%. Table C1 shows how to calculate the present discounted value of the future profits. For each time period, when a benefit is going to be received, apply the formula: Present discounted value = Future value received years in the future (1 + Interest rate)numbers of years t Payments from Firm Present Value $15 million in present $15 million $20 million in one year $25 million in two years $20 million/(1 + 0.15)1 = $17.4 million $25 million/(1 + 0.15)2 = $18.9 million Total $51.3 million Table C1 Calculating Present Discounted Value of a Stock Next, add up all the present values for the different time periods to get a final answer. The present value calculations ask what the amount in the future is worth in the present, given the 15% interest rate. Notice that a different PDV calculation needs to be done separately for amounts received at different times. Then, divide the PDV of total profits by the number of shares, 200 in this case: 51.3 million/200 = 0.2565 million. The price per share should be about $256,500 per share. Of course, in the real world expected profits are a best guess, not a hard piece of data. Deciding which interest rate 524 Appendix C to apply for discounting to the present can be tricky. One needs to take into account both potential capital gains from the future sale of the stock and also dividends that might be paid. Differences of opinion on these issues are exactly why some financial investors want to buy a stock that other people want to sell: they are more optimistic about its future prospects. Concept
ually, however, it all comes down to what you are willing to pay in the present for a stream of benefits to be received in the future. Applying Present Discounted Value to a Bond A similar calculation works in the case of bonds. Financial Markets explains that if the interest rate falls after a bond is issued, so that the investor has locked in a higher rate, then that bond will sell for more than its face value. Conversely, if the interest rate rises after a bond is issued, then the investor is locked into a lower rate, and the bond will sell for less than its face value. The present value calculation sharpens this intuition. Think about a simple two-year bond. It was issued for $3,000 at an interest rate of 8%. Thus, after the first year, the bond pays interest of 240 (which is 3,000 × 8%). At the end of the second year, the bond pays $240 in interest, plus the $3,000 in principle. Calculate how much this bond is worth in the present if the discount rate is 8%. Then, recalculate if interest rates rise and the applicable discount rate is 11%. To carry out these calculations, look at the stream of payments being received from the bond in the future and figure out what they are worth in present discounted value terms. The calculations applying the present value formula are shown in Table C2. Stream of Payments (for the 8% interest rate) Present Value (for the 8% interest rate) Stream of Payments (for the 11% interest rate) Present Value (for the 11% interest rate) $240 payment after one year $240/(1 + 0.08)1 = $222.20 $240 payment after one year $240/(1 + 0.11)1 = $216.20 $3,240 payment after second year $3,240/(1 + 0.08)2 = $2,777.80 $3,240 payment after second year $3,240/(1 + 0.11)2 = $2,629.60 Total $3,000 Total $2,845.80 Table C2 Computing the Present Discounted Value of a Bond The first calculation shows that the present value of a $3,000 bond, issued at 8%, is just $3,000. After all, that is how much money the borrower is receiving. The calculation confirms that the present value is the same for the lender. The bond is moving money around in time,
from those willing to save in the present to those who want to borrow in the present, but the present value of what is received by the borrower is identical to the present value of what will be repaid to the lender. The second calculation shows what happens if the interest rate rises from 8% to 11%. The actual dollar payments in the first column, as determined by the 8% interest rate, do not change. However, the present value of those payments, now discounted at a higher interest rate, is lower. Even though the future dollar payments that the bond is receiving have not changed, a person who tries to sell the bond will find that the investment’s value has fallen. Again, real-world calculations are often more complex, in part because, not only the interest rate prevailing in the market, but also the riskiness of whether the borrower will repay the loan, will change. In any case, the price of a bond is always the present value of a stream of future expected payments. Other Applications Present discounted value is a widely used analytical tool outside the world of finance. Every time a business thinks about making a physical capital investment, it must compare a set of present costs of making that investment to the present discounted value of future benefits. When government thinks about a proposal to, for example, add safety features to a highway, it must compare costs incurred in the present to benefits received in the future. Some academic disputes over environmental policies, like how much to reduce carbon dioxide emissions because of the risk that they will lead to a warming of global temperatures several decades in the future, turn on how one compares present costs This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Appendix C 525 of pollution control with long-run future benefits. Someone who wins the lottery and is scheduled to receive a string of payments over 30 years might be interested in knowing what the present discounted value is of those payments. Whenever a string of costs and benefits stretches from the present into different times in the future, present discounted value becomes an indispensable tool of analysis. 526 Appendix C This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 527 ANSWER KEY Chapter 1 1. Scarcity means human wants for goods and services exceed the available supply. Supply is limited because resources are limited. Demand, however, is virtually unlimited. Whatever the supply, it seems human nature to want more. 2
. 100 people / 10 people per ham = a maximum of 10 hams per month if all residents produce ham. Since consumption is limited by production, the maximum number of hams residents could consume per month is 10. 3. She is very productive at her consulting job, but not very productive growing vegetables. Time spent consulting would produce far more income than it what she could save growing her vegetables using the same amount of time. So on purely economic grounds, it makes more sense for her to maximize her income by applying her labor to what she does best (i.e. specialization of labor). 4. The engineer is better at computer science than at painting. Thus, his time is better spent working for pay at his job and paying a painter to paint his house. Of course, this assumes he does not paint his house for fun! 5. There are many physical systems that would work, for example, the study of planets (micro) in the solar system (macro), or solar systems (micro) in the galaxy (macro). 6. Draw a box outside the original circular flow to represent the foreign country. Draw an arrow from the foreign country to firms, to represents imports. Draw an arrow in the reverse direction representing payments for imports. Draw an arrow from firms to the foreign country to represent exports. Draw an arrow in the reverse direction to represent payments for imports. 7. There are many such problems. Consider the AIDS epidemic. Why are so few AIDS patients in Africa and Southeast Asia treated with the same drugs that are effective in the United States and Europe? It is because neither those patients nor the countries in which they live have the resources to purchase the same drugs. 8. Public enterprise means the factors of production (resources and businesses) are owned and operated by the government. 9. The United States is a large country economically speaking, so it has less need to trade internationally than the other countries mentioned. (This is the same reason that France and Italy have lower ratios than Belgium or Sweden.) One additional reason is that each of the other countries is a member of the European Union, where trade between members occurs without barriers to trade, like tariffs and quotas. Chapter 2 1. The opportunity cost of bus tickets is the number of burgers that must be given up to obtain one more bus ticket. Originally, when the price of bus tickets was 50 cents per trip, this opportunity cost was 0.50/2 =.25 burgers. The reason for this is that at the original prices, one burger ($2) costs
the same as four bus tickets ($0.50), so the opportunity cost of a burger is four bus tickets, and the opportunity cost of a bus ticket is.25 (the inverse of the opportunity cost of a burger). With the new, higher price of bus tickets, the opportunity cost rises to $1/$2 or 0.50. You can see this graphically since the slope of the new budget constraint is steeper than the original one. If Alphonso spends all of his budget on burgers, the higher price of bus tickets has no impact so the vertical intercept of the budget constraint is the same. If he spends all of his budget on bus tickets, he can now afford only half as many, so the vertical intercept is half as much. In short, the budget constraint rotates clockwise around the vertical intercept, steepening as it goes and the opportunity cost of bus tickets increases. 528 Answer Key 2. Because of the improvement in technology, the vertical intercept of the PPF would be at a higher level of healthcare. In other words, the PPF would rotate clockwise around the horizontal intercept. This would make the PPF steeper, corresponding to an increase in the opportunity cost of education, since resources devoted to education would now mean forgoing a greater quantity of healthcare. 3. No. Allocative efficiency requires productive efficiency, because it pertains to choices along the production possibilities frontier. 4. Both the budget constraint and the PPF show the constraint that each operates under. Both show a tradeoff between having more of one good but less of the other. Both show the opportunity cost graphically as the slope of the constraint (budget or PPF). 5. When individuals compare cost per unit in the grocery store, or characteristics of one product versus another, they are behaving approximately like the model describes. 6. Since an op-ed makes a case for what should be, it is considered normative. 7. Assuming that the study is not taking an explicit position about whether soft drink consumption is good or bad, but just reporting the science, it would be considered positive. Chapter 3 1. Since $1.60 per gallon is above the equilibrium price, the quantity demanded would be lower at 550 gallons and the quantity supplied would be higher at 640 gallons. (These results are due to the laws of demand and supply, respectively.) The outcome of lower Qd and higher Qs would be a surplus in the gasoline market of 640 – 550 = 90 gallons. 2. To make it easier to analyze complex problems
. Ceteris paribus allows you to look at the effect of one factor at a time on what it is you are trying to analyze. When you have analyzed all the factors individually, you add the results together to get the final answer. 3. 4. a. An improvement in technology that reduces the cost of production will cause an increase in supply. Alternatively, you can think of this as a reduction in price necessary for firms to supply any quantity. Either way, this can be shown as a rightward (or downward) shift in the supply curve. b. An improvement in product quality is treated as an increase in tastes or preferences, meaning consumers demand more paint at any price level, so demand increases or shifts to the right. If this seems counterintuitive, note that demand in the future for the longer-lasting paint will fall, since consumers are essentially shifting demand from the future to the present. c. An increase in need causes an increase in demand or a rightward shift in the demand curve. d. Factory damage means that firms are unable to supply as much in the present. Technically, this is an increase in the cost of production. Either way you look at it, the supply curve shifts to the left. a. More fuel-efficient cars means there is less need for gasoline. This causes a leftward shift in the demand for gasoline and thus oil. Since the demand curve is shifting down the supply curve, the equilibrium price and This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 529 quantity both fall. b. Cold weather increases the need for heating oil. This causes a rightward shift in the demand for heating oil and thus oil. Since the demand curve is shifting up the supply curve, the equilibrium price and quantity both rise. c. A discovery of new oil will make oil more abundant. This can be shown as a rightward shift in the supply curve, which will cause a decrease in the equilibrium price along with an increase in the equilibrium quantity. (The supply curve shifts down the demand curve so price and quantity follow the law of demand. If price goes down, then the quantity goes up.) d. When an economy slows down, it produces less output and demands less input, including energy, which is used in the production of virtually everything. A decrease in demand for energy will be reflected as a decrease in the demand for oil, or a leftward shift in demand for oil. Since the demand curve
is shifting down the supply curve, both the equilibrium price and quantity of oil will fall. e. Disruption of oil pumping will reduce the supply of oil. This leftward shift in the supply curve will show a movement up the demand curve, resulting in an increase in the equilibrium price of oil and a decrease in the equilibrium quantity. Increased insulation will decrease the demand for heating. This leftward shift in the demand for oil causes a movement down the supply curve, resulting in a decrease in the equilibrium price and quantity of oil. f. g. Solar energy is a substitute for oil-based energy. So if solar energy becomes cheaper, the demand for oil will decrease as consumers switch from oil to solar. The decrease in demand for oil will be shown as a leftward shift in the demand curve. As the demand curve shifts down the supply curve, both equilibrium price and quantity for oil will fall. h. A new, popular kind of plastic will increase the demand for oil. The increase in demand will be shown as a rightward shift in demand, raising the equilibrium price and quantity of oil. 5. Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity. Step 2. Did the economic event affect supply or demand? Jet fuel is a cost of producing air travel, so an increase in jet fuel price affects supply. Step 3. An increase in the price of jet fuel caused a decrease in the cost of air travel. We show this as a downward or rightward shift in supply. Step 4. A rightward shift in supply causes a movement down the demand curve, lowering the equilibrium price of air travel and increasing the equilibrium quantity. 6. Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity. Step 2. Did the economic event affect supply or demand? A tariff is treated like a cost of production, so this affects supply. Step 3. A tariff reduction is equivalent to a decrease in the cost of production, which we can show as a rightward (or downward) shift in supply. Step 4. A rightward shift in supply causes a movement down the demand curve, lowering the equilibrium price and raising the equilibrium quantity. 7. A price ceiling (which is below the equilibrium price) will cause the quantity demanded to rise and the quantity supplied to fall. This is why a price ceiling creates a shortage. 8. A price ceiling is just a legal restriction. Equilibrium is an economic condition. People may or may
not obey the price ceiling, so the actual price may be at or above the price ceiling, but the price ceiling does not change the equilibrium price. 9. A price ceiling is a legal maximum price, but a price floor is a legal minimum price and, consequently, it would leave room for the price to rise to its equilibrium level. In other words, a price floor below equilibrium will not be binding and will have no effect. 10. Assuming that people obey the price ceiling, the market price will be below equilibrium, which means that Qd will be more than Qs. Buyers can only buy what is offered for sale, so the number of transactions will fall to Qs. This is easy to see graphically. By analogous reasoning, with a price floor the market price will be above the equilibrium price, so Qd will be less than Qs. Since the limit on transactions here is demand, the number of transactions will fall to Qd. Note that because both price floors and price ceilings reduce the number of transactions, social surplus is less. 11. Because the losses to consumers are greater than the benefits to producers, so the net effect is negative. Since the 530 Answer Key lost consumer surplus is greater than the additional producer surplus, social surplus falls. Chapter 4 1. Changes in the wage rate (the price of labor) cause a movement along the demand curve. A change in anything else that affects demand for labor (e.g., changes in output, changes in the production process that use more or less labor, government regulation) causes a shift in the demand curve. 2. Changes in the wage rate (the price of labor) cause a movement along the supply curve. A change in anything else that affects supply of labor (e.g., changes in how desirable the job is perceived to be, government policy to promote training in the field) causes a shift in the supply curve. 3. Since a living wage is a suggested minimum wage, it acts like a price floor (assuming, of course, that it is followed). If the living wage is binding, it will cause an excess supply of labor at that wage rate. 4. Changes in the interest rate (i.e., the price of financial capital) cause a movement along the demand curve. A change in anything else (non-price variable) that affects demand for financial capital (e.g., changes in confidence about the future, changes in needs for borrowing) would shift the demand curve. 5. Changes in the interest rate (i.
e., the price of financial capital) cause a movement along the supply curve. A change in anything else that affects the supply of financial capital (a non-price variable) such as income or future needs would shift the supply curve. 6. If market interest rates stay in their normal range, an interest rate limit of 35% would not be binding. If the equilibrium interest rate rose above 35%, the interest rate would be capped at that rate, and the quantity of loans would be lower than the equilibrium quantity, causing a shortage of loans. 7. b and c will lead to a fall in interest rates. At a lower demand, lenders will not be able to charge as much, and with more available lenders, competition for borrowers will drive rates down. 8. a and c will increase the quantity of loans. More people who want to borrow will result in more loans being given, as will more people who want to lend. 9. A price floor prevents a price from falling below a certain level, but has no effect on prices above that level. It will have its biggest effect in creating excess supply (as measured by the entire area inside the dotted lines on the graph, from D to S) if it is substantially above the equilibrium price. This is illustrated in the following figure. It will have a lesser effect if it is slightly above the equilibrium price. This is illustrated in the next figure. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 531 It will have no effect if it is set either slightly or substantially below the equilibrium price, since an equilibrium price above a price floor will not be affected by that price floor. The following figure illustrates these situations. 10. A price ceiling prevents a price from rising above a certain level, but has no effect on prices below that level. It will have its biggest effect in creating excess demand if it is substantially below the equilibrium price. The following figure illustrates these situations. 532 Answer Key When the price ceiling is set substantially or slightly above the equilibrium price, it will have no effect on creating excess demand. The following figure illustrates these situations. 11. Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price floor does not shift a demand curve or a supply curve. However, if the price floor is set above the equilibrium, it will cause the quantity supplied on the supply curve to be greater than the quantity demanded
on the demand curve, leading to excess supply. 12. Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price ceiling does not shift a demand curve or a supply curve. However, if the price ceiling is set below the equilibrium, it will cause the quantity demanded on the demand curve to be greater than the quantity supplied on the supply curve, leading to excess demand. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key Chapter 5 533 1. From point B to point C, price rises from $70 to $80, and Qd decreases from 2,800 to 2,600. So: % change in quantity = 2600 – 2800 (2600 + 2800) ÷ 2 × 100 × 100 = –200 2700 = –7.41 % change in price = 80 – 70 (80 + 70) ÷ 2 × 100 × 100 = 10 75 = 13.33 Elasticity of Demand = –7.41% 13.33% = 0.56 The demand curve is inelastic in this area; that is, its elasticity value is less than one. Answer from Point D to point E: % change in quantity = 2200 – 2400 (2200 + 2400) ÷ 2 × 100 × 100 = –200 2300 = –8.7 % change in price = 100 – 90 (100 + 90) ÷ 2 × 100 × 100 = 10 95 = 10.53 Elasticity of Demand = –8.7% 10.53% = 0.83 The demand curve is inelastic in this area; that is, its elasticity value is less than one. Answer from Point G to point H: % change in quantity = 1600 – 1800 1700 × 100 × 100 = –200 1700 = –11.76 % change in price = 130 – 120 125 × 100 × 100 = 10 125 = 8.00 Elasticity of Demand = –11.76% 8.00% = –1.47 The demand curve is elastic in this interval. 2. From point J to point K, price rises from $8 to $9, and quantity rises from 50 to 70. So: 534 Answer Key % change in quantity = 70 – 50 (70 + 50) ÷ 2 × 100 × 100 = 20 60 = 33.33 % change in price = $9 – $
8 ($9 + $8) ÷ 2 × 100 × 100 = 1 8.5 = 11.76 Elasticity of Supply = 33.33% 11.76% = 2.83 The supply curve is elastic in this area; that is, its elasticity value is greater than one. From point L to point M, the price rises from $10 to $11, while the Qs rises from 80 to 88: % change in quantity = 88 – 80 (88 + 80) ÷ 2 × 100 × 100 = 8 84 = 9.52 %change in price = $11 – $10 ($11 + $10) ÷ 2 × 100 × 100 = 1 10.5 = 9.52 Elasticity of Demand = 9.52% 9.52% = 1.0 The supply curve has unitary elasticity in this area. From point N to point P, the price rises from $12 to $13, and Qs rises from 95 to 100: % change in quantity = 100 – 95 (100 + 95) ÷ 2 ×100 ×100 = 5 97.5 = 5.13 % change in price = $13 – $12 ($13 + $12) ÷ 2 × 100 × 100 = 1 12.5 = 8.0 Elasticity of Supply = 5.13% 8.0% = 0.64 The supply curve is inelastic in this region of the supply curve. 3. The demand curve with constant unitary elasticity is concave because the absolute value of declines in price are not identical. The left side of the curve starts with high prices, and then price falls by smaller amounts as it goes down toward the right side. This results in a slope of demand that is steeper on the left but flatter on the right, creating a curved, concave shape. 4. The constant unitary elasticity is a straight line because the curve slopes upward and both price and quantity are increasing proportionally. 5. Carmakers can pass this cost along to consumers if the demand for these cars is inelastic. If the demand for these cars is elastic, then the manufacturer must pay for the equipment. 6. If the elasticity is 1.4 at current prices, you would advise the company to lower its price on the product, since a This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 535 decrease in price will be offset by the
increase in the amount of the drug sold. If the elasticity were 0.6, then you would advise the company to increase its price. Increases in price will offset the decrease in number of units sold, but increase your total revenue. If elasticity is 1, the total revenue is already maximized, and you would advise that the company maintain its current price level. 7. The percentage change in quantity supplied as a result of a given percentage change in the price of gasoline. 8. Percentage change in quantity demanded = [(change in quantity)/(original quantity)] × 100 = [22 – 30]/[(22 + 30)/2] × 100 = –8/26 × 100 = –30.77 Percentage change in income = [(change in income)/(original income)] × 100 = [38,000 – 25,000]/[(38,000 + 25,000)/2] × 100 = 13/31.5 × 100 = 41.27 In this example, bread is an inferior good because its consumption falls as income rises. 9. The formula for cross-price elasticity is % change in Qd for apples / % change in P of oranges. Multiplying both sides by % change in P of oranges yields: % change in Qd for apples = cross-price elasticity X% change in P of oranges = 0.4 × (–3%) = –1.2%, or a 1.2 % decrease in demand for apples. Chapter 6 1. The rows of the table in the problem do not represent the actual choices available on the budget set; that is, the combinations of round trips and phone minutes that Jeremy can afford with his budget. One of the choices listed in the problem, the six round trips, is not even available on the budget set. If Jeremy has only $10 to spend and a round trip costs $2 and phone calls cost $0.05 per minute, he could spend his entire budget on five round trips but no phone calls or 200 minutes of phone calls, but no round trips or any combination of the two in between. It is easy to see all of his budget options with a little algebra. The equation for a budget line is: Budget = PRT× QRT + PPC × QPC where P and Q are price and quantity of round trips (RT) and phone calls (PC) (per minute). In Jeremy’s case the equation for the budget line is: = $2QRT + $.05
QPC $.05 $10 = $2 × QRT + $.05 × QPC $10 $.05 200 = 40QRT + QPC QPC = 200 - 40QRT If we choose zero through five round trips (column 1), the table below shows how many phone minutes can be afforded with the budget (column 3). The total utility figures are given in the table below. Round Trips Total Utility for Trips Phone Minutes Total Utility for Minutes Total Utility 0 1 2 3 4 0 80 150 210 260 200 160 120 80 40 1100 1040 900 680 380 1100 1120 1050 890 640 536 Answer Key Round Trips Total Utility for Trips Phone Minutes Total Utility for Minutes Total Utility 5 300 0 0 300 Adding up total utility for round trips and phone minutes at different points on the budget line gives total utility at each point on the budget line. The highest possible utility is at the combination of one trip and 160 minutes of phone time, with a total utility of 1120. 2. The first step is to use the total utility figures, shown in the table below, to calculate marginal utility, remembering that marginal utility is equal to the change in total utility divided by the change in trips or minutes. Round Trips Total Utility Marginal Utility (per trip) Phone Minutes Total Utility Marginal Utility (per minute) 0 1 2 3 4 5 0 80 150 210 260 300 - 80 70 60 50 40 200 160 120 80 40 0 1100 1040 900 680 380 0 - 60/40 = 1.5 140/40 = 3.5 220/40 = 5.5 300/40 = 7.5 380/40 = 9.5 Note that we cannot directly compare marginal utilities, since the units are trips versus phone minutes. We need a common denominator for comparison, which is price. Dividing MU by the price, yields columns 4 and 8 in the table below. Round Trips Total Utility Marginal Utility (per trip) MU/P Phone Minutes Total Utility Marginal utility (per minute) MU/P 0 1 2 3 4 5 0 80 150 210 260 300 - 80 70 60 50 40 - 200 1100 60/40 = 1.5 160 1040 140/40 = 3.5 120 900 220/40 = 5.5 80 40 0 680 300/40 =7.5 380 380/40 = 9.5 0 - 80/$2 = 40 70/$2 = 35 60/$2 = 30 50/$2 = 25 40/$2 = 20
1.5/$0.05 = 30 3.5/$0.05 = 70 5.5/$0.05 = 110 7.5/$0.05 = 150 9.5/$0.05 = 190 - Start at the bottom of the table where the combination of round trips and phone minutes is (5, 0). This starting point is arbitrary, but the numbers in this example work best starting from the bottom. Suppose we consider moving to the next point up. At (4, 40), the marginal utility per dollar spent on a round trip is 25. The marginal utility per dollar spent on phone minutes is 190. Since 25 < 190, we are getting much more utility per dollar spent on phone minutes, This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 537 so let’s choose more of those. At (3, 80), MU/PRT is 30 < 150 (the MU/PM), but notice that the difference is narrowing. We keep trading round trips for phone minutes until we get to (1, 160), which is the best we can do. The MU/P comparison is as close as it is going to get (40 vs. 70). Often in the real world, it is not possible to get MU/P exactly equal for both products, so you get as close as you can. 3. This is the opposite of the example explained in the text. A decrease in price has a substitution effect and an income effect. The substitution effect says that because the product is cheaper relative to other things the consumer purchases, he or she will tend to buy more of the product (and less of the other things). The income effect says that after the price decline, the consumer could purchase the same goods as before, and still have money left over to purchase more. For both reasons, a decrease in price causes an increase in quantity demanded. 4. This is a negative income effect. Because your parents’ check failed to arrive, your monthly income is less than normal and your budget constraint shifts in toward the origin. If you only buy normal goods, the decrease in your income means you will buy less of every product. Chapter 7 1. Accounting profit = total revenues minus explicit costs = $1,000,000 – ($600,000 + $150,000 + $200,000) = $50,000. 2. Economic profit = accounting profit minus implicit cost = $50,000
– $30,000 = $20,000. 3. Quantity Variable Cost Fixed Cost Total Cost Average Variable Cost Average Total Cost Marginal Cost 0 $10 $25 $45 $70 $100 $135 $30 $30 $30 $30 $30 $30 $30 $30 $40 $55 $75 $100 $130 $165 - $10.00 $12.50 $15.00 $17.50 $20.00 $22.50 - $40.00 $27.50 $25.00 $25.00 $26.00 $27.50 $10 $15 $20 $25 $30 $35 0 1 2 3 4 5 6 4. b. a. Total revenues in this example will be a quantity of five units multiplied by the price of $25/unit, which equals $125. Total costs when producing five units are $130. Thus, at this level of quantity and output the firm experiences losses (or negative profits) of $5. If price is less than average cost, the firm is not making a profit. At an output of five units, the average cost is $26/unit. Thus, at a glance you can see the firm is making losses. At a second glance, you can see that it must be losing $1 for each unit produced (that is, average cost of $26/unit minus the price of $25/unit). With five units produced, this observation implies total losses of $5. c. When producing five units, marginal costs are $30/unit. Price is $25/unit. Thus, the marginal unit is not adding to profits, but is actually subtracting from profits, which suggests that the firm should reduce its quantity produced. 6. The new table should look like this: 538 Answer Key Labor Cost Machine Cost Total Cost Cost of technology 1 10 × $40 = $400 2 × $50 = $100 $500 Cost of technology 2 7 × $40 = $280 4 × $50 = $200 $480 Cost of technology 3 3 × $40 = $120 7 × $50 = $350 $470 The firm should choose production technology 3 since it has the lowest total cost. This makes sense since, with cheaper machine hours, one would expect a shift in the direction of more machines and less labor. 7. Labor Cost Machine Cost Total Cost Cost of technology 1 10 × $40 = $400 2 × $55 = $110 $510 Cost of technology 2 7 × $40
= $280 4 × $55 = $220 $500 Cost of technology 3 3 × $40 = $120 7 × $55 = $385 $505 The firm should choose production technology 2 since it has the lowest total cost. Because the cost of machines increased (relative to the previous question), you would expect a shift toward less capital and more labor. 8. This is the situation that existed in the United States in the 1970s. Since there is only demand enough for 2.5 firms to reach the bottom of the average cost curve, you would expect one firm will not be around in the long run, and at least one firm will be struggling. Chapter 8 1. No, you would not raise the price. Your product is exactly the same as the product of the many other firms in the market. If your price is greater than that of your competitors, then your customers would switch to them and stop buying from you. You would lose all your sales. 2. Possibly. Independent truckers are by definition small and numerous. All that is required to get into the business is a truck (not an inexpensive asset, though) and a commercial driver’s license. To exit, one need only sell the truck. All trucks are essentially the same, providing transportation from point A to point B. (We’re assuming we not talking about specialized trucks.) Independent truckers must take the going rate for their service, so independent trucking does seem to have most of the characteristics of perfect competition. 3. Holding total cost constant, profits at every output level would increase. 4. When the market price increases, marginal revenue increases. The firm would then increase production up to the point where the new price equals marginal cost, at a quantity of 90. 5. If marginal costs exceeds marginal revenue, then the firm will reduce its profits for every additional unit of output it produces. Profit would be greatest if it reduces output to where MR = MC. 6. The firm will be willing to supply fewer units at every price level. In other words, the firm’s individual supply curve decreases and shifts to the left. 7. With a technological improvement that brings about a reduction in costs of production, an adjustment process will take place in the market. The technological improvement will result in an increase in supply curves, by individual firms and at the market level. The existing firms will experience higher profits for a while, which will attract other firms into the market. This entry process will stop whenever the market supply increases enough (
both by existing and new firms) so profits are driven back to zero. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 539 8. When wages increase, costs of production increase. Some firms would now be making economic losses and would shut down. The supply curve then starts shifting to the left, pushing the market price up. This process ends when all firms remaining in the market earn zero economic profits. The result is a contraction in the output produced in the market. 9. Perfect competition is considered to be “perfect” because both allocative and productive efficiency are met at the same time in a long-run equilibrium. If a market structure results in long-run equilibrium that does not minimize average total costs and/or does not charge a price equal to marginal cost, then either allocative or productive (or both) efficiencies are not met, and therefore the market cannot be labeled “perfect.” 10. Think of the market price as representing the gain to society from a purchase, since it represents what someone is willing to pay. Think of the marginal cost as representing the cost to society from making the last unit of a good. If P > MC, then the benefits from producing more of a good exceed the costs, and society would gain from producing more of the good. If P < MC, then the social costs of producing the marginal good exceed the social benefits, and society should produce less of the good. Only if P = MC, the rule applied by a profit-maximizing perfectly competitive firm, will society’s costs and benefits be in balance. This choice will be the option that brings the greatest overall benefit to society. Chapter 9 a. A patent is a government-enforced barrier to entry. b. This is not a barrier to entry. c. This is not a barrier to entry. d. This is a barrier to entry, but it is not government-enforced. e. This is a barrier to entry, but it is not directly government enforced. 1. 2. a. This is a government-enforced barrier to entry. b. This is an example of a government law, but perhaps it is not much of a barrier to entry if most people can pass the safety test and get insurance. c. Trademarks are enforced by government, and therefore are a barrier to entry. d. This is probably not a barrier to entry, since there are a
number of different ways of getting pure water. e. This is a barrier to entry, but it is not government-enforced. 3. Because of economies of scale, each firm would produce at a higher average cost than before. (They would each have to build their own power lines.) As a result, they would each have to raise prices to cover their higher costs. The policy would fail. 4. Shorter patent protection would make innovation less lucrative, so the amount of research and development would likely decline. 5. If price falls below AVC, the firm will not be able to earn enough revenues even to cover its variable costs. In such a case, it will suffer a smaller loss if it shuts down and produces no output. By contrast, if it stayed in operation and produced the level of output where MR = MC, it would lose all of its fixed costs plus some variable costs. If it shuts down, it only loses its fixed costs. 6. This scenario is called “perfect price discrimination.” The result would be that the monopolist would produce more output, the same amount in fact as would be produced by a perfectly competitive industry. However, there would be no consumer surplus since each buyer is paying exactly what they think the product is worth. Therefore, the monopolist would be earning the maximum possible profits. Chapter 10 1. An increase in demand will manifest itself as a rightward shift in the demand curve, and a rightward shift in 540 Answer Key marginal revenue. The shift in marginal revenue will cause a movement up the marginal cost curve to the new intersection between MR and MC at a higher level of output. The new price can be read by drawing a line up from the new output level to the new demand curve, and then over to the vertical axis. The new price should be higher. The increase in quantity will cause a movement along the average cost curve to a possibly higher level of average cost. The price, though, will increase more, causing an increase in total profits. 2. As long as the original firm is earning positive economic profits, other firms will respond in ways that take away the original firm’s profits. This will manifest itself as a decrease in demand for the original firm’s product, a decrease in the firm’s profit-maximizing price and a decrease in the firm’s profit-maximizing level of output, essentially unwinding the process described in the answer to question 1. In the long-run equilibrium, all firms
in monopolistically competitive markets will earn zero economic profits. 3. a. If the firms form a cartel, they will act like a monopoly, choosing the quantity of output where MR = MC. Drawing a line from the monopoly quantity up to the demand curve shows the monopoly price. Assuming that fixed costs are zero, and with an understanding of cost and profit, we can infer that when the marginal cost curve is horizontal, average cost is the same as marginal cost. Thus, the cartel will earn positive economic profits equal to the area of the rectangle, with a base equal to the monopoly quantity and a height equal to the difference between price (on the demand above the monopoly quantity) and average cost, as shown in the following figure. b. The firms will expand output and cut price as long as there are profits remaining. The long-run equilibrium will occur at the point where average cost equals demand. As a result, the oligopoly will earn zero economic figure. profits competition,” “cutthroat shown next due the as in to c. Pc > Pcc. Qc < Qcc. Profit for the cartel is positive and large. Profit for cutthroat competition is zero. 4. Firm B reasons that if it cheats and Firm A does not notice, it will double its money. Since Firm A’s profits will This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 541 decline substantially, however, it is likely that Firm A will notice and if so, Firm A will cheat also, with the result that Firm B will lose 90% of what it gained by cheating. Firm A will reason that Firm B is unlikely to risk cheating. If neither firm cheats, Firm A earns $1000. If Firm A cheats, assuming Firm B does not cheat, A can boost its profits only a little, since Firm B is so small. If both firms cheat, then Firm A loses at least 50% of what it could have earned. The possibility of a small gain ($50) is probably not enough to induce Firm A to cheat, so in this case it is likely that both firms will collude. Chapter 11 1. Yes, it is true. The HHI example is easy enough: since the market shares of all firms are included in the HHI calculation, a merger between two of the firms will change the HHI. For the four-firm concentration ratio, it is quite possible
that a merger between, say, the fifth and sixth largest firms in the market could create a new firm that is then ranked in the top four in the market. In this case, a merger of two firms, neither in the top four, would still change the four-firm concentration ratio. 2. No, it is not true. The HHI includes the market shares of all firms in its calculation, but the squaring of the market shares has the effect of making the impact of the largest firms relatively bigger than in the 4-firm or 8-firm ratio. 3. The bus companies wanted the broader market definition (i.e., the second definition). If the narrow definition had been used, the combined bus companies would have had a near-monopoly on the market for intercity bus service. But they had only a sliver of the market for intercity transportation when everything else was included. The merger was allowed. 4. The common expectation is that the definition of markets will become broader because of greater competition from faraway places. However, this broadening doesn’t necessarily mean that antitrust authorities can relax. There is also a fear that companies with a local or national monopoly may use the new opportunities to extend their reach across national borders, and that it will be difficult for national authorities to respond. 5. Because outright collusion to raise profits is illegal and because existing regulations include gray areas which firms may be able to exploit. 6. Yes, all curves have normal shapes. 7. Yes it is a natural monopoly because average costs decline over the range that satisfies the market demand. For example, at the point where the demand curve and the average cost curve meet, there are economies of scale. 8. Improvements in technology that allowed phone calls to be made via microwave transmission, communications satellites, and other wireless technologies. 9. More consumer choice. Cheaper phone calls, especially long distance. Better-quality phone service in many cases. 542 Answer Key Cheaper, faster, and better-quality data transmission. Spin-off technologies like free Internet-based calling and video calling. 10. More choice can sometimes make for difficult decisions—not knowing if you got the best plan for your situation, for example. Some phone service providers are less reliable than AT&T used to be. Chapter 12 1. 2. 3. a. positive externality b. negative externality c. positive externality d. negative externality e. negative externality a. b. c
. d. supply shifts left supply shifts left supply stays the same supply shifts left a. price will rise b. price will rise c. price stays the same d. price will rise. 4. The original equilibrium (before the external social cost of pollution is taken into account) is where the private supply curve crosses the demand curve. This original equilibrium is at a price of $15 and a quantity of 440. After taking into account the additional external cost of pollution, the production becomes more costly, and the supply curve shifts up. The new equilibrium will be at a price of $30 and a quantity of 410. 5. The first policy is command-and-control because it is a requirement that applies to all producers. 6. a. market-based b. command-and-control c. command-and-control d. market-based e. market-based 7. Even though state or local governments impose these taxes, a company has the flexibility to adopt technologies that will help it avoid the tax. 8. First, if each firm is required to reduce its garbage output by one-fourth, then Elm will reduce five tons at a cost of $5,500; Maple will reduce 10 tons at a cost of $13,500; Oak will reduce three tons at a cost of $22,500; and Cherry will reduce four tons at a cost of $18,000. Total cost of this approach: $59,500. If the system of marketable permits is put in place, and those permits shrink the weight of allowable garbage by one-quarter, then pollution must still be reduced by the same overall amount. However, now the reduction in pollution will take place where it is least expensive. Reductions in Garbage Who does the reducing? At what cost? First 5 tons Cherry $3,000 This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 543 Reductions in Garbage Who does the reducing? At what cost? Second 5 tons Third 5 tons Fourth 5 tons Cherry Cherry Elm $4,000 $5,000 $5,500 Fifth and sixth 5 tons Elm and Cherry $6,000 each Seventh 5 tons Eighth 5 tons Maple Elm $6,300 $6,500 Ninth and tenth 5 tons Elm and Cherry $7,000 each Thus, the overall pattern of reductions here will be that Elm reduces garbage by 20 tons and has 15 tons of permits to sell. Maple reduces by five tons and
needs to buy five tons of permits. Oak does not reduce garbage at all, and needs to buy 15 tons of permits. Cherry reduces garbage by 25 tons, which leaves it with five tons of permits to sell. The total cost of these reductions would be $56,300, a definite reduction in costs from the $59,500 cost of the commandand-control option. 9. Pollution Charges Marketable Permits Property Rights 10. Incentives to Go Beyond If you keep reducing pollution you reduce your charge If you reduce your pollution you can sell your extra pollution permits The party that has to pay for the pollution has incentive to do so in a cost effect way Flexibility about Where and How Pollution Will Be Reduced Political Process Creates Loopholes and Exceptions Reducing pollution by any method is fine If charge applies to all emissions of pollution then no loopholes Reductions of pollution will happen at firms where it is cheapest to do so, by the least expensive methods If all polluters are required to have permits then there are no loopholes Reducing pollution by any method is fine If the property rights are clearly defined, then it is not legally possible to avoid cleanup a. See the answers in the following table. The marginal cost is calculated as the change in total cost divided by the change in quantity. Total Cost (in thousands of dollars) [marginal cost] Total Benefits (in thousands of dollars) [marginal benefit] 16 million gallons Current situation Current situation 544 Answer Key Total Cost (in thousands of dollars) [marginal cost] Total Benefits (in thousands of dollars) [marginal benefit] 12 million gallons 8 million gallons 4 million gallons 50 [50] 150 [100] 500 [350] 800 [800] 1,300 [500] 1,850 [350] 0 gallons 1,200 [700] 2,000 [150] b. The “optimal” level of pollution is where the marginal benefits of reducing it are equal to the marginal cost. This is at four million gallons. c. Marginal analysis tells us if the marginal costs of cleanup are greater than the marginal benefit, society could use those resources more efficiently elsewhere in the economy. 11. a. See the next table for the answers, which were calculated using the traditional calculation of marginal cost equal to change in total cost divided by change in quantity. Land Restored (in acres) Total Cost [marginal cost] Total Benefit [marginal benefit] 0 100 200 300 400 $0 $20 [0.2]
$80 [0.6] $160 [0.8] $280 [1.2] $0 $140 [1.4] $240 [1] $320 [0.8] $480 [0.6] b. The optimal amount of restored land is 300 acres. Beyond this quantity the marginal costs are greater than the marginal benefits. 12. Protect Not Protect Country B Country A Protect Both A and B have a cost of 10 and a benefit of 16; each country has net = 6 A has a cost of 10 and a benefit of 8 (net = –2); B has a cost of 0 and a benefit of 8 ( net = 8) Not Protect A has a cost of 0 and a benefit of 8 (net = 8); B has a cost of 10 and a benefit of 8 (net = –2) Both A and B have a zero cost and a zero benefit; each country has net = 0 Country B will reason this way: If A protects the environment, then we will have benefits of 6 if we act to protect the environment, but 8 if we do not, so we will not protect it. If A is not protecting the environment, we will have losses of 2 if we protect, but have zero if we do not protect, so again, we will not protect it. Country A will reason in a This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 545 similar manner. The result is that both countries choose to not protect, even though they will achieve the largest social benefits—a combined benefit of 12 for the two countries—if they both choose to protect. Environmental treaties can be viewed as a way for countries to try to extricate themselves from this situation. 13. a. b. Of the choices provided, P, R, and S demonstrate productive efficiency. These are the choices on the production possibility frontier. d. e. institutions. Because you do not have information about c. Allocative efficiency is determined by the preferences—in this case by the preferences of society as expressed these through government and other social preferences, you really cannot say much about allocative efficiency. In the choice between T and R, R should clearly be preferred, because it has both more corn and more trees. This answer illustrates why productive efficiency is beneficial. Compared with choices inside the PPF, it means more of one or both goods. In the choice between T and S, it is
not possible to say which choice is better. True, S is on the PPF and T is not—but that only addresses the issue of productive efficiency. If a society has a strong preference for economic output and places a lower value on trees, then allocative efficiency may lead to a choice of T over S. Of course, the reverse could also be true, leading to a choice of S. Without information on society’s preferences to judge allocative efficiency, this question cannot be answered. f. Compared with command-and-control policies, market-oriented policies allow either more output with the same environmental protection or more environmental protection with the same level of output—or more of both environmental protection and output. Thus, a choice like Q inside the PPF is more likely to represent a command-and-control policy demand than a choice like S on the frontier of the PPF. Chapter 13 1. No. A market demand curve reflects only the private benefits of those who are consuming the product. Positive externalities are benefits that spill over to third parties, so they create social benefits, and are not captured by a market (or private benefit) demand curve. 2. Clearly Samsung is benefiting from the investment, so the 20% increase in profits is a private benefit. If Samsung is unable to capture all of the benefit, perhaps because other companies quickly copy and produce close substitutes, then Samsung’s investment will produce social benefits. 3. a. $102 million. b. If the interest rate is 9%, the cost of financial capital, and the firm can capture the 5% return to society, the 546 Answer Key firm would invest as if its effective rate of return is 4%, so it will invest $183 million. 4. When the Junkbuyers Company purchases something for resale, presumably both the buyer and the seller benefit—otherwise, they would not need to make the transaction. However, the company also reduces the amount of garbage produced, which saves money for households and/or for the city that disposes of garbage. So the social benefits are larger than the private benefits. 5. Government programs that either pay for neighborhood clean-up directly or that provide reduced tax payments for those who clean up or fix up their own property could be enacted. It is also easy to imagine how a city might allow its businesses to form a group that would pay for and manage neighborhood cleanup. 6. Government programs that either pay for education directly or that provide loans or reduced tax payments for education could create
positive spillovers. A city might allow its businesses to form a group that would coordinate business efforts with schools and local colleges and universities—allowing students to obtain real-world experience in their chosen fields and providing businesses with enthusiastic, trained workers. 7. 8. a. Once citizens are protected from crime, it is difficult to exclude someone from this protection, so it is nonexcludable. b. Some satellite radio services, such as SiriusXM, are sold by subscription fee, so it is excludable. c. Once a road is built it is difficult to exclude people, although toll roads can exclude non-payers. d. Primary education can be provided by private companies and so it is excludable. e. Companies sell cell phone service and exclude those who do not pay. a. Two people cannot enjoy the same slice of pizza at the same time, so private goods, such as a slice of pizza, are rivalrous. b. Two people cannot use one laptop at the same time, so they are rivalrous in consumption. c. Public radio can be heard by anyone with a radio, so many people can listen at the same time—the good is nonrivalrous. It is difficult for two people to simultaneously eat an ice cream cone, so it is rivalrous in consumption. d. Chapter 14 3. a. With no union, the equilibrium wage rate would be $18 per hour and there would be 8,000 bus drivers. b. If the union has enough negotiating power to raise the wage to $4 per hour higher than under the original equilibrium, the new wage would be $22 per hour. At this wage, 4,000 workers would be demanded while 10,000 would be supplied, leading to an excess supply of 6,000 workers. 4. Unions have sometimes opposed new technology out of a fear of losing jobs, but in other cases unions have helped to facilitate the introduction of new technology because unionized workers felt that the union was looking after their interests or that their higher skills meant that their jobs were essentially protected. And the new technologies meant increased productivity. 5. In a few other countries (such as France and Spain), the percentage of workers belonging to a union is similar to that in the United States. Union membership rates, however, are generally lower in the United States. When the share of workers whose wages are determined by union negotiations is considered, the United States ranks by far the lowest (because in countries like France and Spain, union negotiations often determine pay even for non
union employees). 6. No. While some unions may cause firms to go bankrupt, other unions help firms to become more competitive. No overall pattern exists. 7. From a social point of view, the benefits of unions and the costs seem to counterbalance. There is no evidence that in countries with a higher percentage of unionized workers, the economies grow more or less slowly. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 9. 547 a. Firms have a profit incentive to sell to everyone, regardless of race, ethnicity, religion, or gender. b. A business that needs to hire workers to expand may also find that if it draws only from its accustomed pool of workers—say, white men—it lacks the workers it needs to expand production. Such a business would have an incentive to hire more women and minorities. c. A discriminatory business that is underpaying its workers may find those workers leaving for jobs with another employer who offers better pay. This market pressure could cause the discriminatory business to behave better. 10. No. The earnings gap does not prove discrimination because it does not compare the wages of men and women in the same job who have the same amounts of education, experience, and productivity. 11. If a large share of immigrants have relatively low skills, then reducing the number of immigrants would shift the supply curve of low-skill labor back to the left, which would tend to raise the equilibrium wage for low-skill labor. Chapter 15 1. a. Poverty falls, inequality rises. b. Poverty rises, inequality falls. 2. Jonathon’s options for working and total income are shown in the following table. His labor-leisure diagram is shown in the figure following the table. Number of Work Hours Earnings from Work Government Benefits Total Income 1,500 1,200 900 600 300 0 $9,000 $7,200 $5,400 $3,600 $1,800 $0 $1,000 $2,800 $4,600 $6,400 $8,200 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 3. The following table shows a policy where only 30 cents in government support is pulled right back for every $1 548 Answer Key of income earned. Jonathon’s labor-leisure diagram is shown in the figure following the table. “
Opportunity set after program” extends from (0, $16,300) to (1,500, $10,000). “Opportunity set before program” slopes downward from (0, $9,000) to (1,500, $0). Number of Work Hours Earnings from Work Government Benefits Total Income 1,500 1,200 900 600 300 0 $9,000 $7,200 $5,400 $3,600 $1,800 $0 $7,300 $7,840 $8,380 $8,920 $9,460 $10,000 $16,300 $15,040 $13,780 $12,520 $22,260 $10,000 4. The earned income tax credit works like this: a poor family receives a tax break that increases according to how much they work. Families that work more get more. In that sense it loosens the poverty trap by encouraging work. As families earn above the poverty level, the earned income tax credit is gradually reduced. For those near-poor families, the earned income tax credit is a partial disincentive to work. 5. TANF attempts to loosen the poverty trap by providing incentives to work in other ways. Specifically, it requires that people work (or complete their education) as a condition of receiving TANF benefits, and it places a time limit on benefits. 6. A useful first step is to rank the households by income, from lowest to highest. Then, since there are 10 households total, the bottom quintile will be the bottom two households, the second quintile will be the third and fourth households, and so on up to the top quintile. The quintiles and percentage of total income for the data provided are shown in the following table. Comparing this distribution to the U.S. income distribution for 2005, the top quintile in the example has a smaller share of total income than in the U.S. distribution and the bottom quintile has a larger share. This pattern usually means that the income distribution in the example is more equal than the U.S. distribution. Income Quintile % of Total Income $10,000 Total first quintile income: $22,000 6.0% This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key Income $12,000 Quintile % of Total Income 549 $16,000 Total second quintile
income: $34,000 9.2% $18,000 $24,000 Total third quintile income: $48,000 13.0% $24,000 $36,000 Total fourth quintile income: $86,000 23.2% $50,000 $80,000 Total top quintile income: $180,000 48.6% $100,000 $370,000 Total Income 7. Just from glancing at the quintile information, it is fairly obvious that income inequality increased in the United Kingdom over this time: The top quintile is getting a lot more, and the lowest quintile is getting a bit less. Converting this information into a Lorenz curve, however, is a little trickier, because the Lorenz curve graphs the cumulative distribution, not the amount received by individual quintiles. Thus, as explained in the text, you have to add up the individual quintile data to convert the data to this form. The following table shows the actual calculations for the share of income in 1979 versus 1991. The figure following the table shows the perfect equality line and the Lorenz curves for 1979 and 1991. As shown, the income distribution in 1979 was closer to the perfect equality line than the income distribution in 1991—that is, the United Kingdom income distribution became more unequal over time. Share of income received 1979 1991 Bottom 20% Bottom 40% Bottom 60% Bottom 80% All 100% 7.0% 6.6% 18.5% 18.1% 35.5% 34.4% 60.3% 57.1% 100.0% 100.0% 550 Answer Key 8. In the market for low-wage labor, information technology shifts the demand for low-wage labor to the left. One reason is that technology can often substitute for low-wage labor in certain kinds of telephone or bookkeeping jobs. In addition, information technology makes it easier for companies to manage connections with low-wage workers in other countries, thus reducing the demand for low-wage workers in the United States. In the market for high-wage labor, information technology shifts the demand for high-wage labor to the right. By using the new information and communications technologies, high-wage labor can become more productive and can oversee more tasks than before. The following figure illustrates these two labor markets. The combination of lower wages inequality. for for labor means high-wage low-wage greater higher wages labor and 9. In the market for low-wage labor,
a skills program will shift supply to the left, which will tend to drive up wages for the remaining low-skill workers. In the market for high-wage labor, a skills program will shift supply to the right (because after the training program there are now more high-skilled workers at every wage), which will tend to drive down wages for high-skill workers. The combination of these two programs will result in a lesser degree of inequality. The following figure illustrates these two labor markets. In the market for high-wage labor, a skills program will shift supply to the right, which will tend to drive down wages for high-skill workers. 10. A very strong push for economic equality might include extremely high taxes on high-wage earners to pay for extremely large government social payments for the poor. Such a policy could limit incentives for the high-wage workers, lock the poor into a poverty trap, and thus reduce output. The PPF in this case will have the standard appearance: it will be downward sloping. 11. For the second hypothesis, a well-funded social safety net might make people feel that even if their company goes This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 551 bankrupt or they need to change jobs or industries, they will have some degree of protection. As a result, people may be more willing to allow markets to work without interference, and not to lobby as hard for rules that would prevent layoffs, set price controls, or block foreign trade. In this case, safety net programs that increase equality could also allow the market to work more freely in a way that could increase output. In this case, at least some portion of the PPF between equality and economic output would slope up. 12. Pure redistribution is more likely to cause a sharp tradeoff between economic output and equality than policies aimed at the ladder of opportunity. A production possibility frontier showing a strict tradeoff between economic output and equality will be downward sloping. A PPF showing that it is possible to increase equality, at least to some extent, while either increasing output or at least not diminishing it would have a PPF that first rises, perhaps has a flat area, and then falls. 13. Many view the redistribution of income to achieve greater equality as taking away from the rich to pay the poor, or as a “zero sum” game. By taking taxes from one group of people and redistributing them to another,
the tax system is robbing some of the American Dream. Chapter 16 1. a. b. c. d. Imperfect information is relatively low; after all, you can see the apples. Imperfect information is relatively low. The neighborhood restaurant probably has a certain local reputation. Imperfect information is relatively high. How can you tell whether the computer is really in good working order? Why are they selling it? Imperfect information is relatively high. What do those flowers really look like? 2. Asymmetric information often exists in the labor market because employers cannot observe many key employee attributes until after the person is hired. Employees, however, know whether they are energetic or detailed-oriented. Employers, therefore, often seek schools to pre-screen candidates. Employers may not even interview a candidate unless he has a degree and often a degree from a particular school. Employers may also view awards, a high grade point average, and other accolades as a signal of hard work, perseverance, and ability. Finally, employers seek references for insights into key attributes such as energy level, work ethic, and so on. 3. It is almost impossible to distinguish whether a health outcome such as life expectancy was the result of personal preferences that might affect health and longevity, such as diet, exercise, certain risky behavior, and consumption of certain items like tobacco, or the result of expenditures on health care (for example, annual check-ups). Chapter 17 1. a. The management of small companies might rather do an IPO right away, but until they get the company up and running, most people would not pay very much for the stock because of the risks involved. b. A small company may be earning few or zero profits, and its owners want to reinvest their earnings in the future growth of the company. If this company issues bonds or borrows money, it is obligated to make interest payments, which can eat up the company’s cash. If the company issues stock, it is not obligated to make payments to anyone (although it may choose to pay dividends). c. Venture capitalists are private investors who can keep close tabs on the management and strategy of the company—and thus reduce the problems of imperfect information about whether the firm is being well run. Venture capitalists often own a substantial portion of the firm and have much better information than a typical shareholder would. 2. From a firm’s point of view, a bond is very similar to a bank loan. Both are ways of borrowing money. Both require paying interest.
The major difference is who must be persuaded to lend money: a bank loan requires persuading the bank, while issuing bonds requires persuading a number of separate bondholders. Since a bank often knows a great deal about a firm (especially if the firm has its accounts with that bank), bank loans are more common where imperfect 552 Answer Key information would otherwise be a problem. 3. a. Remember, equity is the market value of the house minus what is still owed to the bank. Thus: the value of the house is $200,000, Fred owes $180,000 to the bank, and his equity is $20,000. b. The value of Freda’s house is $250,000. It does not matter what price she bought it for. She owes zero to the bank, so her equity is the whole $250,000. c. The value of Frank’s house is $160,000. He owes $60,000 to the bank (the original $80,000 minus the $20,000 he has paid off the loan). His equity is $100,000. 4. Over a sustained period of time, stocks have an average return higher than bonds, and bonds have an average return higher than a savings account. This is because in any given year the value of a savings account changes very little. In contrast, stock values can grow or decline by a very large amount (for example, the S&P 500 increased 26% in 2009 after declining 37% in 2008. The value of a bond, which depends largely on interest rate fluctuations, varies far less than a stock, but more than a savings account. 5. When people believe that a high-risk investment must have a low return, they are getting confused between what risk and return mean. Yes, a high-risk investment might have a low return, but it might also have a high return. Risk refers to the fact that a wide range of outcomes is possible. However, a high-risk investment must, on average, expect a relatively high return or else no one would be willing to take the risk. Thus, it is quite possible—even likely—for an investment to have high risk and high return. Indeed, the reason that an investment has a high expected return is that it also has a high risk. 6. Principal + (principal × rate × time) $5,000 + ($5,000 × 0.06 × 3) = $5,900 7. Principal
+ (principal × rate × time); Interest = Principal × rate × time; $500 = $10,000 × rate × 5 years; $500 = $50,000 × rate; $500/$50,000 = rate; Rate = 1% 8. Principal(1 + interest rate)time = $1,000(1+0.02)5 =$1,104.08 Chapter 18 1. All other things being equal, voter turnout should increase as the cost of casting an informed vote decreases. 2. The cost in time of voting, transportation costs to and from the polling place, and any additional time and effort spent becoming informed about the candidates. 3. The costs of organization and the small benefit to the individual. 4. Domestic cotton producers would lobby heavily to protect themselves from the competition, whereas the consumers have little incentive to organize. 5. True. This is exactly what occurs in a voting cycle. That is, the majority can prefer policy A to policy B, policy B to policy C, but also prefer policy C to policy A. Then, the majority will never reach a conclusive outcome. 6. The problem is an example of a voting cycle. The group will vote for mountain biking over canoeing by 2–1. It will vote for canoeing over the beach by 2–1. If mountain biking is preferred to canoeing and canoeing is preferred to the beach, it might seem that it must be true that mountain biking is the favorite. But in a vote of the beach versus mountain biking, the beach wins by a 2–1 vote. When a voting cycle occurs, choosing a single favorite that is always preferred by a majority becomes impossible. 7. The four Coca-Cola candidates compete with each other for Coca-Cola voters, whereas everyone who prefers Pepsi had only one candidate to vote for. Thus the will of the majority is not satisfied. Chapter 19 1. False. Anything that leads to different levels of productivity between two economies can be a source of comparative This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 553 advantage. For example, the education of workers, the knowledge base of engineers and scientists in a country, the part of a split-up value chain where they have their specialized learning, economies of scale, and other factors can all determine comparative advantage. 2. Brazil has the absolute advantage in producing beef and the United States has the absolute advantage in autos. The opportunity
cost of producing one pound of beef is 1/10 of an auto; in the United States it is 3/4 of an auto. 3. In answering questions like these, it is often helpful to begin by organizing the information in a table, such as in the following table. Notice that, in this case, the productivity of the countries is expressed in terms of how many workers it takes to produce a unit of a product. Country One Sweater One Bottle of wine France 1 worker 1 worker Tunisia 2 workers 3 workers In this example, France has an absolute advantage in the production of both sweaters and wine. You can tell because it takes France less labor to produce a unit of the good. 4. a. In Germany, it takes fewer workers to make either a television or a video camera. Germany has an absolute advantage in the production of both goods. b. Producing an additional television in Germany requires three workers. Shifting those three German workers will reduce video camera production by 3/4 of a camera. Producing an additional television set in Poland requires six workers, and shifting those workers from the other good reduces output of video cameras by 6/ 12 of a camera, or 1/2. Thus, the opportunity cost of producing televisions is lower in Poland, so Poland has the comparative advantage in the production of televisions. Note: Do not let the fractions like 3/4 of a camera or 1/2 of a video camera bother you. If either country was to expand television production by a significant amount—that is, lots more than one unit—then we will be talking about whole cameras and not fractional ones. You can also spot this conclusion by noticing that Poland’s absolute disadvantage is relatively lower in televisions, because Poland needs twice as many workers to produce a television but three times as many to produce a video camera, so the product with the relatively lower absolute disadvantage is Poland’s comparative advantage. c. Producing a video camera in Germany requires four workers, and shifting those four workers away from television production has an opportunity cost of 4/3 television sets. Producing a video camera in Poland requires 12 workers, and shifting those 12 workers away from television production has an opportunity cost of two television sets. Thus, the opportunity cost of producing video cameras is lower in Germany, and video cameras will be Germany’s comparative advantage. In this example, absolute advantage differs from comparative advantage. Germany has the absolute advantage in the production of both goods, but Poland has a comparative
advantage in the production of televisions. e. Germany should specialize, at least to some extent, in the production of video cameras, export video cameras, and import televisions. Conversely, Poland should specialize, at least to some extent, in the production of televisions, export televisions, and import video cameras. d. 5. There are a number of possible advantages of intra-industry trade. Both nations can take advantage of extreme specialization and learning in certain kinds of cars with certain traits, like gas-efficient cars, luxury cars, sportutility vehicles, higher- and lower-quality cars, and so on. Moreover, nations can take advantage of economies of scale, so that large companies will compete against each other across international borders, providing the benefits of competition and variety to customers. This same argument applies to trade between U.S. states, where people often buy products made by people of other states, even though a similar product is made within the boundaries of their own state. All states—and all countries—can benefit from this kind of competition and trade. 6. 554 Answer Key a. Start by plotting the points on a sketch diagram and then drawing a line through them. The following figure illustrates the average costs of production of semiconductors. The curve illustrates economies of scale by showing that as the scale increases—that is, as production at this particular factory goes up—the average cost of production declines. The economies of scale exist up to an output of 40,000 semiconductors; at higher outputs, the average cost of production does not seem to decline any further. b. At any quantity demanded above 40,000, this economy can take full advantage of economies of scale; that is, it can produce at the lowest cost per unit. Indeed, if the quantity demanded was quite high, like 500,000, then there could be a number of different factories all taking full advantage of economies of scale and competing with each other. If the quantity demanded falls below 40,000, then the economy by itself, without foreign trade, cannot take full advantage of economies of scale. c. The simplest answer to this question is that the small country could have a large enough factory to take full advantage of economies of scale, but then export most of the output. For semiconductors, countries like Taiwan and Korea have recently fit this description. Moreover, this country could also import semiconductors from other countries which also have large factories, thus getting the benefits of competition and variety. A slightly more complex answer
is that the country can get these benefits of economies of scale without producing semiconductors, but simply by buying semiconductors made at low cost around the world. An economy, especially a smaller country, may well end up specializing and producing a few items on a large scale, but then trading those items for other items produced on a large scale, and thus gaining the benefits of economies of scale by trade, as well as by direct production. 7. A nation might restrict trade on imported products to protect an industry that is important for national security. For example, nation X and nation Y may be geopolitical rivals, each with ambitions of increased political and economic strength. Even if nation Y has comparative advantage in the production of missile defense systems, it is unlikely that nation Y would seek to export those goods to nation X. It is also the case that, for some nations, the production of a particular good is a key component of national identity. In Japan, the production of rice is culturally very important. It may be difficult for Japan to import rice from a nation like Vietnam, even if Vietnam has a comparative advantage in rice production. Chapter 20 1. This is the opposite case of the Work It Out feature. A reduced tariff is like a decrease in the cost of production, which is shown by a downward (or rightward) shift in the supply curve. 2. A subsidy is like a reduction in cost. This shifts the supply curve down (or to the right), driving the price of sugar down. If the subsidy is large enough, the price of sugar can fall below the cost of production faced by foreign This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Answer Key 555 producers, which means they will lose money on any sugar they produce and sell. 3. Trade barriers raise the price of goods in protected industries. If those products are inputs in other industries, it raises their production costs and then prices, so sales fall in those other industries. Lower sales lead to lower employment. Additionally, if the protected industries are consumer goods, their customers pay higher prices, which reduce demand for other consumer products and thus employment in those industries. 4. Trade based on comparative advantage raises the average wage rate economy-wide, though it can reduce the incomes of import-substituting industries. By moving away from a country’s comparative advantage, trade barriers do the opposite: they give workers in protected industries an advantage, while reducing the average wage economywide.
5. By raising incomes, trade tends to raise working conditions also, even though those conditions may not (yet) be equivalent to those in high-income countries. 6. They typically pay more than the next-best alternative. If a Nike firm did not pay workers at least as much as they would earn, for example, in a subsistence rural lifestyle, they many never come to work for Nike. 7. Since trade barriers raise prices, real incomes fall. The average worker would also earn less. 8. Workers working in other sectors and the protected sector see a decrease in their real wage. 9. If imports can be sold at extremely low prices, domestic firms would have to match those prices to be competitive. By definition, matching prices would imply selling under cost and, therefore, losing money. Firms cannot sustain losses forever. When they leave the industry, importers can “take over,” raising prices to monopoly levels to cover their short-term losses and earn long-term profits. 10. Because low-income countries need to provide necessities—food, clothing, and shelter—to their people. In other words, they consider environmental quality a luxury. 11. Low-income countries can compete for jobs by reducing their environmental standards to attract business to their countries. This could lead to a competitive reduction in regulations, which would lead to greater environmental damage. While pollution management is a cost for businesses, it is tiny relative to other costs, like labor and adequate infrastructure. It is also costly for firms to locate far away from their customers, which many low-income countries are. 12. The decision should not be arbitrary or unnecessarily discriminatory. It should treat foreign companies the same way as domestic companies. It should be based on science. 13. Restricting imports today does not solve the problem. If anything, it makes it worse since it implies using up domestic sources of the products faster than if they are imported. Also, the national security argument can be used to support protection of nearly any product, not just things critical to our national security. 14. The effect of increasing standards may increase costs to the small exporting country. The supply curve of toys will shift to the left. Exports will decrease and toy prices will rise. Tariffs also raise prices. So the effect on the price of toys is the same. A tariff is a “second best” policy and also affects other sectors. However, a common standard across countries is a “first best” policy that attacks the problem at its root.
15. A free trade association offers free trade between its members, but each country can determine its own trade policy outside the association. A common market requires a common external trade policy in addition to free trade within the group. An economic union is a common market with coordinated fiscal and monetary policy. 16. International agreements can serve as a political counterweight to domestic special interests, thereby preventing stronger protectionist measures. 17. Reductions in tariffs, quotas, and other trade barriers, improved transportation, and communication media have made people more aware of what is available in the rest of the world. 556 Answer Key 18. Competition from firms with better or cheaper products can reduce a business’s profits, and may drive it out of business. Workers would similarly lose income or even their jobs. 19. Consumers get better or less expensive products. Businesses with the better or cheaper products increase their profits. Employees of those businesses earn more income. On balance, the gains outweigh the losses to a nation. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 References 557 REFERENCES Welcome to Economics! Bureau of Labor Statistics, U.S. Department of Labor. 2015. "The Employment Situation—February 2015." Accessed March 27, 2015. http://www.bls.gov/news.release/pdf/empsit.pdf. Williamson, Lisa. “US Labor Market in 2012.” Bureau of Labor Statistics. Accessed December 1, 2013. http://www.bls.gov/opub/mlr/2013/03/art1full.pdf. The Heritage Foundation. 2015. "2015 Index of Economic Freedom." Accessed March 11, 2015. http://www.heritage.org/index/ranking. Garling, Caleb. “S.F. plane crash: Reporting, emotions on social media,” The San Francisco Chronicle. July 7, 2013. http://www.sfgate.com/news/article/S-F-plane-crash-Reporting-emotions-on-social-4651639.php. Irvine, Jessica. “Social Networking Sites are Factories of Modern Ideas.” The Sydney Morning Herald. November 25, 2011.http://www.smh.com.au/federal-politics/society-and-culture/social-networking-sites-are-factories-ofmodern-ideas-201

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